Navy Deal With Contractor Leaves Taxpayers With Bill : Defense: Morrison Knudsen passed overruns--now at $400 million--to a subsidiary that was then sold.
At a grimy shipyard along the San Diego waterfront, the Navy cut an unusual deal on April 12, 1989, that lifted an onerous financial burden from the shoulders of a major defense contractor.
By the end of that day, the taxpayers were left footing the bill.
The beneficiary was Morrison Knudsen Corp., which in 1987 had promised to build the Navy four advanced supply ships--known as AOE-6s--for $863 million at its National Steel and Shipbuilding Co. in San Diego.
Two years later, facing massive cost overruns on the AOE-6 program, Morrison Knudsen’s new chairman, William Agee, wanted to make a quick exit from the shipbuilding business. But there was one legal hitch.
As part of its contract for the AOE-6s, the Navy had insisted in 1987 that Morrison Knudsen sign a “performance guarantee” that made it liable for any overruns. Despite expert advice to the contrary, the Navy released the company from this guarantee--and from overruns that by now have grown to exceed $400 million.
The next day, Morrison Knudsen sold the shipyard to its employees, who assumed liability for the overruns. But as government auditors had warned, the financially weak shipyard was never able to bear the overruns by itself and filed claims that successfully passed the financial burden onto the government.
The AOE-6 saga shows how far the government will go when the survival of an important military program is threatened. Amid a defense industry shakeout, the Pentagon at times appears to be stuck between supporting struggling contractors and watching weapons projects disintegrate.
And in hard times, the ever-present political pressure to save thousands of local jobs--a key ingredient in the Morrison Knudsen case--can distort the ostensible goal of the military to get the best weapons at the lowest price.
Nowhere are times leaner than in the nation’s shipyards, whose existence hangs on Navy stewardship. U. S. shipyards long ago lost the ability to compete internationally for commercial work, forcing the Navy to take on enormous financial risks.
In the AOE-6 case, the Navy ignored the advice of government accounting experts at the Defense Contract Audit Agency, who cautioned that the shipyard would face a “high probability” of going bankrupt if it had to assume liability for the overruns.
The defense auditors apparently were right to be worried. Shortly after the release was granted, the shipyard hit the Navy with the first of a series of overrun claims, some of which were recently settled when the Navy agreed to pay $237 million to the shipyard for overruns on the first three ships.
The firms deny the deal amounted to a bailout, even though the Navy originally sought the performance guarantee because it considered Morrison Knudsen’s bid to be a low-ball price, according to Defense Department documents obtained by The Times. Morrison Knudsen is the same firm that wants to build mass transit rail cars for Los Angeles, arguing that the city should select it over foreign rivals because it has offered the lowest price.
Navy officials responsible for the release refused to comment, although the service arranged an interview with two officers who said they were not involved in the Morrison Knudsen release.
“I don’t think anybody in the Navy wants to talk about that right now,” said Capt. Theodore Doroshenk, who is now program manager for the cargo ships. “That was not done during my watch.”
The record of the Navy’s actions is muddled because the service neither obtained a formal legal opinion before granting the release nor wrote a memo that described the basis for its decision, according to a recent audit by the Defense Department inspector general. The Navy could not even find some of the key documents on which the decision was based.
By granting the release, the Navy cost taxpayers at least $142 million to acquire the fourth AOE-6, according to the audit. Some insiders say that estimate is just the down payment on what could ultimately be a $600-million tab.
“It was one of the most egregious contract actions I have seen in a long time,” said Deputy Defense Inspector General Derek Vander Schaaf, the Pentagon’s top law enforcement officer. “I couldn’t understand why anybody would do this.”
The mystery began inside the Naval Sea Systems Command, one of the most powerful and fiercely independent military procurement operations in the Pentagon. The agency, which buys ships, tried to block a review of the Morrison Knudsen affair by Pentagon auditors, Vander Schaaf’s investigation found.
The document that released Morrison Knudsen from its performance guarantee was signed by then-Capt. Eugene Harshbarger, one of the top contracting officials at the agency. He declined to be interviewed for this story.
Harshbarger apparently became involved only after Morrison Knudsen officials approached Everett Pyatt, then assistant Navy secretary for shipbuilding.
“Agee complained about (the performance guarantee), but we sent him down to negotiate with Harshbarger,” Pyatt said. Pyatt does not recall much about the deal except that it “was a lousy situation no matter what happened.”
Not for Morrison Knudsen. Stephen Grant, the firm’s general counsel, said flatly that the deal was a “good development,” adding: “We did not want to stand behind this very difficult construction contract. No one could tell us what the downside exposure was.”
Grant also argued that the release was “good for the Navy,” because the service was able to achieve its goal of preserving the last West Coast facility that can build a ship. Morrison Knudsen had proposed transferring the project to a Gulf Coast shipyard and shutting down National Steel and Shipbuilding.
This West Coast rationale apparently lurked everywhere behind the Navy’s action. The inspector general’s investigation also found it figured into the Navy’s thinking, although it was never formally explained in any document.
Such a geographic rationale was difficult for many officials to comprehend--ships easily sail from the Atlantic to the Pacific. But it made plenty of political sense.
The California congressional delegation was pressuring the Navy to keep the AOE-6 program in San Diego, along with the 2,500 jobs at the shipyard at that time. (The shipyard now employs 4,300 people.)
At least three members of Congress from California wrote to the Navy seeking assurances that the AOE-6 program would stay put. The Naval Sea Systems Command, which confirmed the letters’ existence, declined to release them.
Morrison Knudsen told the Navy it would indeed keep the program in San Diego as long as the company could get out of its performance guarantee, according to correspondence between the company and the Navy.
That was important because Agee wanted to get out of the shipbuilding business. With no other buyers in sight, Morrison Knudsen planned to sell the shipyard to its employees, led by its four top executives. That would satisfy the politicians by saving the shipyard jobs, and it would keep the Navy happy by ensuring that the ships would get built.
But without the guarantee from giant Morrison Knudsen, the Defense Contract Audit Agency argued that the employees could not bear the cost of AOE-6 overruns, which were widely anticipated before the release.
Navy officials were furious over the audit agency’s opposition, according to insiders. To counter the findings, the Navy hired the accounting firm KPMG Peat Marwick to do an independent review of the employee buyout--just two months before Morrison Knudsen got its release. The Navy declined to say how much it paid Peat Marwick, but government documents indicate it was more than a quarter of a million dollars.
Peat Marwick’s confidential review, a copy of which was obtained by The Times, found that Morrison Knudsen had already sapped the shipyard’s financial strength. The report found that the company drained $180 million from the shipyard between 1980 and 1988 in the form of cash dividends--which exceeded the shipyard’s net income by $50 million and contributed to a negative cash flow of $113 million.
Still, Peat Marwick concluded that the employee buyout would succeed and the shipyard would complete the AOE-6 program without a Navy bailout. The Navy was pleased with the findings and used them as a basis for the release.
The inspector general later found, however, that Peat Marwick’s analysis was based on “arbitrary” assumptions provided by the Navy and unsupported by any important documents. The Navy told Peat Marwick to assume the shipyard would lose only $70 million on the AOE-6 contract, even though the Navy’s other estimates put the losses at nearly three times that amount.
During critical weeks before the deal was struck in April, 1989, the parties were locked in negotiations. Morrison Knudsen was fighting Navy demands that the firm provide the shipyard with a financial support package in exchange for the release.
Grant, the Morrison Knudsen attorney, wrote to Harshbarger on March 7, 1989, that the Navy’s demands “were just plain silly.” If the Navy pushed too hard, he threatened, Morrison Knudsen would go to court.
Morrison Knudsen did agree to provide the shipyard with loans of up to $20 million and to guarantee some bonds for a few months, but the total package was judged as inadequate by the inspector general.
Separately, the shipyard was also lobbying the Navy for concessions on a number of issues. On March 17, 1989, shipyard President Richard M. Vortmann wrote to Harshbarger demanding that the Navy settle a longstanding dispute for at least $45 million. Otherwise, Vortmann wrote, “NASSCO’s viability is definitely marginal at best.”
Not long after, the Navy settled the matter for $46 million.
On April 12, Morrison Knudsen got its cherished release. The next day, it sold the shipyard. Four top shipyard executives bought an 18% stake; the rest was acquired by an employee stock ownership plan, financed with a $5-million loan.
Whether the government helped underwrite this transaction also has been investigated. Defense auditors looked into whether the executives bought their stake with more than $1 million in bonuses paid by the shipyard, which may have been charged back to the government as overhead expenses.
An audit of the issue was never concluded, in part because the shipyard has not submitted its overhead expenses for government auditing since 1988, said one former government auditor. Under federal acquisition rules, the shipyard should have submitted those bills for auditing within 90 days. Shipyard officials declined to discuss the executive bonuses and said all their records are open to the government for auditing.
At this point, the newly independent shipyard was liable for cost overruns--which quickly began to mount. The next month, the shipyard filed the first of a series of overrun claims with the Navy, which earlier this year paid $237 million to cover the claims.
Where did the money come from? The Navy took it from funds Congress appropriated for a fourth ship, and used the money to cover overruns on the first three vessels. Then, to pay for the fourth ship, the Navy asked Congress last year for an additional $500 million, which was appropriated with strong support from the California delegation.
Rep. Bill Lowery (R-San Diego) boasted in a 1991 newsletter to his constituents, “As a member of the House Appropriations Committee, I fought hard for this contract which will save 1,000 jobs. This is good news for many families in San Diego during these tough economic times.”
The bad news was that shipbuilding contracts issued by the Naval Sea Systems Command were $5.5 billion over their target costs, the General Accounting Office estimated in 1990. The GAO, which is now updating its estimate, found the Navy had problems with ship design, late equipment and unrealistically low prices under the original contracts. That would fit the pattern on the AOE-6.
Morrison Knudsen’s final bid for the AOE-6 was more than $100 million below its next lowest competitor, according to a report by the inspector general, but National Steel and Shipbuilding contends that the overruns were the Navy’s fault--and that the Navy got off easy by paying just $237 million for the claims.
Fred Hallett, vice president for finance at National Steel and Shipbuilding, said the Navy put the squeeze on the shipyard, adding: “They gave us the absolute minimum they knew that we would accept, and not go to court.”
Hallett said the firm performed well under prior Navy programs, building cargo, cable and hospital ships under budget.
On the AOE-6, however, Hallett said the Navy changed design specifications on the ship and required the shipyard to buy a special engine gear that was delivered late, causing inefficiencies in the entire project. The AOE-6 is the Navy’s first ship with such a gear, whose design was purchased from the Italian navy.
The Navy accepts the blame for the overruns. The service figured it had “superior knowledge” and should have known the gear would take longer than expected, according to Doroshenk, the Navy program manager.
Some officials, however, take sharp exception to this.
“Are you going to believe that the shipyard bid the contract without knowing whether anybody could build the gear?” asked one government investigator familiar with the AOE-6 project. “It was the most important piece of equipment on the ship.”
Indeed, the shipyard had two years of discussions with the Navy before bidding the contract and certified in its bid that it fully understood the ship’s design.
At least some of the shipyard’s problems also resulted from an inexperienced work force. Employees agreed to take a 22% wage cut after a two-week strike in 1987, which led to an exodus of skilled workers, according to Robert Godinez, business manager of the International Assn. of Bridge Structural and Ornamental Iron Workers, the largest union at the yard.
Before the wage cut, the shipyard’s work force averaged 15 to 20 years of experience, but that average fell to two years after the strike, Godinez said.
Government officials close to the AOE-6 program are worried that the cost overruns are not over; the shipyard’s cost control system is so bad that nobody is sure how much the ships will cost, according to government auditors.
To stop the bleeding, the inspector general asserted in a December, 1991, audit that the Navy should forgo the fourth AOE-6 ship.
His audit said the Navy will have too many supply ships, given the post-Cold War reduction in its force of aircraft carriers. But the Naval Sea Systems Command rejected that idea and is preparing to award a contract for the fourth AOE-6 ship.
Meanwhile, the first AOE-6 ship, named the Supply, is still under construction in San Diego Harbor, 1 1/2 years behind schedule. Harshbarger has been promoted to rear admiral.
