DoD ISSUES QUESTIONABLE GUIDANCE ON INFLATION
Economic Price Adjustment Clause in New, Existing, and Option Contracts
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INTRODUCTION
In the midst of decades-high inflation, the Department of Defense (DOD) recently advised its industry partners on who they believe will be SHOULDERING THE BURDEN OF INCREASED COSTS IN EXISTING AND NEW CONTRACTS.
On May 25, 2022, the DOD finally issued its much-needed Guidance on Inflation and Economic Price Adjustment (copy attached) (“Guidance Memorandum”). The Memorandum comes as inflation is steadily rising, forcing contractors with fixed-price contracts to bear the risk and result of skyrocketing supply costs. Consequently, many contractors are finding their profit margins eroding and even falling into a loss position, without much sympathy or cooperation from Contracting Officers.
While the Memorandum reinforces bad news for contractors on existing fixed-price contracts, the Guidance Memorandum provides contractors with valuable insight on how Contracting Officers may address sharing or shifting the risk of inflation on new contracts. The Guidance Memorandum is currently silent on how Contracting Officers should treat contract options, although applicable FAR clauses offer a path forward on most contracts.
This blog post summarizes the impacts of the Guidance Memorandum for (1) new contracts, (2) existing contracts, and (3) the impact on option contracts.
NEW CONTRACTS
The Guidance Memorandum specifically encourages Contracting Officers to include Economic Price Adjustment (EPA) clauses in new contracts now being solicited.
In this way, the Guidance Memorandum does offer some hope to contractors currently negotiating contracts. It highlights that “DOD contractors and contracting officers alike have expressed renewed interest in using Economic Price Adjustment (EPA) clauses.” Additionally, it confirms that “an EPA clause may be an appropriate tool to equitably balance the risk of inflation between the Government and contractor.”
HOWEVER, this direction does not provide Contracting Officers with new authority, as FAR 16.203-2 already allows adding an Economic Price Adjustment clause when (i) there is serious doubt about the stability of market or labor conditions that will exist during an extended period of contract performance, and (ii) contingencies that would otherwise be included in the contract price can be identified and covered separately in the contract. Nonetheless, the newly issued Guidance Memorandum will likely make convincing Contracting Officers to use that authority a much easier proposition. The Guidance Memorandum also offers direction to Contracting Officers regarding how to appropriately craft an EPA clause, including direction to include an allowance for both upward and downward adjustments in price.
As such, contractors should evaluate new solicitations (for fixed-price contracts) to ensure they contain an EPA clause. If the solicitation does not, contractors must account for the possibility of an increase in inflation or other market forces driving supply prices higher and avoid contracts that would leave them overly exposed to such conditions.
Importantly, if a new solicitation contains an EPA clause, contractors should evaluate whether that clause is adequately flexible to account for unforeseen price increases during the life of the project. This should include, just as the DOD urged to its Contracting Officers, (1) considerations for selecting an index to measure inflation that is linked to cost components that are most unstable; (2) identifying limitations regarding the scope of the EPA clause to exclude costs that are unlikely to be affected by inflation; and (3) taking the time and internal effort to develop pre-established formulas for calculating the new pricing, instead of merely reopening price negotiations should the need arise.
EXISTING CONTRACTS
Conversely, the Guidance Memorandum encourages Contracting Officers to continue to effectively stonewall contractors with existing fixed-price contracts without an EPA clause. It reiterates the position used by many Contracting Officers that “[i]n the absence of an applicable contract clause, such as an EPA clause authorizing a contract price adjustment as a result of inflation, there is no authority for providing contractual relief for unanticipated inflation under an FFP contract.” In Excell’s experience, while this is technically accurate in a narrow sense, a detailed understanding and appropriate analysis of applicable Federal Acquisition Regulation (FAR) clauses often allows an access point to recovery of additional incurred costs in most scenarios.
Based on the present-day position being taken by the DoD, this newly issued Guidance Memorandum goes on to reiterate that, without an applicable contract clause or change, Contracting Officers may not (and arguably should not) agree to a contractor’s requests for equitable adjustment to account for inflation. Obviously, this published guidance now mandates that contractors look to other contractual means to recover their unpredictably high incurred costs.
Accordingly, it is Excell’s position that, based upon years of experience in this arena, contractors should base any requests for adjustments in (a) an Economic Price Adjustment clause, if available; (b) an alternative contract clause that authorizes price adjustments; or (c) by identifying established (written) government direction that can be utilized as a factual changed condition or a government-caused matter affecting time, money, or both.
IMPLICATIONS FOR CONTRACTS WITH OPTION YEARS
Notably, the current DOD guidance remains silent as to contracts containing options to extend the contract for additional periods of time (“option contracts”). Thus, under the precepts of the Guidance Memorandum the question is simple: Should Contracting Officers treat options for additional contract periods as part of the existing contract or as a new contract?
To be clear, while the answer ultimately depends on the language of each individual contract, contractors facing an exercise of option years with pricing based on a pre-inflation price analysis conducted in the evaluation of the original contract may find relief under FAR 17.207 “Exercise of Options”.
Specifically, that provision requires that, for the Government to validly exercise an option, “the option must have been evaluated as part of the initial competition and be exercisable at the amount specified in or reasonably determinable from the terms of the basic contract.” FAR 17.207(f).
In fact, based upon existing rulings, the Government’s evaluation of pricing in the original solicitation becomes no longer binding at the time the option is exercised, the Government may not rely upon the initial reasonableness determination to show the option is legally exercised. See Magnum Opus Techs., Inc. v. United States, 94 Fed. Cl. 512, 538 (2010). In Magnum, base rates and pricing in the awarded contract included escalation rates for each of 10 potential option years. However, after award, the base rates and pricing were changed by modification, which made the originally awarded pricing and escalation rates non-binding upon the option years.
Historically, FAR 17.207 has also been interpreted to mean that, once the government acknowledges that the market has changed since the initial price evaluation of the solicitation occurred, the government cannot rely upon its evaluation at the time of the initial award to establish the reasonableness of pricing in exercising its options. See Magnum Opus Techs., Inc. v. United States, 94 Fed. Cl. 512, 538 (2010). Accordingly, relying upon the price evaluation at the time of award despite changed market conditions violates FAR 17.207(d). See Magnum Opus at 539 (internal citations omitted). In essence, given the current market conditions, it is now evident that the DoD has acknowledged via its Memorandum that the market has materially changed.
Finally, if the Government’s exercise of an option on a multiyear contract is improper in any way, contractors may have a remedy for additional costs by treating the exercise as a Constructive Change under the Changes clause.
Thus, whether the rates established for option years have been rendered inapplicable by Changes or modifications to the contract, by changed market conditions, or the defective exercise of an option, contractors should carefully scrutinize every available recourse to ensure option pricing is modified to adequately protect the contractor’s profitability, as well as the profitability of its shareholders, while simultaneously treating the Government to the level of fairness it contracted for.
If you have any questions about this recent development, or would like to discuss your specific situation, Excell Consulting is ready and able to assist. And remember, initial consultation calls to Excell are always FREE! Call (719) 599-8336 today!
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Author’s note: The information contained in this article is for general informational purposes only. This information does not constitute legal advice, is not intended to constitute legal advice, nor should it be relied upon as legal advice for your specific factual pattern or situation. – John G. Balch, CEO, MA, CPCM