5 Potential Pitfalls For Defense Cos. In Emerging Markets
By Erica Teichert
Law360, Washington (September 23, 2013, 5:52 PM ET) -- Foreign markets have become a larger portion of defense and aerospace companies' revenue strategies as the U.S. tightens its defense budget and winds down its military involvement with the Middle East. But firms unaccustomed to operating outside the U.S. may not realize they're treading into complex and sometimes murky legal and regulatory waters. Here, attorneys share with Law360 five factors firms should keep in mind as they venture into emerging markets.
Confusion Over U.S. Export Laws
The U.S. has an extremely robust export control system that could cause defense firms some headaches as they navigate licensing requirements and export restrictions governing their international sales, especially for some of the hottest products, according to attorneys.
In particular, Covington & Burling LLP's international trade and finance group co-chair Peter Lichtenbaum noted that the U.S. has "significant" export controls governing the unmanned aerial vehicle industry as well as a ban on defense sales to China.
"Even if it's not a defense technology, it could still be controlled by [the U.S. Department of Commerce] as a sensitive civil technology," Lichtenbaum said. "One real issue for American firms as they do joint ventures with Chinese companies in the aerospace area is lack of transparency in China regarding whether companies are doing civil work or military work or both. The aerospace sector in China has a lot of government involvement."
Thanks to those potentially blurred lines, American companies have to be hypervigilant that their activities don't run afoul of U.S. laws.
Similarly, some defense contractors have had to worry about ambiguity in the International Traffic in Arms Regulations, which is currently undergoing a major overhaul that could lighten the regulatory burden hanging over some defense products. The new standards for aircraft, gas turbines and related components will take effect Oct. 15 with further reform waves coming in the future.
"I think the current reform efforts are a wonderful step in the right direction and hold promise for making it easier for U.S. companies to do work overseas while at the same time protecting U.S. security interests," said Francis Hoang, managing partner at Fluet Huber & Hoang PLLC.
While ITAR regulations shouldn't prevent defense and aerospace firms from considering foreign deals, Sutherland Asbill & Brennan LLP partner Jeffrey P. Bialos said companies need to be prepared to put in time and effort to understand the full scope of the regime. "In general, the ITAR has — rightly or wrongly, fairly or not — been perceived as a barrier to international cooperation," he said. "They've been doing some degree of reforms, but fundamentally it's a very hard system to penetrate. For companies that haven't done it, it takes infrastructural time and effort."
Running Aground of FCPA
The Foreign Corrupt Practices Act is another major regulatory compliance regime that defense and aerospace firms must keep in mind as they consider foreign market opportunities, as the law has become a strong weapon in the U.S. Department of Justice's anti-corruption arsenal.
While some foreign countries may encourage bribes or other unethical behavior as a means to secure a deal, falling prey to such tactics could cause significant penalties back home for American companies.
"The FCPA has been and will continue to be a significant factor in the defense markets," Bialos said. "There will continue to be quite a number of cases as long as you've got governments with an environment that's conducive to this on the demand side of the equation."
Attorneys also noted that companies should carefully monitor their local investment requirements in foreign markets to make sure they don't violate the FCPA.
"It's a real risk these countries have to manage to make sure their own sales forces and their partners fully understand what is allowable and what is not as a matter of U.S. regulation and corporate policy," Lichtenbaum said.
But by performing necessary due diligence, firms should be able to nix any deals that would violate FCPA standards, attorneys noted.
"It's not necessarily an inhibitor — it just means people have to be very careful that they're compliant and that they know what they're doing and they have good compliance procedures," Gibson Dunn partner Howard Adler said.
Discord Between Local Investment Rules and U.S. Law
Beyond U.S. regulations, defense and aerospace contractors can also run into snags due to their desired markets' local laws, ranging from Sharia law in Saudi Arabia to offsets requirements or other foreign investment rules in many countries.
According to Squire Sanders' aerospace and defense industry chair George N. Grammas, Sharia law can affect how contractors can terminate a representative in Saudi Arabia.
"There might be a decision from a local judicial authority that, notwithstanding the termination clause in your contract, you might be liable for additional winding-down costs or expected profits that the representative thought they would earn," he said.
While the United Arab Emirates doesn't have the same Sharia drawbacks, Grammas noted it has its own joint venture complications.
According to Bialos, several countries also have laws preventing too much foreign investment in their defense industries, including France and Germany. Countries also may favor their own domestic companies by using closed procurement processes or preference legislation.
"Every market, there's always the risk that product standards, tariff barriers [and] nontariff barriers could become trade barriers," he said.
Companies also have to carefully watch what offset payments they are required to make, both to be sure they don't violate the FCPA and that their profits don't take an undue hit, Lichtenbaum said.
"You have to figure out how to do something that's not necessarily in your business plan [and] do so in a way that doesn't cost you as a company an arm and a leg and doesn't result in any ethical issues itself," he said. "It's important to integrate your FCPA requirements with your offset program."
Lichtenbaum noted that companies looking to enter foreign markets have a lot of potential resources for legal and regulatory advice, ranging from law firms to agency officials to U.S. embassies in the country at issue.
"It's a credit to recent secretaries of state that they've placed a much higher priority on the role of the State Department assisting American business," he said. "It's really paying off for smaller companies."
Unclear Conflict Resolution Agreements
Like any other contract, defense and aerospace firms need to plan their conflict resolution procedures before cementing any deal. While some countries may require companies to work out any disputes within their courts or arbitration centers, companies need to know all of their options and push for a neutral environment whenever possible, attorneys said.
According to McKenna Long & Aldridge LLP partner Allen B. Green, expatriate defense firms shouldn't run the risk of having any contract disputes decided in foreign courts, and they won't have the ability to launch bid protests in emerging markets. Instead, they should seek clauses in their contracts that provide that all issues will go through arbitration in a neutral setting if possible.
"It's safer for both parties at the end of the day," he said. "That's what the U.S. seller wants to happen to resolve any dispute."
He recommended that any defense companies considering foreign work place a major emphasis on good contract management and even keep a solid checklist of any laws or issues they need to monitor at any stage of the agreement.
"I don't think there are any showstoppers," Green said. "The whole objective is to manage the risk so you have a profitable contract."
Other attorneys also urged companies to seek outside counsel that has a deep background in the rules and regulations surrounding the country they're working with to prevent any unnecessary problems.
"Every country has its own set of challenges and specific requirements," Hoang said. "Before you do work or even attempt to do work in any specific country, find someone there who has an expertise in that country. Tap into their experience."
Risk of Political Unrest or Displeasure
Beyond the known regulatory and legal complications surrounding emerging markets and foreign defense contracting, Hoang noted that political unrest and instability can create risks in companies' business plans. But those risks could also provide great rewards to adventurous contractors.
"It can obviously be challenging to do business in a country where you don't have the legal and security framework. But for that very reason, there's less competition," Hoang said.
In Hoang's practice, he's seen that smaller defense companies are more likely to plunge into instable markets, which gives them a competitive edge on their larger competition.
"They're willing to go in early and they believe because of their relationships or their expertise in emerging markets, they can navigate those murky waters and get ahead of more established companies who tend to wait a little bit longer," he said. "There are experts and advisers who can help companies navigate those areas."
But the political risks aren't just coming from the emerging countries, according to Adler. As foreign countries turn to the U.S. private defense industry for "self-help" fixes rather than relying on the strength of the U.S. military, private involvement could raise the ire of politicians at home.
"There can be a domestic political risk because Congress may not like some of these transactions," he said. "That's always an inhibitor."
--Editing by Katherine Rautenberg and Sarah Golin.
This article originally appeared in Law360 at: http://www.law360.com/articles/469025