Contractors frequently rely on “shared services” agreements or “interorganizational transfers” with their corporate parents, subsidiaries, and sister companies when performing work for the federal government. These arrangements can offer significant benefits to federal contractors and their customers alike, including easy access to trusted expertise and potentially lower administrative costs. But the Federal Acquisition Regulation (FAR) also recognizes that such agreements may pose risks (such as a lack of competitive pricing) and so imposes important limits on how these agreements can be structured and when their costs can be passed on to the government.
A recent court case involving the Federal Bureau of Investigation’s (FBI) allegations of a “Secret Agreement” related to several companies underscores the importance of ensuring that agreements with corporate affiliates adhere to relevant compliance and billing standards.
What is the case about?
The FBI alleged that five individuals “entered into a ‘Secret Agreement’ in February 2011, providing that each would equally own 20% of” a group of companies, and then “allegedly went on to defraud the United States of hundreds of thousands of dollars from 2011 through 2019 by artificially creating and inflating reimbursable ‘costs’ throughout federally-funded transportation contracts that the Michigan Department of [Transportation] (MDOT) awarded to” one of the companies, which represented itself as a Disadvantaged Business Enterprise (DBE) under the U.S. Department of Transportation’s (DOT) DBE Program. See United States of America v. Jeffrey Bartlett, et al., No. 1:23-cr-20676, 2024 WL 4533554, at *1 (E.D. Mich. Oct. 21, 2024).
The Court summarized the FBI’s allegations as follows:
Defendants’ alleged fraudulent conduct is best considered in three parts. First, on the front end, the Government alleges Defendants conspired to fraudulently obtain and maintain [the company’s] certification as a Disadvantaged Business Enterprise to obtain preferential status when bidding on transportation contracts with MDOT … Second, once awarded a contract, the Government alleges Defendants fraudulently misrepresented [the company’s] overhead and labor costs to artificially inflate MDOT’s reimbursement … Third, on the back end, the Government alleges Defendants orchestrated a scheme to split all ill-gotten gains equally at the end of each fiscal year for each Defendant’s personal benefit.
Id. (footnote omitted).
How does the case relate to compliance and billing requirements for interorganizational agreements?
One of the FBI’s allegations was that the defendants inflated the indirect costs that the company billed to MDOT (and which were passed along to DOT) by failing to observe the FAR’s requirements for interorganizational agreements. See id. at *4-7. Specifically, the Court summarized that:
Generally, contractors may include rental costs in purported overhead expenses, subject to reimbursement. See 48 C.F.R. § 31.205-36. But, critical to the Government’s case, if the contractor rents real or personal property from a commonly-controlled entity, federal regulations prohibit the contractor from seeking full reimbursement. Instead, contractors renting from commonly controlled entities can only include—as part of their reimbursable overhead rate—the normal costs of ownership, such as “depreciation, taxes . . . and maintenance” for the specific piece of rented property. 48 C.F.R. § 31.205–36(b)(3)[.]
Id. at *4 (emphasis omitted). Based on this FAR Cost Principle, the FBI alleged that the company had overbilled the government for “rented surveying equipment,” “company cars,” and “office space” from its allegedly affiliated companies. See id. at *5-6. In the FBI’s view, the company should have billed the government only for depreciation and similar costs associated with owning the equipment and facilities, rather than the full rental payments the company made to its alleged affiliates. Id. at *4.
The Court’s decision concerned only the defendants’ motions to suppress evidence due to alleged violations of the U.S. Constitution’s Fourth Amendment protections from illegal searches and seizure. See id. at *11-20. Although the Court denied the motions, it did not address the merits of the FBI’s allegations related to FAR 31.205-36(b)(3). See id. Nevertheless, the FBI investigation and the United States’ subsequent case against the defendants are a reminder of the importance of the unique issues that arise when a contractor does business with its corporate affiliates.
What are some of the primary compliance considerations when a federal contractor sets up a shared services agreement with one of its affiliates?
As this case highlights, the Cost Principle at FAR 31.205-36(b)(3) is an important consideration when entering into an agreement for rental services from an affiliated entity. The default rule under that provision is that full rental payment from the contractor to its affiliate cannot be passed on to the government (only the normal cost of ownership, such as depreciation, may be billed), with an important exception. “Rental cost of personal property leased from any division, subsidiary, or affiliate of the contractor under common control, that has an established practice of leasing the same or similar property to unaffiliated lessees” is allowable, provided that it meets the requirements for rental costs in Subsection (b)(1) of the provision. See FAR 31.205-36(b)(3) (emphasis added).
Another key Cost Principle (which was not cited in the case) is FAR 31.205-26, governing material costs. Subsection (e) of that provision states:
Allowance for all materials, supplies and services that are sold or transferred between any divisions, subdivisions, subsidiaries, or affiliates of the contractor under a common control shall be on the basis of cost incurred in accordance with this subpart. However, allowance may be at price when—
(1) It is the established practice of the transferring organization to price interorganizational transfers at other than cost for commercial work of the contractor or any division, subsidiary or affiliate of the contractor under a common control; and
(2) The item being transferred qualifies for an exception under 15.403-1(b) and the contracting officer has not determined the price to be unreasonable.
FAR 31.205-26(e). In practice, this Cost Principle often means that only the actual cost of services or supplies from an affiliate (as opposed to the price paid to the affiliate, which would include profit) may be passed on to the government. The exception that permits billing at price may not apply because, for example, the affiliates’ services or supplies are not “commercial” in nature, or because they were not provided on the basis of adequate price competition, under FAR 15.403-1(b).
Note that multiple other Cost Principles address expenses related to corporate affiliates as well. Section 6-314 of the Defense Contract Audit Agency’s (DCAA) Contract Audit Manual (CAM) contains guidance related to “Inter-Organizational Transfers,” including FAR 31.205-26(e).
Can a corporate affiliate participate in a competition for award of a federal subcontract with unaffiliated companies?
Given that billing interorganizational transfers at cost may be permissible under FAR 52.205-26(e) when the affiliate was awarded the work on the basis of adequate price competition, a prime contractor may wonder whether it can permit its own affiliate to compete for award of an anticipated federal subcontract with other independent firms.
The answer is generally yes, but with some qualifications. See, e.g., U.S. ex rel. Howard v. Lockheed Martin Corp., 14 F. Supp. 3d 982, 1006 n.15 (S.D. Ohio 2014) (“FAR 44.202–2 states that ‘careful and thorough consideration’ must be given when ‘[c]lose working relationships or ownership affiliations between the prime contractor and subcontractor may preclude free competition,’ but it does not bar such conduct.”); General Dynamics Corp., Elec. Boat Div., ASBCA No. 23977, 84-1 BCA ¶ 17,027 (finding that subcontracts awarded by prime to its corporate affiliate following competition with unaffiliated offerors “were based upon adequate price competition in this instance”), order clarified by ASBCA No. 23977, 84-2 BCA ¶ 17,294.
Because of the potential for favoritism or other unfair competitive advantages, the prime contractor must take precautions to ensure that the competition is fair and provides the government the best value. As the DCAA has advised:
When auditors determine that a division affiliated with the prime contractor is proposing to perform subcontract effort or interdivisional transfer effort and there are unaffiliated companies in competition to perform as a subcontractor, notify the contracting officer. Because of the potential for bias, the contracting officer should ask offerors to submit a plan explaining how they will ensure that the competition will be conducted fairly and result in the best value for DoD. The Government is not expected to act as a surrogate source selection official or to approve the selection of a particular source.
CAM § 9-104.1.e (Apr. 2024) (emphasis added). Issues to consider and address may include:
- Erecting firewalls to ensure that the affiliated entity does not have unfair access to competitively useful information as compared with other unaffiliated offerors
- Ensuring solicitation terms do not unfairly favor the corporate affiliate
- Documentation of market research and publicization efforts showing that the competitive field is robust
- A methodology for determining that the affiliated subcontractor’s pricing (when not billed at actual cost) is fair and reasonable and
- Checks and balances that add higher-level decision making and oversight to the source selection
Conclusions
Corporate affiliates can offer federal contractors streamlined access to known personnel, capabilities, and products. But federal regulations require careful consideration before entering into and billing the government for such arrangements. While the guiding principle is ensuring the government receives the best value, familiarity with the relevant compliance and billing standards is essential.
* Chris Griesedieck is counsel in the Government Contracts Practice Group. Patrick J. (PJ) Brogan is a law clerk in the Energy and Government Contracts Practice Groups and contributed to this article.
