ASBCA 60086

ARMED SERVICES BOARD OF CONTRACT APPEALS Appeal of -- ) ) Luna Innovations, Inc. ) ASBCA No. 60086 ) Under Contract No. N68335-05-C-0005 et al.) APPEARANCES FOR THE APPELLANT: Nicole D. Picard, Esq. Michael J. Vernick, Esq. Hogan Lovells US LLP Washington, DC APPEARANCES FOR THE GOVERNMENT: E. Michael Chiaparas, Esq. DCMA Chief Trial Attorney Gregory T. Allen, Esq. Trial Attorney Defense Contract Management Agency Chantilly, VA OPINION BY ADMINISTRATIVE JUDGED' ALESSANDRIS Luna Innovations, Inc. (Luna) appeals from a contracting officer's final decision determining that Luna included unallowable employee stock option costs in its fiscal year (FY) 2007 indirect cost pricing proposal, and assessing penalties against Luna due to the inclusion of expressly unallowable costs. As a publically-traded company, Luna was required by Generally Accepted Accounting Principles (GAAP) to account, at the time of award to its employees, for the stock options that could be exercised in later years. Pursuant to Statement of Financial Accounting Standards No. 123 (revised 2004) (FAS 123r), Luna calculated the value of the awarded stock options pursuant to the "Black-Scholes" method. The Defense Contract Management Agency (DCMA) contracting officer found that Luna's use of the Black-Scholes model violated Federal Acquisition Regulation (FAR) 3 l .205-6(i) which makes unallowable compensation for personal services calculated or valued based on changes in stock price, because one of the five variables used by the model was the variance of the stock price. In this appeal, Luna asserts that its employee stock option costs were allowable and, even ifthe costs were not allowable, they were not "expressly unallowable" and thus were not subject to penalty, and finally, even if the costs were expressly unallowable, the contracting officer should have waived the penalties. As explained below, we hold that Luna's employee stock option costs were unallowable, but not expressly unallowable, and uphold the government's final decision in part.  FINDINGS OF FACT Luna Innovations, Inc. Luna is a corporation headquartered in Roanoke, Virginia. Currently, its largest line of business is based on optical fiber technologies. Additionally it has a technology development business, which largely involves government contracts through the small business innovative research program. (Compl. ~ 1; tr. 1/19-20) During the time period at issue, much of Luna's government work was performed for components of the Department of Defense on a cost-reimbursable basis (R4, tabs 1-3). Approximately $14 million of Luna's business, out of a total $60 million, is performed pursuant to contracts with the United States (tr. 1/20). Luna's fiscal year is the calendar year (R4, tab 4 at 62; tr. 1/21 ). During its FY 2007, Luna held open government cost-reimbursement contracts containing FAR 52.216-7, ALLOWABLE COST AND PAYMENT (MAR 2000); FAR 52.233-1, DISPUTES (DEC 1998); and FAR 52.242-3, PENALTIES FOR UNALLOWABLE COSTS (OCT 1995). The Allowable Cost and Payment clause incorporates by reference: ( 1) subpart 31.2 of the FAR in effect on the date of the contract; and (2) subpart 42.7 of the FAR in effect for the period covered by the indirect cost rate proposal. (R4, tab 1 at 7-8, tab 2 at 30-31, tab 3 at 51-52; tr. 1/21) In June 2006, Luna completed an Initial Public Offering (IPO) of its common stock (tr. 1/29). As a publically-traded company, Luna became subject to certain additional accounting rules, including rules for accounting for employee stock options (tr. 1/28-29). As a part of its employee compensation program, Luna issued stock options to select employees and corporate officers during its FY 2007 (R4, tab 4 at 65-66; tr. 1/22). Although Luna had previously issued employee stock options, its prior accounting treatment was not permissible once Luna became a publically-traded company (tr. 1/142). Luna's employee stock options generally had a 10-year term, and had a strike price (the price at which the option could be exercised) set equal to the current market price (tr.