Due Diligence Oopsie
This story broke before we went on vacation and we’ve been meaning to write about it. The story concerns a risk associated with acquiring a smaller company. It’s a risk that most due diligence efforts would not identify.
Say you’re a large, well-established, company. You are acquiring a small company in the same marketspace. Naturally, as part of the due diligence efforts, you obtain a list of recent contract awards. You also obtain a list of what’s in the “pipeline”—i.e., what proposals have been submitted and are awaiting an award decision. You probably also get a list of proposals in process that will be submitted in the near future. You (presumably) have a good picture of what’s been happening, and what is likely to happen, with respect to the near-term future of the company you are acquiring.
If you are good at your job, you looked at the target’s business systems. You evaluated the accounting system and property control system. You looked at the estimating system. You looked at the purchasing system. As part of those efforts, you likely evaluated the risk that the target had material misstatements on its financial statements. You probably evaluated its anti-fraud and anti-corruption controls. You likely reached a conclusion regarding the accuracy of its cost proposal process, and the company’s ability to comply with Truthful Cost or Pricing Data requirements. In short, if you are good at due diligence you should have some idea as to whether or not you are buying contingent liabilities for which reserves need to be established at the time of acquisition.
But would you have evaluated the target company’s ability to tell the truth to potential customers? Would you have assessed its ability to comply with the False Statements Act in its interactions with government personnel?
We don’t think so. At least, we’ve never been part of such a rigorous due diligence process. In order to address those risks, you would have to start from the question: “What if much of the target company’s success wasn’t because of the quality of its product and/or services, or because it was a low-cost provider?” You would have to ask the question, “What if much of the target company’s success stemmed from its sales process, where it misrepresented its qualifications in order to win work?”
It’s possible you might ask those questions. But in our experience, those questions are almost unthinkable. In addition—even if you did ask them, how would you go about testing for them? It’s too out there, too hard. Plus, most due diligence efforts are sprints, and nobody has time for such small probability risks, even if the consequences might be significant.
What happens if the risk materializes after completion of the acquisition? What happens if the risk is materializing on the day of the acquisition?
Let’s ask IBM.
According to the Department of Justice press release (link above), on the exact day that IBM was closing its acquisition of Cúram Software Ltd (Cúram), the company (as a subcontractor) submitted a proposal to the State of Maryland for software and services. Less than a month later, “with IBM’s knowledge,” Cúram participated in a presentation to the source selection evaluators—a presentation that resulted in a contract award.
According to the DOJ, Cúram made “material misrepresentations” to the evaluators “including misrepresentations regarding the development status of the Cúram for Health Care Reform software; the existing functionality of the Cúram software to meet the State’s technical requirements, such as addressing life events and calculating tax credits under the Patient Protection and Affordable Care Act; and the integration of Cúram software with other software needed to provide a properly functioning HIX website.” Allegedly, the misrepresentations led to a contract termination after Cúram was unable to deliver on the promises it had made in its proposal and during its presentation.
Many long-time acquisition practitioners have learned not to fully trust verbiage contained in contractor proposals. We’ve heard contractor proposals called “fantasies” and evaluations termed “creative writing contests.” Maybe that’s true. But we’ve rarely heard those proposed deemed to be material misrepresentations, or violations of the False Statements Act, or of such a serious nature to have led to a situation where each contract invoice was alleged to be a violation of the False Claims Act.
What was the outcome of all this? IBM paid $14.8 million “to settle alleged violations of the False Claims Act arising from material misrepresentations to the State of Maryland during the Maryland Health Benefit Exchange (MHBE) contract award process for the development of Maryland’s Health Insurance Exchange (HIX) website and IT platform.”
Again, this is not something we’ve seen due diligence programs delve into. Accordingly, it’s tough to blame IBM for the situation. On the other hand, during each acquisition there should be a thorough evaluation of the probability that there are hidden contingent liabilities. The acquired company should not get its full payday until sufficient time has passed to reduce the likelihood that the contingent liabilities will materialize.
Business Systems are Back
Recently we noted that DCAA has reinvigorated its audits of contractor business systems. We wrote “it’s becoming clear that DCAA is getting serious about performing more contractor business system audits. We continue to doubt that they will perform as many as they have promised; however, we’re pretty sure they will be performing more than they have in recent years (which is a grand total of ‘very few’).”
Government oversight of contractor business systems (“CBS” in government acronymese; “BusSys” in our vernacular) has evolved since Congress got hornswoggled by DCAA and the Commission on Wartime Contracting back in 2010 – 2011. In some respects, Congress saved contractors from a worse oversight plan, as proposed by DCAA and the DAR Council, by limiting implementation of payment withholds to the largest of defense contracts. But that small bit of grace did not overcome the reality of the final rule: it was unenforceable.
It was unenforceable because neither DCMA nor DCAA had sufficient resources to perform the necessary BusSys reviews. Congress directed, and the DAR Council promulgated, a rule that could not be enforced at the current staffing levels.
And perhaps that was the strategy. Perhaps DCAA and/or DCMA thought that their inability to perform the required audits/reviews would give them good grounds for getting additional budget for additional heads. If that was the plan, it didn’t work. Staffing levels haven’t changed all that much over the past seven years at DCAA.
In addition, Congress’ attention has been focused on the lack of DCAA audits of contractor proposals to establish final billing rates. BusSys audits have faded into the background because everybody has been looking at the incredible backlog of final billing rate proposals DCAA let build up over the same time period. Thus, DCAA was performing neither of the audits to the required levels and Congress still didn’t give the audit agency more money.
Since budgets and staffing haven’t significantly increased, other bureaucratic responses had to be enacted. Many of those responses have been documented in this blog.
With respect to the unaudited contractor proposals to establish final billing rates, DCAA implemented new procedures that led to the majority of those submissions being deemed to be acceptable without performing the required audits. You’d think somebody somewhere would be concerned about that approach, but it turned out not to be the case. Certainly, the contractors who were told their final billing rates would be accepted os submitted without audit were not going to complain.
In fairness, DCAA did some other things that accelerated their audits. They started to perform multi-year audits, where more than one (sometimes as many as three or four) proposals to establish final billing rates were audited at the same time. That helped. (Unless you were the contractor that had to staff up to support them.) Another thing DCAA did was to create “virtual Incurred Cost audit teams” at the Regional level. This helped ensure that sufficient resources and urgency were devoted to the issue.
Finally, Congress “helped” by passing a law that required DCAA to perform its audits of contractor final billing rate proposals within 12 months of receipt. (In recent years, DCAA has been taking roughly three years to audit one year’s worth of indirect cost rates.)
In sum, DCAA “risked-away” the majority of its required audits and focused on performing the remaining few more efficiently. It worked to a very great extent. Problem solved.
While DCAA was working on reducing its “incurred cost” backlog, rule-makers were working hard to make sure that the number of required BusSys reviews were being reduced.
In 2015, DOD issued Class Deviation 2015-O0017 to raise the threshold at which Earned Value Management System (EVMS) reviews were performed from $50 million to $100 million. More specifically, although the EVMS clause is required to be included in cost-type or incentive-type contracts and subcontracts valued at $20 million or more, “no EVMS surveillance activities will be routinely conducted by the [DCMA] on cost or incentive contracts and subcontracts valued from $20 million to $100 million.”
More recently (May 31, 2019), a proposed DFARS rule revision was published in the Federal Register that would, if implemented as a final rule, raise the threshold at which Contractor Purchasing System Reviews (CPSRs) are performed from $25 million to $50 million of qualifying government sales. The rationale for the proposed change was to “appropriately account for inflation, reduce burden on small contractors, and allow a more efficient and effective use of CSPR resources to review larger contractors where more taxpayer dollars are at risk.”
While the BusSys review thresholds are being raised to exempt smaller contractors from the need to be subject to them, DCAA is also preparing to perform more of them. It is important to note that, in the minds of DCAA and Congress, DCAA has solved its embarrassing backlog of unperformed “incurred cost” audits. Thus, the focus has moved to the embarrassing lack of performance of other important audits, such as CAS compliance, defective pricing, and contractor business systems.
One means of increasing the throughput of BusSys audits is to create “virtual business system review teams” at the regional level. This will help to ensure that sufficient resources and urgency are devoted to these audits.
The parallels between the focus on contractor “incurred cost” audits and contractor business system are striking. We see the same strategies being employed.
- Whittle-down the universe of required audits to focus on the bigger contractors.
- Create focused groups of resources to efficiently perform the remaining few.
We expect it will work—at least for DCAA. (We have no information about any DCMA changes; our impression is that DCMA and contractors are largely happy with how DCMA is handling its BusSys reviews.)
But how will the creation of “virtual business system review teams” impact contractors?
Obviously, feedback is limited with such a new approach—but we’ve heard from one contractor that has experienced a BusSys review from a regional team. The feedback was decidedly mixed. Again: just one data point so take that into account. But that one data point is that the regional team did not take the time to gain a deep understanding of the contractor’s operations, which created audit challenges. In order to overcome those challenges and related inefficiencies, the contractor had to get its regular auditors (who did understand its operations) together with the regional auditors to get the “outsiders” comfortable with how things worked there.
So: focused resources but also not a lot of time devoted to depth. A superficial “check-the-box” audit performed in small increments over a long time. Not what that contractor expected (or wanted) to see.
Meanwhile, for the rest of us, we’ll have to wait and see for ourselves how DCAA will be performing its BusSys audits under its new management focus.
Edited to add: Also DCAA has recently republished Contract Audit Manual Chapter 5, which covers audits of BusSys. You might want to check it out to see what has changed.
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Competition
Hello.
After all the hectic stuff, things calmed down and I went on vacation. Now I’m back.
Thanks for your patience. It’s gratifying to see activity on this site even when the new blog posts pause for a while. (One of the benefits of having more than 1,100 articles in the archive, I guess.)
Today I want to talk about competition.
The data published by DOD have shown clearly that competition leads to better contract outcomes. (See our blog article on the 2013 Defense Acquisition Performance Report, where we reported the official conclusion that “… cost and price growth are statistically lower on competed contracts.”) Thus, people who read have known for years that competition is where it’s at. Despite that knowledge, the majority of DOD contract actions are not competitive.
There’s a reason for that counter-intuitive situation. The reason is that most contract actions are modifications to existing contracts. Something has changed—such as quantity of items to be acquired—and the contract needs to be “equitably adjusted” as a result. Those Requests for Equitable Adjustment (REAs) are not competed and thus have to be recorded in the databases as non-competitive contract actions.
Even for other (non-REA) contract actions, often there is only one known source. For example, if your IT system is based on Apple stuff, you are probably going to go back to Apple for new stuff and new licenses. You are not likely to change providers mid-stream, such that half your hardware and software is Apple-based, and the other half is Windows or Android-based. (Look, it was an example, all right? I don’t want a lot of emails telling me how it could be done or that it happens all the time. Mutter to yourself all you want; but leave me out of it.)
To impart some learning: “competition” and “price competition” are two different things, found in two different Parts of the FAR. Competition is, essentially, when the contract award opportunity is made available to more than one bidder—although there are several types or gradations of competition. (See FAR Part 6.) “Adequate price competition” is a term of art found in FAR 15.403-1(c). Adequate price competition is defined as:
- Two or more responsible offerors, competing independently, submit priced offers that satisfy the Government’s expressed requirement;
- Award will be made to the offeror whose proposal represents the best value … where price is a substantial factor in source selection; and
- There is no finding that the price of the otherwise successful offeror is unreasonable. Any finding that the price is unreasonable must be supported by a statement of the facts and approved at a level above the contracting officer.
But (of course) if you are modifying an existing contract, then you have neither competition nor adequate price competition, because only the price of the modification to the existing contract held by the existing contractor is being evaluated.
Recently, the FAR was revised to make it harder for DOD agencies to achieve “adequate price competition.” For civilian agencies –
… a price is also based on adequate price competition when–
(A) There was a reasonable expectation … that two or more responsible offerors, competing independently, would submit priced offers in response to the solicitation's expressed requirement, even though only one offer is received from a responsible offeror and if-
(1) Based on the offer received, the contracting officer can reasonably conclude that the offer was submitted with the expectation of competition, e.g., circumstances indicate that–
(i) The offeror believed that at least one other offeror was capable of submitting a meaningful offer; and
(ii) The offeror had no reason to believe that other potential offerors did not intend to submit an offer; and
(2) The determination that the proposed price is based on adequate price competition and is reasonable has been approved at a level above the contracting officer; or
(B) Price analysis clearly demonstrates that the proposed price is reasonable in comparison with current or recent prices for the same or similar items, adjusted to reflect changes in market conditions, economic conditions, quantities, or terms and conditions under contracts that resulted from adequate price competition.
On the other hand, for DOD agencies and other components subject to NDAA language, the FAR (at 15.403-1(1)(ii)), is clear that the foregoing language is no longer applicable. Instead, contracting officers and buyers at those agencies must comply only with the three “traditional” criteria listed above. If only one offer was received, then adequate price competition has not been achieved and therefore certified cost or pricing data must be obtained to support cost analysis.
We told readers this was coming. Of course, we analyzed the proposed rule as a DFARS revision and not as a FAR revision. But still … our readers had some measure of advance notice on this one.
The FAR rule revision comes a few years after the DFARS was revised. One is tempted to think DOD leaders (and law-makers) want to make it harder to award contracts where only one bid is received.
Now, in related news, let’s talk about TransDigm. We wrote about the TransDigm issue here. If you are unfamiliar with the TransDigm profit story, you might want to read that backgrounder first. If you are too lazy to click that link, suffice to say that, in the view of the DOD OIG and law-makers, TransDigm made too much profit on its sale of spare parts to DOD. Basically, TransDigm said, “Here’s my price. Take it or leave it.” And the DOD contracting officers had to take the price, because there was no other contractor with the spare parts. And even though there were no other bidders, TransDigm often refused to provide cost or pricing data, because it could. There was no other game in town.
That business approach—which was free market capitalism at its finest—didn’t sit well with auditors or with Congresspeople. There were hearings. While every Congressperson loves the free market while campaigning, many don’t seem to love it after election. TransDigm was accused of “price-gouging” (which was, in our view, inaccurate) and was “urged” to reimburse taxpayers for some $16 million in “extreme” profits reaped based on “unethical business practices.”
FederalNewsNetwork reported that, a couple of weeks after the hearings, TransDigm did agree to pay back $16.1 million. We are sure that was a reluctant business decision, perhaps driven by the fact that the DOD was one of its largest customers.
But that wasn’t the end of the story.
A couple of weeks later, the Acting Principal Director, Defense Pricing and Contracting (APD, DPC, OUSD, A&S) issued a memo aimed directly at TransDigm. The new policy was based on (unproven) allegations that TransDigm had “rigged” competitions because it was the only source for spare parts.
From the memo—
The IG report found that TransDigm is the only manufacturer of the majority of the spare parts the IG included in its review, putting TransDigm either in a sole source position or in a situation where it had the opportunity to set the market prices even for competitively awarded parts. ….
Therefore, for all procurement actions not yet awarded as of the date of this memorandum, unless the prices agreed upon are based on adequate price competition or are set by law or regulation, contracting officers are directed to require the submission of uncertified cost or pricing data to support prices proposed by TransDigm and its subsidiaries.
Notice what’s missing from the above. Even if the items are found to be commercial items, TransDigm must still submit uncertified cost or pricing data to support cost analysis.
Okay. TransDigm is now paying a steep price for its attempt to use market forces against the DOD. But what will that mean? We don’t know, but if it were us, we would take the costs of providing the information—and perhaps the costs of modifying our accounting system to record that information—and pass it right back to the DOD customers. Only this time, it wouldn’t be “profit”—it would be legitimate overhead, to which profit would be applied.
So … competition. Always a good thing. And when it cannot be achieved, then sometimes it can be forced.
DOD Rethinks Performance-Based Payments, Because It Has To
I’ve been writing about Performance-Based Payments (PBPs) for a long time. My first article on the topic was published in Contract Management magazine in 2005. (You can find it on this site under “Knowledge Articles” if you’re a member.) In that nearly 15 year-old article, I wrote –
Performance-based payments offer a method of contract financing that can reduce administrative oversight and streamline the payment process. By tying financing payments to technical or programmatic accomplishment, rather than to incurred costs, PBPs offer the ability to reduce administrative costs associated with cost-based billing systems and, perhaps, the intrusion of accountants and auditors into the payment process.
Since those days of innocence, so long ago, things have changed a bit—particularly for DoD contractors. The Department of Defense has, seemingly, tried to impede usage of the FAR’s “preferred method” of contract financing payments. In 2014—five years ago—we told readers that PBPs “were done” in this article. We said what we said based on a final DFARS rule in that redefined use of PBPs in ways not intended by Congress. For example, that new rule required contractors using PBPs to have an adequate accounting system because they would have to report cumulative incurred costs to their contracting officers.
So much for “reduced administrative costs.”
Anyway, others noticed what we noticed. Some of those others were in Congress. The 2017 National Defense Authorization Act (NDAA) (Section 831) to amend the United States Code “to establish a preference for performance-based payments to contractors and would re-establish the policy objective laid out in Federal Acquisition Regulation 32.1001, which established performance-based payments as the preferred Government financing mechanism.” In particular, the USC was revised as follows:
“(2) Performance-based payments shall not be conditioned upon costs incurred in contract performance but on the achievement of performance outcomes listed in paragraph (1).
“(3) The Secretary of Defense shall ensure that nontraditional defense contractors and other private sector companies are eligible for performance-based payments, consistent with best commercial practices.
“(4) (A) In order to receive performance-based payments, a contractor’s accounting system shall be in compliance with Generally Accepted Accounting Principles, and there shall be no requirement for a contractor to develop Government-unique accounting systems or practices as a prerequisite for agreeing to receive performance-based payments.”
In response to the Congressional direction, quoted above, the DAR Council opened a DFARS Case to—once again—revise the DFARS. In this case, DoD was walking back from its stance on PBPs, which at that point was contrary to the original intent of Congress, the “re-established” intent of Congress, and the Federal Acquisition Regulation as well. DoD needed to realign with the rest of the government contracting world.
You’d think that would be quick and easy, but you’d be wrong about that. In the words of one commenter, the DAR Council was “taking its sweet time” to make the required changes. Finally, on April 30, 2019, a proposed rule was issued.
Generally speaking, the proposed rule implements Congressional intent. Specifically, it (finally!) removes the illegal DFARS requirement that limit PBP payment values to amounts not greater than costs incurred up to the time of payment. That requirement resulted in absurd results, such as contractors not being able to invoice for the full negotiated amount of the PBP “trigger” events because they hadn’t yet spent enough money.
(That result is even more absurd when you take into account the historical context of PBPs and why Congress was so dissatisfied with cost-based progress payments. At the time, the A-12 “train wreck” was still fresh in everybody’s minds. We had all learned that “progress payments” didn’t equate with making progress; they equated with spending money.)
So the proposed rule is better than the illegal and absurd current regulatory language, for sure.
But it’s not perfect. It has one flaw that perverts Congressional intent.
In the words of the proposed rule, “the requirement for contractors to report costs incurred when requesting performance-based payments is retained, in order to have the data necessary for negotiation of performance-based payments on future contracts.”
Yeah, that’s not going to work.
In order to report costs incurred, contractors will need to have a “job cost” accounting system. That’s not a GAAP-compliant accounting system; that’s a government-unique requirement that is expressly contrary to the requirements in the U.S. Code we quoted above. So that’s a flaw.
Remember, PBPs are only used on firm, fixed-price contracts where the price “is not subject to any adjustment on the basis of the contractor’s cost experience in performing the contract.” (FAR 16.202-1.) Once the price is negotiated, nobody cares about the contractor’s costs (absent some kind of change). Thus, contractors do not need to have a job-cost accounting system to received a FFP contract, and imposing that requirement on them is forcing them to have one simply to receive PBPs.
Which Congress expressly said cannot be the case.
If you want to submit comments to the DAR Council, the link to the proposed rule, above, has lots of details regarding how to do so.
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