First, we’d like to thank the Justice Department for an unusually detailed press release, in which it announced that several subsidiaries of the United Technologies Corporation (UTC) had agreed to plead guilty to (1) violating the Arms Export Control Act, (2) making false statements in connection with “belated” disclosures of making illegal exports to China, and (3) failing to make timely disclosure of defense related exports to China. As part of the deferred prosecution agreement worked out with the DOJ, the UTC companies agreed to pay $75.7 million and to retain an Independent Monitor for the next two years (who will watch over UTC’s compliance with export control laws and regulations).

Ouch.

The settlement concerned the actions of two UTC subsidiaries, Pratt & Whitney Canada Corp. (PWC) and Hamilton Sunstrand Corporation (HSC). The matter involved illegal sales of defense equipment to China in connection with China’s development of a modern attack helicopter, the Z-10. As the DOJ press release reminded readers—

Since 1989, the United States has imposed a prohibition upon the export to China of all U.S. defense articles and associated technical data as a result of the conduct in June 1989 at Tiananmen Square by the military of the People’s Republic of China.  In February 1990, the U.S. Congress imposed a prohibition upon licenses or approvals for the export of defense articles to the People’s Republic of China.  In codifying the embargo, Congress specifically named helicopters for inclusion in the ban.

Dating back to the 1980s, China sought to develop a military attack helicopter.  Beginning in the 1990s, after Congress had imposed the prohibition on exports to China, China sought to develop its attack helicopter under the guise of a civilian medium helicopter program in order to secure Western assistance.  The Z-10, developed with assistance from Western suppliers, is China’s first modern military attack helicopter.

PWC sold China engines for the Z-10. But according to the DOJ, “PWC determined on its own that these development engines for the Z-10 did not constitute ‘defense articles,’ requiring a U.S. export license, because they were identical to those engines PWC was already supplying China for a commercial helicopter.” That sounds somewhat legit, but (as the DOJ reported), “because the Electronic Engine Control software, made by HSC in the United States to test and operate the PWC engines, was modified for a military helicopter application, it was a defense article and required a U.S. export license.”

So because the software that controlled the engines was modified for military applications, that made the (otherwise commercial) engines into military articles, subject not only to export control but also to a flat-out export prohibition by Congress. DOJ reported, “PWC knowingly and willfully caused this software to be exported to China for the Z-10 without any U.S. export license.  In 2002 and 2003, PWC caused six versions of the military software to be illegally exported from HSC in the United States to PWC in Canada, and then to China, where it was used in the PWC engines for the Z-10.”

Notice the use of the phrase “knowingly and willfully.” The Justice Department was convinced that this export control violation was more than an “oopsie.” It told readers—

PWC knew from the start of the Z-10 project in 2000 that the Chinese were developing an attack helicopter and that supplying it with U.S.-origin components would be illegal.  When the Chinese claimed that a civil version of the helicopter would be developed in parallel, PWC marketing personnel expressed skepticism internally about the ‘sudden appearance’ of the civil program, the timing of which they questioned as ‘real or imagined.’  PWC nevertheless saw an opening for PWC ‘to insist on exclusivity in [the] civil version of this helicopter,’ and stated that the Chinese would ‘no longer make reference to the military program.’ PWC failed to notify UTC or HSC about the attack helicopter until years later and purposely turned a blind eye to the helicopter’s military application.

Apparently, PWC was not a good corporate citizen and kept any doubts about the ultimate use of its engines (and software) to itself, and pulled the wool over HSC’s eyes. DOJ stated, “HSC in the United States had believed it was providing its software to PWC for a civilian helicopter in China, based on claims from PWC.” One wonders whether PWC felt pressure to make its sales numbers, or whether there was another reason it felt compelled to lie to its sister UTC subsidiary and make the China engine deal happen. The Justice Department thinks it knows the answer to that question. It reported—

According to court documents, PWC’s illegal conduct was driven by profit.  PWC anticipated that its work on the Z-10 military attack helicopter in China would open the door to a far more lucrative civilian helicopter market in China, which according to PWC estimates, was potentially worth as much as $2 billion to PWC.

But eventually, HSC realized that it was being lied to. DOJ stated, “By early 2004, HSC learned there might an export problem and stopped working on the Z-10 project.” But that didn’t stop PWC from its determination to make the sale. DOJ stated, “Regardless, PWC on its own modified the software and continued to export it to China through June 2005.”

According to the DOJ, it took pointed “queries” by an outside “investor group” to make UTC realize it had an export control problem on its hands. In July 2006, UTC made an initial disclosure to the State Department and followed up with subsequent disclosures over the next few months. The problem was—according to DOJ—UTC made “numerous false statements” in its disclosures. DOJ reported—

Among other things, the companies falsely asserted that they were unaware until 2003 or 2004 that the Z-10 program involved a military helicopter.  In fact, by the time of the disclosures, all three companies were aware that PWC officials knew at the project’s inception in 2000 that the Z-10 program involved an attack helicopter.

The U.S. Attorney summarized the case thusly—

PWC exported controlled U.S. technology to China, knowing it would be used in the development of a military attack helicopter in violation of the U.S. arms embargo with China. PWC took what it described internally as a ‘calculated risk,’ because it wanted to become the exclusive supplier for a civil helicopter market in China with projected revenues of up to two billion dollars.  Several years after the violations were known, UTC, HSC and PWC disclosed the violations to the government and made false statements in doing so.

We wonder if the UTC subsidiary (Pratt & Whitney Canada) took a $76 million fine into account, when it calculated the risks associated with its intentional export control violation? We think not.

This article continues the story of KBR and its DFAC subcontractor, Tamimi, in support of contingency operations at Camp Anaconda, Iraq. In a recent legal decision, KBR lost out on at about $30 million in payments to Tamimi, because it was unable to show that those payments were based on prices that were fair and reasonable. This is Part 3 in a series of articles exploring that legal decision.

In the previous articles, we told you that KBR wasn’t paying Tamimi for services rendered, because of problems with the procurement file and concerns over Tamimi’s pricing for DFAC services. KBR and Tamimi entered into a series of complex negotiations that resulted in at least three retroactive price discounts. But by this point, the Defense Contract Audit Agency (DCAA) had zeroed-in on Tamimi and its billings to KBR.

The auditors’ focus was on the number of “boots through the door” into the DFACs. As the Court summarized—

… the genesis of this controversy was a misunderstanding about the services to be provided at the DFACs. KBR worked from the standpoint that these were fixed-price contracts that provided the Army with a turnkey service; it would retain a subcontractor to establish a DFAC wherever the Army requested one—a fixed cost—and that subcontractor would be prepared to serve the number of troops that eventually were present at that location, regardless of the number of troops that actually utilized the facility. … DCAA, however, viewed the DFACs as variable-priced contracts where the costs were based on the number of soldiers actually coming through the DFAC doors.

In response to DCAA’s concerns, KBR modified its subcontracts to be more transparent; however—

… this contractual modification came too late to satisfy DCAA, and on February 14, 2004, DCAA issued its first Form 1 against all prior DFAC payments, claiming that KBR was owed only what was spent on meals actually served. … Other Form 1s followed, and at the height of the controversy, DCAA was withholding over $200 million from KBR for DFAC services.

The government’s position evolved and, eventually, “Ms. DeRoche explained that the accuracy of the invoicing and cost information between KBR and its subcontractors was not ‘the substantial question’—the reasonableness was.” [Emphasis added.] The Court wrote—

The [government’s team] began its mission by enlisting the services of a consultant—RCI—to provide analytical support to come up with a ‘should-cost analysis’ whereby the team would pull together the available data to attempt to devise an independent model of what the costs should have been at various DFACs. … However, the [Team] abandoned this effort given the complexity and the number of different variables involved. … One reason in particular for moving away from the should-cost analysis was that it relied on the [Team] having access to particular data for each DFAC facility, and, for some of the relevant sites and periods of performance, no records were kept on the actual number of troops that had eaten at each DFAC site. … Without knowing the exact number of troops at each DFAC site, the should-cost analysis was not going to be particularly useful.

In order to assess the reasonableness of KBR’s (and Tamimi’s) pricing, the government team eventually developed a parametric model and used the results of that model to negotiate a $55 million global settlement with KBR. However (as the Court noted), “According to the model, the site-specific reasonable amount for Camp Anaconda was calculated to be $106,565,119.00, which happened to be greater than the $105,623,149.00 that KBR had invoiced in subcontract costs at the site.” In any case, the settlement price was officially determined to be “fair and reasonable.” The Court found that, “On July 26, 2005, KBR and the Army executed Modification 38 to TO 59. Modification 38 implemented the Global DFAC Settlement and converted KBR’s DFAC subcontract effort—less the $55 million decrement—into a firm-fixed-price contract, thereby establishing the adjusted billing as a reasonable amount immune from future audits.”

But that global settlement did not ease DCAA’s continued concerns with the subcontract prices paid by KBR to Tamimi at Camp Anaconda. “On July 19, 2006, DCAA issued a preliminary findings report regarding DFAC services at Anaconda that questioned $44.8 million in KBR costs.” KBR responded to the preliminary DCAA report, pointing out several flaws with the DCAA analysis. The DCAA auditors reviewed KBR’s response and, in response, began to modify their position. The Court summarized DCAA’s evolving position on the reasonableness of Anaconda DFAC costs as follows—

DCAA did not respond to KBR for almost a year, but during that period its own internal position on the amount of costs that should be questioned varied significantly. By January 2007 David M. Fisher, a DCAA auditor … adjusted the calculation method, which lowered the amount of questioned costs to $39.2 million. … However, by January 19, 2007, Mr. Fisher had further adjusted this figure downward to $28.6 million … and by February 2, 2007, Mr. Fisher had arrived at calculations questioning only $5.1 and $1.6 million,

The Judge recited more internal DCAA maneuvering, but the official position did not change. “On January 29, 2008, DCAA issued a Form 1 suspending a total of $41.1 million—inclusive of the fee collected by KBR on the questioned amount—for amounts billed to the Government for DFAC services provided at Camp Anaconda.” KBR submitted a claim to the cognizant Contracting Officer, but he did not issue a Final Decision. And so KBR filed its appeal in the Court of Federal Claims in June, 2009, roughly two years after DCAA had issued its Form 1.

The Judge’s decision turned on whether or not KBR was able to show that its costs were “reasonable,” as that term is defined in the FAR. As the Judge wrote—

FAR 31.201-3 affords the court significant discretion in determining whether or not claimed costs are reasonable and sets forth a non-exhaustive list of circumstances to be considered. See FAR 31.201-3(b)(1)-(4). Despite this guidance, case law in which a court or the Armed Services Board of Contract Appeals (“ASBCA”) has exercised its discretion and evaluated the reasonableness of a claimed cost in similar circumstances is limited.

But the Judge was clear that KBR had the burden of proof. The government, as defendant, “simply” made the argument that KBR had “failed to meet its burden that Tamimi’s prices were reasonable.” KBR, for its part, argued that its decisions were prudent, when all the facts and circumstances were taken into account. The Judge agreed with KBR—to a point--writing—

Plaintiff [KBR] consistently advocates that it acted in a ‘prudent manner’ in negotiating prices with Tamimi and that, when the realities of the situation KBR faced at Anaconda are taken into consideration—the various environmental factors such as the threat to supply lines and personnel, along with the need to fulfill the demands of the Government in performing under LOGCAP III—the court should find that the outcome with Tamimi, although perhaps not ideal from a ‘conference room’ perspective, was reasonable. … (‘Viewed in the totality of the circumstances, KBR’s actions may not have been perfect but were prudent, and are not properly subject to Government second guessing . . . .”) … (“The standards the Court must apply do not, as suggested by the Government, relate to ‘conference-room’ contracting . . . but rather are those from the crucible of a war . . . .”). The court concurs with plaintiff’s point, with the following caveat: while plaintiff’s decisions must be viewed in the context in which they were made, and thus must take into account the realities that KBR personnel and its subcontractor were facing at the time, this willingness to expand ‘reasonable’ beyond the ‘conference room’ is confined to circumstances when KBR was dealing with realities over which it had no control….

… KBR cannot now point to a deficit in bargaining power and contend that its weakened state entitles it to greater latitude when the court makes a reasonableness determination on the product of those negotiations. A contractor may not itself manufacture—or in this case exacerbate—a situation that leads to higher costs for the Government and then attempt to pass the ultimate financial responsibility for that situation on to the Government. Because it was KBR, and not the Government, that contributed to its weakened negotiation position, it is KBR, and not the Government, that bears the financial risk of whatever fiscal concessions Shabbir Khan was able to wrangle out of KBR due to Tamimi’s greater bargaining power on this issue. The Government agreed to compensate KBR for costs reasonably incurred under LOGCAP III; it did not agree to be an insurer of any business decision that KBR attempted to implement and will not be held to such a standard.

[Emphasis added.]

But the Judge had more (a lot more to say). She wrote—

Plaintiff seeks costs that were incurred during the six-month period … emanating from a war initially conducted as a contingency operation beginning in March 2003 that became a sustained effort; costs that were impacted by fluctuating projections for the number of troops on the ground; costs that were driven by the singular goal of putting DFAC facilities in place to offer warm meals to the troops by July 4, 2003; costs that were the product of first-generation contracts that lacked certain formalities required by plaintiff’s customary procurement policies because the subcontractor undertook to provide DFAC services while its subcontract was being finalized; costs that flowed from fixed-price contracts with a subsidiary in a foreign contractual environment for which the record amply supports the politically infelicitous label of tolerating questionable practices for securing and maintaining business relationships; and costs that were the subject for hand-wringing and finger-pointing once those in authority became aware of the asymmetry, i.e., that the taxpayer was footing the humongous bill for DFAC services that were not utilized. … Correspondingly, the court finds that the Army did not foist upon plaintiff the fixedprice subcontract arrangement with vendors such as Tamimi. … Plaintiff wanted the work, got on the ground early, and took on the risk under its costplus contracts that it would not be able to pass on to the Government its subcontractors’ prices negotiated in a challenging environment when the prime contractor had few options. No one should be heard to play the violin tune of we-couldn’t-abandon-our-commitment-to-feeding-the-troops. Sincere as plaintiff’s commitment was to providing for the troops, this is no proxy for proof of reasonable costs.

KBR’s primary proof of the reasonableness of Tamimi’s pricing was the several negotiations it undertook, negotiations that resulted in retroactive credits and future price decreases. Unfortunately for KBR, Judge Miller found that “the weight of the evidence demonstrates that [KBR’s] negotiations were not conducted reasonably.” She wrote—

Although the court does not agree with defendant that Ms. Hayes [KBR’s negotiator] should have complied with all of KBR’s procurement policies and procedures to yield a reasonable negotiation, the dearth of any contemporaneous notes is disconcerting, not only because of the complexity of the matters dealt with in the negotiations, but also because the only record evidence available to the court is the Negotiation Memorandum with its errors and omissions and Ms. Hayes’s broad-brush testimony. Ms. Hayes did not set any particular target goals for the negotiation, other than obtaining some decrease in price, ownership of the facilities, and a contract extension. It thus becomes difficult to say how successful the negotiations were because the court is unaware of how much KBR wanted to achieve. Except for the initial request for a 45% discount across the board … which was on the order of an opening salvo, the court has no evidence as to how the negotiations actually were conducted. …

When she was selected to negotiate with Tamimi, Ms. Hayes was not particularly informed about the contractual situation concerning Anaconda. … Although she prepared herself for the negotiations over the intervening month, it does not appear that she gained much insight into the circumstances of the situation that she was tasked to negotiate. Her casual attitude in approaching the negotiations … reveals a lack of appreciation of the nuances present in this situation with which every other party to this dispute, including this court, has struggled. The issues at hand were complex and the facts surrounding the dispute went back more than a year, yet during the negotiations, Ms. Hayes did not ask a single KBR employee for analytical support. These observations and, as argued by defendant, the several serious errors reflected in the Negotiation Memorandum regarding the contractual situation at the time—the most notable being that Ms. Hayes seems to have been under the impression that the original prices at Anaconda were fair and reasonable…—do not support plaintiff’s argument for reasonableness.

KBR also attacked the DCAA analysis of price reasonableness. The Court found that DCAA’s position did evolve substantially as the result of its internal discussions. Judge Miller wrote—

Plaintiff [KBR] points out that, after receiving Mr. Bishop’s response a mere month after DCAA issued its preliminary findings, DCAA took approximately a year before responding to KBR. … During that time frame, DCAA’s internal position on how much of KBR’s costs to question varied wildly, from as low $1.6 million to as high as $39.9 million, the amount questioned in the final audit. … Plaintiff cites the testimony of Mr. Moskal to demonstrate that, even as a DCAA supervisor, he could not explain the numerous positions that DCAA occupied. … Illustrative of what plaintiff characterized as DCAA’s ‘moving target,’ … Mr. Moskal could not explain the path from the initial $44.8 million in 2006 to Mr. Fisher’s questioned costs ranging from $39.2 million to $28.7 million, to $5.1 million, to $1.6 million, to Mr. Duggan’s $37.1 million in questioned costs (as well as his $12.2 million and $13.9 million), culminating in November 2007 in the Form 1 that questioned $39.9 million. … Mr. Moskal found no need to support intermediate steps: ‘We’re supporting the final conclusion which is $39.9 million.’ … Plaintiff concludes that ‘DCAA was simply unable to justify the unjustifiable . . . [and that] [i]ts process . . . was corrupted by a drive for results over reasonableness.’ … Further, plaintiff notes that ‘[t]he Government in litigation has abandoned the DCAA’s flawed audit, which is the best evidence of its lack of merit.’ …

[But] defendant [the Government] dismisses plaintiff’s focus on the DCAA audit analysis as ‘primarily a distraction because the Government case does not rely upon the DCAA audit report to defeat KBR’s claim, but rather upon KBR’s failure to meet its burden of proof in response to the costs challenged by the audit report.’ … Defendant contends that the DCAA audit report ‘is just not relevant at this point in the case, having already served its purpose of raising questions to the contracting officer regarding the Camp Anaconda prices.’ … Thus, defendant concludes that, ‘[w]hatever flaws there might have been in the audit report, they do not advance KBR’s case.’

Unfortunately for KBR’s arguments—

While the court understands that circumstances forced plaintiff to disagree with DCAA’s approach, and DCAA’s approach was to question, not establish, the reasonableness of KBR’s costs, it is less than persuasive to present a rebuttal to an approach argued to be unreasonable as proof itself of reasonableness. By plaintiff’s logic, successfully rebutting DCAA’s unreasonable approach, to be detailed further, would establish the reasonableness of KBR’s costs. Successfully rebutting DCAA’s approach could warrant only a finding that plaintiff has fended off that particular avenue of attack, not that it has presented evidence for reasonableness. Given that the precise issue is not the reasonableness of DCAA’s audit, the court concurs with plaintiff that DCAA’s approach was deficient by failing to take into account, and appropriately adjust for, some of the factors that made Anaconda unique among DFACs in Iraq. …

However, rather than illustrate that DCAA was unreasonable in questioning KBR’s costs, the finding that the court can derive from the erratic audit process is that, because of the facts on the ground, it is a difficult task to attempt to unravel and quantify the costs that KBR incurred at Anaconda. The court agrees with defendant that ‘the final [audit] opinion . . . reflected DCAA’s best estimate of the overcharging by KBR.’

[Emphasis added.]

This next part of the decision is critical for those contractors who are having difficulties with DCAA right now. (Okay, that’s everybody.) The Judge wrote—

Regardless of how DCAA arrived at its final amount, the issuance of the Form 1 charged plaintiff with the burden to prove the reasonableness of its costs and establish its entitlement to the sum that the Government was questioning. As a matter of logic, plaintiff’s showing that the Government entertained higher and lower amounts in arriving at the questioned amount does not lead to a finding that KBR’s costs were, in fact, reasonable. That finding becomes sound only if one adds the additional premise that, in the absence of a showing of unreasonableness, a contractor’s costs are reasonable. This substituted default presumption, however, is not the law; plaintiff is not entitled to claim a presumption of reasonableness simply because the Government has not demonstrated persuasively why the questioned costs are unreasonable.

[Emphasis added.]

Despite numerous problems, however, KBR was able to persuade Judge Miller that some of Tamimi’s prices were reasonable. After all, Tamimi did provide DFAC services and soldiers did eat. The Judge spent some time looking at comparable prices and concluded that KBR was entitled to $11.5 Million in direct costs, plus applicable indirect costs and base fee, for a total of about $12 Million. The remainder of DCAA’s Form 1 suspended costs was deemed to be unreasonable.

In the concluding article of this series, we’ll explore some lessons that can be learned from this complex story.

End of Part 3