The Veterans Administration and the “Rule of Two”
The Supreme Court of the United States doesn’t often agree to hear government contracts cases, but when it does then its opinion becomes the law of the land. Recently SCOTUS agreed to hear a bid protest case and its opinion established how the Veterans Administration (VA) will decide to award contracts to service-disabled and other veteran-owned small businesses. The opinion was good news for those small businesses.
Various statutes pertaining to the VA require that “a contracting officer ‘shall award contracts’ by restricting competition to veteran-owned small businesses if the officer reasonably expects that at least two such businesses will submit offers and that ‘the award can be made at a fair and reasonable price that offers best value to the United States.’” That requirement is known as the “Rule of Two.”
According to the SCOTUS case summary—
In 2012, the Department procured an Emergency Notification Service for four medical centers for a one-year period, with an option to extend the agreement for two more, from a non-veteran-owned business. The Department did so through the Federal Supply Schedule (FSS), a streamlined method that allows Government agencies to acquire particular goods and services under prenegotiated terms. After the initial year, the Department exercised its option for an additional year, and the agreement ended in 2013.
Petitioner Kingdomware Technologies, Inc., a service-disabled veteran-owned small business, filed a bid protest with the Government Accountability Office (GAO), alleging that the Department procured multiple contracts through the FSS without employing the Rule of Two. The GAO determined that the Department’s actions were unlawful, but when the Department declined to follow the GAO’s non-binding recommendation, Kingdomware filed suit …. The Court of Federal Claims granted summary judgment to the Government, and the Federal Circuit affirmed, holding that the Department was only required to apply the Rule of Two when necessary to satisfy its annual [socioeconomic] goals.
In a unanimous opinion, SCOTUS held that the statutory language was unambiguous. The language required the VA to use the Rule of Two before contracting under competitive procedures. The Rule of Two is not discretionary; it may not be waived even if the Department has already met its annual socioeconomic goals. Before opening a full and open competition, a VA Contracting Officer must first conduct market research in order to determine whether or not there are at least two service-disabled veteran or veteran-owned small businesses that can perform the work and will submit offers than can be found to be fair and reasonable. If the CO determines there are at least two such small businesses, then the procurement must be “set aside,” or restricted, such that only service-disabled veteran or veteran-owned small business may submit proposals for the contract.
The only exceptions to the foregoing are those in the statute itself, which provide that the VA may use noncompetitive procedures and sole-source contract awards for lower-value contract awards (which we believe means awards below the simplified acquisition threshold). In particular, SCOTUS held that orders under FSS contracts were not exceptions (as the VA had argued) and were thus subject to the Rule of Two.
If you are a service-disabled veteran-owned small business, or simply a veteran-owned small business, and you sell goods or services to the Veterans Administration—or want to sell goods or services to the Veterans Administration—then this SCOTUS opinion is excellent news. You need to make sure that you are on the appropriate VA list of SDVOSBs and VOSBs with all your NAICS codes, so that you can be positioned to submit responsive bids when you receive a call or email from a Contracting Officer. And make no mistake, you will be receiving communications—because the VA has to comply with this SCOTUS ruling.
Don’t Look Now but Your False Claim Act Risk Just Skyrocketed
 The False Claims Act (which includes both civil and criminal statutes) is one of the biggest sticks wielded by the Federal government against allegations of contractor fraud. Alleged violations can easily lead to multi-million dollar settlements, not to mention large (unallowable) legal bills and huge investments of contractor time and resources. Not really a good thing at all.
Reportedly, 70 percent of all suits under the False Claims Act are filed by whistleblowers, called qui tam relators, who are eligible to receive bounties of large percentages of whatever the government collects as a result of the litigation. Your disgruntled employees may become whistleblowers, unless you listen to their concerns and do something about them. Indeed, your company may already be facing a FCA suit and you know nothing about it, because the suits are filed under seal.
Add to this situation the fact that most companies—especially small businesses—really don’t understand how to do a risk analysis that compares the potential FCA liability against the potential profit when they decide to cut corners in the Federal procurement marketplace. We’ve pointed out before just how ill-equipped most business leaders are to decide how much to budget for internal controls and internal audits and contract compliance, simply because they lack information regarding the consequences. Unlike other aspects of the business, they can’t quantify a Return on Investment (ROI) because they lack knowledge and experience in this area.
Examples from this website:
And that’s just three of the many examples we have written about. It’s a decent rule-of-thumb that any company accused of violations of the FCA is going to be out-of-pocket at least $1 million—no matter what. And if the allegations have merit, that number is going to go up and up and up. Granted, the probability of a FCA suit being filed against your company may be low but the consequences are almost certainly going to be higher than you’d care to think about. Therefore it’s imperative to understand the risks when considering how much to invest in fraud prevention. The risks almost always outweigh the cost of anti-fraud activity, which makes such anti-fraud activity a good investment.
That’s always been the math, whether your corporate leadership wanted to run the numbers or not.
And all the math just changed, courtesy of the Supreme Court of the United States.
(This is the part where we remind readers that we are not attorneys and any legal analysis we offer is just that of a layperson. If you want legal advice, please go hire a competent government contracts attorney.)
SCOTUS just issued a decision that changes the risk analysis equation. The recent decision, captioned UNIVERSAL HEALTH SERVICES, INC. v. UNITED STATES EX REL. ESCOBAR, ensures that the probability that you might find yourself the defendant in FCA litigation just increased significantly.
Let’s start with the summary of the case—
Yarushka Rivera, a teenage beneficiary of Massachusetts’ Medicaid program, received counseling services for several years at Arbour Counseling Services, a satellite mental health facility owned and operated by a subsidiary of petitioner Universal Health Services, Inc. She had an adverse reaction to a medication that a purported doctor at Arbour prescribed after diagnosing her with bipolar disorder. Her condition worsened, and she eventually died of a seizure. Respondents, her mother and stepfather, later discovered that few Arbour employees were actually licensed to provide mental health counseling or authorized to prescribe medications or offer counseling services without supervision. Respondents filed a qui tam suit, alleging that Universal Health had violated the False Claims Act (FCA). … Respondents sought to hold Universal Health liable under what is commonly referred to as an ‘implied false certification theory of liability,’ which treats a payment request as a claimant’s implied certification of compliance with relevant statutes, regulations, or contract requirements that are material conditions of payment and treats a failure to disclose a violation as a misrepresentation that renders the claim ‘false or fraudulent.’ Specifically, respondents alleged, Universal Health (acting through Arbour) defrauded the Medicaid program by submitting reimbursement claims that made representations about the specific services provided by specific types of professionals, but that failed to disclose serious violations of Massachusetts Medicaid regulations pertaining to staff qualifications and licensing requirements for these services. Universal Health thus allegedly defrauded the program because Universal Health knowingly misrepresented its compliance with mental health facility requirements that are so central to the provision of mental health counseling that the Medicaid program would have refused to pay these claims had it known of these violations.
SCOTUS, in a unanimous ruling, held that—
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The implied false certification theory can be a basis for FCA liability when a defendant submitting a claim makes specific representations about the goods or services provided, but fails to disclose non-compliance with material statutory, regulatory, or contractual requirements that make those representations misleading with respect to those goods or services.
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By submitting claims for payment using payment codes corresponding to specific counseling services, Universal Health represented that it had provided specific types of treatment. And Arbour staff allegedly made further representations by using National Provider Identification numbers corresponding to specific job titles. By conveying this information without disclosing Arbour’s many violations of basic staff and licensing requirements for mental health facilities, Universal Health’s claims constituted misrepresentations.
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A defendant can have ‘actual knowledge’ that a condition is material even if the Government does not expressly call it a condition of payment. What matters is not the label that the Government attaches to a requirement, but whether the defendant knowingly violated a requirement that the defendant knows is material to the Government’s payment decision.
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A misrepresentation about compliance with a statutory, regulatory, or contractual requirement must be material to the Government’s payment decision in order to be actionable under the FCA. The FCA’s materiality requirement is demanding. An undisclosed fact is material if, for instance, ‘[n]o one can say with reason that the plaintiff would have signed this contract if informed of the likelihood’ of the undisclosed fact. … When evaluating the FCA’s materiality requirement, the Government’s decision to expressly identify a provision as a condition of payment is relevant, but not automatically dispositive. A misrepresentation cannot be deemed material merely because the Government designates compliance with a particular requirement as a condition of payment. Nor is the Government’s option to decline to pay if it knew of the defendant’s noncompliance sufficient for a finding of materiality. Materiality also cannot be found where noncompliance is minor or insubstantial. Moreover, if the Government pays a particular claim in full despite its actual knowledge that certain requirements were violated, that is very strong evidence that those requirements are not material. The FCA thus does not support the Government’s and First Circuit’s expansive view that any statutory, regulatory, or contractual violation is material so long as the defendant knows that the Government would be entitled to refuse payment were it aware of the violation.
What does all that mean (to a layperson)?
Well, to some extent the decision is so new that it’s hard to tell how it will impact future litigation. No doubt learned practitioners and law school students are feverishly typing up reviews of the opinion, even as we are feverishly typing up this article. But while the reviews are likely to be mixed, it seems clear that, by accepting some form of the implied certification theory, SCOTUS has expanded the universe of false claims subject to litigation.
SCOTUS held that the implied certification theory can be an accepted basis for a qui tam suit when a contractor fails to disclose “non-compliance with material statutory, regulatory, or contractual requirements that make those representations misleading with respect to those goods or services” that constitute the subject of the invoice for which payment is being sought. The opinion spends time discussing how to tell whether a requirement is or is not material, and concludes that a requirement is material if the Government would not have entered into the contract, had it known the contractor would not comply with that particular requirement. Further, SCOTUS held that it was the contractor’s knowledge of the materiality of the non-compliance that mattered, and not the Government’s knowledge.
Accordingly, contractors that fail to comply with any statutory, regulatory, or contractual requirement now risk being subject to FCA liability, if it can be alleged that no reasonable party would have entered into the contract had it known that particular requirement would not be complied with. That’s a big deal, in our view.
On the other side of the coin, SCOTUS seemed to have also held that there must be some representation included in or associated with the invoice to create FCA liability. “Materiality also cannot be found where noncompliance is minor or insubstantial.” And that’s good news for contractors, because not every single Section I contract clause is going to be found to be material with respect to invoice submission.
In our view, the issuance of this SCOTUS opinion is a good time to review your government contracts and their terms and conditions, including contract clauses, to see (a) which ones might support a finding that they are material to invoice payment, and (b) which ones you might not be fully complying with. Where you find an intersection between (a) and (b), we think you have a problem that needs to be fixed soon.
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“The prime is responsible for managing the subcontractor.”
This truism was posted recently in a LinkedIn group thread. It was posted as if it were some great profundity, instead of an example of the obvious. Of course the prime is responsible for managing its subcontractors. If you’ve read this blog for any length of time, you know we frequently pontificate on the importance of managing subcontractors. Subcontractor management may be the single most important differentiator between projects that fail and projects that succeed.
Contractors that don’t effectively manage their subcontractors not only risk suboptimal program outcomes, but they also risk being accusing of “excessive pass-through costs.” Excessive pass-through costs are what happens when a prime incurs too much subcontractor costs and can’t show a Contracting Officer that it (the prime) adds value to the work being performed by the subcontractors. (See FAR clauses 52.215-22 and 52.215-23.)
But what does “managing” mean in this context? What does it mean to “manage” subcontractors? Is it the same thing as managing one’s own workforce? If not, what’s the difference?
FAR 42.202(e)(2) states—
The prime contractor is responsible for managing its subcontracts. The CAO’s review of subcontracts is normally limited to evaluating the prime contractor’s management of the subcontracts (see Part 44).
That seems to point toward FAR Part 44 as the location where we can learn about subcontractor management. Unfortunately, while that Part of the FAR has quite a bit to say about the adequacy of contractors’ purchasing systems and granting of consent to subcontract, it has very little to say about the expectations regarding how a prime (or higher tier sub) should manage its subcontractors.
This shouldn’t really be surprising. If you read the FAR Part 42 direction quoted above, and look at the entire section to provide context, it’s quite clear that the statement “The prime contractor is responsible for managing its subcontracts” is directed to the government Contracting Officer and not to anybody else. It’s a reminder to a Contracting Officer not to get overly involved in the prime-subcontractor relationship, to limit any review to the types of contractor management activities specified in FAR Part 44. These contractor management activities are all about placing the subcontract and not about any kind of post-award administrative activities. According to FAR 44.303, the the types of subcontractor “management” activities subject to CO review include—
(a) The results of market research accomplished;
(b) The degree of price competition obtained;
(c) Pricing policies and techniques, including methods of obtaining certified cost or pricing data, and data other than certified cost or pricing data;
(d) Methods of evaluating subcontractor responsibility, including the contractor’s use of the System for Award Management Exclusions (see 9.404) and, if the contractor has subcontracts with parties on the Exclusions list, the documentation, systems, and procedures the contractor has established to protect the Government’s interests (see 9.405-2);
(e) Treatment accorded affiliates and other concerns having close working arrangements with the contractor;
(f) Policies and procedures pertaining to small business concerns, including small disadvantaged, women-owned, veteran-owned, HUBZone, and service-disabled veteran-owned small business concerns;
(g) Planning, award, and postaward management of major subcontract programs;
(h) Compliance with Cost Accounting Standards in awarding subcontracts;
(i) Appropriateness of types of contracts used (see 16.103);
(j) Management control systems, including internal audit procedures, to administer progress payments to subcontractors; and
(k) Implementation of higher-level quality standards.
And that’s about it. While there are some potentially fruitful areas of interest (e.g., “postaward management of major subcontract programs” and “management control systems … to administer progress payments to subcontractors”) the obvious focus of governmental review is on pre-award and award procedures—and not on what happens after a subcontract is awarded. (In a related note, we were unable to find any official definition of what a “major subcontract program” was or what differentiated a “major” subcontract from a “non-major” subcontract. That lack of definition kind of makes it tough for a CO to review much of anything, in our view.)
So why has the GAO told Congress that “The FAR emphasizes the prime contractor's responsibility in managing its subcontractors.” (See GAO-11-61R, Oct. 28, 2010) As we’ve seen, that’s a misleading statement. The FAR absolutely does not emphasize anything even close to what GAO was implying. More to the point, why does DCAA make such a big deal about a prime (or higher tier) contractor’s duty to manage its subcontractors?
Here’s a link to an official DCAA presentation to subcontractors that discusses the responsibilities of the prime (or higher tier) contractor. It states: The prime contractor is primarily responsible for subcontract award, technical and financial performance, monitoring, and payment to the subcontractor for the work accomplished under subcontract terms. That’s quite true and unobjectionable; but subsequently the presentation veers into new territory, stating that “common prime or higher tier subcontract deficiencies” include: “Failure to verify the subcontractor has an adequate accounting system” and “Failure to obtain an adequate incurred cost submission from subcontractor.” Those are interesting notions but, unfortunately for DCAA, they cannot be found anywhere in any contract clause.
More tellingly, our colleagues over at Redstone consulting believe that DCAA and DCMA are “rewriting” FAR 42.202 to require primes and higher tier subs to “audit” their subcontractors. Michael Steen wrote—
If and when DCAA audits a prime contractor indirect cost rate proposal, DCAA is now training its auditors to focus on any and all subcontract costs on any type of flexibly priced prime contract (cost-type, fixed-price incentive, T&M). If the prime contractor cannot demonstrate that it ‘audited’ the costs claimed by a subcontractor (cost-type) subcontract, DCAA is now questioning 100% of those subcontract costs (DCAA is not auditing the subcontract costs on behalf of the prime contractor because that is not DCAA’s responsibility). Virtually the same end-game for T&M contracts with T&M subcontracts; if the prime did not audit the subcontractor records, 100% disallowance. And if you think that a fixed price (FFP) subcontract mitigates prime contractor risk, not exactly if the FFP subcontract is under a cost-type prime contract. DCAA will likely second guess the sufficiency of the prime contractor cost or price analysis leading to a DCAA assertion that the FFP subcontract is not sufficiently documented as a fair and reasonable price; hence, the entire subcontract cost (price) is unreasonable under FAR 31.201-3.
We think this whole thing has gotten out of hand. A minor reminder to Contracting Officers that primes are responsible for managing their subcontractors (duh) has evolved into another way to question the adequacy of a contractor’s purchasing system, or to question incurred costs. Clearly, that’s not what the FAR drafters intended, but that seems to be where we are.
DCAA Revises Policy to Avoid Auditing Contractors’ Incurred Cost Submissions (Again)
In what was arguably a predictable move, the Defense Contract Audit Agency has once again revised its policy so as to exempt more contractors’ incurred cost submissions from audit. MRD 16-PPD-06, issued May 27, 2016, revised (for at least the second time) its policy regarding which incurred cost proposals (which technically should be called “proposals to establish final billing rates” but almost nobody actually calls them that) will be considered to be “low-risk” and therefore accepted without any kind of transaction testing.
Yeah, we’ve been down this road before, haven’t we?
Our article on this topic, from November, 2013, really said all that needs to be said. We pointed out then that DCAA’s plan to reduce its embarrassingly large backlog of unaudited proposals wasn’t working out for the agency. We noted a GAO report “had found that DCAA’s initial assessment of contractor proposals had resulted in more than half the submissions being classified as high-risk, meaning that a full scope audit would be required. In contrast to reality, DCAA’s initial planning has assumed that only about 20 percent of submissions would be found to be high risk. And this was in relation to contractor proposals with ADVs of less than $15 million.” Thus, relaxing the criteria would create more “low-risk” contractor proposals and enable DCAA to reduce its audit backlog without, you know, actually performing audits.
The more recent policy change documented in MRD 16-PPD-16 is just more of the same. More relaxing of criteria to permit more proposals to fall into the “low-risk” category. More backlog “risked-away” because, gosh, it’s just not worth spending taxpayer dollars to audit such low-risk proposals, even though they are more likely to be submitted by small businesses that don’t have a good understanding of the FAR Part 31 cost principles and related requirements, and thus are more likely to have unallowable costs included in them.
If we interpret the new policy correctly, then any incurred cost submission with an Auditable Dollar Value (ADV) of less than $5 million is automatically considered to be low-risk, and shall not be audited. (This assumes the contractor was able to make the schedules tie-out the way DCAA’s math-checks require them to.) Quite literally, an auditor will need to obtain high-level permission in order to classify any such proposal as other than low-risk. The MRD states “FAOs will need to obtain Regional Audit Manager (RAM) approval if performance of an audit is warranted based on significant relevant risk.” The auditors (and their Audit Supervisors and their FAO Managers) will have to make a case to a RAM in order to protect taxpayer dollars by performing an audit on such small dollar proposals.
Whatever.
It’s more of the same. While DCAA’s audit protocols call for months of risk assessment followed by literally years of field work in order to audit one single contractor’s proposal to establish final billing rates, the only way to actually make progress against the backlog of audits is to declare the audits don’t need to be performed, or have been performed via a math-check, or that the proposal is not adequate and can’t be audited.
The purpose of this article is not to bash DCAA. It is simply to document, for the record, the decisions being made. One day some Masters or Ph.D. candidate may stumble across this blog and cite it as source material for a thesis on “Abnormal Psychology as Exhibited by Governmental Organizations: A Case Study on DCAA”.
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