Offset agreements and hidden compliance risks
As an example, a government may look at entering into a contract with a defence company and in return they may ask the defence company to invest in their country. This investment may include building associated factories, roads, technology or local infrastructure. In many cases the offset is totally disconnected with the provision of the original services. This not only applies to defence contracts (although this type of offset agreement is more commonly published); it also happens in the provision of commercial contracts.
Offset agreements can be as complex as the above example, or as simple as a hospital selecting a specific company to supply medical devices and in return that company agrees to support a local charity, provide donations to local schools or provide training for the hospital’s staff on non-medical issues. Indeed, offsets can be simplified right back to the smallest “offset”, which is often seen as a contra agreement: “You buy our product and we will buy yours.”
In the United States, offset agreements in the defence industry are regulated by the Bureau of Industry and Security (BIS) Offset Reporting Regulation. This regulation requires that United States firms entering into an offset agreement related to a defence contract must report to the BIS if the offset agreement exceeds US$5million. However, these United States contractors do not need to report to the BIS on offset agreements entered into by their foreign affiliates or subsidiaries, as long as the contractor itself is not a party to the agreement.
In Europe, the European Defence Agency (EDA) has implemented the Code of Conduct on Offsets, with the participation of 25 of the EDA’s Member States and Norway. The code provides that offset agreements should cap at 100 percent of the contract value, and that all participating Member States have to set up a monitoring procedure to ensure application of the code. Under the code, neither the foreign government nor the contractor is able to receive or offer offsets worth more than the value of the procurement contract.
Although often legitimate, offset agreements have been known to be used to cover bribes and kickbacks. All compliance officers should be aware that these risks do exist, and they must therefore know how to identify and handle them from a compliance perspective. Bribes and kickbacks may not always be clearly identifiable in a contract and are often in the form of some “side agreement” which is not made available to legal or compliance. The risks are vast and extend beyond simple corruption and compliance risks, encompassing financial and revenue recognition risks and conflicts of interest, amongst others.
Why can offset agreements be seen as corrupt?
Offset agreements are often made to support the economic goals of the purchasing countries or the companies making the requests. They also serve to ensure that some of the value that suppliers gain from contracts is reinvested back into local markets. However, the more important offset agreements seem to become to a government, the more likely it is that these agreements are being used as a façade for corruption. This is especially so when offset agreements are of high value.
Corrupt events often occur whereby:
- the person requiring the offset is linked to the request (this occurs commonly when a government decision maker has an investment in the proposed offset and obtains an advantage through the offset)
- the payments made by the offset are made to a fund that is then distributed by the corrupt person, who sends the assets to themselves or to somewhere that they can access
- the payments that are subject to the offset are used towards construction or building contracts, and a person employed by the organisation that has requested the offset benefits from that construction contract as they have an investment in construction company used.
Best practices to protect against the risks involved with offset agreements
- Conduct extensive due diligence on all payment recipients
- Carry out extensive cross checks between the recipient and the company involved, the government department and all the government officials in the transaction
- Have all recipients complete a questionnaire detailing precisely how the money is being used
- Have all concerned recipients in the offset arrangement enter into additional agreements with your company about the use and disbursement of any funds given as part of the offset and requesting appropriate undertakings from key personnel associated with the offset arrangement to ensure that the money is not being used for illegal purposes.
One of the main concerns surrounding offset agreements is the lack of transparency. Details of offsets are not disclosed publicly and are therefore not subject to any kind of review, meaning bribes can easily be hidden in complex offset agreements. It has also been criticised that companies do not conduct audits or monitoring on their offset agreements to judge whether the offsets specified within are realistically achievable or to measure what percentage of an offset has been met. There is the risk that a company will commit itself to an offset without being able to realise it, yet it will not be held accountable by the foreign government.
In order to increase transparency within offset agreements, recommendations are:
- the company giving the offset should hold the funds and disperse them as required by the offset agreement
- the offset agreement should show all the disbursements required and accounts for the full amount of the offset amounts
- the agreement itself and all the payments made thereunder should be published on the website of the involved company
- payments should be verified by an independent compliance expert for accuracy and to make sure they are absent of corrupt activity.
Offset over qualification
If a purchasing country puts too much focus on the reinvestment as opposed to the contract, the participants’ qualifications may be overlooked in favour of how able they are to meet the offsets. When contractors are selected based on the offset rather than their ability to perform the contract this becomes a competition issue. If a government places too much focus on offset arrangements compliance teams should see this as a red flag and start to focus on the transparency elements of the deal.
Revenue recognition issues
Many companies – particularly those based in the United States that follow International Financial Reporting Standards or generally accepted accounting principles – should focus on ensuring that the sale of the products or services is not directly associated with the provision of the offsets. It could be the case that, from an accounting perspective, the delivery of the promised and contractual offset (even if that contract is separate from the underlying contract for products and services) will affect the ability to recognise the sale of the products and services. It is important that the products and services agreement and the offset agreement are reviewed together by financial personnel that have a solid understanding of revenue recognition policies.
Ten things that you can do to make sure your business manages offsets
1. Increase awareness and training
As offset agreements can be highly complex and involve several contracts related to different investments that the company has committed to, employees need to be trained on the risk exposure arising from these offset agreements. It is also essential that employees understand the entire offset-agreement process to prevent them from inadvertently promising bribes to government officials.
2. Implement a policy
Besides training, the nature of offset agreements and the company’s tolerance to anti-corruption in this area need to be addressed in a specific policy. This policy needs to outline when entering into an offset agreement is appropriate, any reporting requirements for entering into offset agreements with particular countries, and which steps the employee needs to follow if they wish to have an offset agreed upon as a part of a transaction.
3. Prepare an approval procedure
Offsets need full transparency in an organisation’s approval process. They should not be left at a local level and, depending on the amount of risk surrounding the offset, they should receive appropriate review at a senior level of the company. The procedures for approval may require disclosure of the offset as part of the bid management process.
4. Conduct due diligence
A comprehensive due diligence process needs to be carried out for any recipient of funds under the offset agreement. For example, due diligence should be conducted on beneficiary companies and sub-contractors under an agreement, paying particular attention to whether there is any background of illicit conduct or conflicts of interest linking the companies to the foreign officials. The information that should be gathered on offset beneficiaries and partners includes their registration records, key principals, corporate structure and owners. High levels of due diligence will include on-the-ground queries with industry sources and customers. The focus is to determine the connections between the offset investments and the products and services that are being negotiated.
5. Oversee the financials
The offset agreement needs financial oversight from a revenue recognition perspective. The finance team need all information on the underlying deal as well as the offset agreement to understand the links between them. The finance team may suggest particular ways to negotiate the contracts to improve the ability to recognise revenue faster in accordance with the company’s policies and accounting practices.
6. Think about structure
The legal department needs to be engaged early to look at how to structure the underlying agreement and the offset obligations. This may require separation or restructuring to address issues in transparency, liability or revenue recognition, or so that due diligence can be a condition of the agreement.
7. Create transparency
Transparency is important in offsets, and it may be necessary to report the agreement and its associated steps on a website or other public document. Transparency initiatives may require offset contracts, payment information or due diligence files to be published, or follow-up reports on the offset and how the work is being completed.
8. Understand reporting obligations
The company needs to understand which reporting obligations it has with respect to the offset agreements. Your home government may require disclosure similar to the defence contracts. It is also possible that some of the obligations under transparency laws may require payments to be disclosed (for example, certain United States–listed companies in the extractive industries have obligations to disclose payments made to governments).
In terms of transparency, both the contractor and the purchasing government (or company) should have a monitoring system in place to ensure that the company is meeting its offset obligations as they are outlined in the offset agreement. Monitoring should also be done on offset partners, with renewal due diligence over the course of the partnership.
10. Create a public relations plan
Build a plan for addressing media enquiries around the offset and how the company has managed the risks associated with the offset agreement. It is very easy to equate an offset agreement with an award of a large services or product transaction and it is important to get ahead of the curve when it comes to dealing with the media and public opinion on the transparency with the transaction as a whole.
The main concern with offset agreements is the lack of transparency and the secrecy in their content. Of course, these offset arrangements can serve legitimate and beneficial purposes such as encouraging growth and development in emerging markets. However, internal controls need to be strengthened by government bodies and by companies themselves. There needs to be close monitoring to ensure that offset agreements remain legitimate and are not used as façades for bribes, and that the obligations within those agreements (for example, to enhance a country’s economic progress) are being met. Controls such as due diligence should also be implemented to detect and remediate any conflicts of interest. Offset agreements need to be highlighted through codes of conduct and warrant a dedicated policy.