By: Paul Emanuelli
This article is an excerpt from the 2021 edition of The Art of Tendering: A Global Due Diligence Guide, which is available for purchase.
In its November 2019 report entitled Ongoing DOD Fraud Risk Assessment Efforts Should Include Contractor Ownership, the U.S. Government Accountability Office (GAO) noted that the Department of Defense (DOD) accounts for about two thirds of federal contracting activity and found that “some companies doing business with DOD may have an opaque ownership structure that conceals other entities or individuals who own, control, or financially benefit from the company.” The GAO also warned that “opaque ownership could be used to facilitate fraud and other unlawful activity.”
As the GAO further detailed, the risk of opaque ownership structures includes price inflation through interrelated companies, as well as access to sensitive military data by ineligible foreign companies:
What GAO Found
The Department of Defense (DOD) faces several types of financial and nonfinancial fraud and national security risks posed by contractors with opaque ownership. These risks, identified through GAO’s review of 32 adjudicated cases, include price inflation through multiple companies owned by the same entity to falsely create the appearance of competition, contractors receiving contracts they were not eligible to receive, and a foreign manufacturer receiving sensitive information or producing faulty equipment through a U.S.-based company. For example, one case involved an ineligible foreign manufacturer that illegally exported sensitive military data and provided defective and nonconforming parts that led to the grounding of at least 47 fighter aircraft, as illustrated below.
The report detailed the multi-tiered beneficial ownership schemes that are created to undermine the transparency of the ultimate contracting parties, who can hide behind the veil of apparently legitimate operations to conduct unauthorized business with government institutions. The GAO noted that “in the United States, no centralized information source or national registry maintains company ownership information.” In fact, the GAO observed that most US states “collect minimal ownership data” and that “very few states collect some form of entity ownership or control information from limited liability companies or corporations.”
As the GAO detailed, one of the proven fraud risks associated with opaque ownership schemes involves the use of related subcontractors to increase costs to government:
Concealing relationship with subcontractor to inflate prices. Contractors can subcontract with companies they own or control to inflate prices for financial benefit. For example, in a 2014 federal court case we examined, a contractor and another company with common ownership pled guilty to major fraud against the United States. They agreed to pay $434 million in criminal penalties and to settle a lawsuit in connection with concealing their relationship with a subcontractor that the contractor directed to fraudulently mark up costs on items that the contractor purchased and resold to DOD. Specifically, the contractor purchased goods from a company that its owners created, controlled, and used to make the fraudulent markups appear legitimate. Further highlighting the relationship between the company and the contractor, contractor personnel were also responsible for hiring individuals to work for the subcontractor. The contractor billed the government an artificially high price for the goods from July 2005 through April 2009 and resulted in a loss to DOD of $48 million.
The GAO also observed that related subcontractor schemes have been used to bill for work that was never performed as another proven price-gouging technique against the government:
Billing for work not performed. Contractors or subcontractors can bill for work not performed by creating fictitious invoices that add costs to a contract. For example, in four court cases we examined, multiple DOD subcontractors were actually shell companies that did not have the inventory they purported to ultimately provide to the government or perform the work indicated in the contract requirements. According to documents filed in U.S. district court, some of these subcontractors hired other companies to perform work, but created additional invoices that added costs for work the subcontractors did not perform. These additional costs were then passed on to DOD.
The report also noted that opaque ownership schemes can help obfuscate existing conflicts of interest and allow contractors to avoid related anti-conflict rules in government procurement:
Disguising conflicts of interest. Contractors or subcontractors can conceal conflicts of interest for financial benefits. We identified a case involving a DOD subcontractor that concealed ownership for illicit financial gain. According to court records, a DOD contractor employee and his spouse formed a company and concealed their interests by not listing their names but listing the names of family members on formation documents. This company became a subcontractor to the company that employed the DOD contractor. The contractor employee, in his official position, wrote letters justifying awards of purchase orders to the subcontractor he owned and approving recommendations that the awards be made to the subcontractor. The co-owner of the subcontractor concealed her involvement by signing contracts using a different name, knowing that the use of her real name could reveal the DOD contractor employee’s ownership of the subcontractor and affect the awards.
The report also warned that opaque ownership schemes have been used to create the appearance of competition and facilitate price-fixing and bid-rigging to inflate the cost of government contracts:
Creating the appearance of competition on a contract to inflate prices. In our review of 32 cases, we also identified the potential risk of companies creating the appearance of competition by submitting bids from fictitious companies. Specifically, we identified one case that involved a DOD contractor whose executives admitted as part of their plea agreements to creating fictitious, inflated bids that were not from actual businesses to ensure that the contractor’s own bid would be selected by DOD as the supposed lowest. In this instance, the contractor was required to obtain at least two competitive bids for certain services and items and provide the bids to DOD for selection. As part of their plea agreements, the individuals involved with the scheme also admitted that the scheme allowed the contractor to control and inflate the prices charged to DOD without any true, competitive bidding, as required. The contractor also fraudulently inflated invoices that were sent to DOD, and two individuals involved in the scheme admitted they were aware of losses to DOD of at least $34.8 million. Court records state that the scheme took place from 2011 to 2013. In 2017, two contractor executives involved with this scheme were sentenced to prison for 70 and 46 months. Additionally, we identified additional cases involving this contractor and its owner bribing government officials in exchange for the approval of fraudulent invoices, steering contracts, and covering up the contractor’s overcharging practices, which has led to at least 22 individuals pleading guilty. Additionally, DOD officials from Defense Pricing and Contracting and DLA identified the risk of different companies concealing common ownership to create the appearance of competition on a solicitation and attempt to inflate prices.
In fact, based on a detailed analysis of two years of federal government bidding data, the GAO found multiple instances in which bidders could have been related to other bidders in the same federal bidding competition:
By analyzing a subset of DOD solicitation data, we further examined the risk that contractors could disguise their ownership to create the appearance of competition. We identified potential relationships among the offerors of solicitations that could indicate common ownership. Our analysis of responses to approximately 2,700 solicitations in the Federal Business Opportunities (FBO) website from fiscal years 2015 through 2017 found indications that at least 16 offerors were potentially related to at least one other offeror when bidding on the same solicitation. This analysis shows indications that offerors may not always compete independently and the relationship among offerors is not always readily apparent to contracting officials or disclosed in SAM registration information.
The GAO explained that the types of relationships it found among competing bidders included bidders who share the same management, bidders who are potentially related to an entity that is excluded from doing business with government, bidders who shared information with one another, ineligible contractors that improperly obtained set-aside contracts by using other eligible fronting organizations, and ineligible foreign contractors that obtained contracts restricted to domestic contractors.
In addition to concerns over fraud, the GAO report also raised serious concerns over the use of opaque ownership schemes as a means of accessing sensitive security information that could compromise national security interests:
DOD officials we spoke with and published DOD research have identified the risk of contractors disguising company ownership as an enabler to do harm to national security interests. Contractors fraudulently misrepresenting themselves to DOD could actually be operated by adversaries seeking to act against the government’s interests. Foreign-owned contractors can conceal ownership information when registering in SAM, which allows contractors to self-attest ownership information. For example, in addition to the 32 cases we identified through our review, we also identified a bid protest filed with GAO challenging a contract award made to a foreign-owned DOD contractor in fiscal year 2018 that prohibited the participation of foreign firms or domestic companies under foreign ownership, control, or influence. This contractor did not disclose its foreign ownership or control in SAM or to DOD, as required by the FAR and the solicitation. As a result of the bid protest, DOD subsequently terminated the contract later in fiscal year 2018 after confirming the foreign ownership with the contractor.
DIA and DLA officials stated that adversarial foreign governments or other malicious entities, such as companies attempting to access sensitive government information, could access sensitive systems to conduct sabotage or surveillance. These entities could infiltrate DOD’s supply chain to introduce components, such as circuit-board chips and routers modified to fail, facilitate state or company espionage, or compromise the integrity of DOD’s information-technology systems. According to CIO officials, adversarial entities could also potentially gain access to sensitive information through their relationship with DOD contractors. For example, DIA officials identified the possibility of foreign or adversarial entities exploiting companies in DOD’s supply chain with financial difficulties, and according to CIO officials, DOD may not always have visibility over foreign entities acquiring a domestic contractor.
The report detailed how the infiltration of the government supply chains through the use of multi-layered organizations could pose significant risks to military operations:
In 2017, the Office of the Director of National Intelligence released a management background paper discussing supply-chain risks, which stated that the multiple layers and networks of suppliers in this chain can allow foreign adversaries the ability to access the supply chain at multiple points. For example, according to the background paper, a hostile foreign intelligence entity could potentially conceal its presence in government supply chains by operating through multiple front organizations, companies, hackers, and organized crime, making it extremely difficult to discover and counter its actions. The paper also states that adversaries may be able to penetrate the supply chain to access sensitive research and development programs, steal intellectual property and personally identifiable information, insert malware into critical components, and mask foreign ownership, control, or influence of key providers of components and services. Furthermore, in April 2018, the U.S.-China Economic and Security Review Commission issued a report identifying a supply-chain threat to U.S. national security that stems from products produced, manufactured, or assembled by entities that are owned, directed, or subsidized by national governments or entities known to pose a supply-chain or intelligence threat to the United States.
DOD officials have also identified an additional risk of contracting with companies that have opaque ownership structures. For example, a 2017 Defense Contract Audit Agency report to Congress described the risk of individuals receiving government contracts or gaining access to government installations who would harm deployed troops. Officials we spoke with from the Joint Staff Logistics Directorate also acknowledged the risk that government funds could be provided to contractors owned by a person or entity that is actively opposing U.S. or coalition forces involved in a contingency operation in which service members are actively engaged in hostilities. These adversaries can potentially use opaque ownership structures to disguise their ownership and contract with the government in areas involved in contingency operations, such as Iraq or Afghanistan, to fund their operations or gain access to military bases.
While the concerns raised by the report are widespread, the GAO’s recommendations for dealing with the vulnerabilities of these government supply chains were sparse. In its single resulting recommendation, the GAO stated that the Office of the Undersecretary of Defense “should include an assessment of risks related to contractor ownership as part of its ongoing efforts to plan and conduct a department-wide fraud risk assessment” and that consistent with leading practices, the Department of Defense “involve relevant stakeholders with knowledge of emerging risks and use this information to help inform other types of risk assessments across the department, including for national security concerns.” However, if the US government and its military apparatus have allowed these vulnerabilities to their supply chains to grow over time, it is questionable whose leading practices could be relied on as a means of now mitigating these ongoing fraud and security risks.
