Compliance Alert: Another reason life is hard for defense contractors
Wednesday, September 6, 2017 at 8:18AM
Bill Steinman in Due Diligence, offset

There are no two ways about it. Indirect offset transactions are burdensome. 

First, they’re hard to find. I’ve heard just about every idiom in the book used to describe their rarity. A needle in a haystack. Scarce as hen’s teeth. Rare as a four-leaf clover. 

To make matters worse, defense contractors face significant pressure to find suitable projects. Companies can face stiff financial penalties and even blacklisting if they fail to discharge their obligations on time. And while we’re piling on woes, the Department of Commerce reports that indirect offset obligations account for roughly 60 percent of all offset requirements worldwide. 

Readers will recall from my prior posts that indirect offset obligations do not relate directly to the contractor’s products or services. Rather, they require the provision of support to businesses that often have no connection to the defense industry.

In most cases, the government imposing the indirect offset obligation does not provide assistance to the contractors seeking out projects to support. That means defense contractors face millions of dollars in indirect offset obligations that they must satisfy in a fixed period of time, but with little to no guidance on how to go about it. To offer yet another idiom -- they’re tossed into the deep end without swimming lessons.

Defense contractors therefore dedicate significant time, effort and treasure to find and execute suitable indirect offset transactions. But contractors must also be wary of corruption risks when satisfying their indirect offset obligations. Let’s delve into some anecdotes to illustrate these risks.

In one recent example, a client with a hefty indirect offset obligation in an African country agreed to provide financial support for the construction of a new tourist hotel along a beautiful stretch of beach. Because the host government sought to boost the tourism industry, every dollar my client spent would result in five dollars’ worth of offset credit. There was only one catch. The local company building the hotel was owned by the spouse of the country’s sitting chief executive. 

While a potentially ugly compliance situation, at least the hotel was actually under construction, with or without my client’s support. The same cannot be said for a similar transaction I encountered a few years earlier. 

In that situation, another client considered providing funds to a conservation group establishing a wildlife refuge in Eastern Europe. Not only was the nonprofit spearheading the effort managed by a senior government official, there were no plans to actually develop the refuge. Instead, the official planned to line her pockets with every single dollar.

One should never underestimate the creative lengths that corrupt officials will go when trying to take advantage of indirect offset obligations. One of my clients identified an opportunity to provide funding for a scholarship program in a Gulf state for high school students who excelled in science, technology, engineering and math. After a little digging, we discovered that the program had been manipulated so that only the children of senior defense officials could participate.

Simply put, because indirect offset transactions generally feature providing money to strangers, they are fertile ground for corruption. That means that before defense contractors open up their proverbial checkbooks in the quest for offset credit, they should -- you guessed it -- conduct some basic due diligence on the recipients of offset support. 

At a minimum, I recommend identifying an indirect offset partner’s ultimate beneficial owners, confirming that it is a legitimate going concern, and ensuring that it will receive payments to an account held in its own name at a legitimate financial institution in its home jurisdiction.

A written agreement documenting the offset support and containing robust compliance provisions is also advisable. For larger transactions, defense contractors should consider implementing steps to verify that the financial support has been spent as intended. This could take the form of an audit of the recipient’s books and records or a site visit, as appropriate. 

A modicum of due diligence on an indirect offset partner can also avoid reputational risks. I recently assisted a client to review an indirect offset transaction involving the construction of a cooling tower in a Gulf state. While our review uncovered no indication of potential corruption risks, a simple media search revealed that the construction contractor was under investigation for mistreating guest workers. 

Our client wisely concluded that earning offset credits was not worth the potential damage to its reputation -- not to mention its moral compass -- by supporting the project. 

In the end, we come back to due diligence as the primary source of protection in offset. 

Indirect offset is challenging enough without stumbling over corruption risks. Most defense contractors wouldn’t dream of paying a sales agent without delving into its background; the same should be true for the recipients of offset support.

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Bill Steinman is a Contributing Editor of the FCPA Blog. He's the senior partner at Steinman & Rodgers LLP, a boutique law firm in Washington, D.C. specializing in international anti-corruption compliance and investigations.

Article originally appeared on The FCPA Blog (http://www.fcpablog.com/).
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