U.S. defense cut could cost billions to implement

WASHINGTON (Reuters) - The Pentagon may have to pay billions of dollars in termination fees and other contract penalties if Congress does not stop $500 billion in automatic defense spending cuts due to take effect on January 2, a top weapons industry executive said on Wednesday.

Sean O'Keefe, chief executive of the North American unit of Europe's EADS , said U.S. defense officials were starting to assess added costs that might be triggered by the automatic cuts required under "sequestration," although they have not begun detailed planning for the across-the-board cuts.

O'Keefe, current chairman of the National Defense Industrial Association trade group, was one of a number of industry executives who met with Defense Secretary Leon Panetta and other top Pentagon officials on Tuesday to discuss the budget cuts.

Most procurement contracts have clauses requiring termination fees that help companies cover initial investments in tooling for new weapons programs and initial materials costs, but industry executives say those fees will not do much to ease the longer-term pain of the cuts facing the industry.

O'Keefe has a unique perspective on the current budget uncertainty after presiding over a similarly chaotic budget process -- albeit on a smaller scale -- in 1989 while serving as the Pentagon's chief financial officer.

In that case, which resulted in a defense spending cut of less than one percent, the Pentagon wound up paying nearly as much in termination fees, penalties for late payments and employee furlough provisions as it saved over all, O'Keefe said.

This time, he said the costs "will easily be in the billions range," although he said it was still unclear if the penalties for breaking multiyear contracts and other deals with suppliers and workers would reach the double-digit billion-dollar range.

The budget cuts have gotten increasing attention from U.S. lawmakers in recent weeks amid urgent warnings from arms companies and military officials about the devastating impact on national security and the weapons industry.

Lockheed Martin Corp Chief Executive Bob Stevens and other executives say they may have to warn hundreds of thousands of employees as early as October about possible layoffs under a federal law that requires 60 to 90 days notice of big job cuts.

O'Keefe declined to give details of Tuesday's meeting with Panetta, but said top U.S. defense officials appeared to be keenly aware of the complexity of executing the additional cuts, and were trying to assess or project the expected level of termination fees and other penalties they might incur.

"They're estimating what they believe to be a reasonable margin ... or reserve that would have to be set aside in order to accommodate for those kind of events," O'Keefe said. He said defense officials had not provided any estimates of the costs.

O'Keefe joined Stevens, General Dynamics Corp Chief Executive Jay Johnson, and Linda Hudson, chief executive of the U.S. unit of BAE Systems , for the meeting with Panetta, Deputy Defense Secretary Ashton Carter, Pentagon acquisition chief Frank Kendall and Comptroller Bob Hale at the Pentagon on Tuesday afternoon, according to multiple sources.

Executives from Northrop Grumman Corp , Boeing Co and other companies participated in a separate meeting with defense officials earlier in the day, they said.

Pentagon Press Secretary George Little declined to give details of the discussions, but confirmed that Panetta met with a number of defense industry executives on Tuesday as part of "an ongoing dialogue with our defense partners."

He said all sides agreed that "sequestration would be devastating to the U.S. military and perhaps to the industrial base," but said the Defense Department was not yet planning how to implement the cuts, which would come on top of $487 billion in cuts already planned over the next decade.

A defense official said Panetta and the industry experts briefly touched on possible impacts to corporate contracts, but no requests or agreements were made on those issues.

O'Keefe said Panetta was well-positioned to deal with the situation as a former director of the White House Office of Management and Budget, lawmaker and White House Chief of Staff.

He declined to give details from Tuesday's meeting, but said Panetta had publicly and repeatedly underscored the devastating consequences sequestration posed for U.S. national security and the broader U.S. economy.

Panetta is expected to raise his concerns at a cabinet meeting on Thursday, according to another source familiar with the meeting, noting that the impact of the automatic budget cuts on other government agencies had been largely overlooked so far.

The White House this week urged Congress to take bipartisan action and find $1.2 trillion in other cuts to avert the mandatory cuts required under the Budget Control Act, which include about $500 billion in cuts to defense spending, and similar cuts to other discretionary spending accounts.

At Tuesday's meeting, industry executives said some Pentagon program managers were already slowing down progress payments and other contracting actions as they braced for sequestration, according to two sources familiar with the meetings.

The executives also quizzed defense officials on how to factor the budget cuts into their proposals for any ongoing competitions, noting that different approaches to the risks could result in widely varying cost estimates.

Many big contractors are also keeping a wary eye on their small- and mid-sized suppliers, which may be particularly hard hit by the downturn in defense spending.

(Additional reporting by David Alexander; Editing by Phil Berlowitz)