On Friday, November 21st, 2014, FH+H Partner Jennifer S. Huber was quoted in a Law360 article titled, BAE-South Korea Row Offers Rare Look At FMS Failure.
BAE-South Korea Row Offers Rare Look At FMS Failure
By Andrew Westney
Law360, New York (November 21, 2014, 3:42 PM ET) -- An unusual complaint filed by a BAE Systems PLC unit claiming it doesn't owe a $43 million bond to the South Korean government after the country backed out of an F-16 upgrade contract with the company shows how the U.S. government’s typically reliable foreign military sales process can go awry, experts say.
BAE Systems Technology Solutions & Services Inc. claimed in Maryland federal court last week that an agreement between the U.S. government and South Korea for upgrades to the country’s F-16 fleet freed BAE from any obligation to pay South Korea for the bid bond, and that South Korea was actually seeking to hold BAE responsible for a hefty increase in the U.S. government’s estimated price for the upgrade program.
While BAE appears to have a good chance of prevailing in its complaint because the U.S. government is ultimately responsible for setting the pricing for foreign military sales contracts, taking the rare step of filing a complaint against a foreign government over such a contract could jeopardize the contractor’s entire relationship with the country, Jennifer Huber, a partner with Fluet Huber & Hoang PLLC, told Law360.
“The real danger here is that BAE has gotten the death penalty, whether they win or lose on the action,” Huber said.
Foreign military sales, known as FMS, require the U.S. government to run the procurement of a contract after negotiating an agreement with a foreign government. Alternatively, a foreign government can seek direct commercial sales, known as DCS, in which it negotiates directly with a contractor.
South Korea’s Defense Acquisition Program Administration, or DAPA, had originally envisioned contracting directly with BAE for its F-16 upgrade program after the company beat out Lockheed Martin Corp., the maker of the F-16 and the only other bidder on the contract, in a 2012 contract competition, according to BAE's complaint.
However, the U.S. government changed the contract to an FMS in 2013 due to the sensitive technology involved, a U.S. Department of Defense official told Law360.
The U.S. government sees the FMS program as a way to build connections with foreign governments, Robert Nichols, a partner with Covington & Burling LLP, told Law360. The Defense Security Cooperation Agency, which oversees the FMS program, does more than apply regulations in putting a foreign military sale together, he added.
“There’s some art to it,” Nichols said. “The DSCA is not simply about acquisition: It’s about security cooperation with our foreign allies, so relationships come into play.”
FMS offers foreign governments a sense of security in working through the U.S. government, which has vast experience in procurement, and offers contractors a buffer between themselves and the foreign government, Covington & Burling associate Jade Totman told Law360.
“FMS is great for some contractors in the sense that when a contractor enters into a direct transaction with a foreign customer, there are a lot of regulatory and legal requirements that the U.S. and foreign government all apply,” Totman said. Having an FMS contract with the government as an intermediary between the foreign government and the contractor “offers a bit of insulation from the liability that can come from that,” according to Totman.
However, foreign governments may not always feel they’re getting the best financial terms possible through the FMS process, Robert Metzger, a shareholder in the D.C. office of Rogers Joseph O’Donnell PC, told Law360.
“Foreign governments often believe that they will be able to get a better deal in a competition where they are dealing directly with the U.S. suppliers, who are able to sharpen the pencils and reduce the price to beat the competition,” Metzger said.
The DSCA takes pride in its “total package approach” through FMS, including not just particular defense items, but years of sustainment, training and related services, according to Totman.
“The problem is, particularly for sophisticated purchasers, that that can inflate the purchase price, and make a one-off transaction seem a lot more expensive and cumbersome,” Totman said.
In December 2013, the U.S. government signed a letter of offer and acceptance for a foreign military sale with South Korea that put an estimated value of $1.7 billion on the entire F-16 upgrade program, with BAE’s part of the deal worth about $1.3 billion and the U.S. government contributing about $400 million in services, according to BAE’s complaint.
In May, the U.S. Air Force awarded BAE a $140 million contract for the first phase of the two-phase upgrade program, calling for the company to provide initial development and long lead production for upgrades of 134 KF-16s for the South Korean military.
However, in August and September, the U.S. government notified South Korea that the overall price of the upgrades could go up by as much as $800 million to around $2.4 billion or $2.5 billion, the complaint alleges.
The increased cost estimate came from a more in-depth Air Force evaluation of the upgrades' costs based on historical data, the DOD official said.
Both DAPA and BAE disagreed with the price increase, according to the complaint. DAPA attempted to negotiate a restoration of the original price of the program with the U.S. government, and BAE proposed steps to the U.S. government to reduce the program cost, the complaint states.
BAE was still ready to complete the contract work under the terms of the December 2013 agreement between the two countries and blamed the dispute on “Korea’s strict budget limitations and the U.S. Air Force's conservative approach to the overall program cost," according to a company statement.
South Korea ultimately asked the U.S. government to terminate the contract for the first phase of the program on Nov. 5 and demanded that BAE pay the bid bond on the contract.
“This is a powerful example of what can go wrong in an international procurement when the purchasing country seeks the benefit of competition, and then finds that the result it thought it obtained in this procurement was undone by the FMS mechanism,” Metzger said.
While foreign governments often chafe at what they perceive as the extra costs of the foreign military sales process compared with working directly with a contractor, it’s rare for a government to go so far as to cancel a contract over its dissatisfaction as South Korea did, Metzger said.
South Korea’s decision to cancel BAE’s contract was highly unusual for the FMS process, the DOD official acknowledged, as the U.S. government takes pains to keep its foreign partners happy. The transition of the sale from DCS to FMS — an uncommon step — may have played a role in the deal's falling apart, as the involvement of the U.S. government entails a different methodology centered on its all-inclusive approach to procurement, including training, sustainment and system integration, the official said.
The Air Force wasn’t involved with pricing the contract from the beginning of the bid process, when South Korea was intent on a direct sale to BAE, which may have led to a larger increase in the price estimate once the service became involved in evaluating the FMS deal agreed to in December, the official said.
In its complaint, BAE claimed that the letter of offer and acceptance between South Korea and the U.S. government freed BAE from any obligation to pay the bond under the terms of separate agreements, called letters of guarantee, between BAE and the country. South Korea insisted that BAE continue to sign new versions of the guarantee requiring it to pay for the bond if it failed to execute the contract after being awarded the bid, long after the bid process was over, the complaint states.
BAE reluctantly continued to accept the language in the guarantee regarding the bid bond that had been agreed to when the contract was intended to be a DCS because South Korea was unlikely to trigger the bid bond payment provision by presenting a direct contract for the upgrade program to the company, according to the complaint.
FMS program rules governing the agreement mean that the country couldn't have a direct contractual relationship with BAE and isn't allowed to seek relief from the company, according to the complaint. DAPA based its claims "not on an alleged violation of the terms of the guarantee, but on BAE TSS’s inability to force the U.S. government to withdraw its proposed price increases,” the complaint states.
Once South Korea chose to structure the upgrades as an FMS and entered into its 2013 agreement with the U.S. government, DAPA wasn't allowed to enter into any contractual relationship with BAE or interfere with the U.S. government’s control of pricing for the contract, according to the complaint.
BAE’s arguments appear to be strong, as the letter of offer and acceptance between the U.S. and Korea means that the U.S. government controls the price of the contract, Huber said.
“It certainly appears that what happened was that the customer was trying to hold BAE to terms that were applicable to the DCS case and not the FMS case, and that they were trying to use leverage to get the U.S. government to lower the price or honor the original price, depending on how you look at it, and it didn't work,” she said.
Contractors will be closely watching the case because if BAE were to lose, companies will have to factor more risk into their bids for foreign business, Huber said.
Metzger said the South Korea-BAE dispute, in which the contractor may have lost out on the deal after not doing anything wrong, could be a case where the U.S. government’s well-meant mechanisms for foreign military sales have worked counter to their purpose of solidifying the country’s security relationships.
“It may be time to take a hard look at some of those so we don’t lose the opportunity to make these sales and don’t disappoint our allies with what they consider to be an unfair price,” Metzger said.
--Editing by Edrienne Su.