Special Report

Next round of high-stakes battle over defense industry cash flow takes shape

November 18, 2019

By Tony Bertuca, Marjorie Censer

When the Pentagon's top negotiator told a public meeting last year that a controversial proposal to change the way the Defense Department paid contractors had been approved at the highest levels, the defense industry was worried.

Shay Assad, at a meeting at the Mark Center in Alexandria, VA, addressed a contingent of industry association officials concerned about a progress payments proposal that could put a serious dent in large companies’ cash flow. The proposal, unveiled in the daily Federal Register, hadn’t gotten much attention from the press, but had immediately raised alarm bells among industry advocates.

John Luddy of the Aerospace Industries Association had learned of the proposal on a Friday.

On that day, he said, he knew “next to nothing” about progress payments. By Monday, “it was the most important thing in my life.”

At the mid-September meeting, Luddy and other industry advocates argued the proposal, which would have restricted industry cash flow, would take a toll on industry’s ability to invest in new technology.

But Assad assured them there was “no daylight” between himself and top Pentagon officials about the government’s proposal to dramatically alter a contract financing policy that had been in place since 2001. He says now he knew the defense industry was “going to lose their minds.”

“The companies were getting an undeserved windfall,” Assad said. “They knew what I was getting at. We knew that industry was going to push back.”

Still, even Assad, who spent 22 years as a Raytheon executive before joining DOD in 2004, was unable to predict the chain of events that would ensue.

Within weeks, industry had mobilized, Congress had sent a rare letter demanding the proposal be completely rescinded and the Pentagon made an unprecedented admission of error. Assad, a longtime adversary of defense industry executives, found himself on unsteady footing.

While Pentagon acquisition chief Ellen Lord ultimately took the public blame for the proposal’s failure, many defense insiders feel it was Assad, who was moved out of the Pentagon last year, who took the private blame.

Now, the department is preparing to launch a new review of the issue before possibly making another run at contract financing reform.

“The tentative plan is that the study will be guided by a DOD steering group . . . with an independent entity conducting the study,” said Lt. Col. Mike Andrews, a Pentagon spokesman.

The study is a matter of huge importance for defense contractors, who hope to convince DOD to protect the predictable levels of cash flow the industry has enjoyed for decades.

David Berteau, president and chief executive of the Professional Services Council, said “it is clearly in the best interest of industry and government to work together on this from the beginning,” while Andrews said industry “will definitely be engaged" during the study.

Assad, meanwhile, warned that defense companies are well-positioned to influence DOD officials and protect their bottom lines at the expense of U.S. taxpayers.

“It has cost billions of dollars and the companies have benefited from billions of dollars,” he said. “I can understand why they don't want the change.”

Inside Defense spoke to more than a dozen current and former government officials and lobbyists about the events leading up to DOD’s rescission last year of its progress payments proposal and Assad’s departure from the Pentagon.

Assad, who was featured in a recent Yahoo News story in which he blamed Lord and other senior defense officials for caving to corporate interests, said his reputation was unfairly tarnished by the chain of events.

“I was the scapegoat,” he said.

Andrews declined to comment on Assad’s specific allegations, except to say that Lord “consistently took full responsibility for any failure” regarding the progress payments proposal and has been working to get “insight and input” from lawmakers and defense companies about how the department can incentivize contractor performance.

Pentagon’s ‘most hated man’ gets an idea

Even before the proposal was released, Assad had been dubbed “the most hated man in the Pentagon” because of his support for pricing policies that displeased the defense industry. But he had the respect of many at DOD; former Defense Secretary Ash Carter in his recent memoir called Assad a “black belt” in Pentagon acquisition.

Assad worked to position himself for success early in the Trump administration, commenting in March 2017 that the new president’s focus on negotiating tougher defense contracts made the pricing chief feel like he was “dying and going to heaven.”

Assad told Inside Defense last month he saw an opportunity in early 2018 when senior defense officials told him they were seeking a mechanism to make contractors more responsive to performance issues.

“I said: ‘Affect their cash flow and they'll respond,’” he recalled.

Working with a team of DOD pricing and acquisition officials, Assad said, he proposed lowering the customary progress payment rate on defense contracts from 80% to 50%. The rate structure has remained largely unchanged since 1985.

The proposal was based on a simple idea: because interest rates were much higher in the past, contractors received progress payments meant to help ensure they wouldn’t have to take out high-interest loans to finance their programs. As interest rates have sunk to historic lows, Assad posited, those payments could be reduced.

But the predictable cash flow of the defense industry has long been one of its selling points to investors. Industry executives have argued that defense firms have lower profit margins than commercial companies, but they have steady cash flow.

Assad said his idea was fully vetted by the Pentagon and approved at senior levels. Still, some members of his team knew it would face heavy criticism.

“It was very predictable,” said one former defense official who worked on the proposal. “I always had my doubts we would pull this off.”

Frank Kendall, DOD’s former acquisition chief who served as Assad’s boss during the Obama administration, said the former pricing chief was treated “very badly” by DOD, but was wrong about progress payments.

“The progress payment change was a fundamental shift in the business model,” Kendall told Inside Defense. “It would add significant uncertainty for industry and negatively impact cash flow. The industry reaction was very predictable.”

Kendall, who now works as an industry consultant, said he personally disagreed with Assad’s proposal.

“I believe in strong, but not excessive financial incentives to industry,” he said. “Shay has felt for a long time that defense firms get an exorbitantly high return on capital. They do, but their return on sales isn’t outrageous and the business model we have is well established, and it isn’t unreasonable.”

But Assad was able to convince Lord, the current acquisition chief, and other senior decisionmakers that cutting the progress payment rate was the right approach.

Lord “was for it,” Assad said. “That’s why it went ahead.”

A former defense official supports Assad’s assertion: “She legitimately saw it as a way to positively influence contractor behavior -- she knew cash was king.” Indeed, Lord herself would later promote the benefits of the proposal.

‘No daylight’

On a Friday in late August 2018, the proposed rule was published in the Federal Register. The Pentagon linked it to a required defense authorization bill provision about performance-based payments, and said DOD had been “providing financing in excess of that warranted based on the historically low interest rates in effect since 2008.”

The new policy, DOD said, would result in saving “hundreds of millions of dollars to the taxpayers by eliminating an unintended consequence of the past practice associated with providing contract financing in excess of what was necessary.”

At the National Defense Industrial Association, the phone started ringing, according to Corbin Evans, the association’s director of regulatory policy. Evans said industry members often called the association about proposed rules, but never in these numbers.

NDIA called other industry associations to organize a response.

By mid-September, the rule seemed to be gaining momentum. Lord told Defense News the rule would allow the Pentagon to reward companies for good performance.

“I believe the lifeblood of most industry is cash flow, so what we will do is regulate the percentage of payments or the amount of profit that can be achieved through what type of performance they demonstrate by the numbers,” she said.

More than a week later, Assad appeared at the public meeting at the Mark Center. At that meeting, he told industry executives there was “no daylight” between himself and top defense officials when it came to the proposal.

Concerned, one industry official told Inside Defense, “We decided we had to go find some daylight.”

Industry lobbyists went to Capitol Hill, where they sought help from the GOP chairmen of the House and Senate Armed Services committees.

Meanwhile, news that the defense industry could face a cash flow disruption spurred a market slide at some of the largest defense firms.

Days later, the GOP chairmen sent a joint letter to then-Deputy Defense Secretary Patrick Shanahan, arguing the rule was “fundamentally flawed” and could not be approved. In less than a week, Shanahan rescinded it, saying it was released “absent full coordination.”

Soon after, he blamed Lord, saying he did not “know the details within Ellen’s shop.”

“She shared with me that they hadn’t fully coordinated the input,” he told reporters. “I said, ‘Well, fine, we’ll just pull it back, we’ll fully coordinate it and we’ll move along.’”

By the end of the month, Assad said he’d been relocated to Boston, where he lived. He had long been commuting from the area to work at the Pentagon, and Assad -- backed by some other defense insiders -- says he was treated unfairly.

In December, Lord told reporters she took responsibility for the progress payments proposal’s failure.

“I don’t think we had done all of our homework before we went into the rule-making process,” she said. “I hold myself accountable, and I’m very involved with a wider team to make sure that we take everything into account.”

Assad retired several months later.

Today, Assad says the assertion the proposal was not “fully coordinated” is bogus, arguing it never would have been cleared by the White House Office of Management and Budget and published in the Federal Register if it that were the case.

Multiple former defense officials say Assad followed regular procedure.

“Shay, to his credit, followed the actual process,” one former official said. “It just blew up in a big way.”

“I was not surprised at all at the pushback,” another former official said. “From early on, it was clear he was going to be thrown under the bus.”

Former congressional staffers said there had long been concern about Assad’s commute to Washington from Boston at taxpayer expense, but DOD leaders in the Obama administration had granted him special dispensation to do so.

Shortly before Assad was reassigned to remain in Boston, DOD provided his travel records to DefenseOne, but chose not to comment further on the situation, calling it a personnel matter.

Assad’s government-funded travel bill since 2012 amounted to more than $500,000, according to DOD.

But in 2013, DOD had said that when Assad became pricing chief, the department was able to eliminate one senior executive service position and three other civilian employees, offsetting his travel expenses.

“The department had that information when they released my travel records,” Assad said. “But there was no attempt to explain. It was all to imply that I was being removed because I was wasting taxpayer money.”

The implication, Assad said, was frustrating because he received a Presidential Rank Award in 2015, in part because senior DOD officials said his work as defense pricing chief had saved the taxpayers millions.

Andrews, the Pentagon spokesman, said the department released Assad’s travel records “to show transparency and accountability” after a reporter claimed DOD had paid “hundreds of thousands, if not millions in travel and per diem for Mr. Assad.”

Assad and people who worked with him say he was a “fall guy” for a proposal that had the backing of senior DOD officials, but ran afoul of defense contractors and their allies in Congress. Concern about his travel expenses, they say, was a convenient way to remove him from the Pentagon.

The Pentagon, meanwhile, declined to discuss the particulars of Assad’s departure.

Next steps

The Government Accountability Office last June recommended the Pentagon conduct a “comprehensive assessment of the effect that its contract financing and profit policies have on the defense industry and update that assessment on a recurring basis.”

The Pentagon is ready to begin moving forward, spurring industry to prepare to make its case.

AIA, for instance, says it is forming a task force composed of contracting and finance experts to address the issue.

However, some of the players on Capitol Hill have changed since last year.

Sen. Jim Inhofe (R-OK), who was instrumental in getting the previous progress payments proposal rescinded, continues to lead the Senate Armed Services Committee, but his House counterpart is now Democrat Adam Smith (WA), who has argued the defense budget is too large and overly influenced by contractors.

Monica Matoush, Smith’s spokeswoman, told Inside Defense the chairman has an “open mind” about DOD’s efforts to pursue contract financing reform.

“Last year, Mr. Smith heard . . . concerns regarding the proposed rule and supported congressional efforts to seek clarity on the path forward,” she said. “In order for the progress payments proposal to be successful, the program must promote efficiencies and performance incentives without creating undue hardship for businesses trying to fulfill their contracts.”

Andrew Hunter, a former Pentagon acquisition official who now works at the Center for Strategic and International Studies, said the “stakes for industry in this contract financing proposal are very high.”

“A large portion of industry’s revenue comes in the form of progress payments, so changes to the progress payment formula will directly impact their bottom line,” he continued. “That is a major reason the department has seen this mechanism as an effective means to incentivize industry to perform better.”

But Hunter cautioned that contract finance policy can be a “pretty blunt instrument.”

“It can set up both positive and negative incentives for industry, often in counterintuitive ways,” he said. “I think it’s appropriate to thoroughly explore what incentives are being created, and where those incentives are best applied, to achieve the outcomes DOD wants.”