[Federal Register: October 31, 2007 (Volume 72, Number 210)] [Rules and Regulations] [Page 61479-61495] From the Federal Register Online via GPO Access [wais.access.gpo.gov] [DOCID:fr31oc07-1] ======================================================================== Rules and Regulations Federal Register ________________________________________________________________________ This section of the FEDERAL REGISTER contains regulatory documents having general applicability and legal effect, most of which are keyed to and codified in the Code of Federal Regulations, which is published under 50 titles pursuant to 44 U.S.C. 1510. The Code of Federal Regulations is sold by the Superintendent of Documents. Prices of new books are listed in the first FEDERAL REGISTER issue of each week. ======================================================================== [[Page 61479]] DEPARTMENT OF AGRICULTURE Food and Nutrition Service 7 CFR Parts 210, 215 and 220 [FNS-2007-0003] RIN 0584-AD38 Procurement Requirements for the National School Lunch, School Breakfast and Special Milk Programs AGENCY: Food and Nutrition Service, USDA. ACTION: Final rule. ----------------------------------------------------------------------- SUMMARY: The Food and Nutrition Service (FNS) is revising the regulations governing procedures related to the procurement of goods and services in the National School Lunch Program, School Breakfast Program and Special Milk Program to remedy deficiencies identified in audits and program reviews. This final rule makes changes in a school food authority's responsibilities for proper procurement procedures and contracts, limits a school food authority's use of nonprofit school food service account funds to costs resulting from proper procurements and contracts, and clarifies a State agency's responsibility to review and approve school food authority procurement procedures and contracts. This final rule also amends the Special Milk Program and School Breakfast Program regulations to make the procurement and contract requirements consistent with the National School Lunch Program regulations. These changes are intended to promote full and open competition in school food authority procurements, clarify State agency responsibilities, and ensure that only allowable contract costs are paid with nonprofit school food service account funds. DATES: This rule is effective November 30, 2007. However, implementation will be phased in for existing contracts. Implementation timeframes are discussed more fully in section III of the SUPPLEMENTARY INFORMATION. FOR FURTHER INFORMATION CONTACT: Melissa Rothstein, Branch Chief, or Lynn Rodgers-Kuperman, Program Analyst, Child Nutrition Division, Program Analysis and Monitoring Branch, Food and Nutrition Service, Department of Agriculture, 3101 Park Center Drive, Room 640, Alexandria, Virginia 22302-1500. FAX (703) 305-2879; telephone (703) 305-2590. SUPPLEMENTARY INFORMATION: I. Background On December 30, 2004, FNS published a Notice of Proposed Rulemaking (proposed rule) in the Federal Register (69 FR 78340) intended to remedy the deficiencies in school food authority procurement practices that are undermining full and open competition and resulting in unallowable uses of nonprofit school food service account funds. The December 2004 rule proposed to: (1) Clarify allowable nonprofit school food service account expenditures for costs resulting from cost reimbursable contracts or cost reimbursable contract provisions; (2) prohibit contract terms that allow payments from the nonprofit school food service account in excess of the contractor's actual net allowable costs, computed by deducting certain rebates, discounts and other credits; and (3) require State agency review and approval of all contracts between school food authorities and food service management companies prior to their execution. As discussed in the preamble to the proposed rule, most school food authorities manage the National School Lunch Program, School Breakfast Program and Special Milk Program on their own. However, some school food authorities choose to contract with a commercial enterprise to manage the programs. These commercial enterprises are collectively known as food service management companies. In regulations published on January 18, 1969, FNS first permitted school food authorities operating under contract with a food service management company to participate in the National School Lunch Program under a pilot program (34 FR 807). On March 1, 1969, FNS issued prototype agreements for use by these school districts (34 FR 3704- 3709). At that time, the only form of payment to a food service management company was a fixed price per plate or other meal equivalency served or delivered that included the contractor's full costs and profit. The food service management company was required to purchase food for the school food authority with invoices sent directly to the school food authority for payment. The cost of such food purchases was limited to the amount agreed upon between the food service management company and the school food authority (34 FR 3704). In effect, this contract was a cost reimbursable contract with a cap on costs plus a fixed management fee. Over time, the limit on costs was abandoned. Currently, food service management company contracts are either an inclusive fixed price per meal, or cost reimbursable with a fixed fee (without a cap on costs) contracts. We understand that the majority of all food service management company contracts are cost reimbursable with a fixed fee. School food authorities use funds from the nonprofit school food service account to pay for costs incurred under both self-managed and food service management company-contracted programs. The funds in the nonprofit school food service account come from federal and nonfederal sources. The federal funds are provided as reimbursements from the U.S. Department of Agriculture (Department) for meals and milk meeting the requirements in 7 CFR 210.10, 215.7 and 220.8 that are served to eligible children. The primary sources of nonfederal revenue are student payments, adult payments and a la carte sales revenue. Additional funding sources include State and local funds and sales revenue from vending and catering activities. Regardless of the source, the school food authority must retain all of these revenues in the restricted nonprofit school food service account and may only expend these revenues for the allowable costs of the school food authority's nonprofit school food service program. When procuring goods or services, including the use of a food service management company, school food authorities must conduct procurements in a manner that provides full and open [[Page 61480]] competition. Full and open competition is necessary to provide a ``level playing field'' so that all potential contractors have the opportunity to win the contract award. Competition is impaired when potential contractors lack the necessary information to properly identify allowable and unallowable costs and establish the best and most responsive price, or when the procurement is written in a way that inhibits the ability of potential contractors to submit bids. A properly conducted procurement results in the school food authority obtaining the best product at the best price. Cost allowability is determined using the applicable program and Departmental regulations (7 CFR parts 210, 215, 220, 3016 and 3019, as applicable) and Office of Management and Budget (OMB) Cost Circulars (A-87 Cost Principles for State, Local Governments and Indian Tribal Governments, or A-122 Cost Principles for Non-profit Organizations, as applicable). The determination regarding allowability is made, in part, based on the character of the recipient (i.e., school food authority) incurring the costs under the Federal program. As school food authorities are generally local governmental entities, all costs would, therefore, be subject to the principles found under OMB Circular A-87. In cases where the school food authority is a private non-profit (e.g., in the case of a parochial school), OMB Circular A-122 would apply. Further discussion of this matter is found later in this preamble (see Applicability of the OMB Cost Circulars to school food authority contracts under Section II of this preamble). The proposed rule clarified that only costs resulting from cost reimbursable contracts or cost reimbursable contracts or cost reimbursable contract provisions that meet applicable cost allowability requirements are allowable nonprofit school food service account expenditures. The proposed rule required that allowable contractor costs paid from the nonprofit school food service account be net of all discounts, rebates and applicable credits. In addition, the proposed rule required contractors to provide sufficient information to permit the school food authority to identify allowable and unallowable costs and the amount of all such discounts, rebates and credits on invoices and bills presented for payment to the school food authority. This requirement serves to make the identification of discounts, rebates and credits more transparent to school food authorities and allows for proper use of nonprofit school food service account funds. This requirement should not place an additional burden on contractors as they already track the costs that are billed to school food authorities and have accounting and billing systems in place for school food authority contracts. Under Generally Accepted Accounting Principles and good business practices, these contractors also must maintain systems to track and report discounts, rebates and credits. OIG Audit Reports The proposed rule was prompted in part by two audits released by the Office of Inspector General (OIG) in 2002, both of which identified deficiencies in school food authority procurement practices that are undermining full and open competition and resulting in unallowable uses of nonprofit school food service account funds. The first audit, released in February 2002 as Audit Report 27010-3-AT, identified a number of instances where a cooperative buying group, using nonprofit school food service account funds, failed to conduct procurement transactions in a manner that provided for full and open competition. For example, one cooperative buying group failed to include all items to be purchased in its bid solicitation and instead purchased items directly from the contractor outside of the terms of the contract. To purchase directly from the contractor without the benefit of a proper procurement limits full and open competition, as other potential contractors are eliminated from consideration. The second audit (OIG Audit Report 207601-0027-CH, released in April 2002) revealed problems in several cost reimbursable contracts between school food authorities and food service management companies. OIG found contracts between school food authorities and food service management companies that lacked controls as to exactly how the company would determine the allowability of costs charged to the school food authority, including how the company would provide the school food authority with the benefits of purchase discounts, rebates, and credits in the determination of net costs. The failure of a school food authority to describe its cost reporting requirements fully in its solicitation document undermines full and open competition by placing unreasonable burdens on potential contractors. Without adequate details on how it must report costs to the school food authority, a potential contractor lacks the information needed to properly establish the fixed price component (management fee) of its offer. In addition, school food authorities cannot determine whether nonprofit school food service account funds may be used to pay all or only part of the costs billed by the contractor. In other cases, OIG found that even though the school food authority's procurement documents required the return of such discounts, rebates, and applicable credits, the food service management company was permitted to keep the discounts and rebates earned through purchases billed to the school food authority. Allowing the food service management company to keep these funds was a material change to the contract; material changes require a rebidding of the contract. The net effect is that excess charges are made against the food service account, thereby diminishing food service resources. Comments in General FNS received 16 comments on the proposed rule within the allotted 60-day comment period. Of the 16 commenters, seven were State agencies, three were food service management companies, and the rest were trade and professional organizations and consultants. The proposed rulemaking allowed interested parties the opportunity to request further information from FNS. Three interested parties (food service management companies and their representatives) requested and received the opportunity to meet with FNS in lieu of requesting the information via other means. These meetings were for informational purposes only. None of the discussions at those meetings constituted comments on the proposed rulemaking. Fourteen of the sixteen commenters supported either one or both of the proposed rule's goals of improving full and open competition in school food service procurements and limiting nonprofit school food service account expenditures to net allowable costs. All but two commenters raised concerns or objections to one or more of the proposed rule's provisions or requested additional guidance. One commenter only addressed long term beverage contracts and one commenter disagreed that the identification of credits and rebates in cost reimbursable procurement solicitations and contracts would foster greater competition in school food service procurements. No specific comments were received on the proposal to make the procurement and contract requirements and the consequences for failing to take corrective action in the Special Milk Program and School Breakfast Program [[Page 61481]] regulations consistent with the National School Lunch Program regulations. II. Discussion of the Rule's Provisions and Related Comments Definitions The proposed rule added definitions of ``Applicable credits,'' ``Contractor,'' and ``Nonprofit school food service account'' to 7 CFR 210.2, 215.2 and 220.2. All subsequent references to regulatory sections are to title 7, Code of Federal Regulations, unless otherwise indicated. ``Applicable credits'' was defined with a cross-reference to definitions provided in OMB Circulars A-87 and A-122. The proposed rule at Sec. Sec. 210.21(e)(1)(i), 215.14a(d)(1)(i) and 220.16(e)(1)(i) required that cost reimbursable contracts include a provision that costs paid to the school food authority's contractor be net of all discounts, rebates and other applicable credits received by the contractor. Examples of applicable credits are discount incentives for volume purchases, credits for returned goods, and rebates paid for the purchase of specific goods. Several commenters asked for clarification on whether earned income would be considered an ``applicable credit'' under the proposed definition. In general, earned income is a payment from the manufacturer to the distributor for work performed by the distributor on behalf of the manufacturer. Some examples of earned income include payments made to a distributor for promoting new products, hosting trade shows, distributing promotional information, or carrying a particular product in inventory. In each of these cases, the distributor must perform some service to receive the payment from the manufacturer. This type of earned income is not related to purchases made by a school food authority using its nonprofit school food service account and, therefore, is not considered an applicable credit. Three commenters asked for clarification on whether a prompt payment discount would be considered an applicable credit. A prompt payment discount is an applicable credit to the nonprofit school food service account only if the school food authority earns the reduction by paying the bill or by providing advance funds to another party to pay the bill on its behalf. We understand that in the majority of school food authority cost reimbursable contracts, distributors and food service management companies obtain goods from suppliers, are billed by those suppliers, pay the suppliers and then deliver the goods at some later point in time to the school food authority. In these arrangements, the prompt payment discounts are not applicable credits to the school food authority. On the proposed definition of ``contractor,'' a number of commenters asked for confirmation that the definition includes all contractors to the school food authority, not just food service management companies. The commenters are correct. Commenters also wanted clarification on whether a purchasing cooperative meets the definition of a contractor. A school food service purchasing cooperative, an organization formed by school food authorities to conduct purchases, is not a contractor to its school food authority members, but instead acts as their purchasing agent. As an agent, the purchasing cooperative must follow the same rules in acquiring goods and services that its school food service members would follow should the members make the acquisitions themselves. Another type of purchasing cooperative is a cooperative buying group, which is an already existing public, for-profit or nonprofit buying group which usually requires the payment of a fee to become a member. In exchange for the membership fee, the cooperative buying group offers its members pre-selected items at prices that are generally lower than the price paid at retail establishments for the same items. While the purchase of a membership from the cooperative buying group might create a contractual relationship between the cooperative buying group and the school food authority, a cooperative buying group is not considered a ``contractor'' under the program regulations. One comment was received on the proposed rule's definition of ``Nonprofit school food service account.'' The proposed rule established the definition of ``Nonprofit school food service account'' to mean the restricted account in which all of the revenue from the food service operations conducted by the school food authority principally for the benefit of school children is retained and used only for the operation or improvement of the nonprofit school food service. The commenter requested the word ``restricted'' be further defined. No change to this definition is being made in this final rule because the nature of the restrictions on the use of nonprofit school food service account funds are explained within the definition itself and at Sec. 210.14(a). In addition to the requests for clarification discussed above, commenters also requested that definitions be added to the final rulemaking for ``cost contract,'' ``fixed price contract,'' ``cost reimbursable contract'' and ``fixed fee.'' The terms ``cost reimbursable contract'' and ``fixed fee'' have been defined in this final rule, because FNS will need to use these terms in regulatory language. However, we did not define the other two terms. The term ``cost contract'' is already defined in Department regulation 7 CFR 3016.3. FNS does not see the need to use the term ``fixed price contract'' in the National School Lunch, Special Milk or School Breakfast Program regulations, and has therefore elected not to define that term in regulatory language. (Please note, however, that while the term ``fixed price contract'' is not used in the regulations, it is a commonly used type of contract in these programs, and will be used at various times in this preamble.) Thus, the final rule adds definitions for ``cost reimbursable contract'' and ``fixed fee'' based on existing regulations, accounting definitions and previously issued policy and guidance. Accordingly, the three definitions proposed for ``applicable credit,'' ``contractor,'' and ``nonprofit school food service account'' are adopted without changes, and definitions for ``cost reimbursable contract'' and ``fixed fee'' are added to this final rulemaking for the National School Lunch, Special Milk and School Breakfast Programs at Sec. Sec. 210.2, 215.2 and 220.2, respectively. Procurement Procedures As a general rule, all procurements in the School Nutrition Programs, whether for goods or services, must be competitive. Sections 210.21(c), 215.14a(c), and 220.16(c) of the proposed rule included the requirement that, in conducting procurements, State agencies and school food authorities may use their own procurement procedures which reflect applicable state and local laws and regulations, as long as procurements made with nonprofit school food service account funds meet the standards set forth in the program regulations and Sec. Sec. 3016.36(b) through 3016.36(i), Sec. 3016.60 and Sec. Sec. 3019.40 through 3019.48, as applicable, and in the applicable OMB Cost Circulars. We have modified the language of Sec. Sec. 210.21(c), 215.14a(c) and 220.16(c) to more accurately reflect the provisions of Sec. Sec. 3016.36(a) and 3016.60(a), which specify that State grantees may elect to follow either the State laws, policies and procedures, or the procurement standards for other governmental grantees and subgrantees in accordance with Sec. 3016.60(b) through (i). Regardless of the option selected, [[Page 61482]] States must ensure that all contracts include any clauses required by Federal statutes and executive orders and that the requirements of Sec. 3016.60(b) and (c) are followed. Two commenters raised issues with procurement procedures in general. The first asked that we consider permitting cost plus percentage of cost contracts. The commenter's rationale for allowing this procurement method was that this form of contract costing may be the most cost effective procedure for school food authority bidding. In a cost plus percentage of cost contract, the contractor earns its fee based on a percentage of the cost of goods it sells under the contract. This contract cost method is prohibited government-wide because this form of contract pricing provides a financial incentive for the contractor to increase costs. The second commenter expressed concern that our position that competition is required for all procurements would prevent school food authorities from taking advantage of ``value added'' products or consider factors other than price in awarding a contract. Although the proposed rule did not directly address this issue, this comment reflects a misunderstanding of procurement practices which we will address briefly in this preamble and in future guidance and training. While a potential contractor may indeed have a better (``value added'') product, if that product does not meet solicitation specifications, the school food authority cannot use the phrase ``value added'' to circumvent proper procurement procedures. It is not appropriate for a school food authority to select products that do not meet solicitation requirements. If the school food authority determines that the value added product is more appropriate than the product it specified in its procurement solicitation, the school food authority must issue a new solicitation or wait until its next bid cycle to change its specifications. This does not mean, however, that a school food authority must consider a product that does not meet the specifications even if that product has the lowest cost. Another concern raised by this commenter and others was that school food authorities could be penalized if they failed to use either sealed bidding or competitive proposals to purchase every item needed during the school year. This is not the case, but does represent a common misunderstanding that the term ``competitive procurement'' means that either the sealed bid or competitive proposal method must be used. Some form of competition is required for every purchase, but not every purchase is subject to the formal (sealed bid or competitive proposal) solicitation methods. There are many items that are purchased in such small quantities that it is not cost effective for the school food authority to conduct a formal procurement to acquire these items. However, just because a purchase will not meet the formal procurement threshold does not mean the school food authority is exempt from competitively procuring the purchase. In these situations, the school food authority would use simplified small purchase procedures. Simplified small purchase procedures are those relatively simple and informal procurement methods for securing services, supplies, or property that may be used when the anticipated acquisition will fall below the Federal simplified acquisition threshold currently set at $100,000. Informal or small purchase procedures, discussed at Sec. 3016.36(d), are relatively simple and informal practices that are not as rigorous as formal procurement procedures, but that still provide competition. For example, a school food authority seeking to purchase several thousand dollars worth of office supplies would not have to issue a formal solicitation document and publicize it widely. Rather, the school food authority could simply fax its list of needed supplies to at least three local suppliers, and then compare the prices received from each. School food authorities must determine and apply any State or local thresholds that are lower, and therefore more restrictive, than the current Federal small procurement threshold of $100,000. Provisions Required in Cost Reimbursable Contracts The proposed rule required, in Sec. Sec. 210.21(e)(1), 215.14a(d)(1), and 220.16(e)(1), that school food authorities include specific solicitation and contract provisions in cost reimbursable contracts or contracts with cost reimbursable terms. These proposed provisions included the requirement that allowable costs be paid to the contractor net of all discounts, rebates, and applicable credits; and that the contractor individually identify on bills and invoices, and maintain documentation of, discounts, rebates, and applicable credits. In addition, the proposed provisions included the requirement that the contractor separately identify for each cost submitted for payment to the school food authority the amount of the cost that is allowable (i.e., can be paid from the nonprofit school food service account) and the amount that is unallowable, as determined in accordance with the applicable regulations and OMB cost circulars. These proposals, taken together, are intended to provide school food authorities with the information they need to identify the net allowable portion of their contract costs that can be funded from the nonprofit school food service account, and the amount of unallowable contract costs that must be funded from other sources. These proposals are also intended to inform contractors about these reporting requirements up front. Applicability of Contract Provisions to Different Contract Types A number of comments were received regarding the applicability of these solicitation and contract terms to fixed price contracts or to the fixed fee components of cost reimbursable contracts. A fixed price contract is a contract cost method that establishes a fixed price, usually on a per unit basis, for the goods and/or services provided by the contractor for the duration of the contract, including renewals. A fixed fee is often one component of a cost reimbursable contract. We did not propose, nor does this final rule require that these same solicitation and contract provisions relating to discounts, rebates, and applicable credits be included in fixed price solicitations or in the resulting fixed price contracts, because contractors have already taken discounts, rebates and other credits into consideration when formulating their prices for fixed price contracts. The same holds true for the fixed fee component of a cost reimbursable contract. However, the cost reimbursable components of any contract would be subject to the requirement that specific provisions relative to discounts, rebates and applicable credits be included. One commenter asked whether fixed fee contracts or the fixed fee components of cost reimbursable contracts that were adjusted over time would be subject to the proposed rulemaking. As long as these changes result from contractually agreed-upon adjustment factors, such as changes in the reimbursement rates for the School Meal Programs or changes in other third-party cost or price indices, the adjustments would not be subject to the contract terms set forth in this rulemaking. Several commenters suggested that FNS mandate the use of fixed price contracts. Based on anecdotal information, some State procurement statutes and regulations already limit [[Page 61483]] public school food authorities to fixed price contracting, while other State agencies have mandated this form of contracting for specific acquisitions, such as acquiring the services of a food service management company. However, mandating the use of fixed price contracts on a national basis is not in the best interest of the school nutrition programs. State agencies and school food authorities, not FNS, should determine whether acquisitions are best suited to fixed price or cost reimbursable contracts. Commenters also expressed concern that by not subjecting fixed price contracts to the provisions of the proposed rule, school food authorities would not be required to determine the allowability of costs resulting from fixed price contracts. As stated above, fixed price contracts are not subject to the provision of the proposed rule requiring that allowable contractor costs paid from the nonprofit school food service account be net of all discounts, rebates, and applicable credits because contractors have already taken into consideration factors such as discounts, rebates and other credits when formulating their prices for fixed price contracts. However, the net cost factor is only one aspect used in determining allowable costs. Expenditures from the nonprofit school food service account for fixed price contracts must still meet the general requirements for allowable costs. To be allowable, a cost must be necessary, reasonable, and allocable. For example, a school seeks to contract for janitorial supplies for the entire school building through a single procurement solicitation. The contract will be awarded on a fixed price per item basis. Under the allowable cost rules, the costs associated with the janitorial supplies purchased for use by the school food service would be an allowable expenditure from the nonprofit school food service account, but costs associated with the janitorial supplies purchased for the rest of the school would not, as they are not allocable to the nonprofit school food service account. The fact that the contract was fixed price would not supersede the cost requirement that to be allowable, a cost must be necessary, reasonable and allocable to the nonprofit school food service. The same principles would apply to the fixed price fee of a cost reimbursable with fixed fee contract. One commenter raised the issue of the risks contractors, particularly food service management companies, incur when including guaranteed return provisions in contracts, and requested that contracts containing such provisions be considered fixed price for purposes of the final rulemaking. The commenter asserted that providing a guaranteed return causes its company to take profit and loss risks similar to what it assumes in fixed price contracts. The commenter further offered that since a company assumes financial risk by agreeing to the guaranteed return provision, it would be inequitable to treat the contract as cost reimbursable. Instead, the commenter indicated the contract should be viewed as fixed price, thus eliminating the need for the company to include discounts, rebates, and other applicable credits on bills and invoices submitted to the school food authority. We disagree. Guaranteed return provisions do not substantially alter the terms of a contract enough to convert it from cost reimbursable to fixed price. Furthermore, guaranteed return provisions are neither new nor unique to the School Meal Programs, nor are these provisions limited to cost reimbursable contracts. By entering into contracts with guaranteed return provisions, the contractor willingly agrees to accept the risk. In their current form, most of these guaranteed return provisions do not place successfully performing contractors at risk. As the commenter noted, guaranteed return provisions provide a financial assurance that certain contractual promises made to the school food authority will be met. There is no Federal requirement that a contract be drafted to eliminate all possible risk to a contractor, nor is a school food authority required to indemnify its contractor against all potential risks that might occur, particularly those that the contractor has agreed to accept. No changes are being made in this final rule based on these comments. Payment of net allowable costs from the nonprofit school food service account Most commenters supported the proposed rule's provisions limiting expenditures from the nonprofit school food service account to net allowable costs. However, there did appear to be some misunderstanding of this proposal. Some commenters asserted that we were proposing that discounts, rebates, and other applicable credits must be returned to the school food authority. Another commenter asserted that the proposal that contractors identify allowable and unallowable costs on invoices would substantially alter the current economic structuring of transactions between food service management companies and school food authorities. To clarify, this provision does not prevent a school food authority from entering into a contract that results in unallowable costs. It does, however, prohibit the school food authority from using nonprofit school food service account funds to pay any amount above net allowable costs. The decision regarding whether discounts, rebates, and other applicable credits are returned to the school food authority is a decision between the school food authority and its contractor. However, the school food authority can only use nonprofit school food service account funds to pay for costs that are net of discounts, rebates, and applicable credits. To prevent any future misunderstanding of this distinction, we have amended this final rule at Sec. Sec. 210.21(f)(1)(i), 215.14a(d)(1)(i) and 220.16(e)(1)(i) to clarify that the limitations on the payment of allowable and unallowable costs pertain only to expenditures from the nonprofit school food service account. Confidentiality and Disclosure of Discounts, Rebates, and Credits One commenter requested confirmation that contractors would be required to disclose discounts, rebates, and other applicable credits whether the amounts were received by the contractor itself, a subsidiary or an affiliate of the contractor. The commenter is correct. The commenter also requested confirmation that the disclosure of such amounts would apply whether the contractor's headquarters is in the United States or otherwise or when these amounts are received by entities under the control of the same parent corporation as the contractor. Again, the commenter is correct. The intent is to promote full and open competition and limit expenditures of the nonprofit school food service account to allowable costs. That would not be achieved if contractors could use their corporate structures to circumvent the disclosure requirements of this rulemaking. Three commenters raised concerns with the protection of confidential business arrangements when reporting discounts, rebates and other applicable credits. FNS is sensitive to the commenters' concerns related to confidential business relationships. We agree with the commenters that the reporting of discounts, rebates and other applicable credits should not compromise business relationships that have been promised confidentiality. We were aware that such confidential business relationships could exist and we considered these relationships in developing the proposed regulation. For [[Page 61484]] this reason, we proposed that the contractor individually identify discounts, rebates or applicable credits on the bills and invoices, but did not propose that the contractor identify the source of the discount, rebate or other applicable credit on the invoice. There are a number of ways for a contractor to provide sufficient information on its billing documents about the nature of the amounts reported without compromising its confidential business relationships. The contractor could provide the school food authority with a list of products upon which a discount, rebate, or other applicable credit could be earned during the term of the contract and then report the amount of discounts, rebates and other applicable credits in aggregate on billing documents to the school food authority; the contractor could identify the discount, rebate, or other applicable credit by earning period, e.g. for products purchased during the month of April the contractor could identify the discount, rebate, or applicable credit by invoice number. Since not all contractors will use the same method to record and report discounts, rebates, and other applicable credits within their corporate recordkeeping systems, FNS does not want to prescribe the specific method that should be used to identify these amounts on school food authority billing documents. Although this final rule does not require the reporting of confidential business information on bills and invoices, it does require that the contractor maintain records and source documents in support of the costs and discounts, rebates and other applicable credits included on bills and invoices to the school food authority and make them available to the school food authority, State agency and Department upon request. This record retention requirement is no different from the existing requirements found in Department regulations at Sec. Sec. 3016.36(i)(10) and 3019.48(d). Contractors have always been required to maintain source documents in support of the costs charged to school food authorities. The intent of the provisions at Sec. Sec. 210.21(f)(1)(iv), 215.14a(d)(1)(iv) and 220.16(e)(1)(iv) and the record retention requirements in the Department's regulations is to provide sufficient information to permit a school food authority to determine the costs billed by its contractors that can be paid from the nonprofit school food service account, and to permit a subsequent review of the contractor's source documents to verify that the costs, discounts, rebates, and other applicable credits were properly reported under the terms of the contract. To eliminate the possibility that readers could misinterpret this requirement, this final rule amends Sec. Sec. 210.21(f)(1)(iv), 215.14a(d)(1)(iv) and 220.16(e)(1)(iv) to clarify that contractors are only required to identify the amount of each discount, rebate or applicable credit on the bill or invoice and whether the amount is a discount, rebate, or in the case of some other form of applicable credit, the nature of that credit. Timing Several commenters expressed concerns with the timing of the reporting required of contractors to identify discounts, rebates and other applicable credits on all bills and invoices sent to the school food authority. Presumably, this would occur on a monthly basis. In commenting on the timing, one commenter suggested requiring potential contractors to include this information up front, by bidding prices as if the discount, rebate or other applicable credit had already been earned, with a subsequent reconciliation at the end of the contract. We considered the option of requiring prices to be bid less discounts, rebates and other applicable credits. However, we do not believe this will improve full and open competition nor will such a requirement maintain the integrity of the nonprofit school food service account given the current state of school food authority procurements, as this information may not always be available to the contractor at the time of bidding. However, since FNS is encouraging State agencies to take a more active role in school food authority procurements, this final rule amends Sec. Sec. 210.21(f)(1)(iv), 215.14a(d)(1)(iv) and 220.16(e)(1)(iv) to permit State agencies to approve reporting on other than a monthly basis, but not less frequently than annually. A State agency may choose to establish reporting timeframes on an individual contract basis or on a Statewide basis. Other commenters on the issue of timing addressed the reporting of discounts, rebates and other applicable credits that result from contract activity, but are not earned or received by the contractor until after the contract has ended. While some discounts, rebates, and other applicable credits will be known to the contractor when bills are issued to the school food authority, others, particularly volume discounts, may not be known until some point in the future. For example, a volume purchase discount is earned when sales of a particular item reach an established target. The contractor may not reach the target sales volume until after the school food authority's contract has ended, even though the purchases by the school contributed to reaching the target volume. This could occur when the timing of the school food authority's contract does not coincide with the timing of the volume discount earning period, or even when the timing of the contract and the volume discount earning period is the same but the contractor does not receive the benefit of a volume discount, rebate or other applicable credit until after the school food authority's contract has concluded. The method for providing the discount, rebate, or other applicable credit amount in this situation depends on whether the contractor and the school food authority maintain an on-going, uninterrupted, contractual relationship, i.e., a subsequent or renewal contract is in place. When the contractor and the school food authority's contractual relationship is uninterrupted, the contractor can include the discount, rebate, or other applicable credit in the next reporting period after it is received. For those situations in which the contractor and the school food authority do not maintain an uninterrupted contractual relationship, the amount of the discount, rebate or applicable credit must be provided to the school food authority once these amounts are known to the contractor. Depending upon the school food authority's financial management practices, the school food authority may need the contractor to identify the period in which the discount, rebate, or other applicable credit was earned so that it can adjust its accounting records accordingly. In such cases, the contractor would need to provide sufficient information for the school food authority to identify the appropriate accounting period requiring adjustment. We agree that the proposed regulatory provisions should be clarified to address this issue. Therefore, we are amending Sec. Sec. 210.21(f), 215.14a(d) and 220.16(e)(1) to require school food authorities to include specific directions in solicitations and contracts for reporting discounts, rebates, and applicable credits after the close of the contract to which the cost reductions apply. Identification of Allowable and Unallowable Costs on Invoices The provision of the proposed rule requiring contractors to identify allowable and unallowable costs on invoices was added to provide school food authorities with the information they need to determine what may be paid out of the nonprofit school food [[Page 61485]] service account. We considered four alternatives when developing this provision of the proposed rule, including: (1) Maintaining the status quo of not requiring specific documentation; (2) requiring that contractors provide source documentation to school food authorities for all costs charged; (3) requiring that contractors have an annual audit for each cost contract with a school food authority to determine allowable and unallowable costs; or (4) requiring that contractors include only allowable costs on invoices. Maintaining the status quo was rejected because OIG audits and investigations indicated that nonprofit school food service account funds have been expended for unallowable costs because the school food authority had insufficient information to identify unallowable costs included on invoices. The requirement that contractors provide source documentation for all costs charged was rejected because it would be excessively burdensome on contractors to provide this information. Similarly, an annual audit requirement was rejected because it would be both burdensome and cost prohibitive for contractors to incur annual audit costs for each of its cost reimbursable contracts with school food authorities. Finally, the fourth alternative of requiring that contractors include only allowable costs on invoices was rejected in developing the proposed rule because it would interfere with the school food authority's right to enter into contracts that contained costs that were unallowable nonprofit school food service account expenditures, but nevertheless represented costs the school food authority was willing to fund from other sources. However, FNS has now reconsidered this fourth alternative (requiring that contractors include only allowable costs on invoices) because a school food authority can elect to contract only for allowable costs. If, in our previous example, the janitorial supplies contract was cost reimbursable instead of fixed price, pursuant to the provisions of this final rule, the contractor would appropriately identify all of the janitorial supplies sold to the school food authority as allowable costs on its monthly invoice. The contractor's identification of allowable and unallowable costs on the invoice does not mean that the school food authority can fund the entire cost of its janitorial supplies contract from its nonprofit school food service account. Because the school food authority, not the contractor, is ultimately responsible for ensuring that expenditures from the nonprofit school food service account are allowable costs as determined in accordance with the applicable OMB cost circular, the school food authority would still be required to fund only its share of the allowable and allocable janitorial supply costs from its nonprofit school food service account. As a result of this reconsideration, this final rule amends Sec. Sec. 210.21(f)(1)(ii), 215.14a(d)(1)(ii) and 220.16(e)(1)(ii) to allow school food authorities to choose between two cost reporting provisions for solicitation documents and contracts. The first cost reporting provision finalizes the provision contained in the proposed rulemaking that contractors identify allowable and unallowable costs on billing documents. The second cost reporting provision requires contractors to exclude unallowable costs from billing documents and to certify that only allowable costs are submitted for payment and that records have been established that maintain the visibility of unallowable costs, including directly associated costs, in a manner suitable for contract cost determination and verification. Regardless of the cost provision chosen, contractors would still be required to report discounts, rebates and other applicable credits, and school food authorities would still be required to limit expenditures of nonprofit school food service account funds to net allowable costs. Applicability of the OMB Cost Circulars to School Food Authority Contracts Two comments were received on the proposed rule's provision that allowable costs be identified by the contractor in accordance with applicable OMB Cost Circulars (A-87 Cost Principles for State, Local Governments and Indian Tribal Governments and A-122 Cost Principles of Non-profit Organizations). These commenters asserted that the cost principles contained within the Federal Acquisition Regulations (FAR) should be used to determine allowable costs that result from contracts with commercial organizations rather than cost principles contained in the OMB Cost Circulars applicable to public and private nonprofit school food authorities. The governing Department regulations (Sec. Sec. 3016.22(b) and 3019.27) make clear that for each type of organization there is a set of Federal principles for determining allowable costs. The determination is made based on the type of recipient incurring the costs under the Federal program. Since commercial organizations are not eligible recipients of the school nutrition funds provided by FNS, their only role can be that of a contractor to an eligible recipient (i.e., a school food authority). As an eligible recipient of federal funds, a public school food authority must use OMB Circular A-87 to determine whether costs are allowable, while a private nonprofit school food authority (e.g., in the case of a parochial school) must use OMB Circular A-122 to make this determination. Only when a commercial organization is contracting directly with the Federal government would the FAR (48 CFR part 31, Subpart 31.2) and its applicable Cost Accounting Standards (48 CFR 9901.306) be used to determine allowable costs. Ultimately, the school food authority, not its contractor, is responsible for ensuring that expenditures from the nonprofit school food service account are allowable costs as determined in accordance with the applicable OMB cost circular. This is not a new requirement. School food authorities have been subject to the OMB cost circulars since November 10, 1981, when the Department issued 7 CFR 3015, Uniform Federal Assistance Regulations (46 FR 55640). Further, limitations on claiming only allowable costs have been in place for school food authorities since at least January 1, 1967 (32 FR 33). A related issue concerning the applicability of the FAR to school food service contracts is the recovery of administrative cost overhead charges from retained discounts and rebates. In this case, one commenter asserted that contractors should be allowed to retain rebates and discounts to cover those corporate indirect costs that are not included in the fixed fee component of their cost reimbursable contracts, and that such actions were permissible for contractors subject to the FAR at 48 CFR part 31, Subpart 31.2. The commenter further asserted that FNS should allow such practices. We disagree. As discussed above, the FAR does not apply to any school food service contracts. Therefore, these suggested practices are not adopted in this final rule. The same commenter also asserted that even if the FAR did not apply to contracts with school food authorities, the OMB cost circulars would allow the contractor to retain the discounts, rebates, and other applicable credits earned on the cost component of its contracts in order to offset its administrative costs charged through its fixed fee. Again, the Department disagrees. The effect of the commenter's position could unnecessarily increase nonprofit school food service expenditures. A cost reimbursable with fixed fee contract consists of the cost [[Page 61486]] component and the fixed fee component. The rebates, discounts and other applicable credits subject to the rulemaking are earned through the cost component of the contract, not the contractor's fixed fee component. If FNS accepted the commenter's position, potential contractors could have an unfair advantage over school food authorities. Without full disclosure of the costs a contractor will actually charge, full and open competition is compromised because the school food authority cannot determine which of the respondents has made the most advantageous offer, taking into consideration price and other factors. The outcome of the commenter's position would be that a school food authority could not rely on the price a contractor bid or the contractual agreement into which it entered. This final rulemaking does not affect how a contractor establishes its full administrative costs in its fixed fee since this is a business decision. However, the principle of a fixed price is that the price is fixed in the manner and for the period of time specified in the contract. We are not aware of any cost principle or procurement provision that permits a contractor to increase the fixed price component of a contract without disclosure of the change and the agreement of the other party to the contract. When a potential contractor submits a fixed price offer, is awarded a contract based on the price, and then contractually agrees to that price, the contractor may not violate the terms of its contract by increasing that price by retaining undisclosed rebates, discounts or other applicable credits. This confirms one of the key points underlying the issuance of the proposed rule as well as this final rule, which is that school food authorities must clearly specify how costs must be billed to the school food authority in order for a potential contractor to determine which costs should be included in its fixed fee. In order to clarify what can be included in fixed fees, the newly added definition of ``fixed fee'' at Sec. Sec. 210.2, 215.2 and 220.2 specifies that the contractor's direct and indirect administrative costs and profit allocable to the contract may be included. A potential contractor is free to determine what portion of its overhead and indirect administrative costs is allocable to a contract in its fixed fee component. However, if a potential contractor chooses to exclude such costs from the fixed fee component, attempting to recover these costs by retaining discounts, rebates and other applicable credits earned through the cost reimbursable portion of the contract is unallowable. If a school food authority permits the contractor to retain these discounts, rebates, and applicable credits the school food authority is responsible for ensuring that the amount that these discounts, rebates, and credits represent is returned the nonprofit school food service account. Contractor Administrative Costs One commenter asserted that contractors should have the option of charging the school food authority a fee for late payments. The commenter did not explain why he believed such charges were prohibited or how the proposed rule would interfere in a contractor's right to include a provision requiring payment of late fees in a contract with a school food authority. There is no provision in this final rule or elsewhere in any of the Child Nutrition Program or Department regulations that would prevent a contractor from negotiating an agreement that imposes a fee when the school food authority fails to pay its debts in a timely manner. In the past, FNS has affirmed the right of contractors to request and enforce provisions addressing the imposition of late payment fees in contracts, as long as such provisions do not conflict with applicable State and local procurement laws and regulations. However, we also continue to maintain the position that the school food authority may not use its nonprofit school food service account funds to pay the cost of such fees. These fees represent fines and penalties, which are unallowable costs under the applicable OMB cost circulars. In keeping with the provisions of this final rulemaking, the contractor would be required to identify any late payment charge on its billing documents as an unallowable cost (i.e., a cost that cannot be funded from the nonprofit school food service account). Two commenters requested clarification that any added costs resulting from implementing this final rule would be allowable charges to school food authorities. Neither of the commenters specifically identified where they would incur increased costs or the amount of any increase, but we would expect any increased costs to be incurred in the allocation and records maintenance of discounts, rebates, and other applicable credits to school food authorities, and/or in the identification and reporting of allowable and unallowable costs. Contractors already track the costs that are billed to school food authorities and have accounting and billing systems in place for school food authority contracts. Further, under Generally Accepted Accounting Principles and good business practices, these contractors maintain systems to track and report discounts and rebates. Any additional cost incurred by contractors for implementing the provisions of this regulation is an element of a company's administrative expenses and is allocable and may be included in the fixed fee component of a cost reimbursable contract. The decision as to whether to record the expense as an overhead, accounting or management cost is a corporate financial management decision. State Agency Review of Procurement Documents Sections 210.16(a)(10), 210.19(a)(6), 215.14a(c)(1) and 220.7(d)(1)(ix) of the proposed rule required State agency review and approval of contracts and contract amendments between school food authorities and food service management companies prior to each contract's execution to ensure that such contracts comply with all program requirements. If a school food authority fails to make changes required by the State agency, then the proposed rule provided at Sec. Sec. 210.19(a)(2), 215.a(c)(3) and 220.16(c)(3) that all costs associated with such contracts would be unallowable charges to the nonprofit school food service account. One commenter was concerned that the proposal for the State agency to review the school food authority's food service management company contract prior to its execution would place a substantial burden on the State agency. The commenter viewed this review as a new requirement. It is not. FNS only proposed to change the timing of this review, not its scope. Under current regulations, State agencies generally do not review school food authority contracts until after the contracts have been executed (i.e., signed by the school food authority and the contractor). Unfortunately, when the State agency finds problems with the terms of an already executed contract, it may be too late to remedy the problems for the current contract, except when State or local laws and procedures permit contract nullification. Since the school food authority is bound to fulfill its contract terms, in the most serious cases, the State agency's only recourse is to disallow all costs resulting from the contract. In this case, school food authorities may not use the nonprofit school food service account to pay these costs. One State agency suggested that a school food authority's compliance with procurement requirements be included in the Single Audit. Since an audit is conducted on a prior period, it would be [[Page 61487]] too late to correct any deficiencies that are found. Generally the only option to respond to audit deficiencies is to disallow the costs associated with noncompliance and seek corrective action to prevent recurrence of the problem. Cost disallowances can seriously undermine the financial integrity of the school's nutrition programs for children. FNS' intent in moving the State agency review of food service management company contracts from after execution to before execution is to provide a means for identifying and correcting problems in contracts before they are signed. This approach helps ensure that school food authorities are not routinely subject to cost disallowances. Another State agency expressed concern that the proposed rule at Sec. 210.19(a)(6) would require a State agency to review previously approved prototype food service management company contracts even when no changes had been made to the contract. This was not our intent, nor do we believe this will occur. This final rulemaking requires school food authorities using a State agency pre-approved prototype food service management company contract to obtain prior written approval of the State agency only when changes are made to that contract (Sec. Sec. 210.16(a)(10) and 220.7(d)(1)(ix)). In response to this comment, we have added a corresponding sentence at Sec. 210.19(a)(6) of this final rule to clarify that when a school food authority is using a State agency prototype food service management company contract, the State agency is only required to review the changes made to that prototype contract. A third State agency, which from the description of its current actions already has an extensive preapproval process for food service management company contracts, expressed concern that the proposed change would impose an additional review on top of the review it already performs. FNS will work with individual State agencies to ensure that any changes resulting from implementing this final rulemaking do not duplicate or diminish a State agency's current approval process. Two State agencies indicated that pre-execution reviews of food service management company contracts are already occurring; four additional commenters supported the proposal. One commenter suggested nonsubstantive rewording of certain sentences at Sec. 210.16(a)(9) and (a)(10). We agree that the commenter's proposed changes make the provisions easier to read and have amended Sec. 210.16(a)(9) and (a)(10) and the corresponding provisions at Sec. 220.7(d)(1)(viii) and (d)(1)(ix) of this final rule accordingly. We also added language to Sec. 210.19(a)(6) to clarify that State agency review of contracts includes review of the supporting documentation to the contract, including the request for proposal or invitation for bid. Other commenters requested that the regulation permit the State agency flexibility in establishing due dates for school food authority procurement documents. Two commenters requested more specific regulatory authority to withhold payments when school food authorities fail to comply with a request for timely submission of required documents. Currently, sufficient regulatory authority exists to permit State agencies to establish reasonable due dates consistent with their resource and work load limitations. However, this final rule amends Sec. Sec. 210.16(a)(10), 210.19(a)(6) and 220.7(d)(1)(ix) to permit State agencies to establish due dates for submission of the documents needed for this approval. Failure of a school food authority to respond to these due dates would result in regulatory noncompliance, and the school food authority's failure to correct this deficiency could result in the withholding of reimbursement pursuant to current Sec. Sec. 210.22 and 220.18. Miscellaneous Comments Several commenters expressed opinions on the provision in the proposed rule at Sec. 210.16(b)(1) that permits a food service management company to submit the 21-day menu and requires compliance with the menu for the first 21 days of food service operations. FNS was not proposing any changes to this provision, but instead used the opportunity of the proposed rulemaking to restructure a cumbersome sentence. One commenter questioned FNS' legal authority to issue the proposed regulation. The Secretary's authority to issue regulations is found at 42 U.S.C. 1779 which authorizes the Secretary to prescribe such regulations as deemed necessary to carry out the provisions of the Child Nutrition Act of 1966 and the Richard B. Russell National School Lunch Act. One commenter suggested clarifying that FNS regulations implement applicable OMB circulars at Sec. 210.21(a) and the deletion of the last sentence at Sec. 210.21(c). We agree and have amended Sec. 210.21(a) and (c) as well as the corresponding provisions at Sec. Sec. 215.14a(a), 215.14(a)(c), 220.16(a) and 220.16(c) accordingly. Another commenter requested clarification as to whether Department regulation 7 CFR part 3015 still applies to FNS's school nutrition programs. While the majority of the Department's requirements that apply to the school nutrition programs have been moved from 7 CFR part 3015 into 7 CFR parts 3106 and 3019, some requirements, particularly those affecting the award of discretionary grants, acknowledgment on audio visual materials and procedures for prior approval of costs, still remain in 7 CFR par