The Future of Novations in Contractor M&A
In corporate transactions involving government contracts, “novation” has become a dreaded process. Many buyers and sellers express uneasiness and concern about having to subject their deal to the U.S. Government’s discretionary framework for accepting the transfer of a government contract from one party to another. In particular, they fear the uncertain timeline and arcane requirements for securing approval.
While the cumbersome novation approval process has drawn significant attention in recent years, the National Defense Authorization Act mark-up released by the House Armed Services Committee earlier this month was again silent on the issue. In the absence of Congressional enthusiasm, the government contracts bar seems to have focused its efforts to fix the novation process on the Section 809 Panel, which is considering ideas to streamline and simplify the defense acquisition system. The American Bar Association Section of Public Contract Law offered thoughts on the current novation process in comments to the panel late last year, and it remains to be seen how the Section 809 Panel will react to those comments in the two public reports the Panel is expected to publish over the coming months.
The ABA comments focused on three primary issues with the current novation process under FAR 42.1204: (1) the timing of novation approvals; (2) corporate entity conversions; and (3) the content of novation packages.
1. Novation Timing: The ABA raised two concerns with the timing of novations. First, the ABA observed that post-closing novation approvals create an awkward gap that requires parties to implement temporary subcontract agreements. Often, the ostensible prime contractor is nothing more than a corporate shell entity, and the arrangement benefits neither the Government nor the companies involved. Second, the ABA also took issue with the lack of firm deadlines for novation processing, leading to novation approvals regularly taking several months or even longer.
The ABA recommended that novation approvals occur pre-closing, following the model for pre-closing approvals under the Hart-Scott-Rodino Anti-Trust Improvement Act and the Committee on Foreign Investment in the United States. The ABA also recommended that novation applications be resolved within 90 days (with certain exceptions).
2. Change in Corporate Entity Structure (Conversions): The ABA also noted that contractors are increasingly changing corporate form (e.g., from an S-Corp. to an LLC), often for tax or capitalization purposes. Because the FAR does not provide guidance on how corporate conversions should be treated, federal procurement officials have applied inconsistent requirements, with some requiring novation packages and others requiring only change-of-name agreements under FAR 42.1204(b).
The ABA recommended that the requirements for change-of-name agreements under FAR 42.1204(b) be clarified to encapsulate corporate conversions.
3. Contents of the Novation Package: Finally, the ABA addressed the lengthy list of documents required by FAR 42.1204(e) as part of the novation package submitted to a contracting officer, noting that many of the required documents are not necessary to protect the Government’s interests and create undue burden on contractors. Instead, the ABA recommended the following simplified list of documents:
- a cover letter certifying that the novation packet is authentic and accurate;
- a novation agreement;
- a list of affected contracts;
- a statement of transferee’s capability to perform;
- the purchase agreement;
- the opinion of legal counsel;
- evidence that classified security requirements have been met; and
- the consent of any sureties.Notably, this simplified list excludes audited financials.
The ABA noted that it simply is not practical, or cost efficient, for a contractor to submit audit financials with a novation package. As a result, government procurement officials often waive this requirement already. Instead, the ABA recommended that a fulsome statement of the transferee’s capability to perform meets the actual purpose of audited financials.
Given their relative brevity, the ABA’s recommendations do not address certain key details such as defining what types of corporate conversions should be covered under name change agreements, and what information on capability to perform the novated contracts a transferee would have to provide to secure novation approval.
We will continue to track efforts to improve the novation process and any related recommendations published by the Section 809 Panel.