February 16, 2017

Retroactive Disallowance Depends on Affirmative Government Misconduct, ASBCA Holds

The Government Contractor, Vol. 59, No. 6

Reprinted from The Government Contractor, with permission of Thomson Reuters. Copyright © 2017. Further use without the permission of West is prohibited. For further information about this publication, please visit, or call 800.328.9352.

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The Armed Services Board of Contract Appeals rejected a contractor's assertion that the statute of limitations and the doctrines of retroactive disallowance and course of dealing barred a Government claim for disallowed costs. The ASBCA sustained the contractor's appeal, in part, on other grounds because consultant costs and legal costs should not have been disallowed.

Technology Systems Inc. (TSI), a small business, had cost-type contracts with the Navy for research and development of ship-navigation software. The dispute concerned the Government's disallowance of expenses TSI used to calculate its indirect cost rates for fiscal year 2007 as well as some direct costs.

The Defense Contract Audit Agency conducted full audits of TSI's final indirect cost rate proposal (ICP) for FYs 1998–2003 and for FY 2006. The FY 2001 audit questioned several costs but primarily questioned the professional fees cost element claimed in overhead and in G&A.

For FYs 2002–2006, DCAA and the Defense Contract Management Agency did not question costs and accepted TSI's indirect rates without change. For FYs 2004 and 2005, DCAA conducted a desk review, instead of a full audit. The desk review for TSI's FY 2005 ICP stated that "no significant costs were questioned in prior years and that no indicators of audit risk had been identified." The FY 2006 full audit found that "the contractor's indirect rates are acceptable as proposed."

Soon after the FY 2007 audit began, TSI "ran into difficulties" with one of the DCAA auditors, the ASBCA said. According to TSI, the auditor lost her temper at a meeting. The Government refused to replace the auditor, who prepared a draft audit questioning over $360,000 in direct and indirect costs.

Before the draft audit could be completed, DCAA halted incurred-costs audits and focused on pricing audits that were holding up contract awards. Four years later, in 2013, DCAA grew concerned about the statute of limitations and resumed its audit of TSI's FY 2007 ICP. A new auditor began work, but DCAA notified the administrative contracting officer (ACO) in 2014 that it could not meet the audit deadline and would instead provide "non-audit" service to help DCMA determine final indirect cost rates. In March 2014, DCAA provided a "decrement memo" itemizing questioned costs.

The decrement memo, prepared by a third DCAA auditor, did not question as many costs as the original draft audit. The third auditor explained that he was not taking as much of a "hard line" on certain labor costs, as compared to the original audit.

The ACO then allowed some additional costs based on new information from TSI, but rejected TSIs argument that DCAA had not questioned the costs in the past. The ACO issued a final decision asserting a claim for $159,303.

TSI appealed. In addition to certain cost-specific arguments, TSI argued that prior audits did not question the disallowed expenses. TSI said that it relied on this and did not preserve what DCAA would have considered to be necessary evidence for the FY 2007 costs. The ASBCA addressed this argument in two parts, first under the doctrine of retroactive disallowance and second under course of dealing.

Retroactive Disallowance

Retroactive disallowance bars Government challenges to incurred costs if a cost or accounting method was previously accepted after final audit of historical costs, the contractor reasonably believed that the method would continue to be approved, and the contractor detri-mentally relied on the prior acceptance. Gould Def. Sys., Inc., ASBCA 24881, 83-2 BCA ¶ 16,676. In this case, Judge Clarke, who was the trial judge, raised the issue.

"Retroactive disallowance is a theory for challenging audits whose heyday has come and gone," the ASBCA said. The last ASBCA decision granting relief based on retroactive disallowance was Lockheed Martin W. Dev. Labs., ASBCA 51452, 02-1 BCA ¶ 31,803; 44 GC ¶ 155.

The ASBCA said that "the seeds of the doctrine's diminution were sown" by the U.S. Supreme Court in Heckler v. Cmty. Health Servs. of Crawford Cnty., Inc., 467 U.S. 51 (1984), which stated that, "the Government may not be estopped on the same terms as any other litigant." The Court of Appeals for the Federal Circuit later held that affirmative misconduct is as an element of an estoppel claim against the Government. Henry v. U.S., 870 F.2d 634 (Fed. Cir. 1989). As a special application of estoppel principles, retroactive disallowance is subject to the affirmative-misconduct requirement, the ASBCA said.

The ASBCA held that retroactive disallowance did not apply in this case. Judge Clarke did not "as-sert that there is a factual predicate for finding affirmative misconduct on the part of the government," the ASBCA said. Without that element, retroactive disallowance does not apply. United Techs. Corp., Pratt & Whitney, ASBCA 47416 et al., 06-1 BCA ¶ 33,289; 43 GC ¶ 303.

In addition, retroactive disallowance does not apply because the Government's failure to challenge TSI's costs in prior audits, without more, was not enough to give TSI a reasonable belief that the costs would not be challenged in the future. This would be the case even if the law did not require an unequivocal Government statement that the costs were considered to be supported. Considering the requirement that the Government make an unequivocal statement on allowability, the case for applying retroactive disallowance "is even more plainly deficient here," the ASBCA said.

Course of Dealing

The ASBCA also rejected this challenge to the Government's claim. Binding precedent follows the Restatement (Second) of Contracts on course of dealing. Sperry Flight Sys.v. U.S., 548 F.2d 915 (Ct. Cl. 1977); 19 GC ¶ 189; see also BAE Sys. Tech. Solutions & Servs., Inc., ASBCA 57581, 13 BCA ¶ 35,414. Under Restatement § 223, a course of dealing is "a sequence of previous conduct between the parties to an agreement which is fairly to be regarded as establishing a common basis of understanding for interpreting their expressions and other conduct." Sperry Flight Systems added that "a course of dealing can supply an enforceable term to a contract ... provided that the conduct which identifies that course of dealing can reasonably be construed as indicative of the parties' intentions—a reflection of their joint or common understanding."

DCAA's failure to question certain costs in prior audits, without more, does not establish a common basis of understanding because the failure to question costs could mean more than one thing. It could mean that the Government is satisfied with TSI's proof, or it could mean that the auditor chose to more carefully investigate certain issues for a variety of legitimate reasons in some years. If there is only speculation as to the meaning of an auditor's silence, that silence cannot "reasonably be construed as indicative of the parties' intentions [or] their joint and common understanding."

Although TSI is a "sympathetic actor," a rule granting TSI relief would "encourage DCAA and COs to question as many costs as possible in early audits so as to ‘speak now or forever hold its peace.' " Instead, auditors should "exercise judgment and discretion in determining the scope of their audits," the ASBCA said in rejecting course of dealing.

Statute of Limitations

Under the Contract Disputes Act, the Government must present a claim against a contractor within six years of its accrual. 41 USCA § 7103(a)(4)(A). Accrual is "the date when all events, that fix the alleged liability of ... the contractor and permit assertion of the claim, were known or should have been known .... [M]onetary damages need not have been incurred." Sikorsky Aircraft Corp. v. U.S., 773 F.3d 1315 (Fed. Cir. 2014) (quoting Federal Acquisition Regulation 33.201).

The costs questioned by the ACO's final decision were in TSI's FY 2007 ICP, which was submitted on June 30, 2008. Even if the mere submission of the ICP started the six-year statute of limitations, the June 23, 2014 ACO's final decision was within the six-year period. The ASBCA said that it was legally impossible for the CO to issue a final decision before the submission of the ICP because the legal bases for the Government's unilateral establishment of the indirect costs, FAR 42.705-1 and FAR 42.302(a)(9), presuppose action on a final ICP from the contractor.

In addition, information about costs for years before FY 2007 did not allow the Government to question later year costs before they were submitted. At most, the prior year information "might be argued to have bearing on when the government knew or should have known that the 2007 costs, as submitted in the FY 2007 ICP, were dubious," but the prior year information would be material only after the FY 2007 ICP submittal.

Items of Cost

Marketing Costs: To disallow TSI's marketing costs, the Government argued that to prove costs under FAR 31.205-33, professional and consultant service costs, a consultant must create "work product." The ASBCA rejected this argument and held that FAR 31.205-33(f) may require the provision of a consultant's work product, if it exists, but it does not require its creation if the work product is not necessary for the consultant to perform its duties. The ASBCA found that TSI's invoices supported a finding that TSI incurred the costs charged by its marketing consultant.

Expensed Computers: The ASBCA concluded that the ACO properly rejected TSI's attempt to ex-pense computers in FY 2007 rather than depreciate them over several years. Expensing the computers conflicted with TSI's prior practice, and TSI did not demonstrate which computers were modified for non-office work so that expensing might be justified.

Travel Costs: The ACO properly disallowed per diem costs that exceeded travel regulation rates. See FAR 31.205-45(a)(2).

Executive Bonuses: TSI was not entitled to recover bonus plan payments. Although FAR 31.2056(f), bonuses and incentive compensation, makes bonus payments allowable, TSI's bonus payments were not allowable under the rule. TSI's bonus plan was defective because the one-page memorandum purporting to establish it "was utterly lacking in clearly defined criteria for making bonus decisions and effectively left decision-making regarding the award of any bonuses to the unfettered discretion" of three bonus recipients. The memos in support of the bonuses reflect their arbitrary nature by ref-erencing generalized achievements without tying them to the amount of the bonuses. Because TSI's bonus policy lacked specificity and constraints, see SplashNote Sys., Inc., ASBCA 57403, 12-1 BCA ¶ 34,899, and effectively provided "unlimited discretion" to management, see Boeing Aerospace Operations, Inc., ASBCA 46274, 46275, 94-2 BCA ¶ 26,802; 36 GC ¶ 348, it was not a compensable cost, the ASBCA said.

Legal Fees: The ASBCA held that TSI was entitled to recover costs to defend itself in a Naval Criminal Investigative Service investigation. It rejected the Government's argument that TSI sought the costs in the wrong year. FAR 31.205-47(g) generally precludes payment of those costs while the investigation is pending. Although another company told TSI that the investigation was over, TSI reasonably waited to seek recovery of the costs until NCIS returned TSI's documents in 2007, and TSI was thus certain that the investigation was complete.

Subcontractor Costs: Contrary to FAR 52.244-2, direct costs for two TSI subcontractors were not pre-approved by the ACO. Although the CO's technical representative (COTR) later determined that the subcontracts were performed in support of TSI's statement of work, the COTR did not address the reasonableness of the costs. This is "fatal to TSI's attempts to provide an after-the-fact justification of these subcontracts," the ASBCA said.

Note—Judge Clarke dissented, in part, on the grounds that retroactive disallowance and course of dealing preclude the Government's claim. On the issue of retroactive disallowance, the dissent said that the critical issue is whether retroactive disallowance, like traditional estoppel, requires "affirmative misconduct." The dissent said that the ASBCA has not unambiguously applied the requirement of affirmative misconduct to retroactive disallowance. The dissent said that the remand guidance in Rumsfeld v. United Techs. Corp., Pratt & Whitney, 315 F.3d 1361 (Fed. Cir. 2003); 45 GC ¶ 45, and the ASBCA's remand decision did not mention retroactive disallowance. See United Techs. Corp, Pratt & Whitney, ASBCA 47416 et al., 06-1 BCA ¶ 33,289. The dissent concluded that 

it is appropriate to treat retroactive disallowance and traditional estoppel differently. This is because traditional estoppel is a permanent prospective bar to the government's action; retroactive disallowance is not. In retroactive disallowance the government may change its standard and disallow costs it had previously allowed, i.e., the "estoppel" only applies between the previous approval(s) and the point when the government provides notice to the contractor that it will impose a different standard in the future. I therefore do not impose the requirement for affirmative misconduct to retroactive disapproval.

The dissent also concluded that the parties' course of dealing should preclude the Government's claim. To establish a course of dealing under the Restatement standard, there must be a "sequence of previous conduct between the parties to an agreement which is fairly to be regarded as establishing a common basis of understanding for interpreting their expressions and other conduct." The dissent said that the unchallenged testimony of TSI's management that the Government's three full audits and two desk reviews approving TSI's documentation and final rates during 2002 to 2006 was a "sequence of previous conduct" that created a "common basis of understanding" between TSI and the Government. TSI reasonably expected that its cost documentation and DCAA's audits were correct. After the Government accepted "the exact same documentation for FYs 2002 to 2006, TSI was entitled to notice and time to change its record keeping to satisfy the auditors." Accordingly, the ASBCA should apply the doctrine of course of dealing, except for recovery of expressly unallowable costs, the dissent said. 

The dissent also disagreed with the majority's decision on the allowability of TSI bonus payments.

Practitioner's Comment

It is often the case that contract disputes involving a relatively small amount can implicate much Government contract law and doctrine. Technology Systems is one of those cases.

As a preliminary matter, it is unusual for the ASBCA to issue a decision with a dissenting opinion— particularly one where both the majority and dissenting opinions are 30 pages each. And it is uncommon for a case to be decided by a senior advisory panel. Here, rather than the typical, three-member panel decision, Technology Systems involved a five-member panel. Generally, cases are elevated to a senior panel when a case of doctrinal importance is in dispute. Complicating the case more is that the judge who tried the case rendered the dissenting opinion. And the contractor was represented pro se, (i.e., without the benefit of counsel); in this regard, it appears that the parties may not have even raised some of the issues decided by the ASBCA. One of those issues is application of the doctrine of retroactive disallowance.

The doctrine of retroactive disallowance saw its genesis in Litton Sys. Inc. v. U. S., 449 F.2d 392 (Ct. Cl. 1971); 13 GC ¶ 473. In that case, the court held that when a contractor engaged in a cost accounting practice "with the Government's knowledge, approval and acquiescence, the [contractor] was entitled to reasonable notice that the Government would no longer approve the use of the method." Litton, 449 F2d. at 401. The doctrine was extended to apply to cost al-lowability issues; but had always been limited to the questions of allowable cost—hence its name. The dissent recognized that the doctrine has been subject to unique application in Government contracts, distinct from the traditional contract doctrine of equitable estoppel. Once the Government provides the contractor definitive notice about the Government's position that a cost is unallowable, the position would apply prospectively, but cannot be applied retroactively.

The dissent noted that, as recently as Raytheon Co., ASBCA 57576 et al., 15-1 BCA ¶ 36,043, the ASBCA had made a distinction between estoppel (which it did not find applied in that case due to a lack of Government affirmative misconduct) and retroactive disallowance (which it reserved to resolve at a later time). The majority found no distinction between the two doctrines. Defense contractors seeking to apply retroactive disallowance will now have to look to the U.S. Court of Federal Claims where the issue has not been resolved. (ASBCA cases are not binding on the court.)

The ASBCA also addressed a related theory of course of dealing, which does not include the affir-mative misconduct standard. As with estoppel, the ASBCA concluded that questions of cost allowability are not especially susceptible to a course of dealing argument. It seems that the ASBCA was driven by the Government's need to question every cost in every audit to avoid running afoul of a course of dealing allegation. Yet, the ASBCA seems to neglect the fact that DCAA's mission is to identify unallowable costs—and that Congress provided six years to do so. That said, the ASBCA left the door open to course of dealing as a defense in cost allowability cases. On the subject of the six-year limitation, the ASBCA reconfirmed precedent set in Raytheon Co., ASBCA 57576 et al. 13 BCA ¶ 35,209; 55 GC ¶ 46, that an ICP starts the clock.

As to the issues on the merits, two aspects of the case are particularly noteworthy. Regarding the evidentiary standards set forth in FAR 31.205-33(f) for consultant costs, the ASBCA held that, despite the mandatory language "shall," a contractor need not show all three elements of evidence: details of agreements, invoices or billings, and work product. DCAA regularly raises the issue of adequate docu-mentation to disallow costs. The ASBCA found that a combination of evidence, including testimony, is sufficient to demonstrate allowability of costs.

Lastly, on the subject of allowable legal proceeding costs under FAR 31.205-47, there has often been an open question of the appropriate period to charge costs that had been segregated under subsection (g), but were subsequently rendered allowable. The ASB-CA set a reasonableness standard as to the certainty of a completed investigation with no adverse action, which would render the segregated costs allowable. Notice by the investigating agency is not necessarily determinative. Here, it was reasonable to wait until return of documents to confirm that the investigation truly was over. The ASBCA did not preclude notice from the agency as a basis to identify the completion of the investigation, but left it to the reasonable judgment of the contractor.


Paul E. Pompeo
Paul E. Pompeo
Washington, DC
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