Offset faces crisis

Offset is a word that has been used in the media for years in all forms and contexts. For some it is a blessing, for some a curse and a ball and chain for others. It has been present in the Polish legal order for twenty two years, was seriously remodelled seven years ago and now it is hit by evident crisis. What can we say about the offset act of 2014 today?

What is offset?

Offset (or compensation) is a mechanism used in international transactions, providing for the compensation of expenses incurred by one of the contractors by the other party to the contract. Offset is widely used around the world for the sourcing of defence-related products. To simplify, as the offset mechanisms used by individual States differ in details, the offset provides that the expenses incurred by one party (state) for the purchase of the weapons system, the other party to the contract (another state or a foreign supplier) should compensate in the form of investments in the buyer’s economy (in particular the defence industry), whereby such compensation most often takes the form of the transfer of modern technology important from the point of view of national defence and security, technology enabling the acquisition of competences in the field of servicing, modernization and modification, and sometimes also independent production of the purchased weapons, as well as the inclusion of domestic undertakings in the seller’s global logistics chains.

In other words, the offset is intended to compensate the domestic economy of the ordering country for the lack of orders for a given product in the domestic industry.

As I mentioned, offset is a common practice in the world and it is estimated that offset mechanisms are used in at least 80 countries. Sometimes this number is estimated at 120-130 countries.

European legal basis

In the European Union, the basis for the use of offset mechanisms is Art. 346 paragraph. 1 lit. b) TFEU¹, which gives each Member State the freedom to choose measures to protect essential security interests which relate to the production or trade in arms, munitions or war material, provided that such measures do not adversely affect the conditions of competition on the internal market with relation to products which are not exclusively intended for military use.

Pursuant to this provision, the Member States are authorized to exclude, by way of a unilateral act (and thus, in the Polish reality, by means of legislative acts), the production and trade in arms, munitions and war material from the general rules of the internal market. This provision constitutes a breach from the general principles of non-discrimination that lay at the foundations of the European Union, as it allows Member States to apply practices that protect their own national arms industry. Without going deeper into the considerations about this very interesting provision of the TFEU, it should be noted that one of the measures referred to in this provision, is offset. Indeed, offset is a tool to protect the basic security interests in the field of production and trade in weapons, as it can provide the industry with access to the latest technologies and to global markets.

Offset alla polacca

On 30 July 2014, a new offset act² entered into force, which remodelled the offset system already well-established in Poland, although its initial reading indicates that this act is in fact a profound amendment to the 1999 act³. The Minister of Economy was replaced by the Minister of National Defence as the head of the ministry responsible for compensation.

While creating the new offset law, great importance was attached to ensuring the compliance of its provisions with Art. 346 TFEU. This was done through two main changes, namely the resignation from the category of indirect offset liabilities and the exclusion of automatic approach in applying the offset.

Offset only direct and justified

The exclusion of the indirect offset means that now the entire offset should go to the defence industry. Thus, the offset ceased to be an instrument compensating the domestic economy for the fact of placing an order abroad, but became associated with the defence sector. This change should be evaluated positively, because currently all compensation benefits must go to the branch of the economy that is directly “affected” by placing an order with a foreign supplier.

According to Art. 7 paragraph 4, the application of offset requires a justification drawn up by the minister managing the department of administration, competent for the contracting authority. On the one hand, such a solution allows the minister of national defence some flexibility in the selection of measures that are to secure the basic interests of state security, but on the other hand, it involves the risk of shaping orders in such a way that the use of offset will appear unprofitable and redundant. The preparation of justification for the application or non-application of the offset itself is preceded by a long and complicated procedure of assessing the existence of the basic interest of state security. The evaluation procedure involves a number of organizational units of the Ministry of National Defence, including the Armament Inspectorate of the Ministry of National Defence and the Support Inspectorate of the Ministry of National Defence as the ordering party (in most cases).

The procedure in which the contract will be performed depends on the assessment of the existence of the basic interest of state security, and, consequently, on the justification for the application of the offset. In the case of a negative assessment, the contract will be subject to the provisions of the Public Procurement Law⁴, while in the case of a positive assessment – it will be subject to Decision No. 367 / MON⁵ and as a result – the offset act.

Freedom or latitude?

Although, from the point of view of compliance with the provisions of the TFEU, the legislator’s resignation from the automatic application of offset at each purchase of military equipment abroad should be assessed positively, in light of the provisions of the 2014 offset act, in my opinion, there is a certain risk related to the assessment of the basic interest of state security and the justification for the application of offset.

The provisions on these procedures, both contained in the act, as well as in the executive regulation⁶ and the decision⁷ of the Ministry of National Defence, are relatively general and do not contain detailed guidelines on how to perform such an assessment. The regulations give far-reaching freedom to the authorities authorized to assess and justify the necessity to apply offset. Although the regulation contains a list of components justifying the application or non-application of the offset, in my opinion there was no precise definition of the weight of individual criteria or, for example, the method of their assessment

I am far from criticizing a priori any manifestations of the discretionary powers of administrative authorities, however, in the case of offset, where on the one hand the basic interests of state security are at stake, and on the other – the interests of the Polish defence industry, i.e. key issues for the entire security and defence system of Poland, those broad discretionary powers should be included in a certain specific framework that will allow such an assessment to be made in an objective and clear manner.

Meanwhile, it seems, the freedom granted by the regulations in assessing the existence of the basic state security interest and in justifying the use of offset, unfortunately, drifts towards arbitrariness, which in the end may turn out to be fatal.

In recent years, a growing reluctance of the Ministry of Defence and the contracting authorities (especially the Armament Inspectorate) towards the offset may be seen⁸. This approach can be understood to some extent. The decision to use the offset inevitably lengthens the entire process of acquiring the weapons system, because negotiations on the supply contract involves sometimes tedious and long-lasting negotiations of the offset liabilities. Offset also often increases the price of the purchased system, which in turn may speak for issuing a justification for not using the offset in a given case.

With or without offset

However, this seems to be a double-edged sword. On the one hand, issuing an opinion about the lack of the basic interest of state security and, consequently, the justification for not using the offset may result in ordering and purchasing a given weapons system at an attractive price and relatively quickly. On the other hand, such a decision will, in a large number of cases, cause that both the contracting authority and the entire Polish defence industry will make a loss. Why the ordering party? Well, by purchasing a ready-made “off-the-shelf” system, the ordering party will become dependent for many years on a foreign supplier as regards the inspections, repairs, modifications and modernizations. As a consequence, throughout the entire life cycle of the equipment which is currently 20-30 years on average, the contracting authority will incur very high costs of maintaining its efficiency and modernity. And it is known that total cost of acquiring and operating a modern weapons system is distributed roughly in the following proportions: 1/3 – purchase cost, 2/3 – operating cost throughout its life cycle.

The negative consequences of such a decision for domestic defence industry are obvious and do not require further comment. No license, no technology transfer and the related competences in the field of servicing, modernization or production of components or the entire systems, and no participation in global supply chains speak for themselves.

Unfortunately, in my opinion, imprecise provisions of the offset act and insufficiently detailed guidelines contained in executive acts provoke too hasty resignation from the use of offset in many cases. Unfortunately, what was supposed to be a gate allowing for some decision-making freedom now turns out to be a wide open or a battered down gate that allows avoiding offset at all costs, what for the Polish defence industry, constantly hungry for new technologies, new products and new quality, may turn out to be disastrous.

Summary

The offset act currently in force, which in fact turns out to be a thorough amendment to the 1999 act, although it is a step in the right direction from the point of view of compliance with Art. 346 paragraph. 1 (b) TFEU, leaves much to be desired as regards the precision of its definitions and the transparency of the procedures which decide whether or not to apply the offset in a specific case. It remains to be hoped that this is only a temporary act, which will be replaced by a completely new, precise law, or perhaps by provisions of a law that will comprehensively regulate our national defence potential. For now, however, we can only keep our fingers crossed for the Polish defence industry and hope that in subsequent proceedings for the acquisition of new weapons systems (and at least a few such procedures are on the horizon), positive opinions will be issued, resulting in the justification in favour of the use of offset.

Author:

Piotr Dudek
Director of the New Technologies Department, Defence & Aerospace
TGC Corporate Lawyers

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[1] Treaty on the Functioning of the European Union of 25 March 1957, including the changes introduced by the Treaty of Lisbon of 13 December 2007

[2]  Act of 26 June 2014 on certain contracts concluded in connection with the execution of orders of fundamental importance for state security (Dz.U.2019.1379)

[3] Act of 10 September 1999 on certain compensation agreements concluded in connection with supply agreements for the purposes of national defence and security (Dz.U.2013.716)

[4] Public Procurement Law of 11 September 2019 (Dz. U. item 2019)

[5] Decision No. 367/MON of the Minister of National Defence of 14 September  2015 on the rules and procedure for awarding contracts of primary importance to state security in the Ministry of National Defence, Armament Inspectorate (Dz.Urz. MON item. 265)

[6] Regulation of the Council of Ministers of 1 December 2014 on the rules and procedure of conduct in the field of justification and assessment of the need to apply an offset to protect the basic interests of state security (Dz.U. item 1819)

[7] Decision No. 39/MON of the Minister of National Defence of 11 February 2015 on the detailed procedure and rules of conduct in the preparation of justification for the need to apply an offset to protect the basic interests of state security (Dz.Urz. MON, item 39, as amended)

[8] By way of example, the contract for the supply of the “fifth generation” F-35 Lightning II aircraft, or unsuccessful negotiations on the delivery of H-225 (EC-725) Caracal helicopters.