Because of military aid to Ukraine and, presumably Israel, the U.S. defense industrial base is strained right now. Manufacturers of platforms and ammunition must deal with a list of regulatory and legal challenges. For more, the Federal Drive with Tom Temin spoke with attorney Justin Chiarodo, a partner at Blank Rome.
Tom Temin And we think of the defense industrial base has strained in terms of capacity to manufacture what’s needed around the world and, you know, missile systems and ammunition and so forth. But what’s emerging is the political risk. Regulatory risk. What’s going on?
Justin Chiarodo It’s a really challenging time for the industry with a lot of uncertainty, sadly to say, both in our domestic politics, which is impacting the ability to keep the lights on in the first place, but also with a real explosion in geopolitical instability in recent years. And I think that’s broadly informed by a transition away from what was more or less a unipolar world to one that’s much more multipolar, right. With the fragmentation and trade in our financial systems and our alliances and our supply chains. So you have this significant pivot away from a world where we were dealing with the global war on terror. Two one, we’re really, really moving to what is going to be a great power competition with our near-peer adversaries and China and Russia. And then conflicts you’re seeing now in Ukraine and unfortunately also in Israel today. So there’s a lot to manage in that. And I think what you’re seeing with the defense base is a recognition that we haven’t really positioned ourselves with the resources and the infrastructure necessary to meet those threats. So this is a time where we’ll be playing catch up and where there’s going to be a lot of effort to try and position us to navigate these challenges going forward.
Tom Temin Well, what are the problems for contractors? I mean, if their client is the military, then all they have to do is make sure they ramp up with the machinery and the people they need to make what is ordered. So how does the international situation really affect them otherwise than a great business opportunity?
Justin Chiarodo Yeah, the challenge is in a couple of ways, right? Obviously, you’ve got the need for the experience, the capabilities domestically, the size of the domestic industrial base has shrunk. So a lot of pressure on that side. But also when you’re dealing with the export of defense articles, you’ve got to deal with a whole other set of issues. Export control laws. If you’re dealing with international counterparties, I’ve got sanctions risk, right? I need to do business with people that meet certain standards of ethics and conduct. I can’t do business with certain prohibited entities. And so you introduce a lot of complexity for any contractor that is thinking about participating in that market. And it’s going to be the biggest challenge for companies that are not really well steeped in that. Right. So the major defense contractors will have the infrastructure and the systems and the sophistication to do this more easily than, I think people down the supply chain or people that might be new to the market.
Tom Temin Well, how does this work? Because let’s take the Howitzer shell, which is being exported all over the place, and there is some organic manufacturing capability of that in DoD, but they do buy a lot of it from several commercial entities. If Congress appropriates money to send a million shells to Ukraine or something where they might go, do they get shipped to the DoD, which then ships them, or are the companies expected to get them to those countries themselves? And is that where the risk is?
Justin Chiarodo Great. Great question Tom. You really got under the Arms Export Control Act. You’ve got a couple of ways for doing this for military sales. The first is through or military sales transactions where the U.S. government is going to be your contracting party and they’ll basically operate as a bit of a middleman between you, the contractor and that foreign government. So that’s going to look much more like a traditional U.S. procurement contract. The contractor may not even know, in fact, that they’re participating in an FMS sale. So that’s for bucket one. Bucket 2R is known or the direct commercial sales or DCS sales transactions where the U.S. company is going to obtain a commercial export license for those defense articles from the State Department, which will allow them to negotiate with and sell directly to a foreign government. So in both cases, those transactions are subject to U.S. export control laws and approvals from the State Department. But the DCS transaction is probably going to involve a little bit more compliance attention directly from the contractor, right, because they’re dealing directly with that foreign party foreign buyer.
Tom Temin Well, if the State Department is the control point, then shouldn’t that make companies automatically safe from doing business with prohibited entities and that kind of thing?
Justin Chiarodo It’s a necessary part, but not a not a complete part of addressing those risks. You know, any company that has an international supply chain today or a customer base needs to know who it’s doing business with and needs to put in place a system of controls and suitable for what they’re doing. As far as making sure companies are not on the sanctioned or prohibited entities list, that they have a sufficient level of comfort, right. With who those counterparties are and really understanding where products that they’re delivering internationally may be winding up. So a big issue that we’ve seen come out of Ukraine in particular is U.S. technology, for example, appearing in weapons that the Russians have used against the Ukrainians. So there is a risk here is really and you’re seeing the Justice Department pay a lot of attention to this with the enforcement of the national security laws and sanctions compliance. It’s getting tremendous attention. I think the Justice Department has characterized sanctions as the new FCPA, the new Foreign Corrupt Practices Act. So it’s something that companies should be investing accordingly and making sure that if they’re operating internationally, that they’re investing the resources necessary to make sure that they’re doing business with the right folks.
Tom Temin We’re speaking with Justin Chiarodo. He’s a partner at the law firm Blank Rome. How does sanctions work against an individual company? Because when the United States imposes sanctions, it’s in the banking system, in the cash flows and this kind of thing. How does it work? I guess it can be reciprocated against American entities operating overseas.
Justin Chiarodo Yeah, it sure can. And I think the big one to watch here is China. The Chinese foreign sanctions law is now coming into, I think, clearer focus. And there were some major defense contractors earlier this year that were added to their prohibited entities list limiting the ability to do import or export transactions with China, prohibiting new investment in China, limiting the ability of senior executives of those companies to get into China. And this really ties, not surprisingly, to Taiwan, which in the recent NDAA was is now an authorized FMS participant. So China is also using its economic power to put some pressure right on on U.S. supply chains. Now, as of now, right, major defense contractors in the U.S. are not going to be doing business with China. So it’s not a direct and immediate impact as much on those companies. But for a large percentage of industry, particularly high tech companies that may be involved in the energy transition market, this is a challenge because still have very strong connections with the Chinese economy and industry and a lot of these areas. So you have, you know, the U.S. and China, yes, they’re in strategic competition in a lot of areas, but they’re also still in partnership, you know, in some other areas and still significant trade partners. So those companies, companies that may particularly have a technology footprint are going to need to be very careful about what kind of business opportunities they’re thinking about pursuing.
Tom Temin I mean, that’s really the big difference between now in the Cold War is that the United States was much more economically independent and China was a relative puny economy in those days. And we didn’t do business with Russia anyway. We didn’t need anything from Russia except vodka maybe, and caviar. So but now, let’s face it, the United States is almost completely economically dependent on China just to take away the flowery language around it. All this electric car, jazz and everything would grind to a halt in 10 seconds without China.
Justin Chiarodo Absolutely. I mean, it’s well-documented that China has a command position in critical minerals and resources necessary to transition to the clean energy economy. And this is a major national security problem for the United States. China is doing this not only within their domestic capacity, but also in alliances and arrangements with countries in other areas where these critical minerals in particular are in abundance. So it’s going to be a tricky path to walk for the United States and its allies and in particular companies that are trying to sort of have their cake and eat it, too. That may be on both sides of this issue. So I think it’s a real risk area. Again, the major defense contractors, very sophisticated, very seasoned. There’s no question about what their markets are going to look like. Right. And under under this new order. But it’s companies that may have technology that has dual use applications, right. That may have conglomerates that have interests and, you know, ancillaries or clean energy. Right. Not necessarily just weapons. They’re going to have to really balance these risks going forward.
Tom Temin As the old saying goes, it’s complicated.
Justin Chiarodo It is complicated. It is complicated. And it’s getting more so. It’s getting more so by the day.