On February 25, 2019, the Office of Inspector General (“OIG”) for the Department of Defense (“DoD”) issued an audit report analyzing the prices of spare aviation parts purchased by the Defense Logistics Agency (“DLA”) and the Army from TransDigm Group, Inc. (“TransDigm”).  The audit was conducted in response to letters from certain Members of Congress, who had inquired whether the spare parts were sold at fair and reasonable prices and in compliance with the Truthful Cost or Pricing Data Act (“Act”).[1]  The OIG’s audit confirmed that both TransDigm and the responsible DoD contracting officers fully complied with the Act and related regulations governing the price negotiations, but the OIG nonetheless concluded that the contractor earned excess profit on the majority of parts sold.  In a highly unusual move, the OIG recommended that DoD request a “voluntary refund” from TransDigm of its allegedly “excessive” profits, and the OIG also recommended a number of changes to statutory, regulatory, and administrative policies governing the provision of cost or pricing data.

The OIG’s Findings

At the request of U.S. Representatives Ro Khanna and Tim Ryan and Senator Elizabeth Warren, the OIG reviewed the price reasonableness of 47 spare aircraft parts DoD procured from TransDigm between January 2015 and January 2017.  Using uncertified cost or pricing data that it collected during the audit, the OIG calculated the apparent profit realized by the contractor on the sale of each part, and concluded that the contractor realized “unreasonable” profits (defined as profits of greater than 15% in the report) on all but one of the parts.  (The OIG arrived at the 15 percent profit percentage, in part, by looking at maximum profit percentages allowed in the FAR for three different types of contracts, none of which were fixed price.)  The OIG applied this finding to a broader sampling of contracts held by TransDigm, and concluded that the contractor had earned $16.1 million in “excess profit” (i.e., profit over 15 percent) for the parts at issue.

The OIG concluded that a number of factors contributed to these supposedly “excessive” profits.  First, TransDigm was the only manufacturer for the majority of spare parts, which the OIG stated allowed TransDigm to set the market price for these parts.  According to the OIG, this dominant market position prevented contracting officers from relying on historical price analysis or competition to ensure price reasonableness because the price of some parts “appeared to be” excessive at the time the part was first sold to the Government, and because other competitors had to buy their parts from TransDigm before reselling to DLA.

Second, the OIG concluded that “performing a cost analysis using certified or uncertified cost data is the most reliable way to determine whether a price is fair and reasonable,” but the FAR does not require contractors to furnish cost or pricing data in some circumstances, such as when bidding on a smaller value awards or when providing a commercial item.  In fact, various statutory and regulatory policies actually discourage contracting officers from requesting uncertified cost data when evaluating price reasonableness.  .

Third, in some cases the Government had an urgent need to acquire the parts.  Thus, where TransDigm exercised its right not to furnish cost data, some Government officials simply moved forward with the procurement, concluding that the prices were justified under the “other reasonable basis exception.”

Finally, the OIG also waded into the policy arena, expressing concern about recent legislative changes to the Act.  Specifically, the FY 2018 National Defense Authorization Act (“NDAA”) raised the threshold for requiring certified cost or pricing data from $750,000 to $2 million.  And the FY 2019 NDAA changed the requirements for a waiver for submission of certified cost or pricing data, allowing contracting officers to obtain a waiver when any one of three circumstances apply:  (i) the item cannot reasonably be obtained without a waiver, (ii) the price can be determined to be fair and reasonable without submission of certified cost or pricing data, and (iii) there are demonstrated benefits to granting a waiver.  Previously, all three conditions had to apply to permit a waiver.  The OIG claimed that these legislative changes had the effect of “making it easier for contractors to avoid providing cost data.”

The OIG’s Recommendations

The OIG made a number of recommended changes that it believed DoD should pursue to address the findings of this report.  As an initial matter, the OIG also took the very unusual step to request that contracting officials pursue a “voluntary refund” from TransDigm for the supposedly excess profits—an amount totaling approximately $16 million.  The OIG recommended this despite finding no actual wrongdoing by TransDigm, and despite its somewhat dubious conclusion that DoD should have procured each item at no more than 15% profit if the contractor only obliged its requests for cost or pricing data.

Additionally, the OIG also announced a number of recommendations directed towards the Principal Director for Defense Pricing and Contracting (“DPC,” formerly known as DPAP).  Specifically, the OIG recommended that DPC take the following actions:

• Review the United State Code, the FAR, and the DFARS to determine changes needed in the acquisition process for sole-sourced parts to ensure that contracting officers obtain uncertified cost data when requested, including considerations for requesting such data when the purchases are below the thresholds currently established.
• Expand existing requirements to mandate reporting by the contracting activity to DPC in all cases where an award is made for parts produced or provided from a sole source and the contractor opts not to provide cost or pricing data.[2]
• Establish a framework for quarterly reporting and validation of consolidated information by the DoD components to the DPC Principal Director.
• Amend the DFARS and DFARS Procedures, Guidance, and Information (PGI) to implement the enhanced reporting requirements described above.
• Create a team of experts to analyze reported data, including the assessment of high risk parts and the identification of lower cost alternatives.

Implications for Contractors

The OIG’s report and recommendations have a range of potential implications and lessons for the defense contractor community—and particularly those that sell specialized spare parts or other items on a sole source basis.

• Increased scrutiny and skepticism, even of lawful practices. Defense contractors are well-acquainted with efforts to crack down on fraudulent or wasteful contracting practices.  But the OIG’s report represents a material departure from a standard “fraud, waste, and abuse” initiative.  Here, the OIG essentially concedes TransDigm’s compliance with applicable laws and regulations, but nonetheless declares that TransDigm reaped “inflated” or “excessive” profits and recommends that TransDigm provide a “voluntary” refund.  In this way the OIG’s report borders on a form of public shaming in an effort to claw-back funds that a contractor fairly received by acting within its rights.  This puts the contractor (and others like it) in a difficult position, both with regard to treatment of funds secured on these prior sales, and future business with DoD.
• Don’t be afraid (or ashamed) of profit. The OIG report appears to presume that contractors must inevitably accept low profit margins on government contracts.  This is not the case.  The FAR explicitly recognizes that profit serves a useful purpose in appropriately incentivizing contractors:

Both the Government and contractors should be concerned with profit as a motivator of efficient and effective contract performance. Negotiations aimed merely at reducing prices by reducing profit, without proper recognition of the function of profit, are not in the Government’s interest.  Negotiation of extremely low profits, use of historical averages, or automatic application of predetermined percentages to total estimated costs do not provide proper motivation for optimum contract performance.[3]

Thus, profit calculations must consider the unique circumstances of the contract at issue.  Although there are statutory limits on profits for certain types of cost-plus-fixed-fee contracts, those limits do not appear applicable to the contracts at issue here.[4]

• Help out your contracting officer—but know your rights. The FAR identifies a number of data points that a contracting officer can rely upon to confirm that a proposed price is fair and reasonable (e.g., historical prices, quotes from competitors, an independent government estimate, market research, etc.), and contractors can look for opportunities to assist contracting officers in compiling this data.  At the same time, however, it is critical for contractors to understand the full scope of their rights and obligations related to the provision of cost data, including those circumstances in which they have no obligation to share such data.  The OIG report suggests that collecting uncertified cost data is the most effective way of ensuring price reasonableness, but as the report itself acknowledges, that does not mean that contractors are required to furnish such data. If such a requirement is adopted, then some contractors—especially in the commercial item area—may simply opt to leave the government market altogether rather than invest in the systems necessary to provide accurate cost or pricing data (whether certified or not).

• There is more to come. The OIG has made a number of recommendations that, if implemented, could significantly alter the price negotiation process for defense contractors—particularly those that produce or sell items on a sole-source basis  Additionally, the FY18 NDAA directed the Government Accountability Office (“GAO”) to conduct “a study of Department of Defense and Defense Logistics Agency processes for purchasing noncompetitive spare parts and make recommendations for how to improve transparency and reporting in this area.”  This report undoubtedly will generate additional interest and scrutiny upon its release, and defense contractors would be well-advised to closely monitor policy and regulatory developments that follow.

[1] This Act was historically known (and is still commonly referred to) as the “Truth in Negotiations Act” or “TINA.”  See 41 U.S.C. chapter 35; FAR 1.110.

[2] The existing reporting requirements, set forth in a 2007 DPAP memorandum, require reporting only where an award is approved despite the contractor’s denial of cost data “because of an exigent situation.”

[3] FAR 15.404-4(a)(3).

[4] See 10 U.S.C. § 2306(d); 41 U.S.C. § 3905.