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Sequestration is the automatic reduction of federal spending triggered when Congress approved spending levels that exceed certain “caps” set forth in the Budget Control Act of 2011.  Sequestration was established to be so painful as to provide a strong incentive for Congress to pass more sensible and targeted deficit reduction legislation.  However, the gridlock in Washington prevailed and sequestration is scheduled to commence on March 1, 2013.

The scope of sequestration.  Sequestration is $1.2 trillion in automatic spending cuts required to start in FY 2013 and continue through FY 2022.  The FY 2013 spending cuts starting on March 1st will be comprised of $54.7 billion from the Department of Defense, and $54.7 billion in non-defense programs.  Since sequestration cuts are commencing halfway through FY 2013, these budget cuts must be achieved rapidly over the remaining seven months of FY 2013.  The percentage reduction of federal budgets is approximately 9 percent for nondefense programs and 13 percent for defense programs.  Certain domestic entitlement programs are exempt from sequestration.  Exemptions include Social Security, federal retirement programs, Medicaid, and the Government Accountability Office recently extended an exemption to cover the U.S. Department of Veterans Affairs.

The effects on government contracting.  The Office of Management and Budget will immediately reduce the flow of appropriated funds to the government agencies not subject to an exemption.  Agencies will be required to reprioritize spending and acquisition activities.  There are both near term and long term consequences for government contractors.

New contracts.  Sequestration will have an immediate impact on the number of new contracts awarded, as agencies eliminate programs that are not critical to their missions.  It is expected that when agencies do award contracts, the contracts will be of a type that reduces the cost risk on the government and its budget.  For instance, agencies will be less likely to use cost-reimbursement and labor-hour contracts, instead favoring firm-fixed-price contracts that provide the government with a greater degree of flexibility.

Existing contracts.  Wherever possible, agencies will take advantage of opportunities to “de-scope” existing contracts.  Secretary Panetta explicitly warned last year that the largest existing contracts would not be spared, including the Joint Strike Fighter, littoral combat ship, and ground vehicle modernization programs.  Deductive change orders should be expected and many contracts will be terminated for convenience.  Terminations for convenience are governed by the Federal Acquisition Regulation (FAR) provision which limit the contractor’s cost recovery. These actions by agencies must be done in compliance with the contract and applicable regulations.  Improper terminations or de-scoping of contracts could result in significant recoveries for terminated contractors.

Claims litigation.  The status quo is that many contractors do not aggressively pursue claims in order to avoid confrontation with their contracting officers.  However, that course of action during steep budget cuts could undermine the contractor’s position.  As the contractor incurs cost overruns from government delay and de-scoping, such overruns could form the basis for adverse contract action by the government.  By aggressively pursuing equitable adjustments or contract claims when the government bears responsibility for some or all of the perceived cost growth, the government might reconsider before terminating that program.

Performance assessments.  Similarly, contractors should aggressively review and seek to correct performance assessments that unduly place blame for contractual issues on the contractor.  Contractors should understand the circumstances under which they may challenge performance assessments under the Contract Disputes Act.

Program metrics.  An often-overlooked tool in federal contracting is the program metric.  Program metrics serve as an early warning system for troubled contracts.  It is foreseeable that troubled contracts with failing metrics would be targets for budget cutting or cancellation.  Program metrics are a double-edged sword, not only will metrics identify for the government which contracts may soon become problems, but contractors can use program metrics to tie government actions to reduced performance or escalating cost.  As variances in program metrics are identified the contractor should investigate and determine whether the variance is the result of government interference.

Cost restructure.  It is likely agencies will seek to restructure contracts.  This is another incentive for contractors to aggressively pursue all claims. An agency will likely offer to resolve existing claims if the agency is seeking to restructure the contract through agreement with the contractor.

Bid protests.  As contractors compete for a limited number of contracts, especially in the first year of sequestration, we will likely see an increase in bid protest litigation.  The stakes will be higher for contractors small and large alike.

Anticipate WARN Act obligations.  In short, the WARN Act (Worker Adjustment and Retraining Notification Act) requires employers with 100 or more employees to issue 60 days advance written notice to affected employees of a plant closing or a mass layoff.  The WARN Act imposes significant liability for the failure to provide the notice. State WARN Acts can be more onerous than federal law.  The decision when to issue a WARN Act notice is a legal decision and a business decision.  The issuance of a WARN Act notice could affect employee morale, or even cause a mass exodus of employees which could inhibit operations.  The uncertainty regarding the duration of sequestration and how agencies will implement its cuts further exacerbates this issue for contractors under the WARN Act.

Despite all of the uncertainty, we know that sequestration will modify how the government chooses to spend its limited resources.  Contractors will be in a better position to weather sequestration if they anticipate these changes and take prudent steps to identify and preserve their rights and remedies.