NASA is one of our principal non-DOD agencies for which we perform these services. The NASA cost principles are essentially the same as those contained in the Defense Acquisition Regulations.

The CHAIRMAN. If you will pardon me, sir, I have read your statement, and it sounds to me-or, at least, it looks to me from having read your statement-as though the whole issue turns on the valuation of that stock. Is that correct?

Mr. NEUMAN. Yes, sir.

The CHAIRMAN. And your view is that the stock is not worth, I take it, nearly as much as the price at which the employer sold it to the ESOP?

Mr. NEUMAN. That is the view of the people who did the audit, Senator. They looked at the activities of the independent appraiser and the only thing they did differently was to use more current and more accurate information than the independent appraiser, which, of course, looks to the company to furnish data. They rely on the data furnished by the company.

If all the data furnished is not accurate or if less than complete information is furnished to the appraiser, obviously any decision reached by that appraiser could not be considered valid. In this particular instance we believe there was data available which the appraiser did not use at the time. We did not make our own independent evaluation.

As a result, we advised the contracting officer to get an independent evaluation. We did not make one, sir. We suggested that he get an independent evaluation, or that he look to the Internal Revenue Service or the Department of Labor both of which have the authority under the statute to make these determinations. This is our part in this particular issue.

The CHAIRMAN. I will appreciate your statement. Frankly, I wonder whether a determination of this sort is your responsibility or whether this should have been left to the normal IRS audit procedures. I think we will probably wind up making our own independent study. Thank you very much.

Mr. NEUMAN. Thank you.

[The prepared statement of Mr. Neuman follows:]

STATEMENT OF FREDERICK NEUMAN, DIRECTOR, DEFENSE CONTRACT AUDIT AGENCY BEFORE THE SENATE FINANCE COMMITTEE 20 JULY 1978

Mr. Chairman, and Members of the Committee: I am Frederick Neuman, Director of the Defense Contract Audi Agency, and with me are Mr. Irving J. Sandler, DCAA's Assistant Director for Policy and Plans, and Mr. John J. Quill, DCAA's Counsel. We are here at your invitation to tell you about the Defense Contract Audit Agency (DCAA) and to relate to you some of our views and the work we perform in connection with the cost of Employee Stock Ownership Flans (ESOP) allocated to Government contracts.

First, a few words to describe our Agency and its mission.

AGENCY MISSION

The Defense Contract Audit Agency was established by the Department of Defense to perform all contract auditing for DoD and to provide accounting and financial services to contract negotiators and administrators. Our work is advisory to the officials holding warrants authorizing them to bind the Government. We (1) evaluate the reasonableness and allowability of estimated costs contained on contractors' proposals for Government contracts, (2) verify the propriety and acceptability of costs charged or allocated to flexibly priced Govern

ment contracts, and (3) review major contractors' practices which, if inefficient and not corrected, lead to excessive costs and contract prices.

AUDITING STANDARDS

Jn performing our audits we use standards which are essentially the same as those governing audits performed by the major public accounting firms; those prescribed by the American Institute of Certified Public Accountants. Our audits also conform to the Standards for Audit of Governmental Organizations, Programs, Activities and Functions promulgated by the General Accounting Office and applied to our Agency through DoD implementation of Office of Management and Budget (OMB) Circular No. A–73.

We are relatively a small organization with some 2800 professional accountants, dedicated to assuring, as best we can, the taxpayers of this country get a dollars worth of value for a dollar spent.

APPROACH TO AUDITING

In performing our reviews, we determine the allowability of costs incurred or to be incurred under Government contracts by applying the applicable parts of the Defense Acquisition Regulation (DAR), formerly called the Armed Services Procurement Regulation. DAR paragraph 15-205.6-Compensation for Personal Services, provides the primary acquisition policy for determining the allowability of ESOP's for the Department of Defense. Additionally paragraph 15-201 stresses reasonableness, allocability and other factors as overall criteria for allowability of costs charged to Government contracts.

OMB Circular No. A-73 also requires all audit organizations to perform audit services for other Executive Branch activities wherever that would be the most economical and efficient way to obtain the needed audit effort. Accordingly and as authorized in our DoD charter (DoD Directive 5105.36), we provide contract audit services to about 25 other Federal agencies at those contractor locations where DoD has a continuing audit interest, or where it is economical from a Government-wide point of view. NASA is one of the principal non-DoD agencies for which we perform these audit services. The NASA cost principles are essentially the same as those contained in the Defense Acquisition Regulation.

ESOP COSTS

While there is no specific mention of ESOPS in the current DoD or NASA contract cost principles or employee compensation, it is recognized that contributions to an Employee Stock Owner Trust is a form of allowable deferred compensation subject only to a review for reasonableness and compliance with IRS rules. Such allowable contributions would include the reasonable cost of stock acquired and related interest incurred by the employee trust to borrow funds for this purpose. At our request, DoD is revising its cost principles to provide specific coverage on ESOPS.

We have had a few problems in applying these cost principles, but these problems relate to unusual contractor arrangements in their ESOPs. For example, a contractor recently asked for reimbursement of contributions made to an employee trust which were then returned to the contractor as payment of interest on its promissory notes. This transaction actually results in no cost to the contractor and such would be the case on its tax return.

The governing DAR cost principle I referred to before—Compensation for Personal Services-requires our auditors to assure that allowable compensation does not exceed Internal Revenue Service Rules. One such rule is that a qualified ESOP be for the exclusive benefit of the employee. An important test for this condition is that the transfer or purchase price of the employer corporation stock acquired by the trust not be more than the fair market value at the time of the transaction. This requires special consideration when the company stock is closely held and a fair market value cannot be readily determined.

For companies where the stock shares are closely held, it may be necessary for the employer to have its stock valued by a reputable, independent, outside organization. Such independent evaluations are reviewed to assure that the data used in making the valuation study is current, accurate, and complete. The valuation expert will generally assume that all data supplied by the company is accurate. In addition, the expert will normally ask corporate management if it knows of any facts that the valuation expert hasn't covered which

might affect the value of the corporation's stock. The expert must rely on the corporation for accurate and complete data. To the extent that the data is wrong or incomplete in any material respect, the derived value of the company's stock loses validity. While our auditors may compute a rough order of magnitude of the impact of such data they are not expected to develop a new appraisal. They would, however, disclose findings of this nature to contracting officers. In a few cases involving such findings they suggested that the contracting officers obtain an independent valuation of what the company's stock is worth.

The valuation of common stock of a closely-held corporation is a complex process and no formula can be devised that will apply in all circumstances. Relatively few problems with ESOPS have surfaced to date. However, in view of complexities involved we have asked our auditors to be alert to the need for assistance in this area. We are exploring the possibility of retaining an independent expert to assist us with stock valuation cases should the problems become more widespread.

That completes my brief overview of our organization and the considerations employed in auditing the cost of ESOPs allocated to Government contracts. I would be pleased to answer any questions you may have.

ADDITIONAL STATEMENT OF FREDERICK NEUMAN, DIRECTOR, DEFENSE CONTRACT AUDIT AGENCY

Mr. Chairman and Members of the Committee: I would like to express my appreciation for this opportunity to supplement my testimony given before your Committee on 20 July 1978. At the time of my original testimony, I was not aware that allegations would be put on the record concerning the personal behavior of one of our auditors. After reading the testimony furnished to you by Mr. David Personette, Executive Vice President, Metropolitan Contact Services, Inc., I feel obligated to state for the record that we believe these allegations to be unfounded.

Mr. Ballard, the manager of our Houston Texas branch office reviewed the testimony of Mr. Personette and denies any conversation concerning the honesty and integrity of Mr. Cunningham; he further denies that he made any statements relative to whether the contractor's procedure under the job-70 program were fraudulant. Additionally, Mr. Ballard strongly asserts that Mr. Personette's comments concerning his personal and professional behavior were completely without merit.

The record will show that the audit actions were completed well before Mr. Personette came to work for the contractor. Additionally, in late 1977 Mr. Cunningham, Chairman of the Board of Metropolitan, called our attention to certain problems perceived by him during the audit. Our Atlanta Region looked into the matter in some depth; our Headquarters staff worked closely with the field auditors and NASA procurement officials to resolve the points of issue. They found Mr. Ballard's conduct to be wholly professional and above reproach. Mr. Ballard's audit experience extends back over a period of 23 years; his record is unblemished and he has been given a number of commendations. His supervisors know him to be a dedicated professional who is mature in outlook and honest in his dealings.

I believe his actions in this matter in no way contravene his professional responsibilities or the legislative intent of encouraging employers to establish ESOPS. Quite to the contrary, it could be viewed that Mr. Ballard's actions foster the goal of ESOPs to enhance the welfare of employees by assuring that full and fair value is received by the employees for the expenditure of amounts held in trust for them.

The Agency is convinced Mr. Ballard acted within the scope of his authority and maintained conduct well within the bounds of professional propriety and generally accepted auditing standards. Additionally, I believe the audit reports issued by our Houston branch office were designed to produce fair and reasonable contract costs that are borne by the taxpaying public and at the same time achieve the objectives contemplated by ESOP legislation.

The CHAIRMAN. We are now favored with the presence of Hon. Jim Mattox who is a Representative from Texas. I would be happy to hear from Congressman Mattox.

STATEMENT OF HON. JIM MATTOX, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF TEXAS

Representative MATTOX. Mr. Chairman, I am honored to be here before you. I think that my testimony will be relatively brief. I know you have had prior testimony, and I think pretty comprehensive testimony, so I will try to be brief about the matter.

I would like to speak from the perspective of being a member of the House Budget Committee. I have been following this entire case that relates to Metropolitan and its dealings with NASA, I think probably since last year. In the course of looking at the documents, I think there is something important here that you would be interested in, because I know how tightfisted you have to be with the dollars of this country.

In the haste in which NASA selected a contractor on this contract, they overruled Metropolitan, despite the fact that Metropolitan's bid was 400,000 lower than the next closest bid. They have now explained that they did not understand that the bid was $400,000 lower and they made a selection, even though Metropolitan was, in effect, outranked by their ranking-which is pretty nebulous in itself-by 12 points out of a possible 1,000.

During the course of the oral and the course of written information, they never once asked Metropolitan to clarify the fact that they were willing to, in effect, eat $400,000 worth of Government costs and take $400,000 out of the profit. They never even considered that.

And it seems to me from a congressional viewpoint, and frankly, from a taxpayers' viewpoint, that that is a pretty shortsighted-type approach. I think that they took that approach, frankly, because of their interest in destroying Metropolitan contracts and, in effect, doing away with that contract and in effect, striking at the heart of the ESOP-type concept, in effect, knocking the ESOP concept out of Government contracting. Because it is my viewpoint that if companies like Metropolitan are knocked out, that means that other Government contractors are not going to be real happy to step forward and establish ESOP's for their employees.

The CHAIRMAN. I am trying to understand what you are saying. Here is a contractor who bid $400,000 less than the next low bidder. Representative MATTOX. That is right.

The CHAIRMAN. So it will cost the Government $400,000 to throw out that contract.

Representative MATTOX. That is right.

The CHAIRMAN. Well, are you saying that this company set up a stockownership plan for the benefit of their employees and a question arose whether there was something wrong about that stockownership plan, and NASA then cost the Government $400,000 by throwing that bid out because of the employees stockownership plan?

Representative MATTOX. That is, in effect, what happened.

The CHAIRMAN. Now, the fact that the employer has a stockownership plan means that those employees get a little better break than they do in some other company, even if the stock is not worth what they think it ought to be worth.

Is that a fair conclusion?

Representative MATTOX. I think that that is a fair conclusion, Mr. Chairman, and I honestly believe that the reason the Government, on this contract, would be losing $400,000 was because of the interest in destroying the ESOP concept in Government contracting.

The CHAIRMAN. That may be it. That may be it. Maybe the Agency's negative feelings about ESOP were a major factor in their hostility toward this company.

Representative MATTOX. You may very well be right, and you have a lot more experience than I have, but it is obvious to me that Metropolitan got a raw deal out of the whole matter.

The CHAIRMAN. Well, my impression is that where the Government suffers that badly by that kind of decision it has to be somebody making a purely selfish decision.

Representative MATTOX. I think that is probably right.

The CHAIRMAN. And, frankly, if you follow it closely enough you will probably find he places his personal prejudices above the good of the Agency.

Representative MATTOX. You may be right there, too.

The thing that impressed me was this. I have listened to some presentation by NASA and the thing that impressed me is that they said they did not understand that you were actually offering us a $400,000 savings and we did not understand that you were going to eat that $400,000. But I tell you one thing: Had they granted the contract to Metropolitan, you can bet that they would be standing right there, with no misunderstanding, and had been willing to say, listen, you are not going to get to pocket that $400,000. We get that.

Let me tell you, there would have been no misunderstanding had they granted the contract to Metropolitan. And it is a pure abuse not to have taken that kind of action. It makes the other companies very leery, because the other companies in the contracting area, I am sure, feel that the reason that Metropolitan lost it was that they established this ESOP-type concept and contracted for it.

I think that from my viewpoint, if NASA has got that kind of money to waste, perhaps we should take a little closer look at their budget the next time and be a little more cautious about granting their money, and they might be a little more cautious in applying the entire overall process.

I have been most displeased with the overall defense that the Government has offered. I do not think that there is anything wrong with the second bidder, Senator. I would not want to impune the integrity of anybody in that organization, but I will

The CHAIRMAN. I do not know who the second bidder was. All I know is that I have seen mischief like that before and it usually is something like I said. But I am not here to say obviously. I would not know that.

Representative MATTOX. I think there is one other point that we ought to make. This is a contract that Metropolitan already had, and Metropolitan was already carrying out the contract and doing an acceptable job on it.

Despite that fact, Metropolitan, recognizing that they were in trouble with NASA, were willing to grant the $400,000 savings. What Metropolitan said was, look, we will do this job with a whole lot