Analysis: What is a Termination for Convenience and What Costs are Allowable?
Background – What is Termination for Convenience?
A termination for convenience, commonly referred to as a T4C, is the government’s right to completely or partially terminate a contractor’s performance of work under a contract when it is in the government’s interest to do so. The government’s contractual right to terminate contracts for their convenience is not new and has existed since circa the Civil War. The general tenants of a T4C are i) the government possesses broad discretion, within the bounds of good faith, to terminate contracts for convenience, ii) the government’s termination action is not considered a breach of contract (if the government’s actions are not in bad faith), and iii) the contractor for which the contract was terminated is generally entitled recovery of limited costs. The contractual authority used to terminate a contract for convenience resides in Federal Acquisition Regulation (FAR) clauses 52.249-1 Termination for the Convenience of the Government (Fixed-Price) (Short Form), 52.249-2 Termination for the Convenience of the Government (Fixed-Price), 52.249-4 Termination for the Convenience of the Government (Services) (Short Form), FAR 52.249-6 Termination (Cost Reimbursement), and 52.212-4(l) Commercial Products and Commercial Services, Termination for the Government’s Convenience. Additionally, termination of government contracts is governed by Part 49 of the FAR.
Reasons, some common and some not, the government terminates contracts for convenience include:
- Changes in need after contract award, e.g., the war has ended, there no longer is a need for supplies
- Changes or advancements in technology or capability after contract award
- Difficulty or impossibility of performance due to contract requirements, e.g., flaws in contract scope of work regarding design or specification
- Lack of funding
- Bid protests
- Expiration of stop work period without government direction to resume work
- Domestic political environment and agendas
- International geo-political conflicts
The overarching objective of a termination for convenience settlement proposal is to ‘fairly’ compensate the contractor for the work performed and related activities arising from the termination.
“A settlement should compensate the contractor fairly for the work done and the preparations made for the terminated portions of the contract, including a reasonable allowance for profit. Fair compensation is a matter of judgment and cannot be measured exactly. In a given case, various methods may be equally appropriate for arriving at fair compensation. The use of business judgment, as distinguished from strict accounting principles, is the heart of a settlement.” [FAR 49.201(a)]
As a Government contract termination for convenience is not a recurring or routine transaction, contractors may incur costs during the settlement process that are of a nonrecurring or nonroutine nature. The applicable regulations recognize, and allow for reimbursement, certain types of costs unique to a government contract termination for convenience situation. A summary of the various types of costs and profit, as well as the underlying FAR Part 49 Termination of Contracts and FAR 31.205-42 Termination Costs requirements, that should be considered when developing a termination settlement proposal are as follows:
- Performance Costs
- Other Costs
- Settlements with Subcontractors
- G&A Expense
- Settlement Expenses
- Request for Equitable Adjustment
- Profit or Fee
2. Notification of Termination
When the government terminates a contract, it is required to do so by written notification. The written notification shall include i) the contractual authority to terminate the contract (see pertinent FAR clauses noted above), ii) the effective date of the termination (typically a T4C action is effective immediately), iii) the extent of the termination action (complete or partial), and iv) any special instructions. Additionally, the written notification will generally include specific contractor directions (see below, FAR 49.104), leading up to submission of a termination settlement proposal:
- Stop work immediately on the terminated portion of the contractand stop placing subcontracts thereunder;
- Terminate all subcontracts related to the terminated portion of the prime contract;
- Immediately advise the TCO of any special circumstances precluding the stoppage of work;
- Perform the continued portion of the contractand submit promptly any request for an equitable adjustment of price for the continued portion, supported by evidence of any increase in the cost, if the termination is partial;
- Take necessary or directed action to protect and preserve property in the contractor’s possession in which the Government has or mayacquire an interest and, as directed by the TCO, deliver the property to the Government;
- Promptly notify the TCO in writingof any legal proceedings growing out of any subcontract or other commitment related to the terminated portion of the contract;
- Settle outstanding liabilities and proposals arising out of termination of subcontracts, obtaining any approvals or ratifications required by the TCO;
- Promptly submit the contractor’s own settlement proposal, supported by appropriate schedules; and
- Dispose of termination inventory, as directed or authorized by the TCO.
3. Complete vs. Partial Termination
A T4C action may be on a complete or partial basis – simply meaning the contract is terminated in its entirety or portions of the contract will remain, and the contractor is obligated to perform, after receipt of the written notification.
Complete Termination – a complete T4C action terminates the entire scope of work under the contract and the contractor is not obligated to perform further, absent any specific instructions provided in the written notification.
Partial Termination – a partial T4C action may be defined differently, however, generally means a reduction in scope. For example, an initial contract requiring delivery of 100 widgets may be reduced through a partial T4C to a quantity of 75. Upon receipt of the written notification, the contractor remains obligated to deliver 75 widgets. Additionally, an initial contract containing a scope of work with five contract line item numbers (CLINs) may be reduced through a T4C to three CLINs. Similar to the above example, the contractor is no longer obligated to perform the two terminated CLINs.
If ongoing costs related to completion of the unterminated portion of the contract are anticipated to increase because of the termination, contractors may seek reimbursement of these increased costs through a request for equitable adjustment.
4. Settlements with Subcontractors
Prime contractors are responsible for dealing with subcontractors regarding the review of and tentative settlement and submission to the government for ratification, proposals received related to the terminated portion of the prime contract. As there is no privity of contract between the government and a subcontractor, the prime contractor will generally be liable to the subcontractor for settlement of the terminated contract. The prime contractor will then be reimbursed by the government for the subcontractor’s government-ratified settlement proposal.
5. Bases for Settlement Proposals
A termination settlement proposal may take two basic forms – Inventory Basis or Total Cost Basis. Both methods are used as a presentation format for which contractors summarize and request reimbursement for various unpaid performance costs incurred prior to the termination or costs incurred after the termination and arising specifically because of the termination.
Inventory Basis – the Inventory Basis is used when termination inventory is involved and the subject of a contractor’s request for reimbursement. The termination inventory is categorized by various type, e.g., raw material, purchased parts, WIP, etc., is inventoried by the contractor and presented to the government for ultimate disposition. The contractor’s incurred performance costs (labor, material, indirect expenses, etc.) are incorporated in the value of the various inventory categories and included in the settlement proposal.
Total Cost Basis – the Total Cost Basis summarizes actual and unpaid costs by cost element, e.g., direct labor, material, indirect expenses, etc., and is frequently used when termination inventory does not exist, or the contractor’s accounting records do not readily capture cost at a unit level.
6. Termination Settlement Proposals
A termination settlement proposal is generally a structured process governed by regulatory procedure (see FAR Part 49) and requires use of various Standard Forms. Standard Forms (SF) generally required in a settlement proposal include the following:
- SF1428 – Inventory Disposal Schedule
- SF1435 – Settlement Proposal (Inventory Basis)
- SF1436 – Settlement Proposal (Total Cost Basis)
- Sf1437 – Settlement Proposal for Cost-Reimbursement Type Contracts
- SF1439 – Schedule of Accounting Information
- SF1440 – Application for Partial Payment
Also, and importantly, effective and successful termination settlement proposals require a thorough presentation, explanation and documentation of two critical elements – entitlement and quantum. These fundamental components clearly articulated and documented will form a legitimate foundation leading to the government’s consideration of the merits, amounts sought for recovery and succeeding negotiation. Alternatively, the government may dismiss early-on a settlement proposal simply due to lack of supporting documentation pertaining to either, or both, the entitlement and quantum aspects. A brief discussion of each is as follows:
Entitlement – explanation of the T4C chronology and related subsequent events for which additional financial liability or increased costs were incurred. A well constructed entitlement argument is a critical first step that will establish the merits and demonstrate required support for ultimate increased costs arising from the contract termination. Entitlement arguments should i) be written clearly and concisely in an active voice, ii) establish a clear nexus between the termination action and the corresponding harm caused, iii) be supported with pertinent explanations, iv) reference relevant dates or key events, and v) cite the authoritative basis (e.g., contract clause) permitting the request for relief.
Quantum – calculation of the cost impacts, damages or amounts being sought due to the T4C. After establishment of a solid entitlement argument, the second step is to calculate the corresponding cost impact. Quantum calculations should be i) logical with a clear ‘audit trail’ of the inputs and source data, ii) consistent with established or permitted cost accounting practices, and iii) compliant with applicable regulatory or contractual requirements.
7. Allowable Costs and Profit
Performance Costs – performance costs include direct labor, material, other direct costs (ODCs) and indirect expenses required to perform the scope of work under the contract. Unpaid contractor performance costs incurred prior to the effective date of the termination and related to the uncompleted items under the contract are reimbursable on an actual cost basis as an element of the termination settlement proposal. Completed and acceptable items on-hand at the point of termination are presented and reimbursable at contract price, rather than cost.
Costs incurred and associated with ‘common items’ – meaning items that are reasonably useable on the contractor’s other work – are not allowable unless the quantity of the common items is in excess of those anticipated for use in the contractor’s ordinary course of business and forecasted production needs or cannot be maintained by the contractor without sustaining a loss.
Performance costs are presented differently, depending on the selected basis of the settlement proposal, i.e., Inventory or Total Cost Basis; however, under either settlement method costs should be included on an actual basis. Indirect expenses (fringe benefits, overhead, material handling) may be applied on a negotiated final, provisional or other rate basis.
The government-issued notification of termination is required to include the effective date of the termination. The effective date is important as that is the date for which all work under the terminated portion of the contract (and corresponding performance costs) should cease. If work cannot be stopped immediately, continuing work and performance costs are generally allowable for a short and reasonable duration after the effective date. In this situation, contractors should document their proactive approach to timely stop work and mitigate costs incurred beyond the effective date of the termination.
Other Costs – Other costs may include both performance (see above) and termination-specific activities. Depending on the contractor’s established cost accounting practices, ODC-type performance activities meeting the definition of other costs may include, e.g., travel, temporary labor, insurances, etc., – basically, direct costs other than labor and material.
Termination-specific other costs typically represent nonrecurring items that arise specifically because of the termination and would not have occurred but for the termination. Costs incurred related to various nonrecurring items are allowable and specifically addressed at FAR 31.205-42, including, loss of useful value of equipment, rental costs under unexpired leases, and alterations of leased property. Other types of nonrecurring costs that may be allowable include mass severance, idle facilities and excessive storage of inventory or unusable equipment.
It cannot be overstated that contractors should develop and maintain sufficient documentation regarding the calculation of nonrecurring cost amounts, as well as mitigation efforts performed to avoid or reduce these costs.
Settlements with Subcontractors – Prime contractors are responsible for dealing with subcontractors regarding the review of and tentative settlement and submission to the government for ratification, proposals received related to the terminated portion of the prime contract. As there is no privity of contract between the government and a subcontractor, the prime contractor is required to settle with subcontractors in the same general conformity as the prime, and liable to the subcontractor for settlement of terminated contracts. The prime contractor will then be reimbursed by the government for the subcontractor’s government-ratified settlement proposal.
The government will not reimburse prime contractors for subcontractor settlement amounts that are in excess of what is allowable in accordance with applicable FAR Parts 31 and 49 requirements (see FAR 49.108-2). In other words, the government will not reimburse prime contractors for increased subcontractor costs resulting from the prime contractor’s failure to flow down to the subcontractor all applicable clauses or requirements related to the termination of contracts.
G&A Expense – G&A expense is allowable and should be applied in accordance with the contractor’s established cost accounting practice; i.e., total cost input, value-added or single element. Generally, G&A expense is applied to all applicable elements of cost contained in the termination settlement proposal, excluding settlement expenses.
Settlement Expenses – Settlement expenses are direct activities arising and required because of the termination for convenience action. These activities generally include accounting, legal and other costs related to the preparation and submission of the contractor’s settlement proposal, review and negotiation of subcontractor settlement requests and preservation and storage of termination inventory.
As a government contract termination for convenience is not a transaction that occurs in the normal course of business, contractors are permitted, on a limited basis, to deviate from their established cost accounting practices when calculating costs incurred for termination settlement proposal purposes. For example, if the contractor’s accounting department is involved in the preparation of a settlement proposal and, normally, records all their time as an element of overall G&A expense, it is permissible to deviate from this practice and charge their actual time incurred related to the settlement proposal directly to the terminated contract as allowable settlement expenses. Contractors should establish separate internal charge numbers to capture all termination settlement-type costs.
Request for Equitable Adjustment – A request for equitable adjustment (REA) may be required when the government partially terminates a contract. A contractor may request an REA in the price or prices of the continued (nonterminated) portion of a fixed-price contract if the costs to complete the continued portion will increase from their initial estimated or negotiated amount because of the partial termination. Examples of the types of performance costs that may increase due to a partial termination are unamortized start-up or nonrecurring activities, per unit material prices and loss of certain efficiencies due to reduced quantities.
Profit or Fee – Profit or fee is allowable and a negotiable item in the overall termination settlement process. Several factors, both objective and subjective, may be relevant and considered during the negotiation, including:
- the percent of completion at the point of termination
- the extent and level of difficulty and complexity of performed work
- the effectiveness and efficiency of subcontractor selection and administration (including termination settlement negotiation)
- cost mitigation initiatives
- the expected level of profit or fee earned had the contract not been terminated
Terminated fixed-price contracts are subject to a potential loss adjustment if the contract would have incurred a loss had it not been terminated. Contractors should perform an estimate-to-complete analysis upon contract termination to determine what the anticipated cost at completion would have been if the contract was not terminated. If, based on this analysis, a loss would have been anticipated, contractors may be required to decrement the performance costs portion of the overall settlement proposal based on the projected loss percentage. In cases of an expected loss position, profit is not allowed as an element of the final settlement amount, rather, decrement or reduction of actual performance costs may be required.
Also, anticipatory profits or consequential damages are not allowable in conjunction with a termination settlement.
Terminations for convenience, although considered a rather extraordinary or nonrecurring event, do frequently occur within the government contracting world. A termination settlement proposal provides a contractual mechanism for contractors to seek reimbursement of incurred and unpaid costs, as well as incremental costs arising specifically because of the termination action. The termination settlement process may be complex or simplified depending on a variety of factors.
The primary objective of the government contract termination for convenience settlement proposal is to fairly compensate the contractor for work performed and efforts made to settle the termination. Fair compensation may be a matter of judgment and the parties may ultimately agree to a bottom-line settlement amount without separate agreement on individual elements of the settlement proposal. Settlement proposals should be based, to the maximum extent possible, on the contractor’s formal financial and accounting books of record and other relevant supporting documentation. Matters for which strict accounting records do not exist and agreement of amounts may be based on judgment or reason should be supported with other contemporaneous or ancillary documentation, as available and applicable.
Clear communication with the government and documentation are key to supporting a settlement proposal and achieving a successful resolution.