Whistleblower complaints against federal contractors can help government agencies drive better deals with those companies—even when the allegations turn out to be unsubstantiated, according to new research.
Under the burden of a whistleblower complaint, contractors are usually willing to assume more risk in projects by limiting their use of “cost-plus” agreements, which make it easier to overcharge government agencies, according to researchers. This renegotiation of contractual terms allows the agency to hedge its bet with a suddenly risky contractor while the contractor benefits from an opportunity to work to overcome the whistleblower’s allegations. Government agencies only reduce total contract dollar volume if the allegations are ultimately deemed to have merit.
“I think it’s a surprisingly sophisticated interplay between the people who bring the information to the attention of the government, the different agencies, and ultimately the suppliers,” says Harvard Business School Assistant Professor Jonas Heese, one of the study’s authors.
“What we document, at a very high level, is that while allegations can shake that trust, they usually don’t lead to a breakup.”
Fraud Allegations and Government Contracting, forthcoming in the Journal of Accounting Research, was co-written by Heese and HBS Assistant Professor Gerardo Perez Cavazos.
Empowering whistleblowers
The False Claims Act enables individual whistleblowers to file suit on behalf of the government alleging unethical behavior on the part of government contractors and to keep a portion of any resulting settlement. Boeing, for example, has paid more than $40 million in settlements stemming from False Claim Act cases in the past five years.
A detailed analysis of 296 such lawsuits between 2000 and 2012 revealed that companies accused of defrauding the government—generally through improper billing—often renegotiated the terms of their contracts with government agencies while the charges were being investigated, according to the researchers. In cases where the investigation did not lead to prosecution, the contract relationship reverted to its previous state within about two years.
“At the most global level, we’re trying to understand the contracting relationship between two companies,” explains Perez Cavazos. “The underlying element you need for those relationships to exist is trust… What we document, at a very high level, is that while allegations can shake that trust, they usually don’t lead to a breakup … but eventually both parties need to renegotiate the contract terms.”
Allegations change the dynamics
To better understand the contract dynamics between government agencies and their suppliers, Heese and Perez Cavazos identified False Claim Act cases against publicly listed companies and matched the legal filings with detailed contract specifications. They assessed the contract relationship between the firm and the government entity four years before and four years after the government learned about the allegations.
They found that after a lawsuit was filed, the government changed the terms to shift more of the contract risk to the supplier during the investigation. It did so by increasing the proportion of work the company performed on a fixed-price basis, as opposed to “cost-plus contracts.” In fixed-price contracts, the supplier provides a product or service to the government at a fixed price. In cost-plus contracts, the supplier bills the government based on reported production costs and profit margin, making it prone to manipulation.
“Government agencies reduce the fraction of the cost-plus contracts granted by approximately 14 percent in the eight quarters following the allegation, suggesting that fraud allegations have a significant impact on contract design, but not dollar volume,” write Heese and Perez Cavazos.
For cases that were found to have merit and resulted in settlement, the government reduced the overall contract dollar volume by an “economically significant” 14.7 percent, Heese and Perez Cavazos reveal.
“As long as the government doesn’t know whether the allegations have merit, the federal agencies will try to minimize their risk exposure, shifting cost-plus contracts to fixed-price ones. Companies are willing to accept worse contracting terms in an effort to rebuild trust with the government,” says Perez Cavazos.
To find out whether a company’s political connections might have affected the consequences it suffered from fraud allegations, the researchers documented company expenditures on political campaigns, current or former politicians serving on their boards, and contributions to political action committees. These measures were not found to have a significant effect on the response of the government agencies to the companies accused of defrauding them, according to Heese.
“Maybe it’s easier for political connections to have an effect on receiving a government contract, and there are some studies that show that, but it’s not necessarily clear that political connections protect you if you actually misbehave,” Heese says.
Lessons for managers
The study’s findings can be applied to customer-supplier contractual relationships in general, says Perez Cavazos, providing a lesson for managers about ways to repair the reputational damage caused by accusations of company wrongdoing, even when unfounded.
“Being open to renegotiating contract terms or taking on some of the risk and offering additional protection to your customers can enable you to rebuild that trust and get back to where you were initially.”
Heese also emphasizes a by-product of the research: a spotlight on the effectiveness of the whistleblower program that has existed under the False Claims Act since the Civil War.
“What we’re showing is that this program provides a good way for whistleblowers to bring information to the attention of the government, and that the government is not overreacting to that information. It is essentially hedging its risk and making some temporary changes and then using the information to do a deeper dive into the accusations. Then, only if there is enough merit, does the government make dramatic changes to its contracting volume,” Heese says.
About the Author
Kristen Senz is a writer and social media creator for Harvard Business School Working Knowledge.
[Image: FangXiaNuo]
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