This post was also written by Steven D. Tibbets.

On December 3, 2010, the U.S. Department of Defense (“DoD”), issued a proposed rule that, if finalized, will increase the DoD Federal Acquisition Regulation Supplement’s (“DFARS”) requirements for contractors’ business systems. The proposed rule defines what constitutes a deficient business system and provides for withholding of payments when deficiencies are identified. Generally, the proposed rule would apply to contractors performing DoD contracts that either: (a) are worth $50 million or more; or (b) are awarded on the basis of cost and pricing data and meet certain dollar value thresholds.

We first reported on this effort approximately a year ago, when the DoD published its initial draft of the proposed rule. We noted that the rule’s definitions regarding what constituted a deficient business system seemed vague and that the DoD’s application of those definitions could be unpredictable. In its revised proposed rule, DoD removed “phrases such as ‘including but not limited to’ and ‘as applicable’” from a list of compliance criteria, but otherwise did not find that the definitions in the proposed rule presented a risk of subjective and inconsistent application of criteria in determining whether business systems are deficient.

Otherwise, the proposed rule provides for a system under which Government auditors will review contractor business systems for DoD contracts over certain dollar thresholds – different thresholds apply to different business systems. Where the Government makes a preliminary finding that deficiency exists, the proposed rule allows the contractor 30 days to respond, after which the Government will review the responses and make a final determination regarding whether a business system is deficient. The consequence for a deficiency under the proposed rule is that a contracting officer is to withhold 5% of payment under a contract until the Government receives a corrective action plan. Upon receipt of a plan, the contracting officer may, but is not required to, reduce the withholding to 2%. The contracting officer may not terminate the withholding until the contractor has implemented its corrective action plan. Thus, the proposed rule’s penalty provisions can harm a contractor’s cash flow position until any deficiencies are corrected.