12 | Partnering Perspectives | Winter 2015

By Patricia A. Gorham and Lawrence A. Dany III

The drive to police Disadvantaged Business Enterprise (DBE) programs increasingly puts suppliers in the crosshairs of civil and criminal false claims act proceedings at all levels of enforcement—federal, state and local. While not a party to an underlying program contract, a non-DBE supplier can be drawn into investigations of pass-through arrangements in which a DBE supplier lends its name to the transaction. Worse still, a supplier can become the target of enforcement efforts alleging that it facilitated false claims or turned a blind eye to the fact that a DBE served only as a pass-through and did not perform a commercially useful function.

The DBE designation refers generally to the myriad of programs at the federal, state and local level designed to promote business opportunities in government-funded contracts for women-owned, minority-owned and other disadvantaged entities. Concerns that these programs have been the target of widespread fraud and abuse have led to increased attention from federal and state prosecutors on both the civil and criminal fronts.

In November 2014, a New York grand jury completed an investigation into abuse of DBE programs in New York City government-funded construction contracts. The grand jury found “systemic criminal conduct,” including schemes in which money was passed through a DBE even though the DBE performed no work; employees of the majority contractor were loaned to the minority contractor then “flipped” back once the work was completed; and front organizations were used in which friends or family provided a DBE facade for the majority contractor actually performing the work. See also L. Dany III & P. Gorham, “Criminalizing Fraud In Minority- and Women-Owned

“… concerns that [DBE] programs have been the target of widespread fraud and abuse have led to increased attention from federal and state prosecutors on both the civil and criminal fronts.”

Suppliers in the Crosshairs: Enforcement of Disadvantaged Business Enterprise Programs

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Business Certification,” New York Law Journal Special Section (February 9, 2015). This increased attention to fraud in DBE programs has resulted in numerous substantial settlements and criminal penalties involving established general contractors and specialty subcontractors—and their suppliers.

The enforcement trend to pursue DBE “pass-through” supply arrangements can embroil non-DBE suppliers in investigations and enforcement actions. A typical concern is that a non-DBE supplier will negotiate with a prime contractor or subcontractor to provide materials for a job and, then, because the project is government-funded, the prime contractor or subcontractor will direct the supplier to work with a DBE. The DBE will purchase the supplies from the non-DBE supplier; the supplies might be delivered to the job site; the supplier will invoice the DBE; and the DBE will add a small percentage fee and submit its invoice to the prime contractor or subcontractor. In such an instance, the fact that the DBE is certified may not shield the non-DBE supplier from an investigation or enforcement action.

Increasingly, federal, state and local prosecutors, inspectors general and other enforcement agencies are staking out the position that suppliers that allow themselves to be involved in these arrangements are aiding and abetting a fraud or a false claim for government payment. Several examples over the past few years illustrate this point.

In a recent settlement with the Department of Justice, a non-DBE supplier agreed to a nearly $5 million penalty under the False Claims Act to resolve allegations that it was complicit in a pass-through scheme. The allegations were that the supplier negotiated and supplied a prime contractor

with materials, while passing invoices through a DBE to make it appear that the DBE had completed the work. (https://www.oig.dot.gov/library-item/32633)

In 2012, a national manufacturer of construction materials agreed to a $950,000 settlement without admitting liability to resolve allegations that it had provided concrete for a government contract by performing subcontracts that were supposed to be performed by a DBE.

Several years ago, an Illinois grand jury indicted a DBE supplier and its principals for acting solely as a broker with respect to government contracts, causing shipment for “actual” suppliers to the contractor. The concern was that the supplier did not perform a commercially useful function, had no role in the actual warehousing or delivery of the materials, and acted as a pass-through between non-DBE suppliers and the contractor despite representations to the contrary. United States v. Azteca Supply Co., Criminal No. 1:10-CR-00080-1 (N.D. Ill.).

Last year, a Special Agent of the Office of Inspector General for the U.S. Department of Transportation swore out a complaint against the regional manager of a general contractor, describing a scenario in which the structural steel for a project was supplied by a non-DBE, and the DBE was used as a pass-through. The agent observed that the DBE had only clerical employees and did not have a warehouse or capacity to store or transport steel. The agent concluded that the DBE did not meaningfully participate in the project and received only a small fraction of the state funds. United States v. Tubbs, Crim. No. 7:14-MAG-2137 (S.D.N.Y.).

A Philadelphia inspector general investigated a circular billing arrangement between a contractor, a supplier and a DBE in which the DBE invoiced the contractor for supplies it did not sell. (https://philadelphiainspectorgeneral.wordpress.com)

Even when not charged in an enforcement action, non-DBE suppliers can find themselves witnesses in, or potential subjects of, investigations.

A supplier concerned about avoiding entanglement in DBE enforcement actions might consider implementing a compliance program and conducting diligence when asked to work with a DBE in connection with a government-funded project. Ideally, such a program would include identifying a compliance officer who would vet diligence on DBE-supply contracts. Understanding the rules

“… federal, state and local prosecutors, inspectors general and other enforcement agencies are staking out the position that suppliers that allow themselves to be involved in [pass-through] arrangements are aiding and abetting a fraud or a false claim for government payment.”

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governing any pertinent DBE program can assist a supplier in its compliance efforts. Although most programs require that the DBE perform a “commercially useful function,” there are differences in how programs evaluate that standard. In general terms, the DBE supplier will be performing a “commercially useful function” if it identifies supply sources, negotiates price, purchases supplies from its own funds, performs invoicing, and schedules or takes delivery.

For example, U.S. Department of Transportation rules require a DBE supplier to be responsible for negotiating price, determining quality and quantity, ordering the materials, and paying for the materials. A “regular dealer” can earn DBE credit for identifying the source of materials, negotiating price, performing quality and quantity control, paying for the materials, and scheduling delivery. However, a “regular dealer” must meet qualification standards that include being an established, regular business that engages under its own name in the purchase, sale or lease of products of the same general character as those involved in the government contract and maintaining a store or warehouse where the products are bought, stocked, sold or leased in the regular course of its business. And, if the entity is a broker and not a regular dealer, DBE credit may be limited to the amount of the commission or fee the broker receives.

Prosecutors are making it known that they may investigate and file charges where they believe a supplier is being willfully blind to schemes to defraud DBE programs. Thus, a supplier might consider collecting the following types of information in order to carefully evaluate an opportunity to participate in a government contract with a DBE program component:

“… a non-DBE supplier agreed to a nearly $5 million penalty under the False Claims Act to resolve allegations that it was complicit in a pass-through scheme.”

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� Is the DBE paying for the materials? � Are the materials being delivered to the DBE? � Does the DBE engage generally, in its own name,

in the purchase and sale or lease of the products being supplied?

� Does the DBE supply materials to more than one contractor? To non-DBE program projects?

� Does the DBE maintain a store, warehouse or other facility where materials are bought, stored or sold?

� What commercially useful function is the DBE performing? Are the contractor and the DBE in agreement as to what the commercially useful function is?

� Is the DBE acting only as a broker for supplies or is it performing other functions on the project?

� Will the contractor count only the value of the work actually performed by the DBE towards the DBE’s goals?

If concerned, a supplier should consider asking the contractor and/or the DBE to address how the arrangement is in compliance with applicable laws and regulations. The supplier also might consider obtaining a representation or warranty in its sales agreement acknowledging that the sale of the supplies does not constitute DBE-program activity.

By taking these steps and being alert to potential fraud on the government, a supplier can minimize the risk of inadvertently participating in arrangements that involve pass-through DBE suppliers and reduce the chances of being swept up in a false claims act investigation or litigation.

“Understanding the rules governing any pertinent DBE program can assist a supplier in its compliance efforts.”

Partners Patricia A. Gorham and Lawrence A. Dany III are partners in Sutherland’s Litigation practice. Patti Gorham has 30 years of experience in complex business litigation. She regularly represents public and private companies, officers and directors, and accounting firms in federal and state court litigation, in internal investigations, before the U.S. Securities and Exchange Commission, and in connection with Department of Justice, grand jury, and other civil and criminal investigative bodies. Larry Dany represents clients in a wide variety of complex commercial, construction, financial services, real estate and white-collar litigation and arbitration across the country. They can be reached at: patricia.gorham@sutherland.com and larry.dany@sutherland.com.