On May 21, the Senate Committee on Armed Services published a troubling report on the results of its year-long inquiry into counterfeit electronic parts in the DoD supply chain. The report found approximately 1,800 cases of suspect counterfeit electronic parts in the defense supply chain during 2009 and 2010 involving over one million individual parts. Over 70 percent of the parts were traced back to China. It concluded there was overwhelming evidence of large numbers of counterfeit parts making their way into critical defense systems, failures by defense contractors and DoD to report counterfeit parts, and gaps in DoD’s knowledge of the scope and impact of such parts on defense systems.

The report praised the amendment offered by Senators Levin and McCain, Section 818 of the 2012 National Defense Authorization Act, seeks to stop the importation of counterfeit parts, strengthen the defense supply chain, and promote the adoption of aggressive counterfeit avoidance practices by DoD and the defense industry. The regulations currently being developed by DoD in response to that legislation, which was signed into law on December 31, 2011, will have significant impact on DoD contractors.

Section 818 requires DoD to assess its policies and systems for the detection of counterfeit electronic parts, implement a risk-based approach to minimize the impact of counterfeit or suspect counterfeit parts on DoD (a similar requirement applies to the Department of Homeland Security), and promulgate regulations that: (1) place on contractors the responsibility for “detecting and avoiding the use or inclusion of counterfeit electronic parts or suspect counterfeit electronic parts in such protects and for any rework or correction action that may be required to remedy the use or inclusion of such parts”; (2) renders unallowable costs of rework or corrective action necessary to remedy the use or inclusion of counterfeit parts under DoD contracts (this may be amended by the 2013 NDAA); and (3) require, wherever possible, that DoD contractors and subcontractors obtain electronic parts from the original manufacturers, authorized dealers, or “trusted suppliers.” DoD is also required to issue or revise guidance on remedial actions to be taken against suppliers who repeatedly fail to detect and avoid counterfeit electronic parts, including consideration of whether to suspend or debar them.

The legislation also imposes a mandatory reporting requirement where DoD contractors and subcontractors become aware, “or have reason to suspect,” that any end item or part in the DoD supply chain contains counterfeit electronic parts or “suspect counterfeit electronic parts.” Those reports must be submitted in writing within 60 days to the appropriate government authorities and the Government-Industry Data Exchange Program (or similar program designated by the Secretary).

Contractors that comply with this reporting requirement will not be subject to civil liability on the basis of that reporting, provided they made a “reasonable effort to determine that the end item, component, part, or material concerned contained counterfeit electronic parts or suspect counterfeit electronic parts.” The safe harbor provision does not shield compliant contractors from criminal liability for trafficking in counterfeit military goods or services, liability which now is up to $5,000,000 and 20 years in prison for the first offense ($15,000,000 for a company), and $15,000,000 and 30 years for subsequent offenses ($30,000,000 for a company). Heightened penalties apply for knowingly or recklessly causing or attempting to cause serious bodily injury or death from the prohibited conduct, up to life in prison.

DoD’s assessment of its internal policies and systems for the detection and avoidance of counterfeit electronic parts must be completed by June 28, 2012, and it must revise the DoD acquisition regulations to address the detection and avoidance of counterfeit parts by September 26, 2012. Because these will have significant impact on contractors, we strongly encourage you to follow these developments, which will be closely tracked on this blog, and, to the extent possible, engage with the DoD on the development of the soon-to-be-promulgated regulations.