Defense Restructuring Costs: Payment Regulations Are Inconsistent with
Legislation (Letter Report, 08/10/95, GAO/NSIAD-95-106).

Section 818 of the National Defense Authorization Act for Fiscal Year
1995 governs payments made by the Defense Department (DOD) to
contractors for costs associated with business combinations, including
mergers and acquisitions. Normally, after a business combination, a new
company will undertake restructuring activities, such as closing plants,
eliminating jobs, and relocating workers.  Section 818 prohibits payment
of restructuring costs until DOD officials certify that projected
savings from the business combination are based on audited cost data and
should reduce costs to DOD.  DOD regulations do not comply with section
818 requirements because all restructuring costs associated with defense
contractor business combinations, for which contractors may be
reimbursed, will not be subject to the section's certification
requirements.  By excluding some restructuring costs that should be
subject to section 818 certification requirements, DOD cannot ensure
that payment of these costs are made only when in the best interests of
the United States.  Further, the regulations cannot ensure that DOD will
be able to meet the section's annual reporting requirements to Congress.
Moreover, DOD plans to pay restructuring costs up to the amount of
savings projected to result from a business combination, which would
result in the payment of those costs without significant projected
savings to DOD.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  NSIAD-95-106
     TITLE:  Defense Restructuring Costs: Payment Regulations Are 
             Inconsistent with Legislation
      DATE:  08/10/95
   SUBJECT:  Department of Defense contractors
             Contractor payments
             Reporting requirements
             Contract costs
             Procurement regulation
             Defense cost control
             Data collection operations
             Compliance
             Questionable payments
             Overhead costs

             
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Cover
================================================================ COVER


Report to Congressional Committees

August 1995

DEFENSE RESTRUCTURING COSTS -
PAYMENT REGULATIONS ARE
INCONSISTENT WITH LEGISLATION

GAO/NSIAD-95-106

Defense Restructuring Costs


Abbreviations
=============================================================== ABBREV

  DOD - Department of Defense
  FAR - Federal Acquisition Regulation

Letter
=============================================================== LETTER


B-259594

August 10, 1995

The Honorable Strom Thurmond
Chairman
The Honorable Sam Nunn
Ranking Minority Member
Committee on Armed Services
United States Senate

The Honorable Floyd Spence
Chairman
The Honorable Ronald V.  Dellums
Ranking Minority Member
Committee on National Security
House of Representatives

Section 818 of the National Defense Authorization Act for Fiscal Year
1995 sets out certain requirements governing payments made by the
Department of Defense (DOD) to its contractors for costs associated
with business combinations, including mergers and acquisitions. 
Normally, after a business combination, a new company will undertake
restructuring activities such as closing facilities, eliminating
jobs, and relocating employees. 

Section 818 prohibits payment of restructuring costs until a senior
DOD official certifies that projected savings from the business
combination are based on audited cost data and should result in
overall reduced costs to DOD.  Section 818 also requires the
Secretary of Defense to report annually on DOD experience with
business combinations, including whether savings associated with each
restructuring actually exceed costs. 

In response to section 818 requirements, DOD issued interim
regulations on restructuring costs effective December 29, 1994.  As
required by the statute, we reviewed the regulations to determine
whether they (1) are consistent with section 818, applicable
procurement laws, and the Federal Acquisition Regulation (FAR) and
(2) ensure that restructuring costs are paid only when in the best
interests of the United States. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :1

DOD's regulations do not comply with section 818 requirements because
all restructuring costs associated with defense contractor business
combinations, for which contractors may be reimbursed, will not be
subject to the section's certification requirements.  The exclusion
of costs from the section's certification requirements is due to a
distinction DOD makes in types of restructuring activities.  By
excluding some restructuring costs that should be subject to section
818 certification requirements, DOD will not be able to ensure that
the payment of these costs are made only when in the best interests
of the United States. 

In addition, the regulations do not contain a mechanism to ensure
that DOD will be able to meet the section's annual reporting
requirement to the Congress.  Moreover, DOD plans to pay
restructuring costs up to the amount of savings projected to result
from a business combination, which would result in the payment of
those costs without significant projected savings to DOD. 


   BACKGROUND
------------------------------------------------------------ Letter :2

Contractors historically have not been permitted to recover
restructuring costs through contracts that were transferred from one
contractor to another in connection with a business combination.  The
rationale was that the government should not pay increased contract
costs that were incurred only because the contractor decided to
combine with another firm. 

In July 1993, DOD changed its long-standing practice of not paying
restructuring costs.  The change, made after several major defense
contractors approached DOD, was intended to encourage contractors to
consolidate and thereby reduce operating and contract costs.  The
change allowed contractors to charge DOD for costs incurred in
connection with a business combination if such costs were permitted
by the FAR\1 and if a DOD contracting officer determined that a
business combination would result in overall reduced costs or
preserve a critical defense capability. 

The Congress enacted section 818 the following year, prohibiting
payment of restructuring costs until a senior DOD official certifies
that projections of savings have been audited and that the savings
should result in overall reduced costs to DOD.  The Congress also
required the Secretary of Defense to issue implementing regulations
by January 1, 1995, and submit annual reports on restructuring
activities during 1995-97. 


--------------------
\1 The FAR contains guidelines for determining whether a particular
cost is an allowable charge to a government contract.  Costs
associated with business combinations that are specifically
identified as unallowable in the FAR include legal and consulting
fees. 


   DOD'S REGULATIONS EXCLUDE SOME
   RESTRUCTURING COSTS FROM
   SECTION 818 CERTIFICATION
   REQUIREMENTS
------------------------------------------------------------ Letter :3

DOD's regulations do not comply with section 818 requirements because
they do not require all costs associated with a business combination
to be subject to the section's certification requirements.  In its
regulations, DOD defines two kinds of "restructuring
activities"--internal and external. 

  Internal activities are those occurring after a business
     combination that involve the facilities or workforce of only one
     of the companies involved in the business combination.  These
     restructuring costs, even if associated with the business
     combination, would not be subject to the certification
     requirements of section 818. 

  External activities are those occurring after a business
     combination that involve facilities or workforces from both of
     the previously separate companies.  The costs associated with
     external activities would be subject to section 818
     certification requirements. 

Section 818 makes no such distinction but addresses the allowability
of restructuring costs regardless of whether the facilities or
workforces from both or only one of the previously separate companies
were involved.  The operative condition in section 818 is that the
restructuring costs be "associated with" the business combination. 

The significance of the distinction made by DOD between internal and
external restructuring activities is illustrated by the following
example offered by one of the military services.  Assume that Company
A purchases Company B and that both companies operate similar test
laboratories.  Assume further that as a result of the business
combination, Company A eliminates its laboratory facilities and
workforce.  Although Company A would not have closed its laboratory
without the business combination, under DOD's interim regulations,
the restructuring activity would be defined as internal and thus
excluded from the required certification because the facilities and
workforce of only one of the two previously separate companies were
involved.  By excluding these "internal" costs, DOD will not be
capturing all restructuring costs subject to section 818 and,
therefore, will not be able to determine whether the savings from the
business combination result in an overall reduced cost to DOD. 
Accordingly, DOD will not be able to ensure that restructuring costs
are paid only when in the best interests of the United States. 


   REGULATIONS DO NOT REQUIRE DATA
   NEEDED TO RESPOND TO ANNUAL
   REPORTING REQUIREMENTS
------------------------------------------------------------ Letter :4

DOD's regulations do not address section 818's requirement for the
Secretary of Defense to report annually to the Congress on its
experience with business combinations, including whether the savings
associated with restructuring activities exceed the costs.  It is
questionable whether DOD can prepare such a report without using
contractor cost and savings data because DOD is not independently
collecting such data.  According to DOD officials, there are no plans
at this time to require contractors to submit data that would show
that actual savings exceed restructuring costs paid by DOD.  Without
such data, the Congress will have no assurance that its decision to
permit the payment of restructuring costs only in limited
circumstances is actually resulting in overall reduced costs to DOD. 


   DOD WOULD PAY RESTRUCTURING
   COSTS WITHOUT SIGNIFICANT
   PROJECTED SAVINGS
------------------------------------------------------------ Letter :5

In a July 1994 congressional hearing, the Deputy Secretary of Defense
testified that restructuring activities in the defense industry were
expected to result in significant benefits to DOD--with savings
exceeding costs by as much as 7 times.  The Deputy Secretary also
testified that DOD should not pay restructuring costs unless it was
absolutely sure that savings would exceed costs.  According to senior
DOD officials, DOD now plans to pay restructuring costs up to the
amount of the savings projected to result from the business
combination, thus resulting in the payment of these costs without
significant projected savings to DOD.  A senior DOD official said
that payments should be made to contractors even if overall reduced
costs do not result because such payments would encourage an orderly
downsizing in a defense industry that currently has excess capacity
and DOD would benefit in the long run. 


   RECOMMENDATIONS
------------------------------------------------------------ Letter :6

We recommend that the Secretary of Defense

  revise the regulations to make clear that all restructuring costs
     associated with a business combination, whether involving
     internal or external activities, are subject to section 818
     certification requirements and

  determine how DOD will comply with the annual congressional
     reporting requirement, and if contractor data is necessary for
     compliance, incorporate such data collection requirements in
     DOD's regulation. 


   AGENCY COMMENTS AND OUR
   EVALUATIONS
------------------------------------------------------------ Letter :7

In commenting on a draft of this report, DOD said that it would
revise the definitions of internal and external restructuring
activities to clarify that activities affecting the operations of
both previously separate companies are external activities.  DOD
concurred that it should have a workable plan for collecting data
required for the section 818 requirements and stated that it would
issue a memorandum to cognizant Defense Contract Management Command
and Military Department activities setting forth the methods for
complying.  (Subsequent to commenting on a draft of this report, DOD
issued the memorandum, which we have not reviewed for compliance with
section 818 requirements.)

A draft of this report contained a third recommendation that DOD
develop an implementation plan to comply with section 818's
requirement that restructuring costs be paid only if projected
savings from a business combination should result in overall reduced
cost to DOD.  In commenting on the draft report, DOD stated that it
has not seen and does not anticipate situations where costs exceed
savings and would not pay costs in excess of savings in the unlikely
event that costs were greater.  Accordingly, we deleted the
recommendation.  We will monitor restructuring payments and savings
in the future. 

DOD indicated that it did not agree with our statement that in 1993
DOD changed its long-standing practice of not paying restructuring
costs.  Although the FAR provides contracting officers with the
flexibility to negotiate appropriate terms on transferred contracts,
our observation that a change in practice occurred was based on
documents signed by senior DOD officials and interviews.  For
example, an April 9, 1993, letter from the Commander, Defense
Contract Management Command, stated that current standard language in
the FAR prevented any increased costs on transferred contracts and
suggested that a review of DOD policy in this area may be warranted. 
The Under Secretary of Defense for Acquisition's July 21, 1993,
response stated that restructuring costs should be allowed and the
standard language be revised if there were projected savings.  DOD
officials told us that increased costs had not been allowed on
transferred contracts before the July 1993 letter. 

DOD's comments are presented in their entirety in appendix I. 


   SCOPE AND METHODOLOGY
------------------------------------------------------------ Letter :8

We discussed various aspects of restructuring activities with
officials from the Offices of the Assistant Secretary of Defense for
Economic Security; the Director of Defense Procurement; the
Secretaries of the Army, the Air Force, and the Navy; the Cost
Accounting Standards Board; the Defense Contract Management Command;
the Defense Contract Audit Agency; and the DOD Inspector General. 

We compared other procurement laws, applicable regulations, and
section 818 and its legislative history to DOD's interim regulations
and examined various proposals, documents, reports, and other records
related to restructuring activities by defense contractors.  We also
examined comments by potentially affected parties as the interim
regulations were being formulated and after they were issued.  We
examined various documents, reports, and other records relative to
specific restructuring activities by several defense contractors.  In
addition, we visited a contractor involved in a business combination
and examined information related to restructuring projects resulting
from the combination. 

We performed our review between September 1994 and May 1995 in
accordance with generally accepted government auditing standards. 


---------------------------------------------------------- Letter :8.1

We are sending copies of this report to the Chairmen of the Senate
Committee on Governmental Affairs and the House Committee on
Government Reform and Oversight; the Secretaries of Defense, the
Army, the Air Force, and the Navy; the Administrator, Office of
Federal Procurement Policy; the Commander, Defense Contract
Management Command; and the Director, Defense Contract Audit Agency. 
We will provide copies to other interested parties upon request. 

Please contact me at (202) 512-4587 if you or your staff have any
questions concerning this report.  Major contributors to this report
are listed in appendix II. 

David E.  Cooper
Director, Acquisition Policy, Technology,
 and Competitiveness Issues




(See figure in printed edition.)Appendix I
COMMENTS FROM THE DEPARTMENT OF
DEFENSE
============================================================== Letter 

See p.  2. 



(See figure in printed edition.)

See p.  3. 



(See figure in printed edition.)

See p.  5. 



(See figure in printed edition.)

See p.  4. 



(See figure in printed edition.)

See p.  4. 

See p.  5. 

See p.  5. 


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix II

NATIONAL SECURITY AND
INTERNATIONAL AFFAIRS DIVISION,
WASHINGTON, D.C. 

John K.  Harper

OFFICE OF GENERAL COUNSEL,
WASHINGTON, D.C. 

William T.  Woods
Roger H.  Ayer

ATLANTA REGIONAL OFFICE

George C.  Burdette
Kelly A.  Davis