Earnings call
A fun dynamic in government contracting is that people treat things that happen before a contract is awarded (pre-award) and things that happen after a contract is awarded (post-award) as if they are two totally different spheres.
This dynamic shows up in organization structures. In government, there's a practice of having different people serve in different roles (a "procuring contracting officer" for pre-award actions and an "administrative contracting officer" for post-award actions). The pattern also exists outside government, too, where "sales" or "growth" teams are structurally separate from "delivery" or "solutions" teams.
In most situations, there's a mental separation that happens in pre-award and post-award. Once award is made, there's a sort of amnesia about all pre-award actions.[1] And, yes, there are perverse incentives and dropped balls in transition. But things mostly work out just fine and the logical separation between pre-award and post-award holds.
Sometimes, though, when pre-award things go wrong, it can create pressures in the post-award environment!
For example, we've talked about the contractor bearing risks of Service Contract Act compliance. And we've talked about how the government tries to manage some of the post-award risks by using firm-fixed price contracts instead of labor-hour/time-and-materials contracts.
I alluded to another pressure last week when I talked about how busy contractors are. There, I joked that "Contractors are also always so damn busy! They're dealing with multiple unhappy Goldilockses and, for the love of god, they need to hit their numbers this quarter!" Companies place pressure on teams to hit their numbers! And bonuses are at stake!
Usually, we think of the pressure to hit quarterly numbers as a pre-award concern. Sales teams need to go drum up enough business to keep the delivery teams going. Always Be Closing, etc. etc.
But the pressure to hit quarterly numbers is also a post-award concern! People have deliverables and internal budget. Failing to deliver on time and on budget can make everyone unhappy. And, every now and then, that pressure causes bad things to happen. Really bad things.
[F]rom at least in or around 2013 through at least in or around July 2016, Craig Perciavalle, 52, Joseph Runkel, 54, and William Adams, 63, all of Mobile, and their co-conspirators allegedly conspired to mislead Austal Limited’s shareholders and the investing public about Austal USA’s financial condition. Specifically, according to the indictment, the defendants artificially suppressed an accounting metric known as an “estimate at completion” (EAC) in relation to multiple LCS ships that Austal USA was building for the U.S. Navy. Suppressing the EACs allegedly had the effect of falsely overstating Austal Limited’s reported earnings in its public financial statements. The indictment further alleges that the defendants and their co-conspirators manipulated the EAC figures in part by using so-called “program challenges”—ostensibly cost-savings goals, but which in reality were “plug” numbers and fraudulent devices to hide growing costs that should have been incorporated into the company’s financial statements. The defendants allegedly did this to maintain and increase the share price of Austal Limited’s stock. According to the indictment, when the higher costs were eventually disclosed to the market, the stock price was significantly negatively impacted, and Austal Limited wrote down over $100 million in previously wrongly booked profits.
Oh, dear, oh dear, oh dear, oh my, heavens to Betsy.[1]
There's a lot in that paragraph, but the gist is that Austal USA (AUSA)'s executives were responsible for delivering Littoral Combat Ships (LCS) to the US Navy and, post-award, they falsely reported lower costs to shareholders and systematically hid those growing costs.
Now, you may be wondering how I can feel so confident that this criminally indicted behavior started with pressure from quarterly targets?
[O]n or about February 27, 2013, Austal’s former CEO emailed Perciavalle in response to an email informing Austal that AUSA’s EBIT and revenue were less than the budget for the month. Austal’s former CEO scolded Perciavalle about AUSA’s “under budget performance,” urged him to “hit the quarter and year end budget numbers,” and warned him that “investors . . . expect us to keep our promise . . . and will not tolerate under delivery.” Perciavalle responded: “I fully understand the importance in meeting our commitments and will continue to drive toward that end.”
That's coming from the SEC complaint.
Ok. Fine. But, what does this have to do with the pre-award/post-award divide and not just financial engineering gone terribly wrong? Also from the complaint:
AUSA’s initial LCS bid did not sufficiently account for rising costs, change orders, or other issues that contributed to cost overruns. AUSA’s budgeted revenue and EBIT for period to period, however, was based on the LCS bid costs, and so the rising costs of building the LCS meant that AUSA was not meeting its budgeted revenue and EBIT.
***
This was because AUSA’s actual costs to build LCS 6 far exceeded AUSA’s budgeted costs in its Navy bid.
***
For example, AUSA had to purchase over twice the amount of aluminum sheets for each LCS ship than initially budgeted because it underestimated the amount aluminum sheets each LCS ship would require.
***
AUSA’s labor costs were also higher than the labor bid costs and were rising with each LCS ship. For example, it was difficult to find welders with experience welding aluminum, so instead of hiring welders who could immediately start doing the job necessary to complete the ships, AUSA spent labor hours teaching those workers aluminum welding. Also, AUSA struggled to hire and retain the skilled labor needed to build the ships.
Look. The cost pressures and challenges with the LCS program have been well documented and existed before the defendants got involved and persist to the present day, so it's maybe unsurprising that the costs were rising. But rising costs meant lower earnings, and lower earnings meant under-delivery, and under-delivery would have meant executives getting the axe.
Yeesh.
So, what lessons can be drawn from all of this? Here's one.
An interesting (?!) fact in all of this is that, although AUSA hid the rising costs from its auditor and shareholders, it did not hide the rising costs from the Navy. According to the SEC complaint:
AUSA sent the Navy monthly [Contract Performance Reports], which included the Navy EACs. These Navy EACs reflected higher LCS EACs than the EACs that AUSA used to calculate its revenue and EBIT. Among other things, these CPRs supported AUSA’s costs, progress, and timing of building the LCS ships. Thus, AUSA had an incentive to report more accurate EACs to the Navy in order to explain any delays in completion and to justify any attempt to obtain payments from the Navy in excess of the contract amount."[2]
I cannot stress enough that this is definitely not legal advice and I am not your lawyer! But it is probably important to make sure that if you're going to report one number to the Navy, to also use that same number with your auditors and shareholders.
Another lesson—certainly a less extreme one—might be that leadership of government contractors should pay attention to the incentives and goals for both pre-award and post-award activities!
It's easy to assume that once you're over the hurdle of a contract award (and protest, I guess), all pre-award sins are forgiven. But that assumption, as this case demonstrates, can be very wrong.
[1] Yes, I'm quoting Rabbit from Winnie the Pooh.
[2] After I read this, I started having a moral crisis around the question of "[d]id having a cost-type contract actually lead to greater corporate transparency? If so, what lessons can we draw from that?!" At the moment, I haven't thought about it enough to have something actually intelligent to say about it.