On May 16, 2013, the Department of Defense (DoD) issued the first in a series of anticipated proposed rules implementing the congressional mandate in Section 818 of the National Defense Authorization Act (NDAA) for Fiscal Year (FY) 2013 that DoD adopt procurement regulations to address the detection and avoidance of counterfeit parts in DoD’s supply chain. 1 The Proposed Rule addresses some of the pending questions concerning DoD’s implementation of Section 818. The proposed regulations, for instance, reveal that DoD does not intend to extend the reach of the rules beyond electronic parts, at least for the immediate future. But the Proposed Rule seems to raise or avoid as many questions as it answers, falling short of the hope that it might provide clarity on the most pressing issues, including DoD’s intentions with respect to designating “trusted suppliers” and what will be expected of prime contractors in managing their respective supply chains. 

This specific rulemaking serves three primary purposes:

  1. establishing the scope of the regulations by defining “electronic part” and “counterfeit part;”
  2. introducing a DFARS Part 231 cost principle that would preclude most DoD contractors from recovering costs associated with purchasing or remediating counterfeit electronic parts; and
  3. requiring certain DoD contractors subject to the Cost Accounting Standards (CAS) to establish and maintain a “counterfeit electronic parts avoidance and detection system.”

Each of these aspects is discussed below.

Comments on the Proposed Rule are due July 15, 2013. While we anticipate that the proposed regulations will undergo substantial revision before they ultimately take effect, it is important for contractors and companies in their supply chains to start to prepare, or continue preparing, for the eventual implementation of this new regime. 

Definitions

Consistent with Section 818, the Proposed Rule is focused on the detection and avoidance of electronic parts. 2 The Proposed Rule would define “electronic part” as “an integrated circuit, a discreet electronic component (including, but not limited to, a transistor, capacitor, resistor, or diode), or a circuit assembly.”3 

The Proposed Rule would define “counterfeit part” broadly to include any part that is misrepresented as obtained from a “legally authorized source” (i.e., the original manufacturer, the current design activity, or an authorized supplier) and/or that is misrepresented as meeting the contractual performance requirements.4 Because a purported or alleged “misrepresentation” concerning the nature or source of a product could render a product “counterfeit” under DoD’s rules and contract clauses, it will be important—if this aspect of the proposal is adopted—for DoD to provide specificity when defining its requirements, especially where it limits procurements to “brand name or equal” products. In such cases, contractors offering an “or equal” product will need to be clear about what they intend to deliver. 

DoD cost principle limiting reimbursement for counterfeit parts

Proposed DFARS 231.205-71 would provide that the costs of counterfeit electronic parts and suspect counterfeit electronic parts and the cost of “rework or corrective action that may be required to remedy the use or inclusion of such parts” are generally unallowable. This would mean that contractors could not seek reimbursement for procuring counterfeit parts from suppliers (e.g., counterfeit parts discovered in inventory) or for the costs associated with removing counterfeit components from other electronic subassemblies or end items. As the rule is presently drafted, contractors would be precluded from recovering such costs even if they could show that they had taken all reasonable steps to reduce the risks of procuring counterfeit parts. Consistent with Section 833 of the FY2013 NDAA, the Proposed Rule would provide a limited exception where all of the following elements are met:

  1. the contractor has established a system to detect and avoid counterfeit electronic parts;
  2. DoD has reviewed and approved the system;
  3. the counterfeit electronic parts are government-furnished property (GFP); and
  4. the contractor provides timely notice to DoD.5 

This exception is extremely narrow, as it could only apply to counterfeit parts provided by the government as GFP.

Interestingly, DoD’s commentary accompanying the Proposed Rule indicates that the exception might apply to parts that are not GFP if the contractor maintains a DoD-approved system to detect and avoid counterfeit parts and provides timely notice to the government.6 The proposed regulatory text itself, however, would clearly limit the exception to GFP. While this contradiction, taken at face value, might indicate some ambiguity concerning DoD’s intentions, the Federal Register notice suggests that the proposed regulatory text reflects DoD’s true intent. DoD stated that it tried to align the exception with Section 833, which only applies to counterfeit electronic parts and suspect counterfeit electronic parts that were provided to the contractor as GFP.7 We would expect DoD to issue a supplemental notice to resolve the potential ambiguity. 

If the regulation is adopted as proposed, it would not provide much of a “safe harbor.” In fact, Section 833 and the DFARS implementation would put contractors in a less favorable position than under federal common law, which generally would hold the government liable in situations where it supplied a counterfeit part as GFP, with the contractor only required to show that it did not have any reason to know that the GFP part was counterfeit or defective.8 

DoD contract clause requiring counterfeit electronic part avoidance and detection system

The Proposed Rule would impose the requirement to establish and maintain a counterfeit electronic parts avoidance and detection system through a new DFARS clause, 252.246-70XX, Contractor Counterfeit Electronic Part Avoidance and Detection System. This clause is central to the Proposed Rule, as it is the mechanism that DoD would use to require that contractors adopt acceptable practices and procedures to reduce the risk of the introduction of counterfeit parts into the supply chain. The following addresses several of the key questions that contractors may have concerning the proposed clause.

Which contracts and contractors would be subject to the 252.246-70XX requirements? 

DFARS 252.246-70XX would be prescribed for DoD procurements of electronic parts (as an end item itself, a component of an end item containing electronic parts, or as part of the delivery of services) where the resulting contract would be subject to CAS.9 The CAS only apply to certain contract types and only after a contractor holds at least one CAS-covered contract that exceeds US$7.5 million, triggering partial CAS coverage.10 The clause would not apply to commercial-item contracts and fixed-price contracts awarded with “adequate price competition,” among other types of contracts. Thus, the applicability of the requirement to adopt a system to detect and avoid counterfeit electronic parts would coincide generally with the triggering of CAS coverage. 

What contractual requirements and compliance obligations would the new clause impose?

The clause would require the contractor to “establish and maintain” a “counterfeit electronic parts avoidance and detection system.” The clause is long on generalities but short on specifics. The clause would dictate that a contractor’s system must include policies and procedures that address the following:

  1. The training of personnel;
  2. The inspection and testing of electronic parts, including criteria for acceptance and rejection;
  3. Processes to abolish counterfeit parts proliferation;
  4. Mechanisms to enable traceability of parts to suppliers;
  5. Use and qualification of trusted suppliers;
  6. The reporting and quarantining of counterfeit electronic parts and suspect counterfeit electronic parts;
  7. Methodologies to identify suspect counterfeit parts and to rapidly determine if a suspect counterfeit part is, in fact, counterfeit;
  8. The design, operation, and maintenance of systems to detect and avoid counterfeit electronic parts and suspect counterfeit electronic parts; and
  9. The flow down of counterfeit avoidance and detection requirements to subcontractors. 

The Proposed Rule, however, does not provide any details to explain what will be expected of contractors in these various areas. 

Possibly the most glaring omission is that while the clause requires that the contractor’s system address the use and qualification of trusted suppliers, the rulemaking provides no guidance concerning which suppliers can or should be deemed “trusted.” The Proposed Rule does not suggest that the scope of “trusted suppliers” is coextensive with the definition of “legally authorized source.” And, in fact, the clause as proposed does not expressly require that the contractor purchase only from authorized suppliers. The clause would seem to allow contractors to purchase from the “gray market”—that is, products that may meet specifications but are not from an authorized source—so long as there is no misrepresentation concerning the origin of the product or component, its markings, and its suitability to meet performance requirements.11 

Further, several of the system requirements are likely too vague to be executable without additional guidance. For instance, a contractor must address the “processes to abolish counterfeit parts proliferation” and “the design, operation, and maintenance of systems to detect and avoid counterfeit electronic parts and suspect counterfeit electronic parts.” DoD has provided no specificity with respect to what a contractor’s system must include in these areas. In some sense, this could be seen as providing DoD contractors with some flexibility. Yet any suggestion of flexibility is likely illusory, because, as discussed below, DoD ultimately will determine whether a contractor’s system passes muster, and in many cases, may do so with the benefit of hindsight, after counterfeit parts are discovered. Contractors could be exposed to draconian withholdings if DoD concludes that a contractor’s system does not satisfy the nebulous “requirements.”

Additionally, the proposed clause does not include any specific subcontract flow-down obligations. Instead, the clause merely indicates that the contractor’s system should address flow down to subcontractors, without any guidance as to how contractors should do so. The Proposed Rule, for example, does not expressly address whether the requirements should flow down to commercial-item subcontractors. The proposed regulations would seem to create the curious result that DoD would not impose 252.246-70XX on commercial-item vendors when contracting directly with them, but would effectively require that CAS-covered prime contractors flow down at least certain aspects of 252.246-70XX when subcontracting with those same commercial-item vendors.

In the commentary accompanying the rule, DoD recognizes that small businesses in the DoD supply chain may be impacted by the requirements (i.e., that large CAS-covered contractors subject to the clause will be forced, in some respects, to flow down certain obligations), but DoD suggests that the impact should be “negligible” insofar as the small businesses are not supplying counterfeit parts. DoD does not explain the basis for this conclusion. In any case, such a detached view fails to account for the costs and burdens associated with implementing protections that can ensure that no counterfeits enter the supply chain. 

In what context would DoD assess a contractor’s compliance with the requirements of 252.246-70XX?

Under the proposal, DoD would assess a contractor’s counterfeit electronic parts avoidance and detection system as part of DoD’s contractor purchasing system review (CPSR). The CPSR is the process through which DoD and other agencies evaluate the way that a contractor spends federal funds and complies with subcontracting requirements and policies. Historically, the Government has conducted such reviews only for flexibly-priced contracts (e.g., cost-reimbursement and time-and-materials contracts), but under the Proposed Rule, DoD would conduct a truncated CPSR for any CAS-covered contract.12

What remedies would be available to the government in the event that a contractor failed to comply with the requirements of 252.246-70XX? 

As mentioned above, review of a contractor’s counterfeit electronic parts avoidance and detection system will occur as part of DoD’s CPSR—either a standard, full-blown CPSR or a truncated review that is focused primarily on supply-chain assurance. Failure to maintain an adequate system to detect and avoid counterfeit electronic parts could result in disapproval of the contractor’s purchasing system and/or withholding of contract payment.

If DoD were to disapprove a contractor’s purchasing system based on deficiencies in its system to avoid and detect counterfeit electronic parts, under DFARS 242-7005, the Contractor Business Systems clause, DoD could withhold up to five per cent of amounts due on progress payments, performance-based payments, and interim cost vouchers.13 And disapproval of a contractor’s purchasing system could have other severe implications for large contractors, requiring that they seek the government’s consent before entering into most subcontracts and undermining chances to secure future flexibly-priced work. Contractors would face these repercussions in addition to potentially bearing the responsibility for the costs associated with replacing and remediating counterfeit parts, as discussed above.