Defense Trade: U.S. Contractors Employ Diverse Activities To Meet Offset
Obligations (Letter Report, 12/18/98, GAO/NSIAD-99-35).

Pursuant to a congressional request, GAO reviewed the types of
activities undertaken by U.S. contractors to meet offset obligations
associated with the sale of defense equipment to various foreign
governments.

GAO noted that: (1) companies undertake a broad array of activities to
satisfy offset requirements; (2) under offset programs, U.S. contractors
commonly award subcontracts for components and subsystems to firms in
purchasing countries, and in a few cases, have made longer-term
commitments covering foreign firm participation in the event of future
sales of weapon systems; (3) this activity has been accompanied by
technology transfers, for example, providing manufacturing technology
needed to produce a component; (4) placing contracts overseas has
resulted in the emergence of additional contractors that are qualified
to participate in weapon system development and production; (5) the
long-term supplier relationships that develop may result in reduced
business opportunities for some U.S. firms; (6) nonetheless, the value
of the export sale, in the transactions examined, greatly exceeded the
amount of work placed overseas; (7) for procurements not directly
related to weapon systems, U.S. prime contractors enlisted their major
subcontractors, their suppliers, and other foreign entities to help meet
offset obligations; (8) U.S. contractors also undertook a wide variety
of activities that could be labelled business development; (9)
contractors provided technical assistance to foreign firms across a wide
range of technologies and industries and assisted foreign firms in
marketing their products in export markets using the expertise of the
contractors' own organizations or consultants; (10) in a few cases, U.S.
contractors advocated a foreign firm's product to the Department of
Defense or suppliers; (11) in isolated cases, offset transactions
involved financial assistance to subsidize particular export sales; (12)
these transactions were limited to foreign markets and therefore did not
involve improper incentive payments under U.S. law; (13) U.S.
contractors also facilitated or established joint ventures with firms in
the offset country; and (14) while a country's economic development
ministry might perform similar activities, the offset program allowed
the country, or firms in the country, to leverage the expertise and
know-how of major U.S. multinational firms.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  NSIAD-99-35
     TITLE:  Defense Trade: U.S. Contractors Employ Diverse Activities 
             To Meet Offset Obligations
      DATE:  12/18/98
   SUBJECT:  Technology transfer
             Foreign military sales agreements
             Department of Defense contractors
             International trade
             Equipment contracts
             Foreign technical aid
             Foreign military arms sales
             Multinational corporations
             Export regulation
             Foreign corporations
IDENTIFIER:  Foreign Military Sales Program
             
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Cover
================================================================ COVER


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

December 1998

DEFENSE TRADE - U.S.  CONTRACTORS
EMPLOY DIVERSE ACTIVITIES TO MEET
OFFSET OBLIGATIONS

GAO/NSIAD-99-35

Defense Trade

(707306)


Abbreviations
=============================================================== ABBREV

  DOD -
  FMS -

Letter
=============================================================== LETTER


B-297767

December 18, 1998

The Honorable Russell D.  Feingold
United States Senate

Dear Senator Feingold: 

This report provides information you requested on the types of
activities undertaken by U.S.  contractors to meet offset obligations
associated with the sale of defense equipment to various foreign
governments.  Offsets are the entire range of industrial and
commercial benefits that are provided to foreign governments as
inducements or conditions for the purchase of military goods and
services.  They include, for example, coproduction and
subcontracting, technology transfers, in-country procurements,
marketing and financial assistance, or joint ventures. 

Our review examined offset transactions of six major U.S.  defense
contractors.  We obtained and analyzed data for over 100 offset
transactions on defense weapon system procurements by countries in
the Middle East, Europe, and Asia.  The transactions were primarily
from ongoing or recently completed offset programs reflecting both
high and low dollar procurements and tied to foreign military sales
(FMS) contracts.  Although the sample is not statistically valid,
contractors have indicated that these transactions are representative
of their offset activities. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :1

Companies undertake a broad array of activities to satisfy offset
requirements.  Under offset programs, U.S.  contractors commonly
award subcontracts for components and subsystems to firms in
purchasing countries, and in a few cases, have made longer term
commitments covering foreign firm participation in the event of
future sales of weapon systems.  This activity has been accompanied
by technology transfers, for example, providing manufacturing
technology needed to produce a component.  Placing contracts overseas
has resulted in the emergence of additional contractors that are
qualified to participate in weapon system development and production. 
However, the long- term supplier relationships that develop may
result in reduced business opportunities for some U.S.  firms. 
Nonetheless, the value of the export sale, in the transactions
examined, greatly exceeded the amount of work placed overseas.  For
procurements not directly related to weapon systems, U.S.  prime
contractors enlisted their major subcontractors, their suppliers, and
other foreign entities to help meet offset obligations. 

U.S.  contractors also undertook a wide variety of activities that
could be labeled business development.  These activities are similar
to those that an economic development ministry performs.  Contractors
provided technical assistance to foreign firms across a wide range of
technologies and industries and assisted foreign firms in marketing
their products in export markets using the expertise of the
contractors' own organizations or consultants.  In a few cases, U.S. 
contractors advocated a foreign firm's product to the Department of
Defense (DOD) or suppliers.  In isolated cases, offset transactions
involved financial assistance to subsidize particular export sales. 
These transactions were limited to foreign markets and therefore did
not involve improper incentive payments under U.S.  law.  U.S. 
contractors also facilitated or established joint ventures with firms
in the offset country.  While a country's economic development
ministry might perform similar activities, the offset program allowed
the country, or firms in the country, to leverage the expertise and
know-how of major U.S.  multi-national firms. 


   BACKGROUND
------------------------------------------------------------ Letter :2

The ever increasing costliness of defense equipment, the limited
defense budgets, the concerns about employment levels, and the
importance of industrial competitiveness in a global economy have led
governments to leverage their imports of major weapon systems so as
to yield benefits for their domestic economies.  Offsets are one way
to achieve these benefits.  Such programs are often an essential part
of a weapons procurement and allow the purchasing government to build
public support for large expenditures of public funds.  It is
difficult to accurately measure the impact of offsets on the overall
U.S.  economy and on specific industry sectors.\1

Military equipment is sold to foreign governments either by DOD
through the FMS program or by defense contractors as direct
commercial sales.  These sales are accompanied by offset agreements
that are established between U.S.  defense contractors and purchasing
governments.  Although the U.S.  government is a party to FMS
agreements and issues licenses for technology transfers as needed, it
is not a party to offset agreements and assumes no liability pursuant
to the agreements. 

In the past, contractors had to absorb the costs of offset
implementation against their negotiated profit margins.  In 1992,
however, DOD recognized that contractors incurred such costs by
allowing their recovery under FMS contracts.  Today, U.S.  defense
contractors may recover administrative costs incurred to implement
their offset agreements under certain circumstances by charging such
costs to the purchasing foreign government through the FMS contracts. 
Figure 1 illustrates the U.S.  government's "hands-off" policy on
offsets and the offset relationships between a U.S.  contractor and a
country purchasing FMS.\2

   Figure 1:  Offset Relationships

   (See figure in printed
   edition.)

   Legend:

   (See figure in printed
   edition.)

    LOA - Letter of Offer and
   Acceptance
    FAR - Federal Acquisition
   Regulations

   (See figure in printed
   edition.)

   Source:  The Management of
   Security Assistance , Defense
   Institute of Security
   Assistance Management, 17th
   Edition, May 1997, p.  303.

   (See figure in printed
   edition.)

Offset agreements ordinarily specify the level of offset required,
normally expressed as a percentage of the sales contract, and the
types of activities that are eligible for offset credits. 
Negotiating an offset credit is an important part of implementing
offset agreements because countries can encourage companies to
undertake highly desirable offset activities by granting additional
offset credit through multipliers.  For example, a country may grant
an offset credit for advanced technology or training activities based
on what the country would have paid to procure or develop the
training or technology itself.  Countries may also offer large
multipliers to encourage desired activities.\3


--------------------
\1 Offset requirements are discussed in more detail in our 1996
report entitled Military Exports:  Offset Demands Continue to Grow
(GAO/NSIAD-96-65, Apr.  12, 1996). 

\2 FMS acquisition, offsets, and offset relationships are discussed
in chapter 11 of the Defense Institute's Security Assistance
Management, 17th Edition, May 1997. 

\3 A multiplier is used to increase the value of an offset project
when determining offset credit.  For example, if a company helped
facilitate a $10,000 export of a product with particular importance,
the country could offer a multiplier of five, thereby increasing the
amount of offset credit to $50,000. 


   WIDE SPECTRUM OF ACTIVITIES
   CONTAINED IN OFFSET AGREEMENTS
------------------------------------------------------------ Letter :3

Offset agreements contain a wide spectrum of activities that U.S. 
contractors agree to undertake to satisfy their obligations.  Offset
agreements tend to be specific in stating requirements and ways they
are to be satisfied.  Offset activities can be grouped into the
following categories:  coproduction and subcontracting related to
defense items, technology transfers, in-country procurements,
marketing assistance, financial assistance, and investments or joint
ventures.  Activities can fall into more than one category.  For
example, coproduction activity may also include the transfer of
technology needed to improve production processes.  As another
example, a contractor can buy carpet and display it prominently in
its executive lobby--a combination of in-country procurement and
marketing assistance activities.  In addition, there are other
activities that do not fit within any of these categories. 


      COPRODUCTION AND
      SUBCONTRACTING, TECHNOLOGY
      TRANSFERS, AND IN-COUNTRY
      PROCUREMENTS ARE WIDELY USED
---------------------------------------------------------- Letter :3.1

Coproduction tied directly to a weapons sale, subcontracting for
defense-related products, and technology transferred as part of those
arrangements, or separately, are transactions commonly found in the
agreements we reviewed.  Procurements of goods and services not
related to the weapon system sales--indirect offset activities--were
also frequently used. 


         COPRODUCTION AND
         SUBCONTRACTING
-------------------------------------------------------- Letter :3.1.1

Coproduction occurs when defense companies located in offset
countries receive contracts to assemble, build, or produce articles
for the weapon system sale.  Subcontracting occurs when a U.S. 
contractor procures defense-related components and subsystems for
export from suppliers in countries where the contractor has offset
obligations.  Foreign subcontracts are either competed within the
purchasing country or directed to an entity within that country. 
Regardless, per the agreements, U.S.  contractors normally insist
that the foreign companies meet certain contract standards for price,
quality, and delivery to become qualified subcontractors.  One U.S. 
contractor stated that foreign companies must meet the same contract
standards as those used to select qualified U.S.  subcontractors. 
Placing contracts overseas has resulted in additional contractors who
are qualified to participate in weapon system development and
production.  However, the long-term supplier relationships that
develop may result in reduced business opportunities for some U.S. 
firms.  In the transactions we reviewed, coproduction and
subcontracting activities ranged from 2.5 percent to 66.7 percent of
the total offset obligation. 

The following examples describe coproduction and subcontracting
activities.  A U.S.  contractor used two foreign defense companies to
assemble an aircraft and produce some of its components and parts. 
Together, the U.S.  contractor and foreign country determined that
these particular components and parts were compatible with the
foreign companies' manufacturing processes and concluded they could
be produced at a lower cost by the foreign companies than by the U.S. 
contractor.\4 These activities equated to about 8.8 percent of the
total offset obligation.  According to the contractor, although the
contractor did not solicit any U.S.  companies to compete for the
contract, it determined that the two foreign companies were
competitive in their price, quality, and delivery.  An Asian
government, per the offset agreement, specified that it would select
industry participants to manufacture airframe spares.  This would
allow all four of the Asian country's aerospace companies to
participate and achieve a proportionate share of the spares
manufacture. 

U.S.  contractors have established longer term relationships covering
foreign firm participation in future sales of the weapon system and
beyond their commitment in the purchasing country.  In many cases,
the foreign subcontractor will become a longer term supplier to the
U.S.  contractor for that item being produced.  For example, an
American defense contractor subcontracted a European defense company
to assemble the tail section for a particular aircraft system sold
worldwide.  The manufacturing know-how was transferred to the company
through a Department of State approved manufacturing license.  In
another illustration, a U.S.  contractor subcontracted with a
European company to manufacture test sets for a weapon system sold
worldwide. 


--------------------
\4 We did not attempt to verify this conclusion because it was
outside the scope of our review. 


         TECHNOLOGY TRANSFERS
-------------------------------------------------------- Letter :3.1.2

Technology transfer is widely used to fulfill offset obligations and
often accompanies coproduction and subcontract activities.  It,
however, is also used in areas unrelated to defense procurements. 
From the contractors' perspective, technology transfers are often a
relatively inexpensive way to earn offset credit because, in some
cases, the contractors already possess the technology the foreign
government desires.  In most cases, the value of the technology
transfer is negotiated between the U.S.  contractor and the foreign
government.  The negotiated value of the technology is often based on
the contractor's prior investment in research and development, the
market value of the technology, or the cost to the foreign government
for developing the technology itself.  Multiples of the negotiated
value are also used, depending on the value the foreign government
places on certain types of technology.  For example, in one European
country, the multiplier for this activity varied between 1 and 20,
depending on the benefits received by that country's industries. 
Recognizing the difficulty in determining the value of technology
transfer, an Asian country and a U.S.  contractor agreed to negotiate
in good faith the mutually acceptable offset credit amount based on
such factors as the market value, the license fees and royalties
appropriate for such technology, the costs to transfer the
technology, the sale or benefits resulting from the transfer, or the
development costs of the technology. 

Many of the purchasing countries prefer projects that require
technology transfers because the transfers generally provide
manufacturing skills and technical assistance that can be used to
help the economic development within the countries.  For example, a
European government wanted to develop an in-country capability by
using indigenous labor that would perform flightline and special
repair activity maintenance.  Thus, a U.S.  defense contractor
provided one of the country's defense companies a comprehensive
technology transfer and training program that permitted the foreign
company to train its country's Air Force personnel to operate,
maintain, and repair a weapon system in accordance with appropriate
U.S.  military and manufacturer standards.  The State Department
permitted this technology to be transferred by approving the
technical assistance and manufacturing license agreements between the
two parties.  The U.S.  contractor received an offset credit when the
training program was established, and it expects to earn future
credit once the European company trains other countries with this
technology.  In another example, an Asian government, per the offset
agreement, indicated a strong desire to infuse technology into the
country's business in order to increase its commercial business
capabilities.  To satisfy this desire, a U.S.  contractor provided an
Asian commercial company with technology and training in the area of
commercial component manufacture. 


         IN-COUNTRY PROCUREMENTS
-------------------------------------------------------- Letter :3.1.3

In-country procurement is an indirect offset activity that entails
purchases of goods and services not related to the foreign weapon
system sale.  In addition to the U.S.  contractors making purchases,
they also employ other parties such as major subcontractors,
suppliers, and foreign entities to help meet their offset
obligations.  In a few cases, U.S.  contractors advocated a foreign
firm's product to DOD or suppliers.  Suppliers will often purchase
items from foreign countries in which a U.S.  contractor has an
offset obligation in an effort to strengthen relationships with the
prime contractor or to establish new relationships with other
customers that will eventually lead to future contracts.  According
to U.S.  contractors, some of these items are purchased because of
need and at competitive prices, others mainly to help satisfy an
offset obligation. 

Contractors often encourage their suppliers to participate in
satisfying their offset obligations.  For example, one U.S.  defense
contractor uses its supplier rating or performance evaluation system
to encourage participation.  The system measures factors such as the
affordability, the quality, and the responsiveness (including offset
cooperation as a subfactor) of the supplier and the supplier's goods. 
Depending on the overall rating, a supplier may receive an increased
percentage of additional work from the contractor or recognition from
other customers.  Another contractor holds periodic conferences or
places a clause within purchase orders as a means to inform suppliers
of its offset obligations with foreign countries. 

Our review indicated U.S.  suppliers purchased items that included a
recovery boiler, a batching system for producing float glass,
satellite hardware, a pulsed laser deposition system, a pressurized
filtration device, a turret punch press, a paper variability
analyzer, an overhead crane system, transformer equipment,
communications equipment, and ergonomic computer workstations. 
Foreign entities purchased 3-axle trailers, ferries, and automobile
parts. 


      OFFSET TRANSACTIONS INCLUDE
      BUSINESS DEVELOPMENT
      ACTIVITIES
---------------------------------------------------------- Letter :3.2

U.S.  contractors also undertook a wide variety of activities that
could be labeled business development and are similar to those
performed by an economic development ministry. 


         MARKETING ASSISTANCE
-------------------------------------------------------- Letter :3.2.1

Marketing assistance is defined as a U.S.  contractor helping foreign
companies penetrate and develop U.S.  and/or non-U.S.  markets by
analyzing the market for the exporter's product or assisting the
exporter in responding to a request for proposals.  To help in this
area, a U.S.  contractor often pays brokers or consultants a fee to
provide such services.  For example, a U.S.  defense contractor paid
a U.S.  broker to coordinate the transfer of oil and gas refining
technology from a European oil company to an Indian oil company.  The
deal provided the opportunity for the European company to penetrate a
new market.  In another case, a U.S.  contractor helped an Asian
defense company that was performing modification work for the U.S. 
Air Force in that region.  Similarly, a U.S.  contractor paid a U.S. 
firm for helping a European company develop a competitive proposal
for a U.S.  military contract.  One final example of marketing
assistance involved a U.S.  contractor funding a European
organization's U.S.  operations.  The European organization promoted
products in the United States, made by its country's small-sized,
high technology businesses.  The U.S.  contractor received credit for
the initial financial support, and it will receive credit for all
future sales made to U.S.  buyers by the small European companies. 


         FINANCIAL ASSISTANCE
-------------------------------------------------------- Letter :3.2.2

Financial assistance is not as frequently used as others that we
reviewed.  Financial assistance is defined as providing funds to a
foreign company in the country where the offset obligation exists to
facilitate an export.  Financial assistance can be in the form of
incentive payments and success or service fees.\5 For example, a U.S. 
defense contractor paid a foreign bank a service fee to provide
financing assistance to a European shipbuilding company so it could
manufacture container ships.  The funds were used to complete the
manufacturing of two vessels sold to a U.S.  shipping company. 
Another example involved a European automotive parts manufacturer, a
subsidiary of a U.S.  automotive company, which acquired 100 percent
of a foreign automotive component company that was going out of
business.  A U.S.  defense contractor provided funds to the foreign
company to help defray the acquisition cost.  The U.S.  contractor
received an offset credit for assisting with the expenses.  In
another case, a contractor sponsored and underwrote a portion of the
expenses for a European orchestra concert tour and industry export
trade promotion show held in the United States. 


--------------------
\5 In 1994, Congress passed the Feingold Amendment prohibiting
incentive payments to induce U.S.  persons or companies to purchase
foreign goods or services to satisfy offset agreements (section 733
of P.L.  103-236).  These transactions do not fall within the
coverage of the Feingold Amendment. 


         INVESTMENTS AND JOINT
         VENTURES
-------------------------------------------------------- Letter :3.2.3

Investments and joint ventures are occasionally used to satisfy
offset obligations.  An investment or joint venture occurs when a
U.S.  contractor serves as a facilitator to bring parties together,
provides start-up costs to develop a new entity, or makes an equity
investment in the foreign country.  For example, a U.S.  defense
contractor and a European defense company negotiated a teaming
agreement.  Jointly, the team will develop an upgraded weapon system
that will generate worldwide sales.  The U.S.  contractor, in turn,
will receive an offset credit for its involvement in the venture.  In
another case, a U.S.  contractor and a European software manufacturer
established a joint development program to build software links
between a systems integrator and the software architecture. 


         OTHER ACTIVITIES
-------------------------------------------------------- Letter :3.2.4

A few activities did not clearly fit into any of the other
categories.  For example, U.S.  contractors may generate potential
offset credits through activities that occur prior to contract award;
a process called "banking".  In one case, a successful contractor
used banked offset credits to help satisfy its offset obligation.  In
another case, a successful contractor bought the unsuccessful
contractor's banked offset credits. 


   AGENCY COMMENTS
------------------------------------------------------------ Letter :4

We requested comments on a draft of this report from the Departments
of Defense, Commerce, and State and U.S.  contractors.  DOD and State
officials responded that they did not have any comments.  Commerce
stated the details of the report complemented its legislatively
mandated report on offsets (see app.  I).  The U.S.  contractors did
not provide written comments but generally agreed with our
description of offset activities. 


   SCOPE AND METHODOLOGY
------------------------------------------------------------ Letter :5

To assess the activities undertaken by U.S.  contractors to satisfy
offset obligations, we analyzed over 100 transactions contained in 19
ongoing or recently completed offset programs by 6 major U.S. 
defense companies with 12 purchasing countries.  We selected the
countries based on their geographic locations and their purchases of
foreign military equipment.  The purchasing countries were Finland,
France, Germany, Greece, Korea, Malaysia, Netherlands, Norway, Saudi
Arabia, Switzerland, Turkey, and Taiwan.  The defense companies were
chosen based on their roles as prime contractors and subcontractors
that provided offset services.  The companies were Boeing, General
Electric, Lockheed Martin, Northrop Grumman, Pratt & Whitney, and
Raytheon. 

We reviewed contractors' records for tracking offset activities and
offset implementation costs charged to FMS contracts.  We visited and
interviewed company officials to obtain detailed data describing the
offset activities.  We examined supporting documentation for selected
charges in order to develop a description of offset activities
undertaken for each program.  We then summarized the activities by
placing them into offset categories.  The contractors reviewed and
agreed with our definitions of the offset categories discussed
previously.  But, due to the proprietary nature of the offset
agreements and programs, we were limited in our ability to present
specific information on activities in these categories.  In addition,
we reviewed offset data reported to the Department of Commerce\6 as
well as foreign subcontracting data reported to DOD.\7

We conducted our review from October 1997 to November 1998 in
accordance with generally accepted government auditing standards. 


--------------------
\6 Under the Defense Production Act amendments of 1992, 50 U.S.C. 
app.  2099, U.S.  firms entering into contracts for the sale of
defense articles or services to foreign countries or firms that are
subject to offset agreements exceeding $5 million in value are
required to furnish certain information to the Department of Commerce
regarding such agreements.  Since 1995, U.S.  firms have been
required to report to the Bureau of Export Administration, on June 15
of each year, offset transactions that receive offset credits of
$250,000 or more claimed from a foreign country. 

\7 A U.S.  firm that is performing or is bidding on a DOD contract
exceeding $10 million is required by 10 U.S.C.  2410g to notify DOD
if the firm or a first-tier subcontractor plans to perform more than
$500,000 of the contract outside the United States and Canada and the
work could be performed inside the United States or Canada.  DOD also
administratively requires U.S.  firms to submit a notification for
contracts exceeding $500,000, when any part that exceeds $100,000
will be performed outside the United States. 


---------------------------------------------------------- Letter :5.1

As agreed with your office, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 30 days
from the date of this letter.  At that time, we will send copies to
interested parties and make copies available to others upon request. 

Please contact me at (202) 512-4841 if you or your staff have any
questions concerning this report.  Major contributors to this report
were
Karen S.  Zuckerstein, Lauri A.  Kay, and Richard E.  Burrell. 

Sincerely yours,

Katherine V.  Schinasi
Associate Director
Defense Acquisitions Issues




(See figure in printed edition.)Appendix I
COMMENTS FROM THE DEPARTMENT OF
COMMERCE
============================================================== Letter 


*** End of document. ***