United States: Defense Department Publishes Interim Final Rule Detailing Its Process For Clearing Contractors Under Foreign Ownership, Control, Or Influence - A Rare Public Review

Overview

On April 9, 2014, the U.S. Department of Defense ("DoD") published an interim final rule (79 Fed. Reg. 19467-19478) outlining the process for granting security clearances to government contractors under foreign ownership, control or influence ("FOCI") – i.e., contractors that have significant ties to foreign persons. It does not impose new requirements on contractors. Rather, its purpose is to codify agency procedures under the National Industrial Security Program ("NISP"). The rule took immediate effect, but is subject to comment until June 9, 2014. The final rule may include changes, but we expect it to look much like the interim final rule.

The interim final rule largely codifies current practice. Its real importance lies in the fact that it was published at all. For decades, the process for approving FOCI mitigation plans has resided in a maze of manuals and directives published and amended without opportunity for public comment. The DoD and the Defense Security Service ("DSS") oversee the FOCI-mitigation process for most (but not all) government agencies. The Department of Energy (and its National Nuclear Security Administration) write their own agreements, as does the Nuclear Regulatory Commission and the Office of the Director of National Intelligence (for the intelligence agencies). But the rest of the U.S. Government (e.g., the Federal Bureau of Investigation) relies on the DSS. One purpose of the interim final rule is to standardize the FOCI program across all components that use the DSS – DoD and non-DoD departments and agencies alike. Publication of the rule in the Code of Federal Regulations opens the process to greater scrutiny. It also may make implementation more inflexible, although DoD has left itself a good deal of discretion.

Background - National Industrial Security Program

Executive Order 12829 established the National Industrial Security Program in 1993 to protect classified information entrusted to the industrial base. The National Industrial Security Program Operating Manual ("NISPOM") describes the requirements, restrictions, and safeguards that must be implemented to protect classified and controlled-unclassified information, including procedures governing companies under FOCI. DSS devotes considerable resources to U.S. contractors under FOCI because foreign direct investment is a valuable and growing part of the U.S. economy and foreign-owned contractors are a significant part of the U.S. defense industrial base. In addition, the Federal Register notice observes that "[t]here is ... an increased probability of unauthorized disclosure of classified information because the owner of a U.S. company has direct authority over all aspects of his company," adding that, without mitigation, "there will be nothing to prevent unauthorized disclosures of classified information since the foreign owner will have unfettered control of the U.S. company." 79 Fed. Reg. at 19469.

Under the NISPOM, companies under FOCI cannot hold facility security clearances unless FOCI is effectively negated or mitigated through corporate governance programs approved by the DSS. NISPOM 2-300(c). This is key in foreign acquisitions of cleared contractors, since cleared contracts may contribute in important ways to the value of the company – and the acquisition may anticipate synergies and technology transfers that may be difficult or impossible under U.S. law. Nevertheless, DSS reports that more than 700 cleared facilities operate under FOCI, and more than 300 operate under full-fledged mitigation agreements that include formal governance restrictions on foreign control. See DSS Access, Vol. 2, No. 4 at 35. Indeed, 30 such agreements were written in calendar year 2011 alone. See 79 Fed. Reg. at 19468.

Highlights of the Interim Final Rule

The Federal Register notice provides background and justification for the interim final rule, emphasizing competition fairness to foreign-owned U.S. contractors and consistency in the application of FOCI policies and procedures – matters which have long been industry concerns. A few notes follow:

FOCI Factors

DoD continues to reserve the right in FOCI determinations to consider "any ... factor that indicates or demonstrates a capability on the part of foreign interests to control or influence the operations or management of the business organization concerned." 79 Fed. Reg. at 19473. But the interim final rule provides additional detail on assessment factors -- including "prior relationships between the U.S. company and the foreign interest." Id. This appears to be directed, among other things, at companies that restructure in order to reduce the FOCI-mitigation burden or that rely heavily on minority shareholders who may have influence that exceeds their nominal role in the corporation. The fact that DoD takes pains to spell out "prior relationships" as a FOCI factor clearly indicates that the past matters – that a historically close relationship will be evaluated as part of the FOCI matrix, notwithstanding the formal ownership structure – for example, the relationship between a contractor and a favored subcontractor.

Constraints on Duration of FOCI Reviews

Several provisions in the interim final rule put constraints on the duration of the FOCI review. DSS must consult with the relevant Government Contracting Activity(ies) ("GCA") regarding the required mitigation plan, and – under the interim final rule – must provide the GCAs with relevant information and 30 days to provide written objections to the mitigation plan, if warranted. Thankfully, the rule gives DSS latitude to move forward after 30 days if no objections are received. The rule also requires DSS to provide written feedback to applicants within 30 days of receipt of the applicant's proposed FOCI action plan (e.g., the mitigation agreement and ancillary agreements, including the Technology Control Plan ("TCP"), which provides for protection of classified and export-controlled information.

Increased Scrutiny by the Under Secretary of Defense for Intelligence

Negotiations of FOCI action plans may also be affected by the requirement that the Under Secretary of Defense for Intelligence ("USD(I)") approve templates for all DSS mitigation plans and implementing procedures. FOCI mitigation plans fall into three major categories:

1. The Security Control Agreement ("SCA") (typically, minority investments that include board representation), which requires the appointment, with DSS approval, of at least one independent cleared U.S. citizen as an Outside Director;
2. The Special Security Agreement ("SSA") (typically, majority control cases), which allows foreign representation on the Board of Directors, but requires the appointment, with DSS approval, of independent cleared U.S. citizens as Outside Directors – typically three, but always a number that exceeds the number of directors representing the foreign shareholder; and
3. The Proxy Agreement ("PA") and Voting Trust ("VT") (reserved for majority control cases involving highly sensitive information or other risk factors, such as government control, shareholder domicile in a country that presents security risks, a history of corporate espionage, etc.), which require that the shareholder's voting rights go to independent cleared U.S. citizen Proxy Holders or Trustees, chosen with U. S. Government approval.

Historically, USD(I) approval was only required for substantive deviations from the templates for these core programs. Under the interim final rule, however, deviations from the templates for the ancillary implementing procedures will also require USD(I) approval: i.e., the TCP, the Electronic Communications Plan ("ECP"), Affiliations Operations Plan (which the interim final rule refers to as "Administrative Support Agreements," a shift in nomenclature that may or may not have significance), and the Facilities Location Plan. These plans are often tailored to meet the needs of a specific company. Going forward, however, DSS will be less likely to deviate substantively from the templates because USD(I) approval would be required. (Notably, the interim final rule, contrary to current practice, does not include a requirement for ECPs at SCA companies. It remains to be seen whether this was intentional or an oversight. DSS retains the authority to require ECPs even when there is no express requirement.)

Mitigation in the Absence of Board Representation: FOCI at U.S.-Controlled Companies

FOCI reviews look at any and all foreign influence, including investments as low as 5%.  Therefore, the interim final rule also outlines FOCI mitigation plans that may be used where there is significant foreign influence, even though there is no foreign representation on the Board.  In such cases, a company may escape one of the major FOCI mitigation plans, yet still be required to take formal measures "to assure that the foreign interest can be effectively denied access to classified information and cannot otherwise adversely affect performance on classified contracts." 79 Fed. Reg. at 19473.

These requirements can arise even if the company is U.S.-controlled and publicly traded where, for example, senior management includes foreign nationals or the company is heavily dependent on, or tied to, foreign interests. The remedies include board resolutions (e.g., acknowledging FOCI and pledging to block unauthorized access to classified information), assignment of specific oversight responsibilities to independent directors, appointment of senior level security committees to consider and oversee matters that affect the performance of classified contracts, and appointment of a technology control officer.

They also include a series of measures that respond to specific FOCI risks unrelated to ownership that may go unnoticed in due diligence reviews, including (but not limited to) amendment or termination of loan agreements, contracts, and "other understandings" with foreign interests; diversification or reduction of foreign-source income, and "demonstration of financial viability independent of foreign interests" (e.g., where a company is closely tied to foreign suppliers, joint venture partners, or subcontractors who provide critical support). Id.

Limited Facility Clearances

Additionally, the interim final rule describes the rarely-used "Limited Facility Clearance" ("Limited FCL"), which is authorized for "a single, narrowly defined purpose when there is foreign ownership or control of a U.S. company" and "the company is either unable or unwilling to implement FOCI negation or mitigation." 79 Fed. Reg. at 19476. (Emphasis added.) Prior guidance held that FOCI mitigation or negation must not be "feasible" in order to authorize a limited clearance.

Although agencies were known to give the prior guidance a liberal reading in order to procure sought-after products or services, the interim final rule openly acknowledges that there are four (4) narrow circumstances where the government will clear a company subject to FOCI without requiring standard FOCI mitigation measures. Three of these entail circumstances in which foreign governments are directly involved, either as sponsors or in conjunction with a cooperative arms program. The fourth is the only Limited FCL generally available, wherein a senior GCA official may sponsor a U.S. company when the other FOCI mitigation agreements "do not apply, and there is a compelling need for the FCL." 79 Fed. Reg. at 19477. (Emphasis added.) The GCA official "must fully describe the compelling need and certify in writing that the sponsoring GCA accepts the risk inherent in not negating or mitigating the FOCI." Id. Notably, the Limited FCL only permits performance on a classified contract issued by the sponsoring agency.

National Interest Determinations

A National Interest Determination ("NID") is required for companies operating under SSAs to access proscribed information (e.g., Top Secret). NIDs require a finding by the GCA that award of the contract is "consistent with the national security interests of the United States." See 32 CFR 2004.5(e). NIDs can be program, project, or contract specific. Program and project NIDs do not require a separate NID for each contract.

At one time, a NID required contracting agencies to negotiate a maze of factors, including an assessment of U.S.-controlled competition. By contrast, the current NID standard is remarkably simple. Nevertheless, agencies continue to balk at NIDs – or (perhaps) find the requirement a convenient excuse for awards to U.S.-controlled competition. For whatever reason, they continue to vex the process, particularly because they can introduce significant delay in contract awards, and those awaiting a fix will not find the solution in the interim final rule.

The rule does require that the GCA initiate action on NIDs during the pre-contract phase, and standardizes procedures each agency must follow to issue and document NIDs. Nevertheless, the rule also refers back to 32 CFR part 2004, which requires GCAs to provide a NID decision within 30 days of receipt, or 60 days if the concurrence of another agency is required, a timetable that, to date, is rarely followed.

Immediate Effect of Interim Final Rule

Publication of the rule as an "interim final rule" – with immediate effect – is consistent with the historic pattern of DoD announcements in this area, which arrive fully constituted, with no invitation for public comment. Changes in policy typically arrive with little to no fanfare and, as "directive-type memoranda" or agency policy statements, are subject to the ebb and flow of agency mood swings.

In this case, however, the rule remains open to comment, and comments on the rule will be accepted until June 9, 2014. Further, although the rule continues to give broad discretion to the agencies – including the discretion to depart from procedures both to grant, as well as to "limit, deny, or revoke" access to classified information, it also lays down a "baseline" that anchors policy to the Code of Federal Regulations, which facilitates transparency.

For More Information

For copies of the interim final rule, or additional information, including information on the process for filing comments, please contact any of the following:

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