Conflict of Interest Rules Could Lead to Divestitures

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  Space News Business

Conflict of Interest Rules Could Lead to Divestitures

By ANTONIE BOESSENKOOL

posted: 14 July 2009
07:15 am ET





PARIS — Northrop Grumman is considering selling its TASC unit, also called its Information Systems’ Advisory Services division, sources said at the Paris Air Show. TASC, which does systems engineering and advisory work, might be just the kind of business to block Northrop from other defense work under new defense procurement reform legislation recently signed into law by U.S. President BarackObama.

Organizational conflict-of-interest (OCI) clauses in the new law will preclude companies from serving in a procurement advisory role and also bidding on the service or product being procured. David Baxt, head of the aerospace and defense group at Jefferies investment bank, confirmed that Northrop is considering a sale of TASC and will soon interview bankers to handle a deal.

A sale of TASC would be uncharacteristic of Northrop’s past sales of businesses on their “last legs and practically dead,” Baxt said at the Paris show. “Why would they ever sell TASC?” The unit is doing at least as well as similar businesses, according to confidential information Baxt said he had seen.

“The debate is, will the requirements on OCI force them to actually get out of that specific business? TASC very specifically for Northrop is going to potentially create an OCI issue if you really believe that the legislation, as proposed and as written and as published for comment, if it actually happens that way,” he added. But, he said, “I don’t think it will. Most of industry doesn’t believe it will.” For that reason, “I’d be surprised to see Northrop actually sell TASC at the end of the day,” Baxt said.

Moreover, any potential buyer may be wary of taking on conflicts as well, he said.

In a statement, Northrop Chairman and Chief Executive Ronald Sugar said, “Northrop Grumman recognizes that improvements to federal acquisition laws benefit the government [and] industry, as well as American taxpayers; therefore, we support the recently passed legislation on defense acquisition reform. As the Defense Department formulates the implementing instructions and guidelines for the new law, we welcome discussions with the department, especially on the section dealing with organizational conflicts of interest.”

The procurement reform law could trigger divestitures by defense companies now that they likely will have to make a choice in some cases between advising or bidding on a program procurement, said Michael Strianese, chairman, president and chief executive of L�3 Communications.

With the new law, “we, like most contractors, will have to make a decision on which side we want to play on, whether it’s the service side or the product side. And I think in most cases, we’re going to default to the product side,” Strianese said at the air show.

“The effect of that is that there are programs where we are being asked to bid by customers – there’s a couple that have recently come up – where we have declined bidding so as not to jeopardize our product business. And customers haven’t been happy about that,” he said. “It’s important to not be part of the source-selection decision if you’re selling a product, but I think the legislation goes way beyond that and I think it’s unduly broad. And I think it will cause problems in the industry, and I think that that would force divestitures.”

Whether companies choose to divest will also depend on how strictly the new law is interpreted, said Steve Grundman, a former Pentagon industrial affairs chief and now aerospace and defense analyst at CRA International.

“Companies who might have planned to significantly grow or actually acquire a capability that creates the potential for those kinds of conflicts of interest are going to pause and probably wait for the rules to play out,” he said at the air show. “This is one of those things where it will be very important how the statutory language gets expressed in rules,” namely the Federal Acquisition Regulations.

“You can certainly imagine a translation of statutory language into law/code, [then] into rules that [are] so strict as to make it value-destroying for a company to hold an important piece of business that provided engineering or other services to program offices and competed for [programs in those offices] at the same time,” he said.

Jeffrey Bialos, who served as the Pentagon’s industrial affairs chief during the administration of former U.S. President Bill Clinton, said the organizational conflicts-of�interest clauses will be “a significant issue for companies that have both subsystems and hardware on the one hand and [systems engineering and technical assistance (SETA)] support contracts on the other. Most of the large primes have that,” including companies such as Lockheed Martin and Northrop, Bialos said.

Those SETA support contracts are, in general terms, for advisory and support services that include work to oversee or evaluate the work of another government contractor. The conflict-of-interest clauses in the new law specifically address SETA contracting and the possibility of resulting conflicts. Northrop’s TASC division does some of this work, as do many of the major government contractors including BAE Systems and CSC, and SETA contracts may become a thorn in the side of contractors where the procurement reform legislation is concerned, observers said.

“If I’m providing SETA support in a program area, helping shape requirements or involved in source selection or valuing products afterwards, the new rule in the law says I or an affiliate can’t provide subsystems into that program. So that creates a dilemma for these companies,” Bialos said.

“I think there is a concern that at some point in time you have SETAs from a company doing oversight of the companies that they work for,” said Jim Albaugh, president and chief executive of Boeing Integrated Defense Systems, St. Louis. “The thing that has happened over the years, though, is [that] the number of contractors has shrunk. There are only a few large companies that are doing the SETA work.”

Boeing is not concerned about possible SETA conflicts, Albaugh said. “We are not in the SETA business to any large degree, so it doesn’t have any measurable impact on us,” he said. “I know other companies have more concern about this than I do.”

Organizational conflicts of interest are not an issue for Waltham, Mass.-based Raytheon, Raytheon Chairman and Chief Executive Bill Swanson said. The company’s work on system requirement efforts, as opposed to system development, is minimal at most.

One possible way the laws might be translated into rules is by allowing methods to mitigate potential conflicts, such as “firewalls” around certain parts of a company’s business, sources said. But feelings are mixed about whether those firewalls work.

Swanson said firewalls between businesses are a viable way of preventing conflicts.

“If a company in the defense community breaches a firewall, for example, in its contracting work, “word gets around and you basically have jeopardized your livelihood,” Swanson said. “You do it at your own risk. You’d be stupid to violate one of those.”

Bialos
, however, said, “Firewalls work to a point, but over time firewalls erode. … Under the law, a firewall alone is generally not acceptable.” Companies now will have to look at multiple choices, such as divestitures or segregating any support business into a structurally separate business, for dealing with conflict-of-interest hiccups the new law could create, according to Bialos.

“Those are options these companies are going to have to look at in the next period, because what you don’t want to find is six months from now, you’re going to bid on program X … and you find out that, whoops, one side of my house has been working on the requirement there for two years. Now a [request for proposals] hits the street, and I can’t bid,” Bailos said.