Defense revises rule on contractor business systems

New proposal lowers the amount the government can withhold from contractors that don’t do enough to protect against waste, fraud and abuse.

The Defense Department has revised a controversial rule issued early this year on withholding payments from contractors that fail to maintain adequate controls against waste, fraud and abuse.

On Friday, the department published in the Federal Register an amended change to the Defense Acquisition Regulations System that clarifies how federal officials will determine when contractor business systems are deficient.

The rule -- the Pentagon's second crack at developing industry standards for business systems -- also lowers the amount of money contracting officials can withhold when documented problems are not corrected.

"Contractor business systems and internal controls are the first line of defense against waste, fraud and abuse," the modified rule stated. "Weak control systems increase the risk of unallowable and unreasonable costs on government contracts."

Defense published its draft rule on Jan. 15. During the following two months, the department received 370 comments from 25 respondents. Most of the feedback came from industry officials, who criticized the plan as short-sighted, ill-defined and unnecessarily burdensome.

"Despite a laudable goal of seeking to establish uniform criteria for what constitutes an acceptable business system, the rule falls short of that goal," wrote the Professional Services Council, a trade association. "It creates more complicated procedures than are necessary to incentivize contractors to ensure that key business systems are 'acceptable,' imposes significant burdens on small and midtier businesses doing business with DoD, and introduces mandatory withholds of contractor funds that could easily be disproportionate to the goals to be achieved or to the government's risk."

The Pentagon addressed many of industry's concerns in its revised proposal, offering more specific standards for contractors' business and accounting systems. Deficiencies in the systems must relate to potential risks to the government, according to Friday's rule. Critics had complained that in the original proposal, business systems could be judged deficient for reasons that would not put the government at risk of waste or abuse.

"The intent of the rule is to withhold payments when a deficiency exists that impairs the government's ability to rely on the system's outputs," the rule stated. "A system must provide reasonable assurance that the relevant system criteria are satisfied and that the risk of material misstatements caused by error or fraud is low."

Arguably more significant, the new rule reduces the amount that contracting officers can withhold from firms from 10 percent to 5 percent, or 2 percent for small businesses. If the contractor submits a corrective action plan within 45 days of a noted deficiency, the department will withhold only 2 percent, or 1 percent for small firms. This is down from the original proposal of 5 percent.

For companies with defects in multiple business systems, the cumulative percentage of payments that can be withheld is 20 percent, or 10 percent for small firms. The original proposal set the threshold at 50 percent. The new rule also eliminates a clause that would allow the government to withhold all payments for deficiencies deemed "highly likely to lead to improper contract payments being made," or problems representing "an unacceptable risk of loss to the government."

Officials did not attempt to calculate how many small business contractors are expected to be affected by the rule change. But based on several financial triggers and thresholds outlined in the notice, the proposal will generally affect midsize and large firms.

Alan Chvotkin, PSC's executive vice president and counsel, said he is more comfortable with the revised plan, but that it's too soon to give his approval. "Substantial improvements have been made," Chvotkin said. "But, it's going to take some time to evaluate."

The rule would provide contracting officers with the authority to withhold payments on cost reimbursement, incentive-type, time and materials, and labor-hour pacts. They also could do so on contracts that provide progress payments based on costs or on a percentage or stage of completion.

A clause would be added to contracts requiring firms to certify that they have no major defects in their systems for accounting; purchasing; estimating; and property, earned value and material management. Auditors from the Defense Contract Audit Agency and other functional specialists would be charged with documenting the business system deficiencies.

The contracting officer and the auditor must approve any corrections to business systems, according to the notice.

Comments on the proposed rule will be accepted until Jan. 3, 2011, and can be e-mailed to with DFARS Case 2009-D038 in the subject line. Comments also can be mailed to:

Defense Acquisition Regulations System
Attn: Mark Gomersall, OUSD (AT&L)DPAP/DARS
Room 3B855, 3060 Defense Pentagon
Washington, D.C. 20301-3060