Best Practices and Procedures to Avoid CUF Investigations and Penalties

As we reported here, a national pipe supplier recently agreed to pay a $4,950,000 fine to settle an investigation by the U.S. Attorney’s office for the Northern District of New York. The supplier agreed that it participated in transactions in which a certified Disadvantaged Business Enterprise (DBE) acted “merely as a pass through” and did not perform a “commercially useful function” (CUF) on U.S. Department of Transportation (DOT) and Environmental Protection Agency (EPA) projects.[1]

Contractors historically have had greater CUF concerns than suppliers. The majority of investigations and penalties in the past involved entities that had contracts directly with the government or one tier removed. What has changed is that the U.S. Attorney’s office has now investigated traditional suppliers did not contract directly with a government entity and were not required to certify any compliance with DBE regulations. The U.S. Attorney’s office contended the traditional supplier was subject to the DBE requirements because it transacted business with a DBE Supplier and contractor that then contracted with the government. In other words, on projects funded by DOT or EPA, the DOT and EPA regulations apply to downstream contractors and suppliers that are not in privity of contract with the government.

This traditional supplier case certainly generated much attention in the construction industry.  After this penalty, the most common request to this office has been for advice on the best practices and procedures to avoid similar criminal investigations and penalties.

The simplest 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. 

However, if this is a transportation project, EPA, Maryland State executive branch procurement[2] or another project with a CUF requirement, we now all understand that this traditional supplier cannot sell material to this DBE Supplier.  The well is poisoned.  The only way for the supplier and customer to avoid risk of fines is to sell the product directly to the non-DBE customer or refrain from selling the product at all. The only other possibility is for the non-DBE customer to get new bids from new DBE suppliers, who will then get pricing information from the traditional supplier.

The 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. To perform a CUF with respect to materials, the DBE must be responsible for negotiating price, determining quality and quantity, ordering the material and paying for the material.  These are the four “pillars” or “touchstones.” If the non-DBE customer has already determined the material it wants to buy and has already negotiated the price, there is no way to “fix” this and no way that the DBE Supplier can perform a CUF within the meaning of these regulations.  These were exactly the facts that resulted in the $4,950,000 fine recently paid.

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 vast majority of investigations and penalties have come from DOT projects.  U.S. Department of Transportation regulations apply only on a limited number of projects, but would include most highways, subway stations and airports.  More government agencies are adopting similar regulations.  The Environmental Protection Agency has adopted modified DOT commercially useful function regulations.  The state of Maryland has passed very similar regulations for any state executive branch procurement. Virginia regulations state that any entity must perform a CUF in order to be a certified DBE.  It is not clear at this point whether any agencies other than DOT will actively initiate CUF investigations or enforcement actions.

The vast majority of investigations have also resulted in settlement agreements with the U.S. Attorney’s office, including the recent $4,950,000 fine. Accordingly, we do not have many “court decisions.” Settlement agreements are not legal precedents 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 projects with CUF requirements. We also know that many contractors and now a national supplier perceive enough of a risk that they will pay significant fines to avoid a prosecution and minimize bad press.

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.

It may behoove traditional suppliers and their customers to promote the development of DBE contractors and suppliers and enter into informal or formal mentor protégé arrangements.  This may help solve the problem of identifying competent DBEs.  This may also help achieve the public policy goals of competition and the development of viable contractors in the market place owned by traditionally disadvantaged groups.  An objective of DBE participation goals in contracting is actual participation by the DBE, so that they obtain the experience necessary to become viable actors in the market.  The use of pass through "paper pushers" or "brokers" that participate "in name only" for a 2% or 3% markup do not achieve these public policy objectives. Only time will tell whether it is possible to ever use DBE Suppliers under the regulations that are not manufacturers or “regular dealers.” It is possible that contractors will eventually have to use DBE subcontractors to achieve their DBE participation goals.

[1] 49 CFR (Code of Federal Regulations) for DOT and 26.55 (c)(2) and 40 CFR 33.503 for EPA.

[2] Maryland State Fin. and Proc. § 14-303 Code Section 9-104(a)(2)  and COMAR 21.11.03.12-1.

[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 just passed in the Spring of 2015 as S.B. 374.