DOD Gets Serious About Supply Chain Integrity

The issue of counterfeit electronic parts in the Department of Defense (DOD) supply chain has taken center stage in recent years given the performance and security concerns that such parts can pose. Hearings before the Senate Armed Services Committee in November 2011 revealed an “open and notorious” counterfeit parts industry and led to the inclusion of Section 818 in the FY 2012 National Defense Authorization Act (NDAA), which was enacted on December 31, 2011. Section 818, which was further amended by the 2013 NDAA, requires the DOD to implement regulations to define, identify, and prevent the use of counterfeit electronic parts in DOD procurements as well as limit the allowability of costs to replace, rework, or take other corrective action in connection with such parts. Notably, the risks and costs associated with these requirements will largely be placed on contractors.

Although final regulations have yet to be issued, the DOD issued proposed rules on May 16, 2013 and December 3, 2013 for industry consideration. As issued, however, the proposals, which raise more questions than they answer, place significant cost and performance risks (including breach, termination, and perhaps even false claims liability) on covered contractors and will almost certainly and significantly increase compliance costs

Proposed Rules for Implementing Section 818 of the FY 2012 NDAA

DFARS Case 2012-D055—May 16, 2013 Proposed Rule

The May 16, 2013 proposed rule (78 Fed. Reg. 28,780) sought to define certain key terms in Section 818 and would, if enacted as proposed, impose new requirements on contractors subject to the Cost Accounting Standards (CAS) or to CAS-covered contracts. Thus, the rule is aimed at larger contractors that perform cost-type work for the military.

Under the proposed rule, a counterfeit electronic part would broadly be defined as any “item from a legally authorized source that is misrepresented by any source to the end user as meeting the performance requirements for the intended use.” Moreover, under the proposed rule: (1) covered contractors would be required to have contract purchasing systems and procedures for detecting and avoiding the use of counterfeit electronic parts or suspected counterfeit electronic parts, and would be responsible for detecting such parts; (2) the government would be authorized to withhold payment if the contractor’s purchasing system fails to meet these requirements; and (3) any costs incurred to replace or rework counterfeit electronic parts would be unallowable. The requirements would be flowed down to subcontractors.

While there is a safe harbor to the regulations, it is limited and would apply only where contractors received the counterfeit parts from the government, have a DOD-approved counterfeit-detection and avoidance system, and where they provided early notice to the government of the counterfeits.

DFARS Case 2012-0352—December 3, 2013 Proposed Rule

The December 3, 2013 proposed rule (78 Fed. Reg. 72,620) requires covered contractors to abide by the quality standards selected by the contracting officer, which would be incorporated into the contract. Specifically, the rule states that “[t]he contractor must ensure that its deliverables meet all the specified quality standards, which also entails ensuring that its subcontractors adhere to the higher level quality standard where appropriate.” Accordingly, as proposed, a contracting officer may unilaterally specify the quality and testing standards that are to apply not only as to the contractor, but any subcontractors (at potentially any tier) based on the particular requirements and risk profile of the engagement. Moreover, the proposed requirements will likely also impact contractors’ purchasing systems, as any such higher-level quality and testing standards, if directed, would presumably be incorporated into those systems and subject to Defense Contract Audit Agency (DCAA) business systems reviews.

The Implications to Contractors From the Section 818 Proposed Rules

The regulations proposed for implementing Section 818 raise a number of significant issues.

The rules present significant financial ramifications. Covered contractors would be responsible for the costs of removing and replacing any counterfeit parts outside of the narrow safe harbor, in addition to incurring substantial costs to augment, or even wholly revamp, their purchasing systems, procedures, and controls to meet the new anti-counterfeit detection and avoidance requirements and any more stringent quality or testing standards required by a contracting officer, at both the prime and subcontractor levels.

There is no apparent limit on DOD’s authority to require expensive rework or even wholesale replacement of actual or suspected counterfeit parts, even when there is no demonstrable impact on performance, security, or system integrity.

Although the rules are directed at larger, CAS-covered contractors, their reach will likely extend beyond this class given the requirements to flow down “counterfeit avoidance and detection requirements” to all subcontractors, regardless of their size or whether they are CAS covered.

Because the rules incorporate counterfeit avoidance procedures as criteria for an acceptable purchasing system, a matter which DCAA reviews during business systems evaluations, a covered contractor’s failure to adopt sufficient procedures could result in the disapproval of its purchasing system and having payments withheld.

The rules lack the necessary specificity or detail to apply them with any acceptable predictability.The definitions for key terms such as “counterfeit electronic part,” “suspected counterfeit part,” and “trusted supplier” are poorly defined such that even new parts purchased from an OEM or other authorized source could still be deemed counterfeit.

Finally, the rules provide no specific standards, benchmarks, or best practices by which the DOD will approve a contractor’s purchasing system. The lack of meaningful guidance places contractors in an untenable position—contractors will have to make substantial investments to implement a counterfeit detection and avoidance system but have no assurances that the government will approve the system for safe harbor protection.

Given the morass of issues, it is unsurprising that DOD has invited stakeholders to attend another public meeting on March 27, 2014 to further discuss the “implementation of the requirements for detection and avoidance of counterfeit electronic parts,” including in particular, the definition and implementation of trusted suppliers. The DOD also indicated that it is preparing a final rule in connection with the May 16, 2013 proposal, so a final rule on the initial set of regulations may soon be forthcoming. However, the March 27 meeting could delay this effort. While there is much uncertainty regarding the direction the military will take to combat counterfeit electronics in its supply chain, we clearly have a long way to go before a fair, balanced, and workable system can be implemented.