Investment or Buy-in
I’ve told the story before about that one DOE contractor that kept winning contract after contract after contract. Its secret? The solicitation stated that the government intended to award a cost-reimbursement contract, but the contractor proposed to accept a firm, fixed-price contract for the same scope of work. The government was delighted to reduce its cost risk associated with an otherwise capable contractor, and gladly awarded that contractor a FFP contract.
The contractor knew it was going to take a loss on the work. It was willing to make an “investment”—knowing that, as its business base grew through new contract awards, that additional work was going to absorb fixed costs, reducing total costs on all contracts. The logic was: the investment was going to be reduced as the indirect cost rates came down.
Well, reality didn’t correspond to the plan.
The fact was that the government knew that the proper contract type was cost-reimbursement, because the scope of work wasn’t fully known. The government knew what it didn’t know, and it guessed there might be quite a bit of scope creep. The contractor’s “investment” didn’t take the possibility of scope creep (without corresponding equitable adjustment to contract price) into its FFP philosophy. As a result of unforeseen cost overruns on its FFP contracts, that contractor become a former contractor.
But the key point here is that the government was pleased to accept the contractor’s “investment” at the time. It seemed like a great decision from the government’s perspective, even though we wonder if it still seemed like a great decision a few years later, when contracts were terminated and the work needed to be reprocured.
There is nothing inherently wrong with a proposing a price lower than the contractor believes it will take to do the job. In fact, so long as the contractor does not intend to “get well” downstream, there is nothing improper with the practice. FAR 3.501 prohibits the practice of “buying-in” but that practice is expressly defined as “submitting an offer below anticipated costs, expecting to—(1) Increase the contract amount after award (e.g., through unnecessary or excessively priced change orders); or (2) Receive follow-on contracts at artificially high prices to recover losses incurred on the buy-in contract.” So long as the contractor avoids either of those two practices, it is free to propose at whatever price it wants to.
Boeing is perhaps the contractor that most obviously practices the concept of investing to win. In fairness, many other contractors do it as well; though we suspect Boeing practices it more consistently (or is better at it).
Now before we get into this topic any deeper, a couple of caveats. First, I own Boeing stock! Not a lot of it, true. But some. It’s been a good stock to own. Second, I work full-time for a company that recently lost out to Boeing in a major competition (MQ-25). Consequently, you may believe that I’m not entirely objective about this topic. So be it.
Frank Kendall, former USD (AT&L) kicked off the discussion in September, 2018, in his article at Forbes entitled “Boeing And The Navy Place A Big, Risky Bet On The MQ-25 Unmanned Air Vehicle.” In that article, Mr. Kendall discussed risks that both Boeing and the Navy were accepting when the Navy let Boeing’s bid—which was significantly below its two competitors’ prices—sway it to awarding the contract to Boeing. Importantly, with respect to the risks that the Navy was taking on, Mr. Kendall wrote—
[The Navy] cannot transfer all the program risk to Boeing; if Boeing fails to execute the program, the Navy customer will not get the UAVs it wants. If Boeing can deliver the aircraft but runs over on costs, claims against the Navy can be expected. Under the fixed price incentive contact, the Navy will also share at least a fraction of the financial risk of development.
…..
There is no doubt that Boeing went into the competition for MQ-25 with its eyes open, but that doesn’t eliminate the risk. Competitive pressures, as in the case of the MQ-25, also incentivize aggressive bids. In this case, because Boeing has not won a major new program for some time, the pressure on management to win can be assumed to have been very strong.
Indeed, recent reports state that Boeing has already recorded a $691 million charge against earnings related to its recent MQ-25 and T-X training jet contract awards. This means that for one or both of those contracts, Boeing has officially forecasted an at-completion overrun that burns through its FPIF cost share, the Navy’s FPIP cost share, any profit it may have proposed—plus an additional $700 million on top of that. That’s a lot of money.
But that has been Boeing’s strategy, according to its CEO, Dennis Muilenburg. According to a US Naval Institute article (written by Ben Werner). The USNI article quoted Boeing's CFO as follows—
“Our T-X and MQ-25 investments are based on deliberate and intentional decisions to create long-term valuable products and services franchises,” Smith said. “In selective key market opportunities such as these, we are taking into account the considerable market potential in our business cases, and not just the initial order quantity with the contracts.”
That article also discussed the possible downside of Boeing’s strategy. It stated—
Analysts, though, voiced some concerns over the expense of creating the bids and fears Boeing executives did not accurately measure the risk to the company’s bottom line when developing bids lower than what competitors offered.
The article also noted that Boeing—a company that reportedly has a warchest of $8 billion in cash on hand—has the resources to make such investments. Not every government contractor has such resources, which is one reason that Boeing keeps winning new contracts.
In fact, Lockheed Martin’s CEO, Marilyn Hewson, clearly stated that LockMart doesn’t have those same resources and cannot compete if the competition is based on the size of the contractor investment. Another USNI article by Ben Werner discussed the situation and possible consequences for future competitions. He wrote—
Lockheed Martin officials say their loss to Boeing in three recent aircraft competitions indicates that Pentagon weapon buyers are valuing low price tags over high-tech capabilities, which may lead the company to question its participation in some future competitions. … “We believe our proposals represented outstanding technical offerings at our lowest possible pricing,” Hewson said. “Had we matched the winning prices and been awarded the contracts, we estimate that we would have incurred cumulative losses across all three programs in excess of $5 billion; an outcome that we do not feel would have been in the best interest of our stockholders or customers.”
LockMart CFO Tanner had some further thoughts, according to the article, which quoted him as follows—
“Those [losses] were disappointing for a lot of reasons. But the fact they really decided, all three, on an LPTA (lowest price technically acceptable) basis, didn’t help the situation,” Tanner said. “It’s not getting the best capabilities for the warfighter in the hands of the warfighter.”
The Lockheed Martin executives’ comments frame the question as one of cost versus capability. When developing new weapon systems, should the Pentagon acquire the “technically acceptable” solution for the lowest price, or should it pay a premium to acquire more (and better) capability?
In addition, we would frame the question in terms cost versus innovation. When developing new weapon systems, should the Pentagon acquire a workable solution based (as much as possible) on nondevelopmental technology, or should it encourage contractors to propose the most innovation possible?
And what about big versus small contractors? If the Pentagon is going to award contracts based on the amount of investment that contractors are willing to make, then only the largest of contractors will win awards. The smaller contractors will be locked out of the “pay for play” competitions.
To sum up these thoughts, it seems that certain larger contractors are willing to pay to play in long-term Pentagon contracts, betting that they will earn back developmental losses over the lives of the programs. They may be right; but we remember the story of that DOE contractor, whose program investments turned out to be larger than it ever dreamed of.
In related news, Boeing announced on October 24, 2018, that it was taking another $179 million in charges related to its KC-46a FPIF tanker program.
Gone But Still Here
Well, it’s time for another trip—this time to attend the 17th Annual Compliance and Ethics Institute, sponsored by the Society of Corporate Compliance and Ethics. Three-and-a-half days of workshops and keynotes and breakout sessions.
Naturally, my focus will be on compliance risks and plans related to Federal government contractors. But I will also be dabbling in other areas, such as UK and Ireland compliance regulations, establishing compliance programs for small and medium-sized businesses, and establishing a culture of compliance in the larger companies.
Yes, yes. I know. The Compliance Institute is being held in Las Vegas. Go ahead and smirk, if you must. But the fact is that, from Sunday through Wednesday, I will be attending about 20 hours of learning. Maintaining my SCCE certification requires 40 hours of CPE annually, and this is going to be a big chunk of my annual requirement. So I’m going to attend all the sessions and make sure to turn in the signed CPE forms at each one of them.
Of course, what happens after class stays in Vegas….
Seriously, though. I’m kind of over Vegas. For a long time I visited the city at least twice a year, to teach Fed Pubs classes. I kind of got all the expensive misbehaviors out of my system. My blackjack days have been over for a long time. At this point, I look forward to having a nice meal with a glass of wine and retiring early to bed.
Federal government contract compliance is what I have done for many years, and it’s nice to see that niche explored within a broader context of “compliance” as it relates to entities other than Federal contractors.
So I’m off to Vegas and, by the time you’re reading these words, I’ll be hip-deep into the SCCE’s Compliance and Ethics Institute. Which means that I won’t be writing any more blog articles until I get back.
See you then.
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Mistakes are Not Cost Accounting Practices
Back from the Society of Corporate Compliance and Ethics (SCCE) annual Compliance & Ethics Institute (CEI). From my perspective, well worth the investment of three-and-a-half days of time. The focus was not on Government contractors, per se, but there was enough related content to keep it interesting. Some of the breakout sessions were full of wonderful content—content that made one think about it and how it could be applied to the day-to-day grind of work.
One of those breakout sessions was taught by a member of the Office of the Inspector General of the Department of the Interior (DOI), Daniel Coney. He had a slide so personally impactful that I took a picture of it with my phone.
When speaking about the discretion OIGs have, he stated (paraphrasing), “Most of our cases are not criminal. We don’t go after people for making mistakes. We don’t go after people when there’s no intent to commit a crime.” Which is good news for many of us!
But then he showed a slide that contained the following sentence:
A MISTAKE REPEATED MORE THAN ONCE IS A DECISION
Whoa.
What I gleaned from that single sentence is that the more a mistake is repeated, the more it looks like intent—or, at least, like negligence.
Remember, the civil False Claims Act (as amended) has a different definition of intent than the criminal statute. To be liable, a defendant must have “knowingly” submitted a false claim; the civil statute defines “knowingly” as including either “deliberate ignorance” or “reckless disregard” for the truth. In our layperson’s interpretation, a defendant cannot claim that the false claim was the result of a mistake when the “mistake“ was the result of ignoring (or not looking for) warning signs that the mistake was being made.
But then we started thinking about cost accounting practices. Most of us know that a contractor subject to either modified or full CAS coverage has constraints over when it can make changes to its cost accounting practices. See, for example, the contract clause 52.230-2, which states (in pertinent part):
… the Contractor, in connection with this contract, shall -- Follow consistently the Contractor’s cost accounting practices in accumulating and reporting contract performance cost data concerning this contract. If any change in cost accounting practices is made for the purposes of any contract or subcontract subject to CAS requirements, the change must be applied prospectively to this contract and the Disclosure Statement must be amended accordingly. If the contract price or cost allowance of this contract is affected by such changes, adjustment shall be made in accordance with subparagraph (a)(4) or (a)(5) of this clause, as appropriate.
Similarly, the clause 52.230-4 states (in pertinent part):
… the Contractor, in connection with this contract, shall -- (i) Follow consistently the Contractor’s cost accounting practices. A change to such practices may be proposed, however, by either the Government or the Contractor, and the Contractor agrees to negotiate with the Contracting Officer the terms and conditions under which a change may be made. After the terms and conditions under which the change is to be made have been agreed to, the change must be applied prospectively to this contract, and the Disclosure Statement, if affected, must be amended accordingly.
The mechanism(s) for disclosing changes to cost accounting practice are established by yet another contract clause (52.230-6).
Finally, see FAR 30.6 (CAS Administration) provides direction to government contracting officers regarding how to administer the requirements of the foregoing contract clauses.
In summary, if you are a CAS-covered contractor, then you need to become somewhat of an expert in the clause requirements and FAR guidance. However, that will only get you so far.
Importantly, none of the foregoing clauses or the cited FAR language actually define the phrase “cost accounting practice.” The phrase is defined in the Cost Accounting Standards regulations themselves (see 48 CFR 9903.302-1) but that’s about it. In addition, you need to read certain court decisions (e.g., Perry v. Martin Marietta) to understand how the courts have interpreted the CAS language.
The tension between the CAS contract clauses, the FAR regulations, and the desires of the contracting parties have led to disagreements regarding whether or not a cost accounting practice has been changed. More to the point of this article, in our experience there is also disagreement regarding whether or not a cost accounting practice has been followed consistently.
As required by the clause language quoted above, when they execute their CAS-covered contracts, contractors agree to follow their cost accounting practices consistently. (We discussed the nuances between “disclosed” and “established” cost accounting practices in this article.) That’s the deal and, if a contractor fails to be consistent, then it may be alleged to have breached its contract. That’s not good.
But what about mistakes?
Does a simple mistake—somebody does something they’re not supposed to do—lead to a contract breach via an allegation that cost accounting practices were not followed consistently?
It depends, doesn’t it?
For a long time we argued that mistakes are not cost accounting practice. We argued that the cost accounting practice is what the contractor intends, not what some ill-trained employee actually does. But if that were literally true then a contractor would almost never have inconsistent cost accounting practices. There would need to be some type of direction from an authority figure in order to find inconsistent cost accounting practices. A smoking gun email would do it. A meeting behind closed doors would do it. But otherwise, not so much. If an employee violated policies and procedures and, as a result, the contractor treated something differently than it had told the government it was going to, that would not be an inconsistent cost accounting practice—because it would be a simple mistake.
Now, having seen and thought about Mr. Coney’s simple sentence, we think a reasonable person could distinguish between a simple mistake and an inconsistency in cost accounting practice based on the number of transactions that were affected.
Obviously, there’s no bright line in this line of reasoning. But we might assert (with some trepidation) the following general guidelines:
Something for CAS-covered contractors to consider, perhaps?
The Importance of a Company Hotline
Recently we came across this article, written by attorneys (and former Federal prosecutors) A. Lee Bentley III and Jason Mehta, entitled “How Contractor Fraud is Reported Shouldn’t Affect How It Gets Investigated.” The article addressed something we have pondered from time to time—i.e., how does the government choose whether to pursue available administrative remedies or civil/criminal remedies?
For example, in one article we discussed differences between allegations of defective pricing and allegations of False Claims associated with defectively priced contracts. We wrote: “Now we have a new rule: If the Federal government detects the defective pricing, then it’s a TINA matter. But if the relator detects the defective pricing, then it’s a FCA matter. Which is inconsistent and, on its face, somewhat inequitable. But that’s the way we’re seeing it these days.”
Subsequently, we questioned that new rule when we came across allegations that BAE Systems (successor to the Stewart & Stevenson FMTV contractor) was being charged with both defective pricing and violations of the FCA—with no qui tam relator in sight.
Nonetheless, the DefenseOne.com article (link in the first sentence) seems to resurrect and support our initial theory. Stated simply: the government’s investigation methodology and selection of legal remedy often depends on the manner in which it learns of the alleged violation(s). The authors wrote:
The traditional way to blow the whistle is to report internally up the chain and—if that does not work—the whistleblower could report suspected wrongdoing to federal contracting officers or to Defense Department hotline numbers. When the allegations are raised up the chain, a series of investigative procedures are initiated and DOD scrutinizes the allegations with appropriate vigor. DOD has contractual rights under the Federal Acquisition Regulations to investigate these allegations, inspect the premises, review documents, and root out fraud. These administrative remedies have been a resounding success when DOD learns of instances of fraud. …
[But] when the government learns about the suspected fraud through a qui tam suit, the DOJ will initiate the investigation. The investigation is given the imprimatur of a “federal case” and the stakes are automatically elevated as the default remedy for a False Claims Act case is not recoupment, but rather civil penalties (recoupment plus extra money as a penalty). In addition to the investigative steps described above, the mere fact that a whistleblower files a False Claims Act suit often results in official DOJ interviews, subpoenas and meetings.
If this hypothesis is true, if the manner in which the government learns of the allegations of wrongdoing affects both the investigatory approach and the potential legal remedies, then wouldn’t you really want employees reporting their concerns to the company hotline? And if it came to that, wouldn’t you really want employees reporting their concerns to the DOD Hotline? Those are the better options, right? Because, according to the article (and our experience) when an employee resorts to filing a qui tam lawsuit under the False Claims Act, then the company will be in for a long and very expensive legal journey.
And if all that is true, then doesn’t that mean you really need to focus on making your company hotline as accessible to employees as possible? We mean, you want employees to use the hotline, right? So you need to make the entire process as user-friendly as possible. Otherwise, you risk having employees use other, less attractive means to have their concerns addressed.
What does that look like? Well, we touched on the topic in an article we published about 18 months ago. We wrote—
Allegations received via internal hotline should be logged. Then they should be investigated. The findings of the investigation should be summarized and the matter should be dispositioned by an independent party in accordance with applicable laws, regulations, and company procedures. Then – and this must always happen – the company must ‘close the loop’ by reporting back the disposition to the employee who made the original hotline allegations. (Obviously if the original reporter was anonymous, that’s not going to happen.)
Employees who call the company hotline to report concerns are not whistle-blowers; they are concerned employees. But you can quickly convert them into whistle-blowers by ignoring their concerns or failing to report back to them the findings of your investigation. And—as we’ve reported—you cannot retaliate against any employee who avails themselves of any fraud reporting mechanism.
In fact—as that last article noted—you are required by DFARS contract clause 252.203-7002 to inform your employees, in writing, of their whistleblower rights. Of course, we are quite confident that defense contractors with that clause in their contracts have already done so. Right?
Thus, focusing on making your company hotline an attractive and user-friendly option for employees with concerns starts with education. You need to tell them about it. For certain defense contractors, you need to tell them about it in writing. But for the rest, perhaps an email blast will be sufficient. Let them know that you want them to use the hotline when appropriate. Obviously, reporting up the chain of command is preferable; but often that approach is problematic for one reason or another. So the company hotline is the best next option.
Because the alternatives are much less pleasant.
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