NEW DISCLOSURE OBLIGATIONS REPRESENT “SEA CHANGE” FOR CONTRACTORS

Smith Pachter McWhorter PLC
Government Contracts Update
Vol. IV, No. 2   November, 2008

By Stephen D. Knight

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.

Under a final rule effective December 12, 2008, contractors must “timely disclose” to the government “credible evidence” of certain federal criminal and civil False Claims Act violations, and “significant” contract overpayments on prime contracts and subcontracts, or face suspension and debarment from government business.  The new rule imposes obligations of “due diligence” on contractors to “prevent and detect criminal conduct” and “full cooperation” with “any government agencies responsible for audits, investigations, or corrective actions.”  The FAR Council stated that this mandatory disclosure represents a “sea change” from existing regulation which the Council achieved by changing FAR 52.203-13, Contractor Code of Business Ethics and Conduct, and FAR 9.4, relating to suspension and debarment.  Importantly, the disclosure obligation affects contracts and subcontracts awarded on and after the effective date, and also reaches “credible evidence” of violations currently known to contractors.  73 Fed. Reg. 67064 (November 12, 2008).

Changes to FAR 52.203-13, Contractor Code of Business Ethics and Conduct

The Original FAR 52.203-13

Just last December 24, 2007, the FAR Council promulgated FAR 52.203-13 to require a contractor code of business ethics and conduct with the award of any contract or subcontract in excess of $5 million with a performance period of at least 120 days. Commercial item contracts and subcontracts, and contracts performed entirely outside of the United States were exempt from this requirement. The original FAR 52.203-13 required that contractors: (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.” It also required contractors (except for small businesses) to establish: (1) “an ongoing business ethics and business conduct awareness program,” and (2) an internal control system. The original regulation required an internal control system to: :

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 listed:

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 Rewrite of FAR 52.203-13

The changes to FAR 52.203-13 rewrite that regulation and introduce heavy burdens on contractors. The new contract clause, which now applies to commercial item contracts and contracts performed outside the United States, continues the obligation to have a written code of business ethics and conduct and to make that code available to each employee engaged in contract performance. But it also requires contractors to:

1. exercise due diligence to prevent and detect fraud;
2. “timely disclose, in writing, to the agency Office of the Inspector General (OIG), with a copy to the Contracting Officer, whenever, in connection with the award, performance, or closeout of this contract or any subcontract thereunder, the Contractor has credible evidence that a principal, employee, agent, or subcontractor of the Contractor has committed –
   1. a violation of Federal criminal law involving fraud, conflict of interest, bribery, or gratuity violations found in Title 18 of the United States Code; or
   2. a violation of the civil False Claims Act (31 U.S.C. 3729-3733).

The key words above are “in connection with the award, performance or closeout of this contract or any subcontract thereunder, the Contractor has credible evidence” of a violation of the listed types of federal criminal law and the civil False Claims Act. The FAR Council’s comments to the new regulation provide little guidance. “Credible evidence” apparently is a higher standard than “reasonable grounds to believe” found in the proposed regulation, and anticipates a contractor’s “preliminary examination of the evidence to determine its credibility before deciding to disclose to the Government.” How preliminary is a “preliminary examination”? The FAR Council’s comments suggest that a “preliminary examination” is not the equal of an internal investigation.

The “in connection with” language has no explanation and the FAR Council’s comments regarding this language are circular:

As to the nexus with the contract, the clause stipulates … that the violation should have occurred “in connection with the award, performance, or closeout of this contract, or any subcontract thereunder.” With regard to the internal control system disclosure required … the violation must be in connection with the award, performance, or closeout, of any Government contract performed by the contractor, or a subcontract thereunder, and the obligation to disclose information lasts until 3 years after final payment. If there is no connection to a Government contract performed by the contractor, or a subcontract thereunder, then it need not be disclosed.

(Emphasis added.)

The Council’s language says, “there must be a connection to a government contract or subcontract; if there is no connection, then there is no duty to disclose.”  The Council provided nothing useful to explain what type of “connection” must exist to trigger the disclosure obligation.  Given the breadth of Title 18 language relating to, for example, gratuities, is providing food to government personnel at contract review meetings enough of a “connection”?  Is a sales agent’s gift to a foreign official enough of a "connection" if the only "connection" to a government contract is the fact that the sales agent’s salary is allocated through the contractor’s general and administrative (G&A) expense pool?

The new FAR 52.203-13 continues the requirement for “an ongoing business ethics awareness and compliance program.”  In a peculiar (and in fact treacherous) twist, the rule purports to exempt small businesses and commercial item contracts from the requirement for a business ethics awareness and compliance program and internal control system.  The exemption is an example of poor drafting, and in fact is a trap, although not an intentional one.  The problem with the "exemption" is that all contractors and subcontractors need to be able to show that they have a mechanism in place to fulfill their disclosure obligations.  And the mechanism that DOJ and the IGs will expect is an ethics and compliance program – the very program from which small businesses and commercial item contractors may otherwise believe they are exempt. 

Accordingly, for two reasons, small businesses and commercial item contractors should not take the exemption seriously.  First, it is clear that small business and commercial item contractors are subject to the basic disclosure rule in the new regulation.  And, if a company fails to make a disclosure, the agency Inspector General and the Department of Justice will probe to find out what mechanism the contractor employed to determine whether a disclosure was required or not.  This is part of the analysis DOJ conducts under the Sentencing Guidelines.  DOJ is not likely to accept an "exemption defense." To the contrary, DOJ will probably invoke the very "exempt" rules on business ethics awareness and compliance programs as the standard for what the contractor should have done to ferret out violations. 

Second, the agency debarring official, before arriving at any debarment decision, considers ten "mitigation factors."  FAR 9.406-1(a).  The first factor invites the following inquiry:    

1. Whether the contractor had effective standards of conduct and internal control systems in place at the time of the activity which constitutes cause for debarment or had adopted such procedures prior to any Government investigation of the activity cited as a cause for debarment. 

FAR 9.406-1(a)(1).   As a consequence, the requirement for standards of conduct and internal control systems, said to be "exempt" for small businesses and commercial contractors under the new disclosure regulation, is fully alive in the debarment regulations.  There is no exemption there. 

The new rule also changes the minimum requirements of the necessary internal control system.  Those changes are highlighted below:

1. The Contractor’s internal control system shall –
   
   1. establish standards and procedures to facilitate timely discovery of improper conduct in connection with Government contracts; and
   2. ensure corrective measures are promptly instituted and carried out.
2. At a minimum, the Contractor’s internal control system shall provide for the following:
   
   1. Assignment of responsibility at a sufficiently high level and adequate resources to ensure effectiveness of the business ethics awareness and compliance program and internal control system.
   2. Reasonable efforts not to include an individual as a principal, whom due diligence would have exposed as having engaged in conduct that is in conflict with the Contractor’s code of business ethics and conduct.
   3. 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, including –
      1. Monitoring and auditing to detect criminal conduct;
      2. Periodic evaluation of the effectiveness of the business ethics awareness and compliance program and internal control system, especially if criminal conduct has been detected; and
      3. Periodic assessment of the risk of criminal conduct, with appropriate steps to design, implement, or modify the business ethics awareness and compliance program and the internal control system as necessary to reduce the risk of criminal conduct identified through this process.
   4. An internal reporting mechanism, such as a hotline, which allows for anonymity or confidentiality, by which employees may report suspected instance of improper conduct, and instructions that encourage employees to make such reports.
   5. Disciplinary action for improper conduct or for failing to take reasonable steps to prevent or detect improper conduct.
   6. Timely disclosure, in writing, to the agency OIG, with a copy to the Contracting Officer, whenever, in connection with the award, performance, or closeout of any Government contract performed by the Contractor or a subcontractor thereunder, the Contractor has credible evidence that a principal, employee, agent, or subcontractor of the Contractor has committed a violation of Federal criminal law involving fraud, conflict of interest, bribery, or gratuity violations found in Title 18 U.S.C. or a violation of the civil False Claims Act (31 U.S.C. 3729-3733) …
   7. Full cooperation with any Government agencies responsible for  investigations or corrective actions.

The new FAR 52.203-13 defines “full cooperation” as disclosure “sufficient for law enforcement to identify the nature and extent of the offense and the individuals responsible for the conduct.  It includes providing timely and complete response to Government auditors’ and investigators’ request for documents and access to employees with information.”  The new contract clause states that “full cooperation” does not require waiver of attorney-client privilege or the attorney work product doctrine, or individuals’ Fifth Amendment rights, nor restrict a contractor from conducting an internal investigation or defending a proceeding or dispute.  The FAR Council’s comments make clear the breadth of the “full cooperation” duty”:

[C]ooperation should include all information requested as well as all pertinent information known by the contractor necessary to complete the investigation, whether the information helps or hurts the contractor.  Contractors are expected to make their employees available for Government investigators and auditors investigating contract fraud and corruption and respond in a timely and complete manner to Government requests for documents and other information required to conduct an investigation of contract fraud and corruption.

In this regard, the new regulation is disingenuous.  At a very practical level, the affirmative duty to “timely disclose credible evidence” of a violation will run headlong into the contractor’s ability to maintain the privilege and the work product doctrine, as well as individual rights and the ability to conduct an effective internal investigation.  How else will a contractor determine whether it has “credible evidence” unless that evidence was developed and evaluated under attorney-client privilege?  How can a contractor provide “timely and complete response to Government auditors’ and investigators’ request for documents and access to employees with information” without implicating attorney work product and employee rights?  The new regulation’s simple invocation that no conflict exists is simply wrong.

Changes to FAR 9.4 on Suspension and Debarment

The new regulation also creates a new ground for suspension and debarment – the “knowing failure by a principal” to timely disclose credible evidence of a violation:

Knowing failure by a principal, until 3 years after final payment on any Government contract awarded to the contractor, to timely disclose to the Government, in connection with the award, performance, or closeout of the contract or a subcontract thereunder, credible evidence of –

1. Violation of Federal criminal law involving fraud, conflict of interest, bribery, or gratuity violations found in Title 18 of the United States Code;
2. Violation of the civil False Claims Act (31 U.S.C. 3729-3733);
3. Significant overpayment(s) on the contract, other than overpayments resulting from contract financing payments as defined in 32.001.

“Principal” means officer, director, owner, partner, or person with “primary management or supervisory responsibilities within a business entity.” The FAR Council’s comments state that “principal” could also include compliance officer or directors of internal audit, as well as other positions of responsibility.

The FAR Council means for this new suspension and debarment ground to cover contractors now, for “credible evidence” of a violation known to a principal, regardless of the existence of contracts that contain the new FAR 52.203-13. The FAR Council’s promulgation comments state:

The Councils do not agree with the respondents who think that disclosure under the internal control system or as a potential cause for suspension/debarment should only apply to conduct occurring after the date the rule is effective or the clause is included in the contract, or internal control system is established.  The laws against these violations were already in place before the rule became effective or any of these other occurrences.  This rule is not establishing a new rule against theft or embezzlement and making it retroactive.  The only thing that was not in place was the requirement to disclose the violation.  If violations relating to an ongoing contract occurred prior to the effective date of the rule, then the contractor must disclose such violations, whether or not the clause is in the contract and whether or not an internal control system is in place, because of the cause for suspension and debarment in Subpart 9.4.

(Emphasis added.)

Under this new rule, contractors are currently vulnerable to suspension and debarment if a principal has knowledge of credible evidence of a violation but does not make a disclosure to the government.

What Should Contractors Do?

All of the implications of these new regulations are far from clear, but contractors should take several actions. First, contractors must bring their ethics and compliance programs into line with the increased requirements of the new FAR 52.203-13. Second, this will mean committing more resources to internal control systems and focusing on how and when a contractor can say it has “credible evidence” of a violation. Third, contractors should be clear on the appropriate interpretation of the “violation in connection with” language discussed above. Contractors must define which instances of credible evidence are “in connection with the award, performance, or closeout of the contract or a subcontract”, and which are not. Fourth, whether the contractor determines that the evidence is not credible or the evidence (if credible) is not of a violation “in connection with the award, performance, or closeout of the contract,” the contractor should document its reasons and factual support for not making a disclosure. Finally, contractors must be vigilant in protecting attorney-client privilege and attorney work product, assessing responsibilities to employees, and developing procedures for the conduct of internal investigations without interfering with government audits and investigations triggered by disclosures.

* * * * *

For a complete list of Recent Developments in Government Contracts, please see the attached index with weblinks to the source documents. If you wish to discuss these or any other government contract issues, please contact the following individuals or view our website at www.smithpachter.com to view additional attorney biographical information:

John S. Pachter 703 847 6260 jpachter@smithpachter.com	Stephen D. Knight 703 847 6284 sknight@smithpachter.com
Richard C. Johnson 703 847 6266 rjohnson@smithpachter.com	Jonathan D. Shaffer 703 847 6280 jshaffer@smithpachter.com
* * * * *	* * * * *
Edmund M. Amorosi 703 847 6268 eamorosi@smithpachter.com	Mary Pat Gregory 703 847 6303 mgregory@smithpachter.com

 

LINKS TO RECENT DEVELOPMENTS IN GOVERNMENT CONTRACTS

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