Contracting with Federal Funds? You Need a Compliance Program

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January 22, 2007

Newspapers chronicle daily the travails of corporations that have been criminally prosecuted or subjected to stiff civil penalties for “fraud, waste and abuse.” Government oversight, investigations and prosecutions have been steadily increasing in the last 20 years following the “Ill Wind” prosecutions of the 1980s. In 1987, the federal government collected only about $87 million from contractors who submitted false or fraudulent claims. Now the total collections from contractors are well over $1 billion annually.

The Enron debacle fueled the government’s enforcement trend by teaching corporate America that:

  • Corporate officers will be held personally responsible for profiting at the expense of investors;
  • Directors will be held personally accountable for failure to detect or deter misconduct; and
  • Compliance programs are essential to corporate health.                                                

As President Bush warned dishonest corporate leaders shortly after the announcement of the WorldCom bankruptcy: “You will be exposed, and you will be punished. No boardroom in America is above or beyond the law.” Whereas the government’s focus used to be primarily defense contractors and the $500 toilet seat procurements, that focus is now increasingly on other business sectors, including construction contractors, and supply and service contractors that sell to the government through “schedule” contracts with the General Services Administration.

This increased scrutiny is evidenced by the questions that have been raised about the billing practices of Halliburton and reports of profiteering in Iraq. The Defense Contract Audit Agency (DCAA), the federal agency that audits the contracts of most agencies, questioned $813 million in costs on a Halliburton contract to provide logistical support to troops in Iraq, and $219 million on a sole source contract to restore Iraq’s oil fields, plus $442 million in “unsupported” costs. Among the costs questioned were $560,000 in heavy equipment costs that the DCAA considered unnecessary.

Even routine audits have become a vehicle to the government to uncover potential fraud. A recent initiative by the Department of Justice’s fraud task force calls for investigators of the Inspector General’s offices to be “embedded” in the contract administration offices of federal agencies. This program has already been implemented by the Navy, and other agencies are expected to follow. Agencies have clearly begun to audit more aggressively. The General Services Administration, for example, has initiated a program to conduct more post award audits aimed at uncovering defective pricing in response to Congressional criticism.

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Further, it is important to remember that even a contract with state and local agencies may be subject to federal audit and enforcement actions if the contract is federally funded. For example, the Inspector General of the U.S. Department of Transportation (USDOT) has pursued and settled a number of False Claims Act actions against highway contractors and engineers under federally funded contracts with state agencies. A contractor on a DOT contract paid the government $1.3 million for “misrepresenting in monthly progress reports its progress in implementing the [disadvantaged business enterprises] bond program.” (DOT OIG press release, February 6, 2001).

Federal as well as state and local government contracting can be a dangerous minefield for the uninformed. Seemingly innocent mistakes in progress payment requests or written certifications can subject a contractor to criminal penalties of five years or more, plus penalties of $5,000 to $11,000 for each false claim, plus treble damages, plus the forfeiture of even unrelated claims under a contract where fraud has been committed, plus suspension or debarment from contracting. In other words, the stakes are high. Fortunately, the potential for compliance problems can be minimized by implementing a comprehensive compliance program that has been established before a problem develops. When the Department of Justice investigates a government contractor, its first question is usually, “Do you have a compliance program,” followed by the question, “Do you consistently follow it?” Savvy contractors should be in a position to answer both questions affirmatively.  


Numerous statutes impose civil and criminal penalties upon federal government contractors for fraud, waste, and abuse. Among them are:
·         False Claims Act (an average of about 400 qui tam false claims cases are filed every year)
·         False Statements Act (criminal penalties of up to five years imprisonment)
·         Forfeiture Statute (forfeiture of claims where fraud has been committed under a federal contract)
·         Anti-Kickback Act
·         Truth in Negotiations Act
·         Bribery and Gratuities statutes
·         Mail and Wire Fraud statutes
·         The Public Integrity Act and recent legislative initiatives to strengthen criminal penalties for violations of conflict-of-interest laws

·         A government contractor also may be suspended or debarred from receiving government contracts or subcontracts for fraudulent conduct.

The government’s investigative and prosecutorial tools include the right to audit the contractor’s books and records (for up to three years after completion of a contract). The Inspector General of each federal agency also has the authority to issue a subpoena for documents. When an agency investigation leads to the suspicion that fraud has been committed, the fraud section of the Department of Justice, as well as the local U.S. Attorney’s office, often become involved. When that happens, the Federal Bureau of Investigation, in concert with the agency Inspector General, usually gather’s the facts for the investigation.

Examples of potential violations by contractors include progress payment requests that contain labor mischarges, product substitutions, false certifications, defective pricing of contracts or modifications, and false schedule updates. The USDOT has provided “guidance” to federal and state transportation officials for detecting fraud. USDOT advises that “consistent cost overruns” because of “bidding by contractor in order to receive the contract” may indicate mischarging. USDOT also warns officials to be on the lookout for collusive bidding (for example, an unsuccessful bidder subcontracting with the successful bidder), conflicts of interest and product substitution (for example, the substitution of foreign-made materials).  Another red flag is “Questionable Documentation from Contractors,” which includes “Any documents or certifications with altered, backdated, modified, or missing information concerning the contractor’s bond and prequalifications, minority- or women owned business status, financial history, previous debarment or suspension, ownership of equipment and facilities, performance on other jobs, etc., for the purpose of obtaining the contract.” (FHWA Briefing, “Fraud Prevention — Suspension/ Debarment,” (February 26, 2002).

The Inspector General of the Department of Defense (DoD) has similarly issued to its auditors and investigators a guide entitled “Indicators of Fraud in Department of Defense Procurement,” which identifies factors suggesting “the presence of, or enhanced potential for, fraud at various stages in the procurement process” from defective pricing in proposals through “progress payment fraud,” “fast pay fraud,” bribery and kickbacks.


Every company that has a contract with the DoD is required to have a compliance program in place. The sophistication of the program depends upon the size of the company and “the extent of their involvement in Government contracting.” (DFARS 203.7000(1)).  

The elements of the compliance program required by DoD are virtually the same as those recommended by the U.S. Sentencing Commission. Companies must “promote an organizational culture that encourages ethical conduct and a commitment to compliance with the law.” (U.S.S.C. Guidelines Manual, § 8B2.1). “Due diligence” includes delegation to an individual or individuals the day-to-day operational responsibilities for the ethics program. “To carry out such operational responsibility, such individual(s) shall be given adequate resources, appropriate authority and direct access to the governing authority or an appropriate subgroup of the governing authority.”  

Compliance programs should consist of the following:
> A written code of business ethics and conduct
> A regular “[i]nternal and/or external” audit program of company policies, procedures and internal compliance  controls
> A hotline or similar mechanism for anonymously reporting suspected ethics and compliance violations
> A compliance and ethics education program for employees
> Disciplinary action for ethics and compliance violations
> Full cooperation with all government investigations (and audits)

Counsel can advise a contractor of the legal risks that a contractor’s compliance program must address, based upon the business sector in which the contractor operates and the federal agencies with which it has contracts. Compliance programs are not “one size fits all.” A construction contractor with DoD contracts faces somewhat different risks than a GSA schedule contractor. The compliance program must be structured to address the specific risks that a particular contractor faces. This is accomplished by matching the necessary internal controls with the specific risks, given the size of the contractor and the level of federal government work it does.

The importance of actually implementing a compliance program is underscored by a Department of Justice policy statement: “A corporate compliance program, even one specifically prohibiting the very conduct in question, does not absolve the corporation from criminal liability under the doctrine of respondeat superior . . .. While the Department recognizes that no compliance program can ever prevent all criminal activity by a corporation’s employees, the critical factors in evaluating any program are whether the program is adequately designed for maximum effectiveness in preventing and detecting wrongdoing by employees and whether corporate management is enforcing the program or is tacitly encouraging or pressuring employees to engage in misconduct to achieve business objectives.” (USDOJ, “Principles of Federal Prosecution of Business Organizations,” January 20, 2003).  


The benefits that a contractor derives from a compliance program are obvious. Potential problems are avoided and, if a problem does surface, the contractor’s potential liability may be reduced by having a compliance program in place. Another less obvious benefit is that, in the wake of the reforms required by the Sarbanes-Oxley Act of 2002 (popularly referred to as SOX), even privately held companies now recognize the business benefits from having a compliance program.  

The impetus for SOX was the wellpublicized corporate accounting and governance scandals. The malfeasance of senior executives at the 20 most notorious companies (Enron, WorldCom, Adelphia, Arthur Andersen and so on.) cost shareholders more than $350 billion in equity. As a result, SOX requires, among other things, that the Chief Executive Officers (CEOs) and Chief Financial Officers (CFOs) of publicly traded companies must certify each company’s financial statements “fairly” present their company’s financial condition and results. They must also certify that the company has an operational system of internal controls over financial reporting. In addition, outside auditors must attest to and report on management’s evaluation of the strength of the company’s internal controls. Whether the company has a corporate ethics program for its senior executives must be publicly disclosed.

Privately held companies are not subject to the disclosure and governance requirements of SOX. Nevertheless, a 2005 survey showed that 80 percent of for-profit private organizations believe that SOX or other corporate governance reform requirements have impacted them. In 2005, 78 percent of private organizations had adopted self-imposed corporate governance requirements, compared with 60 percent in 2004. Audited financial statements are now almost universal, as well as a corporate ethics code. (National Directors Institute, “The Impact of Sarbanes-Oxley on Private and Nonprofit Companies,” March 10, 2005).

Why are SOX reforms being adopted by a growing number of private companies? The reasons are purely business related:
> Best practices increase confidence in the valuation of a company by potential buyers.
> Capital investment is attracted at a lower cost.
> As preparation for Initial Public Offerings (IPOs), compliance with SOX is required as soon as a company files a registration statement under the Securities Act of 1933.  
> Protection of officers and directors from lawsuits for mismanagement or fraud
> Compliance may be required by insurance (D&O) underwriters.
> Compliance creates credibility with customers and business partners.
> Value-added internal controls increase profitability and preserve wealth in closely held companies.

The fiduciary duties of officers and directors to shareholders are the same for public and private companies. Can they have breached their fiduciary duties if they complied with SOX? Stated differently, will a privately held company’s failure to have an independent audit committee, or a code of ethics or some other SOX requirement, lead to claims of mismanagement?

In answering this question, privately held companies should consider the implications of the 2nd Circuit Court of Appeals’ recent decision in Pereira v. Cogan, (2005). Although the court reversed a bankruptcy court’s ruling that the controlling shareholder and directors of a privately held company were liable to a bankruptcy trustee for self-dealing in receiving excess compensation, the Second Circuit did say: “Given the lack of public accountability present in a closely held private corporation, it is arguable that such officers and directors owe a greater duty to the corporation and its shareholders to keep a sharp eye on the controlling shareholder. At the very least, they must uphold the same standard of care as required of officers and directors of public companies that are not so dominated by a founder/controlling shareholder.” The bankrupt company “did not have an audit committee. While Trace [the company] was not alone among privately held companies in Delaware in its choice not have an audit committee, there is no evidence that the Trace Board took over the ‘watchdog’ role that the audit committee would normally hold as it should have done in the absence of such committee.” Thus, SOX standards may be applied to privately held companies.  

The bottom line is that, in addition to establishing a compliance program for prophylactic reasons, privately held government contractors should consider adopting SOX reforms because they make good business sense. n

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