Partial Termination for Convenience Versus Deductive Change

Partial "T4C" Versus Deductive Change: The Amount of the Decrease Is Not Always the Same by Jerome S. Gabig, Jr.

     With large reductions forthcoming in the Department of Defense (DOD) budget, work inevitably will be deleted from many existing contracts. Customarily there are two clauses in federal procurement con­tracts that permit the government to unilat­erally reduce some of a contractor's perfor­mance obligations.1 Depending on the facts, it is possible that the reduction could be processed under either the Termination for Convenience (T4C) of the Government clause or the Changes clause. The dollar amount of the price reduction, however, is calculated differently depending on whether the decrease is treated as a partial termina­tion for convenience or a deductive change. No hard and fast line emerges from the case law that addresses which clause is appropri­ate for reduction in work. 2 This article fo­cuses on the advantages and disadvantages of each clause. 3 Under some circumstances, one clause can be more financially advan­tageous than the other.

Which Clause Applies?

      On one extreme, major reductions clearly fall under the T4C clause. Generally, "a re­duction of the number of units or supplies to be delivered, elimination of identifiable items of work, reduction in the quantity of work required under the contract, or similar reductions in contract tasks" are considered major deductions.4 For example, the dele­tion of 20 percent of the total work on a construction contract has been held to be a major reduction. 5 On the other extreme, mi­nor reductions fall under the Changes clause. Generally, minor reductions are "changes in the specifications or in the scope of work which cause a decrease in the cost of or time required for performance of any part of the contract work."6 Illustrative of work that was properly deleted under the Changes clause was a 12 percent reduction in the number of insulation blankets that a contractor was obligated to install on water heaters for a military housing complex. 7

     Despite this guidance, it can be difficult to distinguish which clause is appropriate because "factual situations do not always demand the exclusive use of either the ter­mination for convenience or the changes clause to the exclusion of the other."8 Hence, where the reductions are neither major nor minor, there is leeway to use either a partial termination for convenience or a deductive change. This leeway is augmented by uncer­tainty involving the scope of the Changes clause. For fixed-price supply contracts, the clause authorizes changes "within the gen­eral scope of this contract . . . [to] drawings, designs, or specifications when the supplies to be furnished are to be specifically manu­factured for the government in accordance with the drawings , designs, or specifica­tions."9 Sometimes the decision whether the Changes clause applies depends on whether the reduced work was a "specification." Generally, specifications are the written description of the work to be done (i.e., the contract requirements). 10 Often there is un­certainty whether the deleted work was part of the specification or a revision to the con­tract quantity. For instance, the Housing and Urban Development Board of Contract Appeals (HUD BCA) has broadly inter­preted the term "specification" to include the number of mobile home units to be de­livered under a contract. 11

     In contrast to the HUD BCA, the Gen­eral Services Board of Contract Appeals (GSBCA) took a strict interpretation of the term "specification" regarding a lease of a mainframe computer, software, training, maintenance, and support services. The agreement also required the contractor to provide the government access to the con­tractor's test facility for 1,936 hours at "no charge." Hours in excess of 1,936 were to be charged at a rate of $325 an hour. After using only 1,588 hours, the government uni­laterally issued a deductive change of $113,000 for the unused 348 hours. Because the reduction in hours did not alter the spec­ifications for the computer system, the re­duction was determined not to fall within the changes clause for a supply contract. 12 As indicated by these two divergent exam­ples, whether a tribunal will strictly or broadly construe the term "specifications" is uncertain. This uncertainty contributes to the confusion whether the Changes clause or the T4C clause should apply.

     If the deleted work is neither major nor minor, a board or court may defer to how the parties contemporaneously treated the deleted work. Hence, if the parties initially approached the reduction as a deductive change, a tribunal is likely to price the de­leted work under the Changes clause. Cor­respondingly, if the parties initially treated the reduction as a partial termination, a tri­bunal is likely to price the deleted work un­der the T4C clause. It is important to rec­ognize, however, that a board or court will give deference to the contemporaneous characterization of the parties only where the reduction is neither major nor minor. If a tribunal is convinced that the reduction was either minor or major but the parties improperly characterized the deleted work, the board or court may independently de­cide whether the action should be treated as a deductive change or a partial termination for convenience. 13 Nevertheless, if the par­ties sign a bilateral agreement concerning the deleted work, the agreement will be dis­positive and it will be too late to question which clause applied to the pricing of the reduction. 14

     Where it is apparent that work will be deleted, each party should calculate how the deduction would be priced under both clauses. If both parties realize that the pric­ing under one clause is more financially ad­vantageous than the other, the contractor is at a disadvantage. Where the deleted work is neither major nor minor, the government has a unilateral right to proceed under either clause. Hence, if the government prefers a deductive change, the contracting officer (CO) can proceed by issuing a Standard Form 30, "Modification of Contract," which identifies in block 13A that the authority for the modification is the Changes clause. Sim­ilarly, if the government prefers a partial ter­mination for convenience, the CO should is­sue the notification required by Federal Acquisition Regulation (FAR) 49.102.

   Frequently, when confronted with having to delete work, COs do not prepare a com­parative price analysis and are indecisive about whether to use a deductive change or partial termination for convenience. Under these circumstances, a contractor has greater opportunity to influence the selec­tion of the clause that is to be used. One technique fm the contractor to influence the selection is to prepare all correspondence to underscore the use of the preferred clause. If a partial termination is favored, the con­tractor should consider seeking guidance from the CO on contracting officer on his preference for the format of the settlement proposal or to inquire whether he would be receptive to the use of a total cost basis.15 If the contractor perceives that a deductive change better serves its financial interests, another technique would be to quickly furnish cost or pricing data with an explanation that the contractor is complying with its obligations under FAR 15.804 for a deductive change.

     Sometimes a CO merely issues a modifi­cation without properly documenting whether the deleted work was under the Changes clause or the T4C clause. In those instances, the techniques described above may still prove to be beneficial. Later, if a dispute occurs over which clause applies, a tribunal is likely to use a rule of contract interpretation that regards the contempor­aneous correspondence between the parties as highly probative of what the parties intended. 16

Pricing Differences

     Regrettably, there is no easy "rule of thumb" to predict which clause is more ben­eficial to a particular party. Even if the focus of attention is limited to fixed-price con­tracts, there are four distinct factual pat­terns to be considered: profitable contracts where the deleted work was also profitable, profitable contracts where the deleted work was unprofitable, loss contracts where the deleted work was profitable, and loss con­tracts where the deleted work was also un­profitable. One prominent author has made the following observation concerning fixed ­price contracts:

Such differences [between the two clauses for the pricing of the deleted work] will be minimal when the deleted work can be done by the contractor for an amount approxi­mating the amount he included in the con­tract for the work. However, if the deleted work will cost more than originally antici­pated, an equitable adjustment under the Changes clause will be greater than the amount recovered by the Government under the Termination For Convenience clause. Conversely, if the deleted work will cost less than originally anticipated, the Government will normally recover a greater amount un­der the Termination clause than under the Changes clause. 17

     Rather than rely on any rules of thumb, both the CO and the contractor should per­form the calculations to determine whether, under the particular facts, the use of either clause would result in any significant finan­cial advantage. Stated in simple terms, the basic concept is that a partial termination for convenience is priced by adding up from zero all the costs incurred for the completed work as well as the anticipated costs for the remaining work whereas a deductive change is priced by subtracting the estimate of fu­ture costs to perform the deleted work from the existing contract price. 18 (In other words, add up from zero for a partial ter­mination for convenience and subtract down from the original contract price for a deduc­tive change.)

     To limit the scope of this discussion, only the pricing formulas for fixed-price contracts will be examined.

Partial Termination For Convenience

     Under the T4C clause applicable to fixed­-price contracts, a contractor is entitled to its direct and indirect costs incurred to perform the terminated portion of the contract as well as a reasonable profit on the completed work. t9 Costs that normally are treated as overhead expenses can be allocated directly to the partially terminated contract and re­covered in a settlement agreement. 20 No profit is allowed on subcontracted work if the subcontractor has not delivered the work to the prime as of the date of the termina­tion. In calculating profit on completed work, the percentage of profit can increase or decrease in relationship to the percentage of profit originally contemplated by the par­ties. 21 A significant factor to consider is the level of difficulty of the completed work in comparison to the deleted work.22 Unlike a deductive change, the rate of profit on a DOD contract that is partially terminated for convenience is not required to follow the weighted guidelines method.23 Where the contractor is anticipated to sustain a loss, no profit is allowed on the completed work.24

     The preferred accounting method for sub­mitting a settlement proposal is the inven­tory basis. 25 Under the inventory basis, the costs for the continued work are segregated from the costs allocated to the terminated work. Typically, the inventory basis results in a settlement proposal that has extensively itemized expenses incurred for the deleted work. Under this method, the contractor is entitled to the sum of (1) the contract price for the remaining work and (2) the cost in­curred for the terminated work as well as a reasonable profit on those costs.

      The only other accounting method iden­tified in the FAR for submitting a settlement proposal is the total cost basis. 26 This method requires the prior approval of the termination contracting officer (TCO). 27 The case law indicates that the total cost basis usually is inappropriate for a partial T4C. 28 The total cost basis generally is used where the contract line items are not struc­tured to accurately price the deleted work. Because it is not feasible to separate the costs of the deleted work from the continued work, this method is analogous to convert­ing the entire contract to a cost reimburse­ment contract.29

     Unlike a cost reimbursement contract, the rules in FAR Part 31 on unallowable costs do not strictly apply. 30 Additionally, a con­tractor is not required to have in place an accounting system that is based on incurred costs. 31 Moreover, a contractor need not document each and every cost item; instead, all that is required is credible evidence that the cost was incurred and that the contractor should recover the cost in order to be made whole.32 Relying on FAR 49.201(a) and predecessor provisions, tribunals have evolved the term "fair compensation" into a principle known as the "fairness concept."33 Under this principle, fundamental fairness is the overriding criterion in the formulation of appropriate terms for settling a conven­ience termination of a fixed-price contract. 34 A significant disadvantage to the total cost basis is that a settlement proposal cannot be submitted under the total cost basis until the continued portion of the contract is complete. 35

     The contractor also may recover an equi­table adjustment where the partial termina­tion results in increased costs in performing the continued portions of the contract. 36 Furthermore, the contractor's cost of preparing the termination proposal is allow­able. Costs involving a termination settle­ment proposal may include legal, account­ing, and management expenses incurred to negotiate a settlement. 37 The contractor may recover the costs of preparing the settlement proposal even if the total costs exceed the ceiling on a fixed-price contract. 38 No profit is paid on the cost of preparing the settle­ment proposal, however. Unlike the cost of preparing a settlement proposal, the cost of preparing a request for equitable adjust­ment for a deductive change probably is not recoverable. 39 This distinction should be a key discriminator for those frequent in­stances where there is minimal monetary difference between the two clauses for the pricing of the deleted work.

     For a fixed-price services contract, the CO may select a "short form" clause that limits the government's liability to pay only for services rendered before the date of termi­nation. 40 Yet before placing the clause in the solicitation the CO must determine that, be­cause of the kind of services rendered, the successful offeror will not incur substantial charges preparing to perform the contract. 41 Although the clause is harsh on contractors, the contract appeals boards have enforced it. 42 Nevertheless, a contractor might be able to avoid the harsh consequences of the "short form" clause if the contractor can show that the CO's decision to use the clause was arbitrary. Where evidence sup­ports that the successful offeror must incur substantial expenses preparing to perform the contract, two contract appeals boards have held that the use of the "short form" clause constituted an abuse of discretion by the COs.43 Using the Christian doc­trine, the boards removed the short form clause from the contract and inserted the basic T4C clause. 44

     Where the contractor would have in­curred a loss had the entire contract been completed, the formula on the following page applies.

Total              Settlement      Contract Price       (Remaining Cost
Recovery   =  Expenses    +  For Accepted    +       x Loss Ratio)
                                                     Work

FAR 49.203 directs the following method for deriving the loss ratio where the settlement is
on an inventory basis:

                                                   (Total Contract Price)
Loss Ratio =   _____________________________________________________
                       [(Total Incurred Cost) + (Estimated Cost To Complete)]


To minimize the decrement under the loss ratio, the contractor should consider seeking to maximize the numerator (i.e., the total contract price) by pursuing any valid price adjustments for matters such as changes to the specifications, government-caused delays, overzealous inspections, or failure of the government to cooperate. 45

Deductive Change
      Under the Changes clause, the government is entitled to an equitable adjustment for a deductive change. This downward adjustment in price is determined by the actual cost the contractor avoided by not having to perform the deleted work.46 In pricing deductive changes, the guiding principle is that the eliminated portion of the work should have no effect on the relative profit or loss position of the contractor as established by the original work before the change was ordered. 47 Accordingly, the government also is entitled to a reduction for both the overhead and profit when calculating a deductive change.48 If the contractor was sustaining a loss on the entire contract, however, the downward equitable adjustment probably should not include a reduction for profit. 49

     The equitable adjustment for a deductive change is based on what it would have cost the contractor to complete the deleted work even if the contractor did not include any costs for the deleted work in its price proposal. Stated another way, the equitable adjustment for a deductive change is predicated on the net savings to the contractor. "This approach upholds the integrity of the competitive bidding system by placing on the contractor, which has possibly obtained a pricing edge by omitting the cost of required work that it ultimately hopes will not be necessary, the risk of a later reduction in the contract price."50

For contracts based on an unbalanced bid, a deductive change should not alter the contractor's profit or loss position from what it would have been if the change had not occurred. 51 An illustrative decision involves a contract for floodwater retarding structures. The awardee's price to construct subgrade slabs using medium grade concrete was $60 a cubic yard. The price to construct cradles and antiseep collars using high-grade cement was $500 a cubic yard. Although the forming of the cradles and collars was more labor intensive than forming the slabs, the board observed that the contractor had submitted an unbalanced bid.52 The difference between a cubic yard of the two types of concrete was the addition of two bags of cement. The increased cost to the contractor for the two bags of cement was $3 dollars. After contract award, the government ordered the contractor to pour only medium-grade concrete because "there was no sufficient technical advantage to be  gained to justify the expenditure" for the top-grade concrete. 53

     Because the parties were unable to agree on an amount for the deductive change, the CO unilaterally issued a modification reducing the price from $500 to $225 per cubic yard. The Department of Agriculture Board of Contract Appeals resolved the pricing dispute by recognizing that the purpose of an equitable adjustment is to keep a contractor whole when the government modifies a contract. Consequently, to prevent any increase or decrease in profit, the contractor was entitled to $497 per cubic yard for con­crete that had been changed from high grade to medium grade. 54

     If the deleted work has not been per­formed and is the subject of a priced con­tract line item (CLIN), the general rule is that the CLIN price is the amount of the downward equitable adjustment.55 Hence, if a contractor submitted an unbalanced bid, the contractor assumes the risk that a de­ductive change of one or more separately priced line items will undermine the antici­pated profit structure. 56 Conversely, a con­tractor can clearly benefit when a deductive change eliminates one or more CLINs that represented work that would resulted in a financial loss.

     Unlike a partial termination for conven­ience that requires the contractor to submit a settlement proposal within one year, the onus is on the government to assert a down­ward adjustment under the Changes clause. There are no strict time limitations on when the government must seek an equitable ad­justment. If a claim is not asserted within a reasonable time or if the delay results in prejudice to the contractor, however, the government can lose its right to seek an equitable adjustment. 57 In actual practice, the government is at a significant disadvan­tage because it has the burden of proof con­cerning the amount of the downward adjustment. 58

     Since the contractor possesses the cost in­formation, the government should audit the contractor's books and records. If possible, the CO should require certified cost and pncmg data. 59 Where actual costs are available because the work has been completed, those amounts should be used to calculate the downward adjustment. Finally, if the government elects to use the Changes clause to delete work from a contract, but a partial termination for convenience would be more advantageous for the contractor, the contractor should encourage the government to calculate the deduction in the same manner as if it were a partial termination for convenience. 60

Summary

     If there is a major reduction of work, the decrease in price should be calculated under the T4C clause. Conversely, if there is only a minor reduction in work, the decrease in price should be calculated under the Changes clause. If the deleted work is nei­ther major nor minor, a CO has discretion to use either clause. Frequently there will be only a minimal difference in the bottom line dollar amount regardless of whether the deduction is priced under the Changes clause or the T4C clause. Nevertheless, it is not uncommon for situations to arise where one clause can provide a significant financial advantage. Consequently, where it is appar­ent that work will be deleted, each party should calculate how the deduction would be priced under both clauses. Where the government is indecisive about selecting a clause, a contractor should consider seeking to sway the CO to use the clause that better serves its financial interests.

See below for Endnotes.
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