When Outsourcing Turns Outrageous

Contractors may have saved the Army money. 

But fraud changes the equation.

July 31, 2006--The U.S. Military has lost billions to fraud and mismanagement by private contractors in Iraq who do everything from cooking soldiers' meals to building hospitals to providing security. That raises a question: Does Pentagon outsourcing make sense?

"The presumption is that it is cheaper," says Jerrold T. Lundquist, director of the defense and aerospace practice at the consulting firm McKinsey & Co. Competitive bidding can keep the price of services down. Contractors are, in theory, more nimble at mobilizing and paring back their forces than a huge military bureaucracy.

A recent study by the nonpartisan Congressional Budget Office concluded that in 2004 the U.S. reduced its costs by one-third for feeding and housing troops by paying one contractor to do the work--a savings of nearly $3 billion. Such findings point to the conclusion that even with a lot of fraud and waste, outsourcing may still pay off.

But some experts on the topic aren't convinced. Because no one has an authoritative overall estimate of how much has been lost in Iraq to contractor deceit and incompetence, and many investigations are just getting under way, the financial harm could in the end outstrip any savings.

There's also the intangible cost of taxpayers seeing their money wasted or stolen rather than spent to support troops risking their lives and dying. "What has happened in Iraq is just disgraceful," says Jeffrey H. Smith, a former Central Intelligence Agency general counsel during the Clinton Administration who now represents military contractors in private law practice.

Instances of military outsourcing gone bad in Iraq are now legion. For example, Parsons Global Services Inc. of Pasadena, Calif., lost its contract to build 150 health centers after it completed just six centers and collected $190 million--$30 million over the project's budget. The U.S. Special Inspector General for Iraq Reconstruction is now reviewing all of Parsons' Iraq work. Officials at Parsons, which eventually completed an additional 13 centers, stand by their work, saying employees performed well under "extremely volatile conditions."

It's difficult to put an accurate price tag on contractor fraud in Iraq. The Government Accountability Office, the investigative arm of Congress, reported earlier this month that the Defense Dept. has recovered about $2 billion since 2001 from all outside contractors and government procurement officials accused of dishonesty or mismanagement, but the GAO didn't isolate those working in Iraq.

Billions Under Scrutiny

The losses to fraud and waste in Iraq are almost certainly in the billions, current and former government officials agree. The Special IG for Iraq Reconstruction says it has more than 80 open investigations and has referred 20 more cases to the Justice Dept. for prosecution. A spokesman for the criminal investigative arm of the Defense Dept. says that office expects a "rise in referrals of potential fraud or corruption cases" because of the recent deployment to Iraq of additional Pentagon investigators and FBI agents.

Democrats on the House Government Reform Committee have identified more than 50 "problem" contracts worth an estimated $21.3 billion that they say are under scrutiny by federal investigators. And that's just what has been publicly disclosed: Federal officials won't discuss other pending investigations because of secrecy insulating some of the contracts and most of the inquiries.

 All told, the Defense Dept. has spent more than $365 billion on the Iraq war and the global fight against terror since late 2002. Roughly $60 billion, or 16%, of the total has been paid to contractors for services, according to the Congressional Research Service.

The use of private companies and individuals to support the military began in earnest in the 1950s during the Korean War, when the Pentagon hired outside firms to help maintain helicopters. Outsourcing spread in the 1980s as the Reagan Administration sought to privatize government functions generally.

The end of the Cold War inspired a broad push by the Clinton Administration to shrink the military and start closing unneeded bases. Those moves resulted in additional outsourcing of food, transportation, and other services.

Bipartisan legislation Congress passed in the 1990s reduced oversight of contractors in the name of increasing efficiency. But as the number of Pentagon contracting officials was trimmed by about 38% during this period, some contractors "exploited the new freedom," says Frank Camm, a senior economist for defense contracting at Rand Corp.

Other safeguards were lifted in the run-up to the Iraq war. By law the Pentagon can circumvent competitive bidding rules in "emergency" situations such as war. The volume of sole-source and other noncompetitive contracts awarded by the military has soared 54% since 2000, from $65 billion to $100 billion.

Bush critics say the absence of competition invites waste and corruption. "The flawed contract approach has greatly contributed to the problems," says California Representative Henry A. Waxman, ranking Democrat on the Government Reform panel. "Instead of competition, the Administration has awarded monopoly cost-plus contracts to favored contractors like Halliburton (HAL )."

But the situation isn't clear-cut. Since the American invasion of Iraq in 2003, skeptics have questioned Halliburton's role in the war, emphasizing that before becoming Vice-President, Dick Cheney headed the Houston company.

 The Army confirmed earlier this month that it was ending a multibillion-dollar, 10-year contract held by Halliburton subsidiary Kellogg, Brown & Root to provide food, water, shelter, and other basic services to troops.

The Pentagon, which has paid KBR $15 billion since 2001, plans to divide the work among four contractors, with KBR permitted to bid for a portion of it. Earlier, Defense Dept. auditors had labeled $1.2 billion in KBR charges as "excessive," "duplicative," or otherwise questionable. KBR officials say its costs were reasonable considering that the work was done under "extraordinarily hostile conditions." KBR also says it has resolved most of the audit disputes with the Army.

KBR's contentions received implicit support from a CBO study issued in October, 2005. The Capitol Hill budget agency examined KBR's work in Iraq during a 12-month period ending in mid-2004.

To perform the tasks KBR completed, the U.S. Army would have had to recruit 41,000 additional troops and spend $8.2 billion, or $2.8 billion more than KBR's costs, the CBO found. Over time, the Pentagon would save billions more by employing KBR, the study projected.

Whether the government is able to take full advantage of such cost savings depends largely on whether it can rein in contract abuse. Authorities on military contracting say there are obvious steps the Pentagon can take:

It could bolster the ranks of procurement staff and institute tougher procedures for awarding and reviewing contracts. But apart from the scrutiny of the large KBR contract, the Pentagon has no plans to make those moves. In fact, the military expects to further reduce its procurement oversight corps.

Smith, the former CIA general counsel who now represents contractors at Washington law firm Arnold & Porter, predicts that without more oversight, military outsourcing will saddle the government with the wrong kind of business partners. "Iraq has attracted patriots and crooks--and there were probably some crooked patriots," he says. "We're going to be cleaning that up for years to come, I fear."