Key Issues for Due Diligence of Government Contracts – Part I

February 1, 2017

Comprehensive due diligence review of any target company is imperative when determining whether to buy another company. Layer on the fact that the target company has government contracts then several unique issues must also be critically evaluated when performing due diligence. Failure to do so could result in a significant loss in value of the target – and its contracts – after the acquisition has closed. What follows is a list of certain key issues that should be analyzed when engaging in due diligence review of a government contractor.

1.    Set-Aside Contracts. One of the first questions to ask when reviewing government contracts to be acquired is whether any of the target company’s contracts are set aside for a small business (determined by the applicable NAICS code for the procurement) or set aside under the socioeconomic set-aside programs of the U.S. Small Business Administration (SBA). If this is the case, the next question to evaluate is what impact the acquisition will have on the contract holder’s eligibility to continue to meet the requisite set aside-qualifications. Will the target company no longer be small or no longer be qualified for the socioeconomic set-aside program as a result of the acquisition?   If the target company is no longer small after it is acquired because the buyer is a large business or due to other affiliation issues, this alone may not be fatal to performance of the contract. The contract will not automatically terminate if the contract holder is no longer small but the government agency can no longer take credit for the set-aside contract towards its small business goals. This is an important consideration for a buyer to take into consideration when valuing a target company and its contracts.

2.    Pending Proposals. Another government contracts issue that must be evaluated during the due diligence process is whether there are any proposals that have been submitted prior to closing which may not be awarded until after the acquisition has closed. What happens in such a case where there is a change of ownership during consideration of a pending proposal?  Changes to the SBA’s rules that went into effect last summer impose new recertification requirements of firms that have proposals pending at the time of acquisition. 

3.    Security Clearances. Another important issue to be considered during due diligence review of government contracts is whether the contracts involve any classified information requiring certain security clearances. If the government contracts at issue involve classified information, the target company has a facility clearance to perform the work. If security clearances are required to perform the contracts and the acquiring company does not have that same level of clearance or higher, notification to the DSS as required under the NISPOM should begin as soon as a determination is made to move forward with the transaction. Obtaining the necessary clearances can create serious delays in closing in a timely manner.

4.    Import/Export Issues. If the target company exports items related to defense or national security then it must comply with the International Traffic in Arms regulations (“ITAR”) administered by the U.S. Department of State. The other export-import regime in the United States is administered by the Department of Commerce and governs dual-use items that have both commercial and military functions under the Export Administration Regulations (“EAR”). If subject to ITAR and EAR, post-closing change of ownership notifications and registrations must be carefully observed and completed.

5.    OCI Issues. If the buyer and the target company perform services in the same industry, it is critical to take an in-depth look to determine whether there could be an organizational conflict of interest issue. There could be a conflict for the buyer presented by the acquisition of certain government contracts that will prevent it from being able to perform a particular contract without mitigation measure being put in place.

6.     Subcontracts, Teaming Agreements, and Joint Ventures. From a government contracts perspective, it is important to review all other agreements – in addition to awarded contracts – such as subcontracts, teaming agreements, and any joint venture agreements. Special attention should be paid to the assignment and change of ownership provisions of these agreements to determine whether the sale of the target company will trigger any notification or consent requirements.

7.    Non-US Buyer. An international buyer is considered a company under foreign ownership, control or influence (“FOCI”). This presents a regulatory snag when purchasing a contractor with an FCL (see discussion above under paragraph 3 regarding security clearances). Companies under FOCI cannot hold an FCL unless FOCI is negated or mitigated to the satisfaction of the CSA. While part of the value of the target is attributable to holding and performing classified contracts, in order to capture that value the cost and time for accomplishment of the foregoing regulatory procedures must be factored into the analysis. If the buyer is a non-U.S. company, then at the same time the parties engage in an analysis of the issues described above relating to classified work, consideration of the national security impact should also begin. The U.S. government through the Executive Branch has the authority to review all mergers, acquisitions, and takeovers that could result in foreign control of persons engaged in interstate commerce under the authority of the Exon-Florio Amendment. Exon-Florio provides for the review of these transactions by the President to be initiated through notice to the Committee on Foreign Investment in the United States (“CFIUS”). CFIUS review involves statutory time periods that can significantly impact and delay closing.

8.    Novation. If a transaction is structured as the sale of substantially all of the assets of the target company or as a certain type of merger transaction, novation of the contracts will be required under FAR Subpart 42.12.  Provisions in the purchase agreement to accommodate the period necessary to obtain novation approval should also be considered.

The foregoing is a list of issues that should be considered when performing due diligence review of government contracts of a target company in any M&A transaction. Careful evaluation and consideration of the foregoing issues will help better capture the value of the subject government contracts and avoid serious, unexpected problems post closing.

About the Author:  Kimi Murakami is counsel with PilieroMazza and focuses her practice on corporate transactions with an emphasis on mergers and acquisitions of government contractors. She also has experience advising on intellectual property matters including trademarks and trade secrets. She can be reached at kmurakami@pilieromazza.com.

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