It used to be a truism that the purpose of managing the supply chain was to ensure sufficient materials and parts so as to execute the program. The prime contractor won the work and subcontracted portions to lower-tier suppliers, who then subbed out some to the next tier of suppliers, and so on and so forth. Primes got graded on the socioeconomic status of their subcontractors, with competitive advantage being conferred to those primes who could locate suppliers that were both good at execution and at being the right shade of socioeconomic category. The same was true for the lower-tier suppliers. If you could quote a decent price plus be a small or small disadvantaged business, you had a decent chance at winning work and making some money along the way.

The decision to subcontract out a portion of the contract’s statement of work – the “make or buy” decision – was based on many factors, perhaps chief among them the notion that suppliers were generally smaller companies with less overhead—and thus cheaper. Often, there were other factors that also went into the make or buy decision. Some suppliers offered technical expertise unavailable to the prime contractor. Other suppliers offered the ability to promise good socioeconomic stats. Still other suppliers (often competitors) offered something even more valuable: the ability to deliver the political capital necessary to keep the program of record funded. To sum up a complex trade-off analysis in one sentence, the make or buy decision often pointed to a “buy”—a decision to subcontract out—even if the decision introduced additional program execution risk.

We’ve written about effective subcontractor management many times on this blog. For example, see this article, written about a year ago. Or see another example, written in 2010. We’ve asserted (with evidence in support of the assertion) that effective subcontractor management is the key to effective program management. We’ve written about the risks associated with subcontracting and the importance of identifying and managing those risks. We’re kind of passionate about the topic, you might say.

Many of the largest prime contractors have made a specialty of subcontracting out large portions of the SOW, to the point where they like to call themselves “system integrators” and point to subcontract management as one of their (few) core competencies. Their program win strategy is to lock-up and deliver large teams of individual corporations (along with those corporations’ local Congresspersons and Senators). And it tends to work for them often enough that they keep on doing it. Either they have figured out how to manage the risks associated with supply chain management or, perhaps, they haven’t noticed that those risks keep increasing … and so they keep on with what has been working for them.

But make no mistake, those risks do keep increasing. We’ve written about those more recent risks, and the need to manage them, as well. Hell, we’ve even ranted about the importance of a secure supply chain more than once on this site, not that you took us seriously enough to mobilize a tiger team to attack the problem. For example, remember that time where we told readers about the revisions to the DFARS that established criteria for a contractor system to detect and avoid counterfeit electronic parts (“CEPDAS”)? It wasn’t that long ago: it was posted in May, 2014. Yeah, that was the one where we noted that a failure to implement an adequate CEPDAS could lead to a disapproved Purchasing System. That wasn’t the entirety of the risk.

In that article, we noted the new DFARS Cost Principle at 231.205-71, which made the cost of counterfeit electronic parts “and the cost of rework or corrective action” necessary to remedy the impacts of counterfeit electronic parts unallowable, unless the contractor has an approved CEPDAS (among other criteria). If you don’t have an approved CEPDAS and your supplier delivers counterfeit electronic parts, you are going to be in a world of financial hurt, hurt which you will only hope will be recoverable through litigation against your supplier.

This is a supply chain management risk and it’s a big risk and it’s hard to mitigate. Thus, since 2014 the make or buy decision has been impacted and we bet not too many companies have revised their make or buy processes and trade-off criteria accordingly. If you are one of the few who are out in front of this issue, then good for you! If not, you may want to read the next part of this article.

We now link to a very recent Department of Justice press release, in which we learn that Mr. Jeffrey Krantz, CEO and owner of Harry Krantz, LLC, a New York company “that bought and sold, among other things, obsolete electronic parts for use by the U.S. Military and commercial buyers,” pleaded guilty to one count of wire fraud. What did Mr. Krantz and his company do? According to the press release, Krantz did the following –

Between 2005 and 2008, KRANTZ purchased and sold, and caused to be purchased and sold, over a thousand chips to Bay Components, which, in turn sold them to the Connecticut company. The chips were marked with certain information, including a certain manufacturer’s name and trademark, a date code, and a military part number. In approximately December 2005, the first shipments of about 330 chips that KRANTZ had sold to Bay Components were rejected by the Connecticut company for being the wrong part because the chip contained the wrong die inside. In 2006, KRANTZ replaced those chips with at least some of the replacement chips bearing the date code 9832. Between 2006 and 2008, KRANTZ sold and caused to be sold at least 900 chips with date code 9832 to Bay Components, the majority of which were sold to the Connecticut company. KRANTZ knew that the chips had originated from a parts supplier in China, and there was a high probability that the chips were falsely remarked not the original chips of the certain manufacturer as represented by the markings on the chip. He also avoided engaging in common practices in the industry, including those which Harry Krantz LLC routinely engaged in for other military parts, to avoid confirming that the chips were likely remarked. The investigation revealed that many of the chips were used in the assembly of U.S. Military and commercial helicopters.

So an unnamed Connecticut company purchased electronic parts from Bay Components, who in turn acquired them from Krantz. The unnamed Connecticut company rejected the first shipments, but permitted its supplier and lower-tier supplier to replace the rejected chips. Unfortunately, Krantz sourced the chips from China and knew they were likely to be counterfeit. The counterfeit chips were sold up the supply chain and installed on “U.S. Military and commercial helicopters.” Now in fairness, let’s note that this all took place a decade ago, well before the recent emphasis on counterfeit electronic part detection and prevention. So that unnamed Connecticut helicopter manufacturer really shouldn’t be embarrassed that it failed to manage the situation. But still, there are some obvious lessons to be learned here.

First lesson: there aren’t that many helicopter manufacturers in Connecticut. It’s kind of obvious who the company is, and we expect Lockheed Martin will implement its own version of CEPDAS after the acquisition is finalized.

Second lesson: if your part supplier delivers a shipment of non-conforming parts, that’s a huge red flag and should spark an immediate investigation. We’re talking about QA folks para-dropping into the supplier’s operation with no warning, along with sniffer dogs trained to detect made-in-China chips. (Okay that may have been a bit over the top, but we suspect you get the drift.) Procurement should not treat that event as a business-as-usual supplier mistake, as it may well just be the tip of a nasty iceberg looming dead ahead. That kind of event is the announcement that the supplier’s risk probability curve has reached an inflection point, and is quickly approaching a 100% certainty that your program is going to have significant negative cost and schedule variances. Does your supply chain team know what to do if there is such an event?

Third lesson: that unnamed Connecticut helicopter manufacturer may have an approved CEPDAS and, if so, its reaction and recovery costs may be allowable. But if not, then we bet a significant amount of unallowable costs were incurred. The negative impacts may be recoverable through litigation against the middleman supplier (Bay Components) or against Krantz directly. But that assumes that either or both companies have the financial resources to compensate the big unnamed Connecticut helicopter manufacturer. If the money (or insurance) isn’t there, then we suspect the big prime may be SOL.

So here’s a timely object lesson on the importance of securing your supply chain and implementing a strong CEPDAS. We’ve been ranting about this stuff for years, but we’re not asking you to listen to us. We’re asking you to look at the unnamed Connecticut helicopter manufacturer and learn from that company’s misadventures.

At this point it’s old news that United Technologies Corporation has sold its Sikorsky subsidiary to Lockheed Martin. The acquisition is generally held to be a “win” for LockMart, and reports state it will be immediately accretive to earnings. So: Good for Lockheed Martin. Also: Good for Sikorsky, which escapes a corporate parent that really didn’t want it.

As is the case with any acquisition, the buyer doesn’t just get the assets; it also gets the liabilities. Due diligence is the process of reviewing the acquisition target to make sure all liabilities – especially including any contingent liabilities – are identified and factored into the purchase price. Due diligence on government contracting targets is a bit different and more focused than “normal” due diligence, because the cost of defending (or settling) a contract non-compliance can change a good deal into a bad one. For example, if the target has weak controls over its estimating and pricing, the due diligence team is supposed to assess the potential for post-closing “defective pricing” allegations to surface. Similarly, if timekeeping controls are week, the team is supposed to evaluate the possibility that systemic labor mischarging might be taking place. For a final example, an evaluation of the controls over identification and segregation of unallowable costs helps identify any potential legal issues in that area.

Presumably, when Lockheed Martin decided to acquire Sikorsky, it performed a rigorous due diligence and worked hard to identify any areas of potential non-compliance that might spark legal issues after the deal closed.

One issue – one contingent liability – that was already on the table months before the acquisition was the legal problem of Sikorsky’s subsidiary, Sikorsky Support Services, Inc. (SSSI). SSSI was awarded a Navy contract in 2006 to provide support to the T-34 and T-44 turoprop training aircraft. In turn, SSSI issued a subcontract to another Sikorsky subsidiary, Derco Aerospace, to procure and manage the spare parts needed to provide that support. Derco billed SSSI its costs for doing so, plus overhead and profit. The U.S. Government objected to that arrangement, and filed suit in October, 2014.

As our readers know, accounting for inter-company costs (or inter-organizational transfers, as they’re more formally called) between related parties under common control is difficult, and companies don’t always get it right. Normally, inter-organizational transfers are done at cost, excluding profit; but there are regulatory exceptions that permit transfers at price (including profit) under certain circumstances. We don’t know whether Derco was entitled to an exception.

In this case, not only is the government alleging that SSSI misbilled its Navy customer, but that SSSI also submitted “false Certificates of Final Indirect Costs” in its annual proposals to establish final billing rates for years 2006 through 2012. The government has alleged “numerous claims for violations of the False Claims Act, for breach of contract and for unjust enrichment.” The government seeks $148 million in restitution for SSSI’s alleged noncompliances.

For its part, Sikorsky stated (in its SEC filing) that “We believe that Derco was lawfully permitted to add profit and overhead to the cost of the parts, and maintain that SSSI did not submit any false certificates. We also believe that we have other substantial legal and factual defenses to the government’s claims.”

That being said, on July 13, 2015, or just a couple of weeks before the Lockheed Martin acquisition was announced, Sikorsky was informed that the Department of Justice had “opened a criminal investigation with respect this matter.” There is a difference – a big difference – between civil and criminal allegations. The DoJ’s subpoena definitely raised the stakes. Sikorsky was quick to note that it intends to “cooperate fully in the investigation.”

We are obviously unclear on the details of the matter or what DoJ’s motivation may have been for moving the matter from civil to criminal. However, we noted in this WaPo story that “the Justice Department also claims SSSI submitted false certificates for aircraft maintenance from 2006 to 2012.” If true, those allegations might have been sufficient to get the criminal thing going. But we don’t know.

We do wonder, though, if the continual series of investigations and allegations, and costs of providing legal defense for those investigations and allegations, played a role in UTC’s decision to sell Sikorsky. UTC is a conglomerate that has huge purely commercial entities. Those entities have their own issues, of course; but they don’t have the same level of regulatory oversight and extreme legal consequences that the government contracting entities do. Maybe the UTC Board of Directors got tired of dealing with the problems of one of its largest government contracting entities, and decided to sell the entity to the largest defense contractor in the world—one that presumably deals with such regulatory oversight and investigations and allegations on a daily basis.

Thus: We wonder if the known contingent liabilities associated with this matter played a role in bringing the sales price down to a point where commenters think that Lockheed Martin got a very good deal, one that is immediately accretive to earnings.