Q&A on Terminations for Convenience (T for Cs)

by Terry S. Nuzzo, CPA

Can the government terminate my contract?

The government has the right to terminate your contract for either default or for convenience.  This newsletter article provides a basic understanding of terminating a contract for convenience.  A discussion of termination for default will be the subject of a future newsletter article.

The government’s right to terminate a contract for convenience is provided in a required contract clause that allows the government to terminate the performance of work under the contract in whole or in part.  This right to terminate the contract also extends to a prime contractor’s subcontracts; however, the termination for convenience clause must be included in the subcontracts.  If the prime contractor does not include the termination for convenience clause in the subcontract and subsequently terminates the subcontract, the prime contract will have breached its contract with the subcontractor.  Accordingly, it is the prime contractor's responsibility to ensure that the termination clauses are in all of its subcontracts or purchase orders.

What am I entitled to if my contract is terminated for convenience?

Under a termination for convenience a contractor is entitled to all the reasonable costs of terminating the work: such as, the cost of the terminated work itself, termination costs, settlement expenses, and a reasonable profit.  The total amount payable to a contractor for a fixed price termination settlement proposal is limited to the total contract price less payments that have been made or are to be made under the contract.  This limitation is considered prior to deducting disposal or other credits arising from the termination and does not include the costs of the termination settlement.  Note that the total amount payable may also be limited by the contract's loss ratio, which means that the amount of loss that would have been incurred on the contract if it had not been terminated will be reflected in the final settlement.  With respect to cost type contracts, these contracts are not subject to settlement limits or loss ratios.  However, cost type contracts can be constrained by the limitation of cost or limitation of funds clauses.

Settlement Methods

Prime contractor termination settlement proposals may be settled through negotiation or by unilateral determination.  There are two principle methods for quantifying and settling the termination settlement proposal by negotiation.  These methods are the inventory basis and the total cost basis. 

Under the inventory basis, only the uncompleted, undelivered goods/services are quantified using the termination cost principles and procedures.  The value of and completed and delivered goods/services are quantified at their contract unit price.

Under the total cost basis, the contract becomes in essence a cost reimbursement contract. Accordingly, under the total cost basis even completed and delivered goods/services are quantified in the termination settlement proposal using the FAR termination cost principles and procedures.  Note that the use of the total cost basis may be used if approved by the contracting officer. 

Unilateral determination is the final method for settling prime contractor termination proposals.  The Terminating Contracting Officer (TCO) may issue a unilateral determination when the contractor fails to submit its termination proposal within the prescribed time period or when the parties cannot mutually agree on the settlement amount.

Termination Costs

The nature and extent of termination costs are guided by the cost principle at FAR 31.205-42.  In the cost principle, eight types of costs are identified that may be included in the contractor's termination settlement proposal.

Common items The costs of items reasonably usable on the contractor's other work are not allowable costs of a termination.  Accordingly, in order for the costs of common items to be allowable costs of a termination they must be in excess of the reasonable quantitative requirements of other work.  Furthermore, in order for them to be usable on other work they must be suitable for use in the contractor's normal course of business. Therefore, even if they are items normally used in the contractor's industry they do not qualify as common items if they are not normally used in the contractor's normal course of business.

Cost continuing after termination Costs that cannot be discontinued immediately after the effective date of termination are generally allowable costs of a termination as long as they are not attributable to the negligent or willful failure of the contractor to stop work and discontinue those costs.  These costs can include idled facilities costs; the costs of deactivating, reassigning, returning or relocating employees; severance payments required by law, agreement or established company policy; the costs of early retirement; the costs of completing parts in order to avoid loss; costs incurred while the contractor determines how to terminate the contract; and plant reconversion costs if their exclusion would be inequitable.

Initial costs Initial costs include various types of non-recurring costs such as excessive spoilage, idle time, reduced productivity and increased training costs encountered in the early period of performance.  They also include various preparatory costs, such as plant rearrangement and alterations; management and plant organization; and manufacturing and production engineering.

Loss of useful value The costs associated with the loss of useful value for special tooling, special test equipment and special machinery are also allowable costs of the termination. The definitions provided in FAR 45.101 should be used in determining whether these items exist under the contract.  The treatment of these items as either a direct or indirect cost is not a determinant factor to their existence.

Rental costs under unexpired leases Rental costs under unexpired leases, less the residual value of such leases, are generally allowable when it can be shown that they have been reasonably necessary for the performance of the terminated contract provided that the amount of rental claimed does not exceed the reasonable use value of the property leased for the period of the contract and such further period as may be reasonable and that the contractor makes all reasonable efforts to terminate, assign, settle, or otherwise reduce the cost of such leases.

Alterations of leased property The cost of alterations and reasonable restorations required by the lease may be allowed when the alterations were necessary for the performance of the contract.

Settlement expenses Accounting, legal, clerical and similar expenses necessary for the preparation and presentation of the proposal to the contracting officer are allowable as are the costs of terminating and settling any subcontracts.  In addition, the costs of inventorying, storing, transporting, protecting and disposing of any termination inventory are also allowable.  The indirect costs associated with the salary and wages incurred as settlement expenses are also allowable.  Frequently, these indirect costs are limited to payroll taxes, fringe benefits, occupancy costs and the costs of immediate supervision.

Subcontractor claims The prime contractor and each subcontractor are responsible for prompt settlement of their respective subcontractors.  Contractors are required to settle with subcontractors in general conformity with the policies and principles relating to settlement of prime contracts.  Accordingly, subcontractor settlements are generally allowable provided that the settlement is not more favorable than what the subcontractor would have been able to obtain had it contracted directly with the government.  Note that the Government's TCO generally must approve or ratify any prime contractor settlements with its subcontractors.  The TCO, however, may, after written request from the prime contractor, give written authorization to the prime contractor to settle terminated subcontract proposals of $100,000 or less without approval or ratification.

Am I Entitled to Profit?

Contractors are entitled to a reasonable profit on its termination costs.   However, profits may not be given on the cost of terminated subcontracts or settlement expenses. 

Is There a Time Limit to Submit a Settlement Proposal?

Prime contractors should submit their termination settlement proposals within one year of the termination date.  Extensions in time to submit the termination settlement proposal may be requested by the contractor and granted by the terminating contracting officer.  Within the one year time period the prime contractor should have also received subcontractor termination settlement proposals.  Therefore, when including a termination clause in subcontracts and purchase orders, prime contractors should imposed a shorter period of time for receiving subcontractor termination settlement proposals than it has for submitting its own proposal.

Will the Settlement Proposal Be Audited?

The government has the authority to audit the prime contractor's termination settlement proposal under several contract clauses.  These clauses are primarily the Audit-Negotiation or Audit-Sealed Bidding clauses.  Note that the more complex and significant a contract termination (dollar amount), the greater the likelihood that the government will audit the termination settlement proposal. 

Summary

The primary objective for contract terminations is to compensate contractors fairly and negotiate a settlement by agreement.  However, a contract termination for convenience is no simple matter and contractors should expect to expend considerable effort and cost in settling their terminated contract.  Understanding the FAR cost principles, settlement proposal preparation process and the consequences of a contract termination can have a significant impact on maximizing the cost recovery.  Fortunately, contractors’ costs incurred to settle a terminated contract are recoverable.  

To help alleviate the financial burden associated with settling a terminated contract, the government allows the submission of interim settlement proposals and partial payment requests.  Government financing (partial payments) is available for as much as 90 percent of the allowable costs incurred prior to final settlement; however, a Contracting Officer may use his/her discretion in determining the amount of partial payments, that discretion must be reasonably exercised and directed at protecting the government's financial interest.

As stated previously, the termination settlement process can be very complex and a contractor’s understanding of not only the process, but also the FAR will have a significant impact on the overall settlement.  Also beware that if a contractor's settlement proposal exceeds applicable thresholds, the negotiation of final settlement price will be subject to the Truth-in-Negotiations Act (TINA).  Accordingly, contractors should ensure that they have a through understanding of the disclosure requirements of TINA.