Pentagon hunting for other instances of price gouging in wake of damning spare parts audit

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The Defense Department said it is implementing a series of steps meant to detect and deter price gauging by its contractors, responding, in part, to an investigation that found one of its largest spare parts suppliers routinely overcharged the military, often by four-digit margins.

For starters, DoD has ordered the top officials within each of its contracting organizations to report to the Pentagon whenever vendors decline to provide cost and pricing information when asked. A group of Defense pricing experts will then review those reports to  help  identify companies who routinely refuse to cooperate with those requests.

Meanwhile, for “high priority” parts, the Defense Contract Management Agency will conduct its own analyses to help determine what those items “should cost.”

Kevin Fahey, DoD, Defense Department
Kevin Fahey, the assistant secretary of Defense for acquisition

Kevin Fahey, the assistant secretary of Defense for acquisition, announced the changes during a House hearing Wednesday, during which lawmakers grilled executives from TransDigm Group, the parent company of more than 100 aviation parts suppliers.

In February, the Pentagon’s inspector general found that the company had earned excess profits on all but one contract out of a sample of 47 that auditors had examined. The most extreme case involved a 4,400% markup, but 17 of them included profit margins of 1,000% or more.

In many cases, TransDigm was the sole-source supplier for those parts, and in all but one instance, its representatives refused to supply the company’s cost data to DoD contracting officers to help justify their prices, putting the military in a take-it-or-leave-it situation for critical parts.

“Is what TransDigm is doing illegal? No. Do I consider gouging our taxpayers for excessive costs immoral and unconscionable in the face of getting our warfighters what they need to fight? Yes,” Fahey told the House Oversight and Reform Committee.

The IG recommended that DoD pursue refunds for at least the excess profits it specifically identified in its audit sample: $13.5 million.

TransDigm defends pricing model

But at Wednesday’s hearing, company executives pointedly and repeatedly refused to commit to returning any of the money.

Nicholas Howley, TransDigm founder and executive chairman

“DoD is a good customer and we value the relationship, but we also have other constituencies that we have to think about,” said Nicholas Howley, the company’s founder and executive chairman. “We have private shareholders, we have employees, we have a management, we have commercial customers, and we’re concerned about implying that we’ve done something wrong or something illegal here. The money is not the issue here. We’re trying to balance those sort of conflicting demands to come to a conclusion.”

And Howley defended the company’s “value based” pricing model, which also involves buying up small firms — or the intellectual property for a particular part — when that item is proprietary and highly-valuable to its customers.

He insisted the approach is commonplace, and likened it to the way in which a household products company might initially sell razors at a low price, then earn larger profits through marked-up blade refills over time.

“(The company) pays all the money up front: You pay all your own development, you put your capital in, you pay all your startup costs, and you don’t make a whole lot of money on new equipment production,” he said. ”You recover your investment in the higher prices and margins in the commercial aftermarket. That’s very common.”

The company claimed the IG had failed to consider many of those up-front investments when it made its “excess profit” determinations on each of the contracts.

But Glenn Fine, the acting DoD IG, said that argument is unpersuasive, because his office’s calculations were based entirely on cost data the company itself eventually provided to auditors, who were armed with the threat of subpoenas.

“They gave us the information broken down with labor, materials and overhead, things like marketing and supplies, and we used that information, we examined it, we came up with our numbers, and we provided the reports to them. They did not contest the accuracy of our figures,” Fine said. “The first time we heard about that was last night when we read their testimony. And even if there are some costs that are not captured in the information that they gave to us, I doubt it is going to turn a $43 part into a $4,300 part … most of these parts are way, way above any reasonable profit margin.”

Existing law creates loopholes, IG says

Transdigm reported $3.8 billion in sales in 2018, 35% of which was in its Defense business. Howley earned $61 million in compensation in 2017, his last year as the firm’s chief executive, making him the sixth-highest paid CEO in the country.

Partly on the basis of those numbers, Howley and the current CEO, Kevin Stein, faced bipartisan furor for their refusal to issue voluntary refunds to the government.

“This is the type of thing that just drives me crazy,” said Rep. Mark Meadows (R-N.C.). “I’ll give you some advice: You better pay the money and start giving us the cost data, even though it may not be required by statute. Because I can tell you that once you raise an issue in a bipartisan way like this, it makes us look for other things. There’s going to be enough wrath to go around, so but my encouragement to you is do those two things, chalk it up to marketing expense, and pay the American taxpayer back immediately. You could have paid a few million dollars back and avoided all of this, and instead you’re going to highlight it in a way that you will not find supportive of future business.”

However, auditors have made clear that there is no reason to believe that TransDigm is the only supplier engaged in excessive markups.

They have stressed that a large part of the reason the company was able to demand such high prices is that under current law, contracting officers have no way to demand that companies turn over cost data when an individual contract falls below the dollar threshold set by the Truth in Negotiations Act. And that information, they say, is often the only viable way to determine if the government is getting a fair and reasonable price if the part is being sold by a company that has an effective monopoly.

In 2017, Congress raised the TINA threshold from $750,000 to $2 million. The intent was to reduce the paperwork burden on companies and make it easier for smaller firms to do business with the Defense Department. But it had the added effect of increasing the number of transactions where contracting officers have no ability to insist on cost data.

Fahey said the Transdigm situation put the department in a difficult position. He said his office is now looking for ways to deal with the problem without adding excessive friction to the acquisition bureaucracy.

“We have to deal with companies like Transdigm — it’s a very small percentage of bad actors that results in rules and regulations that bogs down the entire acquisition system and results in overhead and bureaucracy,” he said. “That’s why this gets under my skin. It makes me sick.”

Asked whether he would be making recommendations for legislative changes, Fahey said yes. But he did not want to do so in an open hearing.

“I would support the recommendations of the DoD IG and we want to work with Congress,” he said. “But I’d rather not talk about it in front of Transdigm, because they’ll go out and try to figure out ways to overcome those too.”

Company reps told to ‘avoid disclosing any cost data’

Since the publication of the IG report, the oversight committee has been conducting its own followup investigation.

Members say committee staff have spoken to whistleblowers and examined documents that indicate the company actively tried to shield its actual costs from contracting officers wherever they could.

For example, they alleged the company sought to break large purchases into smaller chunks so that they would fall below the TINA threshold. In fact, in all but one of the contracts the IG examined, each of them did.

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“We were coached on how to structure agreements. It was suggested to us that we use shorter agreements; don’t sign long-term agreements. We were encouraged to use excuses,’” according to an account of a former sales director-turned-whistleblower provided by Rep. Gerry Connolly (D-Va.)

Similarly, a former director of operations told committee staff that Howley himself encouraged company representatives to “Avoid disclosing any cost data … they told us under their breath we should see what we can do to avoid disclosing cost data. We don’t want to talk about cost, we want to talk about price (profit).”

Howley and Stein denied that the company had any such policies, and said they could not recall any conversations along the lines the whistleblowers described.

“We always tell people, ‘Here are the rules when you deal with the government. You have to comply with all the rules and regulations,’” Howley said.

Whatever disdain Pentagon leaders and members of Congress might feel for the company, it is highly unlikely that the government will be able to sever its business ties with Transdigm anytime soon.

The Defense Department had 4,697 contracts with the firm and its subsidiaries over the past five years, worth a total of $635 million. But 28 percent of those contracts — and 43 percent of their value — were for parts that only Transdigm and its subsidiaries manufacture.

“These figures are extremely bothersome,” Fahey said.

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