New Revenue, New Concerns

Contingency fee contracts are becoming hot, but have their limits.
 

Let's say we told you we could save you hundreds of dollars on your utility bills, and that we'd be willing to do this for free. All we want is to take a percentage of the savings at year's end. Pretty attractive, right?

Well, this is precisely the kind of arrangement that over the years, numerous cities, counties and states have entered into with companies that have specialized skills and the appropriate technology to find additional revenues or savings for government. Called contingency fee contracts, they've been used for various purposes: to bring in more tax dollars, maximize federal payments, go after Medicaid overpayments, launch litigation, find energy savings and more.

Stockton, Calif., for example, has successfully used contractors to identify businesses in which property tax has been misallocated to the county rather than the city. When the contractor finds a company that's been incorrectly identified as outside city limits, Stockton gets the new revenue, and the company gets a take of that - in the neighborhood of 15 percent for the following eight quarters.

Similarly a utility audit in Raleigh, N.C., done on a contingency fee basis, netted the city savings of about $200,000 over 20 months after the contractor took its 15 percent. In 2010, internal auditors will negotiate another contingency fee contract to look for new revenue available from the state's so-called privilege tax, which is paid directly by loggers, miners, sawmills and others in lieu of a traditional sales tax on some of the equipment they buy.

We feel rather confident that contingency fee contracts are going to become even more prevalent in coming months, as the public sector continues to eagerly grasp for any additional dollars it can find - particularly if there's no dollar investment necessary. When we asked Gary VanLandingham, director of the Office of Program Policy Analysis and Government Accountability in Florida, about this, he agreed: "Upfront money right now is very limited," he said. "I wouldn't be surprised if this surfaces in a number of states."

Assuming we're right and that neophyte governments enter into this field, it feels more than worthwhile to point out some of the pitfalls here. Since a government doesn't need to provide any upfront money, contingency fee contracts can escape all kinds of oversight layers that would apply to any process that actually requires cash being spent.

For example, particularly zealous contractors can make mistakes, leaving the government on the hook to repay funds they have happily collected. Many states use contingency fee contracts in their Medicaid programs to ferret out third parties who may be responsible for the payments currently being made by Medicaid. But when the U.S. Department of Health and Human Services' Inspector General's Office looked into these contingency fee contracts, it uncovered problems like New Jersey's decision to submit for more than $200 million in questionable funds based on a consultant's advice. The state claimed some things twice and asked for money back on some items that aren't allowable under Medicaid guidelines, like costs for care to state prisoners. Since then, the Inspector General's Office has continued to explore the area and has about 10 ongoing audits in a half a dozen states. It will publish them in the coming year.

It's no surprise that contractors' efforts to market themselves to states may result in exaggerated claims for potential returns. This isn't just a problem for the contractor. While it may appear that contingency fee contracts cost nothing, they can still consume a fair amount of staff time processing the contract and internal legwork to assist the contractor. What's more, entities that use them most effectively provide internal oversight over the way the contract is implemented, even if they don't do the kind of analysis that would be performed if the government were spending upfront money. What's more, these contracts can easily raise the hackles of the people or organizations accused of underpaying the state or receiving overpayments from the state - even when the dollars involved can seem trivial.

Back in Stockton, auditors found that a contingency fee arrangement to uncover overpayments in its $20 million self-insured employee health benefit plan ended up delivering a somewhat smaller return than forecasted. Initially the contractor said it believed its work would net $400,000 due to overpayment errors involving dependents who weren't eligible for coverage. In fact, the actual overpayments uncovered in this part of the audit amounted to $61,000. Of these, the city's HR staff had already identified and started to recover the majority of the money before the claims investigation began.

Craig Kinton, Dallas city auditor, wanted advice about how to best work with contingency fee contracts; he sent out a query on the Association of Local Government Auditors electronic mailing list. He was kind enough to share some of the best advice he got, which we'll pass along:

  • It's important to know what the limits on recoveries will be and whether there is a "go-forward" period in which the contractor will also expect to get a percentage of the proceeds.
  • Clearly define what revenues or savings the fees will be based on.
  • Set minimums so that a lot of time isn't spent going after pennies.

Rich Oksol, lead internal auditor in Sioux Falls, S.D., also had a suggestion: "Make sure that there is wording such that the contractor/consultant is working exclusively for the benefit of your organization." Alternatively contractors can exploit the intelligence they've gathered about the government to help other organizations play the same game - in reverse.

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