The U.S. regularly spends $500 billion each year on federal contracts, much of it going to small businesses, and it’s easy to see with such large sums of money why fraud is common. Unfortunately, the government is taking a major step in transferring some responsibility for discovering fraud to sureties, and that could end up hurting the small businesses that the government is trying to help.

Williams

In 2014, federal prosecutors brought a lawsuit against two federal contractors initiated by whistleblower Andrew Scollick, who worked as a jobsite supervisor. They accused the company owners of fraud related to their eligibility for work under SBA programs. The complaint alleges that the company owners fraudulently obtained HUB Zone, 8(a) and disabled veteran status. The allegation is common in False Claim Act lawsuits.

What is different about this case in federal court in Washington, D.C., called United States ex rel. Scollick v. Narula, is that the U.S. attorney and whistleblower also named as defendants the sureties  and the surety bond producers. The plaintiffs claim that the bonding defendants knew or should have known through the underwriting process that the contractor had created a shell company that wasn’t actually owned or controlled by a disabled veteran. Treble damages may be required under the False Claims Act.

In March, the judge in the Narula case noted that the parties had paused the long litigation, dating from 2014, to conduct mediation.

The Narula case brings into question who is responsible for verifying the accuracy of information contractors provide to SBA to qualify for set-asides. Common sense would dictate that the entity giving the certification should also be the entity regulating those certifications. If the government will not be responsible for the liability of certifying set-aside contractors, why have the certification in the first place? The Narula case is also problematic because the government appears to be passing this certification responsibility to the bond company and broker. This is an expansion of risk and a heavy burden for both bond underwriters and brokers.

The lasting impact of the case has yet to be determined as the mediation that was supposed to start in March was postponed by the coronavirus pandemic. However, the consequences are already being felt. I’ve talked to many of the country’s top bond companies, and many have completely stopped writing bonds for set-aside contractors. Those that remain are doing so very cautiously and in a limited capacity. One underwriter indicated that the potential risk is not worth the reward for smaller accounts.

Limiting the Pool of Sureties

This should set off alarms at the SBA and federal contracting level. Contractors awarded federal work under set-aside programs may also find themselves limited with respect to the pool of brokers willing to help them. We don’t know what the Narula case brokers knew, but the case has created a dangerous precedent by potentially imposing liability if a contractor misrepresents itself. Even the underwriting process is no guarantee against fraud.

A construction attorney has told me this is a “gray area” and asked why a broker would take on this risk. Most professional brokers are ethical people who want to help contractors and do the right thing. This includes educating and helping set-aside contractors so that they can grow and graduate from these programs. Although the Narula case remains unresolved, a possible consequence is that it may steer small and disadvantaged contractors to brokers ignorant of the law or too unethical to care.

Government fraud needs to be eliminated to help legitimate contractors take advantage of set-aside programs. But surety is a three-party agreement under which a surety indemnifies the bondholder if a contractor defaults on a project or fails to pay suppliers. The bonds were never designed to be insurance against fraud. They serve as a valuable public resource by protecting payment rights of contractors and suppliers, too.

The best choice to eliminate fraud is not to force the responsibility onto bond companies or brokers. The burden should be with the agencies that certify contractors, and they should enforce their own programs. If they shift that burden to sureties and brokers, it will be the small and disadvantaged contractors that suffer as a result.

If you have an idea for a column, please contact Viewpoint Editor Richard Korman at kormanr@enr.com.