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Counterfeit Parts Report — A Guide For Contractors, DOD

Law360, New York (May 24, 2012, 1:09 PM ET) — On May 21, 2012, the Senate Armed Services Committee (SASC) released the final report of its "Inquiry Into Counterfeit Electronic Parts in the Department of Defense Supply Chain." The report followed a two-year investigation and draws upon hearings conducted by the SASC in 2011.

Those hearings, in turn, led to Section 818 of the FY 2012 National Defense Authorization Act, a new law intended to stop importation of counterfeit parts, require the DOD and contractors to improve purchasing practices to favor original manufacturers and “trusted suppliers,” and compel regular and diligent reporting when counterfeit parts are identified or suspected. Section 818 also makes contractors responsible for the costs of rework or corrective action as required to redress counterfeit and suspect counterfeit parts.

Taken as a whole, the report is dramatic and powerful evidence that strong measures are needed at many levels of the the DOD supply chain to reduce vulnerability to counterfeit parts. The report — 72 pages in length, with 521 footnotes, reflecting a review of more than 100,000 pages of documents — exhibits remarkable diligence, and the committee and its staff are to be commended for their thoroughness, as well as for the painstaking attention to detail. There are eight key conclusions advanced by the report:

  1. China is the dominant source country for counterfeit electronic parts that are infiltrating the defense supply chain.
  2. The Chinese government has failed to take steps to stop counterfeiting operations that are openly carried out.
  3. The DOD lacks knowledge of the scope and impact of counterfeit parts on critical defense systems.
  4. The use of counterfeit parts in defense systems can compromise performance and reliability, risk national security, and endanger the safety of military personnel.
  5. 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.
  6. Industry’s reliance on unvetted independent distributors to supply electronic parts for critical military applications results in unacceptable risks.
  7. Weaknesses in the testing regime for electronic parts creates vulnerabilities that are exploited by counterfeiters.
  8. The defense industry routinely failed to report cases of suspect counterfeit parts, putting the integrity of the defense supply chain at risk.

Allowing that the report undoubtedly omits some evidence of the role of Congress and other government agencies contributing to problems, the report marshals considerable evidence to support these eight propositions. Initially, the report provides background on the sources of counterfeit parts, how they come into being, and the motivations of their purveyors. China is the dominant source of counterfeit electronic parts infiltrating the defense supply chain, and the Chinese government has failed to take steps to stop counterfeiting operations.

Consistent with the testimony received in the November 2011 hearings, the report describes the counterfeit parts industry in China as “open and notorious” and is highly critical of the government of China for failing to take meaningful action to stop the practice. In fact, the report points to ever more sophisticated counterfeiting technologies and detection methods. From raw material that, typically, is electronic waste collected from the U.S. and elsewhere in the developed world, China’s counterfeit electronics industry, principally in the Guangdong province, creates counterfeit parts by a combination of improper methods and disguised marking techniques, resulting in parts that may appear bona fide but suffer from many sources of discrepancy and unreliability.

Because so many counterfeit parts are imported into the U.S., the report explains how the 2012 NDAA seeks to prevent counterfeit electronic parts from entering into the U.S. supply chain by enhancing the inspection regime for imported parts and by authorizing government officials to share information with manufacturers.

The report provides a useful explanation of different dangers associated with counterfeit parts. Essentially, there is no way to predict how well counterfeit parts will perform, how long they will last, and the full impact of failure. Even counterfeit parts that appear to work when initially tested can fail when put into the more demanding environments often encountered by military systems.

The report examines why defense industry is vulnerable to counterfeit parts. An essential problem is that the DOD uses parts drawn from the commercial world, where the production cycle for individual components often is very short. Because defense contractors often require parts that are no longer are available from the manufacturer, or an authorized distributor, contractors have resorted to purchasing parts on the open market and from suppliers of dubious reliability.

The existence of well-documented practices, where “major” U.S. defense suppliers (and their subcontractors) have purchased thousands upon thousands of electronic parts from market sources lacking in controls or integrity, helps explain why the new legislation requires companies, whenever possible, to purchase electronic parts from original manufacturers or authorized distributors, or from “trusted suppliers” who earn that designation by satisfying qualification requirements that the DOD is responsible to establish and administer. The DOD is required by Section 818 to issue rules that include these requirements, by June 28, 2012, and contractors may identify their own trusted suppliers subject to audit by DOD officials and certain other conditions.

The committee identified approximately 1,800 cases of suspect counterfeit parts in the defense supply chain in 2009 and 2010. Only in 15 percent of those cases, however, were reports of suspect counterfeit parts submitted to the Government Industry Data Exchange Program. This reinforced the committee’s proposition that actual reporting of counterfeit parts incidents to GIDEP was “severely lacking.” The committee observed that GIDEP can be effective to inform suppliers about counterfeit parts and help in their removal, but is no more effective than it is actually used.

These findings are reflected in a provision of Section 818, which requires the DOD to issue regulations mandating that the DOD and contractors notify GIDEP, or other appropriate government authorities, within 60 days of becoming aware of, or having reason to suspect, a counterfeit part. Even before the due date for regulations required by Section 818, the DOD has acted to improve its own reporting. DOD Instruction 4140.01, issued on Dec. 14, 2011, states that “all occurrences of suspect and confirmed counterfeit parts will be documented in the appropriate reporting system to include the GIDEP.” Similarly, on March 16, 2012, Undersecretary of Defense (Acquisition, Technology and Logistics) Frank Kendall, issued a memorandum, “Overarching DoD Counterfeit Prevention Guidance,” that directs reporting to GIDEP of suspected or confirmed counterfeit items discovered by DOD activities.

Much of the report is devoted to a number of “Case Studies,” which illustrate the complexity of the counterfeit parts problem and the potential harm that the DOD can suffer in mission execution, readiness and in adverse cost consequences. Citing committee staff interviews and documents shared by the DOD and contractors, the report examines, in great detail, counterfeit part incidents involving the Navy’s SH-60B helicopters and P-8A aircraft and the Air Force’s C-130J and C-27J cargo aircraft.

Key findings of these case studies provide support for propositions advanced by the report. China frequently figures as the origin of the counterfeit parts studied. Many of the parts were out of production and unavailable from original makers or authorized suppliers, and instead were purchased from independent distributors. Less than adequate diligence was applied to the original source or distributor, in some cases. Counterfeit electronic parts found their way into important, even critical, systems installed in aircraft and delivered to military customers, introducing failures and failure risk.

In many of the cases cited, contractors reacted without evident urgency and GIDEP or other reporting systems were used inconsistently, if at all. Months, or even years, passed between initial indications of the presence of a counterfeit part and the eventual reporting of the same to the government and corrective action. Indeed, in some examples, the precipitating event for disclosure and corrective action was the Senate committee investigation.

Contractors’ response to indications of counterfeit parts was inconsistent, and the committee suggested that some contractors failed to appreciate the seriousness of the potential threat posed by counterfeits. Documentation of actions taken was shown to be uneven or incomplete and delayed notification up the supply chain detrimentally affected notification to the system customer or operator.

Taken collectively, these case studies help explain why the committee, in Section 818, requires the DOD to produce regulations, no later than Sept. 26, 2012, to require contractors to take responsibility to detect and avoid the use of counterfeit parts and to take corrective action or rework as required to remedy the inclusion of such parts. Section 818 also requires the DOD to issue regulations that require contractors to establish policies and procedures to “eliminate” counterfeits. Such policies are to improve training, inspection and testing of electronic parts, end proliferation of counterfeit parts, add mechanisms to ensure part traceability, and implement other supporting methodologies and systems.

The costs of counterfeit parts was examined in the context of the THAAD case, where memory devices, obtained from an independent electronics distributor, were found to have been installed in 50 Mission Computers delivered to the Missile Defense Agency (MDA) for its THAAD missile system. The cost of fixing the problem, $2.7 million, was charged to the government. The report cited, with apparent approval, the finding of the MDA that the counterfeits were introduced due to “inadequate authenticity rest requirements,” lack of adherence to the supplier’s internal inspection process, and the decision to purchase from brokers.

These findings provide context to understand a feature of Section 818 that makes prohibits the reimbursement of costs of rework and corrective action, and the costs of counterfeit parts. As explained in the report, the law will “[s]trengthen the incentive to avoid and detect counterfeit electronic parts by ensuring that the cost of replacing suspect parts is paid by contractors, not the government.”

There is little “new” in the report in the sense that the themes it explores were evident in the 2011 SASC hearings and are reflected in the provisions of Section 818. However, there is important information in the report’s very thorough presentation. It can serve as a guide to companies — and to the DOD — to understand the pernicious, changing nature of the threat of counterfeit electronic parts.

Because it shows systems, policies and process that did not work well — even if “legal” or representative of current practices — it should assist careful companies in self-evaluation and self-improvement. It also should inform the DOD in how to approach the rules it sets for DOD activities as well as for contractors.

At the same time, the report also points to key responsibilities that reside with the executive branch and which cannot be addressed by contractors. As China is the principal source of counterfeit electronic parts, the administration should act more vigorously to object, through diplomatic channels, to China’s continued tolerance of (if not support for) the counterfeiting industry.

Similarly, it is plain that U.S. Customs and Border Protection can do a much better job stopping this practice at our borders. Section 818 clarifies CBP’s authority to do so. The DOD also can assist by taking parts’ life cycle and availability into account in product design and specification, and by refraining from practices that have favored “least cost” acquisition of electronic parts for maintenance and repair, without due respect for supply chain assurance. Also, law enforcement can be more vigorous in prosecution of importers and distributors who knowingly attempt to distribute counterfeit parts.

The report gives all companies in the defense supply chain a lot to study and much to learn from. At the same time, the problem of counterfeit parts has many authors, and has had a long gestation. Care should be taken, in the rules that the DOD produces, not to unfairly shift the costs and consequences of the problem to industry. While strong corrective measures may be overdue, companies cited in the report undoubtedly were acting in good faith and in conformance with practices previously considered to be representative and acceptable.

--By Robert Metzger and Jeffery M. Chiow, Rogers Joseph O’Donnell PC

Robert Metzger leads Rogers Joseph O’Donnell’s Washington, D.C., office and focuses his practice in the areas of federal, international and state and local procurement. Jeffery Chiow is an associate in the firm's Washington office who focuses his practice on government contracts and government investigations.

The opinions expressed are those of the authors and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

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