FAR FINAL RULE REQUIRES CONTRACTORS, SUBCONTRACTORS
TO IMPLEMENT CODE OF BUSINESS ETHICS AND CONDUCT;
ADDITIONAL ONEROUS REQUIREMENTS MAY FOLLOW

Smith Pachter McWhorter constantly tracks current events, issues, and trends in Government Contracts to keep clients on the cutting edge of legal and policy developments. This e-letter highlights the most important issues, and the attached index provides weblinks to the source documents of these and many more developments.

Contractors and Subcontractors Must Implement Code of Business Ethics and Conduct

On November 23, 2007, the Civilian Agency Acquisition Council and the Defense Acquisition Regulations Council (the Councils) promulgated a final FAR regulation requiring contractors and subcontractors to implement a code of business ethics and conduct.  72 Fed. Reg. 65873 (November 23, 2007).  Effective December 24, 2007, that regulation imposes a new contract clause, FAR 52.203-13, “Contractor Code of Ethics and Conduct,” on contractors receiving a contract in excess of $5 million with a performance period of 120 days or more.  The clause must be included in subcontracts by prime contractors for subcontracts meeting the same criteria.  The clause does not apply to contracts or subcontracts for commercial items under FAR Part 12 or for contracts or subcontracts to be performed entirely outside the United States.

FAR 52.203-13 requires that, within 30 days after contract award, the contractor: (1) shall have a written code of business ethics and conduct; (2) shall provide a copy of the code to each employee engaged in performance of the contract; and (3) “shall promote compliance with its code of business ethics and conduct.”

FAR 52.203-13(c) requires contractors (except for small businesses) to establish within 90 days after award: (1) “an ongoing business ethics and business conduct awareness program,” and (2) an internal control system.  The internal control system must:

1. Facilitate timely discovery of improper conduct in connection with Government contracts; and
2. Ensure corrective measures are promptly instituted and carried out.

As examples of what an internal control system should do, the regulation lists:

1. Periodic reviews of company business practices, procedures, policies, and internal controls for compliance with the Contractor’s code of business ethics and conduct and the special requirements of Government contracting;
2. An internal reporting mechanism, such as a hotline, by which employees may report suspected instances of improper conduct, and instructions that encourage employees to make such reports;
3. Internal and/or external audits, as appropriate; and
4. Disciplinary action for improper conduct.

The regulation also imposes a second clause, FAR 52.203-14, “Display of Hotline Poster(s),” essentially requiring display of agency fraud hotline posters in common work areas and on the company website.

While no one would argue that companies should not conduct business ethically, the new clause poses some practical issues for contractors and subcontractors.  The clause will be a contract requirement and will be as much a part of contract performance as any other clause.  Contractors and subcontractors must consider FAR 52.203-13 in light of other clauses such as FAR 52.215-2, “Audit,” and the FAR termination clauses.  Companies must prepare for government auditors to review the required business ethics and business conduct awareness programs, and internal control systems, and to make the case that such programs and systems are effective.  Companies must understand that FAR 52.203-13 relates directly to the present responsibility requirement of satisfactory record of business integrity; failure to comply with this clause could implicate contract termination and a company’s present responsibility status.  To the extent that the clause requires “disciplinary action for improper conduct,” the government may involve itself with the company’s human resources and employment policies and practices.  The clause implicates the government’s access to proprietary and personnel information; this implication becomes more complex with a prime contractor’s enforcement of the clause on subcontractors.

As challenging as FAR 52.203-13 may be, industry must be prepared for a proposed rule published by the Councils on November 14, 2007, “Compliance Program and Integrity Reporting.”  72 Fed. Reg. 64019.

That proposed rule is the result of a letter dated May 23, 2007, from the Department of Justice (DOJ) to the Councils, and is far more onerous than the November 23 rule.  In its letter, DOJ described its proposed rule: “[W]e propose that the FAR be modified to require that contractors establish and maintain internal controls to detect and prevent fraud in their contracts, and that they notify contracting officers without delay whenever they become aware of a contract overpayment or fraud …”  DOJ stated that, while many government contractors had taken steps to establish corporate compliance programs, “our experience suggests that few have actually responded to the invitation of [DOD] that they report or voluntarily disclose suspected instances of fraud.”  DOJ stated that the FAR change is necessary to keep “pace with reforms in self-governance in industries such as banking, securities and healthcare.”  DOJ requested that the Councils “fast track” the proposal.

The proposed FAR rule would apply under the same conditions as FAR 52.203-13 (contracts and subcontracts in excess of $5 million with a performance period of at least 120 days, excluding commercial items and contracts to be performed entirely outside the United States) and would:

1. Permit debarment “based on a preponderance of the evidence” for “knowing failure to timely disclose an overpayment on a government contract, or a violation of federal criminal law in connection with award or performance of any government contract or subcontract;”
2. Permit suspension “upon adequate evidence” of a “knowing failure to timely disclose an overpayment on a Government contract” or “violation of federal criminal law in connection with the award or performance of any Government contract or subcontract”;
3. Require the contractor to:

1. “exercise due diligence to prevent and detect criminal conduct”; and
2. “otherwise promote an organizational culture that encourages ethical conduct and a commitment to compliance with the law”;
3. “notify, in writing, the agency Office of the Inspector General, with a copy to the Contracting Officer, whenever the Contractor has reasonable grounds to believe that a principal, employee, agent, or subcontractor of the Contractor has committed a violation of Federal criminal law in connection with the award or performance of this contract or subcontract thereunder”;
4. Establish within 90 days after contract award (excluding small businesses) a compliance program that (i) provides “effective training” to “principals and employees, and as appropriate, the Contractor’s agents and subcontractors; and (ii) an internal control system that “at a minimum” provides for, among other things, “monitoring and auditing to detect criminal conduct,” and “full cooperation with any Government agencies responsible for audit, investigation, or corrective action.”

Contractors and subcontractors should take note that the proposed clause would essentially require them to become fraud detection and reporting entities.  The proposed clause would require contractors and subcontractors to exercise due diligence “to prevent and detect criminal conduct.”  This requirement is a dramatic shift in responsibility for contractors.  The terms of the proposed rule and the statements by DOJ demonstrate DOJ’s position that a contractor’s current system of internal controls is not good enough – contractors must do more to “prevent and detect criminal conduct.”  The proposed rule does not articulate specifically what more is required, but states only that an internal control system must “at a minimum” provide for “monitoring and auditing to detect criminal conduct.”  How will contractors and subcontractors know whether their internal controls are sufficient under the proposed rule?  Must contractors and subcontractors become experts in, for example, forensic accounting and private investigation?  What government agency will provide the standards so contractors and subcontractors have a reasonable basis for determining their compliance with these new requirements?  Contractors and subcontractors are not trained police or detectives, yet the proposed rule would require them to act as such.

Not only must contractors and subcontractors exercise due diligence to detect and prevent criminal conduct, but they must also notify the agency IG whenever they have “reasonable grounds to believe a principal, employee, agent, or subcontractor of the Contractor has committed a violation of Federal criminal law in connection with the award or performance of this contract or subcontract.”  This standard – often referred to as “probable cause” in criminal law – is the same as that used for grand juries to render indictments.  Moreover, the requirement that prime contractors exercise this level of criminal detection on subcontractors, and subcontractors on lower-tier subcontractors, would create significant legal and practical issues.  So, the proposed rule would require contractors and subcontractors to exercise due diligence to prevent and detect criminal conduct, to change internal control systems in some undefined way to monitor and audit for crime detection, and to look for and report instances of “probable cause.”  The proposed rule is overreaching, and essentially would “deputize” contractors and subcontractors as agents of the IG.

Contractors and subcontractors should also take note that they could be suspended or debarred for a “knowing failure to timely disclose an overpayment on a government contract, or a violation of federal criminal law in connection with award or performance of any government contract or subcontract.”  What constitutes a “knowing” failure and a “timely” disclosure of an overpayment is nowhere defined, but even a single overpayment could be fatal.  The overpayment is likewise undefined; it could relate to allegations of defective pricing, Cost Accounting Standards noncompliance, FAR Part 31 violations, improper deliveries, or any of a multitude of alleged contract violations to support a government claim of overpayment.

The proposed rule also states: “At a minimum, the Contractor’s internal control system shall provide for the following: …(G) Full cooperation with any Government agencies responsible for audit, investigation, or corrective action.”  The proposed rule does not define “full cooperation,” but the Councils’ comments in the Federal Register make clear that these words bear directly on a contractor’s ability to maintain its attorney-client privilege.  “Full cooperation” may also hold implications for preservation of an individual employee’s Sixth Amendment rights.

DOJ’s May 23, 2007, letter to the Councils followed on the heels of a significant DOJ loss in United States v. Stein, 435 F. Supp 2d 330 (SDNY 2006).

That case involved a tax fraud prosecution in which the government, under a DOJ document called “the Thompson Memorandum,” decided that companies that pay defense legal fees for employees and former employees did not “cooperate,” and should therefore be criminally charged.  The court held:

The Thompson Memorandum discourages and, as a practical matter, often prevents companies from providing employees and former employees with the financial means to exercise their constitutional rights to defend themselves.  This is so even where companies obstruct nothing and, to the contrary, do everything within their power to make a clean breast of the facts to the government and to take responsibility for any offenses they may have committed.  It undermines the proper functioning of the adversary process that the Constitution adopted as the mode of determining guilt or innocence in criminal cases.  The actions of prosecutors who implement it can make matters even worse, as occurred here.

The Court holds that the fact that advancement of legal fees occasionally might be part of an obstruction scheme or indicate a lack of full cooperation by a prospective defendant is insufficient to justify the government’s interference with the right of individual criminal defendants to obtain resources lawfully available to them in order to defend themselves, regardless of the legal standard of scrutiny applied.

            Id. at 368-69.

The conflict between a contractor’s ability to maintain its attorney-client privilege and the proposed rule’s “full cooperation” requirement is obvious – the government will argue that a contractor is not fully cooperating if the contractor does not waive its privilege and disclose the substance of communications with counsel.  In another context, DCAA has requested audit access to privileged materials to assess allowability of consultant costs under FAR 31.205-33.  See DCAA Contract Audit Manual ¶ 7-2105.2.  If the government has pressed for privileged materials under a FAR provision that makes no mention of “full cooperation,” contractors should expect that the government would interpret the proposed rule’s “full cooperation” requirement to be a “full waiver” of attorney-client privilege.

Finally, DOJ may intend its proposed rule to accomplish indirectly what the Thompson Memorandum could not achieve directly.  The government may argue that “full cooperation” under the proposed rule carries the meaning set forth in the Thompson Memorandum, and that such an interpretation is not objectionable because it is a condition of the contract.  The government may argue that the parties can agree to whatever conditions they desire, and if a contractor does not want to agree to this proposed clause then it can decide to avoid government contracts and subcontracts.  Such an argument would be without merit.  If the proposed rule becomes final, it will be a regulation contained in the FAR with the force and effect of law.  Making contractors and subcontractors “choose” between exercising attorney-client privilege and living up to agreements to fund employee defense costs, on the one hand, and doing business with the government, on the other hand, would deprive companies of legitimate markets and would deprive the government of significant sources of supply.  Additionally, some companies are so dedicated to the government market that they effectively would have no choice but to take the proposed clause.

No one can argue that good ethics, high integrity, and compliance do not hold important positions in government contracts.  The DOJ-sponsored proposed regulation simply goes too far and would effectively require contractors and subcontractors to act as government deputies.

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