The development of the defense industry is an urgent priority for the Polish government. Undoubtedly, it is in Poland’s interest to have a solid industrial base for the defense sector, not only to enhance national security but also as a lever for the further transformation of the entire economy.
As demonstrated by countries such as South Korea and Türkiye, which have made significant strides in developing their national defense industries, cooperation with foreign entities can be a successful strategy. Offsetting is a common tool for ensuring such cooperation, especially in the case of technology transfers. That said, making offsetting more flexible would make it more effective, if only by better balancing the scope of protection of the state’s legal interests (contractual risk), and thus reducing the factors that generate excessive costs that are ultimately borne by the Polish side.
Ways to do this include, for example, the liability of foreign suppliers for breaching offset obligations and the form and scope of performance bonds. Below, we take a look some of the key considerations of both.
Liability
First, under the Offset Act, a foreign supplier’s liability for the non-performance or improper performance of an offset contract is based on the principle of strict liability, so it is independent of fault.
Second, in the event of non-performance or improper performance of an offset obligation, foreign suppliers are required to pay a contractual penalty. It is worth noting at this point that, under Polish law, contractual penalties are due regardless of the existence and extent of damage caused by a breach of contract. Although it is rare, a foreign supplier would thus be obliged to pay the penalty, even if the Polish party suffered no damage; it is sufficient for there to be merely a failure to perform or improper performance of an obligation. Thus, this is the most convenient security available to the creditor.
Third, under the Offset Act, 100 percent of the contract value must be reserved to cover penalties for the breach of an offset obligation.
In addition, in practice, contractual penalties are set at amounts above 100 percent of contract values.
Notwithstanding the stipulated contractual penalties, the foreign supplier also bears supplementary indemnity liability to the extent that it exceeds the stipulated contractual penalties. At the same time, Poland’s Offset Act (contrary to practice) does not provide for an upper limit of such liability.
Moreover, regardless of liability to the Treasury for the non-performance or improper performance of an offset contract (as a framework contract), foreign suppliers are expected to bear supplementary indemnity liability to offset recipients (offset beneficiaries), potentially up to 100 percent of the value of the executory contracts concluded. In addition, this “requirement” appears at the stage of negotiating executive contracts, without the possibility of taking it into account at the stage of preparing offset offers, which explains in part why offset negotiations can be quite lengthy.
It seems that such principles of liability of foreign suppliers (even above 200 percent of the value of the offset contract)—although partly understandable given the need to secure the legal interests (contractual risk) of the state—generate excessive costs ultimately borne by the Polish side. The state is thus paying for legal comfort in the event of a potential (and rather rare in practice) breach of contract.
- In this regard, it is worth considering making the level of liability of the foreign supplier to the Treasury more flexible while providing compensation for damage of the offset recipient companies (beneficiaries of the offset) or counting both levels of liability together and relating them to the value of the offset commitment.
- It might also be worth considering linking liability to the insurance coverage of foreign suppliers.
- It would also be worth introducing a statutory preference for substitute performance of the offset commitment in lieu of payment of contractual penalties.
Performance bond
According to the Offset Act, a foreign supplier is required to provide a performance bond in an amount not less than the value of the offset contract, i.e. at least 100 percent.
Moreover, although the law does not require it, the security should cover the entire performance period of the offset contract, which is usually 10 years.
Moreover, in terms of the form of security, despite the formally open catalog of possible collateral, the foreign supplier must choose one of the forms specified by law; in practice, this means a choice between only a statement on voluntary submission to enforcement proceedings, a blank promissory note with a declaration or a bank guarantee.
It is worth pointing out in this regard that despite the existence of other forms of performance bond, in the international legal system the bank guarantee is by far the most common. But it is a costly security, especially considering the significant value and potentially extremely long duration of the collateral. Therefore, practice has also developed the possibility of providing two securities: one cost-free for the entire period of contract performance and a bank guarantee at certain milestones and for certain obligations for a specified, shorter period.
- Notwithstanding the above, it is worth introducing openness to “less costly” forms of security, including those used in international trade, such as insurance guarantees, sureties (including intra-group ones) or letters of credit.
- Above all, however, it is worth statutorily linking the maturity of collateral to the achievement of certain milestones or the final date of performance of the offset agreement, without the need to provide collateral for the entire, long period of performance of the offset agreement.
Other structural changes to ensure more efficient technology transfer
Independent of the above issues related to the cost of providing contractual security, it is also worth noting the need for other changes to the offset mechanism, particularly to increase the efficiency of offset technology transfer.
This includes:
- Ensuring the financing of investments by Polish companies related to the absorption of technology, as there are currently no clear instruments for such support. In this context, it is worth noting the possible state aid, as, further to Article 346 TFEU, the measures taken by the state must not adversely affect the conditions of competition in the internal market “only” for products that are not intended exclusively for military purposes.
- Making it possible to locate offsets (technologies) in Polish entities other than “state-owned companies,” including private companies or joint ventures created for this purpose.
- More strategic approaches to offsets, including in terms of:
- identification of optimal (reasonable and feasible) areas of expected technology transfer,
- adoption of clearer criteria for confirming offset performance, or
- greater openness to standard solutions operating in international legal transactions, if only in the nature of expected licenses, governing law or jurisdiction.
Making offsets more flexible by properly balancing the benefits of broad protection of legal interests with the costs involved in providing them—along with the adoption of instruments to enable more effective technology transfer—can restore the effectiveness and legitimacy of using offsets as an instrument for developing the defense industrial base, which is used extensively by many other economies around the world.
By Jaroslaw Witek, Partner, Dentons