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Advisory Opinion No. 1999-19

Advisory Opinion No. 1999-19

Application Of Conn. Gen. Stat. §1-86e To Independent Contractors’
Use Of State Funds To Benefit Related Party

John Houchin, Director of the Eastern Region of the Department of Mental Retardation ("DMR"), has asked how the restrictions of Conn. Gen. Stat. §1-86e apply to private agencies which contract with DMR and then use state funds to subcontract with or otherwise benefit related parties. Dr. Houchin has described a number of situations in which the independent contractor has control over both sides of a transaction involving the use of state funds, and would like the Commission to review the application of Conn. Gen. Stat. §1-86e to these situations.

According to Edward Morettini of the Office of Internal Audit at DMR, a private provider must report any related party transactions in its the annual audited financial report ("ACOR") submitted to DMR. Under Department of Income Maintenance regulations, the term "related parties" is broadly defined to mean any person or organization "related through marriage, ability to control, ownership, family or business association. Past ability to exercise influence or control need not be shown, only the potential or ability to directly or indirectly exercise influence or control." Regulations of Connecticut State Agencies §17-313b-1(19). By statute, "whenever costs are incurred between related parties, allowable costs shall be defined as and limited to cost to the related party." Conn. Gen. Stat. §1-313b. Mr. Morettini indicates that, under these rules, a related party may not make a profit even if a profit would normally be built into a fair market transaction. Salaries can be paid, but only at a fair market level.

Under Conn. Gen. Stat. §1-86e(a)(1), no person hired by the State as a consultant or independent contractor shall "use the authority provided to the person under the contract, to obtain financial gain for the person, an employee of the person, or a member of the immediate family of any such person or employee." In a recent advisory opinion, the State Ethics Commission held that a potential conflict of interest exists under this section if there is a nexus between the facts in question and the state money and authority granted to the independent contractor or consultant by contract. See Advisory Opinion No. 99-14, __ Conn. L.J. No. __, p.__(_/_/99) (Before hiring or subcontracting with immediate family member, independent contractor must satisfy certain requirements and obtain DMR approval).

Turning to the specific facts presented in Dr. Houchin’s letter, a number of the scenarios involve subcontracting by the independent contractor with companies controlled by the independent contractor, or with companies which control the independent contractor. In one example, a private provider uses his own company to perform subcontract work on properties he owns which are used as Community Living Arrangements ("CLAs"). In another example, the Connecticut private provider is controlled by an out-of-state parent company to which the Connecticut provider annually pays over $500,000 in fees for management services, an arrangement which appears to be well above the fair market value of such services. Of particular concern to DMR is the fact that funds derived from DMR contracts are used to pay the related parties of private providers for services where there has been no open and public bid process. According to Dr. Houchin’s letter, the private provider and its related entity are able to "decide the price, how much of the service is to be provided or required, [and] who or what company is going to provide the service."

Conn. Gen. Stat. §1-86e does apply to these situations. As the State Ethics Commission stated in Advisory Opinion No. 99-14, cited above, a conflict of interest under this section can be avoided if the private agency fully discloses to DMR, in writing, the proposed subcontract and can demonstrate to DMR why this subcontract is an appropriate use of state funds. DMR must then determine whether the company is qualified to perform the services required, and also whether the contract rate is a fair market rate. In order to determine that rate, it may be necessary for DMR to require the private agency to advertise the contract opportunity in a manner analogous to Conn. Gen. Stat. §1-84(i). This means that the private agency would have to demonstrate to DMR that it had gone through an open and public contracting process, including a prior public offer of the contract opportunity and subsequent disclosure to DMR of the responses received and the contract awarded. See Advisory Opinion No. 99-14. Under Conn. Gen. Stat. §1-86e, a private provider may not, as described above, remit $500,000 to a parent company without appropriate documentation.

Another type of scenario raised in Dr. Houchin’s letter involves the leasing of rental properties owned by the private provider or an immediate family member to the private provider for housing for DMR clients. In one example, the private agency’s executive director owns the homes rented by the private agency. The executive director thereby ensures that his rental properties will have little or no exposure to vacancy. His decision-making in his private capacity places rent-paying DMR clients in investment properties he owns. In another example, the executive director of a private agency and his wife own homes that are rented to the private agency. DMR is in effect paying the mortgages of those homes by paying the lease amounts. The executive director determined that the houses owned by him and his wife would be used as CLAs. As a result, rather than having the private provider buy these homes and build equity by paying the mortgage, the executive director and his wife retained ownership and built equity for themselves.

These situations demonstrate a direct conflict of interest under Conn. Gen. Stat. §1-86e. The executive directors of the private agencies have clearly used their authority under the contracts for their own financial gain. According to Dr. Houchin’s letter, there was no attempt made to determine whether these arrangements were the best use of the state money that funds them. In the future, private agencies that wish to lease property owned by a principal or employee or an immediate family member must seek DMR approval before entering into such an arrangement. In order to obtain such approval, they must be able to meet the prerequisites outlined previously, including demonstrating that the arrangement is an appropriate use of state funds and that the lease to be paid is at a fair market rate. Also, of course, they must comply with the related party requirements as enforced by DMR and the Department of Social Services.

In several of the examples provided by Dr. Houchin, some employees of private agencies who may be personally benefiting from related party transactions have not allowed DMR to monitor the transactions to determine whether inappropriate profits have been made. In one situation, for example, the executive director of the contracting agency is also the owner of a for-profit company with which the private agency subcontracts for staffing and maintenance purposes. If the executive director is obtaining direct financial gain from this subcontract, he may have used his authority under the contract in violation of Conn. Gen. Stat. §1-86e, as well as in violation of the related party regulations. To the extent that a private agency refuses to provide the information needed to determine compliance with state ethics law and regulations, it may be necessary for the Ethics Commission to commence an enforcement action.

In certain situations raised in Dr. Houchin’s letter, the private agency’s subcontract activity may so contravene the ethics law that DMR approval should be withheld unless changes are made to the existing arrangement. For example, the former executive director of one private agency, who at times also serves on the board of directors, leases vans to the private agency at a rate far above the market rate. This same individual also runs a real estate company from which the private agency leases space. The real estate company, which does not own the property, charges the private agency almost twice the monthly rent which is paid to the owner. Finally, the individual’s son has been paid to provide lawn mowing and snow plowing services at a rate that seems well in excess of what is necessary for the property in question. In each of these three examples, it appears that, absent a showing to DMR that the arrangement is an appropriate use of state funds, the transaction violates Conn. Gen. Stat. §1-86e as an improper use of the authority granted under the state contract for financial gain to a prohibited individual.

In summary, transactions involving state funds and made between the parties covered by Conn. Gen. Stat. §1-86e will only be acceptable if the private agency involved has received prior written DMR approval. DMR should approve the arrangement only if the subcontractor is qualified to perform the required services, the services are necessary, and the compensation is at the market rate for the work which is actually performed. If an independent contractor fails to provide the appropriate documentation to DMR or pursues an improper transaction, or if, for any reason, DMR fails to adhere to these standards, the matter may become subject to an State Ethics Commission enforcement action, as a possible violation of Conn. Gen. Stat. §1-86e.

Finally, it should be noted that this opinion does not in any way preclude DMR from rejecting an arrangement for reasons other than a failure to comply with the Code of Ethics. For example, the "related party" regulations are broader in their scope than the restrictions under Conn. Gen. Stat. §1-86e. Therefore, the rules outlined in this opinion should not be read to restrict the application of any other statutes, regulations or rules which may apply to contracts made with DMR.

By order of the Commission,

Stanley Burdick,