August 1, 2012

Greedy Contractor Faces Big Consequences for Gaming the DBE System


By Katie Jeremiah

Summer 2012

In May 2012, the former president of Schuylkill Products, Inc. ("Schuylkill"), a Pennsylvania bridge beam manufacturer, was convicted of committing the largest fraud against the Disadvantaged Business Enterprise ("DBE") system in United States history. Joseph Nagle defrauded government agencies by unlawfully diverting to Schuylkill and its wholly owned subsidiary, CDS Engineers, Inc., government funding that had been set aside to benefit socially and economically disadvantaged contractors. The elaborate 15-year scheme involved using Marikina, a small DBE-certified highway construction company owned by a naturalized U.S. citizen born in the Philippines, as a front to obtain more than $136 million in government contracts. Schuylkill personnel pretended to be employees of Marikina with fake business cards, e-mail addresses, stationery, and vehicle decals with Marikina logos. Mr. Nagle now faces up to 330 years of imprisonment for convictions on counts of wire fraud, mail fraud, conspiracy, and money laundering, as well as $250,000 in fines and restitution for each conviction. The former owner of Marikina and at least three other individuals involved in the scheme await sentencing on charges of conspiracy and tax fraud.

Purpose of DBE

The DBE system was developed to provide opportunities for socially and economically disadvantaged individuals. Through the DBE, the government attempts to level the playing field by setting aside certain project funds available only to DBE-certified entities. To be eligible for certification, the disadvantaged individual must demonstrate that he or she can maintain ownership, control, and independence of the business and that the business performs a "commercially useful function."

Tension in the System

Individuals who are eligible for DBE contracts often lack the resources to perform the work or the track record to demonstrate their ability to perform the work, while the businesses with resources and experience are not eligible. This causes a tension between project contenders. There is a temptation to create alliances between struggling DBEs and capable non-DBEs. In such an alliance, the DBE benefits from access to the non-DBE's trained employees, equipment, administrative support, industry reputation, and even steady employment with the non-DBE. The non-DBE can benefit from increased opportunities to win lucrative government contracts. Such alliances are, however, in direct violation of the DBE system because it does not foster the disadvantaged individual's ownership, control, and independence of the DBE business.

Avoiding Violations

While the Marikina scheme involved radical steps and numerous parties to manipulate and circumvent the DBE rules over an extended period, there are certain seemingly innocuous business arrangements that could risk devastating consequences. Contractors and DBEs alike must exercise caution in structuring their relationships to avoid violating more subtle aspects of the DBE regulations.

Contractors must maintain a healthy separation between DBEs and non-DBEs. Regulations do not provide a brightline between permissible working relationships and impermissible alliances. To avoid slipping into an arrangement that could compromise DBE certification and risk being barred from performing government work, contractors should be fully cognizant of the following "red flag" issues:

  • Sweat Equity Doesn't Count. If a non-DBE facilitates the purchase of the DBE business, the initial capital contributions of the disadvantaged individual must be commensurate with the level of ownership. Because DBE regulations require that the disadvantaged individual must own at least 51 percent of the business, the disadvantaged individual's initial capital contribution will need to exceed that of the non-DBE. Unfortunately, "sweat equity" does not qualify as part of the individual's contribution.
  • Avoid Outside Employment. The disadvantaged individual must be cautious about engaging in outside employment. If the disadvantaged individual continues to be employed outside the DBE business, it presumably compromises the level of control that the individual has over the DBE business.
  • Do Not Share Employees. DBEs should avoid shuttling employees between DBE contractor and prime contractor payrolls. Employees who report to a prime contractor in the morning and a DBE in the afternoon create red flags indicating that the DBE is not maintaining independence from the prime contractor.
  • Do Not Share Equipment. The same caution should be applied to sharing tools, equipment, materials, supplies, and administrative resources. DBEs that "lease" equipment belonging to a contractor are prime targets for investigation. Contractors who have covered up their own equipment markings with magnetic logos of the DBE, which, in fact, did not own it, have been convicted of fraud. DBEs that do lease equipment should lease from an entity in the business of leasing and should have a formal lease agreement. Without a formal lease or real ownership of equipment, DBEs compromise the independence of the companies.
  • Limit Subcontracting Work. When a DBE uses a non-DBE contractor to perform DBE work, the DBE's "commercially useful function" is diminished or extinguished. Contractors may be tempted to participate in such an arrangement. It allows a DBE to bring in a contractor with more resources and experienced people, giving it the ability to perform larger projects than it could otherwise handle. It also provides the prime contractor with greater confidence that the DBE's work will get done. Such a front, however, is absolutely prohibited by the DBE rules.

Gaming the System Has Serious Ramifications

When taking advantage of the DBE system, carefully consider the ramifications that business alliances between DBEs and non-DBEs can present. The temptation to develop strategic alliances may be hard to resist, but without carefully considering the arrangement, contractors expose themselves to civil fines, suspension from eligibility for government contracts, debarment, and even criminal prosecution.

Summer 2012

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