On Friday, December 3, the Department of Defense amended a controversial proposed regulation that would allow the Department of Defense to withhold payments to contractors. The Department of Defense has amended it, reissued it, and is asking for further comments.

As background, in January 2010, the Defense Department proposed a rule that would allow contracting officers to withhold payments from companies that have certain “deficiencies” in their business systems (accounting, estimating, purchasing, earned value management, material management and property management). Under the proposed rule, the contracting officer was authorized to withhold payment due to contractors if it was determined that one or more deficiencies in a contractor’s business systems created a potential risk of harm to the government.

The Defense Department received numerous comments on the proposed rule, most criticizing the rule as being vague and unnecessarily burdensome. In response, the Defense Department has published the rule again as a proposed rule, with a request for comments. The new rule would provide contracting officers with authority to withhold payments on cost reimbursement, incentive-type, time and materials, and labor-hour contracts. They could also withhold payments on fixed price contracts that provide progress payments based on costs, or on a percentage or stage of completion.

The intent of the proposed rule is to protect the government by reducing contract payments during performance, in an amount sufficient to mitigate the government’s risk. The withheld amount would not be a “penalty,” but a good-faith estimate of the potential loss due to the risk presented by a “deficient” system, especially where the actual amount of potential damage to the Department of Defense would be difficult to estimate or quantify.

The new proposed rule provides the following items:

1. “Deficiency” is redefined as a failure to maintain one or more system criteria of an acceptable business system.
2. The Defense Contract Audit Agency (DCAA) now only reports deficiencies determined to be significant deficiencies or material weaknesses in accordance with generally accepted government auditing standards, and would make follow-up business systems audits a priority.
3. Contractors would be afforded an opportunity to respond in writing within 30 days to an initial determination of deficiencies in any of their business systems.
4. Contracting officers, in consultation with the DCAA auditor and/or a functional specialist, would determine the acceptability of the contractor’s business systems and would approve/disapprove the system.  
5. The final deficiency determination would be at the sole discretion of the contracting officer, not the DCAA and/or a functional specialist.
6. When the contracting officer determines the contractor has corrected all systems deficiencies, the contracting officer would discontinue the withholding of payments and would release any payments previously withheld.
7. The contracting officer, in consultation with the DCAA auditor and the functional specialist, may discontinue withholding payments prior to audit verification if the contractor submits evidence that the deficiencies have been corrected.
8. A reduced amount can be withheld from companies. The withheld percentage would be reduced from ten percent to five percent (two percent for small businesses) per payment, and from five percent to two percent (one percent for small businesses) per payment if the contractor submits a corrective action plan within 45 days of a contracting officer’s notice of intent to withhold payments.
9. The cumulative percentage of payments that a contracting officer can withhold from companies with defects in multiple business systems would be reduced. The cumulative percentage of payments that a contracting officer could withhold would be reduced from 50 percent to 20 percent (10 percent for small businesses). 
10. The revised rule would eliminate the potential to withhold 100 percent for deficiencies deemed highly likely to lead to improper contract payments being made, or which represent an unacceptable risk of loss to the government.

The new clause setting forth the requirements of this amended rule will be DFARS 252.242-xxxx. The clause will require contractors to certify that they have no major defects in their systems for accounting, purchasing, estimating, and property, earned value and material management.

Comments on the proposed rule will be accepted until January 3, 2011. They can be submitted by email to dfars@osd.mil with DFARS Case 2009-D038 in the subject line, or by mail to Defense Acquisition Regulations System, Attn: Mark Gomersall, OUSD (AT&L)DPAP/DARS, Room 3B855, 3060 Defense Pentagon, Washington, D.C. 20301-3060.