Offsets Offer Traps For Unwary Defense Exporters

By Dietrich Knauth

Law360, New York (October 17, 2014, 2:31 PM EDT) — With defense contractors increasingly looking to drum up business abroad, experts say they must be wary of the frequent demands for offsets — work designed to contribute to the local economy but often used as an excuse for lining a contracting official’s pockets.

Offsets are becoming more common throughout the globe, as a way for governments to ensure that their tax dollars don’t simply enrich foreign defense companies without supporting its own defense industry or overall economy. India, for example, codified a strong offset in 2005, and the defense division of the Confederation of Indian Industry has said that a defense import policy that doesn’t include offsets “robs the country of dignity and makes it vulnerable.”

But defense exports carry risks of running afoul of anti-corruption laws like the U.S. Foreign Corrupt Practices Act and the U.K. Bribery Act, as well as local anti-corruption laws and other extraterritorial anti-bribery laws. Offsets can be used to funnel payments to corrupt government decision makers, and it can be politically difficult for international companies to refuse offset demands even if they are concerned about potential corruption.

“Offsets are the biggest risk area now because [potentially corrupt payments] are not so easily identified,” said Steven Shaw, a senior counsel at Covington & Burling LLP. “Often, the only option if you don’t agree to them is to walk away from the contract, and that’s hard to do.”

Offsets are a topic of increasing discussion and concern within the global defense industry, according to Tim Schultz, vice chairman of the International Forum on Business Ethical Conduct for the Aerospace and Defense Industry and vice president of ethics and business conduct at Raytheon Co.

Shaw and Schultz will both discuss offsets and other corruption risks at IFBEC’s Nov. 6-7 annual conference in Brussels, and are seeking input from global aerospace and defense companies, government officials, international transparency groups and others.

“There’s a lot of money that gets siphoned off that could be used more effectively for social good,” Schultz said.

Offsets can hide corruption even if they appear legitimate on the surface, because procuring officials may recommend or insist on the use of certain suppliers, and contractors need to make sure that the companies they’re working with aren’t being used to enrich the government decision makers, Schultz said.

“In offset agreements, because there are usually multiple actors and various fees, the risk of corruption and improper payments that may be unbeknownst to a contractor necessarily increases,” Schultz said. “You may be asked to do business with suppliers that might build systems that are used in the prime contract, and you need to do a lot of due diligence to determine who those third parties may be.”

Offsets can be direct or indirect, and may include economic development work that’s far removed from the defense contract a company is trying to win, according to Jessica Tillipman, an assistant dean at George Washington University Law School.

“It can be a subcontract related to the procurement, or it can be something completely separate, like building roads or building a new school,” Tillipman said.

Even though offsets are becoming common in some parts of the world, defense companies can’t afford to let their guard down on corruption risks, Tillipman said.

“I look at offsets as another wrinkle on the risk that companies face when doing business abroad, a more complicated wrinkle,” Tillipman said. “For the most part, government contractors have accepted that offsets are a cost of doing business in certain countries. But at the same time, even though it’s become a more normalized part of doing business abroad, it doesn’t mean that companies can relax their compliance programs.”

For example, a partner of a company that comes recommended by a government official should raise an immediate red flag for further investigation, Tillipman said. The connection could be something innocuous, like being on a list of reputable companies that could do the work required, or it could be a sign that a procuring official is funneling funds to a company that he or she has improper ties to, she said.

“With an offset, you’re often being told to use particular people or invest in certain areas that may have an improper connection to a government official,” Tillipman said. “Contractors need to be prepared to walk away or negotiate a different type of offset if that’s feasible.”

Any time a contractor tries to expand its market abroad — something that’s increasingly attractive as a result of budget cuts in the U.S. — they become more vulnerable to bribery risks because they’re often relying on in-country agents or representatives who know the market, know the country, know the institutions and know how to get things done, according to Schultz. Those kinds of connections can often be the same ones that create risks of bribery, he said.

“Those are the people who can often get you into trouble,” Schultz said. “You want to have a rigorous vetting process for representatives where you learn who they are and if they have connections with politically exposed persons who might be government decision-makers in the procurement.”

To protect themselves, companies can ask for audit rights for any fees that they pay so that they know where there money is going and can look for signs of corrupt payments, Schultz said.

Although the FCPA has been the biggest compliance risk for global defense companies, other countries, like Brazil, are passing similar statutes that can reach abroad, and nations like China are being more aggressive in pursuing anti-corruption laws within their own borders, Tillipman said.

“Risk is not just coming from the U.S., it’s all around the globe and that makes offsets even riskier,” Tillipman said.

Published by Law360