October 29, 2006

It used to be that the greatest risks to profitability faced by construction contractors performing public work related to their skill in executing functions unique to their industry. Success—and profits—on a particular project depended on a sound estimate, the selection of competent subcontractors and the employment of conscientious supervisors who knew how to build a building. Now success, profitability and even survival are threatened by circumstances beyond the normal control of the contractor. Increasingly, one of the greatest risks faced by a public construction contractor is an allegation that the contractor has engaged in fraud or the submission of false claims. These allegations can emanate from low-level government employees involved with the project, qui tam relators, inspectors general working for the contracting agency and attorneys within the U.S. Department of Justice. The mere allegation, often trumpeted in news releases or leaks by government officials, can be enough to scare off clients and require disclosures in responsibility questionnaires that may impair a public contractor’s ability to obtain profitable work. Significantly, it does not take much to be accused of fraud. Rules pertaining to government contracting are complex and often were intended to apply to defense contractors building billion dollar weapons’ systems as their exclusive business, not construction contractors who occasionally perform government work. Procedures and policies that may be acceptable in the rough-and -tumble world of purely commercial enterprise may not pass muster under these complex rules. Worse yet, government employees, who may never have known the need to turn a profit to survive, may view policies designed to decrease costs, maximize profits and increase the contractor’s ability to compete for business as unwarranted attempts to steal from the public trough. A prime example of this latter phenomenon is represented by a July 2005 decision in the U.S. Court of Federal Claims, the venue where contractors seeking payment from the government on federal construction projects are required to bring claims, subject to the government’s right to counterclaim and seek offsets. The case, Morse Diesel, Inc. d/b/a Amec Construction Management, Inc. v. United States of America, involved an arrangement between the contractor and its insurance broker whereby the broker rebated part of the commission it received for selling performance and payment bonds to the contractor. The bonding company paid the broker its normal commission, and the broker paid a rebate to the contractor’s parent company. Those involved in the construction industry as well as numerous other businesses will recognize this arrangement as resembling many of the discount and rebate arrangements common in the commercial world, including such things as bulk and prompt payment discounts that many suppliers commonly offer. These types of arrangements allow contractors to lower their overall costs and compete more effectively for work. Presumably this arrangement served to lower the contractor’s costs and allowed it to offer a lower price to the government on the competitively bid lump-sum projects that were the subject of the government’s complaint. However, to U.S. Department of Justice lawyers, this beneficial discount arrangement looked like something sinister and inappropriate: a kickback in violation of the Anti-Kickback Act. By definition, a kickback is a payment made by a subcontractor or supplier to a contractor or its employees to exert or reward “improper” influence on a procurement decision. The classic example is the payoff to a purchasing agent to influence the decision to hire the less than optimal subcontractor. The legislative history of, and early cases under, the Anti-Kickback Act suggest that Congress was aiming to outlaw just such “commercial bribery,” but had no intention of discouraging normal discount and rebate arrangements. All but ignoring the distinction between legal discount arrangements and commercial bribery, the court ruled that the discount arrangement between the contractor and its broker was an illegal kickback. The court struggled to find a way that the arrangement constituted improper influence. Clearly, the arrangement influenced the contractor to maintain its relationship with its broker. However, is it “improper” to be influenced to hire someone by what is in essence a lower price? Many would observe that that is the nature of capitalism and, indeed, the very foundation of the competitive bidding system that the government utilized.

A BAD DECISION

The court never directly discussed the distinction between proper and improper influences. Instead, it made the rather obvious conclusion that the contractor was, in fact, influenced, and observed that: 

 The ultimate customer for the bond services was the Government, which had no knowledge of the kickback scheme and received no financial benefit from [the broker’s] financial largess. In fact, but for [Morse Diesel’s] contracts with the Government, [the brokers and Morse Diesel’s parent] would have earned no brokerage fees on that work, and any financial accommodations made to obtain that work should have been accomplished by submitting the lowest possible price for [Morse Diesel’s] services. Instead, a higher price for bond services was included in the fixed contract price that [Morse Diesel] was awarded.

The ruling is almost bizarre. It suggests that whether or not the discount was “improper,” and therefore a kickback, depended upon how the contactor accounted for the discount. If the discount was recorded as a reduction of its bond costs, it would be okay. If not so recorded, it would be a crime. Such reasoning leads to the anomaly that the guilt or innocence of a briber would depend upon the accounting practices of the one supposedly bribed. Indeed, the reasoning could be applied to turn any discount, not properly accounted for, into a kick-back and to render an actual bribe (such as the surreptitious payment to the purchasing agent) innocent by giving a discount to the ultimate purchaser. The reasoning is all the more bizarre since it was applied in the context of a lump-sum competitive bid contract under which the price paid by the government was governed, not by the contractor’s costs, but by the price determined by the competition. How much it paid for its bonds was irrelevant to the price.

AN EMBOLDENED JUSTICE DEPARTMENT

Because the overall lawsuit between the contractor and the government may go on for many more years, an appellate court reversal of what appears to be an unsound trial court decision may be a long time in coming. And if the case is settled, the reported decision may never be reviewed. In the meantime, Department of Justice lawyers have a decision to point to in asserting that one or another normal discount arrangement is an improper kickback. The consequences of such allegations can be colossal. For Morse Diesel, the arrangement affected some $290 million in government contracts, and the Justice Department is seeking to have it forfeit its right to receive up to $75 million in claims. Indeed, the DOJ has begun to argue in many claims for payment initiated by construction contractors against the government that the government can avoid its contractual payment obligations if it can prove fraudulent activity by a contractor. In fact, it is becoming routine for contractors seeking to enforce their rights under government contracts to be met with counterclaims based upon the False Claims Act and related statutes. While the counterclaims are often of dubious validity and seek to misconstrue minor, innocent failures by a contractor to comply with the letter of a contract into deliberate fraud, they have significant potential to force a contractor to relinquish its contract rights for less than full value. This phenomenon is spreading to the states. Partly as a result of encouragement from Congress, many states and some municipalities have adopted statutes known as “Little False Claims Acts” that subject a public contractor to severe potential liability. At last count, at least 16 states as well as the cities of New York and Chicago had enacted such provisions. California entities have been especially aggressive in using such provisions as a threat to discourage claims and leverage to obtain favorable settlements.

THE BEST DEFENSE IS A GOOD OFFENSE

What is a contractor to do? It could resolve never to perform any work involving any governmental entity. Given the sheer volume of government contracts and the fact that many otherwise private contracts can involve government financing, such a resolution may be difficult and costly to keep. Instead, a prudent contractor who does any government work needs to examine its practices and its personnel, develop appropriate procedures as well as ethics and compliance programs, and educate itself and its employees as to the special requirements of government contracting. Such steps will help avoid improper actions and serve to demonstrate the contractor’s dedication to proper and ethical contracting, should a mistake be made, negating any assertion that the contractor was intentionally trying to take advantage of the government.