Understanding Termination for Convenience: FAR Guidance and Contractor Considerations

Gary Moorhead (00:09):
Welcome to another episode of Imperium's Risk Brief. I'm Gary Moorhead, managing director at Imperium Consulting Group, and today I'm joined with Jordan Rosenfeld, senior director at Imperium Consulting Group. In today's conversation, we will be discussing termination for convenience claims, what they are and some of the key items to consider when quantifying a termination for convenience settlement proposal. Jordan, let's start out by defining what a termination for convenience claim is.

Jordan Rosenfeld (00:40):
Thank you, Gary. A termination for convenience is a contractual right that's written in the contract that allows one party, which would usually be a government entity or basically the owner of the project, to terminate the contract at its discretion. That means it can terminate the contract without any cause just because it works to the benefit of the owner. An example I like to use when I talk to clients about this is, at the end of World War II, the U.S. government has all sorts of contracts to build liberty ships say, and all of a sudden World War II ends and they no longer need those ships, so they can cancel those contracts and it is not a breach of contract. It's allowed per the termination for every convenience clause in the contract. Then there's certain procedures that are followed to determine how much is owed to the person the entity has a contract with.

Gary Moorhead (01:37):
Jordan, you mentioned a termination is a contractual right, and I think what you mean is that most contracts include a provision addressing terminations for convenience. It's our experience that nearly all contracts, both prime contracts, subcontracts, sub-subcontracts, contain a termination for convenience provision. Typically the types of contracts that we see are federal contracts, state municipal contracts and then finally private contracts. What we have found is that there is a wide variation in the provisions, the contractual provisions, found in state and municipal contracts as well as in private contracts regarding the specifics about how you go about pricing termination for convenience claims. On the flip side, federal contracts incorporate the Federal Acquisition Regulation, or what is commonly referred to as the FAR, and the FAR is very specific and provides detailed instructions regarding the pricing and calculation of termination for convenience claims.

Jordan Rosenfeld (02:44):
We find that most terminations though, certainly not all, usually have to do with federal contracts and that's basically the nature of federal procurement. So I think the bulk of our conversation here will be talking about FAR, or Federal Acquisition Regulations, and the provisions that kind of deal with how the procedures and how a contractor gets compensated when there is a termination for convenience. The FAR refers to the contract's termination claim as a settlement proposal. It's not a claim, it's a settlement proposal and hopefully it's a negotiated process.

Gary Moorhead (03:20):
Absolutely. You are very correct regarding how specific the FAR is. The key FAR provisions that relate to termination for convenience claims are two, two parts. Part 49, which is entitled Termination of Contracts, and then Part 31, Contract Costs Principles and Procedures. Part 49 provides guidance on the termination itself. Lots of language about how the government goes about terminating and what the contractor's responsibilities are after being terminated. Part 31 provides cost and pricing guidance relating to all contract pricing regarding federal government contracts and termination for convenience. So let me give you some examples of pricing guidance found in Part 31. For example, there is guidance regarding owned equipment pricing and the use of equipment pricing guides to price owned equipment. That's pretty specific about how you go about pricing owned equipment. There's also guidance regarding owned equipment pricing between entities with common control. For example, if a contractor has a leasing company and they're renting equipment back and forth, there's specific guidance about how the contractor is to handle its cost regarding that situation. Then there's guidance regarding allowable overhead cost and it goes on and on and on. Some of the examples there are donations not being allowable, bad debts not being allowable and then advertising, finally, is my last example. Advertising not directly related to government contracts are also not allowable. So there's very specific guidance in the FAR about cost and pricing rules. So let's talk, Jordan, now about a few key termination for convenience provisions. Can you describe briefly the two methods available to price a termination for convenience?

Jordan Rosenfeld (05:16):
Yes. The FAR Part 49 provides two basic pricing methods for settlement proposal that'll be submitted in a termination for convenience. The first, in what's noted in the FAR as the preferred method, is the inventory basis, and that's a settlement proposal where the contractor would be entitled to the cost incurred on the terminated portion of the work. For work that was completed before the termination, they would just get paid based on their normal contract pricing. The example here would be, say a manufacturing company, let's say Boeing is building jets for the Air Force. In the middle of doing that, the contract is terminated. For all the jets they had completed and delivered, they would just get paid their unit contract price. For those jets that were in progress, hadn't been completed so they hadn't been delivered, the contractor would be entitled to the cost of those, plus they would get a reasonable profit on that. The other method is the total cost basis. Basically with that, the contractor just gets paid all its cost from the beginning of the project through the date of termination. Then they'd also get reasonable profit on top of that. Under construction contracts, the FAR says that the total cost method is the preferred method. That's how most of the settlement proposals that we have worked on get prepared. The FAR also states that the federal cost accounting standards, laid out in Part 31 that you just talked about, are what applies in determining what costs the contractors entitled to in its settlement proposal.

Gary Moorhead (06:53):
Yeah, just to expand a bit on that, from what I've already talked about regarding Part 31 in the FAR. FAR Part 31 provides the rules and standards for determining basically three things. One, what costs are allowable? In other words, what can be charged to the government and what can't be charged to the government. Secondly, how costs must be allocated to contracts. There's all kinds of different cost pools, indirect cost pools, overhead that contractors are allowed to allocate to contracts. Then finally, how costs must be accounted for in federal contracts. So Jordan, Part 31 primarily deals with the cost, but for a termination for convenience, Part 49 specifically addresses how profit is determined. A contractor is allowed profit on their settlement proposal. Can you talk a little bit about how profit is determined in a termination for convenience?

Jordan Rosenfeld (07:50):
So I mentioned that in both the inventory method and the total cost method, it allows that the contract will get profit on its costs, but it's pretty vague as to how that is determined. What the FAR says is that the termination contracting officer, he would be the representative for the government, can determine a "reasonable" profit. That's reasonable in quotes. That's the actual wording. Then it provides eight criteria to be considered in determining that profit. Those criteria include, say the bid profit that the contractor had when he entered into the contract or the actual profit it anticipated it would've earned if it had completed the contract and other things such as the difficulty of the work that it performed. So it's a very gray area and one that's subject to a lot of negotiation in the end. We typically, if you can, like to use, here's what the contractor would've made and that's the percentage profit he would've made and that's what he should get. With all that said, the contract does have some limits. One, the amount that the contractor gets paid is not to exceed the amount of the original contract. Two, if the contractor was going to lose money, then there's an adjustment for lawsuits called that the contractor is going to lose money in this settlement proposal in proportion to the percentage it was complete on the project. Finally, the contractor is not entitled to anticipatory profit and that would be a profit on the work that was terminated and did not perform, unlike in a breach of contract situation where a contractor could sue for the anticipatory profit. So again, it's a very loose definition in the FAR, and it's an area that's subject to a lot of negotiation.

Gary Moorhead (09:40):
Jordan, you mentioned that part 49 does limit the settlement proposal to the total approved contract value. This is a pretty important point for a contractor to recognize. Let me say that again. The settlement proposal is limited to the total approved contract value, not the amount earned, but the total approved contract value. So if the contractor's total actual cost plus overhead plus profit is in excess of the approved contract value, the contractor's settlement proposal is limited to that approved contract value. So what's a contractor to do if their costs, their settlement proposal is in excess of the contract value? Well many times, when a contractor's in that situation, they typically have unapproved change orders or claims associated with the work. Many times that's partly the reason for a termination, sometimes not always, of course. So in those situations, the terminated contractor will have to submit and prove entitlement to unapproved change orders and claims in order to increase the contract value by way therefore to recover all of its costs associated with the settlement proposal.

Jordan Rosenfeld (11:00):
I just want to interject that one of the underlying principles in a termination for convenience is ones that the settlement should compensate the contractor fairly for the work it performed. The objective is to have a negotiated settlement. A settlement proposal is not a claim, it's not litigation. The intent is to reach an agreement that is fair to the contractor and negotiate that agreement. It also recognizes that the contractor wasn't anticipating that it was going to have to prove all its cost that it had incurred. That cost and accounting data provide guides but are not rigid measures for determining what the contractors owed. So even though Part 31 does apply, the contracting officer should give some leeway that estimates might have to be used for certain items and that sort of thing. It's different than a claim that's submitted through the litigation process.

Gary Moorhead (11:55):
Jordan, we've been talking about the FAR and that relates to federal and governmental contracts primarily. Every once in a while we will find a municipal or state contract that incorporates the FAR and these things that we've been talking about regarding the FAR would be applicable, but there are state and private contracts that provide for terminations for convenience. They have a contract provision regarding it. What we have found that there is a wide array of contract language regarding pricing of termination for convenience claims in these types of contracts, private contracts and some state and municipal contracts. Some of these provisions frankly just don't make a lot of sense when you try to apply the language to actually pricing the claim. The main point here is that these contracts are rarely as detailed as we find in the FAR. The guidance in the FAR is way more detailed than what we find in these types of contracts. For example, we've seen provisions that allow for a contractor to recover amounts equal to the work completed. That's actual language in the contract. Equal to the work completed. Well what does that mean? Does that mean costs? Does that mean actual costs? Does that mean some form of percent complete of the schedule of values? It's not really clear. The point here is that there is just not always clear guidance in private and some municipal state contracts.

Jordan Rosenfeld (13:26):
What we've done where there's ambiguity in a state specification say, or a contract, an AIA contract, is that the FAR still provides the guidance for how it should be priced out. Basically FAR is GAAP, or the Generally Accepted Accounting Principle, that we fall back on, except for any specific provision there might be in the state contract or a private contract. Again, we kind of still look to the FAR as giving some guidance as to how a settlement proposal should be prepared.

Gary Moorhead (13:59):
Well Jordan, we're out of time, and I want to thank you for joining me here. The conversation was insightful, but I really want to say is that we've just touched on some of the key provisions and items regarding terminations for convenience. There's a lot more, and I look forward to continuing the discussion with you in a future podcast.

Jordan Rosenfeld (14:21):
It's been my pleasure. Thanks for listening to Imperium's Risk Brief. To continue this conversation with me, Gary or any of our consultants at Imperium, please visit ImperiumCG.com. Thank you very much.