New Rule Expands Counterfeit Reporting

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On Nov. 22, the Federal Acquisition Regulatory Council issued a final rule setting forth new provisions that require the reporting of certain counterfeit and suspect counterfeit parts and certain major or critical nonconformances to the Government–Industry Data Exchange Program. This rule comes more than five years after it was first proposed in the Federal Register in June 2014.

The council describes the final rule as “significantly de-scoped” from the version proposed in 2014, but it nonetheless constitutes an expansion of the existing counterfeit part reporting obligations, which to date have applied only to electronic parts under Defense Department contracts.

The final rule provides that the implementing contract clause (FAR 52.246-26) will be inserted into a contract that concerns one of four categories of items: those that that are subject to higher-level quality standards when the relevant contract includes the clause at FAR 52.246-11; items that the contracting officer has determined to be “critical;” electronic parts or items containing electronic parts, provided that the contract exceeds the simplified acquisition threshold; and services provided in conjunction with any of the three above categories of items.

The new clause set forth in the final rule must be flowed down in subcontracts that fit in any of the categories described above. Notably, the prime contractor is responsible for determining whether the subcontract is for “critical items for which use of the clause is appropriate.” This may impact negotiations between primes and their subcontractors if there are questions as to whether the product clearly fits within the “critical” definition.

The rule also incorporates several carve-outs and exemptions that limit its applicability. Most notably, the clause is not required in contracts or subcontracts for commercial items, which is a significant limitation on applicability.

Additionally, the final rule recognizes exemptions for: foreign corporations that do not have any offices, locations or fiscal paying agents in the United States; contractors that are aware that the relevant item is the subject of “an on-going criminal investigation;” and contractors that have confirmed that the supplier from which they purchased the item in question has not sold the item to anyone else.

The core requirements of FAR 52.246-26 are twofold. First, contractors are required to “screen” the exchange program database to ensure that they do not purchase counterfeit parts or parts that contain major or critical nonconformances.

Second, contractors are required to report to both the contracting officer and the database within 60 days of “becoming aware or having reason to suspect” that an item is a counterfeit part. In addition to counterfeit parts, contractors are also required to submit reports to the database — but not to the contracting officer — when they detect a major or critical nonconformance in a “common item.”

The term “common item” is defined expansively to mean any “item that has multiple applications versus a single or peculiar application.” As one commenter on the proposed rule noted, under this remarkably broad definition, “it is difficult to imagine any item — other than a one-of-a-kind part — that would not be a ‘common item.’”

The final rule is poised to trigger a number of significant questions. One is the scope of the rule. The original proposed rule was breathtaking in its scope, as it could have applied to nearly all contracts with all agencies. The FAR Council’s adoption of a carve-out for commercial items — following a wave of pushback from industry — serves as a useful reminder of the value of preparing substantive comments in response to proposed regulations.

But while the final rule is a narrower than the proposed version, certain aspects of the rule remain quite broad. The definition of a “critical item” is illustrative. Read literally, the definition potentially encompasses contracts for any item, the failure of which prevents performance of an agency’s mission — regardless of safety concerns.

Commentators also raised concerns that a negative report could result in de facto debarment — the inference being that the government will not do business with a contractor that supplies counterfeit parts. In response, the council notes that contractors whose products are reported to the database are “given the opportunity to provide their perspective on the issues presented in the report.”

Thus, although the concern about product blacklisting is not trivial, contractors whose products are reported to the Government–Industry Data Exchange Program are allowed to present their side of the story, which is an opportunity that does not exist under certain other supply chain security rules and regulations that have been recently adopted.

The new rule also could have significant implications for prime-sub relations. In the context of subcontract negotiations, the ambiguous definition of “critical item” will be fodder for disputes about whether a subcontract might be subject to the new rule. Moreover, with the carve-out for commercial items, the new rule adds additional incentive for contractors to contend that their products meet the definition of a commercial item under FAR 2.101 — and correspondingly increases the likelihood of prime-sub disputes about whether a product truly is “commercial.”

And finally, the issuance of a database notice could have a significant reputational impact on contractors. It is essential that these reports be accurate and vetted appropriately to ensure that trade secret information is not being shared broadly and that contractors are assessing the risks holistically. 

Susan Cassidy and Mike Wagner are partners, and Peter Terenzio an associate, at Covington & Burling LLP.

Topics: Defense Contracting, Contracting