Government Contracts — Holding Contractors Accountable for the Supply Chain

Federal agencies are increasingly interested in the sourcing of contractors' goods. As a result, contractors are seeing scrutiny of their supply chains under existing regulations—and they can expect more in the coming year as new rules take hold.

Lorraine Campos, Dan Forman, and Peter Eyre.

In general, federal regulations put the burden of compliance on prime contractors, making them responsible for the actions of their suppliers and subcontractors. That can create problems under, among other things, the Trade Agreements Act of 1979 (TAA). The TAA requires that products sold to the U.S. government be manufactured in the U.S. or a country that has favored trade status with the U.S. And that can lead to complications in an era of global business.

"Many companies have moved manufacturing offshore, often to countries that are not designated countries under the TAA," says Lorraine Campos, a partner in Crowell & Moring's Government Contracts Group. In the pharmaceutical industry, for example, key ingredients are often made in India and China. "The Food and Drug Administration (FDA) certifies manufacturing operations in those countries, but there is confusion on the part of manufacturers when those FDA-approved drugs cannot be sold to the U.S. government because of the country where they were manufactured."

Today, contractors are coming under increased scrutiny for TAA compliance—in part because whistleblowers have a strong financial incentive to report violations and initiate qui tam lawsuits under the False Claims Act (FCA). Government agencies have been investigating potential violations with more frequency, and the Department of Justice (DOJ) is increasing its use of the FCA as a TAA enforcement tool. In April 2015, for example, medical device company Medtronic agreed to pay the federal government $4.41 million to resolve allegations that it violated the FCA by making false statements about the country of origin for products it sold to government agencies. The devices were actually made in China and Malaysia, which are prohibited countries under the TAA.

"We're seeing the government really taking an interest in where the products it buys are coming from," says Campos. Agencies are showing an increased interest in the quality of goods as well. For example, contractors now need to comply with the Department of Defense's (DOD) counterfeit electronic parts rule. The rule was released in 2014, and the Defense Contract Management Agency, which oversees implementation, provided guidance in July 2015. Under the rule, contractors need to implement systems to detect counterfeit electronic parts, and these systems will be reviewed in government audits of contractor purchasing systems. If a contractor does not have an acceptable system, its purchasing system may be disapproved and payments may be withheld by the DOD. If counterfeit parts make their way to the DOD, they may be rejected, with the cost of any repair or corrective action to be picked up by the contractor.

Similarly, contractors need to keep an eye on proposed changes to the Federal Acquisition Regulation that would require more extensive reporting of suspected counterfeit or defective parts. Under these changes, contractors would have to report such parts to a central database—the Government- Industry Data Exchange Program—and check that database before purchasing parts from suppliers. The rule, which is expected to be finalized in 2016, would go further than the DOD's rule and include all parts, not just electronic components.

Complying with this growing range of regulations will require changes to contractors' practices and capabilities. "In a very real sense, you're only as compliant as your supply chain," says Peter Eyre, a partner in Crowell & Moring's Government Contracts Group. "But in order to comply, you have to have visibility far down the supply chain to some very small, minor subassemblies and components. So it's imperative to understand where your products are coming from if you are planning on selling to the government."

What's more, some agencies have started to push for action beyond the written regulations. "They're taking an aggressive position, with the expectation that contractors will actively monitor their subcontractors for compliance, not just have them certify that they are in compliance," says Dan Forman, a partner at Crowell & Moring and co-chair of the firm's Government Contracts Group. "That is raising new questions about the role that prime contractors will play in overseeing their suppliers."

These trends will present challenges and create risks ranging from fines to suspension and debarment—and unwanted publicity. The changing landscape offers opportunity as well. "Like contractors, federal agencies often struggle to keep track of changing regulations and requirements. They see value in companies that keep up to speed on these things," Eyre says. "The companies that understand these regulations—and not only know the rules but also know how to best demonstrate compliance—will have a competitive advantage in working with the federal government."

Executive Orders Drive Regulation

Government contractors have had to contend with more and more regulations in recent years, and a number of those regulations stem from presidential executive orders. In 2015, for example, the White House issued the "fair pay and safe workplace" order in May and an order expanding paid sick leave in September. "Since taking office, the president has issued 13 executive orders that pertain specifically to government contractors, and these have resulted in at least 16 new regulations," says Campos.

In August 2015, a group of trade associations sent a letter to the White House citing the burden that these executive orders are putting on contractors. The letter noted that "the net effect has been to significantly increase the costs of doing business with the government…. Some estimate that nearly 30 cents of every contract dollar goes toward compliance with unique government regulations."

There may well be more of these orders on the horizon, says Campos: "As the president goes through his last year in office, it is likely that the executive branch will continue to take action to implement its policies through these kinds of executive orders."

State Contracting: A Growing Challenge

With federal agency budgets flat and somewhat uncertain over the past few years, a number of large federal contractors have turned to the state-government market to find more business. And there, many are encountering new challenges on the regulatory front.

State contractor regulation is typically not as formalized or comprehensive as federal regulation—and often, not as clear. "The rules are different from state to state, and sometimes there aren't many rules," says Forman. "In general, the states are afforded a greater degree of discretion than federal agencies when it comes to dealing with contractors."

Recently, Forman adds, some state governments have been exercising that discretion in more aggressive ways. "We've seen states using termination for cause as a lever to achieve what they can't achieve through bilateral contractual negotiations," he explains. "We are also seeing states becoming less patient with delays in contract performance, even where the state itself bears some culpability and is more likely to terminate for default. We've also seen states threatening contractors with debarment to get them to accept the terminations for default." That is especially troubling, he adds, because "state debarment will trigger the need for a federal responsibility certification, impacting the contractor's federal business—and even its commercial business."

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