On September 4, 2024, the U.S. Department of Defense (DoD) issued a proposed rule to update its longstanding but little-known regulations for prototype other transactions (OTs), including new sections that authorize follow-on production OTs. The changes would bring the regulations up to date with the current text of DoD’s statutory authority for prototype OT and follow-on production agreements.
Much has changed since DoD’s OT regulations were last amended in 2004. In those years, the regulations have largely sat on the shelf (at 32 C.F.R. Part 3), rarely used and collecting dust while Congress repeatedly updated and expanded DoD’s statutory authority. In practice, DoD Agreements Officers and others draw their authority and guidance directly from the statute itself (10 U.S.C. § 4022). We expect that to continue, and the proposed rule is unlikely to effect any substantive change to current law. Nevertheless, it provides a good reminder of where the requirements stand for DoD OTs in a few key respects.
Nontraditional Defense Contractors
DoD’s prototype OT authority is limited to agreements that meet certain statutory criteria. According to DoD’s Federal Register notice, the most commonly used of these eligibility criteria – accounting for more than 90 percent of all prototype OT awards – is the significant participation of a “nontraditional defense contractor.”[1]
So, who qualifies as “nontraditional”? A nontraditional defense contractor is an entity that has not performed a DoD contract or subcontract subject to Full Cost Accounting Standards (CAS) coverage in the year prior to a solicitation. This is intentionally broad, and, as noted by DoD in its Other Transactions Guide, it includes nearly all small business concerns and even many companies that work exclusively with DoD.[2] It also includes subsidiaries or affiliates of large traditional defense contractors, as long as the specific legal entity at issue is not subject to Full CAS coverage (and, for purposes of the eligibility criteria, will in fact be a significant participant in the prototype project).
DoD’s OT regulations, as currently written, reiterate this by defining nontraditional defense contractor status to apply specifically at the “business unit” level, rather than at the “entity,” consistent with general rules for CAS applicability across different segments within an organization. DoD’s proposed rule would update the regulations to replace “business unit” with “entity” for consistency with the statute, but there is no indication the change is intended to substantively alter the availability of nontraditional status to separate legal entities within a larger corporate family of companies.
The proposed rule also would remove the additional requirement that a “nontraditional defense contractor” not have performed any prototyping or research projects worth more than $500,000 in the past year. That additional requirement was previously removed from the statutory definition.
Broad Definition of Prototype
The proposed rule would implement the broad definition of “Prototype Project” used by DoD and authorized by Congress in recent years. This broad definition, which comes directly from the statute, says that a prototype project can be any combination of the following:
- A proof of concept, model, or process, including a business process.
- Reverse engineering to address obsolescence.
- A pilot or novel application of commercial technologies for defense purposes.
- Agile development activity.
- The creation, design, development, or demonstration of operational utility.
Congress added this definition to the statutory authorization in the National Defense Authorization Act for Fiscal Year 2023. Previously, the statute contained no definition, but the DoD claimed a broad interpretation of “prototype” that was very similar to the current statutory definition. Even before Congress enacted its definition into law, the Government Accountability Office upheld DoD’s broad interpretation of the term as reasonable in multiple challenges to its breadth. See ACI Techs., Inc., B-417011, Jan. 17, 2019, CPD ¶ 24; Oracle America, Inc., B-416061, May 31, 2018, CPD ¶ 180.
Follow-On Production
The proposed rule also would add regulations for follow-on production OT awards. By law, DoD may award an OT or contract for follow-on production efforts on a sole-source basis if the initial prototype OT was awarded using competitive procedures and has been successfully completed. Notably, any agency may award a follow-on production OT or contract following successful completion; it does does not have to be the same agency that awarded the initial prototype OT, as we discussed previously. In fact, multiple DoD agencies may each award their own production OTs or contracts as follow-ons to a successfully completed prototype OT that a single agency had awarded and managed.
To proceed from a prototype to follow-on production OT, the government must make a written determination that the prototype OT was “successfully completed.” According to DoD guidance, “successful completion” means that the prototype project “(1) met the key technical goals of a project; (2) satisfied success metrics incorporated into the Prototype OT; or (3) accomplished a particularly favorable or unexpected result that justifies the transition to production.” Any success metrics incorporated into a prototype OT may be objective or subjective, and success can be determined before the prototype project has ended, to facilitate the transition to a follow-on production OT.
DoD’s Other Transactions Guide advises agreements officers to plan for the follow-on production OT as much as possible in the original prototype OT award. That planning should include a strategy “to obtain necessary IP deliverables (e.g., technical data or computer software), or associated license rights.” Pricing for the follow-on production OT should also be set at the time that the prototype OT is awarded, if the price can be forecast that far in advance.
OTs Are Contracts
DoD’s proposed rule would affirm that although OTs are not “procurement contracts” (or grants or cooperative agreements) and thus not subject to the laws specific to those legal instruments, they are most certainly “legally binding instruments that include the elements of: offer; acceptance; consideration; authority; a legal purpose; a meeting of the minds; and are approved by an Agreements Officer who has authority to bind the Government.” They are, in other words, contracts – contracts that may be enforced, against the Government or the OT Performer in a court of law (namely, the U.S. Court of Federal Claims), even if not subject to the Contract Disputes Act. That never should have been in doubt, but it was a common misconception.
A Few Closing Thoughts
DoD’s proposed rule is yet another signal that DoD’s prototype OTs have matured from pilot program to permanent authority. They are now a fixture of the government contracts industry and, according to the Federal Register notice announcing the proposed rule, “a significant asset in the DoD toolbox for acquisition of items to support the DoD mission.”
DoD continues to tout publicly its “flexibility in negotiation of terms” and “less Government oversight” associated with OTs, which it hopes will encourage participation by businesses that are otherwise “unwilling to forfeit intellectual property rights or adhere to some of the procurement regulations.” In practice, however, this flexibility is all too often leveraged by agreements officers to benefit the Government at the OT performer’s expense, especially with respect to intellectual property rights. The FAR and DFARS and their underlying statutes are the products of many decades of legislation and notice-and-comment rulemaking attempting to balance the Government’s interests with those of a captive industry. As a result, they include significant protections for contractor rights, such as a right to own their inventions or a right to keep their privately developed trade secrets out of the hands of their competitors. Yet there are OTs and OT solicitations now that demand performers give up those rights as a condition of participating in the same kinds of major weapons acquisitions that historically have formed the companies’ lifeblood. Such abuses of the Government’s bargaining position would be unheard of – and legally actionable – in a procurement contract, but OTs often evade such oversight.
When considering its proposed rule, DoD appears to have weighed other alternatives, such deleting its OT regulations altogether or expanding them to include “best practices for DoD practitioners.” It decided against the former because deletion of regulatory coverage for such an important acquisition tool “would be inconsistent with DoD’s policy to support innovation through acquisition policy.” It dismissed the latter as adequately addressed by DoD’s existing Other Transactions Guide. Whether to expect more OT regulations in the future, in furtherance of “innovation through acquisition policy,” is yet to be seen.
The flexibility and speed of OTs, when used correctly, present an opportunity to meet critical defense needs in ways that would otherwise be difficult or impossible. However, the flexibility can introduce new risks to the contracting process, so it remains vital for contractors to review terms with counsel before entering agreements.
Ethan Sterenfeld, a Law Clerk in our Washington, D.C., office, contributed to the writing of this article.
[1] Note that to meet this requirement, a nontraditional defense contractor is not required to be the OT awardee but rather must simply be “participating to a significant extent,” a phrase that has been broadly interpreted and defined by DoD in its internal OT guidance. DoD estimates that the majority of the dollars obligated for such agreements actually went to nontraditional defense contractors, but acknowledges limitations in its access to reliable data.
[2] As DoD observes in the Federal Register: “This definition permits a large number of entities, including nearly all small business concerns, to be considered [nontraditional defense contractors] to help drive innovation.”