Novation of Government Contracts: How to Prepare for and Receive Government Approval

Government contractors, so long as consistent with statute and regulation, should coordinate with the government regarding novation issues to best position themselves for acceptance of proposed novations.

When the owner of a company is looking to sell its business, some of the company’s assets or, in some circumstances, the ownership of the company, a critical question is whether government contracts can be transferred to a third party. While the federal Anti-Assignment Act, 41 U.S.C. § 6305, prohibits the transfer of government contracts to a third party, the government may, when in the government’s interest, recognize a third party as the successor in interest to a government contract when the third party’s interest in the contract arises out of the transfer of all the contractor’s assets or the entire portion of the assets involved in performing the contract. See Federal Acquisition Regulation (FAR) 42.1204(a), Applicability of novation agreements. This act of transferring to a successor in interest is accomplished using a novation agreement.

A key factor is that the government is not obligated to novate a contract. When the government concludes it is not in its interest, the government may refuse to novate the contract and hold the original contractor liable. Although rare, this often happens when the transferee has inadequate resources or finances to perform, poses security concerns, or has poor past performance, or when the transfer may result in an organizational conflict of interest. If the transferee fails to perform, the contract can be terminated for default and the original contractor held liable for all obligations resulting from the default termination. See FAR 42.1204(c).

When seeking a novation, the contractor that holds the contract must submit to the responsible contracting officer (CO) the proposed novation agreement and the following documents set forth at FAR 42.1204(e):

• a document describing the proposed transaction (purchase/sale agreement, memorandum of understanding, etc.)
• a detailed list of all affected government contracts
• evidence of the transferee’s capability to perform
• any other relevant information requested by the responsible CO.

The contractor is also required to provide to the CO additional documentation pertaining to the proposed transaction as it becomes available, including the following:

• an authenticated copy of the document effecting the asset transfer (bill of sale, certificate of merger, etc.)
• certified copies of the resolution of the corporate parties’ boards of directors authorizing the asset transfer and minutes of each company’s stockholder meeting necessary to approve the asset transfer
• an authenticated copy of the transferee’s certificate and articles of incorporation if a corporation was formed for receiving the assets
• a legal opinion of counsel for both the transferor and transferee stating that the transfer was properly effected
• various balance sheets for the transferor and transferee audited by independent accountants
• evidence that any security clearance requirements have been met
• the consent of sureties or a statement that none are required
• any other relevant information requested by the CO.

See FAR 42.1204(f). This procedure must be repeated for each active contract in the contractor’s portfolio.

If the government decides to recognize the successor in interest, the CO will execute a novation agreement with the transferor and the transferee, typically following the format specified in FAR 42.1204(i). Under FAR 42.1204(h), the novation agreement should provide that:

• the transferee assumes all the transferor’s obligations under the contract
• the transferor waives all rights under the contract against the government
• the transferor guarantees performance by the transferee (or provides a satisfactory performance bond)
• nothing in the agreement relieves either company (transferee or transferor) from compliance with any federal law.

The FAR specifies that a novation agreement is not required when ownership changes as a result of a stock purchase, with no legal change in the contracting party. See FAR 42.1204(b). Although in theory this creates a simple standard, many acquisitions are accomplished through more complex mechanisms that blur the line between a stock purchase and asset transfer, thus creating ambiguity as to whether a novation is appropriate.

For example, in the commonly utilized “reverse triangular merger,” the acquired company survives the transaction as a legal entity, retaining the assets and contracts. Delaware courts have held that reverse triangular mergers do not result in assignments under Delaware law. See Meso Scale Diagnostics, LLC v. Roche Diagnostics GmbH, 62 A.3d 62 (Del. Ch. 2013). However, given that COs are not bound by and may not be aware of Delaware rulings, COs may take a reflexive response to ambiguous transactions and comply with the FAR as written. Moreover, even when a novation agreement is not required for a stock sale, the company may still need to obtain a change of name agreement or need to enter into a formal agreement between the contractor and the government to address issues related to the ownership change. See FAR 42.1205; 42.1204(b).

In most circumstances, assuming the parties agree, we recommend alerting the government well in advance regarding potential changes in ownership, so long as consistent with statute and regulation. This is to protect the company’s relationship with the CO, to gauge the CO’s reaction to an upcoming proposed novation, and to discuss any concerns the government has so that they may be addressed as quickly as possible. Our experience has been that an advance conversation with a CO can pave the way for a smooth novation in the future.

Contractors should also take note that the novation process often takes three to six months to complete. Processing novations may be outside the standard wheelhouse of many COs, whose working experience is more often dedicated to acquisition planning and contract administration. Laying advance groundwork with a CO can help smooth that path. And regardless of whether a CO is fluent in novations or is encountering an unusual procedure, the CO will likely be checking a novation submission carefully against the lists of required documents in FAR 42.1204. A well-organized novation package, with a cover letter that identifies the document or documents that satisfy each entry in the FAR lists of requirements, will simplify the CO’s assessment and help speed review. So will using the novation agreement language in FAR 42.1204 to tailor a draft agreement for the CO’s signature. These are simple, low-investment steps that contractors can take on the front end to best position themselves for government acceptance — and timely acceptance — of proposed novations.