ASBCA Teaches Small Business about Cost Allowability and Statute of Limitations
 In a recent decision at the Armed Services Board of Contract Appeals, Administrative Judge O’Sullivan taught Coherent Logix, Inc. (CLX) a couple of important lessons. Readers should review the Judge’s decision and learn those lessons for themselves. In the meantime, here's an article on some of those lessons.
CLX is small business, located in Austin, Texas. “Its principal business focus is on creating technology for high performance data processing using a scalable embedded processor platform.” Whatever that means. Our point is: CLX is the kind of small, agile, innovative technology company that the DoD has focused on courting. One of the lessons here is that, unless the DoD starts to relax some of the regulatory requirements applied to these small, agile, innovative technology companies, it’s going to lose them. But that’s not really the focus in this article.
CLX submitted its annual final indirect cost billing rate proposal for its FY 2007 on August 13, 2008. Apparently it sat fallow for a long time, but eventually auditors from the Defense Contract Audit Agency (DCAA) got around to reviewing it for adequacy. We strongly suspect it was found to be inadequate, but we don't know for sure. In any case a revised proposal was submitted on June 19, 2013—nearly five years after the original submission. DCAA audited the proposal and found it included unallowable costs. $82,396 of those unallowable costs were expressly unallowable – namely, $68,894 for legal fees associated with patents, plus “costs of exhibition at trade shows (advertising costs), travel costs exceeding per diem, undocumented first class airfare, and costs of meals determined to be entertainment.”
Oops!
We’ve written about expressly unallowable costs before. We wrote—
… it is important for contractors to ‘scrub’ their proposals to establish final billing rates (also known as ‘incurred cost proposals’) to ensure that they are not claiming expressly unallowable costs. They are required to certify that they have excluded such costs and, if the Contracting Officer determines that the proposal contained expressly unallowable costs despite that certification, then penalties and interest may be imposed.
Accordingly, readers will be unsurprised to learn that—
On 21 November 2014, the Defense Contract Management Agency (DCMA) administrative contracting officer (ACO) issued his final decision finding that CLX had included expressly unallowable costs in its 2007 submission, consisting of the $68,894 in patent legal fees and $13,204 in other expressly unallowable costs. The ACO assessed a Level One penalty of $73,912 on the portion of these costs allocable to covered contracts, and added interest of $17,239, for a total of $91,151. He also stated that while he had carefully considered CLX's request for waiver of the penalty under FAR 42.709-S(c), he had determined that CLX's request did not meet the FAR criteria for waiver of the penalty. In particular, the ACO stated that the unallowable costs were not inadvertently incorporated into the proposal, but were included because CLX believed them to be allowable.
CLX disputed the ACO’s Contracting Officer’s Final Decision (COFD), asserting that the ACO erred in failing to waive the penalties and, in any case, the ACO’s COFD was barred by the Contract Disputes Act’s six-year Statute of Limitations (CDA SoL).
Judge O’Sullivan first addressed the CDA SoL argument. She noted that Judge Dyk’s ruling in Sikorsky had converted the CDA SoL argument from one of jurisdiction to one of an affirmative defense. Judge Dyk’s decision, which Judge O’Sullivan was bound to follow, had the effect of flipping the burden from the Government to the appellant (in this case, CLX). Instead of requiring the Government to show why the Court had jurisdiction, CLX was required to show why it did not. CLX’s arguments did not persuade the judge.
CLX argued that DCAA had audited prior years’ final rate proposals and had never taken exception to any legal costs (which included patent costs), nor had DCAA objected to any IP Amortization costs (which also included legal fees associated with obtaining the patents). Judge O’Sullivan found that simply including patent-related in legal fees or in IP Amortization expense did not provide the Government with adequate notice that CLX was incurring expressly unallowable legal costs. With respect to an affidavit submitted by Gary Baggett (CLX Controller), Judge O’Sullivan wrote, “Notably, Mr. Baggett states only that CLX made books and records available in prior years that showed its patent-related legal costs, but not that patent-related legal costs were included in CLX's final indirect cost rate proposal for any year prior to its 2007 proposal.”
The Judge was persuaded instead by the Government’s counter-argument, which was—
[The Government’s] claim could not have accrued before 1 August 2013, when CLX provided the General Ledger detail showing the patent legal costs to the DCAA. Diane Chang, a DCAA auditor, provided an affidavit in which she states that DCAA requested the General Ledger detail from CLX on 24 July 2013 and received it on 1August 2013. Ms. Chang also states that she has searched the DCAA files and did not find General Ledger detail anywhere in CLX's 13 August 2008 submission. She further states that the only information CLX provided on legal costs prior to 1 August 2013 was the single line item identifying only generic ‘legal services’ in the amount of $89,196.
So one lesson here is that contractors should provide maximum General Ledger account detail along with submission of their proposals to establish final billing rates, even down to transaction level detail if feasible. We realize that for any company larger than the very smallest size, that’s going to be a ridiculously difficult task, but we think it’s going to be the only way to defeat the Government’s argument (which has now succeeded in two CDA SoL cases) that it never knew of allegedly unallowable costs until the auditor requested and saw the transaction detail.
With respect to CLX’s second argument, which was it included the expressly unallowable costs because it didn’t know any better, Judge O’Sullivan was similarly unpersuaded. CLX argued that it relied on a lack of audit findings in prior DCAA audits and, once it learned its legal fees associated with patents were not allowable, it implemented remedial measures to prevent a future recurrence of such costs. The Judge found that those arguments simply did not meet the prerequisites for penalty waiver found at FAR 42.709-5(c).
In that respect, her decision followed the same logic as was used by Judge James in his August, 2012, decision on the appeal of Inframat Corporation. We discussed that decision in this article. The lesson there is that negligence does not equate to “inadvertence” with respect to penalty waiver. In order to receive a waiver, the contractor must demonstrate “to the contracting officer’s satisfaction” that expressly unallowable costs were included as the result of “unintentional error, notwithstanding the exercise of due care.” In other words, here’s another area where having robust internal controls (including employee training on the requirements of the FAR Cost Principles) would not only tend to reduce the probability of inclusion of unallowable costs, but would also tend to increase the probability of receiving a penalty waiver should they be included.
Thus, dear readers, there are many broadly applicable lessons to be learned in this ASBCA decision. Perhaps the most fundamental lesson is that contractors, regardless of size or sophistication, must invest in internal controls and training, and in having deeply experienced personnel who understand the complex requirements of the FAR Cost Principles and how to support a DCAA audit. Some innovative, agile, technology companies are not willing to make that investment – preferring, instead, to focus on their technology (and perhaps on their marketing). Those contractors should not do business with the DoD, nor should the DoD woo them. If the DoD wants to attract such companies – as it says it does – it needs to carve-out contractual, regulatory (and perhaps statutory) exemptions for them.
In the meantime, contractors should consider the lessons offered by Judge O’Sullivan’s decision and make necessary changes to their operations in order to better assure compliance or, in the case of a legal dispute, victory.
UPDATE: FLIR’S Controls Don’t Stop SEC Fine
In November, 2014, we wrote a rather glowing article about the company FLIR Systems and how its internal controls and proactive employee training acted to prevent it from being sanctioned by the SEC when two of its employees “engaged in a doozy of an FCPA violation.” You can read the details of the Foreign Corrupt Payments Act violations in our original story.
We wrote “Because of [its] investments, FLIR was not held liable (at least so far) when two of its employees made bribes and offered gratuities to five officials of the Saudi government.”
Yeah, about that. We may have been a bit hasty.
In April, 2015, it was reported that FLIR had agreed to pay $9.5 million in order to settle bribery charges filed by the SEC.
The SEC alleged that FLIR “earned more than $7 million in profits from sales influenced by the gifts” made by its two employees to the Saudi officials, according to the story.
Rather than laud the company’s internal controls and employee awareness training sessions, as we did, the SEC stated—
“FLIR’s deficient financial controls failed to identify and stop the activities of employees who served as de facto travel agents for influential foreign officials to travel around the world on the company’s dime.”
The SEC made that statement even though it also said that FLIR detected the conduct, reported the wrongdoing, and “cooperated in the investigation.”
In addition to paying $9.5 million, FLIR Systems must “report to the SEC on its efforts to comply with [the FCPA requirements] for a period of two years,” according to the article.
In fact, a $9.5 million fine is pretty small potatoes if the company really made $7 million in profit from its inadvertent wrongdoing. Certainly it should not be allowed to profit from a violation of the FCPA’s requirements. On the other hand, we don’t get what else the company could have done.
The company trained its employees about the requirements of the FCPA. It diligently reviewed expense transactions, seeking to detect FCPA violations. When it detected anomalous activity, it diligently investigated. When it confirmed a problem, it self-reported to the authorities. When the authorities investigated, the company cooperated. What step is missing?
None. There is no step missing. The company did everything it was supposed to do.
Given all that, what does that final aspect of the settlement mean—the part where the company must report on its efforts to comply with the FCPA for two years? This is one of those head-scratchers where we just don’t get it. If the company is already doing everything it should be doing, and has a history of self-reporting violations, then what possible benefit is there to anybody from adding that final aspect to the settlement agreement?
Those are going be mighty short reports, we think. Here’s an imaginary example of what one quarterly report to the SEC might look like:
DATE: Today
PERIOD COVERED: Fiscal Quarter ending Yesterday
PREPARED BY: FLIR Systems General Counsel, typed by GC’s Executive Assistant
SUMMARY OF ACTIVITY IN REPORTING PERIOD:
- We trained 12 new employees in the requirements of the FCPA.
- We conducted annual refresher training for 200 employees via Computer Based Training (CBT).
- We reviewed 120 expense reports submitted by employees working abroad.
- Two of the expense reports reviewed had an inadequate description of activities.
- We investigated the two expense reports. We required that both be resubmitted with adequate descriptions. They were.
That is all.
So, basically, FLIR has to prepare that type of report and submit it to the SEC eight times (assuming a quarterly report). Where’s the value in that to anybody, including the SEC and the taxpayers who fund the SEC’s enforcement efforts?
Anyway, despite our head-scratching, that’s the story on FLIR Systems, a company where two employees engaged in wrongdoing despite their training. A company that would seem to have done everything reasonably expected of it (except, perhaps, hiring the wrong employees).
Did the investments made in internal controls and employee training actually pay-off in this instance? Well, the picture is not as clear as we’d like, but we still think the answer is yes. Although the company had to disgorge its profits from the tainted sales, in fact the additional fine was relatively trivial. And despite our skepticism at the value added by two years’ worth of additional SEC reporting, we don’t think that reporting will be all that onerous for the company. So, yes. It was better for FLIR to have invested in internal controls and employee training, because we believe things would have gone much worse for the company if it had not done so.
|
UPDATE: Investing Advice
Nearly two years ago – on August 26, 2013, to be exact – we published an article that had nothing to do with government contracts, cost accounting, compliance, or the aerospace/defense industry. In a total departure we offered our readers investing advice. Not only was it a unique topic not otherwise found in our oeuvre of blog articles (or expertise!) we also offered it in the first person point of view, which we rarely use on this site.
(An article on point of view and the use of pronouns is being written and will soon be published, as if you need yet another article not related to anything else on this site.)
We caveated the hell out of the original article, writing “To be clear: I claim no insight or insider knowledge or any expertise in this area whatsoever. So feel free to ignore my investing advice. I really have no business writing about the topic.” That caveat still stands. We claim no expertise and no special insight into the world of investing, and you may want to skip this article because, quite candidly, what the hell do we know?
Not much! Let us be the first to tell you.
But still ….
In that original article we discussed how one could create a fairly well-diversified portfolio without investing a lot of money. We created a hypothetical portfolio of 100 shares each of three American companies, the lot of which could be purchased that day for less than $6,000 total (excluding commissions). We wrote –
I’m not rich—you too can buy 100 shares of Ford right now for $1,700 or so. You can buy 100 shares of Bank of America for $1,500 or so. You can buy 100 shares of Cisco Systems for $2,400 or so. So for less than $6,000, you can have a stock portfolio that includes an American auto manufacturer, a finance company, and a technology company. That’s not too shabby, in terms of diversification.
We did not recommend those stocks in any way whatsoever. That was just a hypothetical example intended to show “what if?” Obviously we were not offering investment advice and we went far out of our way to make that very clear.
But still ….
What if you had taken our advice on August 26, 2013? Where would you be today if you had invested your $5,500 as we had shown?
Just for giggles, we went looked at how you would have fared.
Had you purchased 100 shares of Cisco stock on August 26, 2013, you would have paid $2,383 (excluding commission). As of April 3, 2015, that stock was worth $2,713, so you would have made $330 had you sold it on that day.
Similarly, 100 shares in Bank of America would have cost you $1,449 and you could have sold them for $1,554 on April 3, 2015, for a price appreciation of $105.
Our hypothetical investment in Ford would have cost you $1,641 and you could have sold those 100 shares for $1,603 on April 3, 2015 – which would have been a loss of $38.00.
In sum, your August 26, 2013 investment of $5,473 was worth $5,870 on April 3, 3015. You would have made $397.00.
But that’s not the end of the story. As we told you in the original article, “the other way to make money is through income, or payment of dividends. Many stocks pay dividends to their shareholders.” The math above does not include any dividend payments; and each of those three stocks paid dividends.
The table below shows the total picture (excluding commissions) on the hypothetical investment of $5,500.
As the table shows, even though you would have lost $38.00 on Ford’s share price, at the same time you would have made $90.00 in dividend payments—cold, hard cash paid directly into your bank account by Ford Motor Company. Factoring dividends into the picture shows that you would have made a return on your investment of more than 3 percent.
Similarly you would have seen an ROI of nearly 9 percent on your Bank of America stock, and a whopping 19.35 percent ROI on your Cisco stock. Overall, you would have made $637 for a ROI of nearly 12 percent.
Moreover, since you held on to the stock for more than a year, you would have received favorable capital gain treatment on the stock sale.
Compare that to your fully taxable interest earned from your $5,500 Certificate of Deposit.
One final note:
In the original article we discussed our experience with Apple stock, wherein we bought 10 shares at $650.00 each ($6,500 total investment). At the time we wrote the article, Apple was selling at $503 per share, so we had lost nearly $1,500. On paper. Kind of a bummer.
What happened since then?
Well, first of all Apple split 7/1 so our 10 shares become 70 shares.
Apple did okay and was selling on April 3, 2015 for $125.32 per share. Our original investment of $6,500 was worth $8,772.40, for a gain of $2,272 or 35 percent. Not too shabby.
In addition, Apple has paid $192.60 in dividends on those 10 (now 70) shares.
So in total, while we were down $1,500 when we wrote the original article, our ROI today, should we have sold on April 3, 2015, would have been $2,465 or nearly 40 percent.
So how’s that CD looking now?
Again, we are not offering investment advice nor are we advocating purchasing any shares in any particular company. We’re just talking hypotheticals here.
But still ….
You may want to get serious about investing. It really doesn’t take all that much money to start and, as we hope we’ve shown, even a small initial investment can return some fairly tasty returns.
The Pentagon Doesn’t Want Innovation and Here’s the Proof
 Many years ago Dr. Robert Carman told me about a project he headed at an aerospace/defense contractor in the San Fernando Valley suburb of Los Angeles, wherein he and his team were challenged to design a “concept prototype” engine that might one day replace the Space Shuttle’s main engine. The engine they designed consisted of six parts instead of 1,200. In addition it had a predicted first unit cost of $47,000 (versus $4.5 million) and a predicted engine manufacturing cost of $500,000 instead of $7 million. Similar improvements were predicted for cycle time, thrust, and quality.
It was never built.
According to Dr. Carman, the potential benefits associated with the concept prototype engine were seen as a problem. It was too simple; there were not enough purchased parts; and it didn’t take enough labor to manufacture. If the concept prototype engine were adopted it would put too many people out of work. That was not an acceptable outcome to the individuals with the funding and decision-making authority.
From that experience (and from other similar experiences, we presume) Dr. Carman developed the rule that when people say they want improvement, what they really want is incremental improvement. They want a 10% improvement, not a 90% improvement. They don’t want radical change. They don’t want quantum leaps in affordability. Those changes are disruptive to the status quo.
Leaders want evolution, not revolution. Especially within the traditional monopsony that is the defense marketplace.
When leaders say they want innovation, what they want is spiral development and predictable forward progress. They don’t want disruptive innovation that upsets the status quo and puts jobs at risk.
The Government Accountability Office (GAO) enables this mindset by insisting on design maturity and Technology Readiness Level (TRL) in order to reduce program cost and schedule risk. The Pentagon enables this mindset by creating Program Executive Officers (PEOs) and their teams, who fight for funding and resist efforts to stop work on their programs when something new and better comes along. The same thing could be said for the military services in general, who fight for program funding even when the need and program requirements indicate that there’s a better solution. Congress enables this mindset by focusing on where the funding is being spent (i.e., in whose state and in whose district?) and by insisting that any cost growth and/or schedule delays are a special kind of sin warranting hearings and finger-pointing.
Nobody wants disruptive innovation. Disruptive innovation thwarts competition, because by definition the best solution is that developed by the single bidder who is the innovator. Nobody else can compete. Who in the acquisition community will speak out in favor of less competition? Further, the results of truly disruptive innovation—the kind of change that’s a quantum leap from the status quo—results in immediate obsolescence for weapon systems, for inventory and for depot repairs. It upsets everybody’s apple cart.
Disruptive innovation is the result of a vision plus hard development work, and the Pentagon doesn’t fund that type of effort much anymore. Disruptive innovation gets in the way of carefully managed, centrally planned, incremental improvements. Nobody wants to sponsor a wild hair idea that may, or may not, end up working out. While innovators seek to “fail faster” the current Pentagon mantra is “failure is not an option.”
Thus, disruptive innovation has no patrons and has to fight a difficult battle against the forces that defend the status quo.
The latest piece of evidence in support of our assertion can be found here. It is an article that discusses how U.S. Army special operations units are being forced to use the Distributed Common Ground System (DCGS) – which is “an in-house system built and maintained by traditional defense contractors.” According to the article, “The Distributed Common Ground System, or DCGS, has consistently failed independent tests and earned the ire of soldiers in the field for its poor performance.” Instead of DCGS, the troops want to use the software developed by Palantir, which is a “commercial alternative” that has received great marks by those who’ve used it.
According to the article—
Intelligence officers say they use Palantir to analyze and map a variety of intelligence from hundreds of databases. Palantir costs millions, compared to the billions the military has been pouring into DCGS.
Special operations officials, in a statement to AP, said Palantir had been ‘extremely successful’ in Iraq and Afghanistan and they are working to expand access to Palantir for units deployed in the fight against the Islamic State group. But records and interviews show a history of internal pressure against making and approving such requests.
One veteran special operations intel analyst, who is on his seventh deployment in 12 years, said his recent request for Palantir for a unit heading to Iraq had met with ‘pushback’ both from his own headquarters and from bureaucrats who favor DCGS's analytical component at the Pentagon, special operations command headquarters in Tampa, and Army special operations in Fort Bragg. Another special operations officer also used the term ‘heavy pushback’ in an email about his request for Palantir.
Another article explored the controversy from another angle. It contains a quote from Congressman Duncan Hunter, who said, “You literally have these old tired (bureaucrats) stopping the warfighter from getting what they know works." As the article notes, the Army is attempting to address its soldiers’ concerns by forming “teams of experts to help with DCGS-A training” and by releasing “an RFI for Increment 2, which will boost the system’s ease of use…” A very traditional response by a very traditional defense program, one sold by traditional defense contractors and managed by the traditional military program structure.
Meanwhile, the low-cost innovator, Palantir, continues to outperform its traditional rival. And the troops know it.
So here’s a concrete example of innovative technology that works better and costs less than the traditional product that was designed, developed, and delivered by the traditional defense establishment. The only problem is that it’s disruptive and upsets the status quo. The Pentagon has gotten the innovative technology it said it wanted; but it won’t use it, even if that means soldiers’ lives may be at risk.
And you wonder why we are skeptical about the success of Better Buying Power 3.0.
|
