F-35 Contract Feud Exposes Rift Over 'Fair' Prices

Photo: Lockheed Martin

Shockwaves rippled across the defense industry following the news that Lockheed Martin is challenging the Pentagon over a $6.1 billion “unilateral” contract awarded to the company to continue building F-35 joint strike fighters for the U.S. military.

The low-rate initial production contract announced Nov. 2 would fund 57 F-35s aircraft. “The LRIP 9 contract represents a fair and reasonable deal for the U.S. government, the international partnership and industry,” said Lt. Gen. Chris Bogdan, F-35 program executive officer.

The manufacturer disagrees. Lockheed spokesman Michael J. Rein said in a statement that company was “disappointed with the decision by the government to issue a unilateral contract action.” 

Officials declined to comment further as the company considers taking legal action. The parties are said to be wide apart on program cost estimates and the contractor fee — which partly is derived from program costs. 

Industry sources said this is possibly the largest unilateral contract ever awarded by the Defense Department. The estimated $400 billion F-35 program is the Pentagon’s largest weapons acquisition. 

How did it get to this point? Lockheed and the F-35 program office have been negotiating for 18 months over the terms of the LRIP 9 and 10 deals. Under national security provisions in the federal acquisition regulations, the government can at any point stop negotiations and issue a contract. The JPO can assert that these airplanes are urgently needed by the armed forces and that the contractor has to keep producing them even if they haven’t reached an agreement on the price. Lockheed is obligated to continue the work, but faces the choice of either accepting the terms or appealing the decision — either to the Armed Services Board of Contract Appeals, or to the Court of Federal Claims. The company has 90 days to decide.

What led to a collapse in the negotiations was the JPO rejecting Lockheed’s accounting of what it costs to build these airplanes. One industry source said the government did not believe the cost data submitted, which was based on the previous eight LRIP contracts, was reasonable. The JPO also challenged Lockheed’s claims that its fee should recognize capital outlays the company made to pay for parts, factory upgrades and other program-related expenses. This strikes at the core of the defense industry’s business model, in which a company assumes risks upfront but expects to be rewarded later. The dispute also speaks to brewing disagreements in Defense Department programs between what contractors assert something costs, versus what the government believes it “should cost.” 

Industry analysts were surprised by the developments even though contracting disputes are not unusual in Pentagon programs. The government “used a very extreme approach to definitize the F-35 LRIP 9 contract,” wrote Roman Schweizer, of the Cowen Washington Research Group. The JPO “used a bazooka on LRIP 9,” which could signal long-term troubles for the program.

Schweizer said “bare-knuckle contracting is nothing new to the F-35 program, and the government and Lockheed have used ‘undefinitized contract actions’ to keep the money flowing and the jets coming together while the nitty-gritty was hammered out.” But after the latest standoff over pricing, the government “decided to break the ice with a colossal sledgehammer.”

“Contract officers can use unilateral actions to adjust or tweak contracts but we've never seen it applied this way,” Schweizer noted. 

It is still unclear how this will affect a much-anticipated three-year block-buy deal for at least 450 more aircraft for U.S. and international customers in 2018, he added. “We have been optimistic that deal would really kick the program to another level but are concerned now that if negotiating a two-year pact devolved to this outcome, the prospects for rolling up a deal three times the size may be extremely difficult.”

The LRIP 9 price the government enforced in the contract is a 3.7 percent reduction from the LRIP 8 contract signed in December 2014 and an overall 58 percent price reduction since the LRIP-1 contract, the JPO said in a statement.  Once production of LRIP 9 aircraft is completed, more than 250 F-35s would be in operation by eight nations. The LRIP 9 engine contract between the government and engine manufacturer Pratt & Whitney was signed in April.

Contracting experts speculate that, if Lockheed chooses to take legal action, it will file a claim with the Armed Services Board of Contract Appeals. The ASBCA is a neutral, independent forum that has been in existence for over 50 years. It mostly handles post-award contract disputes between contractors and the Department of Defense, NASA and the CIA. 

Under the Contract Disputes Act, contractors can take their case to the ASBCA or to the Court of Federal Claims.  

“Contractors often choose the board,” said federal contracting attorney Todd Overman, of Bass, Berry & Sims government contracts practice. “It’s not the same level of formality as the Court of Federal Claims,” he said. ASBCA allows the agency to stay involved in the case during the fact-finding process. A decision written by a board judge is binding. The next appeal then goes to the federal circuit court. Without knowing the details of the Lockheed case, Overman guessed that the company did its research and likely believes there is “precedent at the board that will be more helpful to them.” ASBCA judges are known to be “very knowledgeable about DoD programs.”

Legal issues aside, the contractual troubles that are now disrupting the F-35 program are largely the product of the Pentagon’s own decisions on how to compensate contractors under cost-plus contracts. “Industry makes its fee on cost-type contract based on the amount of cost it justifies,” said retired Navy Vice Adm. David Dunaway, former commander of Naval Air Systems Command who oversaw multibillion-dollar programs. 

“We have a fundamental problem in that we can’t quantify value, therefore we can’t come to a price,” Dunaway told National Defense. When incentive fees are assessed in part as a percentage of cost, “you have a system that doesn’t match the free market,” he said. “We need to value things better. That’s a tough problem. In a cost world that’s the way companies make money. It’s counter intuitive when you want to cut costs.”

One of the F-35's toughest critics, Sen. John McCain (R-AZ), chairman of the Senate Armed Services Committee, said in a statement that the "recent breakdown in F-35 contract negotiations between the Department of Defense and Lockheed Martin is troubling and disappointing. It should be seen, more broadly, as yet another symptom of our flawed defense acquisition system in general and the structure of the F-35 program in particular. To be sure, developing advanced fighter aircraft is extremely complicated. But the decision to produce hundreds of aircraft, on a cost-plus basis, before the technology is developed and completed, and to do all of this, lot after lot, without an actual contract in place between the government and industry, is the height of acquisition malpractice."

Topics: Air Power, Acquisition Programs, Defense Contracting