This next issue examines offset arrangements in the international aerospace and defense industry. While countries have diverse views regarding the viability of offset programs, many view them to be integral to achieving economic, industrial and social policy objectives. We highlight two differing approaches by contrasting the current offset landscapes in Poland and the UAE.

Although a properly designed offset program may make a legitimate contribution to the purchasing country's industrial and economic base, such programs are susceptible to bribery and corruption given their general lack of transparency. Our second article provides useful guidance on the mitigation of FCPA risks inherent in offset transactions.

Finally, Poland's new Law on Transparency of Public Life is anticipated to pass the Parliament and be enacted within the next three months. The new law would strengthen the penalties and sanctions for corruption in both the public and private sectors – requiring companies to implement sophisticated internal anticorruption tools and procedures. Although not exclusive to the aerospace and defense industry, the new law would impact the implementation of both defense contracts and related offset activities.

International Offset Programs: Contrasting Approaches and Current Trends

It has been estimated that at least 80 countries worldwide currently require offset arrangements -- in which a purchasing government requires a foreign seller to commit to reinvestment in the importing country in an amount representing a proportion of the underlying contract value -- when purchasing defense equipment, systems or services. The scope of offset obligations can vary widely and can be related to the exported goods or services supplied in the main defense contract (direct offsets), or be entirely unrelated to the underlying contract, either civil or defense-related (indirect offsets). For purchasing countries, offsets offer opportunities to support local industry, acquire technological knowledge and other economic benefits. For defense contractors, offsets can assist entry into new markets, help strengthen relations with companies in local supply chains and play a decisive role in successful procurement bids.

There is no comprehensive international regulation covering offset programs. At the country level, regulatory approaches to offsets include national laws, guidelines, requirements, policies, ad hoc approaches based on government policy, or no regulation at all. The objectives of respective offset programs are equally diverse, with countries treating offsets as commercial opportunities that promote varying development goals.

Contrasting the current offset policies of two countries -- Poland and the United Arab Emirates -- illustrates different objectives and regulatory approaches to implementing offset programs.

POLAND

The Plan for the Technical Modernization of the Armed Forces for 2013-2022, adopted by the Polish Ministry of National Defense (the MoND) provides for the implementation of 30 armaments programs, which are estimated to cost more than PLN 130 billion. In the Budget Act for 2018, the expenditures at the level of PLN 41.1 billion1 are planned for the implementation of tasks related to national defense. According to experts, Polish companies have a chance to win orders worth more than half of this amount. The remaining orders will go to foreign armaments concerns, which, in return for contracts for the supply or modernization of the arms for the Polish Armed Forces, will be essentially obliged to implement investment projects in the national arms industry (the so-called offset).

From the perspective of the Polish legislator, the offset provides the opportunity to quickly purchase modern weapons assuring that the Polish defense industry will be involved.

The Law of 26 June 2014 on Certain Contracts Concluded in Connection with the Execution of Orders of Fundamental Importance for State Security (the so-called "Offset Act") was enacted in Poland in 2014. The Offset Act changed the rules related to investments compensating the selection of a foreign supplier in tenders for the purchase and modernization of arms for the Polish Armed Forces. The offset ceased to be a compensation understood as an economic advantage and has become an exception admissible for reasons of state security. The offset agreement to be concluded between the State Treasury and the foreign supplier is to specify, in particular, the value, subject and schedule for the performance of the supplier's offset obligations and the conditions under which these obligations will be fulfilled. The purpose of the agreement is to protect the basic interests of state security, strengthen the armed forces and the national potential of the armaments industry. At the same time, this applies only to direct offset which is placed in defense plants.

Purposes of the offset application in Poland

The offset is intended to contribute to the expansion of the capabilities of the Polish Armed Forces through the acquisition by the Polish defense industry of technological capabilities used to produce, develop and secure the life cycle of the acquired military equipment and placement of industrial capacities in the economic sectors related to security and defense (direct offset). In proceedings conducted on the basis of the Offset Act, several dozen abilities, which together constitute a catalog of the so-called critical capabilities, were defined.

It is assumed that the plants defined in the regulation of the Council of Ministers as enterprises of special economic and defense importance have adequate human, technical and technological resources which have been developed during the implementation of their existing own production and renovation activities, and offset agreements are to be an instrument enabling the acquisition of modern technologies for the domestic industry. The implementation of such agreements also facilitates cooperation between Polish entrepreneurs and foreign armaments producers and includes Polish entrepreneurs in international supply chains.

In the implementation of projects related to the offsets, the Ministry of National Defense (the MoND) focuses on the expansion of the potential of domestic armaments enterprises which, due to the "offsetting" of military equipment supplies, are to be able to:

  • "fully independently regain the proper level of efficiency and reliability of the acquired military equipment by servicing and maintenance and repair activities of all its elements at the plant's level (Depot Level) and to reintegrate it (restoring the assumed configuration) and issue certificates;
  • produce military equipment and construct individual subsystems and elements, which means in practice the engagement of the offset recipient in deliveries to the Armed Forces of the Republic of Poland and its potential inclusion in the supply chain of the foreign offset provider;
  • develop elements of acquired military equipment in order to maintain their configuration reflecting the development and progress of engineering and technologies, as well as changes in operational requirements of the battlefield"2

UAE

Defense contractors have been, in the past years, struggling to find opportunities to generate offset credits and meet their obligations towards the UAE government. This was mainly due to the lack of available partnering opportunities and the reluctance of defense contractors to comply with some of the restrictions of doing business in the UAE (e.g., foreign investment restrictions). The Tawazun Economic Council ("Tawazun"), which acts both as the regulator for all offset matters and as a business development agency to promote, create and facilitate opportunities for defense contractors, has been making significant efforts to attract investments and help contractors meet their offset obligations. In this spirit, we have seen a few trends develop recently:

  • While Tawazun's original program was intended to focus on aerospace, defense and security, there have been investments in many other sectors during the past decade and the first half of this decade in which Tawazun has granted credits for investments in other non-strategical sectors such as mining, trading and light manufacturing/assembly. The past couple of years have witnessed a much more focused approach from Tawazun which has been directing investments into strategical sectors, refocusing on defense related industries, cyber security, aerospace as well as technology (including A.I.), innovation, education and healthcare.
  • Tawazun has recently offered some defense contractors the opportunity to make pure cash investments in exchange of offset credits. Under this structure, Tawazun would promote a particular project that is wholly-owned by UAE investors (private or public) and offer defense contractors offset credits in exchange of their cash contribution (no technology transfer, no involvement in the project, etc.). This structure is less complicated for defense contractors and may be an "easy" way to meet obligations, however, it often offers lower offset credits than traditional/typical JV structures and raises, in some cases, compliance issues with some defense contractors.
  • Tawazun, and more generally the UAE government, has been considering atypical ways and more strategic ventures to encourage defense contractors to invest in the UAE's target sectors previously mentioned. Such ventures include longer term projects (i.e., setting up a permanent presence in the UAE) with no specific short-term obligations to transfer technology or make specific financial contributions within specific milestones, replacing such obligations with more long-term commitments, which also include commitments to employ, train and develop local UAE nationals.

Mitigating FCPA Risks in Offset Transactions

Offset transactions have become an increasingly important element in defense procurement, and a well-designed offset project can be a key discriminator in winning a defense procurement competition. However, for a number of reasons, offset transactions can create certain Foreign Corrupt Practices Act ("FCPA") compliance risks. This article will briefly examine these risks and recommend steps that companies should take to mitigate them.

What Are Offsets?

Before discussing the corruption risks arising in offset transactions, it makes sense to understand what offsets are and the different forms they can take. Offsets are a type of countertrade mechanism generally connected with the sale of infrastructural and major defense and non-defense products and services to certain foreign governments, which require the seller to provide some reciprocal economic benefit to the purchasing country.

Offsets can either be direct or indirect. In the case of direct offsets, the investment is directly related to the underlying defense procurement contract. For example, if the underlying contract involves a fighter aircraft sale, a direct offset project could involve the manufacture of a portion of the plane, such as the wings or tail section. An indirect offset is unrelated to the underlying procurement contract and essentially could involve anything, either defense or commercial in nature. While a direct offset project could involve co-production or licensed production or subcontracting related to the main contract, an indirect offset project could involve an educational or training program for students in the purchasing country, technology transfer, or other investments in the purchasing country's economy, including cash contributions to a development fund, as approved by that country's offset authority, which is a governmental organization.

What are the corruption risks in offset transactions?

A Transparency International UK report in February 2012 entitled, "Due diligence and corruption risks in defense industry offset programmes" ("TIUK Report") noted that offset transactions give rise to potentially high corruption risks. It stated that:

Offset transactions carry potentially high risks of corruption, not only due to the high level of secrecy within the defence procurement as a whole, but because they usually lack the scrutiny and monitoring of the corresponding acquisition contract. Additionally, most offset transactions have few, if any, transparency and public accountability requirements. See TIUK Report at page 10.

The report also noted the additional risk that offsets could be used by defense companies essentially to bribe individuals in order to win defense contracts, either directly or indirectly through agents, offset brokers and intermediaries. Id.

In addition to the reasons identified in the TIUK Report, offset transactions can create FCPA compliance risks for a number of other reasons. One such reason is the great variety of forms that offset projects can take, especially in the case of indirect offsets, which requires careful and customized risk-based FCPA due diligence on each unique project. Another reason for FCPA compliance risk is that many offset deals are put together by offset brokers, companies or individuals who specialize in structuring offset transactions, and may involve multiple third parties in arranging and implementing an offset project.

However, the most important reason that offset projects give rise to FCPA exposure is the involvement of the foreign government customer and/or offset authority in selecting or approving such projects. This is a huge danger area from the standpoint of FCPA compliance because it creates an opportunity for an official to direct the work (and the defense contractor's funding) to a project that benefits the official either directly or indirectly through business or family connections. As noted in the TIUK Report, an offset project can be used as a bribe to government officials, directly or indirectly, in order to win the underlying defense contract.

A couple of real-life examples will illustrate the type of FCPA risks that can arise in connection with proposed offset projects. For example, in one instance an offset broker brought a defense contractor a proposed deal to obtain Italian offset credits in which the offset broker would arrange for the sale of commercial (non-defense) goods from Italy to a company in Thailand as part of a Thai countertrade deal. The defense contractor's due diligence revealed that the Thai side of the countertrade transaction required approval by a Thai government agency which was run by a close relative of the Thai Prime Minister. Due diligence also revealed that the offset broker would be required to pay some portion of its fee from the defense contractor (a commission based on the dollar value of offset credits awarded) to the Thai government agency in exchange for its approval.

The Thai government agency refused the defense contractor's request for an FCPA certification with respect to the funds that it would receive in connection with the transaction and refused to consent to a due diligence interview by the defense contractor. By following the money flow, the defense contractor's due diligence revealed significant FCPA red flags, which were not negated because of the Thai government agency's refusal to cooperate. In the face of such unresolved red flags, the defense contractor refused to proceed with the proposed transaction.

The offset broker then proposed an alternative project to enable the defense contractor to obtain the Italian offset credits it needed. The new project involved the proposed sale of an Italian company's defense equipment to Egypt. Due diligence revealed that the Italian company selling the equipment was using an agent in Egypt that it had agreed to pay on a commission basis. Because Egyptian Ministry of Defense ("MOD") policy and the MOD's contracts prohibit the use of agents and payment of commissions on defense sales, this proposed offset project also raised significant FCPA red flags. This was because it would have involved part of the defense contractor's fee to the offset broker being paid to an illegal Egyptian agent on a defense sale. As in the first case, these risks would not have been uncovered without the defense contractor's due diligence on the project that followed the money. As in the first example, the defense contractor refused to proceed with the proposed offset project.

What steps should companies take to mitigate these risks?

There are a number of steps that companies should take to mitigate the corruption risks arising from offset transactions. First, companies should conduct risk-based due diligence on the offset brokers and consultants who help create the offset project or who work to get it approved by the foreign government offset authorities. In the case of offset brokers, training them in your company's code of ethics and business conduct and its anti-corruption policy and emphasizing on an ongoing, documented basis the importance of strict compliance also will help to protect your company. It also is very important to include anti-corruption provisions (FCPA representations and warranties, prohibition on subagents without prior approval, audit rights, restrictions on payment in third countries, etc.) in your agreement with the offset broker and to monitor the broker's compliance and refresh your due diligence on an ongoing basis.

Second, as illustrated by the real-life examples above, risk-based due diligence should be conducted on each proposed offset project in order to understand who all of the participants are, including any brokers, agents or other third parties who will be involved in implementing the project, receiving funds from the company, or assisting in obtaining any required approvals or credits. It is important to understand how these third parties may be connected to government officials in the purchasing country by family or business relationships and to ensure that they have the necessary expertise and capability.

Finally, companies should conduct ongoing monitoring and implement controls for the duration of the offset project to ensure that the company's money and other contributions are being used for the intended purpose and are not being misused or diverted for an improper purpose. The basic principle is to always "follow the money" on an ongoing basis for the life of the project.

In certain countries such as the UAE, companies may be required to enter into a joint venture ("JV") with a local company which owns a majority interest as a condition for approving a proposed offset project. In such a case, it is important that the company take certain steps to help ensure compliance with the FCPA and other applicable anti-corruption law by the JV and the local JV partner on an ongoing basis. These steps include: 1) thorough FCPA due diligence on the proposed JV partner and any third parties that will be performing services on its behalf; 2) anti- corruption representations and warranties in the JV agreement; 3) the contractual right for the company to appoint the JV's chief compliance officer and oversee the compliance function; 4) the contractual right for the company to appoint the JV's CFO and to oversee and monitor the JV's expenditures; 5) the adoption and maintenance by the JV of a code of conduct and an FCPA/anti- corruption policy satisfactory to the company and periodic risk-based training of the JV's employees on the requirements of this code and policy; 6) a prohibition on the JV's retention of any third parties without satisfactory risk-based due diligence and prior approval by the company; 7) ensuring the ability of the company to conduct ongoing monitoring and oversight over the JV's operations through its representation on the JV's board and broader contractual rights to audit, etc.; and, finally, 8) termination rights in the JV agreement that enable the company to expeditiously exit the JV on financially satisfactory terms if it has a reasonable belief that its JV partner or the JV may be violating the FCPA.

Conclusion

It would be a mistake to conclude from the foregoing discussion of potential FCPA risks that offset transactions are inherently or frequently corrupt or improper. Based upon my experience of almost 30 years in the aerospace and defense industry, that is not the case. Rather, most offset projects are not corrupt or improper and a well-designed offset project can be a key discriminator in winning a defense procurement competition.

For the reasons discussed above, however, offset transactions present a potentially high FCPA compliance risk for companies in the aerospace and defense industry. Companies can and should effectively mitigate this risk by establishing and maintaining anti-corruption law compliance programs that require thorough risk-based due diligence on proposed offset brokers and other third parties and, especially, on proposed offset projects and the parties involved in them. Such due diligence should not end after the initial approval of a project. Rather, it should continue for the duration of the project through careful oversight, monitoring, and controls to always follow the money.

 

New Law on Transparency of Public Life: How it will Affect my Firm's Business Operations? 

Public hearings on the bill of the new Law on Transparency of Public Life have been completed. The bill has not yet been debated by Parliament. However, we believe the bill will pass and the new law will be enacted within the next three months.

What changes can be expected?

The proposed legislative amendments are designed to counter corruption, and strengthen the penalties and sanctions system for companies that fail to comply with the Law’s requirements. Although the main part of the Law concerns the public sector, significant changes are also expected in the private sector and for large entrepreneurs without any Treasury share in their capital.

Anticorruption procedures

Pursuant to the bill, companies will be required to draft and effectively implement sophisticated internal anticorruption tools and procedures. The proposed tools and procedures are aimed at both preventing and discovering acts of corruption or its financing, and ensuring that any wrongdoings are quickly and efficiently reported. Penalties for failure to comply with the new requirements will be significant. The Polish Antimonopoly Office (UOKiK), for example, will be able to impose penalties as high as PLN 10 million (approximately USD 3 million) per violation, and a ban on participation in public procurement for up to five years may be imposed.

Whistleblowers under special protection

According to the legislature, currently whistleblowers are rarely reporting to their employers and even less frequently to officials of competent authorities any wrongdoing which may have occurred in their companies, for fear of retaliation. This is why the legislature is planning to introduce the concept of whistleblowers and whistleblowing, and the related statutory protections for whistleblowers against retaliatory actions, into the Polish legal system. Among the proposed protection measures is the prohibition from terminating an employment contract or the requirement to pay two years’ severance in the event of termination of an employment contract without clearance from the public prosecutor.

The main goal of the proposed legislative amendments is the transparency of any activity in the public sector. To this end, the bill includes significant restrictions on commercial companies and groups of companies in which more than 20% of shares/stock are owned by the State Treasury (so-called obligated companies). These restrictions are driven by the new law’s proposed introduction of the requirement for such companies to separate their management from their capital. In practice, this may significantly affect such companies’ attractiveness for investors. Moreover, obligated companies will be required to disclose and keep a public register of all civil-law contracts and agreements. However, a significant part of the regulations applies to private entrepreneurs without any capital with the State Treasury that employ more than 50 employees and have an annual turnover of more than EUR 10 million or total assets amounting to more than EUR 10 million.