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October 22, 2019

Federal Circuit Issues Controversial Decision Involving Expressly Unallowable Costs


In its second significant cost allowability decision of the year, the Federal Circuit held that salaries associated with lobbying activities are expressly unallowable under Federal Acquisition Regulation (FAR) 31.205-22.1 Although the decision is limited to salary costs associated with lobbying activities, its rationale creates uncertainty for other types of costs subject to a FAR Part 31 Cost Principle that uses similar "associated with" language. Contractors should anticipate closer scrutiny from auditors, who may feel emboldened by the Federal Circuit's decision to characterize costs as expressly unallowable. The decision may also have implications for compliance with Cost Accounting Standard 405.

Although many types of cost may be generally unallowable, a smaller subset of costs are expressly unallowable. An expressly unallowable costs is "a particular item or type of cost which, under the express provisions of an applicable law, regulation, or contract, is specifically named and stated to be unallowable."2 Contractors are subject to penalty if they submit to the government any expressly unallowable cost.3 Congress made clear that the penalty was intended for limited circumstances where the regulations explicitly prohibit inclusion of a type of cost; providing alcohol as an example.

FAR 31.205-22(a) provides that costs "associated with" a list of lobbying and political activities are unallowable.4 FAR 31.205-22 does not specifically name and state salary, or any other type of cost; it merely states "associated with." The narrow question presented to the Federal Circuit was whether salary costs of employees engaging in such lobbying activity qualify as expressly unallowable costs.

Even though FAR 31.205-22 does not expressly name and state salary or compensation as unallowable, the Federal Circuit nevertheless held that such salary costs are expressly unallowable:

The definition in FAR § 31.001 of an "expressly unallowable cost" refers to "a particular item or type of cost." These two categories of costs confirm that an "expressly unallowable" cost includes more than an explicitly stated "item." Costs unambiguously falling within a generic definition of a "type" of unallowable cost are also "expressly unallowable." Here, salaries of in-house lobbyists are a prototypical lobbying expense. Subsection 22 disallows "costs associated with" activities such as "attempt[ing] to influence . . . legislation . . . through communication with any member or employee of the . . . legislature" or "attend[ing] . . . legislative sessions or committee hearings." Salaries of corporate personnel involved in lobbying are unambiguously "costs associated with" lobbying.5

The Federal Circuit's reasoning raises at least four implications moving forward.

First, whereas the FAR defines expressly unallowable costs as those "specifically named and stated to be unallowable," the Federal Circuit seems to have adopted a broader test that encompasses "[c]osts unambiguously falling within a generic definition of a 'type'" deemed unallowable. Now, instead of asking only which types of costs are specifically named and stated as unallowable, contractors must apparently also consider what types of cost unambiguously fall within generic definitions of types of unallowable costs. The Federal Circuit's attempt to distinguish an item from a type of cost appears specious. And, the Federal Circuit seems to have muddied the differing concepts of unallowable costs, directly associated costs, and expressly unallowable costs.

Moreover, the Federal Circuit's approach strikes as a contradiction of the plain language of the definition of an expressly unallowable cost, and is inconsistent with Congressional intent. The reason that Congress included the "specifically named and stated language" was to avoid penalizing contractors where the regulations lack specificity. The onus is on the government to draft cost principles that are precise.

Relevant here, the Federal Circuit's decision clarified in dicta that its holding effectively overturns, in part, the ASBCA's 2015 decision that bonus and incentive compensation (BAIC) are not "expressly unallowable" under FAR 31.205-22. The ASBCA had concluded such costs did not meet the definition of expressly unallowable because "neither 'BAIC' cost nor 'compensation' cost is specifically named and stated as unallowable under this cost principle, nor are such costs identified as unallowable in any direct or unmistakable terms."6 Without considering the underlying rationale, the Federal Circuit was not persuaded: "That decision is not binding on this court, and in any event, is contrary to the plain language of Subsection 22 to the extent that it concludes that salaries in the form of bonus and incentive compensation for lobbying and political activities are not 'expressly unallowable.'"7

Second, the Federal Circuit's reasoning could impact other cost principles that speak in terms of costs "associated with" a particular activity. FAR 31.205-1, for example, speaks to the allowability of public relations activities "associated with areas such as advertising, customer relations, etc." FAR 31.205-27 governs "expenditures in connection with" business organization costs. Although the Federal Circuit's decision is tied to the language of FAR 31.205-22, the Defense Contract Audit Agency (DCAA) is guaranteed to rely on this case with abandon to assert that a host of costs are expressly unallowable.

Third, despite the concern of DCAA overreach, the Federal Circuit's conclusion seems inherently tied to its understanding of the relationship between lobbying and lobbyists: "salaries of in-house lobbyists are a prototypical lobbying expense." Inherent in the decision is the Federal Circuit's inability to identify any other types of costs associated with lobbying. Thus, in the eyes of the Federal Circuit, salary would qualify as expressly unallowable under the "prototypical lobbying expense" standard. Furthermore, the Federal Circuit examined the history of the cost principle, which, under DAR 15.205.51 specifically disallowed the "applicable portion of the salaries of the contractor's employees . . . engaged in lobbying."8 Thus, to the extent there is a silver lining to this case, it is that it may be limited to salaries, and is dependent on the unique history of the prohibition. It still leaves open the question of what other types of cost are so "unambiguously falling" within an "associated with" type of cost.

Finally, this case implicates CAS 405. That standard directs the segregation of expressly unallowable costs from billings, claims, and proposals. The uncertainty that the Federal Circuit has created regarding the definition of an expressly unallowable cost—which is identical in CAS 405—could lead to an implosion of alleged noncompliances with CAS 405, itself subject to compound daily interest.9

Contractors should consider reviewing their accounting systems and implementing a more risk averse posture with respect to allocation of any types of costs that could be characterized as "unambiguously falling" within a type of cost identified as unallowable, or as a "prototypical expense" of an expressly unallowable costs.

© Arnold & Porter Kaye Scholer LLP 2019 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.

  1. Raytheon Co. v. Secretary of Defense, No. 2018-2371, 2019 WL 5280873 (Oct. 18, 2019).

  2. FAR 31.0001 (emphasis added); see also CAS 405-30(a)(2).

  3. FAR 42.709-1(a)(1).

  4. FAR 31.205-22(a).

  5. Raytheon, No. 2018-2371 at *6-7 (alteration in original, internal citation omitted).

  6. Raytheon Co., ASBCA No. 57576, 15-1 BCA ¶ 36043.

  7. Raytheon, No. 2018-2371 at *4.

  8. Raytheon, No. 2018-2371 at *7.

  9. Gates v. Raytheon co., 548 F.3d 1062, 1070 (Fed. Cir. 2009).