On the heels of the FTC’s opposition to Lockheed Martin’s acquisition of Aerojet Rocketdyne and Lockheed’s termination of the deal, the Department of Defense (DoD) released a report expressing concerns about the state of competition among its contractors.  Of particular note, the report encourages DoD action to (1) increase oversight of M&A transactions and (2) obtain greater IP rights in matters involving defense industrial base contractors.  Although the report is light on specifics and identifies objectives that are in some tension with each other, the report is a reminder to companies that the U.S. Government, the single largest purchaser in the country, remains focused on enhancing competition. To that end, we anticipate seeing Executive Branch action in the coming months that seeks to further that policy objective.

The new report from the Office of the Under Secretary of Defense for Acquisition and Sustainment, issued February 15 along with a White House fact sheet, is titled State of Competition within the Defense Industrial Base and results from a directive in last July’s Executive Order 14036, Promoting Competition in the American Economy.  The report contends that:

Since the 1990s, the defense sector has consolidated substantially, transitioning from 51 to 5 aerospace and defense prime contractors.  As a result, DoD is increasingly reliant on a small number of contractors for critical defense capabilities.  Consolidations that reduce required capability and capacity and the depth of competition would have serious consequences for national security.

Interestingly, the “51 to 5” statistic describes consolidations between 1993 and 2000, and the report later acknowledges that “[t]he landscape has largely remained unchanged since then” with respect to the major defense prime contractors.  But the defense industrial base includes businesses throughout DoD’s supply chain — even upstream suppliers that may not consider themselves “defense contractors.”  And the report highlights concerns with both horizontal mergers (acquisition of businesses with overlapping products or services) and vertical mergers (acquisition of companies at different levels in the supply chain).  The report details various concerns relating to perceived industry consolidation, but is notably silent on the benefits that DoD has presumably received from a more efficient and well-aligned defense industrial base, including from several transactions that it has supported in the past.

The report outlines additional steps for DoD to address competition concerns, including a call to strengthen merger oversight with a “heightened review” of M&A activity.  “Moreover, when a merger threatens DoD interests,” the report details, “DoD will support the Federal Trade Commission (FTC) and Department of Justice (DOJ) in antitrust investigations and recommendations involving the defense industrial base.”  It remains to be seen what DoD’s approach to M&A activity changes under “heightened review” entails.

In the meantime, contractors might expect DoD to increase its focus on securing greater rights in contractor IP when conducting procurements.  The report raises concerns that data rights held by contractors limit competition in DoD procurements and result in “vendor lock” — by which contractors with proprietary data rights in a government system gain an advantage during future procurements.  In response, DoD suggests that it could increase competition by enhancing its rights in contractor background data, including by requiring contractors to provide form, fit and function data sufficient to allow the government to “reverse engineer” the proprietary elements of a larger system and plug in alternative components or subsystems.  The report also suggests that DoD should negotiate broader special license rights in background IP on the front end that would essentially allow DoD to provide background IP to third parties for incorporation into larger systems during follow-on procurements.

The report recognizes, albeit in passing, that “IP rights encourage technology innovations that are critical to DoD’s capabilities and mission by enhancing the return on investment for those entities that invest in creating such technology.”  However, the report does not address the potential impact that requiring additional IP rights in background IP could have on DoD’s persistent efforts to expand participation in the defense industrial base.  Indeed, many companies (particularly those with commercial offerings) rely on protection of their background data rights when developing solutions for DoD platforms, as these rights are often core to a company’s value, including in the commercial market.  Requiring contractors to turn over rights that would allow the government to reverse engineer proprietary solutions or provide those proprietary solutions to competitors is likely to discourage new entrants in the defense industrial base, further highlighting the tension between the report’s stated objectives.