Failure Analysis
A not-for-profit (N4P) entity suddenly collapses into bankruptcy after 80 years of successful operation. Who’s to blame?
Just to be clear, the N4P entity we’re talking about today was a behemoth: running an annual budget of more than $250 million, employing roughly 4,000 people. How does an organization of that size suddenly announce it’s closing its doors, literally with no warning whatsoever?
We’re talking about Federation Employment and Guidance Services (FEGS), which was one of New York City’s largest social services entities, receiving roughly $250 million in state and city grants each year to work with “as many as 12,000 disabled people and other job seekers each day.” One report stated that FEGS administered “hundreds of government service programs.” But on January 29, 2015, FEGS announced it was closing its doors. A New York Daily News article quoted one FEGS staffer as saying, “It’s crazy. It’s an absolute mess. It’s historic mismanagement.”
But was it simply mismanagement that killed an 80 year-old institution?
A recent Law360 article (written by Rick Archer) shed some more light on the causes that led to FEGS’ demise. According to the article—
Chapter 11 papers blamed the bankruptcy on a confluence of factors, including failed expansions and fixed-cost increases that took revenues down to $264 million in the 2014 fiscal year against $285 million in expenses. FEGS … entered bankruptcy with $18.7 million in unpaid advances from city and state agencies on its books.
We look at those two sentences, quoted above, and we see nonsense. There is little substance there, although we couldn’t tell you whether that lack of substance comes from the filing papers or the author’s haste in summarizing them. Neither “failed expansions” nor “fixed-cost increases” would led to a decrease in revenues. Those are factors that might lead to an increase in expenses, but would have little if anything to do with revenue. FEGS’ revenue came from grants. If the grant revenue dried up, that would be a problem. If the grant revenue dried up at the same time management was investing in new service offerings, that would be a problem. If FEGS’ fixed costs (e.g., depreciation) had increased while its top line revenues decreased, that would be a problem. But perhaps all that was just too much to say, and so the author just summarized poorly. Or perhaps the Chapter 11 papers were poorly worded. We don’t know.
What we do know is that, one day, FEGS realized that its expenses exceeded its revenues—by $19 million, or about 7 percent of revenue. Apparently the entity had insufficient funds set aside for a working capital reserve, and so when it realized its income would not cover its expenses, it closed its doors. Was that situation because of mismanagement, or because of a “confluence of factors”?
The unsecured FEGS creditors have a different story to tell. They are pointing fingers at the FEGS auditor, who allegedly failed to warn anybody that the N4P entity was in trouble. According to the Law360 article—
… the creditors' petition blamed the bankruptcy specifically on [the] 2014 annual report showing an $18.3 million loss after years of reports showing the agency slightly in the black. … The petition said these losses include[d] the writeoff of doubtful accounts receivables … and bad debts going back as far as 2010. These were not reflected in the agency’s annual financial statements, which as a result overstated FEGS' revenues and understated its expenses by a significant amount, given the nonprofit’s low margins, the creditors said.
The creditors said Loeb & Troper’s annual audit reports to agency management from 2011 through 2013 did not warn of these mounting problems.
‘Each of these three management letters stated that Loeb & Troper did not identify any material weaknesses in FEGS’s internal controls; nor did the letters disclose any concerns regarding FEGS’s continued accrual of … receivables that should have been either classified as doubtful receivables or subject to a reserve for doubtful receivables,’ they said.
So according to the creditors, it was not mismanagement that killed FEGS—it was the auditor’s fault.
What do we think? Well, this is a bit of a puzzle. Normally we do not expect invoices to state, local, or Federal entities to go unpaid for three or four years. At a certain point—perhaps 90 or 120 days after receipt of the invoice—we expect the contractor to file a claim for unpaid invoices. We don’t know why FEGS let its billed A/R balance extend as long as it did; and certainly we would have expected the auditors to review billed A/R aging with management. But normally you just don’t expect bad debts from government entities. You expect to get paid, absent some allegation of wrongdoing. So we really need to understand the billed A/R story here.
It is possible that it was the unpaid invoices that killed FEGS, and nothing more. The invoices were not paid for a very long time, and that revenue would have covered some or all of the current year expenses. The story could be as simple as that.
We would add here that auditors are accountants, but they aren’t bookkeepers. They don’t do the entity’s bookkeeping (or they shouldn’t, if they want to remain independent). They are not responsible for determining which debts are bad debts; that’s management’s job. On the other hand, the auditors are required to express an opinion on management’s judgment. It would be interesting to have listened to the conversation between auditor and management regarding the aged billed A/R. Obviously the story told to the auditors worked, right up to the time when it didn’t work—and then the write-offs led to a very unfortunate situation.
If you are a government contractor, whether a for-profit or not-for-profit entity, we would expect you to worry about cash flow. We would expect you to review your aged billed (and unbilled) accounts receivable. We would expect you to take action if you had an invoice (or series of invoices) that remained unpaid long after they were due. If you didn’t worry about your cash flow, or didn’t review your A/R, or didn’t take action to collect moneys owed to you, then we would indeed call that mismanagement.
Over on WIFCON the usual suspects have been debating Requests for Equitable Adjustment (REAs) and claims. We’ve been toying with the notion of devoting an article to the topic here, since many people don’t understand the difference between the two contractual actions. It’s a general truism that most government contractors don’t like to file claims; but, in the case of FEGS, maybe that’s exactly what they should have done. Maybe filing a claim to recover invoiced funds that the entity was owed would have led to collecting the billed A/R, and maybe that would have been enough to forestall Chapter 11.
Obviously we don’t know the whole story here. But we’re pretty sure it wasn’t the auditor’s job to collect outstanding Accounts Receivable.
Government-wide Contracting Trends
 The government contracts attorneys at Covington & Burling LLP recently issued a summary article discussing a GAO report analyzing FPDS-NG data over five years (2011 through 2015). (FPDS-NG is the Federal Procurement Data System-Next Generation. It is notorious for being filled with errors and for missing lots of required data. Nonetheless, GAO found it to be “sufficiently reliable” for analyzing trends.) GAO used the data to support several conclusions about government spending during that five-year period, some of which we found to be counter-intuitive.
Let’s start with Covington & Burling’s assessment of the GAO analysis:
Importantly, GAO reported that overall, spending on federal contracts decreased from FY 2011 to FY 2015 by nearly 24%. The primary reason for that decline was a 31% decrease in spending by the DoD agencies during that time, during which civilian spending decreased by less than 7%. GAO noted that the largest decreases occurred for both DoD and civilian agencies around sequestration in FY 2013. But following sequestration, civilian obligations rose back to near FY 2011 levels, while DoD obligations continued to decrease.
The trends identified in GAO’s report stand in direct contrast to the emerging details of the Trump administration’s proposed federal budget, which was released on March 16, 2017 by way of the Office of Management and Budget’s “Budget Blueprint.” That blueprint proposes a significant increase in DoD funding, at the (potentially significant) expense of a variety of civilian agencies.
The GAO report looked at (1) what goods and services were being acquired, (2) the rate of competition, (3) procurement methods/contract types used, and (4) the suppliers the provide goods and services.
As noted in the Covington & Burling summary, GAO found that DoD spending declined by almost one-third during the five-year period reviewed. To understand what happened, you need to understand “sequestration” and its impact to Federal spending. You can get the details in the Wikipedia article (link in previous sentence), but the gist of it is that, in order to resolve the 2011 “debt-ceiling crisis,” President Obama and Congress agreed to create a “Super Committee” with authority to cut Federal spending in order to create a $1.2 trillion reduction in the Federal deficit over 10 years. The Super Committee failed (some asserted that it was sabotaged) and thus automatic “across-the-board” spending cuts went into effect in January, 2013. The automatic cuts were to be split evenly (by dollar amounts) between defense and non-defense spending; however, certain programs (e.g., Social Security, Medicaid, Federal pensions, and veterans’ benefits) were exempted. The Congressional Budget Office estimated that the impact of sequestration was to decrease GDP growth by about 0.6% annually. In other words, sequestration harmed the overall economy.
Unsurprisingly, the GAO study found that “the largest decrease in obligations for both defense and civilian agencies occurred around the time of sequestration in fiscal year 2013.” About one-quarter (26%) of the DoD sequestration reductions came from its procurement accounts; i.e., contracting activity. However (as Covington & Burling noted), “While defense obligations continued to decrease, civilian obligations increased to just under fiscal year 2011 levels.” What that seems to mean is that DoD bore the brunt of the sequestration impacts. Its budget was cut, and continued to decline relative to pre-2013 levels, while the civilian agencies’ budgets took a one-time hit and then began to climb back to previous levels.
Interestingly, the report found that services now make up 60 percent of government-wide contracting obligations. At civilian agencies, services make up 80 percent of contract spending. Looking at what services were being acquired, GAO found that the number one service (in both defense and civilian agencies) was “professional support services.” This category included engineering and technical support. In other words, as the agencies’ budgets (and headcounts) were cut, they outsourced the required efforts to the private sector. Nearly 20 cents of every obligated dollar went to such support services. GAO noted the “risk” of such contractors performing “inherently governmental work.”
With respect to competition, GAO found that the Federal government awarded contracts through competition about 65 percent of the time (DoD lagged with only 55% of awards being made through competition.) In 14 percent of the time, competitive solicitations resulted in receipt of only one offer.
Two-thirds of all contract awards were made on a fixed-price basis. Part 12 (commercial item) procedures accounted for about 25 percent of contract obligations for products and services.
There are many more details in the GAO report, and we suggest you may want to review it in full. However, we have attempted to provide a summary (in addition to the summary provided by Covington & Burling) because we think it’s an interesting study.
WARNING! We are about to talk about politics. We normally strive to avoid political discussions, because in today’s environment you really cannot expect to change anybody’s mind. If you don’t like political discussions or if you are going to get offended by a point of view that is not aligned with your point of view, we suggest you stop reading right now. You’ve gotten everything of value that this article has to offer you.
The counter-intuitive conclusion in the GAO report was how the civilian agencies recovered from the sequestration cuts. DoD’s budget was cut and stayed cut, but the civilian agencies’ spending started to trend back up. We don’t pretend to understand how that happened but, according to GAO, it did happen.
If you remember back to the “Super Committee” and its mission, most people expected it to work. The sequestration was intended to force a compromise. Many people expected that the Draconian budget cuts—the meat-axe across all Federal agencies—would be too unpalatable and thus a compromise would be found. Conservative Republicans would be unwilling to see cuts to defense spending and Liberal Democrats would be unwell to see cuts to civilian agencies such as the EPA. Sequestration was intended to get both sides to the table in order to reach a budget compromise.
As a 2012 Huffington Post article (written by Jason Linkins) stated—
The irony is that at the time of the Super Committee’s formation, it was widely believed that the sequestration was an awesome idea that would totally guarantee the Super Committee’s success. By hanging the sequestration over everyone’s heads like the Sword of Damocles, they reasoned, the members of the Super Committee would be Super Motivated to reach a Super Agreement. Paul Ryan (R-Wis.) heralded the sequestration as a victory of bipartisanship and a welcome change in Congress’ culture.
That plan failed.
Sequestration went into effect. Most observers at the time thought that non-defense programs were going to face the biggest cuts. See, for example, this 2015 article by David Reich and the Center on Budget and Policy Priorities. In it Mr. Reich concludes that “In short, the BCA [Budget Control Act], with its caps and sequestration, will soon mean that the federal government is devoting the lowest share of national income in at least five decades to the services and investments covered by non-defense appropriations.”
But it didn’t work out that way, according to the GAO study. The civilian agencies recovered from the sequestration cuts while the DoD did not. We do not pretend to understand how that happened, but it seems to be the reality of the spending data. If the analysis is correct then the Conservative Republicans were the big losers of the 2011 budget negotiations.
We say this because the threat of huge DoD cuts was supposed to compel those Conservative Republicans to a compromise, just like the threat of huge non-DoD cuts was supposed to compel the Liberal Democrats to a compromise. The compromise never happened but the DoD cuts were long-lasting while the non-DoD cuts were (seemingly) temporary. The Liberal Democrats payed a short-term price for failing to compromise while the Conservative Republicans paid a long-term price.
(Yes. We understand that we are painting with a broad brush. There are moderate and even liberal Republicans, and there are conservative Democrats. We get that. There’s really no need to write us emails pointing that fact out.)
End of political discussion. We now return you to the normal blog articles discussing government contracting and compliance matters.
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Timekeeping Fraud, Mandatory Disclosure, and Consequences
We’ve recently noticed a spate of DOJ press releases dealing with timekeeping fraud. To some extent, such stories have always been there; timekeeping misadventures are the background noise of government contracting. It’s always puzzled us why so many people think they will be the ones to get away with their little lies despite annual training and supervisory timecard reviews, and DCAA floorcheck audits, and ethics/business conduct policies and more required ethics training, and mandatory contractor disclosure requirements, and internal audits, and all the other stuff good contractors do to try to detect or prevent such shenanigans. No matter what we do, we seem to have a small group, about ~ 0.1 percent of the workforce, who seem to be determined to lie about their labor hours.
In a recent article on the topic, we suggested that one causal factor may be that the supervisory review/approval of an employee timesheet isn’t the robust control it’s been portrayed as being. Maybe it was a stronger control 50 or more years ago, when we had paper timecards and supervisors were co-located with their employees. But that’s not the case anymore; nor has it been the case for many years. Times have changed and we wonder whether the average company’s internal controls have adapted to the changed times.
Today most companies use electronic timesheets. Supervisors have the option (if they choose) to click their approval without actually looking at the timesheet being submitted. And even if they look, what does the timesheet tell them? In the average ERP system, a project number is just a group of numbers with little (if any) information. Ditto for the WBS number. The project number/WBS number combination typically doesn’t tell the supervisor much of anything regarding the project or the task being worked on. Consequently, even the best supervisory review is weakened to the point at which its value is questionable.
Today most employees are not co-located with their supervisors. Instead, they work in different buildings, perhaps in different geographic locations that may be hundreds of miles away from the supervisor’s location. How can a “supervisor” be expected to intelligently review and approve a timecard when that supervisor doesn’t know when the employee showed up to work, when the employee departed, and how long the employee took for a lunch break? If the employee takes a sick day or goes on jury duty, how does the supervisor actually know that happened—other than the employee’s recording of hours against a paid time-off account? Conversely, how does the supervisor actually know the employee was present in the workplace—other than the employee’s recording of hours against a project/WBS number?
As we asserted in that prior article, we think one problem is HR. HR is telling companies who the supervisors are, based on organizational structures and who performs annual performance reviews. But that logic doesn’t follow when you’re trying to establish sound internal controls and provide assurance that the supervisor is performing a knowing review of an employee’s timesheet when deciding whether or not to approve it. In our view, companies are far better off if they decouple the organizational hierarchy from the internal control hierarchy, and identify a timecard reviewer/approver who actually knows what the employee is doing on a day-to-day basis, even if that reviewer/approver is outside the employee’s organizational structure. In our view, companies need to identify timesheet supervisors who may well be independent from the employee’s “HR supervisor” because that’s what makes for a knowing review/approval and a solid internal control.
With that in mind, let’s discuss a recent timecard fraud matter over at Charles River Laboratories. Charles River Laboratories (CRL) is a publicly traded company that reported $1.4 billion in sales in its FY 2015. It employs about 11,000 at more than 50 locations scattered throughout the world, including roughly 40 locations within the United States. CRL “provides essential products and services to help pharmaceutical and biotechnology companies, government agencies and leading academic institutions around the globe accelerate their research and drug development efforts.” If you think about it, that’s a fairly risky profile from a timecard review/approval point of view.
Among its many customers, CRL supports the National Institutes of Health (NIH) “for services relating to the development, maintenance, and distribution of colonies of animals as well as the provision of laboratory animals.” As a government contractor, CRL is subject to all the requirements of accurate timecharging and proper labor accounting and billing accuracy, the same as Lockheed Martin or Northrop Grumman, or (probably) your company.
Anyway, according to this DOJ press release, CRL employees from two geographically disparate locations (Raleigh, North Carolina and Kingston, New York) engaged in some kind of timecard fraud. The improper labor hours led to invoices that were inaccurate, because they contained hours that had not been worked. CRL apparently discovered the problem and reported it (as they were very likely required to do under the requirements of the contract clause 52.203-13).
For some reason, the government decided to pursue restitution via the False Claims Act, rather than through an administrative mechanism (such as a billing credit). We don’t know the rationale for doing so. (Sorry to be sketchy on the details; the DOJ never gives many details in its press releases.) It is possible that the rationale was the “reckless disregard” or “deliberate ignorance” standard. Perhaps CRL’s timekeeping and labor accounting controls were viewed as being susceptible to fraud. If management knew its controls were weak and did nothing to enhance them, that might be viewed as meeting the “reckless disregard” standard. If management did nothing to evaluate its controls, that might be viewed as meeting the “deliberate ignorance” standard. Obviously we don’t know what the rationale was; we’re just speculating here.
In our experience—and we have a lot of experience in this area—the government does not normally pursue a False Claims Act case where the contractor made a disclosure of its own volition. This case is a bit different from the norm, and nobody is really talking about why. We did Google an article from the Boston Business Journal (authored by Max Stendahl) and learned—
A spokeswoman for Charles River said that the company and its outside lawyers began an investigation in May 2013 into the inaccurate billing after an employee reported the issue to senior management. The probe confirmed that the company’s research models and services unit had overbilled the government for work related to ‘a small subset of our government contracts,’ the spokeswoman said.
That doesn’t necessarily tell us why the DOJ pursued an FCA suit. However, it does tell us that CRL’s internal controls failed. It took an employee report—via “hotline” or similar means—for CRL management to learn about the timecard fraud. We can speculate that the employee wrongdoing was ongoing for several years. At least, we can speculate that it could have been going on for several years, and would still be going on today without that report to management. Management was in the dark. When management learned about the problem it hired “outside lawyers” to investigate and scope the problem out. That effort led, nearly four years later, to a $1.8 million settlement with the DOJ.
We say it over and over. The business case is obvious. It’s a no-brainer. Internal controls are investments that pay for themselves many times over. In this case, CRL spent untold millions on attorney fees in order to reach a FCA settlement valued at nearly $2 million. What kind of internal audit/compliance function would that kind of money buy you?
Are You Smarter Than the Government?
No. No you’re not.
And yet we keep hearing it. We keep hearing from clients—particularly from clients that are new to government contracting—how they have figured out things better than the Government has. If only the Government will listen to them…
We touched on this phenomenon in this article. We noted that several small business clients had become accustomed to doing business their way. Those clients tended to be a bit surprised when they failed their DCAA pre-award accounting system review because “their way” didn’t map well to “the Government’s way.”
As our old friend Brent Calhoon likes to say, “You can’t do business with the Government. The Government doesn’t do business. The Government does government. So when you do business with the Government, you have to do government.” Too many government contractors haven’t figured out that their cherished, innovative, approaches to government contracting just will not work. They haven’t figured out that the Government wants them to do government.
We worked for several years at a very successful multi-national engineering services corporation. Multiple billions of dollars of annual revenue—about five percent of which was from the Government. Being a 95 percent commercial contractor—and a much respected industry leader in its niche—the company tended to do things its own way. And it hired a bunch of people to come in after the fact and “scrub the books” to make them compliant with government requirements.
It worked, to an extent. Zero CAS noncompliances; zero questioned costs. But the fact of the matter is that you simply cannot audit every single transaction. Eventually one transaction slipped through and $35 million later the company’s False Claim Act suit was settled.1
Now that company generates about half its revenue from Government sources and all accounting is done in accordance with Federal cost accounting rules. Adjustments are made (where necessary) to meet commercial needs. The company has learned which of its customers had the bigger stick.
With all that in mind, let’s discuss the recent ASBCA decision in the appeal of Industrial Consultants, Inc. (DBA W. Fortune & Company). ICI was awarded a contract for HVAC work (that’s heating, ventilation, and air conditioning) at a government facility. ICI was the low bidder (by more than 35 percent) and was awarded the contract. ICI had not attended the pre-bid site visit; however, upon the first post-award visit, ICI “concluded … that the design provided by the government had significant problems [and] then began a campaign to redesign the work, which [it] refused to drop no matter how many times the Corps told [it] to build as designed.”
Discussions, as they say, ensued. ICI refused to submit required documents and insisted that the design was flawed. As the decision noted, “Reacting to this in an internal email, one Corps employee observed ‘He cannot seem to get over the idea that he cannot propose a system rather than simply execute the contract as agreed’.”
The contract was terminated for default.
Continuing its contentious approach to contracting, ICI requested that the T4D be converted into a Termination for Convenience. Among other things, “ICI contended that the government provided defective specifications, failed to cooperate in approving submittals in a timely manner, breached the government's implied warranty of design and violated international building codes.”
The Board was not impressed. The Termination for Default was upheld. We want to quote some more of Judge O’Connell’s decision because it speaks to those contractors who believe they are smarter than the government customer who hired them. He wrote—
We have already rejected ICl's contentions that the government delayed the project. Rather, the record makes it clear that ICI delayed the project because it disagreed with the government's design choices and failed to provide timely or complete submittals. The record strongly suggests that ICI has a basic misunderstanding as to its role as a contractor on a government project. Despite ICl's views to the contrary, and as we now discuss, government contractors must perform the contracts they execute and cannot require the government to rewrite the contract so that they can build some other project they like better.
It is well settled that the government is entitled to enforce its contracts so that it receives the work product provided for in the contract. The government enjoys considerable leeway in determining what to specify. The Federal Circuit has held in the context of selecting the performance of air conditioning equipment that the ‘government may require performance both in excess of, or below, the standard normally accepted in a trade.’
A number of cases from the Federal Circuit and the Court of Claims demonstrate that the contractor's role is to build the project for which it made a binding promise, not some contract that, in hindsight, it believes is more appropriate or makes more sense.
(Emphasis added. Internal citations omitted.)
There is a common misperception that government employees are lazy or unintelligent, and that if they were smarter they’d be working for a contractor. In our experience that’s simply not true. However, that belief is often used as a subtle (or unsubtle) foundation for an arrogance that “we know better than the customer what the customer really needs.” That’s just not the smart way to do government with the Government.
As this decision shows, a much smarter approach to government contracting is to give the customer exactly what you have promised to deliver. Deliver it on time and on budget. Arguing with the customer almost certainly isn’t going to change the bargain you made, and it might just result in a very upset customer.
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