The U.S. Department of Defense (“DOD”) recently issued a final rule that will significantly impact the defense supply chain. The new rule, effective May 6, 2014, implements the provision in Section 818 of the fiscal year (FY) 2012 National Defense Authorization Act (“NDAA”) related to the use of counterfeit electronic parts in DOD products. Specifically, the final rule imposes new obligations that place the responsibility of detecting counterfeit electronic parts on contractors and compliance to those further down the supply chain.

Contractors that are subject to full or modified coverage under the Cost Accounting Standards (“CAS”) (“covered contractors”) must comply with the final rule. In addition, all subcontractors to covered contractors, regardless of their own CAS coverage or size status, are subject to the new regulations. Further, since the final rule applies to commercial items and commercial-off-the-shelf (“COTS”) items subcontracted to covered contractors, suppliers of COTS items in the supply chain must also comply with the new regulations.

Under the final rule, covered contractors must establish a counterfeit part detection and avoidance system when the government acquires goods and services that involve electronic parts.  While last year’s proposed rule made contractors aware of these new responsibilities, the final rule incorporates many substantial alterations requested by industry. Specifically, significant changes made in the final rule include:

  • Limiting the Scope to “Electronic” Parts:  DOD clarified that the final rule only applies to counterfeit electronic parts, suspect electronic parts, and obsolete electronic parts, and does not expand to other items in the DOD supply chain. 
  • Including an Intent Element:  A counterfeit electronic part is now defined as one that has been “knowingly mismarked, misidentified, or otherwise misrepresented,” which mitigates strict liability for instances where errors could have occurred that were not intended to mislead buyers.
  • Using Risk-Based Approach: Covered contractors have some flexibility in designing their counterfeit electronic part detection and avoidance systems, and are not required to follow a “one size fits all” approach. The DOD expressly acknowledged that contractors may adopt “risk-based policies and procedures” for their systems, as long as 12 specific areas of criteria are addressed, including but not limited to: training, inspection, traceability and reporting.
  • Adopting a Reasonable Standard for Identifying Counterfeit Electronic Parts: DOD instituted a “credible evidence” standard to determine suspected counterfeit electric parts. While contractors now have the ability to determine whether there is “reasonable doubt that the electronic part is authentic,” this opportunity may provide more obstacles for contractors, given the uncertainty that may result from an undefined standard.

Despite these requested changes, many burdensome aspects of the proposed rule remain unchanged.  Most importantly, the new counterfeit part detection and avoidance obligations will be flowed down the supply chain. Also, compliance with the new regulations will become part of the existing requirements for a covered contractor’s purchasing system. Failure to comply may result in disapproval of the system by the contracting officer and/or a withholding of payments.

Because the new rule is effective immediately, its provisions will be included in newly awarded contracts to covered contractors. Further, the government will likely try to incorporate the new clauses into existing contracts through modifications. For these reasons, covered contractors, subcontractors and suppliers of electronic parts involved in the DOD supply chain should start reviewing their current policies and procedures to determine if they are in compliance with the requirements of the final rule.