Federal Contracts When Selling a Business

When selling a business, the owner must balance deal certainty, tax consequences, speed, regulatory clearances, third party consents and liability allocation. Owners selling a business that holds prime federal contracts have additional considerations that may limit the structure of the transaction and the categories of available buyers. This Client Alert provides a high-level overview of one issue unique to federal contractors — the Anti-Assignment Act.

Overview:

One diligence consideration in the sale of any business is whether vendor and customer contracts can be transferred to the buyer. For non-Government contracts, applicable laws generally favor the free assignability of contracts. For commercial contracts, silence generally equals the consent to the transfer.

By contrast, the Anti-Assignment Act, 41 USC § 15 (the “Act”), expressly prohibits the transfer of a federal contract. Despite the Act’s absolute prohibition on transfers, courts have made clear that the Government may consent to a transfer, and that certain transfers are allowed even without Government consent. If the Act applies, and the Government withholds consent, or if the contractor does not follow the applicable Federal Acquisition Regulations (“FAR”), then the Government may terminate the contract or hold the seller in breach.

What Types of Transfers Are Subject to the Anti-Assignment Act?

According to FAR 42.1204(a), “novation agreements” with the Government are required if a federal contractor transfers all of the assets involved in performing a federal Government contract, including:

•  the sale of these assets with a provision for assuming liabilities;

•  the transfer of these assets incident to a merger or corporate consolidation; or

•  the contribution of these assets in connection with formation of a new business entity.

A novation agreement is required if a forward merger or asset purchase agreement results in the transfer of a Government contract or all of the assets involved in performing that contract. Some case law suggests that the Act does not always apply to a forward merger, but our experience has been that most buyers in a forward merger will require a novation agreement rather than risk a conflict with the contracting officer overseeing the contract being transferred.

What Transfers Are Not Subject to the Anti-Assignment Act?

FAR 42.1204(b) suggests that novation agreements are not required when a contractor changes ownership as a result of a stock purchase, with no legal change in the party to the Government contract, and when that contracting party remains in control of the assets and is the party performing the contract. (However, even if consent is not required, other FAR provisions may require notice of ownership changes since the ownership change may result in changes to asset valuations or other changes affecting allowable costs.)

Case law interpreting the Act has made clear that a novation agreement is not required where the contract essentially continues with the same entity after closing. This “operation of law” exception to the Act has been held to apply to a reverse triangular merger where the seller merges into a subsidiary of the buyer, and the seller is the surviving company in the merger. The cases determined that the assets of the seller were not transferred in the merger.

Asset sales under Section 363 of the Bankruptcy Code also should not require a novation agreement pursuant to this “operation of law” exception to the Act recognized by the courts.

How Do I Obtain a Novation Agreement?

Business owners accustomed to obtaining a third party’s consent to the assignment of a commercial contract are often surprised by the cost, complexity and time needed to complete a novation agreement with the federal Government. If a novation agreement is required, FAR 42.1024(e) and (f) require the seller to submit the following information to the responsible contracting officer (“RCO”):

•  three signed copies of the proposed novation agreement;

•  the purchase/sale agreement or memorandum of understanding;

•  a list of all affected contracts between the seller and the Government, as of the date of sale or transfer of assets, showing for each, as of that date, the --

-  contract number and type;

-  name and address of the contracting office;

-  total dollar value, as amended; and

-  approximate remaining unpaid balance.

•  evidence of the buyer’s capability to perform;

•  an authenticated copy of the instrument effecting the transfer of assets;

•  a certified copy of each company’s board resolutions authorizing the asset transfer;

•  a certified copy of the minutes of each corporate party’s stockholder meeting necessary to approve the asset transfer;

•  an authenticated copy of the buyer’s certificate and articles of incorporation, if a corporation was formed for the purpose of receiving the assets;

•  legal opinions of counsel for each of the buyer and seller stating that the transfer was properly effected under applicable law and the effective date of the transfer;

•  balance sheets of the buyer and seller as of the dates immediately before and after the transfer of assets, audited by independent accountants;

•  evidence that any security clearance requirements have been met;

•  the consent of sureties on all affected contracts if bonds are required, or a statement from the seller that none are required; and

•  any other relevant information requested by the RCO.

Our clients have found most burdensome the requirements for audited pre- and post-closing financial statements and formal legal opinions from legal counsel for each of the buyer and seller. Sometimes these requirements are waived by the Government, but even when they are, the FAR novation process is time-consuming when compared to obtaining consent to transfer commercial contracts, which often can be accomplished by seller and the consenting third party signing a one-page consent letter. To avoid the cost and time involved, clients often seek to avoid the novation process by choosing a stock purchase or a reverse triangular merger transaction structure, as these structures are effective in avoiding the requirements for novation.

Government Approval Process

If a business sale cannot avoid the novation process, the seller will need to submit the novation documentation to the RCO, who is responsible for coordinating with all Government offices interested in the contracts being transferred.

The RCO determines whether it is in the Government’s interest to allow the transfer to the buyer based upon information received from Government officials, the buyer’s status as a responsible contractor, and any other factors relating to the buyer’s performance that the Government determines would aid or impair the buyer’s ability to perform.

Novations are often approved by the Government, but the process can take several weeks to six months or more to complete. For this reason, parties generally do not make the Government’s novation a condition to closing and instead will covenant to pursue the novation agreement on a post-closing basis. Or, the parties will enter into an interim subcontract whereby the buyer will perform on behalf of the seller pending completion of the novation process. Additionally, the parties may provide for a purchase price adjustment, indemnity, or permanent subcontract if the novation is denied.

If the RCO determines that a novation is not in the Government’s interest, the seller will remain obligated under the contracts, and the contracts could be terminated for default if the seller does not or can no longer perform. Generally, however, special arrangements, such as subcontracting arrangements between the seller and the buyer, or termination for convenience, are agreed to by the Government for contracts that cannot be transferred.

Bottom line: If other important transaction objectives can be achieved, consider structuring acquisitions of federal contracts to avoid the requirement of entering into a novation agreement with the federal Government. If a novation agreement cannot be avoided, involve your legal counsel early and be prepared for a more costly and protracted process than for other contract transfers.