Is it the Navy or the Entire Department of Defense?
You know, or ought to know, that one of our favorite themes here at the Apogee Consulting, Inc. blog is that government contractors are no more corrupt than any other business sector. Despite conventional wisdom, we assert that government contractors are no more corrupt than government employees, or military service people.
It takes two to tango, folks. Where you find contractor corruption, chances are there’s corruption on the other side of the negotiating table as well.
In point of fact, any time you have a large population of individuals, you are going to see a rough bell curve of behavior, with ethically challenged people found outside the mean—and corrupt actors found out beyond the six sigma point. Yet despite piles of evidence to the contrary, auditors and investigators and politicians love to pick on the instances of government contractor wrongdoing, and seemingly ignore the instances of wrongdoing made by civil servants and military service people.
The seeming blindness extends to deployment of internal controls as well. Ask any public accountant about Sarbanes-Oxley controls or Dodd-Frank or the importance of business ethics and “tone at the top” and no doubt you’ll get an earful. But ask any Inspector General or DCAA auditor about those topics, and you’ll get a discussion about contractors’ controls, and damn little about controls in place in the Federal government or in the military services. That’s not to say those controls don’t exist; of course they do—and there are people who think about them and work on them. But we assert that the focus of the Federal government’s efforts to implement controls and evaluate their efficacy is outward facing and not internal facing. We assert the focus is aimed at contractors and not at employees of the Federal government.
But maybe that seeming blindness is clearing a little bit.
Recently, stories have emerged that Secretary of Defense Chuck Hagel is “deeply troubled” by the multitude of military scandals that have made the news in recent months. For example, this article at Defense News reported that Hagel thinks “there may be a ‘systemic’ ethics crisis inside the military.” The article reported—
The sweeping concerns voiced by [the Pentagon spokesperson] come amid recent reports of service members and some high-ranking officers accused of cheating, fraud, drug use, alcohol abuse, gambling and sexual misconduct. Hagel appears to be expanding his concerns beyond the recent problems inside the Air Force’s nuclear missile community. Missileers have been accused of cheating on tests, using drugs, and failing to properly maintain the nation’s arsenal of 450 intercontinental ballistic missiles. …
The Navy on Feb. 4 acknowledged a cheating scandal at its Nuclear Propulsion School in South Carolina, which so far has implicated at least 30 senior enlisted instructors accused of sharing answer sheets to nuclear qualification tests. Seemingly unrelated, the Army recently revealed that about 1,200 soldiers — including 200 officers — are implicated in a long-running scheme by National Guard recruiters to fraudulently collect nearly $100 million in recruiting incentive payments.
With respect to that last sentence, readers may recall that we reported on it right here. We stated—
So, what do we think about this latest evidence of corrupt behavior in our nation’s armed forces?
Well, what we think is that the Army should have done what almost every savvy corporation does, when recruiting referral bonuses are being offered. It should have made the new recruit identify any individual who made the referral, or else check a box on a form that said ‘nobody referred me.’ That would have been a simple, inexpensive, effective control that would have acted to make this kind of ‘wide-ranging’ conspiracy a whole lot harder to execute.
Thus, we are on record (once again) as saying that the fixes to these corruption problems are simple, in the sense that every large corporation in America has similar issues and has deployed controls to detect and/or deter corrupt behavior. Do those controls always work? Of course not. But the corporations don’t pretend the problem doesn’t exist, and they work to combat it. Here’s yet another example of how the DOD is years behind the private sector, where inexpensive and straightforward anti-corruption controls are being implemented and evaluated for efficacy every single day.
In a tradition that goes back at least to World War I, it’s once again time for the DOD to borrow practices from the private sector.
And speaking of borrowing from the private sector, we were bemused to see a report over at The New York Times, which dealt with yet another Navy scandal. The possible scandal involves Inchcape Shipping Services, a Dubai-based Navy contractor. According to a qui tam suit, “employees asserted that Inchcape had received discounts from subcontractors and then pocketed the difference instead of refunding it to the Navy.”
That suit, filed in 2010, led to Inchcape being suspended and at least one subpoena being issued. In 2011, Inchcape turned over billing records from as far back as 2002 to the Naval Criminal Investigative Service (NCIS). In 2012, Inchcape was ordered “to give investigators a copy of an internal company audit from 2008 into some of the questionable billings.”
Isn’t it interesting that Inchcape, a company Headquartered in the UAE, would have performed its own audits, and would have retained them? But perhaps we digress….
What did NCIS and other DOD investigators/auditors do with the treasure trove of information provided by Inchcape. Well, apparently not very much. The NYT reported that Inchcape challenged its suspension in December, 2013, and that Judge Merow at the U.S. Court of Federal Claims was considering ordering that it be lifted, because (according to Judge Merow) “it did not appear that the Navy’s suspension office had ‘conducted any meaningful investigation’ of other documents ‘despite having had time to do so.’”
As our readers know all too well, that’s par for the course.
So what did the Navy do? According to the NYT—
Faced with the possibility that the judge might dismiss the suspension, records show, the Navy agreed to lift it in exchange for promises from the company to follow federal rules, refund overcharges, and hire independent monitors and auditors. … the company has agreed to pay for an independent audit that could help the Justice Department determine how much it may have overcharged the government.
Let’s repeat that: “…the company has agreed to pay for an independent audit that could help the Justice Department determine how much it may have overcharged the government.”
Apparently giving up on waiting for NCIS to complete its investigation, the DOJ told the contractor to hire a private audit firm to conduct the government’s investigation.
That’s … unusual, to say the least.
And others apparently think so as well. The NYT reported—
Contracting experts said it was unusual for the government to turn to an outside auditor in this type of case, and some questioned whether an independent firm could do as thorough a job. … ‘To wait for the Navy to do a serious audit is like waiting for Godot,’ said Charles Tiefer, a professor at the University of Baltimore School of Law and a former member of the federal Commission on Wartime Contracting in Iraq and Afghanistan. ‘Considering that the Navy has sat on its hands for years, getting an accounting from a private firm is a sign of desperation.’
“A sign of desperation”?!?
One might reasonably think that the DOJ or the Navy might turn to DCAA to perform the kind of audit that would identify overbillings. Indeed, they may have done so, only to run up against the fact that DCAA cannot perform timely audits either.
Giving up on the accounting and audit resources of the Federal government, in a “sign of desperation,” the parties have agreed to hire a private sector auditor and (presumably) to rely on its findings.
So this is what it’s come down to … this is the state of affairs in which both contractors and government stakeholders find themselves. The accounting and audit resources of the Department of Defense are worthless to evaluate whether or not a contractor overbilled the DOD.
How sad. We sincerely mean that. How sad.
At a time when DOD leadership is—finally!—waking to the realization that it may have internal control weaknesses that would be unacceptable in a public company, at a time when the Pentagon’s control environment and tone at the top are being questioned by many, at a time when the expertise of the nation’s premier audit agency is needed the most … DCAA is missing in action.
How sad.
A-12 Nightmare Finally Over
The A-12 is the poster child for a failed defense program.
Don’t take our word for it. Read this article written by Herb Fenster, Esq. and published in 1999 in the U.S. Naval Institute’s Proceedings. It’s called: “The A-12 Legacy: It Wasn’t an Airplane—It Was a Trainwreck.” It’s really a very important set of observations regarding how the Navy put General Dynamics and McDonnell Douglas into the firm, fixed-price, mess they found themselves in, and the implications of Secretary of Defense Dick Cheney’s program Termination for Default, which lasted through multiple rounds of litigation starting in roughly 1992 and lasting through until very recently. Even the Supreme Court of the United States weighed-in on the never-ending litigation circus.
Mr. Fenster summed up the situation in a footnote, as follows—
Eleanor Spector was DoD's most knowledgeable procurement executive. She had the additional advantage of having spent several years at NavAir. She later revealed what knowledgeable procurement people all know: A program such as this to produce a new highly sophisticated aircraft, incorporating unproven technologies to accomplish unproven mission objectives presented huge risks. She also had the advantage of having been advised of these risks by Brigadier General Keith Glenn, U.S. Air Force, who had been the B-2 program director and was then functioning as the special access programs director for DoD. He had told her, in unequivocal terms, that the program was far too risky for fixed-price contracting.
In another article published in Air Force Magazine just after the program was terminated, author David Montgomery wrote—
The Secretary's summary execution of the A-12 abruptly ended the saga of a plane that, six months earlier, enjoyed broad congressional support and appeared problem-free. The stealthy, carrier-based attack plane had been naval aviation's top priority since 1984. What caused it to nosedive from preeminence to oblivion?
Investigators and officials place the blame on four factors:
- Overly protective Navy officials, who didn't want to endanger the plane by pointing out problems. A Pentagon analyst first detected a possible cost overrun two years ago, but the Navy program manager continued to describe the A-12 as being on track until after a major Pentagon review last year.
- A ‘don't-rock-the-boat’ segment of the Pentagon bureaucracy, which was aware of the problems but apparently reluctant to buck its superiors to press its case. In one incident, a report noting A-12 problems was tucked away and forgotten.
- Overly optimistic A-12 contractors, who miscalculated the extent of the technical difficulties in producing such a plane and shielded the problems from the government. An inquiry by Navy Deputy General Counsel Chester Paul Beach found that General Dynamics and McDonnell Douglas discovered "increasing cost and schedule variances" but did not alert the Navy in a timely fashion.
- Excessive secrecy, which blanketed the project and prevented examinations that might have brought problems to light. Officials assigned to Secretaries Cheney and Garrett were kept away, standard reporting procedures were abandoned, and information was transmitted verbally rather than in writing.
One important outcome of the A-12 debacle was a critical look at the Earned Value reporting metrics used by the program, which eventually led to a reinvention of EVMS in the early 2000’s. Another important outcome was the recognition that use of cost-based progress payments didn’t reward contractors for making progress; instead, they rewarded contractors for spending money. That recognition led to the creation of Performance-Based Payments in the late 1990’s, which are still considered to be the Federal government’s “preferred” contract financing option, despite Shay Assad’s direction to walk away from their use.
But although there were some positive outcomes, they did not outshine the problems with the program and its termination, much like a silver lining fails to outshine the dark clouds accumulated over 23 years of constant litigation.
The parties finally reached a settlement a week ago, as reported by Reuters. At one point, the government wanted the contractors to repay about $1.5 Billion each, and the contractors wanted to keep their progress payments plus get another $1 Billion plus interest.
Reuters reported that the contractors will not have to repay their progress payments, but the government will not have to pay anything more. In addition, “the Navy will receive three EA-18G electronic attack aircraft from Boeing, and a $200 million credit from General Dynamics toward its work on a new DDG-1000 destroyer.”
So that’s it then.
Our long national nightmare is over.
The multitude of attorneys involved in the legal battles can get back to other clients.
And the Navy will make do with its F-35 variant.
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And Speaking of Terminations
Recently we had occasion to comment on the end of the 23 year-long termination of the Navy’s A-12 stealth fighter program. Now we’ve come across another termination that seems worthy of comment. It’s the VH-71 Presidential Helicopter program, known as the “Kestral.”
The development contract was awarded by the US Navy to Lockheed Martin and Augusta Westland in 2004. As Flight Global reported in 2009—
The aircraft was marketed as a relatively simple adaptation of the successful EH101 helicopter. However, new requirements imposed on the programme after contract award forced the USN to launch a major re-design. The delays and cost overruns plaguing the VH-71 Kestral have become a rallying cry for reforming the DOD acquisition system.
Sound familiar?
Defense Industry Daily reported—
… the total amount paid to Lockheed over the entire contract ends up costing the taxpayer about $2.2 billion. The biggest reason for all that waste is a President’s own office that couldn’t stop adding requirements, but enforcing Navy certification requirements on a helicopter designed to commercial aviation standards wasn’t helpful, either.
Inside Defense reported that the final Termination Settlement payment was $91.1 million. That final payment included “$38.5 million for completed work and $51.6 million in termination fees.” According to the same source, “that brings the termination total to about $203 million.” Thus, it seems that the termination settlement expenses were roughly nine percent of ITD program costs.
Remember that longish article we wrote about Boeing and its inability to get the government to reimburse it for its settlement expenses, because Boeing had exceeded the Limitation of Funds ceiling? Well, when you are tracking your costs for compliance with the LoC/LoF clauses, we suggest you add another eight to ten percent on top of those costs, to cover your termination settlement expenses.
Just a thought ….
The Importance of the Limitation of Funds Clause
As consultants to a diverse group of government contractors, we frequently find ourselves in the position of having to explain requirements associated with various solicitation provisions and contract clauses. Our readers know, of course, that there is a host of provisions and clauses with which to comply, each with individual requirements. Some of them are fairly well known and most everybody has a fair idea of their basic compliance requirements; but others are less well understood and tend to fall towards the bottom of the compliance checklist.
The Limitation of Cost (LoC) and Limitation of Funds (LoF) clauses are two of the latter set. They’re insidious little clauses, because they seem so straight-forward and yet shift risk in subtle and far-reaching ways. A write-up of the clauses from the law firm of Watkins Meegan is entitled, “Two FAR Clauses that Are Sometimes Overlooked,” and, indeed, the clauses are often overlooked or ignored.
Let’s be clear: Contractors ignore the LoC/LoF clause requirements at their own peril.
The two clauses go together because they basically have the same set of requirements. The LoF clause (52.230-21) pertains to cost-type contracts that are incrementally funded, and the LoC clause (52.230-20) pertains to cost-type contracts that have been fully funded. Essentially, the clauses act to limit contractors’ ability to seek reimbursement for otherwise allowable costs they’ve incurred on their cost-type contracts.
It seems counter-intuitive that contractors would be limited in the amount of costs they could recover from their government customers. After all, doesn’t the fact that the contract is a “cost-type” mean that all allowable costs will be reimbursed? It’s the fixed-price contract types that have ceilings on contractor costs. Cost-type contracts are supposed to be low risk because they don’t have any such ceilings. The contractor incurs costs and, if they’re allowable, then the government reimburses them. How can cost-type contracts have cost limits?
We’ve heard that position being espoused many times over the years, and it’s wrong. The LoC/LoF clauses are what make that position wrong. The two clauses establish limits on recoverable costs incurred on cost-type contracts. It’s more than that, actually. The clauses require advance notification of expenditures before they reach certain prescribed limits. If the contractor fails to comply—and comply exactly—with the clause requirements, then the government has the right to refuse to pay allowable costs incurred for the contract if they exceed the specified ceiling. By failing to comply with the LoC/LoF clause requirements, the contractor has essentially converted its cost-type contract into a firm, fixed-price contract. That’s really not a good thing.
We’ve noted it in this blog when contractors run afoul of the clause requirements. For example, in this story we wrote about a hapless contractor that “had failed to comply with the administrative requirements of the Limitation of Cost clause and thus no increase to the contract value would be forthcoming,” but we’ve never really focused on the matter. We remedy that oversight today.
We’re going to assume that you, the reader, are going to mosey over to a FAR site and check out the exact wording of the clauses. We’re going to assume that you are going to actually read your contracts and make sure you understand what your contract clauses require of you. Thus, we are not going to recapitulate the standard FAR clause language here. It’s your responsibility to figure out what you need to do, not ours.
Unless you want to hire us. In which case, let us know how we can assist you!
Instead of reciting the clause language, we are going to focus on a recent decision over at the Armed Service Board of Contract Appeals (ASBCA) in which Boeing learned the hard way about the requirements associated with the LoF clause. Note: this is Boeing we’re talking about—one of the largest defense contractors in the USA. So if Boeing hasn’t figured out the clause requirements with respect to all of its defense programs, you may rest assured that the answer is far from obvious. Here is an opportunity to learn along with Boeing, and for a very small fraction of the company’s cost.
Let us set the stage for you.
Boeing had a cost-plus-award-fee (CPAF) engineering services contract, awarded by the US Air Force. The contract was a Task Order type, meaning that the government would issue orders for certain amounts of services from time to time. Crucially, the contract was “incrementally funded”—meaning that the government would dole out certain amounts of funding from time to time. The contract period of performance encompassed one base year and nine (9) option years.
One Task (Contract Mod 112) was an engineering assignment for Boeing to design, develop, fabricate, install, test and FAA certify a Global Air Traffic Management System for 3 KC-10 aircraft. (That Task was called "the KC-10 GATM assignment".) The specified total estimated cost-plus-award-fee for the assignment was $79,250,000. The specified completion date for the assignment was 30 April 2003. Contract Mod 112 also increased the obligated (allotted) funds in the contract Schedule to a total amount of $133,123,763.97.
The thing about cost-type contracts is that they don’t always go as planned. If the parties could foresee every eventuality, they likely would not use a cost-type contract format. The KC-10 GATM assignment did not seem to go as planned. On 7 January 2002, bilateral Mod 179 increased the total estimated cost-plus-award-fee of the KC-10 GATM assignment to $97,477,602.00 and extended the period of performance to 31 March 2004. On 11 August 2003, Boeing reported to the government that the GATM assignment would not be completed until 31 March 2005 (a two-year delay) and that it was willing to enter into "a Cost Share Arrangement” so as to complete the Task.
A month later (10 September 2003), Boeing and the government “agreed in principle” that the KC-10 GATM assignment would be continued on a cost-reimbursable basis "upon agreement of a new EAC [estimate at completion] and schedule between Boeing and the Government". On 24 September 2003, Boeing provided the government with a schedule showing completion of the assignment on 30 September 2005 (note another six month delay) and an estimated cost at completion of $154.7 million (a cost-growth of roughly $57 million against the original budget of $97.5 million).
As you might suspect, the Air Force customer was not thrilled with the state of affairs. Indeed, although the customer provided some additional funding, it was not as much as Boeing forecasted it would need. On 15 October 2003, Modification 220 increased the total estimated cost-plus-award-fee for the KC-10 GATM assignment to “only” $107,309,826 and extended its performance time to 31 March 2005. A couple of more Mods increased the available funding to $121,603,858—still significantly below the amount Boeing had told the Air Force it would need. Apparently, that was as much funding as the Air Force was willing to provide to Boeing.
After roughly three months of negotiation, on 10 March 2004, the Contracting Officer issued a Stop-Work Order to Boeing. A couple of weeks later, he issued a Termination for Convenience Notice, terminating the KC-10 GATM assignment.
(Familiarity with the T4C process is going to be assumed. If you feel as if you need some background reading, try this piece.)
In response to the T4C Notice, Boeing terminated its subcontract with Honeywell. A few months later, Honeywell submitted its Termination Settlement Proposal (TSP) and asked Boeing for $22,100,059. Boeing looked at that request and then notified its Termination Contracting Officer (TCO) that it would need as much as $154 million to pay off various supplier claims and settle its own situation. (Funny how that amount was really, really, close to the $154.7 million it had told it customer it would need to finish the assignment.) The TCO replied to Boeing’s notification as follows—
It is rare that the TCO requests additional funds to be added to the terminated cost type contracts. There are, at times, the PCO may have reason(s) to add additional funds to the terminated cost type contracts. However, the Government, usually, will stand by the ‘Limitation of Funds’ clause. Per your funding status, we only have $4,719,870.15 remaining in the contract.
Apparently in denial over its financial situation, Boeing came back with another request for more funds, to which the TCO replied—
I have discussed with you before in that this contract is a cost type contract, and the ‘Limitation of Funds’ clause does apply; therefore, no additional funds will be requested. The amount remaining in the contract is it. As discussed earlier, if for some reason the PCO wants to obligate more funds to the contract, he can do so.
Boeing continued to act as if it were ignorant of its precarious financial position, going so far as to submit a “Settlement ROM Proposal” in which it asked for $37.1 million in additional funds. The government did not deign to reply to that request.
Meanwhile, Boeing and Honeywell settled for $10.8 million (roughly 50 cents on the dollar). The Honeywell settlement figure was included in Boeing’s certified TSP, which was audited by DCAA. DCAA “questioned all but $182,185 of the $10.8 million settlement,” and the TCO refused to approve it. On 3 August 2010, the TCO issued a final decision denying ratification of all but $280,294 of the $10,800,000 Honeywell settlement agreement. The final decision was based “primarily on cost allowance [allowability?] and cost allocation grounds, but also invoked the LoF clause as a bar to recovery of any amount that would exceed the funds allotted to the KC-10 GATM assignment.”
Boeing appealed that TCO final decision to the ASBCA.
Judge Freeman first found that the LoF clause applied to the total contract funding and not to the funding of individual Task Orders. This is an important finding because it contradicts other decisions in which each Task Order was found to be a separate contract. (See, for example, this article.) However, Judge Freeman reasoned that the government intended the LoF clause to apply to the entire contract as a whole because there was another contract clause (H-841) that also covered funding allocated to individual Task assignments, and he need to interpret the contract has a whole, giving meaning to all clauses. Readers interested in that aspect of the decision are invited to go read it (page 8).
However, the rest of the decision did not go Boeing’s way.
Judge Freeman found that the Government never promised to increase contract funds to the level sought by Boeing. Importantly, the Judge found that there had been no agreement on the EAC or the performance schedule. Furthermore, the Judge didn’t agree with Boeing’s argument that, by terminating the contract when it was in an overrun condition, the Government waived the LoF requirements. He wrote—
Boeing had notice that the government considered the LOF clause to be applicable to the termination settlements eight months before it concluded the Honeywell settlement agreement. Boeing also knew, or is chargeable with knowing, the terms of the LOF clause, the amount of the allotted funding in the contract and the amount of its incurred costs in performing the contract. Subparagraphs (f) and (h) of the LOF clause expressly provided that Boeing was not obligated to incur, and the government was not obligated to reimburse, any costs of performing the contract, including termination activities, that would exceed the allotted funding in the contract. If Boeing did incur termination costs in excess of the allotted funding, it was a volunteer and did so for its own account.
In other words, Boeing should have included potential subcontract termination liability in its “incurred” costs when reporting pursuant to its LoF clause requirements. When that calculated number approached the funding amount provided by its USAF customer, it should have stopped work. Because Boeing exhausted the funding before subcontractor termination settlement liability was incurred, it was not able to have its subcontractor settlements reimbursed, even though it had received a Termination for Convenience.
This is a great lesson on how the two little understood clauses (Limitation of Cost and Limitation of Funds) turn out to be critically important when a contractor wants the government customer to fund an overrun on a cost-type contract.
Do not ignore the Loc/LoF clause requirements.
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