United States: Government Contractor Advisory: The Government’s Crackdown on Fraud in Disadvantaged Business Enterprise (DBE) Programs Promises to Continue in 2011

The Government's Crackdown on Fraud in Disadvantaged Business Enterprise (DBE) Programs Promises to Continue in 2011

Many state and federal government contracts require participation—whether as a contractor, sub-contractor, supplier, or vendor—by Disadvantaged Business Enterprises (DBEs), i.e., firms that are majority-owned or controlled by women or minorities.¹ These DBE regulatory mandates arise from Title VI of the Civil Rights Act of 1964, and were intended to serve a laudable dual purpose: to forbid gender or racial discrimination in government contracting and to open greater opportunities for participation in government-funded contracts by women and minorities.

Over the years, however, many DBE programs have become susceptible to fraudulent practices by those trying to take perverse advantage of such programs and the billions of government dollars that flow from them. One common abuse has featured non-DBE firms who partner with, and sometimes create, sham firms who meet DBE eligibility criteria on paper but who perform no actual work—or, in the words of DBE regulations, perform no "commercially useful function"—on the government-funded project.

In the final quarter of 2010, federal agencies and law enforcement began cracking down aggressively on DBE fraud. In October 2010, the U.S. Small Business Administration (SBA)—stung by criticism in a Government Accountability Office (GAO) report that highlighted lax oversight by SBA in monitoring contractor compliance in DBE programs—suspended federal contractor GTSI, a software provider, from participation in future federal contracts. SBA accused GTSI of abusing the Small Business Act's "Section 8(a)" set-aside programs, which mandate participation in certain federal contracts by entities that are both small businesses and woman- or minority-owned. GTSI allegedly partnered with companies who, on paper, met Section 8(a) criteria. These small companies won several SBA set-aside contracts, but then left most of the work to GTSI, who allegedly pocketed the vast majority of the Section 8(a) monies while kicking a small percentage back to the Section 8(a) companies.² In November, SBA followed up its action against GTSI with suspensions of contractors EG Solutions and MultimaxArray FirstSource for involvement in some of the same government contracts at issue in the GTSI matter.

Then, in late November 2010, federal authorities in New York announced a criminal probe of the Schiavone Construction Company into alleged DBE fraud on rehabilitation projects on two New York City subway stations and in the city's water treatment system. Schiavone Construction settled the case for $20 million in December. According to published reports, the federal investigation of DBE fraud on these New York City projects continues, with the construction conglomerate Skanska USA as one potential target.

There is little doubt that DBE fraud will be a continuing enforcement priority for law enforcement with the power to prosecute, and regulatory agencies with the power to suspend or debar firms from future participation in public projects.

With that in mind, companies who are DBEs, or who have relationships with DBEs, would be well-served to promptly and thoroughly assess whether or not their practices on government-funded contracts are compliant with the regulations governing DBE participation. Indeed, federal law governing many DBE programs requires that federal grant recipients put a monitoring and enforcement program in place to deter and detect wrongdoing in DBE programs,³ and grant recipients sometimes delegate these monitoring obligations to the general contractors running their projects. In other words, no one involved in DBE set-aside programs is permitted to turn a blind eye to non-compliance.

What follows is a summary of some of the basic rules to follow to ensure compliance with DBE legal standards.

"Commercially Useful Function"

Expenditures to a DBE entity may be counted toward the contract's goals for DBE participation only if the DBE is performing a "commercially useful function."⁴ A DBE performs a commercially useful function when "it is responsible for execution of the work of the contract and is carrying out its responsibilities by actually performing, managing, and supervising the work involved."⁵ To perform a commercially useful function, "the DBE must also be responsible, with respect to materials and supplies used on the contract, for negotiating price, determining quality and quantity, ordering the material, and installing (where applicable) and paying for the material itself."⁶ In other words, to perform a commercially useful function, the DBE must perform work with its own forces and have an active role in negotiating price and ordering materials used on the contract.

Conversely, a DBE does not perform a commercially useful function if "its role is limited to that of an extra participant in a transaction, contract, or project through which funds are passed in order to obtain the appearance of DBE participation."⁷ A common example of this is seen where a general contractor submits paperwork indicating that the DBE is properly certified and is performing the contracted work, but the general contractor actually performs the work with its own forces. Here, a general contractor may run the payroll through the DBE to create the illusion that employees are working for the DBE. The DBE is usually paid a small sum—see, for example, the GTSI allegations above—and the DBE allows the use of its name on invoices, trucks, and equipment to create the appearance of DBE participation. In this scenario, the DBE is a mere pass-through performing no commercially useful function.

It is important to note that if a DBE is certified, it does not necessarily mean that the DBE is performing a commercially useful function. Contractors and grant recipients should not rely on DBE certification alone. The DBE must actually perform the contracted work on the project.

Proper Classification of DBEs

In addition, general contractors should be aware that not all DBE classifications are the same. The DBE classifications set forth in the federal regulations are subcontractor, manufacturer, regular dealer/supplier, and broker. Each classification has a specific definition in the federal regulations governing DBE participation, and each is counted differently toward DBE goals. For example, federal regulations stipulate that if the work is performed by the DBE's own forces, the entire amount (100%) of that construction project may be counted toward DBE goals.⁸ Contractors may count the work of DBE manufacturers at 100%, whereas suppliers may only be counted 60%. In situations where a DBE is neither a manufacturer nor a supplier, a contractor may count the entire amount of fees or commissions charged for assistance in the procurement of materials and supplies. In this last scenario, the DBE is considered a broker.

Red Flags of DBE Fraud

The following are common indicators of potential DBE fraud:

• General contractors always using the same DBE

• Contracts for work for which DBE has no previous history, licenses, or equipment

• DBE has no business office and little equipment

• DBE business owners absent for job

• Ghost employees or certified payroll irregularities

• Small DBE contractors in unusual businesses (bridges, structural steel)

• Large equipment or materials orders embedded in subcontracts

• Duplicate invoices and purchase orders

Keeping these basic rules in mind will reduce the chances of a government contractor being caught in the crosshairs of the next government investigation into DBE fraud. Moreover, given the current enforcement climate, any company working on government contracts with DBE participation is wise to engage counsel to conduct an independent and confidential compliance audit of its DBE practices. Identifying potential non-compliance early, then fixing it before it worsens or leads to a whistleblower's tip to authorities, is always a preferable alternative to the costly and debilitating crisis management that results from a government investigation.

Footnotes

1 Some statutes refer to such entities as DBEs, others as Women-Owned Business Enterprises (WBEs) and/or Minority-Owned Business Enterprises (MBEs). The term DBE is used in this advisory.

2 SBA later reinstated GTSI's eligibility to bid on government work, but only after the imposition of an on-site government monitor and other restrictions. The federal investigation into the GTSI matter is reportedly ongoing.

3 See 49 C.F.R. § 26.37.

4 49 C.F.R. § 26.55(c).

5 Id. § 26.55(c)(1).

6 Id.

7 Id. § 26.55(c)(2).

8 Id. § 26.55(a)(1).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.