Uncertainty surrounding the policies of the new administration is felt across industries. In particular, U.S. and Israeli defense industries are anxious for details of a ten-year, $38.8 billion military assistance package that was signed in Washington this past September. Whether the terms of the aid package are upended entirely or left mostly unchanged by the current incoming administration will have far reaching consequences on future U.S. and Israeli government procurement.

As discussed in this post, since 2007, U.S. and Israeli defense contractors have become accustomed to navigating the terms of an FY2009-FY2018 assistance program. The new 10-year package, however, presents new, unchartered challenges, for which industry will have to prepare and adapt. To do so effectively, companies will want to (i) glean more specific details regarding the terms of the new aid package, especially in light of changing administrations (ii) work towards increasing their eligibility for defense funding by adapting structurally, either through approved M&A activity or B2B cooperation between U.S. and Israeli companies, and, finally, (iii) engage with experts, policy makers and regulators, to ensure their plans align with any current or future compliance constraints.

What is clear, the changing landscape presents challenges and opportunities for both U.S. and Israeli defense contractors.

I.  Introduction to FMF, and Israel’s FMF Programs

Facilitating defense exports to friendly, foreign nations is a core component of U.S. national security and foreign policy. To achieve that objective, the President is permitted to request appropriations to loan or grant “Foreign Military Financing” (“FMF”) to fund these transactions. The U.S. provides friendly foreign nations with FMF funding for the acquisition of U.S. defense products and services through two principal avenues: government-to-government transactions where the U.S. government procures the goods or services and then provides them to foreign governments are referred to as “Foreign Military Sales” (“FMS”), whereas “Direct Commercial Sales” (“DCS”) allow the foreign government to engage directly with U.S. defense contractors.

Private defense contractors are key beneficiaries of the FMF program. And because the vast majority of FMF funding is earmarked for Israel, defense companies actively engaged there have especially benefitted.

For perspective, FY2016 appropriations allocated $4.73 billion for worldwide, FMF expenditures, of which $3.1 billion is reserved for defense purchases by the Government of Israel. These amounts largely reflect a 2007 “MOU on U.S.-Israel Military Assistance”, in which the Bush administration pledged $30 billion in FMF to Israel for distribution between FY2009 and FY2018.  With that FMF program winding down, on September, 14th, 2016, U.S. and Israeli representatives signed the FY2019-FY2028 “MOU on U.S.-Israel Security Assistance”. Details on the new MOU are sparse, though some information can be found in the White House Press Secretary’s, “Fact Sheet: Memorandum of Understanding Reached with Israel”, released on the day the MOU was signed.

As discussed below, the MOU terms discussed in the Fact Sheet and disclosed to the media have alleviated some private-sector concerns, but have substantiated others.

II.  The View on the Ground and OSP

From the perspective of the Israeli Ministry of Defense (“IMOD”), the precedent-setting, $3.8 billion in annual aid is remarkably positive. The fact that the agreement does not appear to have altered offsets and countertrade rules is also viewed positively by many in Israel, although U.S. companies’ views would naturally diverge on this point.[1]

However, the increase in funding has not assuaged the greatest fear of many Israeli defense contractors, namely, the fate of “Offshore Procurement”, or “OSP”. Since the 1980s, the FMF program with Israel has had a unique provision permitting a portion of the funds provided to Israel to be utilized through in-country procurement from Israeli industry, a provision known as OSP. In FY2016, for example, the relevant appropriations legislation provides that of the $3.1 billion apportioned for Israeli FMF, “not less than $815,300,000 shall be available for the procurement in Israel of defense articles and defense services, including research and development”. Against the backdrop of ongoing sequestration, however, the current administration reassessed Israel’s OSP allowances and, after prolonged discussions with the Israeli government, developed a multi-year plan to gradually phase out this aspect of Israel’s FMF program. The Fact Sheet released by the White House explains that the OSP was an “anomaly” of the previous U.S.-Israel MOU and that the decision to discontinue it, “means that Israel will spend more funding, as much as $1.2 billion per year, on the advanced military capabilities that only the U.S. can provide. The acquisition of additional U.S.-produced capabilities and technology provide the best means to ensure Israel preserves its Qualitative Military Edge (QME).”

III.  Coping with and Benefiting from the OSP Phase-Out

The elimination of OSP for Israel has caused angst amongst Israeli defense industry executives, some of whom forecast that the terms of the new MOU will lead to the demise of Israel’s defense sector.[2]  And while Israeli economists are divided as to which companies stand to lose the most from the elimination of OSP funding, it is clear that many Israeli businesses will need to adapt to survive.

For U.S. industry, on the other hand, the new deal means an infusion of a fresh annual market share of well over $1 billion in Israel-bound, government procurement.

IV. Legal Obstacles Adapting to the New MOU

As reported in Israeli media, CEO’s of leading Israeli defense companies, several of which are traded on U.S. stock exchanges, have indicated that the impending termination of OSP funds has compelled them to devise reorganization strategies in attempts at regaining FMF eligibility. For this purpose, senior Israeli defense executives are signaling interest, among other things, in acquiring U.S. companies; greenfield investment in the U.S.; or joint venture and creative teaming opportunities with U.S. companies. Concurrently, Israeli companies are pressing their government for greater support in accessing markets outside of the U.S., including by budgeting for government-sponsored export assistance and by easing rigid Israeli export control licensing processes.

For U.S. contractors, the new market conditions will create opportunities, some of which may be best seized by partnering with Israeli contractors headed to the U.S. Indeed, working jointly with the Israeli industries that have been supplying IMOD with its defense needs for decades, whether through OSP or other funds, could afford U.S. contractors a leg up on competitors less familiar with IMOD’s likely future requirements.

All of the above routes, however, contain substantial compliance challenges that will require appropriate planning.

For example, Israeli defense companies looking to establish U.S. subsidiaries through asset or share-purchase acquisitions will immediately be confronted with the robust review and approval mechanisms of the Committee on Foreign Investment in the U.S. (“CFIUS”). CFIUS has broad authority to determine that foreign control of a domestic enterprise impairs national security, triggering the nearly unbounded discretion of the President to address that concern, including by preventing the proposed  acquisition or requiring divestment of an existing one. Building a new company from the ground up would sidestep CFIUS review, but this form of greenfield investment often requires a prohibitive amount of resources and simply may not be a feasible solution for Israeli companies, especially given the exigencies and timeframe of the new aid package changes. The remaining option, to partner with established U.S. firms, is particularly complex. Current rules are restrictive regarding the use of FMF funding to pay for goods or services provided by Israeli companies, and categorically forbid utilization of FMF funding for projects run by an Israeli prime contractor. For example, one relevant IMOD guideline, reflecting DoD’s FMF rules, states that “[i]t is categorically prohibited to use FMF funds for Israeli subcontracting work, in the context of commercial cooperation, between a U.S. prime contractor and an Israeli subcontractor…; joint venture  arrangements are discouraged…; [and it] is prohibited to use FMF funds to finance expenses associated with managing commercial joint ventures [between Israeli and U.S. defense contractors]”.

V.  Conclusion

Since 2007, U.S. and Israeli defense contractors have become accustomed  to navigating the terms of the FY2009-FY2018 FMF program. The new 10-year package, however, presents new, unchartered challenges, for which industry will have to prepare and adapt. To do so effectively, companies will want to (i) glean more specific details regarding the terms of the FY2019-FY2028 MOU, especially in light of the new changing administration (ii) work towards increasing their FMF-eligibility by adapting structurally, either through approved M&A activity or B2B cooperation between U.S. and Israeli companies, and, finally, (iii) engage with experts, policy makers and regulators, to ensure their plans align with any current or future compliance constraints.

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[1] Offsets and counter trade refers to the practice whereby governments condition their contracts with overseas vendors on those vendors spending designated amounts of money in the government’s home-country. Some Israeli companies that traditionally have benefitted from Israel’s offset requirements vis-à-vis U.S. contractors had been concerned that the new MOU would restrict this practice.

[2] See e.g., Shai Nir, ‘It means buying everything in the U.S.’, Davar Rishon Newspaper, October 2, 2016 (Hebrew), available at http://www.davar1.co.il/18590/ (quoting Shraga Brosh, president of the Manufacturers’ Association of Israel, whose members make up more than 95% of Israeli industrial production, who told Hebrew media that, “[t]he Israeli government’s agreement to [accept] the U.S. [FMF] program means a critical injury to the [Israel] defense sector, together with the loss of thousands of jobs. Instead of the Israeli defense sector continuing to flourish and stand at the forefront of global technology, what will happen is tens of production lines and even complete defense factories will close, thousands of employees will be laid off and the State of Israel will lose its defense-independence.”