Enhanced Due Diligence to Reduce Counterparty Risk

A Powerful Government Contracting Tool to

Reduce Procurement Risks

Enhanced Due Diligence to Reduce Counterparty Risk

Breakout Session #: C12

Presented by: Steven Cady & Nicole Ferenzy

Date: July 23, 2018

Time: 3:30 – 4:45 pm

What Should You Learn Today?

Why enhanced due diligence of counterparties is important

and still necessary despite economic improvements

Financial and non-financial factors that contracting officers

should evaluate to assess a counterparty’s business risk and

viability

Risk mitigation strategies available to contracting officers

to reduce counterparty risk

TODAY’S ECONOMIC

ENVIRONMENT

It has been more than a decade since the start of the Great Recession

and the American economy has recovered in many ways.

3 New York Times, “Cash-Rich Companies Set Record for

Buybacks” May 18, 20184 CNN Money, “The U.S. Economy Just Hit a Milestone” May 1,

2018

1

1 CNN Money, “Corporate America’s Big, Fat Profitable Year”

December 22, 20172 Ibid

Corporate profits just

experienced their largest

increase in five years 1

Unemployment is at a 17-

year low and consumer

confidence is booming 2

Corporate buybacks hit

record in Q1 2018 3

Recent recovery is second-longest economic growth in American history 4

However, many companies and industries are still struggling to

recover and adapt to the new marketplace.

7 CEPR, “Decline of Blue-Collar Jobs, In Graphs” February 22, 20178 The Hill, “Coal industry mired in decline despite Trump pledges”

March 4, 20189 Oil Price.com, “US Oil, Gas Industry Sees 26% Decline in

Employment” August 5, 2016

5 The Washington Post, “More Retailers than ever are going bankrupt” April

16, 20186 CNN Money, “U.S. has lost 5 million manufacturing jobs since 2000” March

29, 2016

5

Retailers going

bankrupt at record pace

More than 5 million

manufacturing jobs have

disappeared since 20006

8The coal industry is in perpetual decline

Blue collar jobs are vanishing 7

Jobs decreased over

26% in the oil and gas

industry9

The divide between the “haves” and the “have-nots” continues to

widen. Cash is more concentrated than ever, with the top 1% of

corporations now controlling over half of the cash in America.

10 S&P Global, “U.S. Corporate Cash Reaches $1.9 Trillion, But Rising Debt

And Tax Reform Pose Risk” May 25, 201711 Ibid

53%Amount of cash in Corporate America (>$1

trillion) controlled by the top 25 corporations,

nearly twice the $510 billion (38%) that they

held just five years ago.10

$6TAmount of debt held by the remaining 99% of

companies against just $920 billion of cash.11

WHY DOES DUE

DILIGENCE MATTER?

Data shows that direct and guaranteed loan delinquency rates are

significantly higher in the Federal government compared to the

commercial market.

12 The FY 2016 U.S. Department of the Treasury Report on Receivables and Debt

Collection Activities (TROR) 13 Board of Governor of the Federal Reserve System – FY 2016

12 13

As an example of diverging trends, while total business bankruptcy

filings are decreasing, DoD contractor bankruptcy filings are

increasing.

-

10,000

20,000

30,000

40,000

50,000

60,000

70,000

-

50

100

150

200

250

300

350

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Total DoD Filings Total Business Filings

14 Defense Finance and Accounting Service (DFAS) – Contractor Bankruptcies15 American Bankruptcy Institute – Bankruptcy Statistics

Chart created by Deloitte with the data from these sources.

1514

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Failed counterparty relationships can result in operational, strategic,

and reputational costs and can negatively affect the government’s

ability to effectively meet its mission.

16 The Hill, August 26, 201517 The Hill, November 22, 2013

18 Guwahati Plus, March 27, 2018

19 New York Times, February 6, 2018

…lied to get loan guarantee…16

…loses $139M in loan default…17

…Contractor bankruptcy

delaying project by a year…

18

…Contractor fails to deliver required supplies…

19

External factors, such as a government shutdown, are outside of a

vendor’s control, and can impact a vendor’s ability to stay viable.

Knowing whether vendors can withstand major events is critical.

Source: Nextgov.com20 Faro & Crowder PA

Delayed Government Payments - Invoices that are several months old

can remain outstanding during a government shutdown, creating cash

shortfalls.

Lack of Contingency Reserves – Contractors must have adequate

reserves to bridge cash shortages and to pay the added costs incurred

due to a shutdown.

Poor Strategic Plans – Contractors must have mitigation strategies to

deal with impacts to schedules, costs, and employees.

Following the 2013 government shutdown, a car-charger manufacturer with a

large government contract filed for bankruptcy due to its difficulty in obtaining

financing to continue operations.20

Case study: The bankruptcy of a large government supplier resulted

in legal fees and the need to quickly evaluate new suppliers to

reduce disruptions to the supply chain.21

Situation

• The vendor filed for bankruptcy in 201422

• It sold its assets in bankruptcy, including its government contracts

Red Flags

• The vendor faced a severe liquidity crisis in the wake of declining

performance and government investigations into one of its

subsidiaries

Result

• The agency risked a significant disruption to its supply chain and

needed to quickly vet new suppliers in order to meet the ongoing

demand for critical goods

• Increased legal fees

21 Chapter11Dockets.com22 United States Bankruptcy Court For the District of Delaware

Case study: A government agency awarded a contract worth over

$150 million to a one-person company that delivered a fraction of

the contracted goods.23

Situation

• Vendor awarded a contract worth over $150 million

• Vendor produced < 1% of the critical goods

• Contract terminated 20 days after award due to late delivery

Red Flags

Result

• Critical goods not provided

• Widespread criticism

• Investigations into agency’s contracting practices

• Vendor had a history of problems with government contracts

under $100,000

• Vendor had been barred from government work until 2019

23 New York Times, February 6, 2018

Case study: A government agency’s proactive actions prevented the

disruption of operations and protected its users’ data when the

contractor managing its critical systems went bankrupt.

Situation

• The contractor filed for bankruptcy in 201324

• The government agency bought the contractor’s systems to

prevent disruptions and to protect users’ data

Red Flags

• Inspector General raised concerns about the contractor’s financial

instability

• FBI investigation exposed violations on contracts

Result

• The agency’s monitoring of the vendor allowed it to take

proactive steps to limit risk, such as using an existing federal

shared service provider with a standardized financial management

solution

24 U.S. Attorney’s Office for the Eastern District of Virginia

Case No. 14-13290-RGM

RISK FACTORS &

POTENTIAL MITIGATION

TECHNIQUES

To assess contractor viability, Contracting Officers should analyze

various financial and non-financial factors, including:

Company’s financial

performance and

trends relative to its

peers

Financial Company’s

operational

weaknesses and risk

areas

Operational

Company’s risk

profile in regards to

its corporate

background and

business

connections

Corporate

Company’s ethical

risks posed by its

business policies

and practices

Ethical

Due Diligence

Areas

Non-financial factors are important because weaknesses or risk

areas may drive a company’s financial decisions.

Ownership

Structure

Business

ConnectionsCustomer

Mix

Operational

Considerations

Personnel

Considerations

Contracting

HistoryLawsuits or

Adverse Media

Policies and

Practices

Poor financial management is a prime reason why many contractors

fail. Financial analysis can reveal a basic understanding of a

company’s strengths and weaknesses.

Profitability

Liquidity Leverage

Profitability ratios calculate a company’s ability to generate

sustained profits from primary business operations.

Higher value relative to a peer’s ratio or to the same ratio from a previous time

period likely indicates the company is better able to generate profits

Profitability

Return on Equity = Net Income / Total Equity

Return on Assets = Net Income / Total Assets

Profit Margin = Net Income or EBITDA25 / Sales

25 Earnings before Interest, Tax, Depreciation and

Amortization

Liquidity ratios measure a company’s ability to meet its debt

obligations and are a major measure of financial health.

Higher value relative to a peer’s ratio or to the same ratio from a previous time

period likely indicates the company is better able to meet its debt obligations

Liquidity

Quick Ratio = (Cash & Cash Equivalents + AR27) / Current Liabilities

Interest Coverage = EBIT26 / Interest Expense

Current Ratio = Current Assets / Current

Liabilities

26 Earnings before Interest and Tax 27 Accounts Receivable

Leverage ratios measure a company’s level of debt. A company’s

debt load is a measure of risk.

Lower value relative to a peer’s ratio or to the same ratio from a previous time

period may indicate the company carries a lower debt load

Leverage

Debt-to-Equity = Debt / Equity

Leverage = Net Debt / EBITDA28

Debt-to-Capital = Debt / (Equity + Debt + Deferred Tax Liability)

28 Earnings before Interest, Tax, Depreciation and

Amortization

Establishing a counterparty risk assessment program and

leveraging leading practices can reduce risk.

Process Ideation

Pre-Award Review

Ongoing Health Checks

Lifecycle Events

Establish a

standardized

process based on

the risk rating of

the contract

Perform rigorous

due diligence on

potential

vendors during

the pre-award

phase

Monitor

contractor risk

and financial

health during the

post-award phase

Analyze and

mitigate risk of

lifecycle events,

including

declining

performance and

relationship

resolution

Contingency Plans

Identify supply

chain risks and

develop

contingency plans

to reduce supplier

disruptions

Process Ideation: A formalized counterparty risk assessment

program can encourage a standard risk review process

throughout the business relationship lifecycle.

Text

Program Policies

Mission & Goals

Measure &

Monitor

Execution Plan

Pre-Award Review: The Federal Acquisition Regulation (FAR)29

and the Defense Federal Acquisition Regulation Supplement

(DFARS)30 provide guidance on the mechanisms that the

government can use to request financial information.

FAR 9.105 – 1 – Obtaining Information

• Contracting officer shall possess information sufficient to be satisfied that a prospective

contractor currently meets the applicable standards in 9.104

• Information on financial resources and performance capability shall be obtained or

updated on as current a basis as is feasible up to the date of the award

DFARS 209.106-2 Requests for Pre-Award Surveys

• The contracting officer may request the completion of the SF 1403

• SF 1403, Section III contains a Financial Capability factor that is addressed in 253.209-1 as

“A determination that the prospective contractor has or can get adequate financial

resources to obtain needed facilities, equipment, materials, etc.”

29 General Services Administration – Federal Acquisition

Regulation

30 Defense Finance and Accounting Services – Defense

Federal Acquisition Regulation Supplement

Contingency Plans: Identification of supply chain risk and

development of contingency plans can help create a more

resilient supply chain

123

Investigate supply chain

relationships and identify risks

Analyze supply chain impact

of mission critical contractor

failures

Develop contingency plans to reduce

disruptions to the supply chain in the

event of contractor failure

Ongoing Health Checks: The financial condition of a company can

change drastically in a short time, so on-going monitoring is

paramount.

Management

Discussions

On-going Financial

Health Reviews

Corporate

Event Reviews

Perform quarterly

financial health

reviews and

analyze the root

cause of any signs

of financial distress

Review corporate

transactions and events

for increased risk

For high-risk or mission

critical contracts, engage in

discussions with management

to better understand red flags

Ongoing Health Checks: The FAR31 and the DFARS32 also provide

guidance on the mechanisms that the government can use to

request financial information during an active contract.

FAR 42.11 – Production Surveillance & Reporting

• Used to determine contractor progress and to identify any factors that may

delay performance

• Involves government review and analysis of the contractor’s performance plans,

schedules, controls, and processes

• Considerations include the contractor’s financial capability

DFARS 242.1104 – Surveillance Requirements

• The Contract Administration Office conducts periodic risk assessments of

contractors to determine the degree of production surveillance needed for all

contracts awarded to that contractor

31 General Services Administration – Federal Acquisition

Regulation

32 Defense Finance and Accounting Services – Defense

Federal Acquisition Regulation Supplement

Lifecycle Events: When a relationship is distressed or cannot be

salvaged, government agencies should take strategic and tactical

actions to reduce the negative impacts.

Risk Mitigation Strategic Alternatives Analysis

Supply Chain Impact Analysis

Development and Analysis of Settlement Alternatives

Bankruptcy & Negotiation Analysis

Reporting: The use of automated tools can help improve

transparency and oversight as well as highlight broader risks and

improvement areas.

Program Improvements

Highlights areas where the

program may be improved

Oversight

Ensures proper

administration and

application of the

program

Measure Program Success

Reveals whether the program

is meeting its mission and

goals

Transparency

Increases

understanding of

decisions and actions

Program Weaknesses

Reveals weaknesses in

the risk assessment

program

Broader Risk Areas

Highlights larger

portfolio risk areas

TAKEAWAYS

By performing enhanced due diligence – both up-front and on-

going – government agencies may significantly reduce the risk

of surprises that can affect the on-time and on-budget

completion of important projects.

Reduces the risk of a mission critical contract being negatively

affected by contractor failure

Reduces negative press and political pressures associated with

deficient procurement decision making and oversight

Allows for consistent application of leading practices, analysis

of trends, and benchmarks for measuring success

Allows for identification of supply chain risk and development

of contingency plans to create a more resilient supply chain

Contacts

Steven Cady

Senior Manager, Deloitte Transactions and Business Analytics LLP

scady@deloitte.com

Nicole Ferenzy

Manager, Deloitte Transactions and Business Analytics LLP

nferenzy@deloitte.com

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