The purpose of this article is to highlight the potentially high Foreign Corrupt Practices Act compliance risks posed by offset transactions for a number of companies in the defense industry and to discuss how to mitigate these risks through an effective anti-corruption law compliance program. My perspective on this comes from working as an in-house and outside counsel for a number of companies in the U.S. aerospace and defense industry for almost three decades and conducting FCPA due diligence on numerous proposed offset brokers and offset projects. In doing this work, I found most offset brokers to be honest and creative companies and individuals with considerable skill and expertise in putting together some very complex deals to satisfy defense companies’ offset obligations in a fairly unique and arcane area separate from the main defense procurement competition. I also found that offsets can play a critical role in defense procurement and that a well-designed offset project can be a key discriminator in winning a defense procurement competition based on the legitimate contribution it makes to the purchasing country’s economy and the political benefit that the purchasing country’s government derives from the offset project with its citizens. While I found that typically the offset brokers and most of the proposed offset projects did not raise FCPA compliance concerns, certain proposed projects did raise such concerns, and I advised my clients to steer clear of these projects. The only way to identify these dangerous or problematic projects was by conducting risk-based FCPA due diligence on each project. I also found that the best and most effective way to conduct this due diligence was in close cooperation and partnership with my client’s offset professionals, with whom I worked to get the necessary information on the proposed projects and the entities and key individuals involved in them. The subject of FCPA risks in offset transactions was examined in considerable detail in a Transparency International UK report in February 2012 titled “Due diligence and corruption risk in defence industry offset programmes.” The report noted 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 TI UK 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. Based upon my experience, I believe that offset transactions can present potentially high corruption risks for companies in the defense industry for the reasons identified in the TI UK Report and a few others, as discussed below. To protect themselves from exposure to liability under the FCPA and other anti-corruption laws, companies need to make sure they are addressing these risks through adequate risk-based due diligence on any third parties involved in the offset transaction — agents, offset brokers and other intermediaries — as well as conducting adequate due diligence on the proposed offset project itself and establishing mechanisms to provide ongoing oversight and monitoring for the duration of the project to help ensure continuing anti-corruption compliance or, put another way, to continue to follow the money to prevent it from being used corruptly. Before discussing the widely varying risks inherent in offset transactions, it would make sense to understand what defense offsets are and the many different forms they can take. As noted in the TI UK Report:
Defense offsets are a counter-trade mechanism agreed between purchasing governments and supplying companies requiring them to put in place a number of additional investments, often unconnected to the main contract, as a condition of undertaking it. They are frequently used as industrial (sometimes even economic or social) policy tools aimed at improving balance of payments accounts and compensating the purchaser’s economy for a public investment that will not have an immediate direct impact on the well-being of the nation. Id. At page 9.

Defense 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 involved the sale of fighter aircraft, 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, as approved by that country’s offset authority, which is a governmental organization. In addition to the reasons identified in the TI UK Report, defense offsets can be dangerous from an FCPA compliance perspective because of the great variety of forms that the projects can take, especially in the case of indirect offset projects. This requires that risk-based due diligence be conducted on each project in order to understand who all of the participants are, including any brokers, agents or other third parties, how they may be connected to government officials in the purchasing country by family or business relationships, and essentially following the money flow from the time the defense contractor enters into the offset agreement through the completion of the offset project. Another reason such offset transactions give rise to 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 other third parties in implementing the offset project. Risk-based due diligence needs to be conducted on each of these third parties. In the case of offset brokers, training them in your company’s code of ethics and business conduct and anti-corruption policy and emphasizing on an ongoing basis the importance of strict compliance also will help to protect your company or client. It also is very important to include anti-corruption provisions (FCPA representations and warranties, prohibition on subagents without prior approval, audit rights, etc.) in your agreement with the offset broker and to monitor the broker’s compliance on an ongoing basis. A third —and, I believe, the most important — reason defense 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. Once again, the remedy is careful risk-based due diligence on the project and the parties involved in it before agreeing to perform a particular project and then ongoing monitoring of the project for its duration. A few hypothetical examples will illustrate the type of FCPA risks that can arise in connection with proposed offset projects. Assume a proposed deal to obtain offset credits from a European country for a U.S. defense contractor in which the offset broker arranges for the sale of commercial (non-defense) goods from the European country to a company in Thailand as part of a Thai counter-trade deal. Assume also that due diligence reveals that the Thai side of the counter-trade transaction requires approval by a Thai government agency which is run by a close relative of the Thai Prime Minister. Finally, assume you learn that the offset broker will 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. If the Thai government agency refuses to provide an FCPA certification with respect to the funds that it will receive in connection with the transaction and refuses to consent to a due diligence interview by the defense contractor, the defense contractor would have FCPA concerns with respect to this project. The defense contractor’s due diligence in following the money flow has revealed significant red flags, which have not been negated because of the Thai government agency’s refusal to cooperate. In the face of such unresolved red flags, it would be very risky to proceed with the proposed transaction. Now assume the broker proposes an alternative project to enable the U.S. defense company to obtain the European country offset credits it needs. The new project involves the proposed sale of the European country’s defense equipment to Egypt. Assume that due diligence reveals that the European country company selling the equipment is using an agent in Egypt that it will pay on a commission basis. Because Egyptian Ministry of Defense policy and the MOD’s contracts prohibit the use of agents and payment of commissions on defense sales, this proposed offset project also raises significant red flags. This is because it would involve 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 due diligence on the project that followed the money. A third hypothetical example involves a proposed offset project in a Middle Eastern country. The ME country’s offset guidelines require that in order to satisfy its offset obligation, a defense contractor must enter into a joint venture that is majority owned by a ME country company. Under the ME country’s rules, the offset credits are not awarded based on the foreign company’s investment in the joint venture company, but rather based only upon whatever profits the joint venture company earns. This raises the ongoing risk, of course, that any improper action taken by the joint venture in its operations potentially could be attributed to the U.S. company to the extent that it either actually knew about and authorized the improper action or, more likely, that it allegedly did not use good faith efforts to ensure that the joint venture adopt and maintain adequate internal controls. Assume that your due diligence on this proposed ME country offset project reveals that a key ME country decision maker who is a senior official in the government agency that will approve the proposed offset project and award offset credits also serves on the board of directors of the ME country’s government owned or controlled company with which the U.S. defense contractor will be entering into the joint venture to satisfy the offset obligation. Apart from the obvious potential conflict of interest requiring disclosure and, hopefully, the official’s recusal from his position in the government agency approving the transaction, there also is a question whether this senior official will benefit financially from approval of the project involving the company on whose board he serves. Assume further that the defense contractor’s ability to conduct FCPA due diligence on this individual is made much more difficult by his refusal to participate in a due diligence interview that the company requests, a not uncommon situation in this ME country. In this case, the company’s due diligence has raised serious FCPA red flags and conflict of interest concerns, which must be satisfactorily addressed before the company can go forward with the proposed project. A final hypothetical example of FCPA concerns that can arise in a proposed offset transaction involves an unusual request made by the offset authority of a Western European country. In order to satisfy a defense contractor’s offset obligation, the offset authority proposes that the contractor purchase and provide the foreign government with a Gulfstream executive jet. Although the request for the plane is made by the foreign government agency and presumably the plane would be given by the company to the foreign government, rather than to any individual or individuals, in exchange for the award of offset credits, this proposed offset project also raises significant FCPA concerns. This conclusion is based on the nature of the proposed offset contribution, an expensive executive jet that is susceptible to being misused for the lavish personal benefit of one or more members of the foreign government’s offset authority and which gives rise to the appearance of impropriety. It would be a mistake to conclude from the foregoing discussion of potential FCPA risks that defense offset transactions are inherently or frequently corrupt or improper. Based upon my experience in the aerospace and defense industry, I do not believe that to be the case. Rather, I believe that most offset projects are not corrupt or improper. As noted above, I also believe that a well-designed offset project can be a key discriminator in winning a defense procurement competition and that offsets are not going away. For the reasons discussed above and illustrated in the examples, however, I also believe that offset transactions present a potentially high FCPA compliance risk for companies in the defense industry. This risk can and should be effectively addressed and mitigated by defense companies 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 throughout the duration of the project through careful oversight and monitoring to always follow the money and other contributions being provided by the defense contractor in exchange for offset credits. This article was first published on Law360.