Tag Archives: Marion Higa

The Billion Dollar Gamble: State Investment

BY DENNIS HOLLIER

Photo: istockphoto.com

What a difference a billion dollars makes.

Until recently, the state treasury – officially, the Treasury Management Branch of the Financial Administration Division of the Department of Budget and Finance – has operated in relative obscurity. With its staff of seven or eight employees, the treasury acts as cash manager for the state government. Its primary responsibility is to make sure the state always has enough cash reserves to meet its ongoing obligations: payroll, debt service, pension contributions, etc.

The treasury also manages the day-to-day investment of so-called excess funds: monies collected, but not yet spent, by state agencies. As it happens, that’s a lot of money – more than $3 billion at last count. Even so, these investments are hardly sexy, consisting mostly of safe, low-yield, highly liquid instruments like U.S Treasury securities, Federal Agency securities, collateralized CDs and something called SLARS, student loan auction rate securities. In other words: boring, boring, boring.

Then, in February 2008, the market for those auction rate securities collapsed. Overnight, the state’s $1 billion investment in SLARS ceased to be either safe or liquid. And suddenly, the treasury didn’t seem so boring after all.

Where the money goes

So, where did it go wrong? Georgina Kawamura, director of the Department of Budget and Finance, and the official state treasurer, describes treasury operations as a juggling act. “Here’s the day,” she says. “We get daily reports from the banks to let us know our ‘checking account’ balance. We also know, on a daily basis, what investments will mature.” These figures, combined with information about payments that will go out, constitute the calculus of the day’s excess funds, the funds available for investment. This begins yet another juggling act.

For the most part, treasury investments are scheduled to mature around large payments. Scott Kami, administrator of the Financial Administration Division (FAD), which oversees day-to-day operations of the treasury, gives the example of payday. Payroll, he says, averages about $8 million per pay period. “Normally, we schedule about half of that to mature on Friday, and the other half to mature on the following Monday. Because, historically, that’s how the checks clear.”

Armed with that information, treasury accountants can now contact brokers, banks and other financial institutions to find investment opportunities. In this way, the treasury’s responsibilities of cash management and investing are always intertwined. Every debt obligation and every dollar of excess cash must be meticulously tracked because, as Kawamura points out, “All the money is invested. All of it is earning interest.”

And yet, in a scathing report on the Department of Budget and Finance released in March, state auditor Marion Higa turns most of these mundane details on their head. For example, the treasury uses an almost indecipherable, handwritten, color-coded monthly calendar to monitor its investments. It calculates excess cash from manually prepared worksheets rather than electronic spreadsheets like Excel. And it deals with brokers through a decidedly informal system of e-mail and faxes.

Still worse, Higa says, is the treasury’s lack of oversight. The report notes that the FAD failed to prepare and review bank reconciliations, failed to produce a monthly investment report, and routinely allowed investment classes to exceed their statutory limits. In her view, it was this lax supervision that allowed the SLARS calamity. When the independent accounting firm Accuity conducted the state’s fiscal year 2008 certified annual financial report, it also said flawed internal controls led to the SLARS purchase. In her report, Higa points out that treasury staff never even saw the offering documents for these investments. Those documents clearly state many of the risks pertaining to SLARS.

The state uses a handwritten monthly calendar to monitor the
treasury’s $3 billion portfolio.

What Are SLARS?

Auction rate securities are basically debt instruments consisting of bundles of securities – in this case, student loans. The interest rates are set through periodic auctions: sellers offer securities at the lowest rate they’re willing to accept; buyers indicate the highest rate they’re willing to pay and how many they want to buy at that rate. This process is designed to determine the lowest interest rate at which all available shares of a security can be sold at par. This is called the clearing rate, and it serves as the interest rate for that entire issue of SLARS until the next auction. In the event an auction fails, the rate is set based on a pre-established relationship to some benchmark, usually the London Interbank Offered Rate, or LIBOR. Naturally, brokers assure buyers that auctions never fail.

To be fair, these auctions appeared to work efficiently for more than 20 years. And because the auctions usually happened every seven, 28 or 35 days, investors like the state treasury could treat SLARS as liquid investments, even though the underlying securities might not mature for 35 years. But sustaining that liquidity meant that all the available SLARS had to sell at every auction. That didn’t always happen, but the underwriting broker quietly bought enough to keep the auction from failing. Between auctions, brokers often tried to unload these securities on their customers.

Nevertheless, in 2007, when the financial markets began to implode, these securities began to accumulate on the wire-houses’ books, and brokers regarded them nervously. They encouraged their sales divisions to push ARS aggressively, even though insiders knew the auctions were becoming tenuous. Another sign of some distress in the market was the steady increase in interest rates, which, in the case of SLARS, eventually reached 7.35 percent (compared with 2.07 percent for two-year CDs.) For most investors, higher interest rates reflect higher risk. And yet, in the six months leading up to the market failure, the Hawaii treasury’s holdings in SLARS went from $427 million to over $1 billion, and from just 14 percent of the state’s portfolio to nearly 30 percent.

Of course, the state of Hawaii wasn’t the only investor surprised by the failure of the ARS market. Thousands of individuals and hundreds of institutional investors were caught off guard. A diverse group of government entities – states, counties, water-district boards, et al. – now found themselves stuck with these now long-term investments. Although most individual investors eventually recouped their investments through settlements with the wire houses that underwrote the auctions and government regulators, institutional investors have been obliged to write down their ARS as part of the “mark to market” standards of generally accepted accounting practices. In the summer of 2008, for example, the state acknowledged a $114 million impairment on its certified annual financial report as a result of its SLARS holdings. Though Hawaii may have the largest holdings, it hasn’t taken the worst blow. Jefferson County, Ala., is verging on bankruptcy due to the failure of the auctions.

Closer to home, Maui County found itself stuck with more than $30 million in SLARS when the market crashed. Like the state, Maui seems to have relied on assurances by a broker, in this case, Merrill Lynch, that these were highly liquid securities. Also like the state, Maui invested heavily in SLARS in the months leading up to the market failure.

Different Responses

Despite the similarities between Maui and the state, there have been striking differences in how they responded to the SLARS debacle. For example, the state continues to defend its investment. “The one thing that gets lost in this whole discussion about ARS,” says Scott Kami, “is that the securities themselves are very sound investments. There hasn’t been any default on them, and we continue to get all our interest paid when it comes due.” Moreover, he says, the yield on the state’s ARS, approximately 1.9 percent, is higher than that earned by the state’s other investments. He points out the yield on 30-day CDs is almost zero.

Kawamura takes another tack. “I think people have put too much emphasis on the write-down,” she says. “Everyone thinks we’ve lost money. We have not.” She acknowledges that accounting principles required the state to estimate an impairment on its SLARS holdings. She also admits that if the state were to sell its holdings today, it would likely incur an additional $250 million loss. But Kawamura views these as purely paper losses. “That’s assuming that you’re going to sell,” she says. “Of course, we haven’t sold, and we don’t intend to.”

But Maui County treasurer Suzanne Doodan is not convinced by the state’s arguments. “I spouted those same lines for the first few months,” she says. “But these are no longer short-term instruments; you have to compare them to 30-year investments.” So, while the state’s 1.9 percent yields on SLARS may look good compared to current rates for bank repos or short-term CDs, they’re low even compared to the 4.75 percent yield on a 30-year U.S. Treasury note. SLARS might have been attractive as short-term investments, but they are liabilities as long-term investments.

This difference in perspective led Maui to pursue a different strategy than the state. This January, the Maui County filed a federal lawsuit against Merrill Lynch, the broker that sold them the SLARS. (To see Maui’s lawsuit filing, click here to download the PDF file.) Like other institutional investors around the country, Maui alleges Merrill sold SLARS as “cash equivalents” even though it knew, or should have known, these investments were unsuitable for Maui’s needs.

The state declines to discuss whether it’s pursuing legal action related to SLARS. “We’re obviously letting our attorneys take care of reviewing our options,” says Kawamura. Tung Chan, commissioner of securities at the Department of Commerce and Consumer Affairs, acknowledges receiving complaints “against these companies – Citi and Merrill – related to ARS.” DCCA policy, though, is not to disclose the name of the complainant. It remains to be seen if the state, in steadfastly defending its investment in SLARS, has lost its opportunity for legal recourse.

“I wonder if they missed the date to file,” Doodan says. “I think it’s a two-year statute of limitations.”

A Better Way

There are other important differences between Maui and the state, according to Doodan. “To my knowledge, the state has only used two brokers for years and years and years,” she says. “In contrast, we go out to at least five, six, seven, eight brokers. And every few years, we go out and solicit new brokers.” It’s also interesting, she notes, that, while Maui has suspended doing business with Merrill, the state continues to use the same broker who sold them the SLARS as bond underwriters. (This same broker, Pete Thompson, of Morgan Stanley Smith Barney, played a key role in persuading the Legislature in 1998 to add SLARS to the list of acceptable investments for the state treasury.)

There is another difference between Maui and the state. To coordinate its investments and cash-management obligations, Maui uses sophisticated, Web-based software called QED. This program was specifically designed for treasury operations and automates many basic functions of a treasury. It continuously updates the status of investments, including the current value of securities. It also provides templates for more than 600 different reports, most of which can be produced almost instantaneously. This ease of reporting simplifies the supervision and oversight of the county treasury. That’s probably why more than 40 states and thousands of counties and smaller government entities use QED.

For its part, the state relies upon a software program called Microsoft Dynamics, which is primarily a program for enterprise solutions or customer contact management. Although it has been adapted to be used for financial purposes, it doesn’t address many of the specific needs of a state treasury. As one expert put it, “This is like hunting an elephant with a shotgun.” This may help explain the treasury’s failure to routinely produce the reports called for by its own investment policies. It may also explain why the state’s investment activities are largely tracked on manual worksheets or even handwritten calendars.

Most state treasuries are far more transparent and seem to sustain much more oversight than Hawaii’s. New Mexico – an apt comparison with Hawaii because of its population of 2 million people and treasury of about $5 billion – offers an excellent model for an efficiently run treasury. “I can tell you,” says chief investment officer Sheila Duffy, “we have a lot of oversight in New Mexico. And we like it.”

Structurally, that oversight takes the form of two standing committees. The Treasury Investment Committee, Duffy says, consists of treasury officials and two securities experts from private industry. The other oversight group, the Board of Finance, supervises the broader activities of the state treasury, which corresponds roughly with Hawaii’s Department of Budget and Finance. Neither group is passive.

“We have a once-a-month report, a book really, that we deliver to the Treasury Committee” and to Board of Finance, Duffy says. This substantial report – produced automatically using QED software – summarizes the treasury’s existing investments, including asset details, yields, and trends compared to a benchmark. These reports and the minutes from committee meetings are available on the treasury’s Web site, along with numerous other reports and resources. In contrast, although Hawaii’s state treasury policy requires monthly status reports for the director of the Department of Budget and Finance, this report hasn’t been prepared since 2007, according to the state auditor. Moreover, there’s no outside authority to review such a report.

The Cure

How can Hawaii improve its often informally structured, poorly supervised and cloistered state treasury? And what can we do about its extraordinary burden of SLARS?

As for the auction rate securities, the answer may be nothing. “For now, our liquidity issue is covered,” says Kawamura, by which she means that, as the treasury’s longer-term investments mature – and they’re allowed by statute to carry some investments out to five years – these are gradually replaced with the SLARS. And the state seems intent on either holding onto them until maturity – another 35 years, in some cases – or waiting until it’s possible to sell them at par. That might seem farfetched. After all, the allegations of fraud, negligence and collusion that have been leveled at the wire houses have stigmatized SLARS as an investment. But some believe the SLARS market will revive; Kami said as much in his Dec. 27 testimony at the state Legislature. Even Maui County finance director Kalbert Young holds out hope.

“I would point out,” Young says, “since the SLARS market failed in February 2008, there’s been a slow return of activity in this market.” He doesn’t mean the actual resumption of successful auctions – not yet, anyway – but that the underlying securities have started looking increasingly attractive to investors. “We’ve been getting calls from other institutions interested in buying our ARS,” he says. “Not at par, of course, but better than it was. Even Merrill Lynch was willing to purchase some.” Nevertheless, Young says, “we still want to pursue our legal filings.”

Improving Hawaii’s treasury operations may prove easier. It’s simple enough to look to the examples of other states, like New Mexico and New Jersey, that have modernized their treasuries. Software solutions typically come with extensive consulting services and are cost effective. (QED costs less than $100,000 a year, after the initial setup.) But the most important lessons probably come from history.

After the disastrous 1994 bankruptcy of Orange County, when the county treasurer’s wild, unsupervised speculation in risky derivatives cost the county over $2 billion, the California state auditor issued some familiar-sounding recommendations: Have a Board of Supervisors approve the treasury’s investment policies; appoint a committee to oversee investment decisions; require frequent, detailed reports from the treasurer; and establish stricter rules governing the selection of brokers and investment advisers.
Those sound a lot like the recommendations of the Hawaii state auditor. They’re also suspiciously close to the kinds of best practices employed in New Mexico. In other words: boring, boring, boring.

Risky Strategies

State’s mix of risky & safe, traditional investments

CASh

Demand Deposits1
$229,770,000

Cash with Fiscal Agents
$5,980,000

U.S. Unemployment Trust
$265,499,000

Investments

Investments Time Certificates of Deposit2
$618,192,000

U.S. Government Securities
$528,130,000

Student Loan Auction Rate Securities3
$1,006,975,000

Repurchase Agreements4
$1,151,620,000

Total Investments
$3,304,917,000

Total Cash and Investments
$3,806,166,000

1. The state routinely failed to reconcile bank statements. In addition, funds were often left in sub-accounts that did not earn interest.

2. At least five times, the state exceeded the 50 percent limit on CDs from a single issuer.

3. The state’s portfolio of SLARS remains at roughly 30 percent of its total investments.

4. Repurchase agreements exceeded the 70 percent statutory limit in four out of 12 months.

Source: State auditor’s report

 

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School Procurement Scandals

BY DENNIS HOLLIER

“It’s OK as long as it’s for the children,” says Marion Higa.

Photo: Kevin Blitz“It’s OK as long as it’s for the children,” says Marion Higa.

The state auditor smiles wanly to show she’s being sarcastic while commenting on her office’s two-part 2009 audit of procurement at the Department of Education. That’s because she’s a stickler for law and order, and the report describes a Wild West of procurement improprieties and contracting schemes. It’s a story of imperious leadership and old-fashioned cronyism. It may also be a parable for what’s wrong with state government. But we’re getting ahead of ourselves. Let’s start at the beginning …

In 2006, the Legislature appropriated $160 million to the DOE for the renovation and repair of 96 schools, the final portion of the department’s Whole School Classroom Renovation Program. Years of neglect had left the public schools with leaking roofs and antiquated plumbing, and in desperate need of paint – facts well known to the DOE. Yet, when the department finally received the appropriation, it apparently had no idea how to spend that $160 million. It had no scopes of work, no budgets, and no timetables for the necessary construction and repairs. Instead, the state auditor’s report reveals that the department spent $18 million to $20 million of the Whole School appropriation to contract out these basic government responsibilities to consultants. The result is a baffling, multilayered system of program-management contractors and construction-management contractors that is the key to understanding how DOE went astray.

Pay attention, this part is confusing: The bottom layer of DOE’s system for orchestrating the Whole School program consists of the contractors at the individual schools, those coordinating the actual work of roofers, plumbers and painters. These contractors, however, are overseen by three companies with contracts ranging from $4.4 million to $7.3 million. These overseers are responsible for providing design- and construction-management services to the lower-level contractors. The construction management contractors, in turn, are overseen by yet another company, a long-time DOE consultant with a $2.3 million contract for primary management over the $160 million program. In all, the department has managed to insert three levels of middlemen between the subcontractors who actually perform the repairs and the DOE officials who are theoretically in charge.

As the report notes, the department – in particular, the Office of School Facilities, which is supposed to oversee construction and maintenance – appears to have outsourced its fundamental responsibilities. Instead, its elaborate system of contracts “provides consultants with the ability to monitor each other, review each other’s proposals, negotiate fees and modifications with each other, and evaluate each other’s performance, all at the department’s expense.” By surrendering these functions, DOE loses some of its most important tools for preventing fraud and abuse. It also exposes itself to a kind of Alice in Wonderland version of procurement.

Some of the effects are outrageous. For example, in DOE’s upside-down world of contracting, it is the construction-management consultants, rather than the department, who determine which projects at each school will be funded, the timetable for the work and how much the construction managers will be paid. In addition, the program-management consultant appears to exercise “excessive control” over contracting: negotiating fees, making award decisions, drafting documents and even directing department staff. At one point, the program-management consultant was allowed to submit a proposal on a construction-management contract, which would have put the company in charge of supervising itself. Under this system, it’s impossible to assure a competitive bidding process or to determine whether the state is getting good value for its money.

To understand how the department got to this point, we have to back up a bit. Although DOE has always handled some procurement, historically the Department of Accounting and General Services was in charge of procuring construction, repairs and maintenance. For years, DOE officials complained that this arrangement was dysfunctional. In 2004, then-superintendent Pat Hamamoto successfully lobbied the Legislature to move this procurement to DOE as well.

The irony is that moving procurement from DAGS to DOE hardly changed anything. For example, DOE did not have staff to handle the increased workload; so more than 200 DAGS employees – nearly all of those who formerly handled DOE procurement – became employees of the DOE. And because DOE did not have the space to accommodate them, those employees simply remained at their desks at DAGS. Only the names at the top of the procurement chain changed.

Despite the superficial nature of the move, DOE officials still tout its advantages. “It has definitely been a benefit to the DOE to have those functions in-house instead of at DAGS,” says Randy Moore, assistant superintendent of the Office of School Facilities, which is responsible for construction and repairs. However, Moore acknowledges that the change might have been less than expected. “Part of it, in hindsight,” he says, “was that we were able to reduce and pretty much eliminate what had been the historic view on the part of DOE – that all of our problems were DAGS. That ‘us-and-them’ attitude is greatly reduced.” Moore also admits that the old criticisms leveled at DAGS were exaggerated. He notes, “With the benefit of hindsight, DAGS did very good work.”

In contrast, the auditor’s report is highly critical of the Office of School Facilities. Although the department’s handling of management consultants may be the most egregious of its findings, the report offers a litany of detailed accusations. A quick scan of some of its headings is instructive: “Solicitation and selection process manipulated to award contract to predetermined contractor”; “Selected contractor given unfair advantage due to improper communications and apparent bias”; “Recently awarded study contract displays apparent lapses in ethics and judgment”; “Subcontractors are used to evade the procurement process.” The criticisms are so many and so intertwined, it’s hard to keep track.

Interestingly, Moore’s predecessor, former assistant superintendent Rae Loui, seems to be connected to many of the charges leveled in the report. Loui left DOE in December 2005 to become a vice president at M&E Pacific, a long-time contractor at DOE (and the program-management contractor overseeing the Whole School program). The auditor’s report suggests that Loui used her influence with former employees to secure a $300,000 construction-management contract for M&E Pacific in 2006, in violation of statutory standards of conduct. Similarly, officials in the Auxiliary Services Branch of the Office of School Facilities improperly offered Loui advice on how to secure playground equipment projects, providing M&E Pacific with an unfair advantage over other competitors. But Loui is not alone in exploiting her DOE connections; other former employees also seem to have used their relationships to get contracts with the department.

Loui did not respond to our requests for an interview.

The auditor’s report lays the blame for all these abuses squarely at Moore’s feet. “The lax tone from the top has unintentionally set the stage for a culture of disregard of procurement rules in the Office of School Facilities. The assistant superintendent of the Office of School Facilities exemplifies the attitude that public procurement rules just get in the way of doing the work.” In other words, Moore either invited misconduct by his outspoken disdain for procurement rules, or he tacitly encouraged a climate of “anything goes” by turning a blind eye to shady practices so long as they “got things done.”

Moore takes the criticism calmly – particularly criticism of department outsourcing. “That occurred because when all this work transferred over from DAGS. The number of people that transferred was not commensurate with the volume of work.” He adds, “Actually, our objective is to staff on a permanent basis for the steady level of work and to contract out for the peaks. And the DAGS people came over during one of those peaks. By the end of the calendar year, that level will be way down and we will no longer be contracting for those services. Actually, we haven’t had any contracts for that in a fairly long time; we’re just working off the old contracts.”

Former superintendent Pat Hamamoto responds to the accusations in the auditor’s report with much the same tone as Moore: What about Loui’s undue influence? “I think there were instances in which it didn’t come out the way it should have.” Have any employees been disciplined? “That’s a personnel matter; it’s confidential.” What has been the response to the report? “I think most of the findings, we took care of them.” It’s as if DOE officials read a different report than the one Higa wrote. Nonetheless, Hamamoto referred the auditor’s report to the Criminal Division of the Office of the Attorney General.

Of course, not everyone believes that the state auditor’s office is the last word in evaluating the effectiveness of government programs. For example, former state highway administrator Pericles Manthos (who had his own run-in with Higa several years ago) points out that the use of program management consultants isn’t unique to Hawaii. “Program management is used in a lot of Mainland states,” he says, “because they just don’t have the manpower, and they haven’t for years.” In addition, Manthos isn’t sure the “bottom line” should be measured by what’s cheapest for the agency. “It should be what’s best for the public.” By that measure, who’s to say expedience isn’t as important as good value and fair play? But Manthos’ primary complaint is that, while an auditor might be good at crunching numbers, that doesn’t mean she can assess complicated subjects like construction or engineering. “The financial finding is important,” Manthos says, “but it’s not the only thing.”

Former superintendent Hamamoto agrees. “Let me explain why,” she says. “When the auditor audits us, there are some considerations that we look at. For example, did she compare us to a large company? Did she consider manpower? etc. When she looks at it from a process standpoint, then I can understand it and put substance to what she says. But, when they get technical about either the way construction contractors are, or make broad generalized statements, yes, we do get concerned. Are they using people with expertise, who understand what’s going on, when they make those audit findings?”

For Higa, procurement rules are simply the standards of good government. “There’s something called a fraud triangle,” she says. On a scrap of paper, she sketches out an equilateral triangle, labeling the sides: opportunity, pressure and rationalization. Opportunity, she says, arises wherever there is a climate of lax enforcement. Pressure can be as simple as “I can’t pay my mortgage this month.” Rationalization, she notes, often takes the form of truisms: “Everyone does it” or “This benefits everyone.” Higa pauses and taps gently on this last leg for emphasis.

“And this is the classic rationalization,” she says. “ ‘We’re doing it for the children.’ ”

What Should Be Done

Included in the state auditor’s report on DOE’s procurement system is a long list of recommendations. Here is a selection:

The superintendent should review the use and structure of $21 million in project and construction management contracts for the Classroom Renovation Project, focusing on

  1. Inappropriate involvement and influence of project management consultants in awarding these contracts.
  2. Whether these management functions qualify as professional services and should be performed 
    in-house.
  3. Why consultants were able to influence/determine the contract and program budgets.
  4. Why consultants were responsible for determining scope, and ultimately compensation, of their own contracts.
  5. Why consultants were provided with so much authority.
  6. Determining whether these contracts violated the procurement code by allowing consultants to determine their own scopes and fees.

For the full list of recommendations, and to read the report in its entirety, visitwww.state.hi.us/auditor/Years/2009reports.htm

 

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Hawaii Procurement Wastes $200 Million

For most people, government is simply the sum of the services it provides: security and safety, for example, in the form of police and fire departments; education, in the form of schools and libraries; and transportation, in the form of roads, harbors and airports. Citizens can measure their government by how effectively it provides those services.

Businesses, though, often see another side of government. That’s because the state government relies on private contractors and consultants to provide many of these services. Contractors design and build the state’s schools and highways; consultants manage everything from state hospitals to social services. Indeed, government is the largest single customer of Hawaii businesses, spending more than a quarter of the state’s $7 billion budget on contracted goods and services. With billions at stake, clearly another measure of government is how efficiently and fairly it procures those services. And yet, by almost any measure, the state’s procurement process is broken.

The easiest way to gauge how dysfunctional the system has become is to glance through reports from the state auditor’s office. In department after department, report after report, procurement practices are found wanting. Indeed, many of the most prominent controversies faced by the state government in recent years have been procurement failures at heart: Two 2009 audits criticize the Department of Business, Economic Development and Tourism for flouting procurement laws by awarding a contract to a firm with ties to the department’s director rather than higher-ranking competitors. The latter DBEDT audit goes so far as to recommend the director’s removal.

Similarly, audits of the state Department of Education, University of Hawaii, Highway Administration, Department of Land and Natural Resources and Hawaii Tourism Authority have all found improper and incompetent procurement conduct. Most of these reports received considerable publicity when they were released, bringing a period of greater scrutiny for the agencies, but they failed to generate more general interest in procurement. Taken together, though, the auditor’s reports and a collection of related decisions by the Office of Administrative Hearings and the U.S. Circuit Courts suggest the state’s procurement difficulties are more widespread (and costly) than any single scandal.

Recent Cases of Wasteful Procurement

 
Phase II of the widening of the Big Island’s
Queen Kaahumanu Highway is supposed to run between
Kona International Airport at Kealakehe Parkway.
But poor procurement has delayed the project
for two years.

PHOTO: COURTESY GOOGLE

Photo Courtesy: Google  Phase II of the widening of the Big 
Island’s Queen Kaahumanu Highway is supposed to run 
between Kona International Airport at Kealakehe Parkway. But 
poor procurement has delayed the project for two years.

Contract No. 1: Widening of Queen Kaahumanu Highway

State Agency: Department of Transportation

Summary: In 2006, the state Legislature appropriated $40 million to widen part of Queen Kaahumanu Highway on the Big Island from two to four lanes. In December 2007, the state Department of Transportation issued a notice to bidders for a design/build contract for Phase II of the project, from Kealakehe Parkway to Keahole Airport Road, with an estimated cost of $60 million. In January 2008, DOT awarded the contract to the low bidder, Goodfellow Bros. Inc. Almost immediately, Kiewit Pacific Co., one of the other two qualified bidders, protested the award, claiming the Request for Proposals was ambiguous and Goodfellow’s bid was nonresponsive to the RFP. So, DOT rescinded the award and again put the contract out for bid. The next December, DOT again awarded the contract to Goodfellow. This time, Hawaiian Dredging, the other qualified bidder, protested that, among other things, the Goodfellow bid failed to meet the basic terms of the RFP. DOT denied the protest, and Hawaiian Dredging appealed to the Office of Administrative Hearings at DCCA. On April 3, 2009, the hearing officer found the Goodfellow bid “unresponsive” and ordered the contract to be re-bid again. This December, DOT issued a new RFP for the project, while simultaneously appealing the OAH ruling to the Circuit Court.

Findings: The inability of DOT engineers and contracting officials to write a clear, unambiguous request for proposals, or to effectively deal with the confusion of contractors during pre-bid consultations, resulted in at least a four-year delay in the highway project, greatly frustrating Kona residents. Also frustrated are the bidding contractors, who presumably all acted in good faith. All have incurred legal fees, lost time and the costs of proposal development. For taxpayers, the costs include lost time and manpower due to repeated procurements, plus extensive legal costs. It’s still unclear when construction will begin.

Contract No. 2: Electronic Voting Machines

State Agency: Office of Elections

Summary: In 2007, the Office of Elections issued an RFP for the lease of electronic voting machines and the purchase of election services for elections from 2008 through 2016. In 2008, the office awarded the contract to Texas-based Hart-InterCivic, which bid $43.4 million. The other qualified bidder, Nebraska-based Election Systems & Software, whose bid was only $18.1 million, protested on the grounds that the Office of Elections didn’t adequately justify the $25.3 million discrepancy in price between the two bids. The office denied the protest, and Election Systems & Software appealed to the Office of Administrative Hearings. The hearing officer found that it was, indeed, the duty of the Office of Elections to do a cost/price analysis. In response, the state’s chief election officer conducted a cost/price analysis himself, concluding that the Hart-InterCivic price was justified. Again, Election Systems & Software appealed to OAH, on the grounds that the chief election officer wasn’t qualified to do a cost/price analysis and that his analysis was inadequate and misleading. In issuing a summary judgment, the hearings officer agreed with Election Systems & Software, finding, among other things, that the state’s chief election officer had “acted in bad faith.” The Office of Elections appealed to Circuit Court.

Findings: The Office of Elections seems to have been predisposed to Hart-InterCivic technology, but failed to write a request for proposal reflecting this. Although the selection committee determined that ES&S technology was more than adequate, election officials were intent on selecting Hart-InterCivic, regardless of the 140 percent price difference. The Office of Elections’ failure to address the price doesn’t simply violate the State Procurement Code, it violates the ethical obligations of those entrusted with taxpayers’ money.

Moreover, it reflects the chief elections officer’s complete lack of experience in both procurement and elections. His desultory and unprofessional execution of the cost/price analysis ordered by OAH borders on criminal negligence. For example, he made no accounting for the fact that the Hart-InterCivic bid included the full purchase price of the voting machines, even though the contract was a lease. In addition, the Hart-InterCivic cost justification doesn’t account for more than $11 million, nearly 20 percent of the contract price. Even so, delays caused by the protracted litigation required the state to use Hart-InterCivic services for the 2008 elections before terminating the contract. In this settlement, taxpayers paid about $3 million more than what OAH had determined was already unreasonable.

The former chief elections officer did not return repeated calls by Hawaii Business for comment.

Contract No. 3: System to Monitor Airport Taxis

State Agency: Department of Transportation

Summary: In 2000, DOT awarded Ted’s Wiring a $1.5 million contract to develop and install a system to track if taxis paid correct fees at Honolulu
International Airport. The project was scheduled for completion by May 2003 and $1.3 million of the contract has already been invoiced and paid. However, despite numerous extensions and the threat of fines, seven years later, the work still has not been finished. In addition, the airport seems to have paid Ted’s Wiring more than $20,000 in 2005 for unrelated work completed in 1986. In May 2009, following publicity about the problem, the state initiated default proceedings against Ted’s Wiring.

Findings: Confusing RFPs and a consistent lack of follow-up or supervision plague airport contracting. The result is the potential for waste and fraud. This is exacerbated by the excessively cozy relationships between airport authorities and contractors. For example, although Ted’s Wiring, a long-time airport contractor, was threatened with fines, in the end, airport authorities assessed no penalties. The appearance of special treatment is not an idle concern: In 2007, several airport officials and contractors were convicted in a bid-rigging scandal that cost the state $4 million. With hundreds of millions of dollars in airport contracts in the works, the efficiency and fairness of the agency’s procurement process is more important than ever.

Who’s to Blame

One expert with strong views on Hawaii’s procurement mess is Terry Thomason, education chair of the Hawaii Procurement Institute, and an attorney specializing in public contracts at the law firm of Alston Hunt Floyd & Ing. (Thomason and other AHFI attorneys represent Election Systems & Software in its dispute with the Office of Elections.) Thomason divides Hawaii’s procurement troubles into three categories. There are a few “bad eggs,” he acknowledges, officials like the state’s former chief elections officer who operate in bad faith. The second kind of procurement problem, and more common, Thomason says, is like the airport official, “kind of a slow thinker – they don’t know how to do it correctly, so they give out periodic payments. But 99 percent of these are honest mistakes.” However, according to Thomason, the greatest cost to taxpayers is the third category: the state’s piecemeal approach to contracting.

“Scan the state procurement office Web site,” Thomason says, “and you will see a multitude of contracts for minor construction/repair/maintenance. For instance, you will see DOE projects for schools that include individual contracts for roofing, plumbing, painting, etc. Often, these requirements are at the same school or schools in the same area. All of those contracts were competed separately through the entire solicitation process – with potential for protests on each requirement – and separate contract awards for each.” For each procurement, he says, time is needed to issue the solicitation, perform evaluations, award a contract and resolve any protests. Each repetition, each delay adds to the cost of the project.

“It’s inefficient,” Thomason says. “It’s mowing the grass with scissors.”

Better Ways

He points out that there are much more effective ways to handle procurement. Federal contracting officers at Pearl Harbor or Schofield Barracks routinely use techniques like multiple-award-task-order contracts or indefinite-delivery/indefinite-quantity contracts to speed up procurement. “Army and Navy contracting agencies anticipate that requirements will arise,” Thomason says. MATOC or ID/IQ contracts allow them to issue solicitations in advance, even before money is appropriated, so projects can get started as soon as the need arises. With the state, that’s just the beginning of the process.

What’s more, Hawaii’s slow, incremental approach to procurement may cost the state federal money. For example, our inability to quickly award contracts for projects may be behind our poor ranking in spending federal stimulus funds – a Congressional panel ranked Hawaii 48th out of 50 states. The state’s procurement system simply can’t get contracts out the door quickly enough. For Thomason, this is particularly galling. “We should be the fastest,” he says. “We’re a tiny little state with a very defined area. And we have experts down the road who are doing many different types of contracts, more of them, and faster.”

The costs of our broken procurement system are enormous. Consider just our three case studies: millions of dollars wasted in legal fees and delayed work at the Queen Kaahumanu Highway widening; more than $25 million nearly squandered at the Office of Elections; $1.3 million spent on nothing at Honolulu Airport. At that rate, procurement looks like a primary cause of our budget shortfall. Thomason believes this waste amounts to 10 percent to 20 percent of our spending. “Are we out of money?” he asks. “I don’t think we are. If you just look at the things that are done repeatedly, you think, ‘Wait a minute; we could easily save 10 percent here.’ I think our budget for contracts is in excess of $2 billion a year. Just 10 percent would be more than $200 million. That would make breathing a lot easier for budget negotiators down at the Legislature.”

State Sen. Norman Sakamoto, who is interested in procurement issues, believes Thomason’s estimates are reasonable. “I would say 20 percent is high,” he says. “But if we look at global costs, I’m comfortable with 10 percent. It’s certainly more than a couple percent.”

There’s no sign, though, that the state is prepared to make changes. To begin with, the understaffed State Procurement Office (SPO), which should be the center for innovation and reform, has a very narrow definition of procurement. State procurement officer Aaron Fujioka likes to point out that procurement technically takes place in a very short window, usually 30 to 90 days. Strictly speaking, he says, procurement is simply the process of announcing an invitation for bids or a request for proposals, the steps used to select among bidders, and the rules for identifying winning bids. “People think the process is this big,” Fujioka says, his arms outstretched, “but really only this part is procurement,” he adds, bringing his hands close together. For instance, he says, the beginning of the process – writing accurate and unambiguous requests for proposals – is outside the scope of procurement. That’s planning. Likewise, making sure contractors fulfill their obligations in a timely manner is not procurement. That’s project management.

Many experts believe the SPO should take a more expansive view of procurement. State auditor Marion Higa argues that, because of the principles involved – creating a level playing field for contractors and getting good value for the taxpayers’ dollars – procurement should extend down to the departments and agencies writing RFPs. “He (Fujioka) is correct in that it’s not within his jurisdiction, per se; but as SPO, shouldn’t he also be promoting that the key here is how you spec out your acquisition?”

Others point out that the SPO has not done a good job conveying the importance of procurement laws to state employees. State Rep. Blake Oshiro (also an attorney at Alston Hunt Floyd & Ing) notes that government officials continually complain that the process is difficult and cumbersome. “You have to wonder if they know what the Procurement Code is supposed to accomplish,” he says. “Fairness, openness, competition. My guess is they don’t.” The result is widespread contempt for the norms of government procurement.

The irony is that Hawaii’s procurement law, patterned after the American Bar Association’s model code adopted by 27 states, is flexible and more than adequate. What’s lacking is the leadership to enforce existing rules and develop new approaches. Instead, the state seems to be moving the other way. Last year, the Legislature passed laws that limit the ability of companies to protest contract awards – a key check on procurement misbehavior. Perhaps worse, insiders say, the SPO is circulating draft legislation designed to “simplify and streamline” the procurement process by eliminating basic safeguards, like requiring pre-bid conferences and cost analyses.

The SPO’s perspective will likely be emphasized this month when a legislative task force recommends centralizing procurement once again in that office.

Given this trend, it’s hard to ignore the impression that procurement is a dirty word among state officials. Yet, at its roots, procurement law is simply about ensuring a fair playing field and getting good value for the taxpayers’ dollar. In fact, as Terry Thomason puts it, “A dynamic procurement system is the very measure of good government.”

Seven Steps to Better Procurement

  1. Develop a fulltime, professional procurement staff in all departments: For most staff, state procurement is now an added responsibility to their usual duties.
  2. Make salaries of procurement professionals competitive with private industry: You get what you pay for.
  3. Recentralize supervision of procurement in the State Procurement Office: Decentralizing, which was meant to expedite the process, resulted in waste and fraud.
  4. Remove exemptions from state procurement code: Far from promoting autonomy, granting exemptions from the code to certain agencies exposes them to litigation, waste and fraud.
  5. Encourage, rather than discourage, reasonable protests of contract awards: A lively, expeditious protest system is our most effective way to check misconduct and inefficiency in the solicitation process.
  6. Educate, educate, educate: And not only about Hawaii procurement laws, but about innovative procurement practices in the federal government and elsewhere. Remain open to novel or mainstream procurement innovations.
  7. Invest time and resources in acquisition planning: Up-front planning will make for a smooth process during the formation and administration of a contract.

 

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