Appeal of an ASBCA decision finding that the government had not been damaged by a contractor’s failure to properly account for post-retirement benefits costs is affirmed. The court ruled that for 11 years, the contractor had not properly accounted for post-retirement benefits resulting in $253 million of unallowable costs. Nevertheless, the contractor had also amended its post-retirement benefits plan resulting in over $300 million in benefits savings. The court held that the savings from the plan amendment offset the $253 million in unallowable costs. The government, therefore, had not been damaged by the contractor’s accounting error.
The FAR allows contractors to seek reimbursement for post-retirement benefits (PRB) costs—i.e., non-pension benefits paid to retired employees like health care, life insurance, and disability. Since 1995, the FAR has required that to be allowable, PRB costs must be calculated in accordance with Statement of Financial Accounting Standard (FAS) 106.
Despite the 1995 FAR amendment requiring use of FAS 106, Northrop Grumman, for many years, used an accounting method established by the Deficit Reduction Act of 1984 (DEFRA) to calculate its PRB costs. The main difference between the DEFRA and FAS 106 methods is that DEFRA calculates PRB costs based on current medical costs while FAS 106 includes future increases in medical costs. As a practical matter, this means that costs computed under the DEFRA method start lower and increase over time, while costs computed under FAS 106 start higher and decrease over time.
In 2006, Northrop switched from the DEFRA method to FAS 106 to calculate PRB costs. As part of this switch, Northrop Grumman had to calculate a “transition obligation”—that is, the difference between the PRB costs that would have accrued since 1995 had Northrop used the FAS 106 method, and the costs that actually accrued under the DEFRA method. Northrop determined that its transition obligation was about $305 million. In other words, Northrop owed retired employees $305 million in PRB costs.
But around the same time that Northrop switched accounting methods, it amended its benefit plan to cap the amount it would contribute to PRB plans regardless of future healthcare cost increases. As a result of this amendment, Northrop’s PRB costs were reduced by $307 million.
Meanwhile, the Defense Contract Management Agency determined that $253 million of Northrop’s transition obligation was unallowable because the company did not use the proper accounting method from 1995 to 2006. As a result, DCMA required Northrop to deduct the $253 million from its annual PRB reimbursement, amortized over 20 years.
Northrop submitted a claim to DCMA for the $253 million, but it was denied. Northrop then appealed to ASBCA. The board determined that that Northrop’s $253 million transition obligation was unallowable because the company did not use the FAS 106 method between 1995 and 2006.
But the board also found that under the amendment to its PRB plan, Northrop had saved $307 million from its future plan obligations. Because the main difference between DEFRA and FAS 106 concerns the accounting of future increases, the costs that Northrop had eliminated were the same costs that it owed as part of the transition obligation. Thus, the board concluded, Northrop did not actually incur the $253 million in costs between 1995 and 2006. And, as a result, the government did not and would not suffer any damage due to Northrop’s failure to use the proper accounting method. The government appealed the board’s determination to the Federal Circuit.
The court agreed with the board, reasoning that Northrop’s amendment to its PRB plan effectively eliminated the $253 million in disputed PRB costs from the transition obligation such that those costs were never charged and would never be charged to the government. Northrop’s failure to use FAS 106 between 1995 and 2006 meant—due to the nature of FAS 106 accounting—that Northrop had not properly calculated its future costs. But Northrop’s amendment to the plan eliminated the effect of future healthcare costs and thus obviated those same costs that comprised the $253 million in dispute.
The government, however, argued in various ways that the $253 million in dispute had or would be charged to the government. The government contended that because Northrop had underfunded its PRB costs between 1995 and 2006, those costs will always remain unallowable, and the government was therefore required to disallow them in Northrop’s future PRB reimbursement claims.
The court, however, reasoned that this argument would only have merit if Northrop had not amended it PRB plan, because that underfunded amount would have been part of the transition obligation. But Northrop’s amendment to the plan eradicated what it owed in PRB costs. This meant that Northrop never actually submitted any unallowable costs for reimbursement, and the government had no basis to disallow costs that were never submitted.
Still, the government argued, Northrop’s amendment was a separate event, distinct from its switch to FAS 106 accounting and thus the amendment should not be used to offset the transition obligation. Indeed, the government asserted, had either event happened without the other, the government would be entitled to disallow the disputed $253 million.
The court did not find this compelling. The fact remained, both the amendment and the switch in accounting methods occurred at the same time. While the amendment did not transform the $253 million in underfunded PRB costs into allowable costs, it still lowered the entire accumulated value of Northrop’s PRB plan, which was used to calculate the transition obligation. The amendment cannot be viewed in isolation from the transition obligation because it completely eliminated the transition obligation.
The government further argued that because the amendment and the switch in accounting methods were separate events, the government was entitled to receive the full benefit of the plan amendment. Had Northrop used the FAS 106 method between 1995 and 2006 as required, the argument continued, then the government would have realized the $307 million in cost reduction.
But the court disagreed, reasoning that the government had not been deprived of anything. To the contrary, the government had benefitted from Northrop’s failure to use FAS 106 accounting; it had saved $253 million between 1995 and 2006. Allowing the government to disallow those costs going forward would actually result in a double benefit to the government.
Finally, the government argued that ASBCA erred in determining that Northrop never incurred the PRB costs calculated under FAS 106. The government reasoned that regardless of the method used to calculate PRB costs, Northrop still incurred PRB costs between 1995 and 2006 because its employees were earning PRB benefits during that time. Those costs, therefore, must be part of Northrop’s transition obligation because they were not timely funded.
But this argument missed the mark. Whether Northrop incurred the $253 million in PRB costs was irrelevant because Northrop never actually charged the government for those costs. The government was never damaged by Northrop’s accounting error.
Northrop Grumman is represented by Donald B. Verrilli, Jr. of Munger, Tolles & Olson LLP as well as Ginger Anders, Charles Baek, Stephen John McBrady, and Nicole J. Owren-Wiest of Crowell & Moring LLP. The government is represented by Daniel B. Volk, Joseph H. Hunt, Robert Edward Kirschman, Jr., and Patricia M. McCarthy of the U.S. Department of Justice as well as Robert Lyn Duecaster of the Defense Contract Management Agency.
