United States: ASBCA Continues To Apply The Expressly Unallowable Cost Standard In An Unworkable Way

Recently, in Raytheon Co., ASBCA Nos. 57576, et al (June 26, 2015), the ASBCA confirmed that a narrow reading of the term "expressly unallowable" costs is appropriate under the CAS and FAR. The Board reaffirmed previous holdings that expressly unallowable costs "must be an item of cost or a type of cost that is specifically named and stated as unallowable by law, regulation or contract" and must be "unallowable in direct and unmistakable terms." Notably, this decision removes any doubt that DCAA was wrong when recently it issued overreaching guidance to its Regional Directors instructing auditors how to liberally (and incorrectly) identify expressly unallowable costs, which we discussed in a previous alert. Accordingly, contractors should adamantly contest DCAA assertions and/or DCMA findings of penalties for any costs that are not explicitly listed as unallowable in FAR Part 31. However, the ASBCA misapplied the definition of expressly unallowable costs, reaching incorrect and troubling conclusions.

Unfortunately, the Raytheon decision does nothing to resolve the long-standing dispute between contractors and the government regarding the proper application of expressly unallowable penalties. Specifically, while the Board acknowledged that a cost is only subject to penalty if it is "specifically named and stated to be unallowable," the Board then found that certain bonus and incentive costs where an employee billed time to unallowable legal activity and long term compensation costs that include a Total Shareholder Return (TSR) element, both which are not expressly referenced anywhere in the FAR, are expressly unallowable. Thus, contractors will be left guessing at whether the government will consider particular costs to be expressly unallowable even if they are not specifically named in the FAR.

In Raytheon, the government claimed that Raytheon had violated CAS 405 by failing to identify and exclude from billings the costs of bonus and incentive compensation for employees engaged in activities generating unallowable costs under: FAR 31.205-1, public relations and advertising costs; FAR 31.205-22, lobbying and political activity costs; FAR 31.205-27, organization costs; and FAR 31.205-47, legal costs. A brief summary of each finding is described below.

• FAR 31.205-1—Public Relations and Advertising Costs. The government alleged that certain bonus and incentive compensation costs were expressly unallowable under FAR 31.205-1 because the costs were the equivalent of "salaries" and "fringe benefits," which are expressly stated to be unallowable in FAR 31.205-1 when such costs are associated with public relations and advertising. The Board held that the bonus and incentive compensation costs were not expressly unallowable costs subject to penalty because bonus and incentive compensation costs are neither salary nor fringe benefits and bonus and incentive compensation was not specifically named and stated as unallowable under FAR 31.205-1.
• FAR 31.205-22—Lobby and Political Activity Costs. The government argued that bonus and incentive compensation associated with lobbying and political activity was expressly unallowable under FAR 31.205-22. The Board again held that because FAR 31.205-22 does not specifically name or state bonus and incentive compensation or compensation as unallowable in any direct or unmistakable terms, the costs were not expressly unallowable.
• FAR 31.205-27—Organization Costs. The government argued that the language included in FAR 31.205-27, which states that costs incurred "in connection with" certain organization-type activity, made bonus and incentive compensation costs associated with organization costs expressly unallowable. The Board disagreed and held that the costs were not expressly unallowable under FAR 31.205-27 because neither bonus and incentive compensation nor compensation was specifically named and stated as unallowable under this regulation.
• FAR 31.205-47—Legal Costs. The government argued that bonus and incentive compensation was expressly unallowable under FAR 31.205-47 as legal costs incurred by a contractor for "the pay of directors, officers, and employees" (emphasis added) for the time devoted to the questioned legal proceedings. More specifically, the government argued that Raytheon should have removed from its incurred cost submissions a portion of employee bonus and incentive compensation equal to the amount of unallowable labor claimed for employees that billed time for unallowable legal activities. In this instance, the Board agreed with the government and held that a portion of bonus and incentive compensation costs were expressly unallowable under this regulation because, based on the regulatory history, "pay" includes "all elements of compensation-related costs and expenses of employees, officers and directors," which includes bonuses and incentive compensation. We disagree with this holding, however, contractors should be prepared for government assertions that a portion of bonus and incentive compensation costs are unallowable where employees bill time to unallowable legal activity and also earn a bonus during that same year.

The Board also held that certain compensation costs including a TSR element were expressly unallowable under FAR 31.205-6(i), Compensation Based on Changes in the Prices of Corporate Securities, even though FAR 31.205-6(i) contains no reference to TSR related compensation. The Board is wrong—not only are these costs not expressly unallowable, they are, in fact, allowable. Historically, both contractors and the government have treated such costs as allowable because long term incentive compensation with a TSR element is performance-based compensation and is not based on changes in the prices of corporate securities. While the Board generally reached the correct conclusion regarding the narrow definition of expressly unallowable costs, the Board incorrectly applied its standard under both FAR 31.205-47 and 31.205-6(i).

In response to the Board's narrow reading of expressly unallowable costs, contractors should aggressively contest DCAA or DCMA determinations of expressly unallowable costs that are not specifically named and stated as unallowable and otherwise identified in the Cost Principle in any direct or unmistakable terms. With regard to the Board's holding on compensation costs including a TSR element, it remains to be seen whether this decision will be appealed to the Court of Appeals for the Federal Circuit. In the meantime, contractors should remove from incurred cost submissions compensation costs with a TSR element to avoid a penalty assessment.

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