- June 2016
Beware of Your Liability Exposure for DBE Fraud When Selling to Government Contractors
Wholesaler-distributors often supply products and materials to contractors for use on public procurement projects that are funded, at least in part, with government funds. Under federal, state and local laws and regulations, a certain portion of that government contract may need to be awarded, or subcontracted, by the general contractor to Disadvantaged Business Enterprises, or DBEs. For example, the U.S. Department of Transportation spends about $50 billion per year on construction projects and about $5 billion goes to DBEs.
Generally, a DBE must be majority owned and controlled by socially and economically disadvantaged individuals, including minorities and women. Government certification that the business qualifies as a DBE only confirms that this business ownership requirement is met.
A number of recent Justice Department criminal and civil enforcement actions have involved a scenario where the Contractor -- often after having received the Distributor’s quote and worked out product quality, quantity and logistics -- asks the Distributor (who is not a DBE) to supply product on a public procurement project through a designated DBE as a conduit - rather than have the Distributor sell directly to the Contractor. The Contractor then claims credit for the DBE’s “participation” on the project toward the contract goal. For its role, the DBE receives a small fee for the use of its name and DBE certification. However, DBE utilization is lawful only if the DBE actually performs a “commercially useful function” in the product supply chain.
The Justice Department and other enforcement authorities have challenged these arrangements and charged the Distributor and Contractor with DBE fraud because the designated DBE was a mere “pass-through” entity, and did not perform any commercially useful function. The Distributor may face criminal and/or civil liability for participation in this scheme, even if the DBE has been duly certified by the government as a Disadvantaged Business Enterprise. (DBE “certification” only means the DBE has sufficient ownership and control by minority or disadvantaged individuals. Whether the DBE actually has the capability and performs a commercially useful function is a separate determination made for each contract, based on the specific facts of the transactions involved.)
What’s a Commercially Useful Function?
Generally under federal regulations a DBE performs a commercially useful function when it is responsible for execution of the contract and is carrying out its contractual responsibilities by actually performing, managing and supervising the work involved - negotiating product price with the Distributor, determining quality and quantity, placing orders, receiving, warehousing and delivering the products, paying the Distributor and invoicing the Contractor. A DBE that acts as a mere “front” or “pass-through” (i.e., an extraneous participant in the transaction through which funds are passed in order to obtain the appearance of DBE participation) will not qualify.
Criminal DBE fraud cases involving a pass-through DBE prosecuted by the U.S. Attorney’s Office have resulted in prison sentences for individuals involved ranging from 3 years probation to 7 years in prison. The federal government and private whistleblowers (who could be a competitor of the Distributor or the DBE) may also seek substantial civil penalties in DBE fraud cases under the federal False Claims Act. Since 2011, the U.S. Department of Transportation (USDOT) has recovered over $245 million in fines, restitution and forfeitures in these cases. Penalties may include debarment from future government contract work.
A Distributor who sells product through a pass-through DBE - even if the DBE is “certified” - is a potential target for enforcement actions.
For example, in a recent federal case in New York a materials wholesaler paid nearly $5 million to settle a DBE fraud claim brought by the U.S. Department of Justice. Without admitting liability, the wholesaler acknowledged that it supplied materials to federal contractors through a DBE that the government could prove at trial served as a “pass-through” on several project contracts. In fact, the wholesaler negotiated terms directly with the contractors and used the DBE as a pass-through. Wholesaler invoices were sent to the DBE; the DBE transferred the invoice information to its own invoices and added a markup; the DBE then sent its invoices to the contactors for payment. The wholesaler’s conduct enabled the contractors to certify falsely that the DBE supplied the materials and served a commercially useful function, which all parties knew was not the case, according to the complaint. The settlement was not an admission of liability. The DBE in this case was duly certified by New York and several other states as a Native American owned DBE, but it really did no work in the transaction.
Red Flags Indicating a Pass-Through DBE
The USDOT Office of the Inspector General has issued the following “red flag” indicators of DBE fraud:
• DBE owner lacking background, expertise, or equipment to perform subcontract work
• Employees shuttling back and forth between Contractor and DBE payrolls
• Business names on equipment and vehicles covered with paint or magnetic signs
• Orders and payment for necessary supplies made by individuals not employed by DBE
• Contractor facilitated purchase of DBE-owned business
• DBE owner never present at job site
• Contractor always uses the same DBE
• Financial agreements between Contractor and DBE
• Joint bank accounts (Contractor/DBE)
• Absence of written contracts
Wholesaler-distributors must exercise thorough due diligence review and oversight when asked to sell products and materials for a government funded project to, or through, a DBE. An understanding of the applicable laws, rules and regulations and compliance guidance from professional advisors is essential. When a contractor-customer attempts to just insert a DBE between the contractor and a non-DBE Distributor, the tough answer must be that the Distributor will not participate in the transaction, for the Contractor’s protection, the protection of the DBE and the protection of the Distributor.
Government scrutiny, claims and prosecutions of distributors and contractors using a pass- through DBE are on the increase and penalties are severe. Most of the rules have been in force for many years, but the recent increased enforcement environment necessitates that all Distributors review their methods of operation in this area. Old practices are under heavy scrutiny by not only law enforcement but by other businesses and the media. Remember, the fact that a DBE has achieved government certification only confirms the entity’s status – the DBE must also add real value in the transaction which confirms the DBE’s performance of the necessary, required commercially useful function.
Distributors and Common Supplier Liable for Illegal Boycott of Competing Start-up Distributor
Is it lawful for two distributors to carry out a plan to contact their mutual suppliers with a threat to withhold their future purchases from the supplier unless the supplier agrees to refuse to sell a newly-formed distributor in the same market area? No, was the answer in a recent antitrust case, where the jury concluded the distributors “conspired to persuade, induce, or coerce any steel mill not to sell” product to the new market entrant. (MM Steel, LP v. JSW Steel (USA) Inc., et al., 5th Cir. 2015).
Also caught up in this antitrust conspiracy was JSW Steel, a steel supplier who, the jury found, “knowingly joined” the distributors’ scheme and refused to sell product to the plaintiff, MM Steel. After 24 months in business, MM closed its doors but did prevail in its antitrust lawsuit after a six week jury trial, recovering an astounding $52 million in damages for lost future profits, which was trebled to over $150 million.
In September 2011, two longtime salesmen departed their Gulf Coast steel distribution firm and started their own distributorship – MM Steel – in direct competition with their former firm and another local distributor. The two established distributors were not pleased with having MM as a new market entrant. They met and formed an agreement to coerce and induce their steel suppliers not to sell product to MM, or else the suppliers would lose the distributors’ business. The group boycott plan succeeded in convincing several suppliers to refuse to sell MM.
Before ceasing operations, MM sued the distributors and several steel suppliers in federal district court, alleging all defendants engaged in an illegal group boycott under the Sherman antitrust law, to deprive MM of product to re-sell. Following the jury verdict for MM, all defendants appealed but MM settled with the distributor-defendants, leaving JSW and Nucor as the remaining parties.
On appeal, JSW did not challenge the existence of the distributors’ conspiracy against MM – but they did argue there was no evidence to support the jury’s finding that JSW knowingly joined the conspiracy. The appeals court disagreed, noting the following events:
• August 2, 2011 - JSW signs a one-year supply agreement with MM, with stated monthly purchases, and also extends credit to MM.
• September 8, 2011 – Distributor #1 and Distributor #2 executives first meet and form conspiracy to coerce mills not to supply MM.
• September 19, 2011 – Distributor #1 meets with JSW and says JSW has a choice to make: do business with us or with MM.
• October 4, 2011 – Distributor #2 meets with JSW and threatens to cease buying from JSW if JSW sells to MM.
• October 20, 2011 – JSW reverses course, and informs MM that it would not be selling to MM going forward, acknowledging “the gravity of its decision.” In making this decision, JSW risked a breach of contract claim for terminating its one-year supply agreement with MM.
The court noted that a manufacturer generally has a right to deal, or refuse to deal, with whomever it likes – however, a company’s refusal to sell must be an independent business decision, not one made in concert with competitors or customers. While evidence of mere complaints from a distributor to a manufacturer about a competing distributor would not be sufficient evidence to establish a conspiracy, or that a manufacturer joined a conspiracy, evidence that a manufacturer responded to a distributor’s actual threat can show concerted action by the manufacturer that is not independent conduct. The demarcation between a complaint and a threat is oftentimes unclear but, as this case illustrates, it can be of great legal importance when the threat succeeds in blocking a supply source.
In contrast, the verdict against Nucor was reversed. The evidence showed that Nucor’s decision not to sell MM was based on Nucor’s own independent business decision. The appeals court cited these events:
• September 1, 2011 – MM leaves Nucor’s executive a voicemail announcing formation of MM and desire to buy from Nucor. Nucor executive immediately emails reassurance to its longstanding distributor-customer that Nucor had no intent to add distribution. Nucor cited its “incumbency practice” whereby Nucor remains loyal to established customers in order to maintain Nucor’s existing supply chain.
• September 2, 2011 – MM makes contact with three Nucor employees and each employee declines to quote or discuss potential sales to MM.
• September 8, 2011 – Distributor #1 and Distributor #2 first meet and form the conspiracy to coerce mills to refuse sales to MM.
Nucor declined to sell MM several days before the formation of the conspiracy. Therefore Nucor could not possibly have joined a conspiracy that had not yet been formed. Further, its conduct was consistent with its internal incumbency practice of supporting its established distribution network, evidencing that Nucor made an independent business decision. Therefore, the appeals court set aside the verdict against Nucor.