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RJO Update: Government Contracts
June 2012

DoD’s Counterfeit Parts Rule Is Coming Soon

By Robert S. Metzger and Jeffery M. Chiow


A Senate Armed Services Committee (SASC) investigation into the national security threat posed by counterfeit parts from China and elsewhere that end up in the U.S. military supply chain led to the passage late last year of Section 818 of the 2012 National Defense Authorization Act (NDAA).1 Under Section 818, contractors must establish robust compliance policies and procedures and are made responsible for the costs of counterfeit electronic parts and the associated costs of rework and corrective action. The final report of the SASC’s investigation, released May 21, 2012, provides compelling evidence of the need to reduce the vulnerability of the Department of Defense (DoD) supply chain to counterfeit electronic parts. Congress’s first effort at addressing the problem shifts primary responsibility for costs and risk to government contractors, subcontractors and suppliers. As enacted, Section 818 does not provide any “safe harbor” for contractors that comply with the spirit and letter of the law, even those whose counterfeit detection and avoidance systems receive DoD approval and purchase only from original parts manufacturers or their authorized distributors if, for any reason, their products are determined to incorporate a suspect or counterfeit part.

Responsible contractors have some cause for hope, as the House-passed version of the 2013 NDAA would amend Section 818 to provide that the costs of counterfeit parts and their remediation would be allowable in some circumstances. Contractors would not have to bear those costs alone if (i) the cost was incurred by a contractor with a DoD-approved system to detect and avoid counterfeit electronic parts; (ii) the contractor purchased electronic parts only from original equipment managers (OEMs), their authorized dealers or designated “trusted suppliers,” and(iii) the contractor provided timely notice of any suspect or counterfeit electronic parts to DoD. On May 24, 2012, the SASC announced completion of its version of the 2013 NDAA which did not incorporate any such “safe harbor” provision. Thus, it remains to be seen whether the final version of the 2013 NDAA will amend Section 818.

Whatever changes the future may bring, contractors anticipating implementation of new compliance rules required by Section 818 currently have much of the information they need to build or strengthen policies and procedures to detect and prevent the introduction of counterfeit electronic parts. Guidance for compliance efforts can be found in the SASC Report, other reports by GAO, federal agencies and industry, implementation actions by DoD, and recommendations from standard-setting organizations.

WHAT THE LAW REQUIRES

Section 818 sets two important deadlines. First, within 180 days of enactment (June 28, 2012), DoD must complete an assessment of its internal policies and systems for the detection and avoidance of counterfeit electronic parts. DoD also must issue “guidance” on agency measures to minimize acquisition risk and establish remedial actions to be taken when counterfeit parts are detected. Ninety days later (September 26, 2012), DoD must revise the DFARs to address the detection and avoidance of counterfeit parts. Those regulations will impose new requirements upon contractors, for which they should now be preparing.

IMMINENT RULES FOR CONTRACTORS

To mitigate risk, “whenever possible,” Section 818 requires DoD and all DoD contractors and subcontractors to obtain electronic parts from OEMs or their authorized dealers or from “trusted suppliers” that obtain parts exclusively from OEMs or their authorized dealers. Electronic parts no longer in production also must be purchased from such trusted suppliers. Whenever purchase from these reliable sources is not possible, contractors must notify DoD and the electronic parts must be inspected, tested and authenticated.

Under Section 818, DoD is required to establish qualification requirements to identify trusted suppliers. Contractors and subcontractors are allowed to identify additional trusted suppliers so long as their trusted supplier programs comply with industry standards and are subject to audit by DoD. Contractors must assume the responsibility for authenticity of parts from any source, as Section 818 provides no safe harbor from the rule that the costs of counterfeits and associated corrective action or rework are unallowable, no matter what precautions contractors take.

Whenever contractors know or “have reason to suspect” that they have received counterfeit electronic parts, they are required to make a written report to the appropriate government authorities and the Government Industry Data Exchange Program (GIDEP), or a similar incident reporting database, within 60 days. Section 818 encourages contractor reporting of suspected counterfeit parts by barring lawsuits by the supplier of a part reported as counterfeit, where a reporting contractor makes a “reasonable effort” to determine that the item contained counterfeit electronic parts.

Section 818 requires contractors to establish policies and procedures to eliminate counterfeit electronic parts from the defense supply chain.2 These new contractor systems will need to address several areas including:

  • training personnel
  • inspection and testing of electronic parts
  • processes to “abolish counterfeit parts proliferation”
  • mechanisms to enable parts traceability
  • use of trusted suppliers
  • reporting and quarantining counterfeit and suspect counterfeit electronic parts
  • methods to identify suspect counterfeit parts and rapidly confirm or deny suspect counterfeit parts
  • design, operation and maintenance of systems to detect and avoid counterfeit and suspect counterfeit parts, and
  • flow down of counterfeit detection and avoidance requirements to subcontractors.

Section 818 requires DoD to establish a process to approve or disapprove these new contractor systems.

DOD’S INTERNAL ASSESSMENT

Under Section 818, DoD must first establish Department-wide definitions of the terms “counterfeit electronic part” and “suspect counterfeit electronic part.” Second, DoD must implement a risk-based approach for its own procurement personnel to minimize the impact of counterfeit electronic parts. Third, for suppliers who fail to demonstrate supply chain integrity, DoD must issue or revise guidance to consider, among other things, suspension and debarment. Fourth, DoD must establish a reporting system for government employees and contractors to make written reports to appropriate government officials and GIDEP (or similar) within 60 days of discovering suspected counterfeit electronic parts. Fifth, DoD must also develop a process to analyze, assess and act on those required reports.

DoD has already defined “counterfeit materiel” and included the definition in a March 16, 2012 Memorandum signed by the Undersecretary of Defense for Acquisition Technology & Logistics (AT&L), titled “Overarching DoD Counterfeit Prevention Guidance.” In the memo, DoD addresses several requirements of Section 818. These include mandatory government notice, testing and verification when “critical items” are not obtained from the original manufacturer or an authorized distributor; DoD evaluation of counterfeit risk and implementation of countermeasures; identification and application of industry anti-counterfeiting standards; GIDEP reporting; DoD handling of counterfeit incident notifications; quarantine and disposition of suspected and confirmed counterfeit parts; and DoD training.

OTHER GUIDANCE AVAILABLE TO CONTRACTORS

While the law leaves implementation to DoD, the detailed requirements set forth above and in DoD’s Overarching Guidance memo provide an excellent core around which contractors can shape their counterfeit detection and avoidance policies and procedures. Further, the SASC Report provides a thorough introduction to the history and current state of the counterfeit parts problem and offers lessons learned by major defense contractors. Prior reports from such sources as GAO, the Department of Commerce, industry groups, consultants and supply chain scholars offer additional context for companies seeking to understand the counterfeit parts problem. The authors of this Update have written comprehensive summaries that are to be published this summer.

While DoD has not, and may not, adopt a particular industry standard for counterfeit detection and avoidance, there are published and draft standards that provide contractors a starting point to examine their current or proposed policies. A standard for aerospace adopted by NASA and DoD and cited approvingly by the SASC Report, AS5553, is a good place to start. A sound policy to detect and avoid counterfeits will likely include the following:

  • supplier certification based on a third-party standard
  • auditing suppliers and reviewing business references
  • tracing parts back to the place of origin
  • reporting to and consulting GIDEP
  • material inspection and quality control
  • developing or hiring anti-counterfeit expertise.

WHAT TO DO WHILE WAITING FOR THE NEW REGULATIONS

When DoD issues regulations in September, they are likely to arrive as Interim Rules and may be effective immediately. It is not clear what opportunity industry will have to respond pursuant to “notice and comment” requirements. Application of the law will be very different across the diverse landscape of suppliers and their vendors which constitutes the affected “defense industrial base.” As Section 818 is rolled out, RJO will be closely examining the proposed regulations and assessing how the new rules will affect company functions including; purchasing, supply chain management, materiel management and QA, as well as considering overall business risk.

Even before the new regulations are published, companies can get a head start and ease their ultimate costs of compliance and the challenges of new system implementation while at the same time reducing their counterfeit parts liability. In this regard, there are key questions to consider: Where are our existing products at risk of counterfeits? What can we do to establish stronger vendor controls? Can we influence future designs and specifications to minimize exposure? What actions are necessary now to sample, inspect or test our inventory? Do we have a disciplined approach to risk-based assessment of where counterfeits might be and where the greatest harm could occur? Are our counterfeit detection and avoidance policies and procedures clearly defined to require reporting and remedial action, and do personnel understand these requirements?

How We Can Assist

If you have any questions about this subject, please contact Bob Metzger (rmetzger@rjo.com) and Jeff Chiow (jchiow@rjo.com). Bob and Jeff who regularly represent and counsel defense and aerospace companies have made numerous presentations to leading industry organizations and have authored several articles on the new counterfeit parts law. These articles are available on our web site, at http://www.rjo.com/govcontracts.html. Please visit our web site now and in the future as we continue to track and analyze developments in counterfeit parts law.

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1 Pub. L. No. 112-81 § 818 (introduced as Amendment No. 1092 to S. 1867, 112th Cong., 1st Sess).

2 Section 818 applies to all tiers in the supply chain and to every electronic part where the end item is to be sold to DoD under a contract covered by the Cost Accounting Standards. The law speaks of detecting and avoiding counterfeit parts, but requires that contractors establish systems to eliminate them. 


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