Satisfying offset obligations is hard. Readers will recall that offsets are financial obligations imposed on defense contractors by foreign government customers as a condition to defense procurements.
For every dollar of financial benefit the defense contractor creates in the country in question, it is given credit towards satisfying its obligation.
Approximately 40 percent of offset obligations directly relate to the equipment sold. This includes requirements to engage local subcontractors and suppliers whose wares will be integrated into the relevant product. The remaining 60 percent consists of indirect offset obligations, which have no relationship to the contractor’s products and services.
Think of a company that manufactures attack helicopters providing funds to build a desalination plant. In some circumstances, the local government will lend a hand, steering the contractor to key development projects. The U.A.E., for example, has built a lot of cooling towers — stand-alone industrial air conditioning facilities — with money from defense contractors seeking to satisfy their offset obligations.
However, in the vast majority of cases, the defense contractor is left to its own devices to find local projects to support. I’ve been told by offset professionals on numerous occasions that finding a suitable indirect offset deal is like looking for the needle in the proverbial haystack. Many defense contractors maintain separate departments whose sole responsibility is to find and evaluate indirect offset transactions. But even a full-time staff of professionals seeking out the right deals just isn’t enough. It turns out that Ringo Starr was right — sometimes you need a little help from your friends. Enter offset advisors.
Much like the international sales agents and consultants with which we are all familiar, offset advisors provide crucial and legitimate services. They help companies identify and structure transactions that will earn offset credits. Offset advisors frequently assist with preparing and submitting applications for offset credit to the governmental authorities that administer offset programs. And just like marketing intermediaries, offset advisors present potential corruption risks. These risks take several forms, from structuring sham transactions that funnel money into the hands of foreign officials to paying bribes to offset officials to secure credit for their principals.
Before delving into the risks, let me say that I have worked with numerous offset advisors over the years, and have found the vast majority of them to be highly creative and dedicated to ethical business conduct. The purpose of the analysis that follows is not to warn companies off of engaging offset advisors. Instead, it’s important for all parties to be cognizant of the potential concerns, and address them appropriately. Let’s review some common sources of risk, and how to address them.
First, as with any third party business partner, defense contractors should determine whether their offset advisors have any connections to foreign officials. Offset advisors of course expect compensation for their services. If the advisor is owned or controlled by foreign officials, then payment to the advisor will inure to the direct benefit of those officials. It’s equally important to identify familial connections to foreign officials. You should be waving red flags if the spouse of your offset advisor’s managing director is a defense procurement official, a senior customs officer or an employee of the offset authority.
Second, defense contractors should be concerned with the risk that an offset advisor could offer or pay bribes to help secure credits (or any other improper advantage, for that matter). The review and approval of indirect offset transactions involves significant interaction with foreign officials. Offset regulations generally require the supplier to submit a written application to the offset authority — a governmental body — to be awarded credit for a proposed indirect offset transaction.
In many jurisdictions, the review of a proposed indirect offset transaction is a two-step process. In the first step, the supplier seeks pre-approval from the government that it intends to grant credit for a proposed transaction. This gives the supplier a preliminary “thumbs-up” from the government before the supplier actually spends any money.
In the second step, the supplier seeks final, definitive approval of offset credits once it has actually provided financial support to an indirect offset transaction. The length and complexity of the application process means that offset advisors have a significant interaction with foreign government officials.
Just as contractors must be concerned with third party agents paying bribes to help them win contracts, so too must they be wary of offset advisors making corrupt payments to help them secure offset credits. As discussed in my first post about offsets, companies face draconian penalties for failing to satisfy their offset obligations in the time allotted. Consequences range from fines to blacklisting.
It is therefore in an advisor’s best interest to help its client avoid these consequences. It’s also important to bear in mind that many offset advisors are compensated using a contingency fee. If their principals don’t receive offset credits, they don’t earn a dime for their troubles. As with commissions sales agents, this raises potential corruption risks.
Finally, beware spurious offset transactions. I’ll talk about the specific risks that arise from indirect offset transactions in my next post, but I’ve seen numerous situations in which offset advisors have proposed transactions that proved to be conduits for bribery.
I’ve seen circumstances where an offset advisor knowingly recommended that my client provide funding to a company that turned out to be merely a shell, with no ongoing business operations. After a little digging, it became clear that the offset support funds would flow directly into the coffers of a foreign official.
In other cases, the offset advisor proposed economic support for a legitimate project, but where the profits flowed to a foreign official. In one example, the offset advisor recommended that my client provide funds for the construction of an industrial park. The good news is that my client was able to verify that the construction company was a bona fide business, and was indeed in the process of building the site. The bad news is that the construction company was beneficially owned by a local defense procurement official.
In both of these situations, the offset advisors in question were quite aware of connections to foreign officials.
So how should defense contractors deal with these challenges? The answer is robust due diligence.
I consistently advise clients to subject their offset advisors to the same risk-based due diligence that they apply to their sales agents. It makes sense to do so. Just like sales agents, offset advisors have regular contact with foreign officials. They might not assist defense contractors to win contracts, but they assist contractors to secure a governmental benefit, which certainly falls within the broad “obtain or retain business” language of the FCPA.
From a practical standpoint, conducting due diligence on offset advisors likely won’t impose significant additional compliance burden. Even my clients with offset obligations in the hundreds of millions of dollars have only a handful of third party offset advisors. In other words, the marginal cost is immaterial, and the compliance benefits are substantial.
Defense contractors should also subject potential offset projects to due diligence. Again, I recommend a tailored, risk-based review, to determine whether they are bona fide projects, raise any red flags, comport with applicable law, and have any worrisome connections to foreign officials.
As I said before, I firmly believe that the vast majority of offset advisors provide legitimate services. They help defense contractors, faced with onerous indirect offset obligations, to navigate local economies and find viable projects. They help defense contractors wrestle with complex regulations governing the submission of requests for offset credits.
But as with every international third party relationship, particularly those with interactions with foreign governments, bribery risks abound. Provided that contractors expend the effort to weed out dubious advisors and spurious projects, they can navigate those risks unscathed.
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.