Avoiding Risk Accepting Orders from Disadvantaged Business Enterprises

Avoid Risk  Accepting Orders from Disadvantaged Business Enterprises

Most public procurement contracts have participation goals or requirements for minorities and other disadvantaged groups (Disadvantaged Business Enterprise or “DBE”).  Public Procurement is a tremendous opportunity for construction industry general contractors, subcontractors and suppliers. In 2014, the total value of new federal construction in the U.S. was $22.9 billion.[1] State and local government spending added much more. Dealing with Disadvantaged Business Enterprise regulation is an opportunity to do new business and to promote the development of experienced and financially strong minority partners. This opportunity does come with some risk, but that risk can be managed with care and training.

Enforcement of Commercially Useful Function Requirements

A national supplier of construction materials (Supplier) has now agreed to pay a fine of $4,945,000 to the United States for participating in transactions in which a certified Disadvantaged Business Enterprise (DBE) acted “merely as a pass through” and did not perform a “commercially useful function.”

The U.S. Department of Transportation (DOT) has always had the most complete regulations on DBE participation goals. DOT regulations state that there are no DBE participation points unless the DBE contractor performs a “commercially useful function” (CUF).  The regulations do not allow the DBE to be an “extra participant in a transaction, contract or project, through which funds are passed in order to obtain the appearance of DBE participation.” A DBE performs a CUF when it is actually performing, managing, and supervising the work. To perform a CUF with respect to materials, the DBE must also be responsible for negotiating price, determining quality and quantity, ordering the material and installing materials (where applicable) and paying for the material.  

The Environmental Protection Agency has adopted modified DOT commercially useful function regulations.  Several other state and local governments have passed regulations very similar to the DOT standards for most state public procurement.

The recently settled case involved a series of transactions on multiple projects by both the DOT and EPA. This resulted in a settlement agreement (Settlement Agreement) between the government and the Supplier, so there was no “court decision.” This is not a legal precedent and we do not know how a court would have ruled on these facts.  Nonetheless, we know how federal prosecutors view conduct that is very common in the market place by suppliers, DBEs, subcontractors and general contractors.  The use of pass through “paper pushers” or “brokers” that participate “in name only” for a 2% or 3% markup will result in investigations and prosecutions.

On the DOT Inspector General website (http://www.oig.dot.gov./) you can find recent DBE enforcement actions on DOT projects.  Historically, common violations have involved false or illegitimate DBE contractors set up or controlled by non-DBE contractors. The issues are control, independence, management and profits of the DBE. In other words, does the DBE contractor truly own, control and manage its contracting business? Most or all of these defendants had a contract with the government or were one tier removed. Most of these defendants were contractually required to make certifications to the government regarding the DBE participation.  Accordingly past cases have involved a breach of contract or a more direct fraud on the government, which has always resulted in substantial fines, probation and even jail time in almost all jurisdictions.

The investigation in the $4,945,000 fine CUF case was based on the civil federal False Claims Act.  Any person who knowingly presents . . .  a false or fraudulent claim for payment or approval to the government . . . is subject to a civil penalty of not less than $5,000 and not more than $10,000 for each instance of a false claim.[2] The defendant is also liable for three times the government’s actual damage as a result. The $4,950,000 fine DOT enforcement action simply involved a lot of invoices on multiple projects. The point is that this civil false claims act violation does not need to involve an active fraud. Anyone who knowingly participates, including remote subcontractors and suppliers, is at risk of a False Claims Act prosecution.

“Knowledge” is a key factor in any False Claim Act prosecution. There is no violation unless the defendant “knowingly presents, or causes to be presented, [or conspires to present] a false or fraudulent claim for payment.” There is no affirmative obligation to investigate the role that any DBE will play in a project. Risk arises, however, when knowledge is undeniably “dumped” upon you. This occurs most commonly when a non-DBE supplier and their customer communicate about a project for months, trade quotes and purchase orders, transfer technical data and shop drawings. The DBE Supplier is then injected into the contract tiers shortly before a project begins. All parties know at this point that this DBE is not performing a CUF. These were the facts of the $4,945,000 fine CUF case.

The statute of limitations on the federal False claims Act is at least six (6) years.[3]  Accordingly, it could be a long time before you learn the cost of behavior on projects today. Investigators are also free to broaden investigations into all projects in which you have participated in the last six years once an investigation begins.  Whistleblowers are also a concern, since they can file civil False Claim Act complaints.  The government then has the option to take over the case. In any event, the whistleblower can share in the eventual proceeds of the action.

There are still doubts about whether this CUF regulation could apply to a third tier supplier that did not contract directly with a government entity and did not expressly certify anything to any government entity.  In other words, we do not know what a court would have done with this case.

The Settlement Agreement in the $4,945,000 fine CUF case confirms that the Supplier “did not contract directly with a government entity for any of the federally-funded contracts.” Neither did the Supplier “certify –nor was it required to certify –to any government entity that it had or would comply with DBE regulations in connection with those contracts and projects. Nevertheless, the United States contends that . . . [the Supplier] was subject to the DBE requirements  because [it] transacted business with a company that had itself contracted with a government entity to perform work on a project that was funded by DOT or EPA, and the DOT Regulations and EPA  Regulations  apply  both  to  contractors  in privity  with  government  entities  and  to downstream contractors that are not.”

It is also significant that the DBE in this case was a DOT certified “Regular Dealer” in the materials purchased.  This emphasizes again that CUF requires a “transactional analysis.” A DBE must perform a CUF in every transaction.  Proper certification does not mean that the DBE performance qualifies for DBE participation credit. Similarly, the fact that a DBE owns warehouses and trucks or has many employees may mean that the DBE is capable of performing a CUF.  However, the proper analysis is the role the DBE played in this particular transaction.

Under the DOT regulation, the DBE must be responsible for negotiating price, determining quality and quantity, ordering the material and paying for the material to perform a CUF with respect to materials. The Settlement Agreement in this recent case confirms that “various prime contractors represented falsely that [the DBE] had performed a commercially useful function by negotiating price and other terms of sale when, in reality, the prime contractors had negotiated terms with [the Supplier] and used [the DBE] merely as a pass through. [The DBE] collected invoices from [the Supplier]; transferred the information from those invoices to [the DBE's] own invoices and added a markup; and passed [the DBE] invoices on to the prime contractors. The prime contractors then represented falsely to federal, state and/or local contract-letting authorities that [the DBE] supplied materials that, in reality, [the Supplier] supplied. In this connection, [the Supplier’s] conduct enabled various prime contractors to certify falsely that materials were supplied by [the DBE] when the parties –i.e. [the Supplier, the DBE], and the prime contractors - knew that was not the case, resulting in the submission to government entities of false or fraudulent claims for payment from federal funds.”

Copies of the Settlement Agreement and the United States Attorney Office press release are available on request to the undersigned. The investigation of the DBE and prime contractors in this case may continue. The results will probably appear at the DOT Inspector General’s website in the future http://www.oig.dot.gov./     

Is it Possible to be a DBE Supplier under DOT Regulations?

Many general contractors and subcontractors are reluctant to use DBE subcontractors, feeling that they are difficult or impossible to find. There may be greater chances of default or impact on the project schedule. General contractors and subcontractors may also be reluctant to subcontract part of the labor, if this is their primary source of profit on a project. This has lead to an industry practice of obtaining DBE participation through the supply of materials. Materials make up a significant portion of any construction contract price. There may be less chance of delays or other defaults that can impact completion of the project.

The actual participation of DBE Suppliers varies, but at times the DBE Suppliers are “mere pass throughs,” that have no on site presence and only receive the traditional supplier invoices, mark them up 2 or 3% and reinvoice the end user. This does not seem to achieve the public policy objective of getting actual experience for disadvantaged groups, so that they will eventually no longer be disadvantaged.  This may also violate public procurement regulations.

With the $4,945,000 fine CUF case, general contractors, subcontractors and traditional non DBE suppliers are now concerned about their risk in violating CUF regulations. This problem may be only on DOT and EPA regulations, although other state and local regulations are similar. The investigation was also resolved by a voluntary settlement agreement, so we do not know how a court would interpret these regulations or whether a court would impose a penalty.

DOT regulations do not allow the DBE to be an “extra participant in a transaction, contract or project, through which funds are passed in order to obtain the appearance of DBE participation.” A DBE performs a CUF when it is actually performing, managing, and supervising the work. To perform a CUF with respect to materials, the DBE must also be responsible for negotiating price, determining quality and quantity, ordering the material and paying for the material.[4]

These last four requirements are sometimes referred to as the four “pillars” or “touchstones” of legitimate CUF participation. General contractors, subcontractors and traditional non DBE suppliers now more often insist that a DBE suppliers actually negotiate the price, determine the quality and quantity, order the material and pay for the material.”

Is this a safe harbor?  Or is it possible that a DBE Supplier is still a “pass through” or “extra participant in a transaction, contract or project, through which funds are passed in order to obtain the appearance of DBE participation?” It is questionable whether the public policy objectives are achieved by such a relationship, although there may be good experience in negotiating price, determining quality and quantity, etc. Reliance on these four “pillars” or “touchstones” may be misplaced and may not satisfy the DOT regulations for legitimate CUF participation.

An internet search for 49 CFR 26.55 will locate the U.S. Department of Transportation Code of Federal Regulations on this subject. You will see that these four “pillars” or “touchstones” appear 49 CFR 26.55(c).  However, this and the immediately prior subsections seem to be speaking about subcontractors and not suppliers, stating that “[w]hen a DBE participates in a contract, you count only the value of the work actually performed by the DBE toward DBE goals”[5] and that you “[c]ount the entire amount of that portion of a construction contract . . . .that is performed by the DBE's own forces. Include the cost of supplies and materials obtained by the DBE for the work of the contract.”[6]

49 CFR 26.55(c) then states [emphasis added]:

(c) Count expenditures to a DBE contractor toward DBE goals only if the DBE is performing a commercially useful function on that contract.

(1) 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. 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. To determine whether a DBE is performing a commercially useful function, you must evaluate the amount of work subcontracted, industry practices, whether the amount the firm is to be paid under the contract is commensurate with the work it is actually performing and the DBE credit claimed for its performance of the work, and other relevant factors.

(2) 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. In determining whether a DBE is such an extra participant, you must examine similar transactions, particularly those in which DBEs do not participate.

(3) If a DBE does not perform or exercise responsibility for at least 30 percent of the total cost of its contract with its own work force, or the DBE subcontracts a greater portion of the work of a contract than would be expected on the basis of normal industry practice for the type of work involved, you must presume that it is not performing a commercially useful function.[7]

The “four pillars’ appear in a discussion of a “DBE contractor” that is “actually performing, managing, and supervising the work involved” in the contract. Immediately following is the statement that the DBE cannot be “an extra participant in a transaction, contract, or project through which funds are passed in order to obtain the appearance of DBE participation.”

What do we make of the next subsection?  It states that the DBE must “perform or exercise responsibility for at least 30 percent of the total cost of its contract with its own work force.”  How does that apply to a DBE Supplier with no on site presence? All of these provisions, including the “four pillars,” may apply only to a subcontractor with an onsite presence and the materials that the subcontractor purchases.  DBE subcontractor labor counts towards DBE participation goals if the work is performed by the DBE’s own forces.  The materials that the DBE subcontractor uses do NOT count unless that DBE subcontractor was responsible for “negotiating price, determining quality and quantity, ordering the material and paying for the material.”[8]  The materials do not count if the general contractor performed any of these roles in acquisition of the materials.

Then a following subsection of the DOT regulations state [emphasis added]:

(e) Count expenditures with DBEs for materials or supplies toward DBE goals as provided in the following:

(1)(i) If the materials or supplies are obtained from a DBE manufacturer, count 100 percent of the cost of the materials or supplies toward DBE goals.

(ii) For purposes of this paragraph (e)(1), a manufacturer is a firm that operates or maintains a factory or establishment that produces, on the premises, the materials, supplies, articles, or equipment required under the contract and of the general character described by the specifications.

(2)(i) If the materials or supplies are purchased from a DBE regular dealer, count 60 percent of the cost of the materials or supplies toward DBE goals.

(ii) For purposes of this section, a regular dealer is a firm that owns, operates, or maintains a store, warehouse, or other establishment in which the materials, supplies, articles or equipment of the general character described by the specifications and required under the contract are bought, kept in stock, and regularly sold or leased to the public in the usual course of business.

(A) To be a regular dealer, the firm must be an established, regular business that engages, as its principal business and under its own name, in the purchase and sale or lease of the products in question.

(B) A person may be a regular dealer in such bulk items as petroleum products, steel, cement, gravel, stone, or asphalt without owning, operating, or maintaining a place of business as provided in this paragraph (e)(2)(ii) if the person both owns and operates distribution equipment for the products. Any supplementing of regular dealers' own distribution equipment shall be by a long-term lease agreement and not on an ad hoc or contract-by-contract basis.

(C) Packagers, brokers, manufacturers' representatives, or other persons who arrange or expedite transactions are not regular dealers within the meaning of this paragraph (e)(2). . . . . .

(4) You must determine the amount of credit awarded to a firm for the provisions of materials and supplies (e.g., whether a firm is acting as a regular dealer or a transaction expediter) on a contract-by-contract basis.

(f) If a firm is not currently certified as a DBE in accordance with the standards of subpart D of this part at the time of the execution of the contract, do not count the firm's participation toward any DBE goals, except as provided for in §26.87(i).[9]

This may be the only portion of the DOT regulations that contemplates the purchase of materials from a DBE Supplier, defined as either a DBE manufacturer or a “regular dealer.”  A regular dealer must be certified as a regular dealer by the DOT. A regular dealer must own, operate, or maintain a store, warehouse, or other establishment in which the materials required under the contract are kept in stock, and regularly sold to the public in the usual course of business.  The regular dealer must be an established, regular business. If the supplier qualifies, then the general contractor can then only count sixty percent (60%) of the cost of those materials towards DBE participation goals.  However, notice there is no apparent CUF requirement to be regular dealer.

Accordingly, supplies purchased by or from a DBE may count towards DBE participation goals on a DOT project only if:

1. They are purchased by and used by a DBE subcontractor that performed a portion of a construction contract with the DBE's own forces and negotiated the price, determined the quality and quantity, ordered and paid for the materials, or
2. If the materials were purchased from a DBE manufacturer, or
3. If the materials were purchased from a certified DBE regular dealer, in which case only sixty per cent (60%) of the cost counts towards DBE participation goals.

DOT regulations apply only on federal transportation projects.  However, more state and federal government agencies are adopting similar regulations.^[10] The vast majority of investigations and penalties have come from DOT projects. It is not clear at this point whether state and local governments will ever actively initiate CUF investigations or enforcement actions. The risk is there, however, and the costs can be significant for suppliers and contractors.

Regular Dealers

As discussed in the immediately prior subsection, a regular dealer must own, operate, or maintain a store, warehouse, or other establishment in which the materials required under the contract are kept in stock, and regularly sold to the public in the usual course of business.  The regular dealer must be an established, regular business. Sixty per cent (60%) of the cost of materials purchased from a qualified regular dealer count towards DBE participation goals.^[11]

A DBE must meet the criteria as a regular dealer on a contract-by-contract basis. In other words, a DBE that acts as a regular dealer on one contract (receiving DBE credit for 60 percent of the value of the goods supplied) does not necessarily act as a regular dealer on other contracts. The DBE may act simply as a “transaction expediter” or “broker” (receiving DBE credit only for the fee or commission).

In order to qualify as a regular dealer on a particular contract, the DBE must “regularly” engage in the purchase and sale or lease of the products involved in the contract to the general public. This involves attention to the activities of the business over time, both within and outside of the DBE program. There is a difference between the regular sale or lease of the products and merely occasional or ad hoc involvement with them. It is not critical that every single item be physically present in the DBE’s store or warehouse before it is sold to a contractor. However, the store or warehouse should be more than a token location. For example, a mere showroom, the existence of a hard-copy or on-line catalog, or the presence of small amounts of material are generally not sufficient to demonstrate that a firm regularly deals in the items.^[12]

In some circumstances, items are “drop-shipped” directly from a manufacturer’s facility to a job site, never in the physical possession of or transported by a supplier. In many such cases, the supplier’s role may involve nothing more than contacting the manufacturer and placing a job-specific order for an item that the manufacturer then transports to the job site. The supplier’s role may then be better described as that of a “broker” or “transaction expediter.”^[13]

Notice that there is no apparent CUF requirement in this definition of a regular dealer in the DOT regulation. There is also no apparent prohibition in the regulation against acting as an “extra participant in a transaction, contract or project, through which funds are passed in order to obtain the appearance of DBE participation,”^[14] although there is discussion of CUF and “extra participants” in DOT’s Official Questions and Answers.^[15]  In the regulation itself, both of these requirements appear only in the discussion of expenditures to a DBE contractor, discussed above.[16] This may make the result in the $4,950,000 fine case, discussed above, curious.

Notice that 49 CFR 26.55 (e)(2)(ii)(B) states that a person may be a regular dealer in such bulk items as petroleum products, steel, cement, gravel, stone, or asphalt without owning, operating, or maintaining a place of business, if the person both owns and operates distribution equipment for the products. Legitimate DBE participation credit is available for the trucking services provided by a DBE trucker that owns at least one truck. DBE participation credit is also available for sixty per cent (60%) of the cost of bulk items delivered by that DBE trucker, even if the DBE trucker has no store or warehouse. This is an opportunity for DBE truckers and general contractor purchasers.

Best Practices and Procedures to Avoid CUF Investigations and Penalties

The simplest and most obvious response is that the DBE Supplier must be involved in the project from the earliest communication between the traditional supplier and their customer, if you are on a project with a CUF.  Historically, it has been very common that the traditional supplier and their customer communicate about the project for months, trade quotes and purchase orders, transfer technical data and shop drawings.  The DBE Supplier is injected into the contract tiers shortly before a project begins.  These were the facts of the $4,945,000 fine CUF case. On a project with a CUF, the general contractor, the DBE and the traditional supplier are at risk.

Contractors must identify their DBE Suppliers at an earlier stage of the project. It is already common that contractors need to identify their DBEs at the contract bid stage. This just needs to be done earlier, so that the DBE Supplier is the entity negotiating price, determining quality and quantity and ordering the material from the traditional supplier. We all understand that it can be difficult to identify competent DBEs to perform these functions.  However, this problem is constant. Traditional suppliers and their customers have this problem whether the DBE Supplier becomes involved at the bid stage or the day before the project begins.

There is no obvious prohibition against including the contractor, the DBE and the traditional supplier in all communications.  What is critical is that the DBE is involved in all communications and is the entity actually negotiating price, determining quality and quantity, ordering the material and later paying for the material.

We cannot be certain that complying with the four pillars or touchstones will be a “safe harbor” for contractors, DBEs and traditional suppliers. Even if the DBE is responsible for negotiating price, determining quality and quantity, ordering the material and paying for the material, will it still be possible to say that the DBE is an “extra participant in a transaction, contract or project, through which funds are passed in order to obtain the appearance of DBE participation?”  If the DBE does not perform or exercise responsibility for at least 30 percent of the total cost of its contract with its own work force, there is a presumption that there is no commercially useful function under the regulations.  This may also be a problem in the future, although it is not clear what this regulatory statement means for DBE Suppliers. 

The only truly safe harbor on a DOT project is if:

1. The materials are sold to a DBE subcontractor that performed a portion of a construction contract with the DBE's own forces and negotiated the price, determined the quality and quantity, ordered and paid for the material, or
2. If the materials were purchased from a DBE manufacturer, or
3. If the materials were purchased from a certified DBE regular dealer, in which case only sixty per cent (60%) of the cost counts towards DBE participation goals.

We hope this newsletter is helpful to you in understanding some of the recent events, concepts and issues involved in construction law. It is important to understand, however, that this law firm is not providing you legal or professional advice in supplying you this newsletter. We have generalized and simplified many legal concepts, so that the explanations are short, uncluttered and easily understandable. You should consult this firm or another attorney in dealing with any specific problem.

[1] http://www.statista.com/topics/1256/public-construction/.

[2] Subject to inflation increases under 31 U.S.C.A. §3279(a)(1)(G).

[3] 31 U.S.C.A. §3279, et seq. Virginia’s False Claims Act is at Va. Code Anno. §8.01-216.1, et seq. (Michie 1950) and Maryland’s False Claims Act was passed in the Spring of 2015 as S.B. 374. 

[4] 49 CFR (Code of Federal Regulations) for DOT and 26.55 (c)(2) and 40 CFR 33.503 for EPA.

[5] 49 CFR 26.55 (a).

[6] 49 CFR 26.55 (a)(1).

[7] 49 CFR 26.55 (c)(1) – (3).

[8] 49 CFR 26.55 (c)(1).

[9] 49 CFR 26.55 (E)(1) & (2) & (f).

[10] See e.g. Maryland State Fin. & Proc. § 14-303 Code Section 9-104(a)(2)  and COMAR 21.11.03.12-1; Maryland State Code Education § 5-301(h) and COMAR 23.03.03.06(D); Maryland Minority Business Enterprise Program Manual (July 2014) at pages 6, 36 & 105-115; Philadelphia Code § 17-600.

[11] It is not clear whether a regular dealer must be separately certified as a regular dealer by the DOT, in addition to certification as a DBE.   The DOT Official Questions and Answers 49 CFR Part 26. April 15, 2016, pp. 50- 51indicate that there is no separate certification, only a later administrative decision that the DBE acted as a regular dealer.  https://www.transportation.gov/sites/dot.gov/files/docs/Official%20Questions%20and%20Answers%204-15-16.pdf.

[12] This explanation seems somewhat circular and inconstant, but does come from the DOT Official Questions and Answers 49 CFR Part 26. April 15, 2016, pp. 50-51 at https://www.transportation.gov/sites/dot.gov/files/docs/Official%20Questions%20and%20Answers%204-15-16.pdf .

[13] DOT Official Questions and Answers 49 CFR Part 26. April 15, 2016, pp. 51 at https://www.transportation.gov/sites/dot.gov/files/docs/Official%20Questions%20and%20Answers%204-15-16.pdf [In such a situation, the supplier’s role may often be better described as that of a “broker” or “transaction expediter” (see 26.55(e)(2)(ii)(C)) than as a “regular dealer.” In such a case, DBE credit is limited to the fee or commission the firm receives for its services. If the firm does not provide any commercially useful function (i.e., it is simply inserted as an extra participant in a transaction), then no DBE credit can be counted].

[14] 49 CFR 26.55 (c)(2).

[15] See DOT Official Questions and Answers 49 CFR Part 26. April 15, 2016, pp. 51 at https://www.transportation.gov/sites/dot.gov/files/docs/Official%20Questions%20and%20Answers%204-15-16.pdf.

[16] 49 CFR 26.55 (c)(1) – (2).