Procurement Requirements for the National School Lunch, School Breakfast and Special Milk Programs, 61479-61495 [E7-21420]

Agencies

• DEPARTMENT OF AGRICULTURE
• Food and Nutrition Service

[Federal Register Volume 72, Number 210 (Wednesday, October 31, 2007)]
[Rules and Regulations]
[Pages 61479-61495]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E7-21420]



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Federal Register / Vol. 72, No. 210 / Wednesday, October 31, 2007 / 
Rules and Regulations

[[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 A