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DKF & Wierzbowski Eversheds defence and security networking meeting: Discussion of the new Offset Act

  • Poland
  • Diversified industrials - Aerospace, defence and security

16-07-2014

On 30 June – 1 July 2014, together with the Deutsches Kompensations Forum, we held a defence and security networking meeting in Warsaw. On 26 June 2014 the Polish Parliament adopted a new Offset Act (the Act on Certain Agreements Concluded in Connection with Contracts Essential for National Security), and thus the timing of the conference could not have been better. And just as our conference started the Polish Armaments Inspectorate announced that Raytheon and MBDA had qualified for the final stage of the Midrange Antiaircraft and Antimissile Air Defence System procurement (the Vistula Program), worth about EUR 6bn. The conference was an ideal place to congratulate the successful competitors. In my reflections, I would like to share my thoughts on the main topics that raised concerns about the new Offset Act: application, scope of offset, performance security, and penalties.

When will the new Offset Act enter into force?

The new Offset Act was signed into law by the President of Poland on 7 July 2014 and will come into force 14 days after publication in the Journal of Laws. It is expected that this will happen within the next 2 months. Consequently, the Vistula Program may be the first where the new Offset Act will be applicable. Under Art. 34 of the new Offset Act, in the case of offset agreements concluded before the new Offset Act enters into force, the old Offset Act (the Act on Certain Compensating Agreements Concluded in Connection with Supply Agreements for the Needs of Defence and State Security of 10 September 1999) will continue to apply. The old Offset Act will also apply to amendments of offset agreements concluded before the new Offset Act enters into force but amended after the new Offset Act enters into force. The old Offset Act will also apply to procedures for conclusion of an offset agreement commenced before the new Offset Act enters into force.

Consequently, the new Offset Act will apply only to offset agreements concluded under proceedings commenced after the new Offset Act enters into force.

Applicability of the new Offset Act

Under the new Offset Act there is no automatic application of the Offset Act. Consequently the new Offset Act does not include the EUR 5m threshold which was a prerequisite for application of the old Offset Act. Instead, application of the new Offset Act will be decided on a case-by-case basis.

The new Offset Act may be applied only if the specific procurement has been exempted from the Polish Public Procurement Law under Art. 346 of the Treaty on the Functioning of the European Union, according to which “any Member State may take such measures as it considers necessary for the protection of the essential interests of its security which are connected with the production of or trade in arms, munitions and war material; such measures shall not adversely affect the conditions of competition in the internal market regarding products which are not intended for specifically military purposes.” In such case, the procurement is subject to the procedures set forth in Ministry of National Defence Decision No. 118/MON (see my article on this topic here).

Whenever the ministry considers exempting the award of a contract under TFEU Art. 346 and Public Procurement Law Art. 4(5b), which is the first step required for the new Offset Act to be applied, it will have to proceed in accordance with the Regulation of the Council of Ministers of 12 February 2013 on the Procedure for Assessment of the Existence of an Essential Interest of State Security. Under this regulation, exemption of the contract process from the procurement regime must be justified by the contracting authority (the Armaments Inspectorate) by showing:

  1. An essential interest of national security justifying exemption of the procurement from the procurement regime under TFEU Art. 346 and the need to assure the security of supply of military equipment or the proper repair and renovation of existing military equipment
  2. A causal link between the subject matter of the procurement and the essential interest of national security, describing the influence of the procurement on such national interests, and
  3. The effect that the exemption of the procurement from the Public Procurement Law will have on conditions of competition in the internal market for products which are not intended for specifically military purposes.

The contracting authority’s application for exemption will be reviewed by the Minister of National Defence.

The specific factors to be taken into account by the ministry when considering such an application are governed by Decision of the Minister of National Defence No. 92/MON of 21 March 2014 on the Procedure for Qualification of Contracts and the Assessment of the Existence of an Essential Interest of National Security. In deciding on the existence of an essential interest of national security, the following aspects are to be taken into account:

  • The principle of proportionality of the measures adopted
  • Political and military circumstances of Poland as a member of international structures and international obligations pertaining to arms and disarmament
  • The influence of the acquired technology on the protection of essential interests of state security pertaining to the development and maintenance of Polish scientific potential for the benefit of national defence and the scientific priorities of the Polish Armed Forces
  • External and internal threats to the defence and security of the state
  • Areas where there are threats of corruption or corrupt mechanisms.

As provided in the new Offset Act, an offset agreement is an agreement ensuring the protection of essential interests of national security. Under Art. 7(4) of the new Offset Act, application of the act requires justification in accordance with TFEU Art. 346(1)(b). Such justification is to be prepared by the minister responsible for managing the government section supervising the contracting authority and reviewed by the Council of Ministers. The procedure and specific criteria which the Council of Ministers will consider when deciding if application of the new Offset Act is required under TFEU Art. 346 will be specified in a secondary regulation (to be issued by the Council of Ministers after the new Offset Act enters into force). The criteria may be similar to those considered when exempting an award procedure from the Public Procurement Law under Decision 92/MON. The justification for the use of offset measures should indicate what specific essential interests of national security—not economic interests—could be threatened if no offset measures were applied, and why. The justification should also explain why other possible measures, such as “polonization,” are insufficient for ensuring the protection of the essential national security interests at stake.

As provided in new Offset Act Art. 8(1), the contracting authority must notify the Minister of National Defence before commencing a procurement procedure exempted from the Public Procurement Law under TFEU Art. 346. Thereafter, the Minister of National Defence, considering the justification for applying the Offset Act under TFEU Art. 346 as decided by the Council of Ministers, will obtain an opinion from the Offset Committee and provide the contracting authority the guidelines for the offset along with a draft of the offset agreement.

Scope of offset

Because the application of the new Offset Act requires justification under TFEU Art. 346, offsets are narrower under the new regulations than under the old Offset Act. Both direct and indirect offset obligations were provided for in the old regulations, but now only direct offset obligations relating to the subject matter of the supply will be applied.

Under new Offset Act Art. 2(2), an offset obligation is an undertaking by a foreign supplier to the State Treasury and the offset recipient consisting in particular of transfer of technology or knowhow, along with intellectual property rights or rights of use under a licence, ensuring the independence from the foreign supplier required by the State Treasury for sustaining or providing in the territory of the Republic of Poland the transfer of production, service, maintenance and repair and other potential required for the protection of essential interests of national security. Under this definition, indirect offset obligations will no longer be applicable under the new Offset Act. Moreover, the scope of the offset obligations will have to be directly linked to the subject matter of the supply and the justification for applying offset obligations to ensure the protection of essential interests of national security. The scope of the offset measures must be proportionate and go no further than necessary to protect the specified essential interests of national security which could be threatened if no offset measures were applied.

Performance security

The new Offset Act provides in Art. 20(1) that the Minister of National Defence, no later than the date of conclusion of the offset agreement, shall require the foreign supplier to submit security for performance of the offset agreement, which under Art. 20(2) may include more specifically:

  1. A notarial deed in which the foreign supplier submits to execution under Civil Procedure Code Art. 777 §1(5) (allowing the State Treasury to proceed directly to enforcement of obligations against the foreign supplier, e.g. contractual penalties, without first obtaining a judgment from a civil court)
  2. A bank guarantee
  3. A promissory note in blanco of the foreign supplier with a promissory note agreement.

The value of the offset agreement performance security may not be lower than the value of the offset agreement.

Since the new Offset Act provides an open list of the types of security which may be used, other types of securities may be allowed. We believe that offset performance security might also be submitted in the form of:

  • An insurance guarantee,
  • A government guarantee,

or other types which provide the State Treasury the same level of security as provided by the three types of security specifically mentioned in the new Offset Act.

It is not clear from the wording of the new Offset Act, however, whether the Minister of National Defence has the right to indicate the type of security that the foreign supplier is required to submit, or whether the minister may only demand submission of security and it is up to the foreign supplier to decide what type of security it will submit. Some indicators may be derived from similar provisions of the Public Procurement Law concerning security for contract performance under Art. 147. The Public Procurement Law provides that the contracting authority may require a bidder to submit such security and lists in Art. 148(1) five types of security which may be submitted (a closed list), but clearly provides that the type of security is “at the bidder’s choice.” Although we cannot exclude that the Ministry of National Defence will require upfront that the foreign supplier submit security in a specific form, we believe that the ministry will take a more flexible approach. Because the offset agreement will be concluded after the foreign supplier submits its offset proposal and after negotiation of the proposal, there is room for the ministry and the foreign supplier to agree on the form in which the security will be submitted. The foreign supplier may propose the forms of security in the offset proposal—suited to its corporate structure and the subject of the supply contract—and then negotiate the security with the ministry. Surely if the types of security proposed by the foreign supplier are satisfactory to the ministry and together provide a solid guarantee for the State Treasury securing its potential claims, mutual agreement in this regard would be possible. The foreign supplier may propose security in one or more forms.

Reduction of security

The negotiations between the foreign supplier and the ministry may also pertain to the possible reduction of the security during the performance of the offset agreement. Again, the provisions of the new Offset Act may be compared with the Public Procurement Law, which clearly provides when the contracting authority should return the security, while the new Offset Act does not include such provisions. Thus one may take the approach that the method of returning the security submitted by the foreign supplier is a matter to be decided in the offset agreement and during negotiations. As the performance of the offset agreement is in most cases long-lasting, a fair and businesslike settlement should provide that the value of the security is reduced by the value of the offset obligations as they are fulfilled by the foreign supplier during the performance of the contract and applied by the ministry toward the value of the offset agreement.

Penalties

Under new Offset Act Art. 23 (2) and (3), if an offset obligation is not performed, the foreign supplier must pay a contractual penalty equal to the value of the unperformed offset obligation, and if an offset obligation is not properly performed, the foreign supplier must pay a contractual penalty equal to the value of the part of the offset obligation which was not properly performed. In the offset agreement, the foreign supplier may have one or more different offset obligations relating to the subject matter of the supply. Penalties can be applied separately to those offset obligations. Such offset obligations will be performed pursuant to the offset agreement and may have defined milestones that should be completed by specific deadlines provided in the schedule. Under new Offset Act Art. 23(1), the foreign supplier’s offset obligation will expire upon payment of the contractual penalty or damages.

The obligation of the foreign supplier is not limited to the value of the offset obligation, however, if the loss sustained by the State Treasury exceeds the value of the contractual penalty. In such case, the foreign supplier must pay the excess damages. Whether or not the foreign supplier is at fault in failing to perform the offset obligation is irrelevant to its liability.

Under the new Offset Act, a contractual penalty may be due if a particular offset obligation has not been performed or has been performed improperly. This means that the penalty may not be applied if the period for fulfilling a specific offset obligation has not expired, even if the foreign supplier is behind schedule in meeting specific milestones within the particular offset obligation. The offset agreement may also include the provisions related to standard contractual penalties for delay in implementing a specific offset obligation that may serve as a disciplinary sanction. It seems that such penalties shall not be treated as the penalties under the new Offset Act Art. 23.

The Minister of National Defence may issue a declaration of non-performance or improper performance of an offset obligation after an evaluation of the performance of offset obligations by the foreign supplier. Under new Offset Act Art. 16, the foreign supplier is required to submit a report to the ministry on the realization of offset obligations by 31 March of each year. The ministry may also demand information on the performance of any offset obligations at any time, particularly when the deadline for performance of a specific offset obligation has passed. The ministry may also conduct an inspection of the performance of offset obligations at any time, after which it will issue a report on which offset obligations have been fulfilled and which have not. Considering the possible ways in which the ministry may declare that a particular offset obligation has or has not been fulfilled, we believe that the assessment of penalties against the foreign supplier will be tied to a finding by the ministry that a specific offset obligation has not been performed or has been performed improperly. In such case, the foreign supplier may seek to avoid paying penalties by negotiating with the ministry to amend the offset obligation, especially if the foreign supplier was unable to fulfil the offset obligation for reasons beyond its control.

The new Offset Act also provides in Art. 21 that in case of a material change of circumstances during the performance of the offset agreement, the parties may change the offset recipient, the offset provider, the subject of the offset obligation or its value, or the period in which the specific offset obligation should be performed, and/or exchange the offset obligation for a new or different offset obligation. This provision will allow the foreign supplier and the State Treasury to modify offset obligations in situations where the performance of certain offset obligations becomes impossible or will no longer serve the interests of the State Treasury. In such cases, it should be assumed that the foreign supplier will not be required to pay contractual penalties if the offset obligation is modified. If the offset obligations are to be modified, the modification should be made before the offset agreement expires, because under Polish law an obligation cannot be modified when it no longer exists. Modification requires the mutual consent of the foreign supplier and the State Treasury, and neither party may force the other party to conclude an annex to the offset agreement implementing the modification.

The future…

The above considerations pertain only to a number of important issues which are of concern to companies involved in the Polish defence sector. There are other issues that are equally important, such as the applicability of the new Offset Act to domestic companies controlled by foreign suppliers, the methods for valuing offset obligations, the criteria for evaluating offset proposals, the period for conclusion of the offset agreement, the possibility of applying polonization and offset at the same time, and so on. The situation is complicated further by the fact that administration of offsets will be shifted from the Ministry of Economy to the Ministry of National Defence, which means that this ministry will have to cope with new responsibilities and a new perspective. The functioning of the new Offset Act will very much depend on the practice developed by the Ministry of National Defence.

Nonetheless, considering that the Ministry of National Defence has coped so far with managing some of the most complicated projects in the history of Poland and has successfully implemented numerous projects in the defence sector, we may expect that it will also cope with the responsibility of managing offsets. It should not be forgotten that successfully doing business with the Ministry of National Defence in this new situation will also depend on how foreign contractors are able to negotiate. Our broad experience in dealing with Polish government institutions shows that the Polish government is always open to discussion on fair and equal terms and displays a willingness to make mutually advantageous decisions.

We hope that everyone who attended the DKF and Wierzbowski Eversheds Defence & Security networking meeting enjoyed the conference and that you share our optimism. We wish you all the best in the new perspective.

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Renata Misiewicz
PR team
+48 22 50 50 719
renata.misiewicz@eversheds-sutherland.pl