Bill Steinman: Managing mandatory subcontracts on offset deals

Your company has just won a major contract with a foreign government, and before you can even break out the champagne, your customer instructs you to engage a specific local subcontractor. Don’t worry — it might not be ideal that your customer is telling you who to work with, but it’s not always a show stopper. 

Welcome to the world of direct offset.  

In a direct offset transaction, a defense contractor can satisfy its offset obligations by engaging local subcontractors for work that’s directly related to, and sometimes incorporated into, the contractor’s products.  In other words, the deal that earns you offset credit “directly” relates to the products you sold. Common examples of direct offset include:

• subcontractor relationships — the contractor acquires products or services from local companies

• licensing arrangements — the contractor licenses the manufacture of some of its components to a local firm, and

• technology transfer — the contractor licenses the technology and know-how to service, maintain and repair its products to a local entity.  

The Commerce Department reports that in 2015 — the most recent year for which we have data — direct offset accounted for almost 42 perecent of all U.S. companies’ offset obligations. 

In some cases, a defense contractor is free to select the local firms with which to work. However, in many instances, the defense contractor’s government customer instructs it to engage a specific local entity, as in my example above. There is a whole host of reasons why it makes sense for a government end user to mandate the engagement of a specific local entity. I often see this with complex integrated systems, in circumstances where there aren’t a lot of viable alternatives, or where the country in question has (or wants!) a well-developed armaments industry. 

For example, I recently assisted a client that manufactures aircraft in establishing an agreement with a direct offset subcontractor in a developing country. The subcontractor will supply various aircraft components and control surfaces, and my client’s customer said this was the company to engage. After doing the appropriate due diligence, my client determined that this company was the only local company that had existing capabilities to do work of this nature. In other words, while the local government told my client to work with that specific subcontractor, it was probably because they had significant, bona fide experience and were actually the only game in town.

On occasion, companies will encounter a mandatory direct offset subcontractor that is relatively new on the scene and doesn’t yet have significant expertise in the industry in question. I have seen several situations recently where such a subcontractor would not — outside the direct offset context — have the requisite experience or demonstrated technical capabilities to satisfy the defense contractor’s supply chain evaluation process. While this should be recognized as a red flag under the FCPA, it does not always mean that you should reflexively reject working with the subcontractor as part of a direct offset arrangement. Direct offset is a special world unto itself, and there may be factors present that overcome the concerns. 

For example, the government customer may be seeking to foster indigenous industrial development in the aerospace and defense sector. Consider Saudi Vision 2030. According to official Saudi publications, the Ministry of Defense (“MOD”) currently spends 2 percent of its mammoth defense budget on local purchases. By 2030, the MOD plans to increase that number to 50 percent. To achieve this ambitious localization goal, the Saudi government will, among other things, establish “strategic partnerships with leading companies” in order to “transfer knowledge and technology, and build national expertise in the fields of manufacturing, maintenance, repair, research and development.” 

Since the announcement of Vision 2030, numerous multinational aerospace and defense companies have been encouraged by the MOD to engage newly-established Saudi companies as subcontractors. In my view, the Saudi government’s explicit goal of fostering local manufacturing, where little currently exists, helps to provide a reasoned business justification for engaging a Saudi subcontractor that might otherwise be lighter on experience than you would require. 

While we might be able to get comfortable with a mandated subcontractor in the offset context, that does not mean that we can turn a blind eye to corruption risks. As with any third party relationship, risk-based due diligence is necessary to identify potential concerns. First and foremost, it is critical to examine and document the circumstances in which the local government recommended the direct offset subcontractor. The least risky end of the spectrum is a situation where the defense contractor’s offset agreement with the foreign government specifies the engagement of a particular local company. Verbal instructions from a foreign official fall on the riskier end of the range. Resistance from local officials to document the requirement to work with a specific subcontractor should also raise red flags. 

Second, it is important to thoroughly document the subcontractor’s ability to perform the services in question. This is often a relatively straightforward exercise. In the example described above where the local company supplied aircraft components and control surfaces to my client, the subcontractor had a long history of manufacturing aerospace equipment. Indeed, my client had purchased equipment from the local company from time to time, in transactions unrelated to offset. In the case of a fledgling company, you will have to dig deeper to understand the skillsets your subcontractor’s personnel bring to the relationship and what you can reasonably expect them to accomplish.

Third, companies should consider the same type of due diligence information that they would in any other subcontractor transaction of comparable risk, including identification of the subcontractor’s ultimate beneficial owners, connections to foreign officials, an evaluation of the subcontractor’s reputation, and the like. In circumstances where the foreign government customer has mandated the use of a particular local vendor, due diligence can be challenging. After all, they’re certainly aware that your customer has told you to engage them, which means there’s very little incentive to cooperate. The good news is that, in my experience, most subcontractors understand why defense contractors have to undertake due diligence and they participate in the process, even if begrudgingly. 

Direct offset obligations often force companies to be creative, and to judge each situation on its individual merits. Depending on the facts at hand, companies should not reflexively dismiss transactions that might raise potential concerns outside the offset context.  

Tune in next time when I’ll discuss a growing trend in offset — governments offering companies offset in exchange for large cash payments. 

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Bill Steinman, pictured above, 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.