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What You Need to Know About Mergers and Acquisitions Involving Government Contractors and Their Suppliers - Volume 2
February, 16th 2016

This posting is the second in a ten-part series on unique issues that arise in the acquisition and disposition of a company that performs government contracts or subcontracts. Part 1 focused on the types of deal structures that are subject to the anti-assignment statutes, and therefore require Government consent. We explained that consent is not required for stock purchases, is required for asset sales, and may be required for other types of transactions, including mergers. This posting, Part 2, addresses the consent process, including the who, what, when, and how of obtaining a novation agreement. It also includes practical tips, based on our experience, for navigating the novation process efficiently and successfully.

The Novation Process

The first step in the novation process is to identify the responsible contracting officer. The FAR contemplates that one responsible contracting officer will be the single point of contact for the novation of all of the government contracts to be transferred. If any of the affected government contracts held by the transferor have been assigned to an administrative contracting officer (“ACO”), that ACO will be the responsible contracting officer. FAR 42.1202(a)(1). If the affected government contracts are in more than one plant or division of the transferor, the responsible contracting officer will be the ACO responsible for the transferor’s corporate office. FAR 42.1202(a)(2). If none of the transferor’s government contracts have been assigned to an ACO, the responsible contracting officer is the contracting officer responsible for the largest unsettled dollar balance – including both unbilled and billed but not yet paid. FAR 42.1202(b). Finally, if several transferors are involved, such as where two or more independently incorporated affiliates, or the assets of two or more such affiliates, are being acquired in a single transaction, the responsible contracting officer is the ACO administering the largest unsettled dollar balance or the contracting officer (or ACO) designated by the agency having the largest unsettled dollar balance, if none of the affected contracts have been assigned to an ACO. FAR 42.1202(c).

The FAR does not require a contractor to submit a formal novation request to the responsible contracting officer, and a novation agreement cannot be processed, until the government contract has been transferred. Put more crisply – the novation always follows the closing. Nevertheless, it is the best practice to contact the responsible contracting officer much earlier in the process. The responsible contracting officer has extraordinarily broad discretion in determining whether it is in the best interest of the Government to grant or deny the novation request, what documentation to require in support of the novation, and how quickly the novation process moves. See FAR 42.1203(c); FAR 42.1204(e)(4); FAR 42.1204(g). Reaching out to the responsible contracting officer well in advance of the transfer has numerous advantages. Specifically, it allows you to establish a good working relationship with the responsible contracting officer, to make your case for the novation before the transfer has occurred, to identify and address potential concerns before closing, to discuss the waiver of certain potentially burdensome documentation requirements, and to assess whether there is a risk that the Government may deny the novation request. The more progress you can make with the responsible contracting officer before closing, the less time it will take to obtain the novation agreement after closing.

With regard to the formal novation request, the FAR identifies numerous documents that must be submitted to the responsible contracting officer. Many of those documents can and should be submitted before the transaction closes. Those include:

Three signed copies of the proposed novation agreement;
The document describing the proposed transaction (e.g., the purchase agreement);
A list of the affected contracts and orders, including (a) the government contract number and type; (b) the name and address of the contracting office; (c) the total dollar value as amended; and (d) the approximate remaining unpaid balance;
Evidence of the transferee’s capability to perform; and
Any other information requested by the contracting officer.
FAR 42.1204(e). The fourth category of information bears particular emphasis and explanation. Providing evidence of the transferee’s capability to perform is your “sales pitch” for persuading the responsible contracting officer to grant the novation request. Such evidence could include, without limitation, information regarding the transferee’s financial stability, its experience with similar work, its performance of other government contracts, its applicable certifications and qualifications, its business systems, its favorable audit history, its possession of relevant security clearances, its management, and any other information bearing on its responsibility and ability to perform the contracts in accordance with their requirements.

The FAR also lists additional documents that you must provide to the responsible contracting officer as they become available, generally after the deal has closed. These include:

An authenticated copy of the instrument affecting the transfer (e.g., bill of sale, certificate of merger, contract, deed, agreement, or court decree);
Appropriate corporate approval of the transfer consisting of certified copies of board resolutions and/or stockholder minutes;
An authenticated copy of the transferee’s certificate and articles of incorporation (if a corporation was formed to receive assets involved in performing government contracts);
Opinion of legal counsel for the transferor and the transferee stating that the transfer was properly effected under applicable law and the effective date of the transfer;
Balance sheets of the transferor and the transferee as of the dates immediately before and after the transfer of assets, audited by independent accountants;
Evidence that any security clearance requirements have been met; and
The consent of sureties on all contracts transferred or a statement from the transferor that none are required.
FAR 42.1204(f). Most of this information is relatively easy and inexpensive to obtain. The requirement for audited balance sheets, however, can be burdensome. Some contractors, including most small businesses, do not maintain audited financial statements. Requiring such contractors to obtain audited balance sheets would be costly and could also significantly delay the novation process. Accordingly, many contracting officers will waive this requirement, and instead accept unaudited balance sheets or other proof that all of the assets have been transferred.

The requirement for opinions of counsel also merits brief attention. These need not and should not be lengthy or elaborate documents. Corporate counsel for the transferor and the transferee should be able to prepare such opinions quickly and inexpensively since they are familiar with the transaction. While it will be necessary for the opinion to include some assumptions and caveats, these should be kept to a minimum, typically no more than a few paragraphs, in order to avoid rejection by the responsible contracting officer. We often find it useful to have our clients submit drafts of the opinion letters, before the formal novation request, so their form and content can be approved in advance.

The Novation Agreement

As noted above, the FAR requires submission of three signed copies of the “proposed” novation agreement. The FAR includes a standard form novation agreement for the assignment of government contracts. FAR 42.1204(i). The standard form is required where the transferor and transferee are corporations and all of the transferor’s assets are transferred. Id. The form may be adapted for use in other contexts, but the Government generally will not accept modifications to the key terms. Id. In our experience, proposing significant changes to those terms serves little purpose, other than to delay approval of the novation agreement.

Many provisions in the novation agreement are what you would expect in a consent to assignment. The transferor relinquishes its rights under the contract; the transferee agrees to be bound by the contract; the Government recognizes the transferee as the successor in interest to the transferor; the parties agree that the Government will pay the transferee rather than the transferor; and the contracts remain in full force and effect. Lurking within the standard novation agreement, however, are several unusual terms that strongly favor the Government. There is little you can do to change these terms, but you should be aware of their implications.

The transferor is required to waive any claims and rights it may have against the Government, but the Government is not required to waive any rights or claims it may have against the transferor. Novation Agreement, ¶¶ (b)(1), (b)(5). In fact, the transferor must guarantee the transferee’s payment of all liabilities and performance of all obligations under the contract. Id., ¶ (b)(8). This guarantee applies not only to liabilities and obligations that exist at the time of the novation, but also to liabilities or obligations the transferee may undertake in any future modification to the government contract – whether or not the transferor receives notice of, or consents to, that modification. Id. As an alternative, the Government may accept a performance bond in lieu of a guarantee. FAR 42.1204(h)(3).

The requirement for a guarantee may have little practical significance in cases where the transferee is purchasing all of the transferor’s assets, such that the transferee has no assets left to make good on the guarantee. Where only a portion of the transferee’s assets are being transferred, on the other hand, such as in the case of selling an unincorporated division, the requirement to guarantee the transferee’s performance can expose the transferor to significant risk. In these cases, it is in the transferor’s interest to ensure that the transferee is a responsible contractor with sufficient resources and capability to perform the transferred contracts, including any foreseeable modifications. Indemnification is possible, but the Government would have little incentive to pursue a transferee with few resources unless and until the transferor’s assets have been exhausted.

The standard novation agreement also makes unallowable government contract costs exceeding those that would have been incurred by the transferor, even if the novation decreases the overall cost to the Government. Novation Agreement, ¶ (b)(7). For example, the Government could disallow cost increases resulting from a higher overhead rate, even if those costs were more than offset by a decrease in the applicable general and administrative expense (“G&A”) rate. This provision is relevant not only to valuing the transferred contracts but also to post-transfer compliance with cost accounting requirements.

The FAR further provides that any separate agreement between the transferor and the transferee regarding assumption of liabilities should be referenced specifically in the novation agreement. FAR 42.1203(e). Examples of liabilities identified in this provision include long-term incentive compensation plans, cost accounting standards non-compliances, environmental cleanup costs, and final overhead costs.

The Approval Process

Upon receipt of a novation request, the responsible contracting officer is required to notify each contract administration office and contracting office of the request, provide those offices with a list of affected contracts, and request submission of any comments or objections to the proposed transfer within 30 days after their receipt of such notification. FAR 42.1203(b)(2), (b)(3). The responsible contracting officer must then determine whether it is in the best interest of the Government to grant the novation. FAR 42.1203(c). In addition to the formal novation submission provided by the contractor, the responsible contracting officer is required to consider:

The comments received from the affected contract administration offices and contracting offices;
The transferee’s responsibility under FAR Subpart 9.1, Responsible Prospective Contractors; and
Any factor relating to the transferee’s performance of government contracts that could impair the transferee’s ability to perform the contract satisfactorily.
FAR 42.1203(c). With regard to the third “catchall” category of information, responsible contracting officers often consult the Contractor Performance Assessment Reporting System (“CPARS”).

When considering whether to grant a novation request, the responsible contracting officer is also required to identify and evaluate any significant organizational conflicts of interest (“OCIs”). FAR 42.1204(d). A responsible contracting officer generally will not allow the novation of a government contract to a transferee with a significant OCI unless that OCI can be avoided or mitigated. However, if the responsible contracting officer determines that a conflict of interest cannot be resolved, but nevertheless finds that it is in the best interest of the Government to approve the novation request, he or she may submit a request for higher-level approval to waive the OCI. Id.

There is no mandatory deadline for the responsible contracting officer to act upon a novation request. In our experience, the process typically requires between two and six months. Longer timeframes may be required for very large deals or if the responsible contracting officer has concerns regarding the transferee’s ability to perform.

Most novation requests are approved. Contractors have little recourse for a denial. If your request is denied, the best course of action typically is to have your attorney reach out to agency counsel to discuss whether there are any circumstances under which the Government might agree to the novation. Although a claim for denial of a novation request may be a theoretical possibility, the probability of success would be very low due to the extraordinarily broad discretion that is afforded to contracting officers in this area.

Novation Deal Terms

Novation cannot, by its nature, be a condition to closing, since formal Government approval can only be obtained after a government contract has been transferred. Instead, most purchase agreements include a provision requiring the parties to cooperate with each other to obtain the novation after closing. Such cooperation is critical. Although the FAR requires the transferee to submit the novation packet, much of the necessary information – including financial statements, corporate approvals, and other documents – will be in the transferor’s possession.

While the approval process is pending, it is common for the parties to enter into a pre-novation subcontract whereby: (1) the transferor, who the Government still regards as the entity holding the contract, subcontracts all of the work to the transferee, and (2) the transferor agrees pay the transferee for that work. Pre-novation subcontracts are more complex than traditional subcontracts in at least one important respect. They are intended to allow the subcontractor maximum control over the business it has just purchased, in effect allowing the subcontractor to act as though it were the prime contractor. Yet the prime contractor still remains in privity with the Government, meaning that affording the subcontractor complete control can create significant liability and risk for the prime. This risk is typically mitigated through a broad indemnification provision. Separately, it should be noted that a pre-novation subcontract requires the transferor to remain in existence as a legal entity, to have at least one employee with authority to bind the transferor, and to maintain its SAM registration.

It is also common for the purchase agreement to address what happens in the event the novation request is denied. Potential strategies include indemnification, a purchase price adjustment, and/or a permanent subcontract similar to the pre-novation subcontract described above.

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