Debt Limit Breach to Squeeze US Government Contractors First

Federal contractors would be among the first to experience serious financial consequences in the event Congress fails to raise the debt limit and government agencies can’t pay their bills as the fiscal year ends.

The government’s fourth fiscal quarter is typically the busiest part of a contractor’s year and can be a make-or-break period for the annual bottom line. Agencies spend about one-third of their annual procurement dollars in July, August, and September, and fourth quarter contract disruptions could have devastating financial consequences for the federal vendor base. That could lead to bankruptcies and layoffs among contractors.

The Congressional Budget Office last month that failure to raise or suspend the debt limit, which was reached Jan. 19, “would ultimately lead to delayed payments for some government activities, a default on the government’s debt obligations, or both.”

The Congressional Budget Office reported Feb. 15 that without congressional action, the federal government between July and September will no longer be able to borrow funds to meet its obligations using “extraordinary measures” for accounting for debt. That date could come sooner if revenues collected over the next three to four months are lower than anticipated.

If the Treasury can’t take on new debt, the government can only pay bills with the cash it receives, and federal revenue varies from month to month. A 2021 study by the Bipartisan Policy Center estimated that after a debt breach, Treasury would only be able to meet about 60% of its financial obligations with cash on hand. That figure is the most recent available, according to Rachel Snyderman, BPC’s senior associate director of business and economic policy, who added that a new report with 2023 figures would be published in the next few months.

With Congress and the White House still far apart on resolving the debt limit issue and the time remaining until the Treasury runs out of alternatives so uncertain, the slow pace of updates on major IT and professional services opportunities could be an early sign that agencies are looking for funding assurances before committing to large, long-term projects. As a result, some new work may get pushed into the new fiscal year.

Weeks or months in advance of a full-blown federal debt limit crisis, private-sector government partners will already be looking at actions to protect their businesses.

Some of the financial risks executives must weigh to mitigate risk to their firms include whether to invest thousands or millions of dollars on bid proposals that may not result in funded contracts, to commit to long-term employee contracts when work may not materialize as planned, or to borrow for new plant and equipment investment.

Complete breach of the debt limit and all emergency measures by the Treasury Department would be unprecedented, and precise impacts are hard to quantify. Their severity will depend on how agencies manage cash flows, how agencies prioritize financial obligations, how long the breach lasts, and how credit and currency markets react, along with other financial and legal impacts.

Even if government operations don’t come to a screeching halt, contractors will be particularly vulnerable. Immediate problems could include stop work orders, canceled contracts, and frozen, delayed, or reduced contract payments. Depending on the length of the breach, agencies may resort to something akin to rolling blackouts—scheduling payments on an intermittent basis as cash on hand permits.

As a result, vendors, particularly those with low cash reserves, would see dwindling bank accounts and be forced to take immediate action to stanch losses.

One common response to payment stoppages is for contractors to furlough or lay off employees, but this option could bring problems if used in the current debt limit crisis scenario. For instance, those actions may violate individual employment contracts, leading to employee lawsuits or triggering expensive termination fees.

Cy Alba, head of PilieroMazza’s government contracts practice group, said mid-sized and larger contractors could get squeezed by having to comply with the Worker Adjustment and Retraining Notification Act. The WARN Act requires companies with at least 100 employees to provide 60 days advance notice before mass layoffs or plant closings.

Carrying a large work force for two months after a contract is abruptly canceled or delayed would cause serious financial hardship for companies lacking deep pockets.

Experienced employees who get laid off could be hard to win back, forcing contractors to increase spending for recruiting and training in the event project accounts are restored.

Federal agencies could face potential employment problems too. If they furlough employees in program and contract offices, it could lead to project delays and slow or halt work on contracted projects. Like their commercial partners, agencies could be forced to recruit and train new—and less experienced—employees to replenish their ranks.

Lost revenue may also lead to tightened credit, delayed loan payments, and delayed supplier payments. This, in turn, could expose vendors to a cascading series of additional financial and legal difficulties, including penalties for contract delays and breaches, loan defaults, and subcontract breaches.

Other scenarios could compound these problems, Alba said. Agencies could try to absolve themselves from liability in the event of a debt breach by invoking the “sovereign acts doctrine” that holds agencies harmless from damages and liabilities resulting from contract problems caused by government actions that are deemed “public and general.”

“This could run contractors and subcontractors into bankruptcy, " Alba explains.

In the construction industry, for example, payment freezes could lead to Miller Act claims on a prime contractor’s construction bonds. The Miller Act requires contractors to post a payment bond for federal construction contracts exceeding $150,000. The payment bond provides a way for subcontractors and suppliers to recover payment in the event that the contractor defaults on its obligations.

“Because many bonds, especially for small businesses, are personally guaranteed, the bonding agents will seek to recover from contractors and their owners, who may, in turn go bankrupt,” Alba said.

Companies discouraged by cash flow disruptions could decide to leave the federal marketplace, speeding the steady decline in the federal industrial base.

A complete government default could result in a hit to the government’s credit rating, higher interest rates, reduced foreign investment and a lower dollar value, and higher supply chain costs.

Contractors holding fixed price contracts are particularly vulnerable to rising costs for supplies, either imported or domestically sourced.

Without adequate inflation adjustment clauses in their contracts, vendors may be unable to recoup higher-than-expected supply and operations costs which, in turn, could lead them to petition agencies for relief under terms outlined in the Federal Acquisition Regulations Part 50.

This path toward relief would be time consuming and drive up overhead costs, and results are not guaranteed.