The Securities and Exchange Commission and the Department of Justice have conducted sweeps of the energy and the pharmaceutical industries looking for potential violations of the Foreign Corrupt Practices Act. Based on risk, the defense industry could be next.
A new benchmark report examining global corruption risks in the defense sector reveals that most governments are still in their infancy when it comes to anti-corruption measures, leaving defense companies vulnerable in these countries.
According to the report conducted by Transparency International, 57 of the 82 governments it assessed are at a high or even critical risk of corruption. The TI report graded each country “A” through “F” based on a detailed assessment of 77 questions that covered five prominent risk areas, including political, financial, personnel, operations, and procurement.
Mark Pyman, director of Transparency International U.K.'s Defense and Security Program, says the idea for the index came about because more and more defense companies and defense officials genuinely want to improve their anti-corruption practices. “They're always asking us, ‘how can we measure our progress in combating corruption in this sector?'” says Pyman.
According to the index, Germany and Australia are the only countries that earned an “A.” This means the country is “accountable to their citizens” and “transparent about their spending and activities, and have strong controls in place to combat corruption that are actively enforced,” the report said.
About 30 percent of the countries have generally high or moderate transparency, getting Bs and Cs, meaning that they address at least some corruption risks. Other low-risk countries, for example, include the United States, Austria, Britain, Sweden, South Korea, Norway, and Taiwan.
Attributes of countries in these groups include shortcomings in managing corruption risks in field operations; a lack of well-trained and experienced procurement officials; evidence that acquisition decisions are political in nature; and the use of non-transparent spending for major portions of the defense spending.
“While the Department of Defense and national security agencies are successful in minimizing corruption risk through adoption and effective enforcement of codes of conduct, greater efforts must be made to safeguard the procurement system and increase the transparency of the defense budget,” Claudia Dumas, TI-USA's president and CEO, said in a prepared statement.
“The business community has been very slow in coming to grips with these offset programs. That's a big problem in its own right.”
—Mark Pyman,
Director of the Defense and Security Program,
Transparency International
A majority of countries (69 percent) scored in the bottom three grades—D, E, and F—lacked basic accountability measures. These countries includes 20 of the largest 30 arms importers in the world—such as India, United Arab Emirates, Singapore, Thailand, and Turkey—and 16 of the largest 30 arms exporters—such as China, Russia, and Israel.
Prevalent Risks
Defense companies should use the new index as a tool to identify their highest risk areas. “Based on that, they can devote more training, auditing, resources, and tighter controls in those more challenging countries,” says Jack Shane, a partner with law firm Wiley Rein.
Procurement in the defense sector is especially complex and poses unique risks that are often poorly controlled by governments, the TI report found. Thus, when it comes to entering into contracts, Pyman recommends that defense companies tailor their anti-corruption controls to the country in which they do business in.
If you're entering into a contract with one of the “critical risk” countries, “you need to put as many precautions and safety checks that you possibly have into place around the contract to make sure you're not at risk of corruption,” Pyman says. “On the other hand, if you're doing a contract with Australia or Germany, you probably don't need as many controls.”
One particularly common—but often ignored—risk in the government defense sector is offset contracts. Offset contracts are arrangements made between a government and a company in which the company must reinvest a percentage of the main contract back into the country.
TYPES OF CORRUPTION RISK
Transparency International's “Government Defense Anti-Corruption Index” found varying degrees of corruption risks for the five risk areas:
Political corruption risk: The capacity of legislatures to hold defense establishments to account is severely limited. There are minimal formal mechanisms for scrutiny of defense policy in 45 percent of countries, and evidence of highly effective mechanisms in only 12 percent of countries studied.
Financial corruption risks: Considerable secrecy surrounds finance in defense and security. Three quarters of countries examined do not publicly reveal the percentage of secret defense and security expenditure.
Personnel corruption risk: Over 70 percent of the countries examined possess robust payment systems, and in nearly 90 percent of countries at least some formal measures are in place for personnel found to have taken part in corruption. However, significant improvements are necessary to support whistleblowers in the defense sector. Whistleblower protection is lacking in 76 of the 82 countries examined. In addition, very little attention is paid to better preparing personnel in sensitive positions, such as increasing staff rotation and training.
Operations corruption risks: The overwhelming majority of nations lacks any military doctrine addressing corruption risk on operations and have not institutionalized anti-corruption training or monitoring mechanisms for use in the field.
Procurement corruption risks: Serious challenges are observed in this key risk area. Transparency is largely absent and proper controls of complex components of the procurement cycle, including subcontractors, brokers, financing packages, and offsets programs, are often lacking.
Source: Transparency International.
A case in point: If a deal is worth $100 million, the government might require the contractor to invest an additional $50 million into developing goods or services in the country. In the process of that deal, however, the government official may neglect to inform you that a close relative sits on the board of the sub-contractor that is receiving the offset, for example, “so there are lots of potential corruption risks in these offset programs,” says Pyman.
In the TI index, only 10 percent of governments impose stringent due diligence requirements on contractors during offset contract negotiations and assess offset contract performance with audits. Forty-five percent of governments do not impose any due diligence or auditing requirements on offset contracts.
“The business community has been very slow in coming to grips with these offset programs,” says Pyman. “That's a big problem in its own right.”
To reduce corruption risks, a company must engage in the same level of due diligence as it would with the prime contractor, advises Kelly Currie, a partner with law firm Crowell Moring. “Who are the individuals carrying out the offset contract? Who are the beneficiaries? Where is the money really going?” he says. More likely you have to hire someone with the capacity to do that type of investigation for you on the ground in that country,” he says.
Currie says over the last few years, companies are getting better at their due diligence efforts when it comes to offset contracts. They're becoming “much more attuned” to offset contracts and “putting a lot more effort and documentation” into their due diligence processes, he says.
Shane further advises that companies conduct additional due diligence if using third-party agents in those high-risk countries. In addition, training people on the ground—such as sales representatives and brokers—so that they understand and abide by the company's anti-corruption policies and procedures is “absolutely critical,” he says.
Such due diligence is especially important given that the TI index revealed that 35 percent of countries have either ineffective restrictions—or no restrictions at all—on the use of agents and intermediaries in the procurement cycle. Another 40 percent have some controls over the participation of agents and intermediaries, but enforcement may be weak. Just seven countries strongly control and limit the use of agents, or forbid them altogether.
Lack of whistleblower protections is another prominent risk in the defense sector of the majority of governments, making it all the more important for companies to have robust internal whistleblower protections in place. In the TI index, governments were scored based on the following questions: Are whistleblower facilities in place? If so, are they effective? If they are effective, what proof is there that they've been used and have worked well?
Based on the answers to these questions, only three governments—Germany, Norway, and Singapore—received the highest scores for actively encourage whistleblowing. Other countries that scored well include the United States, Australia, and Taiwan.
Currie advises that every company should at least have in a place a mechanism for employees to report concerns anonymously. Employees should have the option of reporting through e-mail or by phone, he says.
Those are just a couple of the most common risks in the government defense sector; using the entire index as a benchmark allows for “a much more educated discussion” when negotiating government contracts, Pyman says, and “puts compliance professionals much more center stage” when it comes to helping their companies gain a competitive business advantage.
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