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Navigating the Regulatory Maze: 8 Crucial Insights for Dealmakers in Government Contracts M&A
Government contracting has historically been viewed as a relatively stable industry, making public sector-focused businesses fertile ground for mergers and acquisitions (M&A) activity. Companies serving the US government, whether as prime contractors or subcontractors, are attractive acquisition targets because they often enjoy historically stable customer demand and consistent cash flow. Investors are actively putting significant capital behind strategies focused on commerciality, rapid deployment of technology, and creative contracting mechanisms.
However, deals involving these entities carry unique complexities. Government contracting is, and will remain, a highly regulated industry. Successful M&A requires specialized expertise to navigate the specific challenges and demanding compliance requirements. Without proper planning, regulatory complexity can easily erode deal value or lead to significant post-closing exposure.
Here are eight critical factors dealmakers must understand when engaging in M&A involving government contractors:
1. Government Contracts Are Not Commercial Contracts
Unlike standard commercial agreements, contracts awarded by the US government are fundamentally different. They typically contain an extensive list of Federal Acquisition Regulation (FAR) clauses and other regulatory provisions that dictate the rights and obligations of the parties. Even with an ongoing overhaul of acquisition regulations aiming to relax some compliance obligations, foundational precepts remain. For instance, the government retains an automatic right to terminate most prime contracts for its convenience and can unilaterally change the scope of work and other contract terms. Furthermore, the government’s obligations, especially in multi-year agreements, are often subject to the availability of appropriated funds.
2. Assignment is Restricted by Statute
A key difference is that government contracts are often not freely assignable assets. Under the Anti-Assignment Act, a prime contract cannot be assigned without approval from the customer. This prohibition is generally not found within the contract itself but is instead detailed in Subpart 42.12 of the FAR. In an asset sale, parties must execute the assignment instrument and then seek post-closing approval from the government. This lengthy novation process requires transaction parties to establish an interim arrangement to govern contract performance between closing and final approval, a period that can last several months.
3. Ownership Disclosure is Mandatory
The US government expects contractors to disclose, at a minimum, their immediate owner and their highest-level owner. For companies holding security clearances, more extensive ownership disclosures are required by agencies such as the Defense Counterintelligence and Security Agency (DCSA). This includes providing a full organizational chart and identifying any foreign equity holders with 5% or more interest, even if they are entirely passive investors. We are seeing an uptick in procuring agencies, like the Department of Energy, requiring disclosure of foreign affiliates even when no industrial security issues are implicated.
4. Foreign Involvement Requires Mitigation
If the DCSA or another US government agency determines that a cleared contractor is subject to Foreign Ownership, Control, or Influence (FOCI), the contractor must mitigate the FOCI to the government’s satisfaction. Mitigation requirements vary based on the nature of the FOCI, ranging from a simple board resolution to a comprehensive proxy agreement that places governance responsibility and voting rights with government-approved individuals who are unconnected to the company or its owner.
Additionally, regardless of security clearance status, transactions may require pre-closing review by the Committee on Foreign Investment in the United States (CFIUS). A CFIUS review can significantly lengthen the time between signing and closing and may result in further mitigation obligations.
5. Specialized Governmental Authorizations Matter
Dealmakers must understand the permits and governmental authorizations an acquisition target relies on. For contractors in the defense and national security sectors, maintaining a registration with the Department of State under the International Traffic in Arms Regulations (ITAR) is crucial. The ITAR requires notification to the State Department in connection with changes of ownership or control. For foreign buyers, the ITAR mandates an additional pre-closing notification, impacting the closing timeline. Similarly, if a company holds Federal Communications Commission (FCC) licenses or engages in certain regulated activities, it often must obtain FCC approval before effecting a change of control.
6. Socioeconomic Preferences Present Compliance Pitfalls
The US government uses socioeconomic preferences—designed to boost participation by small businesses, including those owned by women, veterans, and the economically disadvantaged—in several aspects of procurement. Many prime contracts are awarded on a set-aside basis, limiting competition to eligible businesses. Due diligence must confirm that past claims to such preferential status are accurate, accounting for the size of the target and its affiliates. This is a complex area that continues to attract significant enforcement attention, and dealmakers must consider whether the proposed transaction will jeopardize the target’s ability to claim status going forward or retain previously awarded contracts.
7. Unique Accounting and Disclosure Rules Apply
Many government contractors must adhere to unique accounting and disclosure practices that can be a source of historical liability. For applicable businesses, the Cost Accounting Standards (CAS) require alignment of accounting methods to a set of government standards and disclosure of how specific costs are accounted for. The Truthful Cost and Pricing Data statute obligates certain contractors to provide certified cost or pricing data to justify their proposed pricing, sometimes revealing anticipated margins to the government customer. Furthermore, contractors may be subject to government audits and compliance reviews, which can result in repayment obligations and other liabilities.
8. Non-Compliance Can Lead to Enforcement Action
Ordinary compliance issues in government contracting can quickly spiral into major incidents, such as government investigations or whistleblower actions. The False Claims Act (FCA) is actively used by the Department of Justice (DOJ), or by a private party, to pursue treble damages and statutory penalties against companies that submit a false claim for payment to the US government. The DOJ has substantially increased its use of the FCA to police contractor compliance with contract terms, particularly targeting complex regulatory areas like cybersecurity and supply chain compliance. This high level of scrutiny and potential liability requires enhanced diligence.
Key Takeaways for Dealmakers
The intersection of specialized regulatory approvals, unique compliance requirements, and intense government scrutiny means that government contracts M&A demands specialized expertise. Early, informed risk identification is a crucial element of due diligence for public sector-focused businesses. To avoid mid-deal surprises and ensure long-term value, buyers and sellers must conduct nuanced business and legal diligence into how target companies approach their sales to the US government.
Government Contracts, M&A, Acquisitions, Dealmakers, FAR, FOCI, CFIUS, False Claims Act, Private Equity, Compliance, Defense Contracting, Regulatory Risk, MarketUS