Government Procurement Fraud

Could SOX Be Used to Hold Contractors Accountable?

By Gerald H. Lander, Valerie J. Kimball, and Kimberly A. Martyn
FEBRUARY 2008 - Federal government funds are a limited resource expended to benefit the
country in areas such as social issues, national defense, homeland security, and natural disaster
relief. The U.S. government is the largest consumer of prime contracts. Over the last five years,
spending on federal contracts was the fastest-growing part of the discretionary budget. Between
2000 and 2005, procurement spending rose 86%, twice as fast as other discretionary spending,
which rose 43%. Indeed, federal contract expenditures now consume almost 40 cents of every
dollar of discretionary spending. For example, Lockheed Martin and its subsidiaries were
awarded over $19 billion of prime contracts from the Department of Defense in 2005 (see 100
Companies Receiving the Largest Dollar Volume of Prime Contract Awards Fiscal 2005,
siadapp.dmdc.osd.mil/procurement/historical_reports/ statistics/p01/fy2005/top100.htm).
According to U.S. Department of Justice (DOJ) statistics reported for the fiscal year ending
September 30, 2005, the United States recouped more than $1.4 billion dollars in settlements and
judgments pursuing allegations of fraud. For the fiscal year ending September 30, 2006, the
government recovered a record total of more than $3.1 billion in settlements and judgments from
cases involving claims of fraud. According to a November 2006 DOJ report, defense
procurement fraud accounted for $609 million in settlement and judgment awards in 2006.
Procurement fraud squanders limited funds, threatens safety and national defense, cheats
American taxpayers, and harms government efforts to obtain needed goods and services. What
follows is a discussion of types of procurement fraud and what is being done to prevent and
discover it. In addition, the authors recommend that section 406 of the Sarbanes-Oxley Act of
2002 (SOX), which requires all publicly held companies to have a code of ethics and specifies
what that code should contain, be incorporated into the Governments Cost Accounting
Standards (CAS). These standards should also be modified and expanded to cover all fully
covered CAS contracts. The databases that track companies banned from future government
contracts should also be expanded to include individuals, to mitigate the possibility of
individuals who are found personally liable under the proposed CAS (which incorporates SOX)
from participating in future government contracts.
Government Acquisition Methods
The U.S. procurement process begins with requests for acquisition of goods or services, using
three acquisition or bidding process methods:

Competitive or advertised bidding;

Competitive proposals or negotiations; and

Sole source.

At any stage of the procurement process, anyone with the knowledge, opportunity, and need can
take advantage of the contract. The goal is to purchase the most appropriate and highest-quality
goods or services for the lowest cost.
Competitive or advertised bidding. The government uses competitive or advertised bidding when
it has exact specifications for the product or service required. When evaluating bids, the
government considers price and other important factors such as experience and past
performance. In this process, requests for procurement must specify the governments
requirements clearly, accurately, and completely. No negotiation occurs between the government
and bidders. This method promotes competition. Fair and honest consideration is implied and
given to all bidders soliciting the government contract. By bidding, the contractor agrees to all
specified conditions.
Legitimate reasons for rejecting a low bid include that the bid price may be considered
unrealistic, the bidder may be deemed unresponsive (e.g., a poor reputation for the follow-up
parts market), failing to conform to standards, a conflict of interest, or the appearance of
favoritism.
Competitive proposals or negotiations. This more flexible method of contracting often begins
with a government agency request. In a competitive negotiation, the government has an idea of
what it requires but lacks the resources to establish specifications and costs. Thus, contractors
have a degree of freedom to develop the procurement proposal and an opportunity to sway the
government to pay higher prices. After an agreement is reached, a contract is written and signed
by both parties.
Sole source. In this method, the government contacts the contractor it wants to supply the
product or service. The sole source process vests much power with contracting officers, but its
rationale must be justified to the responsible oversight individual, committee, or government
agency, such as Congress (e.g., by showing that it is the best or only way for the contracting
agency to acquire the goods and services needed). A request for a proposal to the contractor
selected is delivered and is answered by the contractor, later resolving other issues such as price
and delivery terms. Finally, a contract is written and signed by both parties.
Competitive Versus Noncompetitive Bidding
Detractors claim that the government increasingly uses unfavorable contracts and avoids the
proven benefits of competitive bidding for negotiated deals that tend to cost more.
Noncompetitive awards increased by 115% from 2000 to 2005, rising from $67.5 billion to $145
billion (U.S. Representative Henry Waxman, Dollars, Not Sense, House Government Reform
Committee, www.democrats.reform.house.gov/Documents/ 20060620140127-02294.pdf, 2006,
p. 15). Many different categories of noncompetitive contracts exist. Of the $145 billion in
noncompetitive contracts awarded in 2005, $97.8 billion were no-bid contracts, a 110% increase
from 2000; $63.4 billion was awarded under the rationale that only one contractor could supply
the needed goods or services. The other $34.4 billion in no-bid contract dollars was awarded
under such exceptions as emergency circumstances ($8.7 billion) and where a statute authorizes
or requires restricted competition ($2.9 billion) (Waxman 2006). Much of this increase is related

to the rebuilding of Iraq and the recovery from Hurricane Katrina. Federal acquisition law
provides exemptions from competitive sourcing requirements under certain circumstances, such
as emergencies, or if there is only one source for the required service. Still, the use of these types
of contracts has increased from 33% of federal contract dollars in 2000 to 38% in 2005 (Waxman
2006).
In response to growing procurement spending, on July 28, 2006, U.S. Representative Leonard
Boswell introduced the Competitiveness in Contracting Act to limit noncompetitive awards of
federal contracts in response to major disasters and emergencies. The House overwhelmingly
passed the bill, renamed the Accountability in Contracting Act, on March 15, 2007. The
legislation limits the awards of no-bid contracts for emergencies to one year. The bill passed the
Senate with an amendment (S.680) and, as of press time, had been sent back to the House.
Government Contract Fraud
Upon awarding a contract, potential fraud exists in areas such as product substitution, cost
mischarging, defective pricing, progress payment fraud, and antitrust violations.
Defective pricing. This practice arises from intentionally using old or inaccurate cost data to
inflate costs. Under the Truth in Negotiations Act, contractors must submit cost or pricing data
prior to negotiations, and certify that the data are accurate, complete, and current as of the close
of negotiations. Submitting defective (inaccurate, incomplete, or noncurrent) data entitles the
government to a price reduction under a contract clause included whenever certified cost or
pricing data are required. Existing defective pricing data does not indicate fraudulent behavior,
and recovery under the contract clause is not based on fraudulent intent. This clause makes
contractors liable for the overpayment along with simple interest computed from the date of
overpayment to the date the government is repaid [at the applicable underpayment rate effective
for each quarter prescribed by the Secretary of the Treasury under 26 USC 6621(a)(2)], and for a
penalty equal to the amount of the overpayment, if the contractor or subcontractor knowingly
submitted defective data.
Significant fraud indicators in defective pricing cases include:

Falsifications or alterations of supporting data;

Failure to update cost or pricing data when past activity indicates price decreases;

Failure to completely disclose data known to responsible contractor personnel;

Distortion of overhead accounts or base line information by transferring charges or

accounts that have a material impact on government contracts;

Protracted delay in release of data to the government to preclude possible price

reductions;

Repeated denials by responsible contractor employees of the existence of historical

records that are subsequently found;

Submitting fictitious documents;

Failing to disclose internal documents on vendor discounts; and

Nondisclosure of actual costs for follow-up contracts. (See U.S. Army Logistics
Management College, Procurement Fraud, ALM-31-6082c, 2006,
www.almc.army.mil/ledd/8a-f17/Adobe/Fraud.pdf.)

Progress payments fraud. Payments made to contractors based on costs incurred or on a

percentage or phase of completion can result in progress payment fraud. Because the government
relies heavily on the contractors integrity, progress payments are not always audited beforehand.
Such fraud cases usually involve erroneous labor charges for work not yet performed, charges for
materials not purchased, or false documentation of the phase of completion. This fraud is
perpetrated to receive more money in a cost-type contract, but could also be committed to
influence future contract awards (e.g., as when contracts are awarded in phases, with funds
dependent upon completion of prior phases).
Organizations That Detect and Prevent Fraud
National Procurement Fraud Task Force. Deputy Attorney General Paul J. McNulty announced
on October 10, 2006, the establishment of a new national procurement fraud initiative by the
Justice Departments Criminal Division (www.usdoj.gov/criminal/npftf/pr/press_
releases/2006/oct/10-10-06procfraudannounce.pdf). The task forces charge is to detect, prevent,
and prosecute procurement fraud resulting from increased contracting activity for national
security and other government programs.
The task force is expected to reinforce the governments efforts against procurement fraud and to
increase criminal enforcement, focusing on defective pricing, product substitution, misuse of
classified and procurement-sensitive information, false claims, grant frauds, labor mischarging,
accounting fraud, foreign military sales fraud, ethics and conflict-of-interest violations, and
public corruption.
Inspector General and SIGIR. The Inspector General Act of 1978 established the Inspector
General as the primary advisor to the Secretary of Defense for issues related to prevention of
fraud and abuse in the Department of Defense (DOD). Congress also instituted the Special
Inspector General for Iraq Reconstruction (SIGIR) to oversee the $18.4 billion reconstruction
fund. As a result, the Department of Defense Inspector General has limited its audit role in order
to prevent duplication of efforts due to the oversight provided by the SIGIR, the DOD audit
community, and the Government Accountability Office (GAO).
Defense Contract Audit Agency. Established in 1965, the Defense Contract Audit Agency
(DCAA; www.dcaa.mil) centralized audit functions for the various branches of the military. The
DCAA performs standardized contract audits for the DOD and certain other government

agencies, along with accounting and financial advisory services related to procurement contracts.
DCAA audit services include pre- and post-award contract audits and contractor internal control
systems audits. DCAA auditors also provide negotiation assistance in the form of procurement
liaison services and fact-finding analysis of contractor information after audits.
In conformity with Government Auditing Standards, DCAA auditors are not responsible for
proving fraud. DCAAs mission is to perform contract audits of commercial companies, and not
to perform investigations, said a Pentagon official explaining the audit agency (Neil King Jr.,
Pentagon Auditor Requests Probe of Halliburton, Wall Street Journal, Jan. 15, 2004). When
auditors suspect unlawful activity, they make a referral to the appropriate investigative
organization. Still, the DOD Inspector Generals 1993 Handbook on Fraud Indicators for
Contract Auditors says that auditors should design audit steps to reasonably assure detection of
irregularities and illegal acts, and report fraud indicators to investigators, but cannot
automatically conclude that an indication of fraud means that fraud exists. Indeed, as with all
audits, professional skepticism is necessary.
In fiscal year 2006, the DCAA audited $121.1 billion of incurred costs on contracts and forward
pricing proposals of $182.3 billion. U.S. taxpayers saved a net $2.3 billion due to audit findings.
Thus, the return on investment in the DCAA was approximately 520%.
Laws Designed to Prevent Fraud
Procurement Integrity Act. Private consultants, many of them former governmental employees,
often assist in the procurement process. These consultants serve as liaisons between government
officials and contractors. The government strictly regulates contractor re-employment after a
contractor leaves a governmental position. Government employees must take annual ethical
training regarding this issue and are encouraged to contact the governments human resource
department before accepting a position with a contractor, in order to avoid the appearance of a
conflict of interest. Failure to comply with the governments ethical guidelines can result in
blacklisting and criminal charges.
The Procurement Integrity Act of 1988 (as amended), which provides the basis for these
guidelines, focuses on contractor and government-official inappropriate contacts. It expressly
addresses offers of employment, disclosure of information, and compensation of former officials.
Remedies to punish violators include criminal prosecution, civil suits, and administrative
ramifications. The Act specifies that government employees with access to contractor bid,
proposal, or source-selection information may not, except as provided by law, disclose that
information prior to the awarding of a contract.
Moreover, no one may knowingly obtain this type of information before an award, regardless of
the proposed contracts dollar amount. A government employee participating personally and
substantially in procurement must report any offer for non-federal employment made by a
contractor. The employee can either reject the offer of employment or exclude himself from
further participation in the procurement process.

False Claims Act Qui Tam Actions. The False Claims Act, passed during the Civil War,
punishes military contractors who cheat the government. In 1986, an effort led by U.S. Senator
Chuck Grassley strengthened the law to encourage the use of qui tam (abbreviated from the Latin
He who sues for the king sues for himself) actions, where citizens are authorized to bring, as
private Attorneys General, lawsuits on behalf of the government. Under the new provisions,
whistleblowers can file cases against government contractors who commit fraud. Violations of
federal law can result in false claims under the act (see Shawn Zeller, Face-Off Over Fraud,
Government Executive, July 15, 2005).
The whistleblower begins the qui tam process by retaining a private attorney who investigates
the whistleblowers allegations and, if appropriate, files the lawsuit acting on the governments
behalf alleging violations of the False Claims Act. Qui tam suits are filed secretly so the
defendant and others do not learn of the lawsuit. The DOJ is served a copy of the complaint, plus
a written disclosure statement detailing the alleged fraud, to provide the government with an
opportunity to investigate the allegations (see T.A. Lewis, The False Claims Act and Its Qui
Tam Provisiona Primer, The Government Accountants Journal, Winter 2000, p. 36-44).
The DOJ proceeds to investigate the allegations and may decide to work with the
whistleblowers attorney. If the DOJ declines to proceed, the whistleblower and the attorney can
still move forward. A contractor found guilty of making false claims for federal funds is liable
for three times the governments loss, plus a civil penalty of $5,500 to $11,000 for each false
claim (Justice Department Recovers $1.4 Billion in Fraud and False Claims in Fiscal Year 2005;
More Than $15 Billion Since 1986, DOJ press release, Nov. 7, 2005).
If the contractor settles, or is found to have made false claims, the award is shared with the
whistleblower. For example, government participation in a qui tam action results in the
whistleblower receiving 15% to 25% of any settlement or judgment attributable to the fraud. On
the other hand, lack of government participation increases the whistleblowers share by as much
as 30%. The DOJ reported that whistleblowers were awarded $166 million for fiscal year 2005.
According to Kimberly Palmer (Downfall, Government Executive, July 1, 2006), Almost half
of fraud investigations in federal agencies are instigated by a tip from someone who notices
something isnt quite right. The increase in False Claims Act lawsuits may relate to increased
incentives for whistleblowers to come forward since the 1986 legislation. Indeed, the number of
cases filed under the law jumped from 60 in 1988 to more than 400 in 2004. According to Zeller,
Awards rose from less than $1 million in 1988 to more than $1 billion in 2003, with some cases
now yielding judgments in the hundreds of millions (Face-Off over Fraud, Government
Executive, July 2005). Nevertheless, federal government employees are limited in their ability to
act as whistleblowers. According to Lewis (2000), The courts generally reason that federal
employees should not personally benefit for simply doing what they are required and paid to do
which is to report fraud.
As reported by the DOJ in November 2005: Of the $1.4 billion in settlements and judgments
received in 2005, $1.1 billion relates to suits initiated by whistleblowers under the False Claims
Acts qui tam provisions. In 2006, the DOJ reported that of the $3.1 billion recovered by the
government for fraud, $1.3 billion was from suits brought by whistleblowers under the provision.

Oracle, which agreed to pay $498.5 million for false pricing information provided by PeopleSoft
to obtain a government contract, made the largest payment under the False Claims Act; the
whistleblower receives a $17,730,000 reward.
Sarbanes-Oxley Act of 2002. SOX has dramatically affected overall awareness and management
of internal controls in public corporations. Responsibility for accurate financial reporting has
landed squarely on senior management, including CEOs and CFOs who now face the potential
for personal criminal liability.
SOX section 406 directed the SEC to issue rules requiring public entities to disclose whether
they have adopted a code of ethics (business code of conduct or employee code of conduct) that
applies to the organizations key officers. The SEC adopted final rules implementing section 406
in January 2003.
The final rules (see Disclosure Required by Sections 406 and 407 of the Sarbanes-Oxley Act of
2002, June 24, 2003; www.sec.gov/rules/final/33-8177.htm) define code of ethics as written
standards that are reasonably designed to deter wrongdoing and to promote:

Honest and ethical conduct, including the ethical handling of actual or apparent conflicts
of interest between personal and professional relationships;

Full, fair, accurate, timely, and understandable disclosure in reports and documents that a
company files with the SEC and in other company communications;

Compliance with applicable governmental laws, rules, and regulations;

The prompt internal reporting of any violations of the code of ethics to an appropriate
person or persons identified in the code of ethics; and

Accountability for adherence to the code of ethics.

To comply with the SECs requirements for implementation of SOX section 406, the registrant
must do the following:

File with the SEC, as an exhibit to its annual report, a copy of its code of ethics that
applies to the registrants principal executive officer, principal financial officer, principal
accounting officer or controller, or persons performing similar functions;

Post the text of such code of ethics on its website and disclose, in its annual report, its
location; or

Provide instructions in its annual report how any person may request, without charge, a
copy of such code of ethics.

Companies not complying with the SEC guidelines would be subject to the same procedures and
due process under the SEC Enforcement Division and the Office of Compliance Inspections and
Examinations as in any other Act.
Although SOX does not mandate business ethics training or the adoption of codes of ethics or
conduct, it requires that the company disclose whether it has adopted a code per the above
definition. If the company has not adopted such a code, it must disclose why. There are increased
penalties for corporations and personal liabilities for individuals held accountable for violating
the requirements of SOX section 406 and the implementation guidelines in paragraph 229.406,
regardless of whether a company has a formal code. Many penalties have doubled or tripled
under the United States Sentencing Commissions Increased Penalties Under the SarbanesOxley Act of 2002 (January 2003). Of particular interest is required compliance with applicable
governmental laws, rules, and regulationsespecially important for companies that contract to
perform government work.
A Proposal
The authors recommend incorporating SOX section 406 for incorporation into the Cost
Accounting Standards (CAS) 419 for Government Contracts. This written standard would apply
to all fully covered CAS contracts to make privately held companies and their subsidiaries
subject to SOX. At present, any subsidiary not publicly held avoids compliance with SOX and
the related penalties for failure to follow ethical standards. Thus, incorporating SOX into CAS
mandates the SOX ethics requirement for CAS-covered contracts.
Furthermore, the authors recommend using CAS 419 to incorporate SOX-associated standards
and penalties, such as:

Honest and ethical conduct, including the ethical handling of actual or apparent conflicts
of interest;

Full, fair, accurate, timely, and understandable company disclosures in government

reports and other company public communications;

Compliance with applicable governmental laws, rules, and regulations;

Prompt internal reporting of any violations of the code of ethics to appropriate persons
identified in the code of ethics;

Accountability for adherence to the code of ethics. Perhaps the United States Sentencing
Commissions guidelines should be applied. However, if a contractor appropriately
handles transgressing employees and institutes or modifies internal controls so that the
transgression is unlikely to reoccur, the contractor might be allowed to continue contract
performance and be eligible for future government contracts. If the contractor doesnt
follow the policies, then the CAS penalties would apply, in addition to the contractor
potentially becoming ineligible for future contracts.

Social responsibility (a corporate atmosphere conducive to moral decision making such

as the reasonable-person view versus profiteering/price gauging), government contracting
in times of crisis and emergency such as war, national disasters, and national security.

CAS 419 should be required for all contracts subject to full CAS. (CAS applicability depends on
the type and size of the contract. That guidance can be found within CFR 9903.201-1 and CFR
9903.201-2.)
The Next Steps
The attention given to the detection and prevention of fraud is justifiable because spending on
federal contracts has increased by 86% over the last five years. The increase in recovery in
settlements and judgments from cases involving fraud against the government provides incentive
for both the government and civilians.
Increasing financial penalties with the qui tam provision under the False Claims Act helps to
mitigate fraud losses; however, fines are not enough. Taxpayers have a right to expect long-term
incarceration for contractors found guilty of procurement fraud in order to discourage others
from defrauding the government. The penalties must be severe to discourage those tempted by
opportunity.
Before the 1980s, all cases brought under the False Claims Act were prosecuted as criminal, not
civil, cases. But research in the early 1980s revealed that criminal prosecution did little to stop
procurement fraud. The DOJ was also limited in the number of cases it could litigate, due to the
high cost of federal prosecution, so most fraudulent contractors got off the hook. However, the
recent formation of the National Procurement Fraud Task Force and its plans to increase criminal
enforcement, along with the strengthening of the False Claims Act, increase the risk of
prosecution.
Most important, companies that receive government contracts should be socially responsible and
conduct themselves in the highest ethical manner. To limit government procurement fraud and
increase the responsibility of all companies, public and private, engaged in government
contracts, the authors propose that CAS 419 incorporate the standards and penalties associated
with SOX section 406. This would require companies to abide by a code of conduct or ethics,
and entail monitoring by government audit agencies for compliance. A companys code of
conduct or ethics would be reviewed for appropriateness, and any violations would be reported.
Databases established to track companies banned from future government contracts could be
expanded to include individuals, to prevent violators from simply closing one business and
starting another.
Increased spending on government contracts magnifies the potential for procurement fraud.
Taxpayers deserve that the funding for fraud detection agencies be expanded, and the number of
qualified auditors be increased, in proportion to procurement spending.