What's the low-down on the flow down?

Anyone who has ever dealt with a flow-down finding coming out of a property management system analysis (PMSA) or a contractor purchasing system review (CPSR) will tell you that odds are the finding fell into one of three buckets: failing to flow something down, flowing it down incorrectly or not flowing it down to the correct parties. Is it really that complicated? For example, when it comes to government property, Federal Acquisition Regulation (FAR) 52.245-1 requires contractors to“… include the requirements of this clause in all subcontracts under which Government property is acquired or furnished for subcontract performance” (FAR 52.245-1(b)(3)).

Most of us who have worked on or with a government contract have dealt with flow downs. But does anyone really understand what a flow down is? Or what exactly should flow down? And, arguably the most difficult question of all, a question that sometimes causes wide disagreement between the government and contractors: To whom should something flow down? Before getting back to government property and the requirements of FAR 52.245-1(b)(3), let’s dive in and get the low-down on flow down.

What is a flow down?

If you’ve been following along with us, our two previous articles, “Contractor Purchasing and Property Management Business Systems—Two Sides of the Same Coin” [1], and “Back to Basics: the Interconnectedness of the Defense Federal Acquisition Regulation (FAR) Supplement (DFARS) Business Systems, [2] both discussed the degree of overlap and interconnectedness between the six (6) DFARS business systems [3] with the former specifically highlighting the relationship between the contractor purchasing system and contractor property management system.

As we can see, the flow-down language cited in their respective system criteria contains the same basic requirement, appropriate flow-down of contract terms and conditions:

flowdown to subcontractors

However, for all of the definitions, provisions and clauses contained within the FAR, you would be hard-pressed to find a definition of “flow down.” Any first-year law student will tell you when a contract does not define a particular term, the common understanding of the term prevails. A quick search using your favorite search engine will yield something along the lines of: “A flow-down clause is a contract provision by which the parties incorporate the terms of the general contract between the owner and the general contractor into the lower tier agreement.” [4]

In other words, flow down (in government contracting terms) is the means by which the government imposes the incorporation of prime contract requirements into lower-tier agreements, thereby ensuring consistent application of those requirements.

What exactly to flow down?

Does this sound familiar? While putting the subcontract together, our procurement folks gather a list of flow downs from our prime contract. They then go out to acquisition.gov, navigate to the respective clauses, highlight, copy and then paste into the subcontract. They’ve met the requirement, right? Some acquisition activities might be surprised to find out that only a handful of clauses are subject to the straight copy and paste approach such as FAR 52.222-21, Prohibition of Segregated Facilities, which reads: “The Contractor shall include this clause in every subcontract and purchase order that is subject to the Equal Opportunity clause of this contract.”

The other, and by far the vast majority of, flow downs usually read like FAR 52.245-1(b)(3) where the contractor shall include the “requirements” or the “substance” or a particular portion of this clause in its subcontracts. The questions is … why are they written that way?

This largely has to do with the concept of privity of contract where the government’s contractual relationship is only with the prime and not the subcontractors. By extension, the prime contractor’s contractual relationship is only with its first-tier subcontractor and not lower tiers. If a contractor were to copy and paste the clauses into its subcontracts, it either wouldn’t make sense or, worse, would distort the concept of privity. Most flow-down clauses use terms that reflect the privity of the contract and include language such as “The government shall …” or “The contracting officer must …” or “The contractor shall report […] to the government …” None of those terms have meaning or context in a subcontract because neither the government nor the subcontractor has any direct contractual relationship that a “copy/paste” clause would impart.

In a real sense, the government wants the prime contractor’s actions to mirror the government’s actions in similar circumstances. As stated in the Defense Contract Management Agency manual “Surveillance – Document Results, Corrective Actions & Provide Feedback,” it is “… the prime contractor’s responsibility to manage its supply chain. Prime contractors have wide latitude as to how they control their supply chain, and are ultimately responsible for flow down and execution of contract requirements.”

The government leaves it up to the contractor to define “how” this is to be done, which is often a delicate balance.

Whom to flow down?

To whom do clauses and requirements flow down should be a straightforward answer. If you answered subcontractors, you are correct. Unfortunately, as with many things related to government contract compliance, it is not that straightforward because the immediate next question is what exactly is a subcontractor?

Generally, most people view subcontractors as simply those that are contracted to perform a part of prime contractor’s contract. ASTM International consensus standard E3015 − 15 (Reapproved 2020) Standard Guide for Management of Customer-Owned Property Assets in Possession of Supplier, Contractor or Subcontractor offers the following definition of subcontract: “A contract subordinate to another contract in which a party has contracted for the performance of certain work and, in turn, engages a third party to perform the whole or a part of that which is included in the original contract.’

The FAR and Defense FAR Supplement (DFARS), on the other hand, are less definitive. In fact, there is no single definition of subcontract or subcontractor in the FAR or DFARS. According to the Department of Defense's Section 809 panel [5]:

“A search of the FAR and DFARS produced 27 distinct definitions of the term subcontract. Seventeen of these definitions were essentially the same with only minor differences. The other 10 were unique in one way or another but shared many of the same common elements. 41 U.S.C. § 87, the Anti-Kickback Act, implemented at FAR 3.5 was the only definition based in statute (see Appendix F, Table F-3). The FAR and DFARS search also produced 21 distinct definitions of subcontractor. Most of those definitions shared common elements that could be conducive to drafting a single, common definition.”
“The FAR and DFARS search also produced 21 distinct definitions of subcontractor. Most of these definitions shared common elements that could be conducive to drafting a single, common definition. Several had a unique element that would require an accommodation.” [6]

As we can see, the government has not taken a stance to globally define subcontract or subcontractor. But perhaps the real issue is not how subcontractors are defined; rather it is how subcontractors are identified. At its core, it is up to individual prime contractors to identify and classify “subcontractors.”

Without diving deep into FAR Part 44, Subcontracting Policies and Procedures, the contractor is required to provide notification of intent to place a subcontract, and the contracting officer will provide their consent. This action demonstrates that the identification of subcontractors starts with the contractor. For those contractors with an approved purchasing system, the notification and consent portion is generally not required.

What about vendors that provide supplies and/or services that the contractor uses to perform a contract? Is the office supply store a subcontractor because they provide the paper clips used on the subcontract? Vendors are not typically engaged to perform a whole or a part of a contract and don’t fit identification as subcontractors. But it is still up to the contractor’s purchasing organization to identify and distinguish between vendors and subcontractors.

To illustrate the importance of having contractors define subcontractors and identify who their subcontractors are a bit further, consider this bit of light cost accounting. When contractors consider their general and administrative (G&A) expenses, they must also consider the allocation base for those costs, i.e., which costs do they distribute their G&A expenses over to arrive at a G&A rate. G&A expenses represent the cost of the management and administration of the business unit as a whole.[1] For contractors with contracts subject to the Cost Accounting Standards (CAS), the standards recognize three acceptable bases for allocation of the G&A expenses: total cost input, value-added cost input or a single element cost input base. For this discussion, the value-added cost input base actually provides a lot of insight into the importance of contractors defining subcontractors: The value-added cost input base "shall be used as an allocation base where inclusion of material and subcontract costs would significantly distort the allocation of the G&A expense pool in relation to the benefits received, and where costs other than direct labor are significant measures of total activity. A value-added cost input base is total cost input less material and subcontract costs.” [8]

Contractors with a value-added cost input base exclude subcontractor and material costs from receiving G&A. Typically, contractors with a value-added input base also utilize a separate indirect cost pool and, in turn, an indirect rate for handling subcontractor and material costs. Contractors are required to determine the costs and groupings that go into these pools. The contractor must define and identify costs that qualify as subcontractor costs in order to receive this indirect rate.

For contractors with CAS-covered contracts, these practices must be disclosed in the Cost Accounting Standards Board Disclosure Statement (CASB DS-1) which is reviewed, and the disclosed practices are audited by the government. The key point here is that the contractor discloses its practices of identifying and excluding subcontractor and material costs from its G&A base and identifies its subcontractor and material costs to receive the handling rate. Contractors have to have a definition of what a subcontractor is and must be able to identify their subcontractors to successfully pass a government review and/or audit of its cost accounting practices.

The definition and identification of subcontracts and subcontractors respectively, while never expressly stated, are solely the responsibility of the contractor.

Back to the requirements of FAR 52.245-1

Let’s go back to the beginning of our discussion with FAR 52.245-1(b)(3) stating that the contractor shall “… include the requirements of this clause in all subcontracts under which Government property is acquired or furnished for subcontract performance.” The FAR 52.245-1 clause itself is a performance-based requirement, describing what needs to be done and not how to do it. It prescribes outcomes and outputs of a contractor’s property management system. That property management system depends upon the nature of the contractor’s business, the type and quantity of property, and the risks involved, a subset of which would be the surveillance of the subcontractor’s system. To the extent the prime contractor identifies a supplier as a subcontractor, the type and scope of assessment and surveillance is a prime contractor, not a government, decision, since the government has no privity with lower-tier suppliers. This language reflects the need to balance the government’s requirements for consistency through the contracting/supply chain (what needs to be done) while offering the prime contractor discretion on how to do it.

Contractors, like the government, must consider other factors, including commercial practices, supplier risk, cost, schedule and performance criteria. These may be acceptable depending upon the circumstances properly disclosed in the prime contractor’s disclosure statement, subcontracting plan or accounting or purchasing procedure; contractors need some degree of discretion on actual flow-down practice, for contractors must be able to navigate their business relationships with suppliers.

There has been anecdotal evidence of contractors receiving questions and even corrective action requests related to disagreements by the government over what a subcontractor is. Some of these disagreements revolved around the contractor’s alternate sites or divisions and even some around flowing down requirements to vendors. These disagreements often stem from another part of the clause:

"The Contractor’s responsibility extends from the initial acquisition and receipt of property, through stewardship, custody, and use until formally relieved of responsibility by authorized means, including delivery, consumption, expending, sale (as surplus property), or other disposition, or via a completed investigation, evaluation, and final determination for lost property. This requirement applies to all Government property under the Contractor’s accountability, stewardship, possession or control, including its vendors or subcontractors (see paragraph (f)(1)(v) of this clause).”

This language clearly distinguishes between vendor or subcontractors since only the subcontractor portion gets its own requirements at FAR 52.245-1 (f)(1)(v). In other words, FAR 52.245-1(f)(1)(v) does not apply vendors, only subcontractors.

The above underlined portion is an extension of the contractor’s stewardship responsibility to state that “you the contractor are responsible for property at the vendor or subcontractor, but with subcontractors you have additional responsibility.” One could argue that some sort of surveillance of property with vendors is required. This could include requiring them to be insured or otherwise meet some sort of professional standard. But clearly, vendors are generally subject to different terms and conditions, especially if they are commercial entities.

FAR Part 45, the part of the FAR that prescribes the government’s actions related to government property as well as the source of the prescription of FAR 52.245-1, states:
“Agencies will not generally require contractors to establish property management systems that are separate from a contractor’s established procedures, practices, and systems used to account for and manage contractor-owned property.”

This government policy stance, often overlooked, clearly supports the view that contractors should not be required to do something different. The question is who is in a better position to identify a subcontractor: the government or the contractor?

A would-be government prescription to a contractor about its definition or identification of subcontractor in essence “breaks” several things. First off, it goes against the prohibition in FAR Part 45 of requiring contractors to do things differently. Second, it can cause direct conflict with a contractor’s purchasing procedures and, in cases of contractors with approved purchasing systems, upend the government’s own approval of the system that includes procedures for the contractor to identify and define subcontractors. Third, the government risks forcing a CAS noncompliance by prescribing different or special definitions for subcontractors in different circumstances. Contractors with CAS-covered contracts are required to treat all costs incurred for the same purpose, in like circumstances, consistently, [9] which the government would already have reviewed and audited as both part of the CAS disclosure statement and any related accounting system audit and system approval.

Ultimately, contractors should take a position within their policies and procedures considering what is reasonable and consistent given their business environment, type of government property, cost accounting practices, procurement practices, and any other business system or regulatory dependencies and interdependencies that may be applicable in order to ensure that they appropriately flow down contractual requirements.

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Article is a reprint from NPMA The Property Professional, Volume 33, Issue 6, December 2021. NPMA is the largest association for asset property management professionals who are responsible for the effective and efficient management of equipment, materials, and other moveable and durable assets for their organization. Established in 1970, NPMA has members throughout the U.S., in Canada and overseas. NPMA serves as a center of excellence, education, and evolution for the profession. Recognized as world-class professionals, members benefit from the finest products, programs, and services that promote professional development. Learn more at npma.org.

References

[1] Contract Management magazine – August 2021. National Contract Management Association

[2] Back to Basics: The Interconnectedness of the Defense Federal Acquisition Regulation (FAR) Supplement (DFARS) Business Systems” (National Property Management Association “Property Professional magazine, Volume 32, Issue 4, August 2020

[3] Based on an Interim Rule published in the Federal Register on May 18, 2011, DoD Contracting Officers are required to determine the acceptability of a contractor’s business system, approve, or disapprove the system, and pursue correction of any deficiencies. The following contractor business systems were affected: Accounting, Purchasing, Material Management and Accounting, Cost Estimating, Property Management, and Earned Value Management

[4] USLEGAL.com “Flowdown Clause Law and Legal Definition”; Flow Down Clause Law and Legal Definition | USLegal, Inc.

[5] Section 809 Panel – Defense Technical Information Center (dtic.mil)

[6] Section 820 of the National Defense Authorization Act for FY 2018 amended 41 U.S.C. 1906(c)(1) to change the definition of "subcontract" in certain circumstances.

[7] CAS 410: 9904.410-2

[8] CAS 410: 9904.410-50(d)(2)

[9] CAS 402: 9904.402-40

What's the low-down on flow down?