Contractors Should Rethink Their Cost Accounting Practices After the Federal Circuit's Latest Raytheon Decision
In a decision that threatens to further upend the settled accounting practices of many government contractors, the United States Court of Appeals for the Federal Circuit held recently that Raytheon Co. charged unallowable indirect lobbying and corporate development costs to the Department of Defense (DoD) in violation of cost principles in Federal Acquisition Regulation (FAR) Subpart 31.2. The decision, Secretary of Defense v. Raytheon Company, Raytheon Missile Systems, No. 2021-2304 (Fed. Cir. Jan. 3, 2023), overturned an Armed Services Board of Contract Appeals (ASBCA or Board) opinion in which the Board found that the government had not met its "high" burden of showing that Raytheon's costs were "expressly unallowable" and thus subject to penalties. In so holding, the Raytheon decision not only requires contractors to rethink their internal policies on lobbying and corporate development costs, but also invites government second-guessing of numerous other cost categories and may expose contractors to penalties for even reasonable cost accounting practices.
Under cost-reimbursement contracts, like those at issue in Raytheon, the government only pays the contractor's allowable and allocable direct and indirect costs. See 48 C.F.R. § 52.216-7. FAR Subpart 31.2 makes various types of cost generally unallowable, though only some of those costs are considered "expressly unallowable," i.e., "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." See 48 C.F.R. § 31.001. Contractors who include expressly unallowable costs in an indirect-cost rate proposal are subject to penalties. See 10 U.S.C. § 2324(b) (2020); 41 U.S.C. § 4303(b).
In the Raytheon case, DoD claimed that Raytheon included expressly unallowable salary costs associated with lobbying and corporate organization activities in the company's final indirect-cost proposals for 2007 and 2008. These salary costs arose from the activities of Raytheon's Government Relations and Corporate Development departments.
As to the first category of challenged cost, employees in Raytheon's Government Relations department performed both lobbying and non-lobbying activities, e.g., information gathering, meeting with congresspeople and internal Raytheon customers, administering the company's political action committee (PAC), and responding to requests from congressional staffers. These personnel were salaried employees and regularly engaged in lobbying activities during the 40-hour work week (8 a.m. to 5 p.m., Monday through Friday), as well as before and after regular work hours and on weekends. During the relevant time period, Raytheon policy instructed Government Relations employees to record "all compensated time spent on lobbying activities," i.e., lobbying performed within the 40-hour work week. Raytheon then identified and withdrew the costs associated with that time from the company's incurred-cost submissions. Raytheon personnel were not expected, however, to record uncompensated time spent on lobbying activities outside of normal working hours.
As to the second category of cost, Raytheon employees in the Corporate Development department supported the company's strategic development and growth activities, including corporate acquisitions and divestures. Raytheon policy instructed these employees to record their time only after the company decided to pursue a corporate acquisition or divestiture, but not when engaging in pre-decision research or strategic planning. Raytheon's incurred-cost submissions did not include any salary costs associated with corporate development time that was recorded after making the decision to pursue a transaction.
Under FAR 31.205-22 "lobbying and political activity costs" include "[c]osts associated with . . . [a]ttempts to influence the outcomes of" elections, referenda, initiatives, or the introduction, enactment, or modification of legislation." By its terms, FAR 31.205-22 provides that many (but not all) costs "associated with" lobbying activities are "unallowable." 48 C.F.R. § 31.205-22(a)-(b). Similarly, FAR 31.205-27 makes certain corporate "organization or reorganization" costs unallowable, including those incurred "in connection with . . . planning or executing . . . mergers and acquisitions." See 48 C.F.R. § 31.205-27. Salaries paid to employees who engage in lobbying and organization activities are not identified as unallowable costs in either of the relevant FAR provisions.1
The ASBCA's Decision
In an audit of Raytheon's 2007 and 2008 incurred-cost submissions, the Defense Contract Audit Agency (DCAA) challenged the relevant salary costs on the basis that the company's time-recording policies were contrary to FAR 31.205-22 (Lobbying and Political Activity Costs) and FAR 31.205-27 (Organization Costs). DoD demanded that Raytheon repay the salary costs and assessed penalties for allegedly charging expressly unallowable costs. Raytheon appealed the government's claim to the ASBCA, which held that the salary costs were not expressly unallowable because, in its view, Raytheon's policies reasonably interpreted the controlling FAR cost principles and did not result in increased costs to the government. See Appeals of Raytheon Co., ASBCA No. 59435, 21-1 B.C.A. ¶ 37,796 (Feb. 1, 2021).
As to the lobbying-related costs, the ASBCA found Raytheon's employees were well trained on the FAR's lobbying reporting requirement. It also found that Raytheon's practice of recording only paid lobbying time was consistent with FAR 31.205-22 because employees were compensated based on a 40-hour work week and thus the government was not charged for lobbying activities outside of normal hours, even though such activities were part of the employees' regular duties. In this regard, the ASBCA noted that, while such off-the-clock lobbying "logically" would also be factored into the employees' salaries, the government failed to introduce evidence on this point. In contrast, Raytheon demonstrated through testimony that its practice of excluding after-hours lobbying costs was consistent with the company's Cost Accounting Standards (CAS) disclosure statement and industry practice.
Similarly, the Board held that the government did not show the organization costs were expressly unallowable under FAR 31.205-27. Instead, the ASBCA found that Raytheon's policy of recording corporate development time only after the company had decided to pursue a transaction was a "permissible articulation of the line between allowable economic- or market-planning costs…and unallowable organization costs," not an expressly unauthorized approach that should be subject to penalties.
The Federal Circuit's Decision
On appeal to the Federal Circuit, DoD argued that Raytheon's accounting practices violated FAR 31.205-22 and FAR 31.205-27. The Federal Circuit agreed, holding that: (1) Raytheon's time-paid accounting practice necessarily charged the government for expressly unallowable costs because Raytheon employees regularly engaged in after-hours lobbying and thus the salaries paid to those employees must have included compensation for lobbying activities in violation of FAR 31.205-22; and (2) Raytheon's "bright-line" policy on organization costs was "plainly inconsistent" with FAR 31.205-27 because, according to the Court, the portion of salaries paid for pre-planning activities is expressly unallowable because such activities are an essential part of every corporate transaction.
With respect to the salary costs associated with off-the-clock lobbying, the Court first seized on a footnote in the ASBCA's decision in which the Board recognized that, "logically," "night and weekend [lobbying] work would be factored into the salary paid to lobbyists." It then cited the definition of "salary," which the Court characterized as encompassing compensation for work performed, "regardless of when." From this, the Court reasoned that Raytheon's time-paid policy "necessarily compensated" the company's in-house lobbyists for time spent lobbying after regular hours, even though the ASBCA found the government had presented no testimony to carry its burden on this point.
The Court went on to claim that FAR 31.201-6(e)(2) "confirms" its interpretation, relying on an uncontextualized excerpt from that provision to conclude that salary costs should be considered expressly unallowable to the extent they are "directly associated" with "proscribed activity," such as lobbying. The Court then declared its own incomplete recitation of FAR 31.201-6(e)(2) to be "instructive," despite conceding that the provision is not "directly applicable" to matters of cost allowability. Compounding this error, the Court also ignored other parts of FAR 31.201-6, which instruct that salary costs should be treated as directly associated, unallowable costs only if they are material in amount, a finding that neither the ASBCA, nor the Court, made in Raytheon. See FAR 31.201-6(d), (e)(1) and (e)(3).
Next, the Court rejected Raytheon's argument that salaried employees are not entitled to compensation for work performed outside normal business hours under the Fair Labor Standards Act (FLSA), speculating — without evidence — that Raytheon's in-house lobbyists "could have" worked less during those hours to offset time spent working earlier or later in the day or on weekends. Then, in a roundabout twist of logic, the Court justified its speculation on this factual point in a footnote by observing that no after-hours time records were generated under Raytheon's policy. Yet this finding only begs the question as to how the Court could find that the government met its burden of proving the salary costs were expressly unallowable. Finally, despite testimony that Raytheon's policies aligned with the cost accounting practices it had disclosed to the government, the Court found no "substantial evidence" that the government had consented to Raytheon's practices because the company's CAS disclosure statements were not in evidence.
The Federal Circuit also agreed with DoD that Raytheon's corporate development policies resulted in the company charging expressly unallowable costs. On this point, Raytheon argued that its written policies adequately reflected a reasonable distinction, in the face of ambiguity in the FAR, between general corporate planning activities and activities undertaken for a specific acquisition or divesture. The ASBCA agreed with this position, but the Court did not, finding that: (1) every decision to pursue a corporate transaction necessarily involves some preliminary planning and thus Raytheon's policy drew an unreasonable bright-line; (2) there is no overlap between allowable economic-planning costs on one hand and unallowable organization-costs on the other, such that creating a policy to capture that distinction was not impossible; and (3) any difficulty drawing a line between such allowable and unallowable costs did not excuse Raytheon's decision to establish policies that violated FAR 31.205-27.
The Court reversed and remanded the case to the Board to determine the amount of unallowable costs improperly charged to the government.
- Whose Burden is it Anyway? Despite the settled principle that the government has a "high" burden of proving that a contractor's costs are expressly unallowable, the Raytheon decision seemingly shifts that burden to contractors. Throughout its opinion, the Federal Circuit's analysis springs from the flawed premise that all salaries are structured in the same way and that the contractor (Raytheon) had not presented enough evidence to prove that its salary costs were not expressly unallowable. This approach improperly shifted the government's burden of proof to Raytheon on a matter in which it is the government that seeks not only to recover amounts it previously paid, but also to punish the contractor for its alleged wrongdoing through the assessment of penalties.
- Contractor Cost Accounting Practices. With respect to both the government relations costs and corporate development costs, the Court rejected the policies instituted by Raytheon as an exercise of good-faith, business judgment — policies that the Board had previously determined to represent a "reasonable reading" of the relevant FAR provisions. So where does that leave contractors? A reasonable conclusion is that all salaried contractor employees will now be required to record all their work time and document all their daily work activities to ensure that the costs associated with their compensation are not later deemed unallowable for a lack of evidence. This new dynamic almost certainly will result in increased costs (e.g., for new systems, training, administrative personnel) that will be passed on as an allowable cost to the government and ultimately the American taxpayer. That is probably not the outcome the Federal Circuit intended for the federal procurement system, though it is nonetheless the outcome created.
- Practical Implications. Implementing new time and record-keeping systems could be extremely onerous and expensive. For example, with respect to the corporate development costs at issue in Raytheon, it appears that contractors may no longer rely solely on standardized rules to logically segregate unallowable costs based on objective milestones in the lifecycle of a corporate transaction (e.g., a board resolution or vote to pursue an acquisition or divestiture). Instead, salaried contractor employees may need to track all of their time and then accounting personnel will have to make subjective judgments about when each salaried employee stopped general corporate planning activities and started transaction-specific planning. As the Federal Circuit observed, such judgments "can sometimes be difficult" (to put it lightly) and there is no shortage of questions for cost-reimbursement contractors to address in the wake of the Raytheon case. Should contractors review and revise all their cost accounting practices, or should they focus solely on the policies addressing lobbying and organizations costs? Must all salaried employees track all their work time and activities? Should time be recorded in hourly increments, fractions of an hour, or minute-by-minute? What level of detail is required for time entries by salaried employees? Should contractors invest in new time-keeping systems and are those cost recoverable from the government?
All told, Raytheon has the potential to disrupt the established cost accounting practices of many entities doing business with the federal government and, at the very least, contractors should review their cost accounting and timekeeping policies. If you have any questions about the Raytheon decision or properly accounting for costs, please contact one of the Miller & Chevalier attorneys listed below:
1In a related 2019 decision also involving Raytheon, the Federal Circuit held that the salaries of Raytheon in-house lobbyists were expressly unallowable — even though FAR 31.205-22 does not "specifically name" salaries — because the Court found that such costs are of a "type" contemplated as unallowable. See Raytheon Co. v. Sec'y of Def., 940 F.3d 1310, 1314 (Fed. Cir. 2019) (interpreting FAR 31.001 and FAR 31.205-22). The Court appears to have carried this approach forward in the most recent Raytheon case, finding — without discussion — that salary costs "associated with" lobbying activities and salary costs incurred "in connection with" organization activities are expressly unallowable, not just unallowable. See Raytheon, No. 2021-2304 at 7-11. This interpretation further blurs the line between unallowable and expressly unallowable costs and potentially exposes contractors to penalties for virtually any "type of cost" that relates to an expressly unallowable cost. Compare id., with FAR 31.201-6 (requiring that indirect costs "directly associated" with expressly unallowable costs must be removed from cost pools only if such costs are "material in amount").
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