Contracting for Audit Services
A recent poster on Bob Antonio’s supremely excellent website for all things related to government contracting asked, “Can a private firm or [independent] CPA audit, and find acceptable, an accounting system of a prospective federal contractor?”
Discussion followed, in which other posters explored whether an audit of a contractor’s costs or a contractor’s “business systems” would be an inherently governmental function or, even if not inherently governmental, whether that role was reserved exclusively for DCAA to perform with respect to DOD contracts. It was noted that non-DOD agencies might ask DCAA to perform such audits on a reimbursable basis, or perhaps have the agency Inspector General perform them. In some cases, prime contractors perform audits and/or reviews of their subcontractors, and only use DCAA (or other agency auditors) as a last resort, when the subcontractor objects to opening its books to the prime’s auditors. One poster noted that, as an independent CPA, s/he had been performing contract audits “for Primes and one Agency for approximately 12 years.” Apparently there had been no objection to having an outside entity audit a contractor’s costs during that long period.
Based on the various posts, the answer to the original question posed on the website discussion forum was “YES”. There is nothing in the FAR or DFARS or DOD policy that mandates all audits of contractor costs and reviews of contractor systems must be reserved solely and exclusively for DCAA to perform. Which is a good thing because, as we’ve noted before, DCAA is in over its head and it can’t get its audit workload performed timely.
In recognition of the hole that DCAA has dug for itself (and by extension for the rest of the Defense Department acquisition workforce), the DAR Council recently proposed a significant revision to the performance of business system reviews. While many commenters criticized the proposed rule (and for excellent reasons), there was a tacit recognition that something needs to be done. The current business system management regime, which relies on DCAA reviews of three of the six contractor business systems (as well as timely follow-up audits to evaluate the efficacy of contractor corrective action plans submitted in response to DCAA audit findings) is not working. The defense acquisition system is not functioning and the situation is getting worse instead of better.
Even though DCAA has been methodically reducing its audit workload for several years, primarily by foisting the workload onto the backs of DCMA Contracting Officers, the DOD audit agency is still hobbled by a ginormous audit backlog, by ridiculously burdensome bureaucratic audit procedures, and by a largely demoralized staff.1 It is almost inarguable that, despite all reforms undertaken by DCAA in the past five years, audits are still too slow and do not give Contracting Officers much (if anything) of value to use in negotiations with contractors.
In response, the DAR Council has proposed revisions to the DFARS to address gaps in the business system oversight process, and DCMA has implemented revisions to when it requests (and how it uses) DCAA audits to support its contracting objectives. We believe it’s clear: the Defense Department is preparing to move on without DCAA. The Pentagon is preparing to conduct contract audits and business system reviews by entities other than DCAA.
In addition, as Darrell Oyer noted in his recent newsletter, the Department of Defense has already loosened the tight hold DCAA has had on contract audits, and has given Contracting Officers more discretion to use outside CPA firms to perform the audits once reserved exclusively for DCAA. On October 16, 2014, DOD Instruction 7600.02 (“Audit Policies”) was revised by the DOD Office of the Inspector General. The new DODI stated –
The DoD Components will contract for audit services when applicable expertise is unavailable within the DoD audit organization, augmentation of the DoD audit organization’s audit staff is necessary to execute the annual audit plan, or temporary audit assistance is required to meet audit reporting requirements mandated by law or a DoD issuance. Such contracts must comply with section 237.270 of the Defense Federal Acquisition Regulation Supplement.
The SOWs associated with procuring outside contract audit services must be reviewed by the OIG. But as we interpret the Instruction, the results of that review may not matter. In other words, our reading of the DODI is that while the OIG must review the proposed SOW, and that the OIG may make recommendations regarding that SOW, the Component does not have to accept the OIG recommendation.
In addition, the DODI stated—
The OAIG APO may give a DoD Component audit organization authorization to contract for multiple, similar audits, provided that the requesting agency presents sufficient justification. Once authorization is given for contracting for similar audits and the initial statement of work is reviewed, the requesting agency does not have to submit individual statements of work for review unless changes have been made to the statement of work. The requesting agency must report to the OAIG APO what audits were contracted for under the authorization.
We don’t want to read too much into this revised Instruction. Even so, it seems to foreshadow a greater use of outside auditors by DOD. It seems to be in response to a widespread recognition that the critical role once fulfilled by DCAA still needs to be fulfilled – just not by DCAA. Your mileage may vary, but that’s how it seems to us here at Apogee Consulting, Inc.
1 From a recent e-mail received by Apogee Consulting, Inc.:
“I worked at DCAA for 27 years until … I left DCAA for DCMA …. My last 4 years at DCAA were pretty bad. At times I questioned my mental sanity and health. After leaving DCAA, I realized that it was not me, DCAA was even worse than I realized ….I love my job at DCMA because I go to work everyday and actually work hard doing what DCAA did once long ago. In three months at DCMA, I have issued more reports on proposals than I did in my last 10 years at DCAA. Honestly, I pinch myself everyday that I was lucky enough to escape DCAA and keep my federal career. … The level of documentation for work papers, stat samples and audit opinions is insane. No other word for it. No one can document work to the expected GAGAS level and do timely work. It's that simple. …DCMA has taken all of DCAA's work because DCAA can't do anything. Upper DCMA management has no use for DCAA. ACO's have no use for DCAA. … DCMA is doing the job DCAA once did. DCMA is using common sense and professional judgment something that is long gone in DCAA.”
Settlement Agreements are Tricky Things
We are not attorneys. Relying on this website for legal advice is like relying on your mother-in-law for an accurate analysis of the latest Taylor Swift break-up song. Don’t do it. (Unless your mother-in-law works for Swift’s music company or knows her personally. In which case, please have Taylor call us.)
Having said that, let us now discuss the matter of Kenney Orthopedic, LLC v. The United States. Kenney’s suit at the U.S. Court of Federal Claims alleged that the U.S. Government – specifically, the Veterans Administration – breached a settlement agreement the parties had executed as part of settling another dispute.
Let’s recap: the parties settled one dispute and memorialized the terms of that settlement in written document, which led to the parties having another dispute when the terms of the settlement were (allegedly) not properly fulfilled. That’s two bites of the same apple. And as we will learn, Kenney really had three bites, because its CoFC suit was filed twice.
Hmm. Sounds disputatious, not to mention litigious. We’re going to go way out on a limb here, but we bet lawyers were involved.
Here’s a link to the second decision on Kenney’s third suit.
The initial dispute started in August, 2006, when Kenney received a contract from the VA “to supply prosthetic and orthotic devices and services to the VA Medical Center (‘VAMC’) in Lexington, Kentucky.
Before we go any further, let’s all remember that the VA has been in recent news regarding standards of care and administrative “challenges” associated with managing patient care. The “patients” at issue are veterans of military service. On this day (if not every day) let us remember the service and sacrifice of our veterans. In addition, let’s acknowledge the VA staff and administrators who struggle with a difficult system to provide care to wounded warriors. And let’s also acknowledge the VA contractors who support those struggles and, by doing so, support those who served and sacrificed.
Anyway, the Kenney and the VA disagreed as to whether or not Kenney was fulfilling the terms of its contract. Events transpired and Kenney found itself terminated for default (T4D) because of alleged non-performance and a failure to respond to a “cure notice”. Fourteen months had passed since contract award.
Fourteen months after that (January 2, 2008) Kenney filed suit at the U.S. Court of Federal Claims, “alleging breach of contract and three tort claims.” Seven months later (August, 2008), the suit was dismissed without prejudice because “Plaintiffs did not satisfy the jurisdictional prerequisite of the Contract Disputes Act, 41 U.S.C. § 605(a), that Plaintiffs submit a certified claim to the Contracting Officer (‘CO’) before filing suit in the United States Court of Federal Claims.” (We note the tort claims were dismissed for lack of jurisdiction.)
A couple of quick “lessons learned” so far:
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If you receive a “cure notice” from your government customer, that is an important signal that things are really not going well with respect to either your performance or your customer relationship. You really should not ignore a “cure notice” and, if you should happen to do so, you should not be surprised when your contract is terminated for default. Which is emphatically not a good thing.
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If you are going to all the trouble of hiring an attorney and filing a suit against the Federal government in a Federal court, remember that you must first file a certified claim with your cognizant CO and give the CO a chance to resolve it. We understand that you feel it is unlikely you will receive a fair and impartial decision after all the acrimony and finger-pointing and name-calling that has taken you to the point where you feel you have to file a lawsuit, but you still have to do it anyway.
Subsequently, Kenney filed its certified claim with the CO and did not receive a satisfactory resolution at that level, so a few months later (January 16, 2009) the company was back at the Court of Federal Claims, this time alleging breach of contract and for breach of the implied covenant of good faith and fair dealing.” Judge Braden wrote—
On August 17, 2009, the court issued a Memorandum Opinion and Order determining that: Plaintiffs’ claims were not barred by the statute of limitations; the court had jurisdiction over Plaintiffs’ breach of the implied covenant of good faith and fair dealing claim; and the January 16, 2009 Complaint stated a claim for which relief could be granted.
It was at that point the parties “engaged in negotiations resulting in a Settlement Agreement.” That written agreement called for Kenney to dismiss its claims in return for a payment of $200,000. In addition, the Settlement Agreement called for the VA to take the following actions—
(1) add Plaintiffs to ‘its list of contract vendors for prosthetics at the Lexington VA Medical Center’ within 10 days of execution of the Settlement Agreement or on June 1, 2011, whichever was later; (2) treat Plaintiffs ‘in the same fashion as other similarly situated offerors in the solicitation for any future contract;’ and (3) ‘designate a Contracting Officers’ [sic] Technical Representative (COTR), other than [Ms.] Peggy Allawat, [as the VA contact] for future interaction with Plaintiff.’
Another lesson learned: note that serious negotiations took place only after the court agreed to hear the case. This comports with our recent experiences, wherein Contracting Officers too often do not really exert themselves to resolve disputes (despite what the FAR requires) and, instead, leave it to the attorneys. Once “adult supervision” enters the picture, serious negotiations take place and many disputes are quickly resolved. Apparently, COs are not held accountable for failing to comply with the FAR in this area.
It took the parties another two years but, by May, 2011 the Settlement Agreement had been executed and the suit was dismissed with prejudice on June 3, 2011.
And then Kenney went back to the court for a third time, now alleging that the VA violated the terms of the agreement.
Kenney alleged three breaches:
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It took the VA too long to add Kenney to its list of VAMC vendors.
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Kenney was treated differently than other vendors.
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The former COTR, Ms. Allawat, continued to hinder Kenney’s business prospects at the VAMC.
Judge Braden was not persuaded by Kenney’s arguments. She found that the VA had added Kenney to its vendor list within 10 days of the Settlement Agreement being signed by both parties. Although Kenney had argued that the clock started running on May 17, 2011 – when Kenney executed the agreement – Judge Braden ruled that the clock started running on May 31, 2011 – when the Government executed the agreement. She wrote, “As a matter of law … a contract is not executed until both parties manifest assent by signing the document.” Since Kenney had been added to the vendor list on June 9, the VA had met the requirements of the Agreement.
Further, Judge Braden found that a subsequent VA solicitation and award of a Blanket Purchase Agreement (BPA) to Kenney evidenced that it had been treated equally. She noted that Kenney offered no evidence of disparate treatment.
Finally, Judge Braden found that, indeed, the VA had given Kenney another Contracting Officer’s Technical Representative (COTR), replacing Ms. Allawat. Even if (as alleged) Ms. Allawat continued to make comments regarding Kenney to other members of the VAMC staff, such behavior was not covered by the Settlement Agreement. She wrote—
The VA assigned Mr. Hurt as Kenney’s COTR. … And, after the BPA award, Mr. Hurt became Kenney’s COTR. … Kenney has offered no evidence that Ms. Allawat ever ‘interacted’ with it. The Settlement Agreement does not prohibit, as Plaintiffs contend, Ms. Allawat otherwise from ‘interacting’ with VA staff. … Plaintiffs have not offered evidence that the VA failed to ‘designate a [COTR], other than [Ms.] Allawat, for future interaction with Plaintiff[s].’ This is all the Settlement Agreement required. The integration clause therein precludes the court from adding additional requirements
Judge Braden granted the Government’s Motion for Summary Judgment and Kenney lost its third suit.
Settlement Agreements are tricky things. It is important for the parties to think about what they want to get out of a negotiated settlement, and to ensure the terms of the agreement reflect those intentions. In the euphoria of nearing an agreement and resolving a long-standing dispute, it is all too easy to execute an agreement that will not lead to the desired end-state. The closer the parties get to the final language, the more pains must be taken to ensure that language will, indeed, resolve the dispute in the manner the parties intend. This is the final lesson we learned from today’s story about Kenney Orthopedic, LLC, and its three trips to the U.S. Court of Federal Claims.
Happy Veterans’ Day.
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Prime-Subcontractor Litigation
The Cost Principle at 31.205-47 discusses the allowability of the costs associated with legal proceedings. Such costs include “administrative and clerical expenses; the costs of legal services, whether performed by in-house or private counsel; the costs of the services of accountants, consultants, or others retained by the contractor to assist it; costs of employees, officers, and directors; and any similar costs incurred before, during, and after commencement of a judicial or administrative proceeding which bears a direct relationship to the proceeding.”
The rules governing the allowability of the costs associated with legal proceedings are complex and we recommend you do not attempt to rely on common sense in making your determinations between allowable and unallowable costs. With that said, we would like to focus today on the costs of legal proceedings between a prime contractor and its subcontractors.
We have written fairly extensively on the topic of effective subcontractor management. We have also addressed several prime-subcontractor disputes on this site. Our most recent foray into the topic was the article on the litigation between CH2M Hill and DynCorp, where CH2M Hill (the subcontractor) was suing DynCorp (the prime contractor) for “its fair share of the profits” of the contract. In that article we noted that DynCorp had a “challenging” 2014, of which its litigation was but a small part.
Similarly, Orbital Sciences has had a “challenging” 2014, with the most obvious challenge being the recent failure of its Antares resupply mission to the International Space Station (ISS). As we understand it, the rocket failed mere seconds into its planned flight, crashing back to the ground and disintegrating into a fireball on its Wallops Island, Virginia, launch pad. Before the failure, Orbital had been planning to launch its Antares rocket again in April 2016. Now, not so much.
Meanwhile, Orbital’s dispute with one of its subcontractors has gotten ugly.
On October 21, 2014, Orbital filed suit in the District Court of Eastern Virginia, alleging that Integrated Systems and Machinery (ISM) had failed to deliver contractually required hardware. One report described the hardware being “held hostage” as—
new gimbals and cylinders for the hydraulic system used by the slow-moving, truck-like Transporter Erector vehicle that hauls Orbital’s Antares cargo rocket and Cygnus space freighter out of their Wallops Island, Virginia, hangar and raises them vertical at their Mid-Atlantic Regional Spaceport launch pad over a kilometer away.
Orbital claims that ISM has refused to deliver the hardware because of “unresolved contractual matters,” and further claims that it is ready to pay ISM upon delivery. According to another article –
The components Huber’s firm has been withholding were ordered by Orbital in 2012 as part of a long-planned upgrade for the Transporter Erector Launcher that Orbital uses to haul Antares out to the pad and hold it upright for liftoff. But the mobile launch platform was among the equipment damaged Oct. 28 when Antares failed 15 seconds after liftoff and came crashing back down.
In other words, the explosion may have damaged the launch pad to such an extent that the “upgrade” may no longer be feasible. What’s worse, the same article notes that Orbital is no longer planning its 2015 launch, and may not launch again at Wallops Island until 2016. That obviously puts a new spin on the value of the parts that ISM is allegedly holding hostage. Perhaps in recognition of his newly weakened bargaining position, the ISM President (Kevin Huber) offered to release “a partial shipment” to Orbital immediately. Orbital did not officially respond to the offer but ISM claimed that the offer had been “tentatively accepted” pending a formal agreement.
If Orbital has had a challenging year, so has ISM. ISM and Huber have been tangled in litigation with Huber’s former employer, Advanced Fluid Systems (AFS), which filed suit in 2013, alleging that Huber unlawfully transferred trade secrets regarding the Transporter Erector vehicle’s hydraulic systems. AFS is suing for $10 million in damages. Reportedly, AFS built the hydraulics under a 2009 contract from the Virginia Commercial Space Flight Authority. AFS alleged in its suit that Huber “gave technical information about the hydraulics systems to a Charlotte, N.C., company called Livingston & Haven in September 2012.” The suit claimed that AFS found “evidence of the alleged data transfer on a corporate laptop collected from Huber after he left the company in 2012.” The AFS complaint alleged that –
Huber, who was working full time for Advanced Fluid Systems at the time of the alleged transfer, subsequently conspired to steer servicing work for the Transporter Erector’s hydraulics systems to Livingston & Haven, and to his own company, Integrated Systems and Machinery of New York … Huber provided Orbital with bids for the work on behalf of both Advanced Fluid Systems and Livingston & Haven, substantially inflating the quote from Advanced Fluid Systems….
Orbital Sciences was named in the complaint, but was later dismissed as a defendant after it settled with AFS “out of court” in May, 2014. That leaves the litigation between current and former Orbital subcontractors, while the prime stays above the fray.
But Orbital is not entirely above the fray. Just to add another level of complexity, apparently the ownership of the Transporter Erector vehicle itself is in dispute. SpaceNews reported—
Ownership of the vehicle itself is the subject of a lawsuit Orbital filed in the Richmond, Va., Circuit Court in September against the Virginia Commercial Space Flight Authority.
Originally, the Virginia Commercial Space Flight Authority owned the vehicle. Orbital took ownership in 2010, when it bought the Transporter Erector and other ground-support equipment in a $42 million deal to provide the state-run authority with cash to cover overruns incurred during construction of Antares’ launchpad at the Mid-Atlantic Regional Spaceport — a corner of Wallops Flight Facility the state leased from NASA.
The state, Orbital said in its lawsuit, was supposed to buy back all of this equipment, which Orbital said could support launches of rockets besides Antares. In the case of the Transporter Erector, the state disagreed. The authority repurchased $25.5 million worth of hardware from Orbital, but balked at paying $16.5 million for the transporter and associated hardware, which the state claimed were specific to Antares, according to Orbital’s complaint.
The Aerospace Corp., a government-financed think tank focused on military engineering projects, was brought in to mediate and, in 2012, ruled in Orbital’s favor. Virginia nevertheless refused to take the transporter back, forcing orbital to sue, the company claims.
It is not clear which entity (if any) would claim ownership of the vehicle now – except perhaps to use as the basis of a multi-million dollar insurance claim.
To sum up, this situation is a quagmire of litigation. Accusations and allegations have been flying back and forth. Lawyers and litigators have been busy. Orbital Sciences is a party in some of the litigation. So is AFS. So is ISM. So is Huber. So is Livingston & Haven. And so is the Virginia Commercial Space Flight Authority. It’s hard for us to guess at the amount of attorney fees that have been incurred, and which continue to be racked-up each day.
Meanwhile, the FAR Cost Principle establishes the allowability of such costs. 31.205-47(f)(5) states that the following costs are not allowable –
Costs of legal, accounting, and consultant services and directly associated costs incurred in connection with the defense or prosecution of lawsuits or appeals between contractors arising from either—
(i) An agreement or contract concerning a teaming arrangement, a joint venture, or similar arrangement of shared interest; or
(ii) Dual sourcing, coproduction, or similar programs, are unallowable, except when—
(A) Incurred as a result of compliance with specific terms and conditions of the contract or written instructions from the contracting officer, or
(B) When agreed to in writing by the contracting officer.
Based on the foregoing language, we believe that all costs incurred by all the various parties to the various lawsuits are unallowable. That’s a lot of profit dollars.
Audit Clause Meets Attorney-Client Privilege
Frequently, government auditors and investigators demand that contractors provide documents that attorneys consider to be subject to privilege, and thus protected. The situation creates conflict between what the auditors assert they need for their audit and what the attorneys assert they do not have to provide to anybody. Indeed, the attorneys assert that there are adverse consequences from providing material protected by the attorney-client privilege.
The matter often comes up in audits of consultants’ expenses, where invoices from external attorneys are requested so that they can be reviewed for allowability. The matter can arise in requests for internal audits and/or internal investigations conducted at the behest of corporate counsel. The matter almost always bubbles up in audits of contractor disclosures made pursuant to the 52.203-13 contract clause. The tension between evidentiary support and legal privilege comes up in other contexts as well.
And it’s almost always a problem.
The problem is that providing auditors or investigators with attorney-privileged material may act to waive that privilege with respect to downstream litigation. We wrote about that problem right here. We discussed a recent case where privilege was deemed to have been waived when an internal investigation was provided to the GSA Inspector General, and we opined that “Such reviews should only be provided to outsiders (including government personnel such as DCAA auditors or Agency Inspectors General) under very carefully considered circumstances, lest the door be opened for qui tam relators and opposing counsel to obtain a bounty of documents that would have otherwise been protected.”
More recently, a D.C. district court told KBR that its 89 internal fraud investigation reports (prepared under privilege and related to alleged violations of KBR’s ethics policy) were not protected by the attorney-client privilege. According to an analysis of the court’s decision, prepared by the attorneys at GreenbergTaurig—
… the court reasoned that because these investigations are required by federal procurement regulations, the company would have had to conduct them anyway, regardless of whether they had been advised to do so by an attorney. The court relied on the ‘mandatory’ nature of the investigations in reaching its conclusion that the documents were neither privileged nor protected by the work product doctrine.
KBR quickly appealed via a writ of mandamus, and the D.C. Circuit Court of Appeals reversed. In a unanimous decision, the Appellate Court found that the doctrine of attorney-client privilege protected KBR’s internal investigations. That was a fortunate outcome, both for KBR and for other government contractors.
The conflict arose again when two Department of Energy contractors at the Hanford Waste Treatment & Immobilization Plant (“WTP”) refused to provide the DOE Inspector General with more than 4,300 requested documents. Both the prime contractor (Bechtel National, Inc.) and its subcontractor (URS Energy and Construction, Inc.) allegedly refused to cooperate with the DOE IG’s investigation into the firing of a whistle-blower (Ms. Donna Busche). Allegedly, Ms. Busche was fired by URS “after raising safety concerns” regarding activities at the $12 Billion project to treat radioactive waste at the site, which played a key role in the World War II “Manhattan Project” and the “Cold War” arms race that followed.
The DOE IG spent six months investigating whether or not Ms. Busche was terminated in retaliation for her “blowing the whistle” on unsafe practices. According to the DOE IG, its investigators could not reach any conclusions “because of a material scope limitation.” In other words, because the DOE contractors refused to provide the requested documents, the auditors had nothing to audit. According to the DOE IG—
On the advice of outside counsel, both contractors took the position that the documents in question were subject to either attorney-client or attorney work product privilege. Also, URS made a unilateral determination that certain documents were not relevant to our examination. Specifically, Bechtel withheld 235 documents and URS withheld 4,305 documents. Of the 4,305 withheld documents, URS' attorney eventually agreed to provide access to a portion of the 2,754 documents that URS had concluded were non-responsive but which were not subject to the asserted attorney-client privilege. Attorneys representing both Bechtel and URS stated that the assertion of privilege was necessary given the likelihood of litigation regarding the Busche matter. Their basic concern was that releasing the documents to the Office of Inspector General would constitute a waiver of privilege in future proceedings.
The DOE IG told Bechtel and URS that their contracts with DOE contained clauses that required all documents “acquired or generated under the contract, including those for which attorney-client and attorney work product privilege were asserted.” However, the contractors’ attorneys didn’t agree with that interpretation of the clauses’ requirements. The DOE IG reported that “It was the position of counsel for both Bechtel and URS that these clauses were too broad and that they were unenforceable, specifically in situations where litigation was either in process or was likely.”
And the contractors’ attorneys stuck to that position, despite pressure applied to the companies.
That position did not sit well with Senator Claire McCaskill, (D-MO). You may remember Senator McCaskill from her grilling of then-DCAA Director April Stephenson. Ms. McCaskill reportedly “slammed” the two contractors, writing (in a letter to the Secretary of Energy) that she would like him to tell her how they would be held accountable “for their noncompliance, including withholding of fees and recovery of costs incurred” by the DOE IG.
Bechtel had its own take on the situation. It wrote—
Bechtel went above and beyond in cooperating with the OIG's investigation--providing requested documents for review and people to interview, in accordance with the protocol agreed to with the IG. Furthermore, we offered to work with the OIG to provide access to documents that are protected under the law, in a way that preserves those protections, but the OIG declined our offer.Â
And there the matter sits (so far as we know).
Meanwhile, news reports indicate that KBR is back in court, fighting a demand by a qui tam relator that it turn over documents provided to the government. The relator’s attorneys are arguing that KBR waived attorney-client privilege when it decided to provide the documents.
And so it goes …
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