Offset obligations. We love to hate them. While governments champion offset programs as a way to create social and economic benefits from international defense spending, aerospace and defense companies must begrudgingly accept them and then labor tirelessly to fulfill them.
For compliance professionals, offsets represent a potential fount of corruption risks.
For readers who don’t wrestle with offsets on a regular basis, here’s a brief primer.
Offsets — also referred to as countertrade or industrial cooperation — are financial obligations imposed on a defense contractor by a foreign government customer. As a condition of purchasing defense equipment or services, the foreign government imposes a requirement for the defense contractor to create or support transactions that cause a specified amount of financial benefit to flow into the purchasing country.
For every dollar (or yen, euro, riyal, dinar, shekel, etc.) of financial benefit the defense contractor creates in the country in question, it is given credit towards satisfying its obligation. Thus, it is common to express approved offset transactions in terms of the “credits” granted by the local government.
Sometimes an offset transaction relates directly to the defense equipment sold, such as when a contractor hires a local firm to supply components that will be integrated into the product in question. These arrangements are known as “direct” offsets.
In other circumstances, the offset transaction bears no connection to the defense contractor’s products or services. For example, a contractor might satisfy some of its offset obligations by providing financial support to a local software firm that wants to open an office in Silicon Valley.
These so-called “indirect” offset requirements have historically constituted roughly 60 percent of the obligations imposed by foreign governments on defense contractors, and they are notoriously difficult to satisfy. Defense contractors are frequently afforded scant guidance on how to find in-country businesses to support, and must also compete with their fellow contractors to identify viable indirect offset projects.
To make matters worse, offset obligations come along with deadlines. If a defense contractor fails to discharge its obligations by the deadline, it could face liquidated damages or even blacklisting. Needless to say, offsets are considered a thorn in the side of the defense and aerospace industry.
There is, however, no escaping offset. Approximately 80 countries impose offset obligations on aerospace and defense contractors as a condition to buying their wares, and the size of these obligations is awe-inspiring.
According to the U.S. Commerce Department, U.S. defense firms incurred over $34 billion in new offset obligations over the last five years. To put this number in perspective, U.S. contractors secured contracts with foreign governments worth approximately $74.5 billion during the same time period. In other words, U.S. contractors’ offset obligations were almost half as large as the total value of their foreign defense sales. Defense and aerospace contractors outside the United States surely face comparable requirements. A sizeable burden indeed.
The combination of massive requirements, draconian penalties for missing deadlines and little official guidance on how to find transactions that will generate credits, offset obligations are fertile ground for compliance missteps.
In this series of posts, I’ll review the common sources of risk, and outline practical steps for addressing them.
First, I’ll tackle offset advisors — third parties engaged by defense and aerospace companies to identify and structure transactions that will (hopefully) generate offset credit, and then help interface with the government offset authority. Many advisors work on a contingency fee basis, often calculated as a percentage of the value of the credits awarded by the government. Government interaction and contingent compensation — certainly familiar sources of corruption risks.
Second, I’ll delve into indirect offset partners. As described above, these are typically private businesses located in the country imposing the offset burden, and who receive some form of financial support from a defense contractor. The contractor hopes to earn offset credits in return for the support. In some very high profile cases, indirect offset partners were nothing but conduits for bribes paid to government procurement officials.
Third, I’ll examine the risks presented by direct offset subcontractors, who provide the defense contractor with components and services that are directly related to the products sold. In many situations, government customers afford defense contractors no choice in who to work with. Such requirements make sense when the subcontractor is a going concern with existing capabilities to provide the products in services in question. This, however, is not always the case.
Fourth, we’ll review situations in which governments offer companies the opportunity to discharge offset obligations in exchange for large cash payments. Cash for credit schemes are on the rise, and while delivering large amounts of money into the hands of a government agency might make compliance professionals squirm, I believe that these programs are viable, provided they’re subject to robust due diligence and appropriate controls.
Finally, I’ll share my thoughts on how to implement a practical process to review and manage compliance challenges in offset transactions. I’ll draw on prevailing best practices in the industry, and demonstrate that companies can discharge their offset obligations and toe the line on compliance.
Bill Steinman is a Contributing Editor of the FCPA Blog. He’s the senior partner at Steinman & Rodgers LLP, a boutique law firm in Washington, D.C. specializing in international anti-corruption compliance and investigations.