The high cost of savings
By Marjorie Censer,
T hree years ago, the Pentagon began cancel- ing the Army’s ambitious modernization program, which would have cost billions and created a sophisticated network of vehicles, drones and radios. ¶ This kind of cut might appeal to politicians calling for significant decreases in government spending. ¶ But turns out, it’s not that simple. Even years later, the Defense Department and the Army are still negotiating with the contractor and estimate they’ll pay a fee of almost $500 million — on top of the roughly $19 billion an Army study estimated the service already paid for the complex program that never came to fruition. ¶
With the Pentagon looking to trim its budget and politicians finding traction in urging government cuts, these cancellations could become all the more common and the government could face even more drawn out and expensive negotiations.
“With all of the budget pressures that agencies are going to be faced with ... we are going to be seeing a lot more terminations, restructures and changes to contracts,” said Elizabeth A. Ferrell, chairwoman of McKenna Long & Aldridge’s terminations and contract restructures group, which was only established last year. Companies “believe that their programs are at risk.”
Contract termination is a complex legal process, but essentially the trouble starts when the government needs to terminate for convenience, rather than for cause.
If a termination is for cause or default — meaning something has gone wrong with the program — the government is off the hook. But if it’s for convenience — which is typically what happens — the government must pay the contractor the costs it will incur to shut down the contract.
Analysts and attorneys say the government is often in a position of weakness in these negotiations as contractors with expensive attorneys fight for large fees.
The Army confirmed this month that it expects to pay nearly $500 million — still $200 million shy of the level it anticipated — to close out with prime contractor Boeing the sprawling Future Combat Systems program, which began to shut down in 2009 when then-Defense Secretary Robert Gates cut its manned ground vehicle component.
The high-priority program was made up of multiple parts, including a family of vehicles, unmanned air and ground systems and high-tech radios, all connected by a network. While some pieces have been salvaged, the program as it was imagined was never built.
The vehicle cancellation fee alone is expected to hit about $164 million, according to the service.
In a statement, the Army said termination negotiations — being handled by the Defense Contract Management Agency — are still ongoing because the contractor has a year to present termination fee proposals. Most of those negotiations are expected to end in December; some are slated to continue until July 2013.
New contract language needed?
“I think contract termination costs are going to become an increasing consideration,” said Todd Harrison, a senior fellow at the Center for Strategic and Budgetary Assessments. The government has “got to do a better job, I think, from now on in writing contracts, thinking through what would happen if this contract were terminated at any given point.”
In the case of the Army’s FCS program, the contract’s payment structure was split between a fixed fee earned annually and an incentive fee paid out incrementally based on achieving key goals. Boeing was able to earn part of those fees even before the goal event, said Paul Francis of the Government Accountability Office.
“The contractor could earn 80 percent of its fee by the time it got to critical design review, and really it’s not until that point that you have information about whether this is a going concern or not,” he said.
Gates cited its contract structure as one of the program’s many flaws when he began the process of unraveling it, first by canceling the vehicle piece. Eventually, the Army found itself negotiating to terminate most pieces of the complex program.
“Boeing continues to cooperate with the Army on termination negotiations,” the company said in a statement. “Since discussions are ongoing, we’d prefer not to speculate on the conclusion.”
Cheaper to just continue
Under government regulations, once a program is terminated, the contractor must stop work and terminate its subcontracts with other companies, according to a GAO report on terminations. It creates a termination inventory of the materials it has made or bought and submits a settlement proposal for what it believes the government owes.
These proposals typically have three parts: costs the company has incurred for the work it’s done, which can include direct costs such as materials and indirect such as overhead; a fee or profit on that work; and termination costs, which are generally related to putting together the settlement proposal, negotiating with subcontractors and dealing with the unneeded inventory.
In some cases, the Army has said letting a program go forward — even if unwanted — would be preferable to paying high termination fees.
At a 2011 hearing, Army Secretary John McHugh told Congress that the service planned to move forward with what’s known as a “proof of concept” for the Medium Extended Air Defense System, a missile program developed in cooperation with Italy and Germany.
Even though the proof of concept was set to cost hundreds of millions, McHugh said it made more sense than the alternative.
“If we withdrew this year, there are substantial withdrawal fees that the United States would have to bear and pay into the program that would not make it a wise decision,” McHugh said.
Harrison argues there can be other considerations as well.
“If you cancel a program for a major platform that you’re going to need eventually, then you have to restart a new program and redo a lot of the development program,” he said. “You end up doing a lot of the same work again, so you don’t actually save any money in the long run.”