Insights and Commentary from Dentons

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1 dentons.com Insights and Commentary from Dentons The combination of Dentons US and McKenna Long & Aldridge offers our clients access to 1,100 lawyers and professionals in 21 US locations. Clients inside the US benefit from unrivaled access to markets around the world, and international clients benefit from increased strength and reach across the US. This document was authored by representatives of McKenna Long & Aldridge prior to our combination s launch and continues to be offered to provide our clients with the information they need to do business in an increasingly complex, interconnected and competitive marketplace.

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3 Counterfeit Parts and the New Law: Are We All DOD Contractors? By Shawn Cheadle, Christopher W. Myers and Kelly P. Garehime Counterfeiting is no longer a problem just for the luxury goods industry. Instead of Rolex watches or Louis Vuitton purses, counterfeiters are turning their attention to something more mundane: small, cheap electronic parts that are critical to the modern world. Spurred by huge demand from the electronics industry and a growing stockpile of discarded electronics that serve as the raw materials, an entire industry has sprung up around refinishing old electronic parts and selling them as new. This obviously creates a reliability issue electronic parts have a limited lifespan, and old parts may already be at or near the end of one. For the federal government, however, the risk is more grave. In 2008, BusinessWeek brought this issue to the world s attention, warning of fatal equipment failure and even foreign espionage when fake electronic parts from China are incorporated into US weapons systems. 1 CHEAT SHEET The stakes are high. US defense systems have become increasingly dependent on electronic parts to enable their advanced capabilities, requiring the detection, correction and avoidance of counterfeit parts. Contractors carry the burden. Contractors performing Cost Accounting Standards (CAS) are required to maintain a counterfeit electronic parts detection and avoidance system. There is a narrow safe harbor. Contractors can recover costs associated with counterfeit electronic parts in certain limited circumstances. Rules also impact suppliers. Flowdown requirements likely apply to all suppliers in support of a prime contractor. ACC DOCKET OCTOBER

4 COUNTERFEIT PARTS AND THE NEW LAW: ARE WE ALL DOD CONTRACTORS? Though not swift, the government s response to this issue has been significant. In 2012, Congress reacted with legislation, and the Department of Defense (DOD) recently implemented new regulations that will significantly affect the industry. As in-house counsel for any company that produces items containing electronic parts, these recent laws and regulations may impact you, regardless of whether your company directly supports the defense industry. This article documents the implications of the escalating counterfeit parts issue for both commercial and defense manufacturers, and it explains the statutes and regulations that address this issue. Most importantly, you will discover that the laws and regulations essentially provide for strict liability for parties in the supply base of a DOD contract. This article also suggests best practices that your company should consider as this issue, and the regulations intended to address it, evolve in the coming years. Recent history of counterfeiting While electronic part counterfeiting has been a problem since the advent of the computer age in the mid-1980s, it has recently exploded into a multibillion dollar market. 2 These parts affect not only US defense and space systems, but also our everyday electronics from home appliances to automobiles and even city buses. 3 Several high-profile government prosecutions have added fuel to the fire. For example, in 2010, a small supplier of raw titanium material was indicted by the Department of Justice (DOJ) and prosecuted for selling titanium billet that was allegedly misrepresented as rolled billet instead of cut billet. The strength properties could be substantially different and affect aircraft struts and similar applications requiring strength in material. While a few executives of the company were also indicted and charged personally, the case ended in their favor, as there was ultimately no finding of wrongdoing. Nevertheless, the negative impact to the business and the importance of providing genuine materials rang across the industry. In November 2011, General Patrick O Reilly, then director of the Missile Defense Agency, declared: We do not want a $12 million missile defense interceptor s reliability compromised by a $2 counterfeit part. 4 The message is the same today for all DOD procurements, and NASA is quickly following suit with its own message for space missions by promulgating similar restrictive legislation. As was the focus in the BusinessWeek article, the predominant source of counterfeit electronic parts comes from the Pacific Rim, with the significant majority coming from China. Many of the world s discarded computers and circuit boards find their way to China, where they are washed in rivers, crudely refurbished, often remarked, and ultimately, sold back to unauthorized distributors and brokers in the United States and other industrialized nations. Over the last six years, counterfeiting of electronic parts has grown, largely for two reasons: obsolescence and profitability. The defense and space industry continues to struggle with electronic parts becoming obsolete, often needing to acquire electronic parts that may have been out of production for decades. And the financial motivation is strong: Counterfeiters quite literally can turn trash into parts that, while cheap, can be sold in high quantities. Highlights of the Senate s investigation and report In response to growing concerns and public awareness of the counterfeit problem, in March 2011, the Senate Armed Services Committee (SASC) initiated a year-long investigation into counterfeit electronic parts in the DOD supply chain. The results of this investigation were published in a May 2012 report (the Report), 5 which explained that on at least 1,800 separate occasions between 2009 and 2010, suspect counterfeit electronic parts made their way into critical defense systems. The total number of individual suspect parts exceeded 1 million. The Report found that counterfeit electronic parts are a pervasive and costly DOD supply-chain problem that create safety, performance, reliability and national-security risks. The Report specifically focused on counterfeit electronic parts because US defense systems have become increasingly dependent on electronic parts to enable their advanced capabilities, and the chances are high that a small Shawn Cheadle is general counsel, Military Space, Lockheed Martin Space Systems Company. Cheadle also serves as ediscovery counsel for Space Systems, and is an ACC board member, frequent speaker and author. shawn.cheadle@lmco.com Christopher W. Myers, a partner at McKenna Long & Aldridge, focuses his practice on government contracts litigation and counseling, with an emphasis on claims and disputes, internal investigations, False Claims Act litigation and bid protests. cmyers@mckennalong.com Kelly P. Garehime, an associate at McKenna Long & Aldridge, focuses her practice on government contracts litigation and counseling, with an emphasis on cost accounting, internal investigations and compliance, and litigation before the boards of contract appeals. kgarehime@mckennalong.com 44 ASSOCIATION OF CORPORATE COUNSEL

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6 COUNTERFEIT PARTS AND THE NEW LAW: ARE WE ALL DOD CONTRACTORS? counterfeit electronic part will go undetected. The Report included key SASC investigation conclusions that directly impact contractors, which include, among others, the following: Permitting contractors to recover costs incurred as a result of their own failure to detect counterfeit electronic parts does not encourage the adoption of aggressive counterfeit avoidance and detection programs. Weaknesses in the testing regime for electronic parts create vulnerabilities that are exploited by counterfeiters. The defense industry routinely failed to report cases of suspect counterfeit parts putting the integrity of the defense supply chain at risk. These findings eventually shaped the legislation and regulations pertaining to counterfeit electronic parts, which are described below. Section 818 of the FY 2012 NDAA Based on the SASC findings, Senator Carl Levin (D-Michigan) and Senator John McCain (R-Arizona) drafted an amendment to the Fiscal Year (FY) 2012 National Defense Authorization Act (NDAA) 6 to promote counterfeit detection and avoidance practices by DOD and the defense industry. The Senate adopted a revised version of the amendment, Section 818 of the FY 2012 NDAA (Section 818), which President Barack Obama signed into law on Dec. 31, Section 818 required the Secretary of Defense to revise the DOD Federal Acquisition Regulation Supplement (DFARS) to include new regulatory requirements related to the detection, correction and avoidance of counterfeit parts. Key provisions of Section 818 include the following: DOD and contractors must purchase electronic parts from original parts manufacturers or trusted suppliers who obtain parts only from original parts manufacturers or authorized dealers. Contractors that become aware of counterfeit electronic parts must notify the government within 60 days in writing. Contractor costs associated with replacement and rework due to counterfeit parts are unallowable. Certain major defense contractors are required to establish a business system to detect counterfeit parts. In short, Section 818 places the entire burden of eliminating counterfeit electronic parts on industry. For example, under Section 818, the costs of counterfeit parts and the costs of rework and corrective action are unallowable, even if the contractor conducted adequate testing of the parts and was unaware that the parts were counterfeit when they were installed in the product. Section 818 requires DOD to create a new program to enhance contractor detection and avoidance of counterfeit electronic parts. Under the legislation, contractors supplying electronic parts are required to establish policies and procedures dedicated to training personnel, inspecting and testing electronic parts, tracing parts, ensuring the use of trusted suppliers, using methodologies to identify suspect counterfeit parts and to rapidly determine if a suspect counterfeit part is, in fact, counterfeit, reporting and quarantining counterfeit parts, and flowing down counterfeit avoidance and detection requirements to subcontractors. Finally, DOD is required to review and approve contractor detection and avoidance systems using a process comparable to what is now in use for other contractor business systems. For contractors, Section 818 signified several burdensome consequences, In short, Section 818 places the entire burden of eliminating counterfeit electronic parts on industry. most of which have been implemented through the DFARS discussed below. Section 833 of the FY 2013 NDAA The second piece of legislation related to counterfeit parts came just one year later in Section 833 of the FY 2013 NDAA (Section 833). 7 As previously explained, Congress required in Section 818 that all costs associated with counterfeit parts, including the cost of the parts and any required rework or corrective action, are unallowable under government contracts. This cost allowability provision is one of the primary enforcement mechanisms for the new counterfeit parts regime (in addition to purchasing system disapproval and resultant withholds discussed below). When Section 818 was enacted, the government contracting community objected on the basis that it unfairly shifted to contractors all cost risk associated with counterfeit electronic parts, even when the government may contribute to the issue. For example, Section 818 would disallow costs associated with a counterfeit electronic part that was provided by the government to the contractor as government-furnished property (GFP) and incorporated into an end item by the contractor. This is, of course, contrary to long-standing government contract principles, including the Federal Acquisition Regulation (FAR) government property clause, which warrants that GFP will be suitable for contract performance, and FAR inspection and testing clauses, which generally entitle the contractor to be reimbursed for nonconforming work and required rework ASSOCIATION OF CORPORATE COUNSEL

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8 COUNTERFEIT PARTS AND THE NEW LAW: ARE WE ALL DOD CONTRACTORS? Twelve counterfeit electronic parts detection and avoidance system criteria 1. Training 2. Inspection and testing 3. Processes to abolish counterfeits 4. Mechanisms for traceability 5. Use and qualification of trusted suppliers 6. Reporting and quarantine of counterfeits 7. Ability to identify counterfeits 8. Systems to detect and avoid counterfeits 9. Flowdown of requirements to subcontractors 10. Processes to keep informed of current counterfeiting information and trends 11. Processes for screening GIDEP reports and other sources of counterfeiting information 12. Control of obsolete electronic parts Congress responded to this complaint by amending Section 818 through the enactment of Section 833, which created a narrow safe harbor that would allow contractors to recover costs associated with counterfeit electronic parts in certain limited circumstances. Specifically, Section 833 provides that such costs may be allowable if: (a) the contractor has a DOD-approved counterfeit electronic parts detection and avoidance system; (b) the counterfeit or suspect counterfeit part at issue was provided to the contractor as GFP in accordance with FAR Part 45; and (c) the covered contractor provides timely notice to the government. As a result of Congress use of the conjunctive and, the Section 833 safe harbor does not apply unless you satisfy all three elements. As a result, the safe harbor will have zero applicability until the Defense Contract Management Agency (DCMA) conducts its initial review and approval of your purchasing system a process that may take several years. And even assuming the counterfeit electronic parts detection and avoidance element of your purchasing system is approved, the safe harbor will only apply in the narrow circumstances where the part at issue was provided as GFP and you provided timely notice. The DFARS final rule On May 6, 2014, DOD issued its final rule on counterfeit electronic parts. The final rule came nearly a year after DOD issued the proposed rule on May 16, During that time, DOD received a large number of public comments and held a public meeting where industry companies voiced concerns with the proposed rule. As a result of this input, the final rule was substantially different than the proposed rule. While the final rule is a marked improvement over the proposed rule, substantial compliance challenges remain for contractors. The fundamental requirements of the rule are as follows: (a) contractors performing Cost Accounting Standards (CAS)-covered contracts are required to maintain a counterfeit electronic parts detection and avoidance system as part of their purchasing system; and (b) costs associated with counterfeit electronic parts and any related rework or corrective action are unallowable. These requirements are implemented through a new DFARS contract clause, revisions to the DFARS purchasing system clause and a new DFARS cost principle. These new requirements are described below. Applicability The rule ostensibly applies only to CAS-covered contractors, but its ultimate reach will be much greater. The clause itself limits its application to CAS-covered contractors, though the prescriptive clause has no such limitation, meaning the government will likely incorporate it into all contracts involving delivery of electronic parts. This may cause confusion if your company is not subject to CAS but, nevertheless, receives contracts that contain the clause. 9 Once the rule applies, contractors are required to flow the requirements of the clause down to all subcontracts requiring delivery of electronic parts, including subcontracts for commercial and commercial off-the-shelf (COTS) items. 10 This flowdown need not be a verbatim recitation of the clause but, instead, must include the substance of the clause in all subcontracts. Thus, contractors can fashion the subcontract clause as they see fit, and subcontractors should be aware that the precise wording of the flowdown may be subject to negotiation. In any event, while the rule itself is limited to CAS-covered contracts at the prime level, its applicability is much broader below the prime level, and it will apply throughout the supply chain. Note that there is some ambiguity with regard to the rule s applicability to small businesses. The prescriptive clause at DFARS exempts solicitations and contracts that are set aside for small businesses, meaning such prime contracts should never include the clause. This exemption appears unnecessary because contractors performing small business set-asides will not be subject to CAS, and therefore, the rule will not apply to them. Some commentators have suggested that this exempts small business subcontractors from these requirements. However, as previously noted, the contract clause at DFARS requires that the clause be flowed down to all subcontracts. Definitions The final rule applies to counterfeit electronic parts and suspect counterfeit electronic parts, both of which are 48 ASSOCIATION OF CORPORATE COUNSEL

9 defined terms. Counterfeit electronic parts are defined as follows: [A]n unlawful or unauthorized reproduction, substitution, or alteration that has been knowingly mismarked, misidentified, or otherwise misrepresented to be an authentic, unmodified electronic part from the original manufacturer, or a source with the express written authority of the original manufacturer or current design activity, including an authorized aftermarket manufacturer. Unlawful or unauthorized substitution includes used electronic parts represented as new, or the false identification of grade, serial number, lot number, date code, or performance characteristics. This definition is substantially narrower and clearer than the proposed rule, which did not include an explicit intent element and included language that arguably would have converted many ordinary contract non-compliances into counterfeit issues. Suspect counterfeit electronic parts are defined as electronic parts for which credible evidence... provides reasonable doubt that the electronic part is authentic. The final rule s incorporation of the term credible evidence is significant because it should provide contractors the ability to conduct an investigation to determine whether a part is, in fact, a suspect counterfeit part before the reporting or cost disallowance provisions of the rule are triggered. If the initial investigation reveals that the part is authentic, then there is no prohibition against the contractor recovering the costs of the part and the investigation. Unfortunately, contractors familiar with the FAR Mandatory Disclosure Rule will be all too familiar with the fact that the term credible evidence is undefined and is a continuing source of uncertainty for contractors. Purchasing system requirements In the short term, the most significant impact on defense contractors subject to the new rule is the substantial new purchasing system requirements. Specifically, contractors now must maintain an adequate counterfeit electronic parts detection and avoidance system as part of their purchasing system. 11 The rule sets forth 12 criteria for an adequate system (see sidebar). Notably, many of these specific criteria are vague and undefined, and it will be up to contractors to interpret and implement the requirements in their existing purchasing systems. The rule requires that this system adopt a risk-based approach that takes into account: (1) the likelihood that a particular part is counterfeit; (2) the potential consequences of a counterfeit; and (3) the likelihood that a counterfeit will be detected through inspection and testing. Again, it is up to contractors to develop processes and procedures for quantifying and weighing these factors. The rule provides for DCMA review and approval of the counterfeit electronic parts detection and avoidance system in connection with contractor purchasing system reviews. 12 This means that if DCMA determines that a contractor s counterfeit electronic parts detection and avoidance system is inadequate, the government may disapprove the contractor s purchasing system and withhold payments. Contractor challenges The rule creates a number of immediate challenges for contractors as they transition to operating under this new requirement. For example, the preamble to the rule states that it applies to contractor inventory that is currently on the shelf, but it provides no additional guidance on what this means. Many contractors will be faced with the situation of having inventory that was purchased from brokers many years ago that is suddenly subject to their counterfeit electronic parts detection and avoidance system. Traceability for electronic components in these items It is entirely up to contractors to manage the challenges associated with maintaining aging government weapons systems, some of which have been in service for 40 years or more. may be difficult, if not impossible, and short of retesting every item, it will be challenging for contractors to be sure of the authenticity of such parts. Contractors should work with their contracting officers to have the government share some of this burden through an equitable adjustment to the contract to cover increased testing or to agree to assume some portion of the risk. Similarly, the rule requires contractors to manage risks associated with part obsolescence, but does not provide any guidance. Thus, it is entirely up to contractors to manage the challenges associated with maintaining aging government weapons systems, some of which have been in service for 40 years or more. Sourcing parts from the OEM/OCM, or an authorized distributor, that have been out of production for decades will prove difficult, if not impossible. Again, contractors should work proactively with their customers to share some of this risk and should consider including terms in their subcontracts requiring long-term availability of parts, when appropriate. Impact to suppliers on DOD contracts (with focus on commercial and small businesses) As previously described, the DFARS expressly applies to CAS-covered contractors, but the flowdown requirements likely apply to all suppliers in support of a prime contractor, regardless of CAS coverage. Therefore, even small business OEMs and OCMs, whether commercial or ACC DOCKET OCTOBER

10 HAVE A COMMENT ON THIS ARTICLE? VISIT ACC S BLOG AT Proposed FAR rule would expand contractor reporting of nonconforming items 79 Fed. Reg. 33,164 Recently, the FAR Council proposed additional reporting requirements for nonconforming items, including counterfeit parts. These requirements include the following: GIDEP reporting required within 60 days after a contractor becomes aware that: (a) an item is counterfeit or suspect counterfeit; or (b) an item contains a major or critical nonconformance that is one of the following: i. a common item; and ii. constitutes a quality control deviation from a lower level subcontractor that resulted in the release of nonconforming items to more than one customer. Contracting Officer reporting required within 30 days from when a contractor becomes aware that any end item, component, subassembly, part or material contained in supplies purchased by the contractor for delivery to or for the government is counterfeit or suspect counterfeit. defense electronics manufacturers and suppliers in the middle, likely must conform to the requirements of the DFARS. This means traceability of the products or what we sometimes call Chain of Custody must be established from the OEM or OCM all the way to the prime contractor. The requirements of the DFARS essentially become mandatory flowdowns throughout the supply chain. These two requirements are likely to cause your company to implement changes to existing traceability requirements and changes to contracting practices where the DFARS clause or the substance thereof must be inserted in your supplier contracts. Electronic parts suppliers may address these requirements by having a DOD-status product line and compliant procedures, or they may apply the requirements to their entire product line. If these practices are unusual, they may drive cost increases across your electronic product lines. While not a new topic, the entire electronics industry will also likely see an increase in obsolescence prevention and notice clauses in DOD contracts. Obsolescence is thought to be the funnel to fraudulent electronic parts. When parts become difficult to find throughout industry, counterfeit parts brokers turn to China and other hotbeds for counterfeiters to fulfill orders. Procedures to avoid obsolescence and avoid counterfeits will essentially become mandatory for companies not generally considered in the defense industry. Path forward as industry adjusts Above all else, the primary tenet of the new DFARS is to avoid the procurement and receipt of counterfeit parts. Buying directly from OEMs and OCMs is the safest approach, but using only their authorized distributors and brokers is also key. You will want to caution your buyers, however, that an authorized distributor for an OEM or OCM may not be authorized to sell all products manufactured by that OEM or OCM. OEMs and OCMs will need to insist on greater accuracy and updates to their authorized distributor lists, whether posted on the company website or in marketing materials. Even more confusing is that some products and sectors of the industry simply do not use distribution chains, so authorized distributors do not exist. Avoiding bad actors for such electronic part procurements will continue to be a challenge for suppliers who support DOD procurements, even at the lower tiers. You should also be wary of warranty provisions that might void the warranty if parts were purchased from an unauthorized distributor or broker. As part of the traceability element of the rule, it will be useful to review passthrough warranties, or to request the OEM or OCM s warranty provision. In addition, current inventories must be monitored carefully. You may need to introduce new restrictions on the use of electronic parts for which your company cannot verify traceability or authenticity. Such parts should be restricted from use in support of DOD contracts (and NASA contracts in the near future), and this use restriction should flow with the parts to the ultimate end-user. Not installing such restrictions may expose your company to the strict liability of the DFARS and, potentially, to the criminal liability associated with counterfeiting under Title 18 of the US Code. ACC EXTRAS ON Anti-Counterfeiting ACC Docket New Regulatory Expectations for Service Providers to Financial Institutions (June 2014). Creative Anti-Counterfeiting: Solutions for Combating Counterfeiting Online (Nov. 2011). Program Materials The Never-Ending Battle Against Counterfeits and Pirates How To Get Ahead (Oct. 2013). Trademark Counterfeiting: How Mark Owners Can Protect Themselves (July 2010). Lessons Learned From Hewlett Packard: How To Conduct Investigations? (June 2007). ACC HAS MORE MATERIAL ON THIS SUBJECT ON OUR WEBSITE. VISIT WHERE YOU CAN BROWSE OUR RESOURCES BY PRACTICE AREA OR SEARCH BY KEYWORD. 50 ASSOCIATION OF CORPORATE COUNSEL

11 These new counterfeit electronic part requirements will trickle well beyond the traditional government contracts community. This is not an area where companies should accept the risk as though the DFARS will never affect their business. The stakes are too high. A failure to address these concerns proactively could place you and your company in unfamiliar territory from DCMA audits to investigations by the Office of Inspector General and DOJ. ACC NOTES 1 Dangerous Fakes: How counterfeit, defective computer components from China are getting into U.S. warplanes and ships, by Brian Grow, Chi-Chu Tschang, Cliff Edwards and Brian Burnsed, BusinessWeek (Oct. 2, 2008, 5:00 pm). 2 Rick Rothacker, FBI has investigated DesignLine over used parts, attorney says (Nov. 16, 2013), Charlotte Observer (Nov. 16, 2013), Watching Wash & the World McClatchy DC, www. mcclatchydc.com/2013/11/16/208776/ fbi-has-investigated-designline.html. 3 Monte Whaley, RTD seeks to break mall-shuttle contract with bankrupt bus maker, The Denver Post (Dec. 19, 2013, 12:56 pm), com/news/ci_ /rtd-seeksto-break-mallshuttle-contract. 4 Donna Miles, Missile Agency Guards Against Counterfeit Parts (Nov. 8, 2011), Am. Forces Press Serv., newsarticle.aspx?id= Inquiry Into Counterfeit Elec. Parts in the Dep t of Def. Supply Chain, S. Rep. No , 112 th Cong. 2d Sess. (2012), 112srpt167/pdf/CRPT-112srpt167.pdf. 6 Nat l Def. Authorization Act for Fiscal Year 2012, Pub. L. No (Dec. 31, 2011), gov/fdsys/pkg/plaw-112publ81/ pdf/plaw-112publ81.pdf. 7 Nat l Def. Authorization Act for Fiscal Year 2013, 833, H.R. 4310, 112 th Cong. 2d Sess. (Jan. 3, 2012), www. gpo.gov/fdsys/pkg/bills-112hr4310enr/ pdf/bills-112hr4310enr.pdf. 8 FAR (d)(2), See DFARS , DFARS DFARS DFARS