By: Elizabeth Ferrell, Partner, McKenna Long & Aldridge LLP, Thomas Lemmer, Partner, McKenna Long & Aldridge LLP, and Tyson Bareis, Associate, McKenna Long & Aldridge LLP
With the recent shutdown caused by failure to enact a Continuing Resolution funding the government for the start of FY2014, contractors are understandably wary of Congress’ ability to reach an agreement on raising the debt ceiling. If the debt ceiling is not raised, and the US Treasury cannot meet all of the United States’ financial obligations when they become due, government contractors are likely to be among those adversely affected. This Client Alert focuses on what could happen if the Government does not raise the debt ceiling and how contractors can prepare for this possible circumstance.
The Federal Debt Ceiling
The national debt is the total amount of money borrowed by the Government to fulfill the financial obligations imposed by past Congresses and past Administrations. A statutory debt limit (presently codified at 31 USC 3101) has restricted the total federal debt since 1917. Most recently, the federal debt ceiling has been raised to $16.699 trillion (Pub. L. 113-3 (February 4, 2013)). In the history of the United States, Congress has never failed to raise the debt limit when necessary. As a result of various fiscal measures implemented by Treasury Secretary Jacob J. Lew, Treasury’s ability to meet all US financial obligations will continue through October 17, 2013.
The ability to borrow and issue new debt instruments is central to the Treasury Department’s cash management systems and ability to handle the daily fluctuations between revenue flowing into the Treasury and outlays from it. When the debt limit is reached, Treasury’s borrowing authority ends, so the Department cannot issue new debt to manage cash flow or to pay interest on the federal deficit. As a result, the Government cannot pay its bills or invest surpluses which may accumulate in various trust funds as required by law.
A Government default on financial obligations resulting from a failure to raise the debt ceiling is different from a Government shutdown that results from the failure of Congress to pass appropriations legislation. A shutdown occurs because the Government may not incur new financial obligations in the absence of appropriations without violating the Anti-Deficiency Act. A default means that the Government cannot pay financial obligations that have already been incurred. Raising the debt ceiling is not about the availability of funds; it is about managing cash flow.
If the debt ceiling is not raised and default occurs, the Department of the Treasury will prioritize and decide which outstanding financial obligations are paid and in what order. The Treasury Department has no legal requirement to pay obligations in the order in which they were received and may choose to make payments “in any order it finds will best serve the interests of the United States.” Comp. Gen. B-138524 (Oct. 9, 1985). Most experts believe that in this event, Treasury will use available funds to first pay interest on outstanding debt and entitlement obligations, although Secretary Lew has not said what he will do and has cautioned that “any plan to prioritize some payments over others is simply default by another name.”
Impact on Government Contractors
If the Treasury lacks funds to meet all the United States’ financial commitments, it is likely that some payments to government contractors will be delayed or deferred, including payments for invoices for work that has been completed or for delivered goods, progress payments, contract financing payments, and other payments, such as those for lease or settlement agreements. Contractors should anticipate a disruption in cash flow.
It is important to note that the failure to raise the debt ceiling does not affect the ability of the Government to obligate funds for a contract so long as sufficient appropriations exist. Generally, contractors should continue to perform within the limits of obligated funding, with the expectation that payment will be delayed. Under the standard Limitation of Funds, Limitation of Costs and Limitation of Government Obligation clauses (FAR 52.232-20-22), the Government is not required to pay more than the funded amount, and the contractor is not obligated to incur costs or continue performance in excess of funding.
In certain circumstances, the Government’s failure to pay can amount to a material breach of contract which would entitle the contractor to stop work. Whether or not a contractor has a duty to proceed with performance under the contract or may stop work upon a material breach by the Government often depends upon which of two alternative disputes clauses is in the contract. SeeFAR 52.233-1; 52.233-1, Alt. 1. Any decision to stop work for nonpayment by the Government should only be undertaken after close review of the materiality of the breach and the pertinent FAR clauses in the contract. Contractors should expect that the Government will challenge any decision to stop work and may decide that a termination for default is appropriate. It is important to note that in extreme cases, inadequate or late payments may put a contractor in a position in which it simply cannot continue performance. In such circumstances, a default may be excused if the contractor can show a nexus between the failure to perform and the Government’s failure to pay.
The good news is that contractors may be entitled to interest for delayed payments under the Prompt Payment Act (Pub. L. 97-177; FAR Subpart 32.9; 5 CFR 1315)(“PPA”). The PPA applies to invoice payments so long as contract performance is satisfactory, and the invoice contains certain required information. The PPA does not apply to contract financing payments. If payment is late, FAR 32.907(f) specifically provides that “[t]he temporary unavailability of funds to make timely payment does not relieve an agency from the obligation to pay interest penalties.” The PPA interest rate is set by the Treasury Department, and the current rate is 1.75 percent per annum (78 Fed. Reg. 38811, 39063 (June 28, 2013)) .
A prime contractor’s obligation to pay subcontractors depends on the terms of the subcontract. In the case of a Government default in making payment, it is important for contractors to determine whether the subcontract contains a “pay-when-paid” clause and whether subcontractors may stop work in the absence of payment. Contractors may also have to consider whether the ability of small subcontractors to continue to perform may be jeopardized by cash flow disruption and whether to finance continued performance until payments resume.
In anticipation of delayed contract payments resulting from a failure to raise the debt ceiling, it is most important for contractors to take stock of existing contracts: Contractors should begin to assess the status of invoicing and contract payments. Contractors also should analyze their prime contract disputes clauses. Contractors should expect disruption of cash flow and begin now to dialogue with contracting officers and subcontractors to ensure the fewest adverse impacts from contract payment delays.