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Testimony: 

Before the Committee on Small Business, House of Representatives: 

United States Government Accountability Office: 
GAO: 

For Release on Delivery: 
Expected at 2:00 p.m. EDT:
Wednesday, March 25, 2009: 

HUBZone Program: 

Fraud and Abuse Identified in Four Metropolitan Areas: 

Statement of Gregory D. Kutz, Managing Director: 
Forensic Audits and Special Investigations: 

GAO-09-519T: 

Madam Chairwoman and Members of the Committee: 

Thank you for the opportunity to discuss the results of our 
investigation of the Small Business Administration's (SBA) Historically 
Underutilized Business Zone (HUBZone) program. Created in 1997, the 
HUBZone program provides federal contracting assistance to small 
businesses in economically distressed communities, or HUBZone areas, 
with the intent of stimulating economic development in those areas. On 
July 17, 2008, we testified before this committee that SBA's lack of 
controls over the HUBZone program exposed the government to fraud and 
abuse[Footnote 1] and that SBA's mechanisms to certify and monitor 
HUBZone firms provide limited assurance that only eligible firms 
participate in the program.[Footnote 2] In our testimony, we identified 
10 firms from the Washington, D.C., metropolitan area that were 
participating in the HUBZone program even though they clearly did not 
meet eligibility requirements. Of the 10 firms, 6 did not meet both 
principal office and employee residency requirements while 4 met the 
principal office requirement but significantly failed the employee 
residency requirement.[Footnote 3] We reported in our July 2008 
testimony that federal agencies had obligated a total of nearly $26 
million in HUBZone contract obligations to these 10 firms since 2006. 

After the hearing, you requested that we perform a follow-on 
investigation. We describe the results of this investigation and 
further background about the HUBZone program in a companion report that 
is being made public today.[Footnote 4] This testimony will summarize 
our overall findings. Specifically, this testimony will address (1) 
whether cases of fraud and abuse in the program exist outside of the 
Washington, D.C., metro area; (2) what actions, if any, SBA has taken 
to establish an effective fraud prevention system for the HUBZone 
program; and (3) what actions, if any, SBA has taken on the 10 firms 
that we found misrepresented their HUBZone status in July 2008. 

To meet these objectives, we identified and investigated selected 
HUBZone firms based on certain criteria, such as magnitude of HUBZone 
contracts and firm location. We also interviewed SBA officials and 
reviewed SBA data. A more detailed discussion of our scope and 
methodology is provided in our separate report. We conducted our 
investigation from September 2008 through March 2009 in accordance with 
quality standards for investigations as set forth by the President's 
Council on Integrity and Efficiency. 

In summary, we found the following: 

* Fraud and abuse in the HUBZone program extends beyond the Washington, 
D.C., area. We identified 19 firms in Texas, Alabama, and California 
participating in the HUBZone program that clearly do not meet program 
requirements (i.e., principal office location or percentage of 
employees in HUBZone and subcontracting limitations). In fiscal years 
2006 and 2007, federal agencies obligated nearly $30 million to these 
19 firms for performance as the prime contractor on HUBZone contracts 
and a total of $187 million on all federal contracts. 

* Although SBA has initiated steps to strengthen its internal controls 
as a result of our 2008 testimonies and report, substantial work 
remains for incorporating a fraud prevention system that includes 
effective fraud controls consisting of (1) front-end controls at the 
application stage, (2) fraud detection and monitoring of firms already 
in the program, and (3) the aggressive pursuit and prosecution of 
individuals committing fraud. 

* SBA has taken some enforcement steps on the 10 firms previously 
identified by GAO that knowingly did not meet HUBZone program 
requirements. However, as of February 2009, according to SBA's Dynamic 
Small Business Web site, 7 of the 10 firms that we investigated were 
still HUBZone certified. SBA's failure to promptly remove firms from 
the HUBZone program and examine some of the most egregious cases from 
our testimony has resulted in an additional $7.2 million in HUBZone 
obligations and about $25 million in HUBZone contracts to these firms. 

Selected Case Studies of Fraud and Abuse Outside the Washington, D.C., 
Metro Area: 

HUBZone program fraud and abuse continues to be problematic for the 
federal government. We identified 19 firms in Texas, Alabama, and 
California participating in the HUBZone program even though they 
clearly do not meet program requirements (i.e., principal office 
location or percentage of employees residing in the HUBZone and 
subcontracting limitations).[Footnote 5] Although we cannot conclude 
whether this is a systemic problem based on these cases, the issue of 
misrepresentation clearly extends beyond the Washington, D.C., 
metropolitan area where we conducted our initial investigation. In 
fiscal years 2006 and 2007, federal agencies had obligated nearly $30 
million to these 19 firms for performance as the prime contractor on 
federal HUBZone contracts.[Footnote 6] 

HUBZone regulations also place restrictions on the amount of work that 
can be subcontracted to non-HUBZone firms. Specifically, HUBZone 
regulations generally require a firm to expend at least 50 percent of 
the personnel costs of a contract on its own employees. As part of our 
investigative work, we found examples of service firms that 
subcontracted most HUBZone contract work to other non-HUBZone firms and 
thus did not meet this program requirement. When a firm subcontracts 
the majority of its work to other non-HUBZone firms, it is undermining 
the HUBZone program's stated purpose of stimulating development in 
economically distressed areas, as well as evading eligibility 
requirements for principal office and 35 percent residency requirement. 

Examples of firms that did not meet HUBZone requirements included the 
following: 

* An environmental consulting firm located in Fort Worth, Texas, that 
violated HUBZone program requirements because it did not expend at 
least 50 percent of personnel costs on its own employees or use 
personnel from other HUBZone firms.[Footnote 7] From fiscal year 2006 
through fiscal year 2007, the Department of the Army obligated more 
than $2.3 million in HUBZone contracts to this firm. At the time of our 
investigation, company documents showed that the company was 
subcontracting from 71 to 89 percent of its total contract obligations 
to other non-HUBZone firms--in some cases, large firms. The principal 
admitted that her firm was not meeting the subcontracting performance 
requirement of HUBZone regulations. Further, the principal stated that 
the firm made bids on HUBZone contracts knowing that the company would 
have to subcontract work to other firms after the award. The principal 
added that other large firms use HUBZone firms in this manner, 
referring to these HUBZone firms as "contract vehicles." 

* A ground maintenance services company located in Jacksonville, 
Alabama, failed to meet both principal office and 35 percent residency 
requirements. From fiscal year 2006 through fiscal year 2007, this firm 
received more than $900,000 in HUBZone set-aside obligations. However, 
our investigation found that the purported principal office was in fact 
a residential trailer occupied by someone not associated with the 
company. The company had represented its office as located in "suite 
19," when in reality, the address was associated with trailer 19 in a 
residential trailer park. The two employees of the firm--a father and a 
son--lived in non-HUBZone areas that are located about 90 miles from 
the trailer park. This firm also subcontracted most of its HUBZone work 
to non-HUBZone firms. 

* An information technology firm in Huntsville, Alabama, failed to meet 
both principal office and 35 percent residency requirements. From 
fiscal year 2006 through fiscal year 2007, federal agencies obligated 
over $5 million in HUBZone awards to this firm, consisting mainly of 
two HUBZone set-aside contracts. Based on our review of payroll records 
and written correspondence that we received from the firm, we 
determined that only 18 of 116 of the firm's employees (16 percent) who 
were employed in December 2007 lived in HUBZone-designated areas. In 
addition, our investigation found that no employees were located at the 
location listed as a principal office. The firm's president 
acknowledged that he "had recently become aware" that he was not in 
compliance with HUBZone requirements and was taking "corrective 
actions." However, the firm continued to represent itself as a HUBZone 
firm even after this acknowledgment. 

According to HUBZone regulations, persons or firms are subject to 
criminal penalties for knowingly making false statements or 
misrepresentations in connection with the HUBZone program, including 
failure to correct "continuing representations" that are no longer 
true. During the application process, applicants are not only reminded 
of the program eligibility requirements, but are required to agree to 
the statement that anyone failing to correct "continuing 
representations" shall be subject to fines, imprisonment, and 
penalties. Further, the Federal Acquisition Regulation (FAR) requires 
all prospective contractors to update the government's Online 
Representations and Certifications Application, which includes a 
statement certifying whether the firm is currently a HUBZone firm and 
that there have been "no material changes in ownership and control, 
principal office, or HUBZone employee percentage since it was certified 
by the SBA." Of the 19 firms that did not meet HUBZone eligibility 
requirements, we found that all of them continued to represent 
themselves as eligible HUBZone interests to SBA. Because the 19 case 
examples clearly are not eligible, we consider each firm's continued 
representation indicative of fraud, abuse, or both related to this 
program. 

SBA Has Not Incorporated Effective Fraud Controls: 

Our June 2008 report[Footnote 8] and July 2008 testimony clearly showed 
that SBA did not have effective internal controls related to the 
HUBZone program. In response to our findings and recommendations, SBA 
initiated a process of reengineering the HUBZone program. SBA officials 
stated that this process is intended to make improvements to the 
program that are necessary for making the program more effective while 
also minimizing fraud and abuse. To that end, SBA has hired business 
consultants and reached out to GAO in an attempt to identify control 
weaknesses in the HUBZone program and to strengthen its fraud 
prevention controls. As of the end of our fieldwork, SBA did not have 
in place the key elements of an effective fraud prevention system. 
[Footnote 9] A well-designed fraud prevention system (which can also 
be used to prevent waste and abuse) should consist of three crucial 
elements: (1) up-front preventive controls, (2) detection and monitoring, 
and (3) investigations and prosecutions. For the HUBZone program this 
would mean (1) front-end controls at the application stage, (2) fraud 
detection and monitoring of firms already in the program, and (3) 
decertification from the program of ineligible firms and the aggressive 
pursuit and prosecution of individuals committing fraud. 

Preventive controls. We have previously reported that fraud prevention 
is the most efficient and effective means to minimize fraud, waste, and 
abuse.[Footnote 10] Thus, controls that prevent fraudulent firms and 
individuals from entering the program in the first place are the most 
important element in an effective fraud prevention program. SBA 
officials stated that as part of their interim process they are now 
requesting from all firms that apply to the HUBZone program 
documentation that demonstrates their eligibility. While requiring 
additional documentation has some value as a deterrent, the most 
effective preventive controls involve the verification of information, 
such as verifying a principal office location through an unannounced 
site visit. Moreover, SBA did not adequately field-test its interim 
process for processing applications. If it had done so, SBA would have 
known that it did not have the resources to effectively carry out its 
review of applications in a timely manner. As a result, SBA had a 
backlog of about 800 HUBZone applications as of January 2009. At that 
time, SBA officials stated that it would take about 6 months to process 
each HUBZone application--well over the 1 month goal set forth in SBA 
regulations. 

Detection and monitoring. Although preventive controls are the most 
effective way to prevent fraud, continual monitoring is an important 
component in detecting and deterring fraud. We reported in June 2008 
that the mechanisms SBA used to monitor HUBZone firms provided limited 
assurance that only eligible firms participate in the program. SBA 
officials stated that during this fiscal year, they will be conducting 
program examinations on all HUBZone firms that received contracts in 
fiscal year 2007 to determine whether they still meet HUBZone 
requirements. In addition, SBA officials stated that as of September 
2008, SBA had eliminated its backlog of recertifications. Although SBA 
has initiated several positive steps, SBA will need to make further 
progress to achieve an effective fraud monitoring program, including 
steps to (1) verify the validity of a stated principal office during 
its recertification and application processes; (2) establish a 
streamlined and risk-based methodology for selecting firms for program 
examinations going forward; (3) incorporate an "element of surprise" 
into its program examinations, such as using random, unannounced site 
visits; and (4) review whether HUBZone firms are expending at least 50 
percent of the personnel costs of a contract on their own personnel. 

Investigation and prosecution. The final element of an effective fraud 
prevention system is the aggressive investigation and prosecution of 
individuals who commit fraud against the federal government. However, 
SBA currently does not have an effective process for investigating 
fraud and abuse within the HUBZone program. To date, other than the 
firms identified by our prior investigation, the SBA program office has 
never referred any firms for debarment and/or suspension proceedings 
based on findings from its program eligibility reviews. By failing to 
hold firms accountable, SBA has sent a message to the contracting 
community that there is no punishment or consequences for committing 
fraud or abusing the intent of the HUBZone program. 

SBA Has Initiated Some Enforcement Actions against 10 HUBZone Firms 
Previously Investigated by GAO: 

SBA has taken some enforcement steps on the 10 firms that we found did 
not meet HUBZone program requirements as of July 2008. According to 
SBA, as of January 2009, 2 of the firms have been removed from the 
program and 2 others are in the process of being removed.[Footnote 11] 
However, SBA's failure to examine some of the most egregious cases we 
previously identified[Footnote 12] has resulted in an additional $7.2 
million in HUBZone obligations and about $25 million in HUBZone set- 
aside or price preference contracts to these firms. 

In the written statement for the July 2008 hearing, the Acting 
Administrator of SBA stated that SBA would take "immediate steps to 
require site visits for those HUBZone firms that have received HUBZone 
contracts and will be instituting suspension and debarment proceedings 
against firms that have intentionally misrepresented their HUBZone 
status." However, as of February 2009, according to SBA's Dynamic Small 
Business Web site, 7 of the 10 firms that we investigated were still 
HUBZone certified. SBA has removed 2 firms from the HUBZone program and 
is in the process of providing due process to 2 additional firms to 
determine whether they should be removed.[Footnote 13] SBA officials 
stated that no action will be taken on 3 firms because SBA's program 
evaluations concluded that these firms met all the eligibility 
requirements of the HUBZone program. We attempted to verify SBA's work, 
but were not provided with the requested documentation to support its 
conclusion that the firms moved into compliance after our July 2008 
testimony. SBA officials said that they have not yet performed program 
evaluations for 3 of the most egregious firms because they are 
experiencing technical problems with SBA's caseload system. As such, 
these 3 firms remain eligible to receive HUBZone set-aside contracts. 
SBA is also pursuing suspension and debarment actions for 7 of these 
firms, and the Department of Justice is considering civil actions in 5 
of the 10 cases. 

Recommendations for Executive Action: 

We will be referring all the cases we identified to SBA for further 
action. In our report, we also recommended that the Administrator of 
SBA expeditiously implement our June 2008 recommendations and take the 
following four actions: 

* Consider incorporating a risk-based mechanism for conducting 
unannounced site visits as part of the screening and monitoring 
process. 

* Consider incorporating policies and procedures into SBA's program 
examinations for evaluating if a HUBZone firm is expending at least 50 
percent of the personnel costs of a contract using its own employees. 

* Ensure appropriate policies and procedures are in place for the 
prompt reporting and referral of fraud and abuse to SBA's Office of 
Inspector General as well as SBA's Suspension and Debarment Official. 

* Take appropriate enforcement actions on the 19 HUBZone firms we found 
to violate HUBZone program requirements to include, where applicable, 
immediate removal or decertification from the program, and coordination 
with SBA's Office of Inspector General as well as SBA's Suspension and 
Debarment Official. 

In written comments on a draft of our report, SBA agreed with three of 
our four recommendations. SBA disagreed with our recommendation to 
consider incorporating policies and procedures into SBA's program 
examinations for evaluating if a HUBZone firm is complying with the 
performance of work requirements by expending at least 50 percent of 
the personnel costs of a contract on its own employees. SBA stated that 
although this requirement is included in SBA HUBZone regulations, it is 
not a criterion for HUBZone program eligibility but rather a mandatory 
contract term. SBA stated that contracting officers are required by the 
FAR to insert such clauses regarding subcontracting limitations. While 
we recognize that contracting officers have a responsibility for 
monitoring the subcontracting limitation, SBA also has this 
responsibility. In order to receive HUBZone certification, a firm must 
certify to SBA that it will abide by this performance requirement, and 
SBA is required by statute to establish procedures to verify such 
certifications. Therefore, we continue to believe that SBA should 
consider incorporating policies and procedures into its program 
examinations for evaluating if a HUBZone firm is meeting the 
performance of work requirements. 

Madam Chairwoman, this concludes my statement. I would be pleased to 
answer any questions that you or other members of the committee may 
have at this time. 

Contacts and Acknowledgments: 

For further information about this testimony, please contact Gregory D. 
Kutz at (202) 512-6722 or kutzg@gao.gov. Contact points for our Offices 
of Congressional Relations and Public Affairs may be found on the last 
page of this testimony. In addition to the individual named above, 
Bruce Causseaux, Senior Level Contract and Procurement Fraud 
Specialist; Matt Valenta, Assistant Director; Erika Axelson; Gary 
Bianchi; Donald Brown; Bruce Causseaux; Eric Eskew; Dennis Fauber; 
Craig Fischer; Robert Graves; Betsy Isom; Jason Kelly; Julia Kennon; 
Barbara Lewis; Olivia Lopez; Jeff McDermott; Andrew McIntosh; John 
Mingus; Andy O'Connell; Mary Osorno; and Chris Rodgers also provided 
assistance on this testimony. 

[End of section] 

Footnotes: 

[1] GAO, HUBZone Program: SBA's Control Weaknesses Exposed the 
Government to Fraud and Abuse, [hyperlink, 
http://www.gao.gov/products/GAO-08-964T] (Washington, D.C.: July 17, 
2008). 

[2] GAO, Small Business Administration: Additional Actions Are Needed 
to Certify and Monitor HUBZone Businesses and Assess Program Results, 
[hyperlink, http://www.gao.gov/products/GAO-08-975T] (Washington, D.C.: 
July 17, 2008). 

[3] Firms that participate in the program generally must meet certain 
requirements, including (1) at least 35 percent of its employees must 
live in a HUBZone, (2) the principal office (i.e., the location where 
the greatest number of qualifying employees perform their work) must be 
located in a HUBZone, and (3) once a firm receives a HUBZone contract, 
the firm is required to abide by certain subcontracting limitations. 

[4] GAO, HUBZone Program: Fraud and Abuse Identified in Four 
Metropolitan Areas, [hyperlink, http://www.gao.gov/products/GAO-09-440] 
(Washington, D.C.: Mar. 25, 2009). 

[5] These 19 firms had principal offices in or near four metropolitan 
areas: Dallas, Texas; Huntsville, Alabama; San Antonio, Texas; and San 
Diego, California. 

[6] These 19 firms received a total of $187 million in federal 
obligations in fiscal years 2006 and 2007. 

[7] See 13 C.F.R. § 126.700. 

[8] GAO, Small Business Administration: Additional Actions Are Needed 
to Certify and Monitor HUBZone Businesses and Assess Program Results, 
[hyperlink, http://www.gao.gov/products/GAO-08-643] (Washington, D.C.: 
June 17, 2008). 

[9] Internal controls comprise the plans, methods, and procedures used 
to meet missions, goals, and objectives and also serve as the first 
line of defense in safeguarding assets and preventing and detecting 
errors and fraud. Fraud prevention, on the other hand, requires a 
system of rules, which, in aggregate, minimize the likelihood of fraud 
occurring while maximizing the possibility of detecting any fraudulent 
activity that may transpire. 

[10] GAO, Hurricanes Katrina and Rita Disaster Relief: Prevention is 
the Key to Minimizing Fraud, Waste, and Abuse in Recovery Efforts, 
[hyperlink, http://www.gao.gov/products/GAO-07-418T] (Washington, D.C.: 
Jan. 29, 2007), and Individual Disaster Assistance Programs: Framework 
for Fraud Prevention, Detection, and Prosecution, [hyperlink, 
http://www.gao.gov/products/GAO-06-954T] (Washington, D.C.: July 12, 
2006). 

[11] As of February 2009, 7 of the 10 firms were still HUBZone 
certified, according to SBA's Dynamic Small Business Web site. One of 
the 2 firms in the process of being removed was no longer listed as 
HUBZone certified. 

[12] [hyperlink, http://www.gao.gov/products/GAO-08-964T]. 

[13] A firm that SBA has decertified may seek certification no sooner 
than 1 year from the date of decertification. If the firm was 
decertified for failure to notify SBA of a material change affecting 
its eligibility, it must include with its application for certification 
a full explanation of why it failed to notify SBA of the material 
change. 

[End of section] 

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