United States: A White Paper Regarding Department Of Defense Implementation Of Section 818 Of The National Defense Authorization Act For Fiscal Year 2012

I. INTRODUCTION

"No type of company or organization has been untouched by counterfeit electronic parts. Even the most reliable of parts sources have discovered counterfeit parts within their inventories."¹

Counterfeiting has affected governments, businesses, and consumers throughout the course of history. Today, the International Chamber of Commerce estimates the total global economic value of counterfeiting and piracy is as much as $600 billion per year, with the United States suffering the most significant impact.² For the federal contracting community, the infiltration of suspect and counterfeit parts into the supply chain has become a considerable concern.³

Concerns regarding counterfeit parts in the United States Government's supply chain led to the enactment of Section 818 of the Fiscal Year ("FY") 2012 National Defense Authorization Act ("NDAA FY '12") requiring the Department of Defense ("DoD") to issue regulations regarding the definition, prevention, detection and reporting of actual or suspected counterfeit parts in the defense procurement supply chain.⁴ Section 818 further requires the Department of Homeland Security ("DHS") to create a "risk-based methodology" to enhance targeting of counterfeit electronics parts imported into the United States.⁵ And it gives the Secretary of Treasury specific permission to disclose to trademark rightholders certain information on detained suspect counterfeit shipments.⁶

Because "[a]lmost anything is at risk of being counterfeited, including fasteners used on aircraft, electronics used on missile guidance systems, and materials used in body armor and engine mounts,"⁷ counterfeit parts in the defense supply chain pose safety and national security risks, and "drive up the cost of defense systems,"⁸ Issued in advance of DoD's required regulations implementing Section 818, this white paper provides perspectives from a broad cross-section of the government contracting community on the key considerations associated with implementing the legislation's stated goals of avoiding, detecting, and addressing counterfeit parts in the defense supply chain.

A. Brief History of the Counterfeit Parts Problem

A variety of factors have rendered the defense supply chain susceptible to counterfeit parts. First, many deployed U.S. defense systems utilize components that are military and commercial-grade obsolete parts, i.e. parts that are no longer made by (or in the inventory of) the original component manufacturer ("OCM") or its authorized dealers.⁹ If the OCM or its integrating Original Equipment Manufacturer ("OEM") ceases production, the continuing need for obsolete parts often forces DoD and its contractors to purchase replacement parts from independent distributors, brokers or other sources; this creates a risk that counterfeit parts may be introduced into the DoD supply chain.¹⁰

Second, counterfeiters have become quite sophisticated at their illegal trade. Counterfeiters continually refine their tactics and processes in order to avoid detection.¹¹

Third, counterfeiting is not considered an illegal enterprise in certain countries. To the contrary, certain governments, notably China, permit open counterfeiting, creating a stable environment from which counterfeiters can operate to "manufacture," distribute and sell counterfeit parts openly in public markets or via the Internet without any disclaimers or disclosures.¹² Indeed, "[t]here are dozens of Internet sites that specialize in the trade of electronic parts, with a large number of China-based distributors posting parts for sale."¹³ China is not the only country from which counterfeit parts are finding their way into the defense supply chain. Counterfeits may be made in one country and shipped to other countries to be integrated into, or shipped and used in, other parts, equipment, or systems. In addition to foreign sources, there is a domestic counterfeit distribution chain as well.¹⁴

B. Enactment of Section 818 of NDAA FY '12

In March 2011, the SASC launched an investigation into counterfeit parts in the defense supply chain. This bipartisan investigation identified 1,800 cases of counterfeit electronics in U.S. weapon systems over a two year period from 2009 to 2010, with the total number of suspect parts exceeding one million.¹⁵

On November 8, 2011, the SASC held a hearing "to explore the problem of counterfeit electronic parts infiltrating critical defense systems and the risk those parts pose to such systems."¹⁶ Shortly thereafter, on November 17, 2011, a bipartisan amendment to the NDAA FY '12 was introduced to "stop the importation of counterfeit electronic parts into the United States, address weaknesses in the defense supply chain and to promote the adoption of aggressive counterfeit avoidance practices by DoD and the defense industry."¹⁷ A revised version of the amendment was passed as Section 818 of the NDAA signed by President Obama on December 31, 2011. Ultimately, Section 818 seeks to avoid, detect and mitigate the effects of counterfeit electronic parts throughout the defense supply chain.

II. LEGAL ANALYSIS OF SECTION 818

A. An Overview

Section 818 imposes a new regime on defense contractors and DoD for the detection and avoidance of counterfeit electronic parts in the defense supply chain. Contractors are to detect and avoid the use of counterfeit electronic parts in supplies and systems delivered to DoD and are responsible for rework or corrective action required to remedy the inclusion of counterfeit parts. Section 818 also requires that, "whenever possible," DoD contractors and subcontractors at all tiers shall obtain electronic parts from original manufacturer of the parts or components (OMs) or their authorized dealers or from "trusted suppliers" who obtain parts exclusively from OMs or their authorized dealers. These policies and procedures must address: (i) Training of personnel; (ii) Inspection and testing of electronic parts; (iii) Processes to abolish counterfeit parts proliferation; (iv) Mechanisms to enable traceability of parts; (v) Use of trusted suppliers; (vi) Reporting and quarantining of counterfeit electronic parts and suspect counterfeit electronic parts; (vii) Methodologies to identify suspect counterfeit parts and to rapidly determine if a suspect counterfeit part is, in fact, counterfeit; (viii) Design, operation, and maintenance of systems to detect and avoid counterfeit electronic parts and suspect counterfeit electronic parts; and (ix) Flow down of counterfeit avoidance and detection requirements to subcontractors. The Section also requires DoD to establish a mandatory reporting program. The law seeks to "eliminate" counterfeit electronic parts from the defense supply chain. DoD also must implement processes, similar to those recently implemented for contractor business systems, for the review and approval of contractor counterfeit compliance systems.¹⁸

Section 818 takes a holistic approach to the complex problem of counterfeit electronic parts. Parts of the law focus on potential suppliers of components, and aim to improve detection of counterfeits at the borders, enhance the ability to exclude bogus parts from entry into the United States, and toughen enforcement of anti-counterfeiting laws. Other aspects of the law concern the potential buyers and users of components, targeting the purchasing practices of DoD, its contractors and lower-tier subcontractors and suppliers. An overarching policy of the law is to restrict sources of supply, whenever possible, to OMs, authorized dealers and trusted suppliers, and to better manage decisions to use alternative sources by purchasers of electronic parts and items containing electronic parts, including OMs, suppliers, and ultimately DoD and its contractors and subcontractors.

The law also reaches the use and disposition of electronic parts by contractors by imposing new requirements for receiving inspection, traceability, test and acceptance, and new rules for proper disposition and action on known or suspect counterfeit electronic parts.

There is an information component to the law as well, through the requirement to report counterfeit parts to the appropriate authority and the Government-Industry Data Exchange Program ("GIDEP") or similar DoD-designated program.¹⁹ The law, and the regulations to be issued, will impose obligations for correction, disposition and other remedial action.

The Government, its contractors, subcontractors and suppliers also must address the financial impacts of the new law resulting from the implementation of new processes and procedures, potential increased costs due to limiting suppliers to OEMs, OCMs, and trusted suppliers, and replacement and remedial activity costs. With regard to this latter point, "the cost of counterfeit electronic parts and suspect counterfeit electronic parts and the cost of rework or corrective action that may be required to remedy the use or inclusion of such parts are not allowable costs under [DoD] contracts."²⁰

Section 818 implementation will impose additional requirements on contractor systems, and may impact many parts of a contractor's performing organization, including Supply Chain Assurance, Quality Assurance, Purchasing, Engineering, Manufacturing, Product Support, Business Management, Contracts and Finance.

B. Supply-Side Measures

Section 818 seeks to improve the ability of federal officials to detect counterfeit and suspect electronic parts, by strengthening the inspection regime for imported electronic parts. DHS and DoD will establish and implement a "risk-based methodology" for enhanced targeting of electronic parts imported from any country. Further, Congress reaffirmed CBP authority to share unredacted information from and samples of suspect products, their packaging and labels, with the company whose product is suspected of being counterfeited, by specifically authorizing such sharing in order to better identify and exclude counterfeit parts at our borders.²¹ While clarified CBP authority to resume working with rightsholders, and increased enforcement sanctions, should improve the ability of United States officials to exclude counterfeit electronic parts purchased from foreign sources for import into the United States, there is more to be done. See Part IV.B.4.b . Customs, infra. While cutting off the supply of counterfeit parts from international sources is an obvious and compelling strategy to deal with the threat posed by counterfeit electronic parts, it does not address the threat from domestic sources of counterfeits.

Successful detection is key to avoidance. Though various laws dealing with counterfeit parts and unauthorized use of trademarks or intellectual property already are in effect, Section 818 amended 18 U.S.C. § 2320 to add a criminal offense for trafficking in military goods or service known to be counterfeit where use, malfunction or failure is likely to cause serious injury or death, impairment of combat operations or other significant harm to national security. The law broadens the definition of the existing "trafficking" offense to include "attempts" or "conspiracy" to traffic in counterfeit military goods or service. Further, definitions of a "counterfeit military good or service" are added to define such item or service as one that is falsely identified or labeled as meeting a military specification, or intended for use in a military or national security application.

The combination of these measures – improved detection, better exclusion at the border, and tougher enforcement –has the potential to cut the inflow of counterfeit electronic parts to U.S. contractors to a significant extent and reduce the risk that parts will be included in delivered defense systems.

C. Demand-Side Measures

As discussed above, contractor purchasing practices are a key focus of Section 818, and changes here seek to reduce the risk of counterfeits, requiring contractors to obtain needed parts from original and reliable sources. The new law requires DoD suppliers, "where possible," to purchase electronic parts from OMs, authorized dealers, or "trusted suppliers." Procedures are to be established to notify DoD of purchases from other than OMs, their authorized dealers and trusted suppliers. Notification will trigger inspection, testing and authentication requirements. DoD must establish qualification requirements under which it will "qualify" trusted suppliers, i.e., requirements to demonstrate that the trusted supplier has appropriate policies and procedures in place. Contractors and subcontractors also will be able to identify and use additional trusted suppliers that comply with "established industry standards" and the pending regulations. When such suppliers are used, however, the contractor/subcontractor is responsible for the authenticity of the suppliers' parts.²² The selection of such suppliers will be subject to DoD review and audit.

Not all requirements can be met from OCMs, OEMs and authorized dealers, so the new rules on purchasing practices will permit qualification of some independent distributors and brokers. DoD's qualification requirements may include that the would-be trusted suppliers demonstrate designated quality control, maintain documentation of source history and parts pedigree, and possess and provide appropriate certifications.

D. Use & Disposition Measures

As to its own purchasing activities, DoD is to issue guidance and regulations addressing inspection and test of parts (and reporting and quarantining of parts found to be counterfeit or suspect). The details of DoD's implementation of these requirements are yet not available, but contractor obligations are rigorous. Where necessary parts are unavailable from OEMs or authorized dealers, "inspection, testing and authentication" is required when another source is used. Also required are "methodologies to identify suspect counterfeit parts" and systems to detect and avoid counterfeit and suspect electronic parts. A compliant program to detect and avoid counterfeit electronic parts must flow down to subcontractors "counterfeit avoidance and detection requirements." There is no stated restriction on how far down the requirement is to flow.

These additional inspection and test requirements will create new costs. DoD will bear some new costs to the extent contractors allocate such costs to overhead under cost-type and flexibly-priced contracts and when they affect forward-pricing rates for fixed-price contracts.

A compliant contractor program, to detect and avoid counterfeit electronic parts must include "processes to abolish counterfeit parts proliferation." Thus, rather than return suspect parts to the vendor where there is risk of further disposition of dubious parts by resale, the implementing regulations may require that following reporting of such suspect parts, ultimately questionable or counterfeit parts be destroyed unless retained for investigative or evidentiary purposes. This approach would be consistent with Section 818's requirement that contractors have policies and processes to quarantine and dispose of counterfeit and suspect counterfeit electronic parts.

E. Information Measures

Section 818 may increase the availability and retention of information relevant to the detection and avoidance of counterfeit electronic parts in the DoD supply chain, and may improve reporting of such parts to prospective customers, end users and enforcement agencies. For example, Section 818(e) requires covered contractors to have policies and procedures that ensure the traceability of parts. Covered contractors must also flowdown appropriate requirements to their subcontractors.

A contractor or subcontractor that becomes aware, or "has reasons to suspect," that any end item, component, part, or material purchased by DoD contains counterfeit (or suspect) electronic parts, must submit a report on the DoD-designated system within 60 days. And, DoD is to issue new regulations that require reporting "to appropriate Government authorities," under the same circumstances. This may mean that companies at any tier will be required to notify program officers or contracting officers of suspected or actual counterfeit parts. Notably, the rule also requires DoD personnel to submit a report when they become aware or have reason to suspect counterfeits. Section 818 provides that a reporting contractor shall not be subject to civil liability for satisfying its reporting obligations where a "reasonable effort" was made to determine whether a counterfeit or suspect counterfeit part was present. This safe harbor may incentivize cooperation from all tiers of contractors. As noted in Section IV.B.4.d.2 Safe Harbor, infra, Section 818(c)(5) regulations should address the logistics and requirements that trigger the safe harbor and other risk issues, such as restrictions on the reporting of foreign events, protection of intellectual property, privacy, and reporting when national security restrictions apply.

The regulations must consider these potentially competing interests to ensure that contractors and their subcontractors can comply with Section 818 reporting requirements without violating other laws, rules and regulations. In addition to regulations, contractors and subcontractors may need to address these kinds of requirements in their contracts to ensure that they get timely and complete information needed for reporting.

F. Financial Measures

The new law treats as "unallowable" the costs of counterfeit and suspect counterfeit electronic parts and of required rework or corrective action. The implementing regulations will need to define what constitutes a "suspect" counterfeit covered by the unallowable cost proscription. Contractors likely will object if DoD treats as unallowable reasonable costs including: costs incurred by contractors to implement the mandated compliance program and processes, costs incurred at the direction of the Government, and costs incurred by contractors to detect or avoid use of counterfeit parts where a part ultimately is not proved to be counterfeit. Contractors may urge that such costs should be treated as allowable and allocable costs incurred in association with the implementation of the contractor's valid compliance program.

The regulations implementing Section 818 may result in higher direct costs for material, as the law discourages purchasing of parts from "least cost, technically acceptable" sources, in preference to likely more expensive, trusted sources. For example, higher tier purchasers will likely seek to impose more liability on downstream suppliers, and those suppliers may increase price to reflect the additional risks for accepting such liability. There will sometimes be added engineering and manufacturing costs. There will be recurring costs for additional inspection and test, as well as for costs of quarantine and ultimate disposition, and higher overhead costs for many functions whose jobs may be rendered more complex and costly in order to comply with the new requirements.

Financial consequences of the new law may go well beyond costs that can be managed by government contractors. It has been suggested by some contractors that certain sources of supply of electronic parts, including OCMs as well as those that use and distribute such parts (OEMs, dealers/distributors, brokers, etc.), will find it no longer attractive, or economically feasible, to participate in the defense electronics supply chain. Prohibitive costs could arise if DoD and its contractors find they no longer have access to commercial technology and supply sources.

Given that Section 818 requires system audits like the contractor business systems rule²³, DoD may seek to decrement progress payments where a contractor fails to measure up to the requirements of a compliant supply chain assurance system.²⁴ Such a policy would pose an additional cost risk for contractors.

G. Remedial Measures

Section 818 requires DoD, in its new guidance, to address "remedial actions," including but not limited to suspension and debarment, that will be taken in the case of a supplier that repeatedly fails to detect or avoid counterfeit parts or fails to exercise due diligence. These risks are addressed in more detail below.

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Footnotes

1 U.S. DEP'T OF COMMERCE, DEFENSE INDUSTRIAL BASE ASSESSMENT: COUNTERFEIT ELECTRONICS 7 (2010).

2 See International Chamber of Commerce, http://www.iccwbo.org/advocacy-codes-and-rules/bascap/about/ (last visited July 30, 2012).

3 U.S. GOV'T ACCOUNTABILITY OFFICE REPORT, GAO-10-389, DEFENSE SUPPLIER BASE, DOD SHOULD LEVERAGE ONGOING INITIATIVES IN DEVELOPING ITS PROGRAM TO MITIGATE RISK OF COUNTERFEIT PARTS (2010) ("2010 GAO REPORT: MITIGATE RISK OF COUNTERFEIT PARTS"). While the Department of Defense ("DoD") has not yet adopted a Department-wide definition of "counterfeit parts," DoD endorsed a definition that includes genuine parts that have been recycled but which are offered as new. See SAE International, SAE Aerospace Standard 5553, Counterfeit Parts; Avoidance, Detection, Mitigation and Disposition (April 2009) (defines counterfeit for the aerospace industry and endorsed by DoD). DoD has issued guidance stating that counterfeit materiel is "an item that is an unauthorized copy or substitute that has been identified, marked, and/or altered by a source other than the item's legally authorized source and has been misrepresented to be an authorized item of the legally authorized source." Memorandum from the Under Secretary of Defense, Overarching DoD Counterfeit Prevention Guidance (March 16, 2012).

4 National Defense Authorization Act for Fiscal Year 2012, Pub. L. No. 112-81, § 818(b)(1), 125 Stat. 1298, 1494 (2011) ("Section 818").

5 Section 818(d).

6 Section 818(g)(1). Jurisdiction over Lanham Act enforcement was retained by Treasury when the Customs Service and Border Patrol were transferred to DHS to form Customs & Border Protection ("CBP").

7 2010 GAO REPORT: MITIGATE RISK OF COUNTERFEIT PARTS.

8 S. COMM. ON ARMED SERVS., INQUIRY INTO COUNTERFEIT ELECTRONIC PARTS IN THE DEPARTMENT OF DEFENSE SUPPLY CHAIN, S. REP. NO. 112-167, at iv (2012) ("SASC REPORT: COUNTERFEIT ELECTRONIC PARTS").

9 The Committee's Investigation into Counterfeit Electronic Parts in the Department of Defense Supply Chain: Hearing Before S. Comm. on Armed Servs., 112th Cong. (2011) ("SASC Hearing: Counterfeit Electronic Parts") (Statement of Sen. Carl Levin)(noting that "The defense community is critically reliant on a technology that obsoletes itself every 18 months, is made in unsecure locations and over which we have absolutely no market share influence").

10 The United States Senate Armed Services Committee's ("SASC") investigation concluded that "unvetted independent distributors are the source of the overwhelming majority of suspect parts in the defense supply chain." SASC REPORT: COUNTERFEIT ELECTRONIC PARTS at v. Indeed, as a result of the two-year SASC investigation, the SASC's Report announced eight key conclusions:

SASC Report: Counterfeit Electronic Parts at vi thru viii.

11 Id. (quoting Vivek Kamath, Vice President of Supply Chain Operations at Raytheon Company).

12 SASC REPORT: COUNTERFEIT ELECTRONIC PARTS at vi.

13 SASC Hearing: Counterfeit Electronic Parts (Statement of Sen. Carl Levin).

14 SASC Report: COUNTERFEIT ELECTRONIC PARTS at 13-14, 16.

15 See SASC REPORT: COUNTERFEIT ELECTRONIC PARTS at 12.

16 SASC REPORT: COUNTERFEIT ELECTRONIC PARTS at 66.

17 S. 1867, Amendment No. 1092, 112th Cong. (2011).

18 Section 818(e)(2)(B).

19 Section 818(c)(4).

20 Section 818(c)(2)(B).

21 Section 818(g)(1).

22 Under Section 818, as written, it seems that a contractor is always responsible for the authenticity of parts supplied to DoD no matter the source or circumstance.

23 Section 818(e)(2)(B) ("establish processes for the review and approval of contractor systems for the detection and avoidance of counterfeit electronic parts and suspect counterfeit electronic parts, which processes shall be comparable to the processes established for contractor business systems under section 893 of the Ike Skelton National Defense Authorization Act for Fiscal Year 2011 (Public Law 111–383; 124 Stat. 4311; 10 U.S.C. 2302 note).").

24 See, e.g., Section 818(e)(4).

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