Military Offsets: Regulations Needed to Implement Prohibition on Incentive Payments

Published by the Government Accountability Office on 1997-08-12.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                   United States General Accounting Office

GAO                Report to the Honorable
                   Russell D. Feingold, U.S. Senate

August 1997
                   MILITARY OFFSETS
                   Regulations Needed to
                   Implement Prohibition
                   on Incentive Payments

                   United States
GAO                General Accounting Office
                   Washington, D.C. 20548

                   National Security and
                   International Affairs Division


                   August 12, 1997

                   The Honorable Russell D. Feingold
                   United States Senate

                   Dear Senator Feingold:

                   This report responds to your request for information on the
                   implementation of the statutory prohibition governing incentive payments
                   on offset programs, known as the “Feingold Amendment.”1 Specifically,
                   you asked us to address (1) the status of the Department of State’s efforts
                   to issue implementing regulations and (2) the need for such regulations.

                   The Department of State has made little progress in developing regulations
Results in Brief   implementing the Feingold Amendment because of internal disagreements
                   over which organizational component should draft implementing language
                   and the low priority assigned to completing this task. Regulations are
                   needed to clarify key definitions contained in the law and establish how
                   State will implement the law’s enforcement and penalty provisions.

                   Foreign governments obtain U. S. military items and services in two major
Background         ways—U.S. government sales under the foreign military sales (FMS)
                   program and commercial sales by individuals and business entities. The
                   Department of State approves (1) the sale of items and services sold under
                   the FMS program and (2) export licenses for military items sold by
                   contractors as a direct commercial sale.2

                   Offsets are a range of industrial and commercial compensations provided
                   to foreign governments and firms as inducements or conditions for the
                   purchase of U.S. military goods and services. Offset arrangements are not
                   new to defense export sales. The use of offsets began in the late 1950s in
                   Europe and Japan. In 1984, we reported that offsets were a common
                   practice and that demands for offsets on defense sales would continue to

                    Section 733 of P.L. 103-236, April 30, 1994, amended the Arms Export Control Act (AECA) by inserting
                   a prohibition on incentive payments, 22 U.S.C. 2779a.
                    AECA authorizes the Department of Defense (DOD), under the FMS program, to sell defense articles
                   and services to foreign governments or international organizations from existing stock (section 21), as
                   well as in cases where DOD procures defense articles or services from a defense contractor for
                   ultimate sale to the foreign country (section 22), 22 U.S.C. 2761 and 2762, respectively. Agreements
                   reached under either of these FMS arrangements are subject to Department of State review. Also, State
                   controls direct commercial sales under authority provided in section 38 of AECA, 22 U.S.C. 2778.

                   Page 1                                                         GAO/NSIAD-97-189 Military Offsets

                      increase.3 In 1996, we reported that demands for offsets in defense export
                      sales had increased; countries that previously pursued offsets were
                      demanding more and countries that previously did not require offsets
                      required them as a matter of policy.4

                      The Feingold Amendment, enacted in April 1994, prohibits U.S.
                      contractors from making incentive payments to a U.S. company or
                      individual to induce or persuade them to buy goods or services from a
                      foreign country that has an offset agreement with the contractor.5 It only
                      applies to defense articles or services “sold under” the AECA. It does not
                      apply to commercial sales, which are licensed under, but not sold under,
                      the AECA. However, for consistency purposes, the majority of the seven
                      defense contractors we contacted said that they act as if the amendment
                      applies to both FMS and direct commercial sale contracts. Violations of the
                      Feingold Amendment are punishable by civil fines (not to exceed the
                      greater of $500,000, or five times the amount of the incentive payment) and
                      administrative sanctions.

                      A July 1994 presidential memorandum delegated implementation of
                      Feingold Amendment functions to the Secretary of State and authorized
                      the Secretary to redelegate implementing responsibility within the
                      Department. The Secretary, on October 5, 1994, redelegated responsibility
                      for implementing the Feingold Amendment to State’s Under Secretary for
                      International Affairs (now the Under Secretary for Arms Control and
                      International Security Affairs).

                      Three years after State was given responsibility for implementing the
Lack of Regulations   Feingold Amendment, it still has no finite plan for carrying out the
on Prohibition on     legislation and has not issued implementing regulations. According to
Incentive Payments    State officials, the following factors have contributed to the delay:
                      (1) disagreement over which organizational component within the
                      Department should be responsible for drafting implementing language and
                      (2) assignment of higher priorities to other initiatives. Specifically, two
                      offices serving under the Under Secretary for Arms Control and
                      International Security Affairs—the Office of Arms Transfer and Export
                      Control Policy and the Office of Defense Trade Controls—have not been
                      able to agree on which office should proceed with implementation efforts.

                       Trade Offsets in Foreign Military Sales (GAO/NSIAD-84-102, Apr. 13, 1984).
                       Military Offsets: Offset Demands Continue to Grow (GAO/NSIAD-96-65, Apr. 12, 1996).
                       P.L. 103-236, section 733, April 30, 1994, 22 U.S.C. 2779a.

                      Page 2                                                         GAO/NSIAD-97-189 Military Offsets

                  According to State Department officials, implementing the Feingold
                  Amendment was a low priority for them.

                  There are several uncertainties regarding the Feingold Amendment that
Regulations Are   warrant clarification in implementing regulations. These relate to (1) the
Needed            term “incentive payments,” (2) the terms “owned” and “controlled” within
                  the definition of “United States person,” and (3) the law’s enforcement and
                  penalty provisions.

                  One of the key terms in the Feingold Amendment is the term “incentive
                  payments.” This term is defined in the act6 and further explained in the
                  conference report on the legislation.7 As indicated in the definition, the
                  prohibition applies to incentive payments in the form of direct monetary
                  compensation. The conference report explains that this includes cash
                  payments, payments made by checks, and the extension of credit or
                  inducements to encourage the extension of credit from a bank at lower
                  interest rates. The report further explains that the legislation is not
                  intended to prevent defense contractors from paying (as a bonus) “success
                  fees” to consultants, brokers, or agents the contractors retain for the
                  lawful implementation of offset agreements; however, it does not explain
                  how brokers or agents, who often shared fees with purchasers, would
                  need to change their business practices. It would be useful for State to
                  inform defense contractors of these important distinctions through the
                  issuance of regulations.

                  Another uncertainty involves the definition of the term, “United States
                  person.” The Feingold Amendment prohibits defense contractors from
                  making incentive payments to a United States person, which includes
                  companies that are “owned or controlled in fact” by a U.S. individual. It is
                  unclear exactly what facts would be sufficient to constitute “owned or
                  controlled” under the Feingold Amendment. Regulations on this point
                  would be beneficial for defense contractors to comply with the

                   This term is defined as meaning “. . .direct monetary compensation made by a United States supplier
                  of defense articles or defense services or by any employee, agent or subcontractor thereof to any other
                  United States person to induce or persuade that United States person to purchase or acquire goods or
                  services produced, manufactured, grown, or extracted, in whole or in part, in the foreign country
                  which is purchasing those defense articles or services from the United States supplier. . .” 22 U.S.C.
                   H.R. Rep. No. 103-482, at pp. 259-260 (1994).

                  Page 3                                                         GAO/NSIAD-97-189 Military Offsets

                     The legislation generally authorizes the exercise of the same powers by
                     the State Department that are provided for in certain sections of the
                     Export Administration Act (EAA), which is administered by the Department
                     of Commerce.8 These sections contain various penalty and sanction
                     provisions for violations of the EAA, as well as provisions for Commerce’s
                     enforcement of the EAA. In implementing these provisions, Commerce has
                     issued detailed regulations covering such matters as procedures for
                     reporting violations, as well as administrative proceedings, including rules
                     for discovery, subpoenas, and hearings.9

                     Six of the seven defense contractors we talked with agreed on the need to
                     clarify the terms “owned” and “controlled” as used in the amendment. In
                     addition, three of the contractors said that clarifying the term “incentive
                     payment” would be helpful. In this regard, two contractors commented
                     that clarification is needed as to whether some nonmonetary forms of
                     payment (such as credit-related inducements) are prohibited; the other
                     said that clarification on the circumstances under which foreign brokers
                     can and cannot be used would be helpful. Additionally, two of the
                     contractors commented on the need to clarify that the amendment’s
                     prohibition on incentive payments only applies to FMS contracts.

                     Because the Under Secretary of State for Arms Control and International
Recommendation       Security Affairs has not issued needed regulations for implementing the
                     Feingold Amendment, we recommend that the Secretary of State establish
                     a specific time frame for the Under Secretary to develop the regulations to
                     implement the Amendment. At a minimum, these regulations should
                     (1) clarify the term “incentive payments,” (2) define the terms “owned” and
                     “controlled” as used to define a U.S. person, and (3) spell out how State
                     intends to enforce the amendment and impose and administer penalties
                     for violations.

                     We obtained comments on a draft of this report from the Departments of
Agency Comments      State, Defense, and Commerce, each of which have a role in collecting
and Our Evaluation   data and developing policy on offsets. State, Defense, and Commerce took
                     different positions on our recommendation. State asserted that it was
                     confident the Feingold Amendment was being implemented in an

                     Specifically, subsections (c), (d), (e), and (f) of section 11 and subsection (a) of section 12, 50 U.S.C.
                     App. 2410 and 2411, respectively.
                      These regulations can be found in 15 C.F.R. Parts 764 (Enforcement and Protective Measures) and 766
                     (Administrative Enforcement Proceedings).

                     Page 4                                                            GAO/NSIAD-97-189 Military Offsets

    appropriate fashion under existing DOD procedures, thereby indicating that
    regulations were not necessary. DOD, on the other hand, agreed with us
    that regulations were needed and that State ought to develop them.
    Commerce did not express an opinion as to whether regulations were
    needed, but provided a technical correction that we have incorporated in
    the text.

    State indicated that it had taken its position for the following reasons:

•   Existing DOD mechanisms would reveal whether commissions and agent
    fees are paid in connection with FMS contracts.
•   DOD frequently conducts audits of U.S. defense contractors to ensure
    contract compliance and could become aware of illegal activities involving
    incentive payments through this process.
•   Information contained in notifications to the Congress of planned FMS
    contracts indicates that since the Feingold Amendment was enacted, no
    offsets have been proposed in connection with FMS contracts and,
    therefore, no incentive payments could have been made.

    Our analysis indicates that DOD mechanisms, which were designed for
    other purposes, can contribute relevant information to help implement the
    Feingold Amendment, but they are not adequate substitutes for having
    specific regulations that provide a guide for the practical implementation
    of the legislation. How the terms will be defined for operational purposes
    and what the enforcement mechanisms will be have yet to be established.
    DOD also commented that while it agrees with State that controls in place
    (such as contract audits) help to detect violations, DOD’s position is that a
    need still exists for State to issue regulations that clarify terms and
    eliminate confusion. Moreover, according to data we obtained at the
    Defense Security Assistance Agency, 17 of the congressional notifications
    sent between May 1994 and September 1996 indicate that offset
    agreements have been proposed in connection with FMS contracts. We also
    found that contractor data reported to Commerce for fiscal year 1995
    indicate that new offset agreements were established in connection with
    four other FMS contracts.10

    Furthermore, the President delegated the responsibility for implementing
    the Feingold Amendment to State, not DOD, and State has not sought
    administrative relief from that responsibility. Therefore, we continue to

     The Defense Production Act Amendments of 1992, 50 U.S.C. App. 2099, require that U.S. firms
    entering into offset agreements associated with contracts for the sale of defense articles and/or
    services to foreign governments or companies provide Commerce certain information regarding those
    agreements when they exceed $5 million.

    Page 5                                                      GAO/NSIAD-97-189 Military Offsets

              believe State needs to establish a specific timeframe for developing

              Comments from State and Commerce are reprinted in their entirety in
              appendixes I and II, respectively. DOD comments were provided orally by
              the Director of Foreign Transfer, Office of the Under Secretary of Defense
              for Acquisition and Technology.

              To determine the Department of State’s efforts to develop and issue a
Scope and     regulation to implement an April 1994 amendment to the AECA, we met
Methodology   with officials from Offices of Defense Trade Controls, Arms Transfer and
              Export Control Policy, and the Legal Adviser, Department of State. Also,
              by letter dated April 3, 1997, we requested the Department of State to
              respond in writing as to: (1) its intentions to issue regulations
              implementing the Feingold Amendment; (2) the current development
              status of the regulations and expected time frame for publishing them; and
              (3) what impediments, if any, were perceived to the effective
              implementation or enforcement of the amendment. As of June 25, 1997,
              the date we transmitted a draft of this report to the Department of State
              for its review, State had not responded to our April 3, 1997, letter of
              inquiry. However, in its July 8th response to a draft of this product, State
              addressed some of the issues raised in our April letter.

              To address the need for implementing regulations, we reviewed the
              language and legislative history of the Feingold Amendment to the AECA
              establishing a prohibition against certain incentive payments. We also
              discussed the need for implementing regulations with officials from seven
              major defense contractors. We interviewed officials from the Department
              of Commerce and the Defense Security Assistance Agency to determine
              their role, if any, in implementing the Feingold Amendment.

              We performed our review between March and July 1997 in accordance
              with generally accepted government auditing standards.

              We are sending copies of this report to the Secretaries of State, Defense,
              and Commerce; the Director, Office of Management and Budget; and
              interested congressional committees. Copies will also be made available to
              others upon request.

              Page 6                                         GAO/NSIAD-97-189 Military Offsets

Please contact me at (202) 512-4383 if you or your staff have any questions
concerning this report. Major contributors to this report were John D.
Heere, William T. Woods, Raymond J. Wyrsch, and Karen S. Zuckerstein.

Sincerely yours,

Katherine V. Schinasi
Associate Director
Defense Acquisitions Issues

Page 7                                        GAO/NSIAD-97-189 Military Offsets

Letter                                                                                    1

Appendix I                                                                               10

Comments From the
Department of State
Appendix II                                                                              14

Comments From the
Department of


                      AECA     Arms Export Control Act
                      DOD      Department of Defense
                      EAA      Export Administration Act
                      FMS      foreign military sales

                      Page 8                               GAO/NSIAD-97-189 Military Offsets
Page 9   GAO/NSIAD-97-189 Military Offsets
Appendix I

Comments From the Department of State

Note: GAO’s comment
supplementing those
comments in the report
text appear at the end of
this appendix.

                            Page 10   GAO/NSIAD-97-189 Military Offsets
Appendix I
Comments From the Department of State

Page 11                                 GAO/NSIAD-97-189 Military Offsets
                 Appendix I
                 Comments From the Department of State

See comment 1.

                 Page 12                                 GAO/NSIAD-97-189 Military Offsets
              Appendix I
              Comments From the Department of State

              The following is GAO’s comment on the Department of State’s letter dated
              July 8, 1997.

              1. State’s assertion that the Department of Defense (DOD) concurs with its
GAO Comment   position is inconsistent with the comments we obtained directly from DOD.
              As discussed on page 5, DOD stated that while it agrees with State that
              controls in place help to detect violations, DOD’s position is that a need still
              exists for State to issue regulations that clarify terms and eliminate

              Page 13                                          GAO/NSIAD-97-189 Military Offsets
Appendix II

Comments From the Department of

See footnote 9 on page 4.

(707268)                    Page 14   GAO/NSIAD-97-189 Military Offsets
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