Defense Infrastructure: Army Has a Process to Manage Litigation Costs for the Military Housing Privatization Initiative
Published: 2014-04-03T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: In 1996, Congress enacted the MHPI, which provided the Department of Defense with a variety of authorities that may be used to obtain private-sector financing and management to repair, renovate, construct, and operate military family housing. The Army has invested $1.97 billion and the private sector has invested $12.6 billion in the initial development of MHPI projects at 44 installations.
The Senate report accompanying a proposed version of the National Defense Authorization Act for Fiscal Year 2014 mandated GAO to examine the Army’s litigation costs related to MHPI, specifically any litigation costs not accounted for during the MHPI’s annual budget process. This report examines the extent to which the Army has implemented its process to manage funds for litigation not accounted for in the budget and identifies any effects that the litigation and audit costs have had on managing the MHPI projects.
To conduct its work, GAO examined the Army’s process for managing litigation, interviewed Army officials, and analyzed documents to determine whether litigation and audit costs have had any effects on managing the MHPI projects.
GAO is not making recommendations in this report. DOD provided technical comments on a draft of this report, which were incorporated as appropriate.
section_title: What GAO Found
paragraphs: The Army has a standard process to manage litigation costs of its Military Housing Privatization Initiative (MHPI) projects that are not accounted for in the annual budget process. Army officials indicated that there is one case between four Army MHPI projects and Pinnacle Property Management (Pinnacle) that met the dollar threshold criteria and that would have been approved through this process. However, Army officials did not use the standard process because the Army determined that it needed to limit access to Pinnacle litigation information to avoid disclosing any information material to the litigation strategy. As a result, the Army used an alternative process to review and approve litigation costs for Pinnacle that is consistent with MHPI operating agreements. Had the standard process been followed, litigation and litigation cost information would have been shared with the MHPI projects construction company, Clark Realty Capital (Clark), and four different offices within the Army. Army and Clark officials decided to use the alternative process allowed by the MHPI’s operating agreements so that fewer personnel would be aware of ongoing litigation information involving Pinnacle. The alternative process allows the Army and Clark to directly approve specific actions on behalf of the MHPI project, such as approving litigation and audit expenses, and allows sharing information with only Clark and one Army office.
According to Army officials and our analysis of these four MHPI projects’ accounts, Pinnacle litigation expenses have not prevented the projects from meeting their normal operating requirements, such as conducting maintenance or paying for utilities. Rents collected from these four MHPI projects funded the normal operating requirements for these projects as well as the Pinnacle litigation and audit expenses. Rents collected in excess of operating expenses normally are available for other purposes such as construction; capital, repair, and replacement of buildings; and future reinvestment. However, because litigation expenses were also paid from the rents collected at the four MHPI projects involved in the litigation, some funds have not been available for these purposes. Nevertheless, Army officials said that the Pinnacle litigation and audit costs have had no effects on the four projects’ ability to move forward with construction as planned so far or to meet any scheduled capital repair projects because these projects were developed within anticipated funding levels.
The Army property-management agreements provide that the party that substantially prevails in a legal action may recoup their legal expenses. Army officials stated that they expect the MHPI projects to prevail in the litigation and recoup most, or even all, the costs of conducting the litigation.

section_title: Letter
paragraphs: The Department of the Army uses private-sector partners to help manage  military family housing at 44 installations in the United States, including  management of accounts paying for construction, repairs, renovations,  and any litigation costs. In 1996, Congress enacted the Military Housing  Privatization Initiative (MHPI), which provided the Department of Defense  (DOD) with a variety of authorities that may be used to obtain private- sector financing and management to repair, renovate, construct, and  operate military family housing. The Army’s goal for the MHPI is to  significantly improve the quality of housing offered to military members  and their families so the Army can continue to attract and retain military  personnel. Section 2803 of the National Defense Authorization Act for  Fiscal Year 2013 was intended to strengthen the oversight of the MHPI by  implementing a series of measures for financial integrity and  accountability, and requires the Secretary of Defense to submit expanded  reports to Congress on expenditures and receipts related to the MHPI.  Furthermore, section 2806 of the National Defense Authorization Act for  Fiscal Year 2014 added a requirement that these expanded reports  specifically include any unique variances associated with litigation costs.
The Senate report accompanying a proposed version of the National  Defense Authorization Act for Fiscal Year 2014 mandated GAO to  examine the Army’s litigation costs related to the MHPI, specifically any  litigation costs not accounted for during the MHPI’s annual budget  process. In this report, we (1) examine the extent to which the Army has  implemented its process to manage funds for litigation not accounted for  during the MHPI projects annual budget process, and (2) identify any  effects that the litigation and audit costs have had on managing the MHPI  projects.
To examine the extent to which the Army has implemented its process to  manage and document the use of MHPI projects’ funds for litigation not  accounted for during the MHPI’s annual budget process, we obtained and  reviewed Army guidance used to manage MHPI projects’ funds for  litigation expenses and documentation the Army has received from its  partners to justify litigation and audit expenses. We also interviewed Army  officials from the Office of the Deputy Assistant Secretary of the Army  (Installations, Housing & Partnerships), the Office of the Assistant Chief of  Staff for Installation Management, the Office of the Army General  Counsel, and MHPI project asset managers who have knowledge of  MHPI guidance and practices used in managing MHPI projects’ funds  spent on litigation.
To determine whether Army litigation and audit costs have had any  effects on managing the MHPI projects, we discussed with Army officials  any litigation and audit expenses not accounted for during the MHPI  annual budget process to determine whether these costs had adversely  affected any of the accounts used to manage the MHPI projects involved  in litigation. We also obtained and analyzed MHPI project-management  account documentation to determine whether litigation and audit costs  had any effects on MHPI project accounts. Specifically, we obtained and  analyzed the MHPI projects’ budgeted operating expenses from calendar  years 2009 through 2013 to determine whether the projects had to reduce  their operating expenses due to litigation. To assess the reliability of  these cost data for Army MHPI projects involved in litigation not  accounted for during the MHPI annual budget process, we met with Army  officials to discuss these data and the processes and controls that were  used to maintain the data. We determined that these cost data are  sufficiently reliable for our purpose of reporting budgeted operating  expenses for calendar years 2009 through 2013.
We conducted this performance audit from July 2013 to April 2014 in  accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
subsections: section_title: Background
subsections: section_title: Military Housing Privatization Initiative
paragraphs: Congress established the MHPI in 1996 to provide an alternative funding  mechanism to ensure adequate military family housing was available  when needed by renovating existing inadequate housing and constructing  new homes on and around military bases. The Department of the Army  currently has 34 MHPI projects at 44 installations in the United States.  Since these projects began, the Army has invested $1.97 billion and the  private sector has invested $12.6 billion in the initial development of the  military housing projects. In a typical privatized military housing project,  the developer is a limited liability company or partnership that has been  formed for the purpose of acquiring debt, leasing land, and building and  managing a specific project or projects. The limited liability company is  typically composed of one or several private-sector members, such as  construction firms, real-estate managers, or other entities with expertise  in housing construction and renovation. In those cases where a military  department has made an investment in the limited liability company, the  department may also be a member of the limited liability company. In a  typical privatized military housing project, a military department leases  land to a developer for a term of 50 years. The military department  generally conveys existing homes on the leased land to the developer for  the duration of the lease. The developer is responsible for constructing  new homes or renovating existing houses and then leasing this housing,  giving preference to service members and their families. Although the  developers enter into these agreements to construct or renovate military  housing, the developer normally enters into various contracts with design  builders and subcontractors to carry out the actual construction and  renovation. The developer also typically hires a property-management  firm to oversee the day-to-day operations of the MHPI project, such as  ensuring that maintenance is provided to houses in accordance with the  approved budget.
section_title: Army MHPI Project- Litigation Costs Involving Pinnacle Were Not Accounted for during MHPI Annual Budget Process
paragraphs: According to Army officials, the only litigation that has caused the  expenditure of funds not accounted for during the MHPI’s annual budget  process for operating costs to-date is litigation involving Clark Realty  Capital (Clark) and Pinnacle Property Management (Pinnacle). Clark  Pinnacle Family Communities oversees some of the highest-profile  installations in the Army’s MHPI program. The company is a joint venture  between Clark, based in the Washington, D.C., area, and Pinnacle, based  in Seattle. Starting in 2002, in collaboration with the Army, Clark Pinnacle  led the development of four projects in six locations totaling more than  11,000 homes at a value of about $2 billion. The four projects are
Presidio of Monterey, and Naval Post Graduate School, California;
Fort Irwin, Moffett Federal Airfield, and Parks Reserve Forces Training
Fort Benning, Georgia; and
Fort Belvoir, Virginia.
Although the agreements at the projects vary, generally Clark is the  managing partner of the MHPI entities and handled the construction and  development. Pinnacle was the property-management firm actually  conducting day-to-day property-management activities (e.g.,  maintenance) at the projects once they were completed. According to  Army officials, Clark, through a series of internal audits, determined in  2010 that Pinnacle allegedly was involved in substantial and systemic  fraud in the management of the privatized housing at Fort Benning, and  ultimately found similar alleged fraud in the management of the privatized  housing at Fort Belvoir. As a result, Clark initiated audits of the two  California MHPI projects managed by Pinnacle and began to uncover  alleged circumstances similar to those at Fort Benning and Fort Belvoir.
section_title: Litigation against Pinnacle
paragraphs: In 2010, Clark asked the Army for permission to remove Pinnacle as  property manager at Fort Benning and Fort Belvoir because of alleged  willful misconduct by Pinnacle employees, and for approval to initiate  related litigation on behalf of the MHPI entities against Pinnacle; the Army  agreed. Subsequent to the initiation of the Fort Belvoir and Fort Benning  litigation, Pinnacle attempted to unilaterally amend the terms of the  California property-management agreements to make it harder to remove  them as property manager. In response, the California MHPI entities then  brought suit in California court against Pinnacle seeking a declaratory  judgment that the agreements had not been effectively amended by  Pinnacle. Pinnacle then filed a cross-suit seeking to uphold the  amendments. According to Army officials, the Army wanted Pinnacle  removed as the MHPI projects’ property manager due to the alleged fraud  and mismanagement. Additionally, Army officials stated that they have  been motivated by concerns for resident safety because it has been  alleged that Pinnacle engaged in falsifying records regarding  maintenance and repairs that Pinnacle employees were responsible for  performing at all four project locations.
An Army official stated that Pinnacle has attempted to obtain information  on the amount of funds the MHPI projects have spent on litigation and  other litigation strategy-type information, such as documents provided to  the Army by Clark, both through discovery and through a Freedom of  Information Act request, which the Army (with Department of Justice  assistance) successfully denied. According to Army officials, the relevant  property-management agreements include a provision that a party who  sues under the agreement and substantially prevails is entitled to recoup  their legal fees from the losing party. Further, our review found that the  MHPI projects’ property-management agreements include a provision  allowing the substantially prevailing party in litigation brought to enforce or  interpret the agreements to be repaid for all court costs and for the  reasonable fees and expenses of attorneys and certified public  accountants. Because legal fees are potentially recoverable, they are  material both to the litigation and to any potential settlement negotiations.
In June 2010, Pinnacle was removed as property manager at Fort  Benning, and in December 2012 Pinnacle was removed from  management at Fort Belvoir. Pinnacle remains property manager at the  two California projects pending resolution of the litigation described  above.
section_title: The Army Followed a Process to Manage MHPI Litigation Funds Not Accounted for in the Budget That Limits Access to Litigation Information
paragraphs: The Army has a standard process to manage MHPI projects’ funds for the  costs of litigation not accounted for in the MHPI projects’ annual budget  process, but instead used an alternative process designed to limit access  to information about the Pinnacle litigation. The alternative process is  consistent with the relevant MHPI projects’ operating agreements. The  standard process has thresholds governing potential withdrawals or  expenditures for Army MHPI project litigation expenses. In the standard  process, Army officials generally make major decisions related to MHPI  projects, including litigation costs, by following guidance in the Residential  Communities Initiative Portfolio and Asset Management Handbook. For  example, the Army treats litigation not accounted for in the budget  process as a major decision requiring higher-level approval within the  Army when costs exceed either 5 to 10 percent of the annual budget or  $250,000 over budget. In the standard process, Army officials generally  seek approval of such major decisions from either the Office of the  Assistant Chief of Staff for Installation Management or the Office of the  Assistant Secretary of the Army (Installations, Energy and Environment).  The process involves sharing litigation information and estimated costs  between the developer and four offices within the Army (MHPI Project  Office, Garrison Commander, Office of the Assistant Chief of Staff for  Installation Management, and the Office of the Assistant Secretary of the  Army ). However, according to  Army officials, the standard process has not yet been used to approve  any major decisions regarding litigation expenses, because the Pinnacle  cases are the only cases that met the major-decision threshold criteria  whose litigation expenses have been approved and would have gone  through this process had decisions not been made to restrict access to  information pertaining to this litigation.
Although the Pinnacle cases met the major-decision threshold criteria,  according to Army officials, Army officials decided to use an alternative  management process to review and approve litigation costs so they could  restrict information and confine decision making to a higher organizational  level. This process is consistent with the MHPI projects’ operating  agreements for managing these projects and allows for Clark and only  one Army office to review associated cost information. Specifically, these  agreements do not specify any internal deliberative process within the  Army, but rather only require that Army agreement is obtained for certain  major decisions. As a result, the Deputy Assistant Secretary of the Army  (Installations, Housing & Partnerships), acting on behalf of the Army, can  directly approve specific actions proposed by Clark senior leadership on  behalf of the MHPI project, such as approving the litigation and audit  budget and expenses. Additionally, Army officials stated that while the  standard process was not followed, the alternative process did allow for  information regarding the Pinnacle litigation to be periodically coordinated  with high-level officials within the Office of the Assistant Chief of Staff for  Installation Management. Army officials stated that they wanted to restrict  access to the litigation and audit cost estimates because legal fees are  potentially recoverable and as a result are material both to the litigation  and to any potential settlement negotiations.
According to Army officials, throughout the litigation process, Army and  Clark officials have regularly shared litigation documents and met to  discuss the Pinnacle litigation. After the approval of the MHPI project’s  annual operating budgets, the Deputy Assistant Secretary of the Army  (Installations, Housing & Partnerships) and counsel in the Office of the  Army General Counsel reviewed Clark’s proposed budget for Pinnacle  litigation and audit expenses for that year. Further, the Army and Clark  met approximately quarterly with counsel representing the four MHPI  projects in the Pinnacle litigation to discuss any significant developments  in the cases, specific plans for the next quarter, and general plans for the  rest of the year—including any anticipated changes in the legal and audit  expenses previously budgeted for. Army officials stated that they also  plan to conduct a full review of the costs at the end of the litigation to  ensure that all charges by outside counsel were fair and reasonable.
section_title: Army MHPI Project Costs for the Pinnacle Litigation Have Not Prevented Housing Projects from Meeting Normal Operating Requirements
paragraphs: According to Army officials and our analysis of the project-management  accounts for the four locations involved in the Pinnacle litigation, the  expenditure of funds to pay litigation and audit expenses have not  prevented the projects from meeting normal operating requirements, such  as conducting maintenance or paying for utilities, from the time the  litigation began in 2010. Within each MHPI project, the Army receives  revenue and distributes the cash flow in a specified order to accounts,  such as the revenue account; operating-expenses account; capital,  repair, and replacement account; debt-service account; and construction  and reinvestment accounts. Figure 1 shows the flow of funding within the  Army MHPI projects.
Revenue account: The revenue account is funded by servicemember  rent, which is typically based on the Basic Allowance for Housing  allotments received. This funding is typically disbursed on a monthly basis  to pay the budgeted amounts for the operating expense account; capital,  repair, and replacement account; and debt-service account. According to  Army officials, Pinnacle litigation and audit expenses were also paid from  revenues that flowed into the MHPI projects.
Operating-expenses account: Each Army MHPI project has an account  to pay for all operating expenses including maintenance, utilities, and  other administrative costs. According to Army officials, they assist in the  development of and approve each MHPI project’s annual budget for  operating expenses. MHPI project asset managers for the four projects  connected to Pinnacle litigation stated that their projects have not had to  reduce their operating expenses during the Pinnacle litigation.  Furthermore, MHPI project asset managers stated that any increases or  decreases in budgeted operating expenses from year to year were due to  fluctuations in housing occupancy and changes in utility and maintenance  costs and not litigation expenses. Table 1 provides a summary of the four  MHPI projects’ budgeted operating expenses from calendar years 2009  through 2013. Although Pinnacle litigation and audit expenses were not  incurred until 2010, this table shows budgeted operating expenses for  2009 to provide a comparison of expenses prior to the start of litigation.
Capital, repair, and replacement account: This account includes funds  for repair and replacement of older components of homes and community  facilities. The Army requested an audit of the projects’ financial data from  January 2009 through June 2012 and the audit results showed that no  maintenance was deferred during this period.
Debt-service account: This account is used to pay the outstanding debt  for the MHPI project. Based on our review of MHPI project account data,  we found that all four MHPI projects have little or no balance in this  account because debt is paid off throughout the year.
Construction account and Reinvestment account:  Construction Account—Before the start of an MHPI project, a plan is  developed for construction, and needed funding levels are determined.  This plan is reviewed annually based on actual and estimated costs to  determine if any changes are needed to the development scope of the  project. This account is used to pay for the initial development and  construction of the MHPI project, which according to Army officials  generally lasts during the first 7 to 10 years of project operations. As  discussed earlier, the revenue account funds the budgeted amounts for  the operating expense account; the capital, repair, and replacement  account; and the debt-service account, and any funding not needed for  these purposes flows to the construction account. However, because  litigation expenses were also paid from the revenue account, officials  stated that additional funding has not transferred into the construction  account as otherwise would likely have occurred. Nevertheless, Army  officials said that the Pinnacle litigation and audit costs have had no  effects on the projects’ ability to move forward with construction as  planned because these projects were developed within anticipated  funding levels. According to Army officials, currently all four of the projects  are nearing the end or have recently completed the initial development  period, and after the development and approval of a 5-year future plan,  the construction account will be closed.
Reinvestment Account—According to Army officials, any funds remaining  in the construction accounts when the projects reach the end of their  initial development and construction phase are moved to the reinvestment  account. This account is also used to hold the MHPI projects’ excess  cash flow that is not required after payment of the operating expenses,  debt service, and other payments. Funds start to accumulate in the  reinvestment account for future use in renovation or replacement of  homes after the initial development and construction of the project ends.  Since all four of the projects are still in or have recently completed this  initial development phase—and based on our review of MHPI project  account data—no funds have accumulated in the reinvestment accounts  as of February 2014. Due to the MHPI projects’ incurring litigation and  audit expenses, less funding will ultimately be available to transition from  the MHPI projects’ construction account to the reinvestment account  unless litigation concludes prior to the transition, and funds are recouped  assuming the projects prevail in the litigation with Pinnacle.
The MHPI projects’ property-management agreements provide that the  party that substantially prevails in a legal action may recoup their legal  expenses. Army officials stated that they expect the MHPI projects to  prevail in the litigation and recoup most, or even all, the costs of  conducting the litigation.
section_title: Agency Comments
paragraphs: This report does not include any recommendations. We provided a draft  of this report to DOD for comment. However, DOD did not provide written  comments and provided technical comments, which we incorporated in  our report as appropriate.
We are sending copies of this report to the appropriate congressional  committees; the Secretary of Defense; the Secretary of the Army; and the  Director, Office of Management and Budget. In addition, the report is  available at no charge on the GAO website at http://www.gao.gov.
If you or your staff have any questions about this report, please contact  me at (202) 512-4523 or LeporeB@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on  the last page of this report. GAO staff who made key contributions to this  report are listed in appendix I.
section_title: Appendix I: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Laura Durland (Assistant  Director), Chaneé Gaskin, Stephanie Moriarty, Carol Petersen, Richard  Powelson, Amie Steele, John Van Schaik, and Michael Willems made key  contributions to this report.