Continued Uncertainties Surround Sequestration

by Richard Goldstein, Vincent J. Napoleon and Tiana M. Butcher; Nixon Peabody, LLP
February 13, 2013

NH&RA member firm, Nixon Peabody recent released an article detailing the potential threats of the looming sequestration cuts. The full article can be found on the Nixon Peabody website and is also included below.

In his recent State of the Union address, President Obama urged Congress to adopt an alternative to the sequestration cuts scheduled to take effect on March 1, 2013. Although Republicans and Democrats in Congress have previously offered proposals to avert the cuts, the parties remain deadlocked over whether the sequestration cuts should be replaced by a plan that involves strictly cost-cutting measures or a plan that involves new tax revenue as well as cost-cutting measures. Due to the deadlock, many members of Congress suggest that sequestration is inevitable and some members even perceive the cuts as the only real way to reduce the deficit. In addition to sequestration, agencies are further limited by the threat of future budget cuts. Agencies have developed plans to dramatically cut costs and the Department of Defense has even begun to implement cost reduction measures. Regardless of what happens on March 1, one thing is certain—federal reductions in spending are imminent.

What is sequestration?

Sequestration is the automatic cancellation of spending across the federal government to enforce budget policy goals. It was first authorized by the Gramm-Rudman-Hollings Balanced Budget and Emergency Deficit Control Act of 1985 (“Gramm-Rudman-Hollings Act”) and was included in the Budget Control Act of 2011 (the “Budget Control Act”). Much like the Gramm-Rudman-Hollings Act, the Budget Control Act includes a provision that calls for a series of automatic spending reductions, which were originally scheduled to be triggered on January 2, 2013, but have been delayed by the American Taxpayer Relief Act of 2012, and will take effect on March 1, 2013.

Sequestration cuts under the Budget Control Act, which are set to occur on March 1, 2013, will be divided equally between the Department of Defense and other federal spending. Originally $109 billion was subject to automatic cuts in fiscal year 2013. The American Taxpayer Relief Act reduced the amount subject to automatic cuts by $24 billion. However, the extension also reduced the amount of time agencies will have to implement the cuts. The potential cuts, coupled with the likely decrease in budget allocations from the 2013 levels, have agency officials, contractors, and the economy poised for a dramatic reduction in government spending. The automatic trigger of sequestration may be far from ideal but, given the inability of Congress to reach an agreement on spending reductions, it is increasingly likely that sequestration will occur.

Many agencies are preparing for sequestration and other reductions in spending and are expected to announce their sequestration plans in the coming days. For example, the Department of Defense is at risk of being forced to impose $49 billion in cuts from its anticipated 2013 spending. Defense Secretary Leon Panetta recently warned that cuts to the Defense Department triggered by sequestration would pose the “most serious readiness crisis” to the country in over a decade. The Department of Defense expects that cuts in spending would result in furloughs for the military’s 800,000 civilian workers, hiring freezes, and significant reductions in training. A February 6, 2013, USA Today article highlights plans proposed by the military services in preparation for sequestration. Among other things, the Army anticipates that the sequestration cuts will require a decrease in funding for intelligence aircraft, surveillance aircraft, and new soldier equipment. The Air Force plans would include cuts in support to more than 30 weapons systems and spending on aircraft maintenance by one-third. The Navy would decrease the number of flying hours for its warplanes on aircraft carriers in the Middle East by over fifty percent. The deployment of a naval aircraft carrier scheduled to leave for the Persian Gulf this week has already been cancelled. In addition, the department likely would defer or reduce maintenance and repairs to military facilities, aircraft, and other equipment and renegotiate many existing contracts in addition to significantly reducing funds for new contracts.

The White House recently issued a fact sheet highlighting examples of how the sequester would impact middle-class families, jobs, and economic security. The fact sheet noted that, among other things, sequestration would result in a cut of up to $902 million in Small Business Administration loan guarantees; a reduction of nearly 1,000 research grants and awards by the National Science Foundation; and the possible loss of 10,000 teaching jobs, funding for 70,000 children on Head Start, and 7,200 special education teachers and staff. Experts suggest that the sequestration cuts impact every industry and would have broad implications on the overall economy.

Certain programs are exempt from sequestration cuts. These include programs administered by the Department of Veterans Affairs, Social Security, Medicaid, refundable tax credits to individuals, and certain low-income programs (such as the Children’s Health Insurance Program, Supplemental Nutrition Assistance Program, Temporary Assistance for Needy Families, and Supplemental Security Income). However, administrative expenses related to these programs are subject to sequestration. Non-exempt programs will face reductions across every program, project, and activity. This across-the-board application limits OMB’s discretion to redirect cuts away from sensitive programs.

What does sequestration mean for contractors?

Sequestration reduces the legal authority of agencies to obligate new federal funds to projects. This means that there will be fewer new contracts and significantly greater competition. A decrease in spending means that any future solicitations will be limited and focused on fundamental agency missions. Contracting officers are likely to favor contractors with strong performance ratings and an ability to do “more with less.” Contracting officers are also likely to favor fixed price or IDIQ contracts, shifting the burden of the inherent risks of such contracts to the contractor.

As a general matter, contracts for which funds have already been obligated would be safe. However, many may now be at risk if the government exercises its right to terminate a contract for convenience or make changes to the contract to meet its cost-cutting burden under sequestration. In addition, the government may reduce the allocation of funds for ongoing multi-year contracts or not exercise options to renew existing contracts.

Contractors responding to cost-cutting measures should be mindful of how these events may trigger other compliance obligations. For example, as the market for contractor goods and services shrinks in the United States, contractors may consider opportunities in other markets. However, contractors interested in expanding into international markets must be aware of export control rules and Foreign Corrupt Practices Act requirements. In addition, a contractor facing a significant decline in business may be forced to consider reducing its workforce. A company must be familiar with federal and state WARN Act requirements in the event that such reductions in force becomes necessary.

In the wind of sequestration, there is a difficult business environment on the horizon for government contractors. Keeping the lines of communication open so that contracting officers can share concerns and contractors can offer realistic but cost-effective solutions will benefit both parties as they navigate this new territory of budget uncertainty.