WR&F Government Contracts Issue Update: Performing Legal Due Diligence

The end of the last decade saw a significant increase in the number of acquisitions of corporations; many of these acquired companies are U.S. Government contractors. As a result, lawyers who practice in Government contracting increasingly have been called upon to evaluate the government contracts business of the acquired company. With this upswing, practitioners have had to develop tools to perform this evaluative function. Indeed, Wiley, Rein, & Fielding has participated recently in a number of “due diligence” reviews.

Counsel who conduct due diligence reviews as part of the prospective merger or acquisition know that no one analytical method can be used for every acquisition. There are some tools, however, that can be modified and used often. One such tool is a list of subjects on which representatives of the selling company can be questioned to test the health and the risks of their business. Another tool is the representations and warranties that the seller can be asked to make in the documents that are exchanged at settlement. A third is a method of review that tries to merge a financial analysis of the seller’s business with an analysis of the legal risks of the business. Generally, these areas of inquiry provide a relatively comprehensive picture of a targeted company’s health vis-a-vis its government contracts and subcontracts. A brief description of each of these tools follows.

The Subjects of Inquiry

In any acquisition of a government contractor the buyer’s lawyers must question exhaustively the seller on numerous critical topics, including for example,

• whether the targeted company, including its vital personnel, have been or soon might be debarred, proposed for debarment or suspended. It is critical to identify any risk that the target might become ineligible for federal contracts.

• The prospect’s litigation exposure in the government contracts context. This includes examining both existing and anticipated claims against and from the government, as well as subcontractors.

• Examination of each government contract (including those completed but not closed out and those expected but not yet in effect) to obtain an accurate picture of what business stream can be reasonably expected. This can be difficult, in today’s marketplace, where contractors often have multiple award, indefinite delivery, indefinite quantity contracts, which are merely marketing vehicles.

• Understanding the contractor’s intellectual property and data rights. Misinterpreting the target’s rights in intellectual property and data vis-a-vis the government can cause extreme swings in the ultimate valuation of that company.

• Determination of what volume of a contractor’s work is performed under classified contracts and the corresponding classification levels. (If possible, counsel with the pertinent security clearances should be retained to examine the classified contracts).

• Examination of the contractor’s compliance with ethical rules, such as gratuities and conflict of interest laws. A company with an established compliance program will give the prospective acquirer more comfort that no surprises will arise.

A List of Representations and Warranties

In addition, a buyer ordinarily will require the seller of a Government contracting business to give written representations and warranties about the seller’s business. These will provide the buyer recourse if the representations and warrants are inaccurate. The representations generally will cover the following topic areas:

(a) Government Contracts Compliance;
(b) Investigations and Audits;
(c) Financing Arrangements and Claims; and
(d) No Suspension or Debarment.

One additional tool for the performance of a due diligence review for a lawyer is to try to merge the lawyers’ review with the financial review of the Government contracts, in order to make both reviews more efficient and effective.

Usually, the financial review proceeds from a balance sheet prepared by the seller. The major components of that sheet can be broken down for an in-depth review, to analyze receivables, revenue, direct costs and indirect costs by contract and by year. The resulting review might try to ask any number of questions: Which of the seller’s contracts are profitable? What are the major causes for unusual profit or loss on any of these contracts? What is the seller’s competitive assessment for replacing its most profitable contracts with new business? What billed receivables are more than thirty days old? What are the causes for any delays in payment? Why are certain receivables unbilled? When will they be billed? — And so on.

In addition, the financial review ought to look closely at all recent correspondence with the Government’s auditors. It should include an analysis of any recent or forthcoming audit submittals to identify any obvious issues that are likely to arise from the Government’s audit.

Once the financial audit has reached answers to questions like the foregoing, the legal audit ought to merge with the financial – to study, most carefully, the largest Government contracts, as well as the most profitable contracts, as well as the details of any financial discovery which involves a possible issue of compliance with the law. Because unusual financial consequences often invite the customer’s closest scrutiny, one part of the lawyers’ review should be to follow the trail of the financial review of the seller’s Government contracts. In real life, these are often the places where risks become liabilities.