Internal Controls: C-17 Payment Procedures Can Be Improved	 
(30-MAY-01, GAO-01-515R).					 
								 
The Federal Acquisition Streamlining Act of 1994 contained a new 
provision for the use of Performance-Based Payment (PBP) as an	 
alternative to other forms of contract financing. According to	 
the Department of Defense (DOD), in fiscal year 1999, the paying 
office processed approximately one million invoices for 363,000  
major contracts. Of these, 195 contracts, or less than one	 
percent of all contracts, contained performance-based provisions.
These contracts are so few in number because they are a 	 
relatively new form of contracting within DOD. However, in	 
November 2000 the Under Secretary of Defense directed that	 
performance-based financing will be the preferred contract	 
financing method for future fixed-price contracts in DOD. This	 
report reviews the C-17 aircraft production program as a case	 
study to examine the business processes used to make investment  
expenditures during the production phase of a major weapons	 
system. GAO selected this contract because it is mature, stable, 
and is performance-based rather than cost-based. GAO found	 
internal control weaknesses in the C-17 program concerning	 
compliance with regulations, policies, and procedures over (1)	 
establishing withhold amounts by the Air Force contracting	 
officer for conditionally accepted items, (2) processing by the  
Administrative Contracting Officer for performance-based payment 
requests, (3) processing by the Administrative Contracting	 
Officer of invoices for delivered aircraft, and (4) processing of
a delivery payment by the paying office at the Defense Finance	 
Accounting Service Columbus Center on a contract containing	 
performance-based payment provisions.				 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-01-515R					        
    ACCNO:   A01087						        
  TITLE:     Internal Controls: C-17 Payment Procedures Can Be	      
             Improved                                                         
     DATE:   05/30/2001 
  SUBJECT:   Financial management				 
	     Fixed price contracts				 
	     Internal controls					 
	     Military aircraft					 
	     Air Force procurement				 
	     Contractor payments				 
	     Contract performance				 
	     C-17 Aircraft					 

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GAO-01-515R
     
GAO- 01- 515R C- 17 Payment Procedures

United States General Accounting Office Washington, DC 20548

May 30, 2001 Brigadier General Edward M. Harrington, Director Defense
Contract Management Agency

Col. Ted F. Bowlds, Program Director C- 17 System Program Office (ASC/ YC)

Thomas R. Bloom, Director Defense Finance and Accounting Service

Subject: Internal Controls: C- 17 Payment Procedures Can Be Improved We are
currently reviewing the business processes associated with the Air Force?s
C17 aircraft production program focusing on acquisition, asset management,
and accounting. 1 Our underlying objective was to conduct a case study to
examine the business processes used to make investment expenditures during
the production phase of a major weapons system. We selected the C- 17
program because (1) it is currently a mature, stable program, (2) we have
prior experience in reviewing the program, and (3) its current contract is
performance- based rather than cost- based. We will be issuing a separate
report on the end- to- end procurement business process, which includes
acquisition, asset management, and accounting.

The purpose of this letter is to report certain internal control weaknesses
specific to the C- 17 program. These internal control weaknesses concern
compliance with regulations, policies, and procedures over (1) establishing
withhold amounts by the Air Force contracting officer for conditionally
accepted items, (2) processing by the Administrative Contracting Officer
(ACO) of performance- based payment requests, (3) processing by the ACO of
invoices for delivered aircraft, and (4) processing of a delivery payment by
the paying office at the Defense Finance and Accounting Service (DFAS)
Columbus Center on a contract containing performance- based payment
provisions.

The current C- 17 production contract is performance- based- i. e., it ties
payments to the accomplishment of specific milestones. This type of contract
has not been frequently used by the Department of Defense (DOD) in the past,
but will be the preferred type of financing used by DOD for fixed- price
contracts in the future.

1 The specific C- 17 production contract we reviewed is F33657- 96- C- 2059
dated June 1, 1996. This contract is for the multiyear production of 80
aircraft, P- 41 through P- 120.

GAO- 01- 515R C- 17 Payment Procedures Page 2

Results in Brief

We identified weaknesses in the internal controls over the approval and
processing of payments for the C- 17 contract we reviewed. Specifically, we
found that

 the contracting officer did not estimate sufficient amounts to be withheld
from payments for conditionally accepted aircraft,

 the ACO allowed the contractor to transmit approved performance- based
payment (PBP) requests to the paying office rather than transmitting them
directly,

 the ACO did not review invoices for delivered aircraft in a thorough and
timely manner, and

 the paying office used incorrect payment criteria for one aircraft
delivery, which resulted in an overpayment.

We are making a number of recommendations regarding the need to improve
payment processing controls by following the applicable regulations,
policies, and procedures. DOD agreed or partially agreed with 5 of our 6
recommendations. In general, DOD expressed the view that there were no
control weaknesses in the payment procedures for the C- 17. In particular,
DOD did not seem to fully appreciate our concern that the ACO needed to play
a more prevalent role in ensuring the accuracy and propriety of payments as
contemplated by current government requirements. We continue to believe that
following existing requirements and our related recommendations is important
and that the ACO is the government official in the best position to carry
out these responsibilities. Regarding our recommendation dealing with
inadequate amounts withheld for incomplete, but conditionally accepted
aircraft, we believe that withholding anything less than an amount based on
the rate of profit cited in the C- 17 production contract is not in the best
interest of the government.

Background

The Federal Acquisition Streamlining Act of 1994 contained a new provision
for the use of PBPs as an alternative to other forms of contract financing.
According to DOD, in fiscal year 1999, the paying office processed
approximately 1 million invoices for 363,000 major contracts. Of these, 195
contracts, or less than 1 percent of all contracts, contained performance-
based provisions. These contracts are so few in number because they are a
relatively new form of contracting within DOD. However, on November 13,
2000, the Under Secretary of Defense (Acquisition, Technology, and
Logistics) directed that performance- based financing will be the preferred
contract financing method for future fixed- price contracts in DOD.

Payments under this new type of contract financing method are contingent
upon meeting certain performance criteria. The current C- 17 production
contract- under which the Air Force will pay $14.5 billion for 80 aircraft--
contains provisions that tie payments to accomplishing 7 production
milestones. For example, milestone 5 requires the contractor to complete the
forward, center, aft, and wing sections prior to payment for that milestone.
Interim payments are based on fixed amounts

GAO- 01- 515R C- 17 Payment Procedures Page 3 specified in the contract (e.
g., the contractor received a payment of $31,944,374 for

completion of milestone 5 for aircraft P- 69). These payments are referred
to in the Federal Acquisition Regulation (FAR) Part 32.102 (f) as PBPs.

Under contracts containing PBP provisions such as the C- 17 multiyear
contract, DOD follows two different processes to ensure payments are
properly authorized: (1) one process for interim payments, such as
completion of milestones 1 through 6 based on PBP requests and (2) another
process for delivery payments based on an invoice. Under the process for a
PBP request, the contractor generates a completion report and submits it to
a Defense Contract Management Agency (DCMA) quality assurance (QA) official
for certification that the milestone requirements have been met. After
receiving this certification, the contractor submits a PBP request package
to the DCMA ACO. The ACO is required to review and approve the payment
request before transmitting it to the paying office. This procedure is
extremely important because PBP requests do not require a receiving and
inspection report that is independent of the PBP request.

In contrast to the interim payment process, delivery payments require other
procedures. Just prior to delivery of the aircraft, the Air Force C- 17
contracting officer and the contractor negotiate the amount to be withheld
from the delivery payment for conditionally accepted 2 items. Upon delivery
of the C- 17 aircraft, the contractor generates the receiving report
containing the unit price and negotiated amount to be withheld and submits
it to the DCMA QA representative for acceptance. After the DCMA QA
representative accepts the receiving report and returns it to the
contractor, the contractor modifies the report by adding information on the
previous payments and the net amount due, and marking it as the invoice. The
contractor then submits (1) the original invoice to the paying office for
payment and (2) copies of the invoice to the ACO. The ACO gives one copy to
his representative, who enters the receiving report information into the
paying office system. Upon receipt of the invoice, the paying office
determines whether the contractor is entitled to payment by matching payment
data on the invoice to its records (purchase order and receiving report).
The ACO is responsible for resolving any disputes that arise between the
contractor and the government over the payment amount or timing of the
payment.

Objective, Scope, and Methodology

The objective of this part of our work on the C- 17 was to evaluate controls
over the payment process for both interim and delivery payments on a
performance- based contract. To evaluate the payment procedures for the C-
17, we walked through the procedures for both PBPs and delivery payments
with officials from the contractor as well as DCMA, DFAS, and the Air Force.
We compared these procedures with the FAR and with DOD and Air Force
policies and procedures. We also reviewed

2 Conditional acceptance means that a contracting officer has determined
that it is in the government?s best interest to accept an item that does not
conform to contract specifications or is otherwise incomplete, with the
expectation that the contractor will later correct nonconformances or
complete other work.

GAO- 01- 515R C- 17 Payment Procedures Page 4 documentation for selected
recent transactions to gain further evidence about what

procedures were followed. We conducted this analysis of the payment process
in accordance with generally accepted government auditing standards and in
conjunction with our evaluation of the Air Force?s procurement business
process from July 2000 through March 2001.

Contracting Officer Not Estimating Sufficient Withholds for Conditionally
Accepted Items

The Air Force generally accepts C- 17 aircraft that are incomplete or do not
fully conform to contract specifications with the understanding that the
contractor will complete the work after delivery. To ensure that this work
is eventually completed and that the government does not pay for incomplete
work, a portion of the final payment for the aircraft is withheld until the
work is finished. During prior work on the C- 17, we noted that the amounts
withheld were less than the estimated cost and profit to complete this work.
3 During our current review, we found that this situation continues to
exist.

The FAR Part 46.407( f) states that amounts withheld from payments generally
should be at least sufficient to cover the estimated cost and related profit
to correct deficiencies and complete unfinished work. The estimated cost to
complete unfinished work should reflect a combination of material and labor
plus a rate for overhead and profit. However, the contracting officer stated
that in calculating withhold amounts for this contract, he used a rate of
profit that was between 5 and 7 percent lower than the estimated rate of
profit included in the production contract.

We reviewed the amounts withheld on all 30 aircraft delivered from August
1998 through December 2000. The amount initially withheld from the delivery
payments on these 30 aircraft ranged from $715,000 to $4.6 million, or $72.2
million in total. Based on the contracting officer?s statement that an
additional 5 to 7 percent should have been withheld, we used the lower
estimate of 5 percent to calculate the additional amount that should have
been withheld. As of January 29, 2001, the 30 aircraft had withheld amounts
still outstanding totaling $38.2 million. We calculated the amount of
additional profit that should have also been withheld on this $38.2 million
to be over $1.7 million.

Recommendation We recommend that the contracting officer follow the
requirements of FAR Part 46.407( f) by negotiating a withhold amount that
represents the full value of the unfinished work and thereby better protects
the government?s interests.

3 Defense Acquisition: Guidance Is Needed on Payments for Conditionally
Accepted Items

(GAO/ NSIAD- 98- 20, Dec. 12, 1997).

GAO- 01- 515R C- 17 Payment Procedures Page 5

Required Payment Procedures Are Not Followed by the ACO for Performance-
Based Payment Requests

The DCMA QA representative properly certifies that a milestone has been
completed by physically inspecting the aircraft and reviewing the
contractor's milestone completion report. After DCMA QA?s certification, the
contractor prepares the PBP request and sends it to the DCMA ACO for his
review and approval. We found that the DCMA ACO does not properly transmit
PBP requests to the paying office as required by the FAR. As a result, there
is the potential that unauthorized and inaccurate payments can go
undetected.

According to FAR Part 32.1007, the contracting officer responsible for
administration of the contract is responsible for receiving, approving, and
transmitting all performance- based payment requests to the appropriate
payment office. However, the ACO for the C- 17 does not fully comply with
this procedure. Instead, after approving and signing the PBP request, the
ACO returns one copy to the contractor and relies on the contractor to send
it to the paying office for payment. According to the ACO, this practice
relieves the ACO of the administrative duties associated with mailing and
tracking the PBP requests. The contractor?s officials recognize that this
reflects an internal control weakness. However, contractor officials stated
that they have been processing the approved PBP requests in this manner
because it allows them to ensure that the PBP requests are transmitted to
the paying office on a timely basis.

An internal control weakness exists when the ACO allows the contractor to
send PBP requests to the paying office. Although the ACO signs the request,
he has no assurance that the contractor will not alter the request after it
is approved. The ACO can only ensure the request?s accuracy by independently
transmitting it to the paying office. Without this independent verification
and transmission of the request to the paying office, unauthorized and
improper payments can go undetected.

Recommendation We recommend that the ACO transmit all PBP requests to the
paying office as required by FAR Part 32.1007.

Specified Payment Procedures Are Not Followed by the ACO for Delivered
Aircraft

When an aircraft is delivered to the Air Force, the ACO is responsible for
verifying the delivery of the aircraft and the accuracy of the payment
invoiced amount. The Air Force Materiel Command (AFMC) Financial Management
Handbook states that the ACO is responsible for (1) verifying delivery of
the aircraft and (2) calculating the amount of payment. To help prevent
erroneous payments from being made, we believe the ACO should carry out
these responsibilities prior to submitting receiving report information to
the paying office. The ACO stated that, for verifying delivery of the
aircraft, he relies on DCMA QA?s approval of the receiving report, which is
done before the ACO?s representative submits the independent receiving
report to the

GAO- 01- 515R C- 17 Payment Procedures Page 6 paying office. However, he
indicated that he does not usually recalculate the amount

of the payment until after the receiving report is sent to the paying
office. Moreover, the recalculation does not include a verification of
previous payments made. The ACO stated that he was not aware of the
provisions in the AFMC Financial Management Handbook stating that he is to
validate not only the delivery of the aircraft but also the payment amount.
Without the ACO?s independent verification of the payment amount, including
withholds, the paying office may make an inaccurate payment based on the
invoice amount.

When an aircraft is delivered, the contractor submits a DD Form 250
(Material Inspection and Receiving Report) to the DCMA QA representative
showing the unit price of the aircraft being delivered and the negotiated
withholds, if any. The QA representative signs the DD Form 250 receiving
report to indicate that he has inspected and accepted delivery of the
aircraft. After signing it, the QA representative returns the DD Form 250
receiving report to the contractor. The contractor then modifies the DD Form
250 receiving report by adding payment information and marking it as the
invoice copy. 4 The invoice copy shows the unit price of the aircraft, less
the negotiated withhold amounts and the total previous PBPs made for the
aircraft, and a calculation of the net balance due. The contractor sends the
invoice to the paying office for payment and, at about the same time,
provides copies to the ACO office.

An important aspect for ensuring that the payment is authorized is the
independent review by the ACO that the amount is correct and the item has
been accepted prior to his submitting the receiving report to the paying
office. We found that the ACO typically reviews the invoices after (1) they
have been sent to the paying office and (2) the ACO?s representative has
entered the receiving report information into the paying office system. The
ACO stated that he processes invoices in this manner because he was not
aware of the AFMC Handbook provisions stating that he is to validate not
only the delivery of the aircraft but also the payment amount. As a result,
for the C- 17 contract, the paying office has no way to independently verify
that the contractor has accurately calculated the net balance due and
correctly reflected the negotiated amount of withholds, or to know if anyone
else has verified their accuracy.

Recommendation To ensure that the paying office does not process delivery
payments based on inaccurate information on the invoice, we recommend that
the ACO, in accordance with the guidelines contained in the AFMC handbook,
verify delivery of the aircraft and calculate the amount of payment. We also
recommend that these verifications occur before the ACO representative
enters the receiving report information into the paying office system. We
further recommend that, to reduce the likelihood of the need for corrections
at the paying office, the ACO should review the payment information as soon
as possible after receiving invoices from the contractor.

4 The DD Form 250, Material Inspection and Receiving Report, can serve
multiple functions in the payment process. The form can serve as the
shipment document and as the material inspection and acceptance document. In
addition, the DD Form 250 can serve as the contractor invoice when the
contractor submits it for payment to the paying office clearly marking the
DD Form 250 as the "ORIGINAL INVOICE".

GAO- 01- 515R C- 17 Payment Procedures Page 7

Paying Office Lacks Experience with Performance- Based Financing

During the course of our review, we identified an overpayment totaling
$30,655 for the delivery of a C- 17 aircraft. While the contractor provided
accurate payment information on the invoice, the paying office did not
follow contract terms in processing the delivery payment on the PBP
contract. As previously mentioned, PBP contracts are relatively new at DOD
and few in number.

When the contractor discovered the overpayment, the contractor contacted the
paying office to resolve the problem. The contractor?s invoice clearly
identified the actual PBPs made and showed the correct final amount ($
12,685,386) to be paid for delivery of the aircraft. The overpayment
occurred because a voucher examiner at the paying office did not deduct from
the unit price of the aircraft the actual amount previously paid to the
contractor. Instead, the voucher examiner incorrectly deducted 90 percent of
the unit price since most payments containing contract financing provisions
processed at the paying office use the percentage method. As shown in the
table below, deducting 90 percent of the unit price rather than the actual
amount previously paid resulted in a $30,655 overpayment.

Table 1: Comparison of Correct Payment Calculation Based on Amounts
Previously Paid and Paying Office?s Calculation Based on Percentage of Unit
Price

Payment amount Payment amount based on amounts based on percentage
previously paid of unit price

Unit price of aircraft $171,528,554 $171,528,554 Less: Actual prior payments
- 154,406,354 - Percentage of unit

price (90 percent) -- - 154,375,699 Withholds - 4,436,814 - 4,436,814
Balance due $ 12,685,386 $ 12,716,041

Difference (amount overpaid) $30,655 Source: GAO, based on information
provided by contractor. The contractor and the paying office resolved the
overpayment quickly and the contractor refunded the $30,655 less than a week
after the original payment was made.

Recommendation We recommend that the paying office management provide
instructions to staff who process delivery payments for PBP contracts to
help ensure that they recognize these types of payments and process them in
accordance with the terms specified in the contract.

GAO- 01- 515R C- 17 Payment Procedures Page 8 Agency Comments and Our
Evaluation

DOD concurred with one of our recommendations, partially concurred with four
others, and did not concur with one. In general, DOD did not perceive risks
with its current payment procedures for the C- 17 because it believes that
the contracting officer withholds amounts sufficient to protect the
government?s interests and that the contractor properly processes requests
for payment. However, regulations and other guidance indicate that the
government has more responsibility for these actions. Our recommendations
pertain to controls that are intended to minimize the risk of making
payments either for the incorrect amount or for services that were not
rendered.

First, DOD did not concur with our recommendation that the contracting
officer negotiate a withhold amount that represents the full value of the
unfinished work and thereby adequately protects the government?s interests.
DOD stated that it believed the contracting officer withheld an amount
?sufficient to cover the estimated cost and related profit to correct
deficiencies and complete unfinished work? in accordance with the FAR.
However, as we stated in the report, the amounts withheld were based on a
profit rate that was less than the profit rate cited in the production
contract. If the full amount of profit for unfinished work is not withheld,
the contractor has in effect received a portion of its profit prior to
completing the associated work. Withholding anything less than the full
contract profit rate is not in the best interest of the government.

Second, DOD did not fully concur with our four recommendations pertaining to
the ACO?s role and responsibilities. Specifically, DOD made the following
comments.

 DOD partially concurred with the recommendation that the ACO, rather than
the contractor, transmit all performance- based payment requests to the
paying office, as required by the FAR. However, DOD stated that it is
acceptable to rely on the contractor to transmit the payment requests
because the ACO monitors payments using the paying office?s payment system.
The ACO?s monitoring of payments, however, occurs after the payments are
made to the contractor. While monitoring serves as a compensating control,
if the ACO found that a payment amount was incorrect, follow- up procedures
would have to be carried out to correct the erroneous payment. Not only
would this involve added administrative burden, but as we recently reported,
5 DOD has difficulties resolving payment errors. Therefore, a preventive
control, as we recommended, would be preferable.

 DOD partially concurred with our recommendation that the ACO verify
delivery of the aircraft and calculate the amount of payment, in accordance
with the AFMC Handbook. While DOD agrees that these procedures are
necessary, it does not believe these are appropriate responsibilities of the
ACO under the current process. We agree that the ACO can rely on the DCMA QA
representative?s signature on the receiving report as verification of
delivery. However, the ACO?s office was not reviewing that information until
after invoices were sent to the paying office. Also, we do not agree that
the ACO can rely on the paying office to

5 Contract Management: Excess Payments and Underpayments Continue to Be a
Problem at DOD

(GAO- 01- 309, Feb. 22, 2001).

GAO- 01- 515R C- 17 Payment Procedures Page 9 calculate the payment because
it does not have any independent information

about the accuracy of withholds for incomplete work. The ACO obtains
information on the agreed- upon withhold amounts from the program
contracting officer. Therefore, only the ACO is in a position to verify the
accuracy of the payment information.

 DOD also indicated that the AFMC Handbook is not applicable to ACOs who
work for DCMA. Regardless of whether the AFMC Handbook is applicable to the
DCMA ACO, calculating the payment is an important function that needs to be
performed by the ACO, as explained above. In addition, during our review,
the program contracting officer said that he believed this is an important
responsibility. Moreover, this responsibility is important for major
contracts for all of the military services. Therefore, the responsibility
for calculating payments should be specified in whatever guidance the ACO
follows, such as the DCMA One Book. The One Book does not currently require
the ACO to calculate payments.

 DOD partially concurred with our recommendation that the verifications of
delivery and payment accuracy occur before the ACO representative enters the
receiving report information into the paying office system. We agree that
DCMA QA verifies delivery prior to the acceptance data being entered in the
system. However, as stated above, the ACO is in a unique position to verify
the accuracy of the payment information on the invoice. Also, this
verification should be done prior to the entry of acceptance information
because doing so would ensure that the invoice is accurate before the paying
office begins processing it for payment and avoids the need for burdensome
corrective actions if the paying office were to process an inaccurate
invoice.

 DOD partially concurred with the recommendation that the ACO review the
payment information as soon as possible after receiving invoices from the
contractor. DOD agreed that invoices should be reviewed by the government
prior to payment, but not necessarily by the ACO. Again, as explained above,
the ACO is the only person in a position to verify the accuracy of payment
information prior to submission of invoices to the paying office because the
paying office does not have information about withhold amounts.

Finally, DOD concurred with the recommendation that DFAS management provide
instructions to staff who process delivery payments for performance- based
contracts. It stated that while additional local operating procedures have
already been issued by the paying office, DFAS will also reiterate the
importance of properly determining entitlement for PBPs by disseminating
interim guidance to staff no later than June 25, 2001.

----- We acknowledge and appreciate the cooperation and assistance provided
by the Air Force, DCMA, and DFAS officials and staff during our audit of the
C- 17 business processes. We are sending copies of this letter to Senator
John Warner, Chairman, and Senator Carl Levin, Ranking Member, Senate
Committee on Armed Services; Senator George V. Voinovich, Chairman, and
Senator Richard J. Durbin, Ranking

GAO- 01- 515R C- 17 Payment Procedures Page 10 Member, Subcommittee on
Oversight of Government Management, Restructuring,

and the District of Columbia, Senate Committee on Governmental Affairs;
Representative Bob Stump, Chairman, and Representative Ike Shelton, Ranking
Minority Member, House Committee on Armed Services; and Representative Steve
Horn, Chairman, and Representative Jim Turner, Ranking Minority Member,
Subcommittee on Government Efficiency, Financial Management, and
Intergovernmental Relations, House Committee on Government Reform. We are
also sending copies to the Honorable Donald H. Rumsfeld, Secretary of
Defense and Dr. Lawrence J. Delaney, Acting Secretary of the Air Force. The
letter will also be available on GAO?s home page at http:// www. gao. gov.
If you have any questions or need assistance in addressing these matters,
please contact me at (202) 512- 9505. Key contributors to this assignment
were Larry Bridges, Kristi Karls, and Keith McDaniel.

Sincerely yours, Gregory D. Kutz Director, Financial Management and

Assurance Issues

GAO- 01- 515R C- 17 Payment Procedures Page 11

GAO- 01- 515R C- 17 Payment Procedures Page 12

GAO- 01- 515R C- 17 Payment Procedures Page 13

GAO- 01- 515R C- 17 Payment Procedures Page 14

GAO- 01- 515R C- 17 Payment Procedures Page 15

GAO- 01- 515R C- 17 Payment Procedures Page 16 GAO Comments

1. In its comments, DOD said that the contracting officer does not recall
saying that

?an additional 5 to 7 percent should have been withheld.? We have
documentation of more than one conversation with the contracting officer
during which he told us what the range of the profit margin was for the C-
17 production contract and the profit rate that he used for determining
withhold amounts. We then calculated that the difference between the two
profit rates ranged from 5 to 7 percent.

(192011)
*** End of document. ***