Saturday, February 25, 2012

Identifying Procurement Contract Risk

This case study’s thesis is that “the Defense Supply Center Columbus (DSCC) was justified in terminating for default an indefinite-delivery purchase order (IDPO) contract at a firm fixed price (FFP) when New Era Contract Sales (New Era) failed to supply coupling tubes as required by a June 29, 2006, delivery order.

Contract performance. 
When New Era, a government contractor, made delivery on a July 6, 2004, IDPO received from DSCC for coupling tubes, a contract was formed.  The contract obligated New Era to supply parts for two years at a firm fixed price.  New Era’s pricing to DSCC was based on a two-year quote from its supplier, Harrison.  New Era’s contract with DSCC contained a standard supply contract default clause but no price adjustment clause.

When New Era received DSCC’s second IDPO on June 30, 2006, it found that Harrison had been sold and its new owner would not honor the original price quote.  On July 5, 2006, New Era asked DSCC to cancel its contract with no liability for either party because its supplier refused to honor the quoted pricing due to an increase in material costs.  When DSCC refused, New Era asked to negotiate a new price based on a new supplier’s higher price quote.  DSCC again refused and terminated the contract for default when New Era did not fill the order.  New Era appealed the decision to the Armed Services Board of Contract Appeals (ASBCA) based on the provisions of the default clause, Federal Acquisition Regulation (FAR) 52.249-8.
FAR 52.249-8.   
The clause stated DSCC’s default contract rights but provided an exception for contractor liability if the following occurred: “If the failure to perform is caused by the default of a subcontractor at any tier, and if the cause of the default is beyond the control of both the Contractor and subcontractor, and without the fault or negligence of either . . . .unless the subcontracted supplies or services were obtainable from other sources in sufficient time for the Contractor to meet the required delivery schedule.”

New Era’s opposing view of the thesis. 
New Era believes that its nonperformance is excusable under FAR 52.249-8.  The refusal of its subcontractor’s new owner to honor the original price quoted to New Era was “beyond its [New Era’s] control and without its fault or negligence.”  Similarly, the subcontractor’s refusal to perform was also “beyond its [the subcontractor’s] control and without its fault or negligence” because Harrison had quoted an unusually low price two years ago and because the present cost of titanium had increased dramatically.  As a result, New Era’s subcontractor would have only been able to supply product from its distributor at a cost/unit of more than three times the original contract price.  New Era states that as a small business owner, it could not absorb the resulting $23,904.66 loss.

New Era also asserts that it had taken “all reasonable action” to perform the contract by looking for alternative sources from which to obtain the product in time to meet the contract delivery date.  However, since none of these alternative suppliers carried stock of the needed item and produced only on an “as-needed basis,” this option would not have enabled New Era to deliver in a timely manner.  Although DSCC offered to extend the delivery date in exchange for a $510.18 contract price reduction, New Era believed it should not have had to incur this extra cost because DSCC did not respond for eight months to New Era’s request to cancel the contract without liability because it could not perform.

Because these unforeseen circumstances regarding pricing and product availability were beyond its control, New Era asserts that it was not negligent in its nonperformance of DSCC’s June 29, 2006, order and should be discharged without liability from its contract with DSCC. 

DSCC’s supporting view of the thesis. 
New Era entered into a binding IDPO contact when it fulfilled DSCC’s July 6, 2004 delivery order, obligating itself to honor the offered prices for two years.  As the FFP contract contained no price adjustment clause, New Era accepted the risk of increased prices from its subcontractor.  Thus, New Era’s claim that a price increase was beyond both it and its subcontractor’s control was not a basis on which to abandon performance under the contract’s default clause.  New Era and its subcontractor did not take “all reasonable action” to perform because they could have provided the ordered parts, even though at a loss.

DSCC seeks affirmation from ASBCA of its decision to terminate New Era’s contract for default and to recover costs from having to reprocure from a new source.  The Board found New Era in default of the contract and affirmed DSCC’s actions and request for reimbursement for additional procurement costs.  The Board stated that renegotiating a contract because of a supplier’s price increase would defeat the purpose of a firm-fixed-price contract, which was to protect DSCC from price variations.  It also noted that DSCC had grounds for termination when New Era notified it on July 5, 2006, that it could not make delivery on DSCC’s second order. 

Lessons for contract managers include the importance of protecting against contract risk and of making contingency plans.  New Era should have taken the time to understand the contract terms, particularly the implications of filling the first order of an IDPO contract at a FFP, as well as the consequences of default and the lack of a price escalation clause.   It should have also locked its supplier into a contractual agreement as to pricing and the subcontractor’s liability for default, instead of depending solely upon a price quote.  New Era would have ultimately been better off had it performed the contract at a loss and then brought suit against its supplier.  Good advice for contract managers would be to expect the best but plan for the worse, and when in doubt, seek legal advice quickly before a problem escalates.

Copyright 2012 James L. Alyea. All Rights Reserved.

Case Study Reference:
“IDENTIFYING CONTRACT RISK AND CONTINGENCY PLANNING” by Jack Horan, Contract Management, Aug., 2009. Retrieved from