The rise of offset

Offset deals in public international defence procurement are one of the most secretive, complex and riskiest aspects of international defence trade. Such deals often include de­cade-long obligations and investments that defence vendors have to fund, operate, and manage; and oblige vendors to achieve cer­tain results in foreign opaque and unknown markets. Offset obligations are material in value, and are estimated to be worth $450 billion worldwide. What is more, offsets are extremely resource-intensive, as they very of­ten require defence vendors to transfer their technology and knowledge to both public and private entities of the buyer-countries.

To add to that, offset deals are often covered by national security policies and are outside the scope of public scrutiny – that makes them a breeding ground for potential corruption.

Background

So why do defence vendors engage in offset deals? The answer is that those deals, which are often referred to as “sweeteners”, are re­quired worldwide, and are on the increase. The vendors are required to engage in either direct or indirect offsets – often, offset packa­ges include both elements. Direct offsets are directly related to the main contract – for ex­ample, the procuring country may oblige the vendor to produce part of the items within the main contract in the procuring country, as well as transfer related technology and to train the domestic producers how to use it.

An indirect offset is unrelated to the main contract, and may include financing local bu­sinesses, setting up factories and selling part of the local production in the vendor’s home country, promoting tourism, and many other economy-boosting initiatives. Overall, most offset policies differ from market to market, and the types of offset investments are mostly selected on a discretionary basis – therefore, each offset package is unique.

Traditionally, the goal of offset mandates has been to recoup some of the costs that are incurred due to sourcing expensive weapo­ns systems from foreign entities using public funds. Recently, however, many countries have become more pragmatic – an example is the United Arab Emirates. The U.A.E. has been deploying offset deals to reduce its economic dependency on oil-related industries by requi­ring defence vendors, through indirect offsets, to invest in the U.A.E.’s domestic IT and other high-value-added sectors.

Another aspect worth noting is that the unique nature of offset packages makes valua­tion challenging. Most offset policies require 30% to 120% of the value of the main contract to be generated by the vendor in the domestic market of the purchaser, which is achieved by adhering to market-specific requirements; purchasing countries also use multipliers to promote activity in certain sectors, locations or socioeconomic groups.

For example, the UAE, among other conditi­ons, allow vendors to claim $5 in offset credit for each $1 created by promoting exports of UAE companies to new markets; a higher multiplier can be claimed if the exporter is an SME that hires many graduates.

Evolution through European Politics

With the recent turmoil in the global ge­opolitical arena, and increasing defence budgets of Eastern countries (Eastern Eu­rope, the Middle-East, India, Japan), the defence market has been experiencing an increased rate of procurement, both in value and in volume of deals. What is more, the economic and political situati­on in Europe incentivizes major European countries to re-kindle global relationships and foster stronger links with the develo­ping world – the recent sales of French fighter aircraft could be considered to be an example.

Significant economic connections are a strong way to develop international relati­ons. For example, we note the involvement of Francois Hollande, President of France, in the recent Dassault Rafale sales to In­dia. After years of unsuccessful bids, inclu­ding three-year negotiations regarding the purchase 126 Rafales which did not come to fruition, Hollande persuaded Naren­dra Modi, the Prime Minister of India, to procure 36 units from Dassault in ready-to-fly condition – the latter term was in fact contrary to Modi’s Make In India policy, which aims to securing offsets in defence purchases.

Considering the availability of competitor aircraft, it appears that the strategic poli­tics behind the defence deal were aimed at creating a long-term economic relation-ship through offsets. In fact, following the agreement, Hollande promised to invest €2 billion in India, including building AR­EVA’s ‘European Pressurized Reactors’ in Jaitapur, deals in rail and cinema, which will fall in line with Modi’s Make In India programme. It is likely that the economic connections that arise from the multi-bil­lion offset deals will establish a long-term partnership between France and India.

Key risks and issues

Considering the above, it is necessary for the contractors and the subcontractors to evaluate and mitigate risk. Entering a new market under such conditions is risky from a compliance point of view, especially when offset and local content obligations entail close cooperation with potentially “corrupt” domestic companies.

The willingness of regulators to pragma­tically prosecute international companies for foreign bribery is clear, as seen in FCPA enforcements against Siemens (settled for $800 million), Alstom (settled for $772 million) or KBR/Haliburton (settled for $579 million). What is more, post-settle­ment expenses, such as retaining a cor­porate monitor, can reach tens of millions of dollars. Even in defence deals, where the ‘national security’ argument had tra­ditionally been used to justify the lack of transparency, enforcement is growing, as seen in BAE Systems’ $400 million settle­ment in 2010.

Of the key risks and issues – such as deal structuring-related due diligence of pre­scribed domestic partners, valuation and performance-related implications on ac­counting and internal books and records, protection of intellectual property rights, etc. – this article focuses more on the key risk that leaves the vendor and its board di­rectly responsible for ABC violations – the third-party risk. Offset packages by nature involve many government-prescribed do­mestic partners, often through a handful of gateway intermediaries.

Due to the significant resources commit­ted, domestic partners are, for example, potentially able to channel kickbacks to public officials and engage in other cor­rupt practices which expose the prime contract to various bribery risks. Further, to cope with offset performance and other local issues, third-party advisors are often brought in by vendors to manage and advise. These third-party consultants are typically local well-connected experts – their local knowledge allows them to complete offset obligations efficiently. Ho­wever, they also pose high corruption and bribery risks, which may lead to the main vendor being sanctioned in their home country for the actions of the third party (90% of the FCPA-related cases have invol­ved third-party corruption). In addition, third parties and domestic partners are often remunerated on a success-based commission – inadequate performance re­porting and other types of fraud expose the vendor to liabilities in both the buyer country and its own.

Conclusion

In conclusion, the offset industry is booming – which has both positive and negative ef­fects. The positive effects of offset deals are that they promote globalization and economic development of certain markets, as well as allows for countries to form new trade-friendly relationships. The negative effect is that they open defence and other contractors to potential liabilities, both from their own offset programs, and from those obligations that are agreed with pre­scribed domestic partners – such partners usually come with their own accounting, internal controls, books and records, and procurement methods, which potentially expose the vendors and contractors to lia­bilities at their home countries.

The highest risk for vendors is non-compli­ance, which can lead to sanctions in mul­tiple jurisdictions and the loss of the main contract. Vendors should proactively ensu­re that controls, culture and compliance standards in their offset arrangements meet or exceed the standards in their pri­mary business lines.

Finally, and most importantly, it is vital to remember that in offsets, one size does not fit all – a flexible, risk-adjusted approach is of crucial importance.

By Derek Patterson, Principal at Forensic Risk Alliance, and Lukas Bartusevicius, Business Development Analyst at Forensic Risk Alliance.

Read the article: The Rise of Offset

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