Transactions that involve government contracts carry a unique set of challenges. Unlike a typical merger or acquisition, deals involving government contracts require the navigation of a complex web of federal laws, regulations, security requirements, and procurement nuances that substantially impact valuation, integration, and post-closing operations. As such, in the due diligence process, it is imperative to conduct tailored due diligence to identify red flags and key value drivers that could impact the proposed transaction and reduce the risk of post-closing litigation. In this fourth installment of PilieroMazza’s blog series, “Managing Litigation Risk During the Business Lifecycle,” we explore the key areas of focus when conducting due diligence on a government contractor target. Visit this link to access Parts 1-3 in this blog series.
A. Understanding the Target’s Government Contracts Portfolio
Before diving into the data room, the acquiring company should have a high-level understanding of the target’s contract portfolio to ensure that they are approaching due diligence through the appropriate lens. In preparing an initial due diligence request list, the acquiring company should ask questions that help them understand the target’s contract base. While typical transactional due diligence considerations remain central to the due diligence process (i.e., focusing on the largest revenue-generating contracts, looking out for material provisions like assignment/change of control and restrictions on termination, etc.), there are certain questions that are particularly unique to government contracts. These questions include, but are not limited to, the following:
1. Types of Contracts: Are the contracts cost-plus, fixed price, or time and materials?
2. Special Designations: Does the target company have any special designations (i.e., 8(a), Service-Disabled Veteran-Owned Small Businesses (SDVOSB), Women-Owned Small Businesses (WOSB), Historically Underutilized Business Zone (HUBZone), etc.)?
3. Contract Relationships: Does the target act as the prime contractor or subcontractor?
4. Audits: Is the target company subject to any audits, particularly audits through the Defense Contract Audit Agency (which may have stricter requirements)?
5. Performance Assessment: Has the target company received any evaluations through the Contractor Performance Reporting System? If so, what was the customer’s satisfaction level with respect to the target company’s performance?
6. Performance Issues: Are there any active protests, terminations for default, claims, or requests for equitable adjustment that may impact revenue continuity or result in post-closing liabilities?
B. Regulatory, Compliance, and Security Considerations
Once the acquiring company has a solid grasp on the overall landscape of the target company, a second layer to the due diligence of government contracts involves understanding the target company’s compliance posture. Federal Acquisition Regulations (FAR) and agency-specific rules (e.g., Defense Federal Acquisition Regulations (DFARS) could affect nearly every aspect of a target company’s operations. As a result, the acquiring company should focus its due diligence on certain key risk areas that may impact the target company’s operations, such as misclassification under small business programs (i.e., 8(a), SDVOSB, WOSB, HUBZone, etc.), noncompliance with Cost Accounting Standards, and potential exposure under the False Claims Act.
Given the high level of regulation in the governmental sector, a robust regulatory diligence workstream is critical. At a minimum, the acquiring company should review:
1. FAR/DFARS compliance policies and internal controls;
2. Participation in any set-aside programs (e., 8(a), SDVOSB, WOSB, HUBZone, etc.) and current size status; and
3. Risks under the False Claims Act (e., whistleblower complaints and internal investigations).
If the target company holds classified contracts or processes Controlled Unclassified Information, the acquiring company should make it a point to review the target company’s security clearances, such as Facility Security Clearances and Personnel Security Clearances. The acquiring company should also confirm the extent to which the target company has robust cybersecurity systems and procedures in place. Noncompliance with security processes – especially those outlined in NIST SP 800-171 and the Cybersecurity Maturity Model Certification – can be deal-breaking, particularly for defense or intelligence sector targets. Furthermore, the acquiring company should assess whether there are any cross-border issues, such as if the target is foreign-owned or maintains any contracts with foreign entities or governments, as this may trigger mitigation under Foreign Ownership, Control, or Influence, the need to engage with the Defense Counterintelligence and Security Agency, or review by the Committee on Foreign Investment in the United States (CFIUS), particularly where classified contracts or export-controlled technologies are involved.
The acquiring company should also consider any intellectual property or data rights that the target entity possesses. If these rights are tied to any government contracts, this could potentially limit future commercialization or create certain barriers to exit. Specifically, the acquiring company should confirm (1) which rights, if any, the governmental entities that are parties to the respective government contracts have received, such as unlimited rights, government purpose rights, or restricted or limited access and (2) whether proprietary assets are adequately protected.
C. Post-Closing Integration
Even in the due diligence phase, the acquiring company should be actively thinking about post-closing mechanics and plan for integration with a mindset towards government contracts. For example, certain government contracts may require recertification of special designations (i.e., 8(a), SDVOSB, WOSB, HUBZone, etc.). Additionally, many government contracts cannot be assigned without a novation agreement under FAR Section 42.1204, or by obtaining certain consents or notices in advance of the closing date. The novation process can take months, meaning that there could potentially be a gap between closing and when the acquiring company can officially assume the obligations under the government contracts. By anticipating these issues, the acquiring company can plan around any novation risks and avoid cash flow or performance disruptions following the integration.
The acquisition of an entity that handles government contracts can also trigger certain Organizational Conflicts of Interest (OCI) under FAR Subpart 9.5, particularly if the acquiring company works in an adjacent or overlapping area of a federal program. An OCI could disqualify the combined entity from future work, unless properly mitigated through firewalls, divestitures, or teaming arrangements.
Post-closing performance and integration could be impacted by the retention of cleared personnel and other staff designated as “key personnel” under existing contracts. If those individuals leave, or if the acquiring company cannot maintain required staffing levels (especially in highly cleared environments, such as defense), performance can suffer, and contract obligations may be breached. As such, the acquiring company should negotiate appropriate retention packages, transition plans, and knowledge transfer processes to mitigate these risks.
Finally, CFIUS could play a gatekeeping role in transactions that involve foreign buyers. If the target company handles sensitive personal data, export-controlled technologies, or operates in sectors that pose certain national security issues (i.e., aerospace, defense, energy, etc.), CFIUS filings may be mandatory. Such CFIUS reviews and filings can delay closing or impose ongoing compliance requirements, such as mitigation agreements or carve-outs for sensitive operations, so it is important for the acquiring company to keep this on their radar as they work through due diligence.
D. Conclusion
Transactions involving government contracts offer significant potential, but the acquiring company should tread lightly, as these transactions require a careful, informed approach. Unlike a typical merger or acquisition, these deals hinge on compliance, clearances, audits, and approvals from agencies that are not necessarily focused on facilitating expedited closings. As such, due diligence of government contracts is far more than a “box-checking” exercise – it is the front line of litigation risk management. Many post-closing disputes and investigations arise not from bad faith but from gaps in understanding government contracting obligations and compliance requirements. By focusing on due diligence on three related but distinct areas – contract viability, regulatory compliance, and integration feasibility – the acquiring company can lower litigation risks and appropriately tailor the proposed deal structure.
If you have any questions regarding acquiring a business and the associated litigation risks, PilieroMazza attorneys are here to assist you. Please contact Cy Alba, Abby Baker, Tim Valley, Ashley Krause, or another member of the Firm’s Mergers & Acquisitions, Government Contracts, or Litigation & Dispute Resolution practice groups.
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If you’re seeking practical insights to gain a competitive edge by understanding the government’s compliance requirements, tune into PilieroMazza’s podcasts: GovCon Live!, Clocking in with PilieroMazza, and Ex Rel. Radio.
