Risk & Compliance

War Dance: Will SEC Go Light on DOD Contractors?

The increasing importance of the military supply chain has some wondering if defense contractors will get an easier ride from the Securities and Ex...
Craig SchneiderApril 7, 2003

It’s been a long time — 18 years, to be exact — since the CFO at a high-profile defense contractor resigned because of a dog. But Peter Stockton remembers it like it was yesterday.

In the spring of 1985, Stockton, then chief investigator for the House Energy Commerce Committee’s subcommittee on oversight and investigation, was in the middle of a $2 billion fraud case against General Dynamics for cost overruns on the 688 attack submarine. The evidence was mounting: Stockton says audiotapes had the company’s CEO and chairman talking about stock manipulation and “how he was going to screw the Navy.” The Securities and Exchange Commission also subpoenaed 45 boxes’ worth of records from General Dynamics.

But it was the subcommittee’s subpoena of one overhead claims voucher that started a firestorm of controversy and ultimately forced out the company’s CFO and CEO. The voucher showed that a vice president at General Dynamics had boarded his dog at a kennel when the executive flew off to a board meeting — and then charged the expense to the U.S. government. Recalls Stockton: “There was just an outcry over that [overhead abuse] issue.”

These days, with U.S. troops slugging it out in Iraq, there’s scant attention given to the accounting practices of DOD contractors. In fact, the only question being asked of munitions makers right now is whether their products work as advertised.

Even then, the U.S. government doesn’t appear overly eager to shine a light on black-box projects. In late February, for example, a judge tossed out a seven-year-old suit against TRW alleging that the defense contractor falsified 1996 test results of its antimissile defense system. The reason for the dismissal? Reportedly, government attorneys argued that documents requested by TRW for its defense could jeopardize national security.

The veil of secrecy that shrouds many black-box projects appears to extend to the accounting for some of those projects as well. A number of government agencies oversee the bookkeeping on defense projects. But in an audit of spending for fiscal year 2000, the Pentagon’s Inspector General’s Office found $1.1 trillion in bookkeeping entries that could not be tracked or justified.

Moreover, it’s nearly impossible to determine how much information defense oversight agencies share with the Securities and Exchange Commission, the regulatory body charged with vouchsafing the accounting of publicly traded companies. And given the heightened role of defense contractors in President Bush’s war on terrorism — and the growing importance of the military-supply chain in the ongoing struggle in Iraq — some critics wonder if the SEC would have the temerity to launch a rear-guard assault on a Department of Defense contractor.

Dina Rasor is one of those asking that question. Rasor, head of the military reform project of the National Whistleblower Center, doubts that the SEC will investigate DOD contractors while shots are being fired in the Middle East. “Right now,” she says, “it’s probably hard for the SEC to go after defense contactors because we’re on a war footing.”

Since September 11, 2001, the commission has filed one civil suit against defense contractors. The lawsuit, against Patriot Missile-maker Raytheon, alleged that Raytheon CFO Frank Caine had violated Regulation Fair Disclosure. In January, Raytheon management indicated that the commission had launched an informal investigation regarding accounting practices and revenue recognition at the company’s Raytheon Aircraft subsidiary — a non-DOD business. In announcing the probe, Raytheon management asserted that it believes the company’s accounting practices are appropriate.

So far, nothing has come of the informal Raytheon investigation. Given the war in Iraq, Stockton’s not sure anything will. “You really don’t want to take on a contractor in the midst of [a war],” asserts Stockton, who now serves as senior investigator at the non-profit Project On Government Oversight (POGO). “I think it raises the patriotism flag.”

There’s No Accounting for Waste

Of course, an SEC investigation can show that a company’s done nothing wrong — and right now, that’s the assumption in the Raytheon probe. As of press time, the company had not received a Wells notice, or any other indication that the SEC might be looking to ratchet up its investigation.

The odds are good there won’t be any ratcheting up, either. Historically, the SEC has not been particularly aggressive in going after defense contractors. Take the General Dynamics case. Two years after the Congressional hearings on the company closed, Stockton went to the SEC’s offices to look at the 45 boxes of documents the commission had subpoenaed from the defense manufacturer. What he found shocked him. “When we went down to the SEC to look at the files,” Stockton recounts, “they hadn’t even opened their boxes.”

This seeming lack of interest in defense contractor cases appears to be rule at the SEC, rather than the exception. A search of the SEC database reveals that, since 1999, the SEC has filed only three complaints against military suppliers: the Raytheon Reg FD case and complaints against two minor defense contractors.

To some, those statistics are surprising. Certainly, the Department of Justice has lodged scores of complaints and suits against defense contractors. And Stanley Soya, partner with Morrison & Foerster and former attorney for the Department of Defense’s Office of the Inspector General, says bookkeeping is often a key element in DOD fraud cases.

“If you look at the kinds of problems that give rise to potential False Claims Act liability or potential False Statements Act liability,” Soya says, “what you see is that the nature of that activity is in many instances the result of fraudulent accounting practices and problems with internal control systems.”

But some SEC-watchers point out that the commission’s well-documented lack of funds and manpower often leaves the agency with little choice but to focus on high-profile, winnable cases. Marion Koenigs, senior manager at Ten Eyck Associates and seven-year veteran of the SEC enforcement division, notes that the commission must prioritize investigations, particularly given the workload triggered by the passage of the Sarbanes-Oxley Act in 2002. The SEC staff, she points out, attempts to suss out if there is an egregious violation, or if an informant has them on “a wild goose chase.”

Making that assessment could be tougher in a DOD-related case, given the sensitive nature of many defense projects. It’s also unclear if the commission has the resources to successfully decipher the bookkeeping on black-box projects — or what kind of information they could get from targeted companies. “If they encountered problems getting documents under subpoena,” Koenigs hypothesizes, “it would certainly slow up the case and might make it be less of a priority.”

Backing off entirely, however, would probably depend a lot on “how the staff felt about the strength of the allegations,” Koenigs says.

Five Days Off

But Gary Goodenow, a former Miami SEC staff member in the division of enforcement for six years, offers a different explanation for the apparent lack of commission action against defense contractors.

“The penalties for ripping off Uncle Sam are so draconian that an SEC inquiry pales into relative insignificance,” notes Goodenow, who as senior counsel made the final recommendations on which cases the office would investigate. “If the possible fraud somehow touched their dealings with the DOD, and not just the market, then the SEC left the matter to the criminal enforcement experts.”

Even then, defense contractors seem to get off relatively easy. According to a POGO study of 43 top federal contractors (mostly defense contractors), 16 of the companies have been convicted of a total of 28 criminal violations over the past dozen years. Mostly, the federal investigations have centered on procurement fraud.

General Electric, for example, is believed to have committed 63 violations and alleged violations during that time period and paid nearly $1 billion in fees, settlements, and restitution for the alleged abuses. During the same stretch of time, Lockheed Martin, Boeing, Raytheon, and Fluor, reportedly paid about $789 million to cover a total of 142 violations and alleged violations against the government.

While $1.8 billion over twelve years is not exactly small potatoes, it pales in comparison to the amount of money defense contractors pulled in from government contracts during that time. “[The fines] meted out are a pittance,” says Tony Tinker, accounting professor at Baruch College, “especially the cases with accounting fraud, double billing, or misuse of overhead charges.

In fact, some critics charge that the restitution charges are essentially the cost of doing business in the defense industry. And despite the numerous charges levied against DOD suppliers in the Nineties, only one contractor was suspended or barred from doing business with the government.

In 1992, GE was suspended from receiving government contracts — for five days.

Stockton believes the lack of contractor debarment and suspension during the Nineties had a knock-on effect at the SEC. After watching scores of defense contractors come under fire — and then watching the same contractors escape debarment or suspension — he claims the SEC enforcement division staff became discouraged.

“They generally didn’t believe that the Justice Department would take action against defense contractors,” Stockton claims, “so it wasn’t their favorite issue to be assigned to.”

Plenty of Grief

SEC spokesman John Heine, however, is quick to dismiss claims that the commission’s enforcement staff plays favorites or can be pressured. Says Heine: “We bring actions against parties who violate securities laws regardless of who they are and what business they’re in.”

But others aren’t so sure the SEC is above it all. Tinker of Baruch College notes that Congress is charged with overseeing the SEC — a role that includes approving the commission’s commissioners. “[The SEC is] set up in a way that they can be compromised and open to pressure,” Tinker argues.

And Steven Artuso, an analyst at Pittsburg Research, points out that the SEC was late launching investigations into high-profile accounting scandals at Enron and Worldcom — and isn’t likely to be ahead of the pack when it comes to DOD-related investigations. “You can’t exactly expect the SEC to be on the ball with Defense,” he argues, “especially when you consider there are links between the companies and other government agencies.”

Some Washington watchers say some defense contractors also have close ties to Capitol Hill. If a government agency goes after a big defense contractor, claims Rasor, “you get a lot of grief, from members of Congress, lobbyists.”

Consider the political forces that Stockton says almost shut down his investigation of General Dynamics. On many of the subpoenaed overhead vouchers, he recalls, the subcommittee found evidence of several senior members of Congress having “two-thirds of their social life paid for by defense contractors: going to the Kennedy Center, playing golf, lavish trips.”

What’s more, defense contractors tend to be major employers in a number of Congressional districts. The SEC is not likely to make many friends on Capitol Hill by investigating a large defense contractor at a time when companies in other sectors are laying off workers and shuttering factories.

A Higher Standard?

Still, some insiders insist the commission would not shy away from investigating defense contractors. “I don’t think the SEC is precluded in any way from doing anything with a government contractor,” asserts Gary Illiano, regional director of professional standards for Grant Thornton and former staff member of the New York office of the SEC enforcement division for four years. “They would conduct the investigation in their usual fashion.”

Other observers argue that defense contractors answer to a higher standard than securities law. They point out that a slew of government agencies — including the Defense Contract Audit Agency, the Inspector General, and the General Accounting Office — regularly monitor the bookkeeping of defense contractors.

Penalties for sham transactions can be substantial, too. “The accounting and fraud provisions are much tougher under laws other than those over which the SEC has authority,” says Marshall Doke, a government contracts attorney at law firm Gardere Wynne Sewell.

But critics say laws governing the bookkeeping of defense contractors are hardly effective. As proof, they point to the lack of suspensions and debarments. “There are plenty of regulations against defense contractors,” grants Tinker. “But they don’t really serve as much of a deterrent.”

Certainly, accounting in the military industrial complex would never pass muster for a Fortune 500 company. In his confirmation hearings two years ago, Secretary of Defense Donald Rumsfeld conceded he had concerns about the bookkeeping for military projects, calling the problem “monumental.”

Rumsfeld and those inside the military have set out a plan to improve the Pentagon’s internal control systems. The goal? “They’re trying to get to a clean audit just like corporations are supposed to do,” notes Rasor.

Then again, finance departments at corporations generally have an idea where their payables go. According to Rasor, the Department of Defense still “can’t find one out of every four dollars they try to get.”

With U.S. Marines now fighting on the streets of Baghdad, however, it seems unlikely that an overworked and understaffed SEC will step into the breach.