B-204458.OM, MAY 6, 1982

B-204458.OM: May 6, 1982

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FN1 DOD HAS DISAGREED WITH OUR CONCLUSION THAT FOREIGN CUSTOMERS ARE TO BE CHARGED THE REPLACEMENT COST OF ITEMS SOLD FROM DOD STOCK FUND INVENTORY. ACQUISITION) COSTS ARE TO BE CHARGED. WE HAVE NO DOUBT THAT THE SUBJECT SALES FALL SQUARELY WITHIN BOTH THE TERMS AND INTENT OF SECTION 21 OF THE ARMS EXPORT CONTROL ACT. IS INCONSISTENT WITH THE INTENDED MEANING OF THE APPLICABLE LEGISLATION AND REGULATIONS. THE TWO BASIC TYPES OF SALES ARE (1) DIRECT SALES BY THE UNITED STATES FROM EXISTING DOD STOCK (REFERRED TO AS CASH SALES FROM STOCK. WHICH ARE GOVERNED BY SECTION 21 OF THE ACT). WHICH ARE GOVERNED BY SECTION 22). SECTION 21 REQUIRES THAT FOREIGN COUNTRIES BE CHARGED THE ESTIMATED REPLACEMENT COST OF THOSE DEFENSE ARTICLES THAT ARE INTENDED TO BE REPLACED.

B-204458.OM, MAY 6, 1982

SUBJECT: FOREIGN MILITARY SALES PRICING OF CERTAIN STOCK FUND SALES (FILE B-204458; CODE 903048)

ACTING DIRECTOR, AFMD:

THIS REFERS TO YOUR MEMORANDUM OF APRIL 16, 1982, REQUESTING OUR LEGAL ASSISTANCE IN RESPONDING TO THE DEPARTMENT OF DEFENSE'S (DOD) COMMENTS ON A GAO REPORT ISSUED LAST YEAR ON STOCK FUND SALES TO CUSTOMERS UNDER THE FOREIGN MILITARY SALES PROGRAM. FN1 DOD HAS DISAGREED WITH OUR CONCLUSION THAT FOREIGN CUSTOMERS ARE TO BE CHARGED THE REPLACEMENT COST OF ITEMS SOLD FROM DOD STOCK FUND INVENTORY, CONTENDING THAT THE PROCUREMENT (I.E., ACQUISITION) COSTS ARE TO BE CHARGED.

AS EXPLAINED MORE FULLY BELOW, WE HAVE NO DOUBT THAT THE SUBJECT SALES FALL SQUARELY WITHIN BOTH THE TERMS AND INTENT OF SECTION 21 OF THE ARMS EXPORT CONTROL ACT, THUS REQUIRING THE CHARGING OF THE REPLACEMENT COSTS OF THE ITEMS SOLD. DOD'S CHARACTERIZATION OF THESE TRANSACTIONS AS SECTION 22 PROCUREMENT FOR CASH SALES, THUS REQUIRING THE CHARGING OF THE PROCUREMENT COST OF THE ITEMS, IS INCONSISTENT WITH THE INTENDED MEANING OF THE APPLICABLE LEGISLATION AND REGULATIONS.

I. BACKGROUND:

THE ARMS EXPORT CONTROL ACT (22 U.S.C. SECS. 2751 ET SEQ.) GENERALLY AUTHORIZES THE SALE OF DEFENSE ARTICLES TO FOREIGN COUNTRIES ON A COST REIMBURSEMENT BASIS. THE TWO BASIC TYPES OF SALES ARE (1) DIRECT SALES BY THE UNITED STATES FROM EXISTING DOD STOCK (REFERRED TO AS CASH SALES FROM STOCK, WHICH ARE GOVERNED BY SECTION 21 OF THE ACT); AND (2) UNITED STATES' PROCUREMENT OF ARTICLES FROM DEFENSE CONTRACTORS FOR RESALE TO THE FOREIGN COUNTRIES (REFERRED TO AS PROCUREMENT FOR CASH SALES, WHICH ARE GOVERNED BY SECTION 22). CONCERNING CASH SALES FROM STOCK, SECTION 21 REQUIRES THAT FOREIGN COUNTRIES BE CHARGED THE ESTIMATED REPLACEMENT COST OF THOSE DEFENSE ARTICLES THAT ARE INTENDED TO BE REPLACED. FN2 AS TO PROCUREMENT FOR CASH SALES, SECTION 22 REQUIRES THAT FOREIGN COUNTRIES BE CHARGED THE FULL AMOUNT OF THE SALES CONTRACTS WITH THE DEFENSE CONTRACTORS (THE PROCUREMENT COST) WHICH WILL ASSURE THE UNITED STATES AGAINST ANY LOSS ON THE CONTRACTS.

ON THE ASSUMPTION THAT THE SECTION 21 COST RECOVERY REQUIREMENTS GOVERNED, OUR 1981 REPORT CRITICIZED DOD FOR NOT PROPERLY CHARGING FOREIGN COUNTRIES THE REPLACEMENT COST OF DEFENSE ARTICLES SOLD FROM INVENTORY THROUGH DOD STOCK FUNDS. THIS FAILURE WAS ATTRIBUTABLE TO CERTAIN IDENTIFIED WEAKNESSES IN DOD'S PRICING POLICIES AND PRACTICES, NAMELY; (1) THE USE OF UNREALISTICALLY LOW INFLATION FACTORS IN COMPUTING REPLACEMENT COSTS, (2) THE FAILURE TO COMPOUND INFLATION FACTORS IN SETTING SALES PRICES FOR THOSE ITEMS PURCHASED MORE THAN A YEAR PRIOR TO THEIR SALE, AND (3) THE FAILURE TO UPDATE THE SALES PRICES TO BE CHARGED.

IN A LETTER DATED JANUARY 2, 1982, DOD STATED THAT OUR USE OF REPLACEMENT COST PRICING WAS ERRONEOUS, STATING:

"YOUR DISCUSSIONS FAIL TO RECOGNIZE THE FACT THAT ITEMS CAN BE PROCURED AND STORED IN DOD INVENTORIES FOR FMS CUSTOMERS. SUCH PROCUREMENTS TAKE PLACE UNDER COOPERATIVE LOGISTICS SUPPLY SUPPORT AGREEMENTS (CLSSAS). SALES UNDER CLSSAS ARE NOT SUBJECT TO AECA REPLACEMENT PRICING REQUIREMENTS BUT RATHER TO AECA SECTION 22 NEW PROCUREMENT PRICING REQUIREMENTS. THE BASIC RULE FOR CLSSAS IS THAT THE FMS SELLING PRICE MUST RECOUP PROCUREMENT COST AND THE COST OF HOLDING INVENTORY."

COOPERATIVE LOGISTICS SUPPLY SUPPORT AGREEMENTS (CLSSAS) CONSIST OF TWO SEPARATE TRANSACTIONS: FOREIGN MILITARY SALES ORDERS (FMSO) NO. 1 AND NO. 2. UNDER A FMSO NO. 1, THE PURCHASING GOVERNMENT BUYS EQUITY IN A SPECIFIED DOLLAR AMOUNT OF DOD STOCKS BY ADVANCING 5/17 OF THE TOTAL ESTIMATED COST OF THE FUTURE REQUISITION. UNDER A FMSO NO. 2, THE PURCHASER SUBMITS REQUISITIONS FOR COMMON REPAIR PARTS AND SECONDARY ITEMS IN THE DOD STOCK FUND, PAYING THE REMAINING 12/17.

II. QUESTION: DOES THE ARMS EXPORT CONTROL ACT REQUIRE THE CHARGING OF THE REPLACEMENT COST OR THE PROCUREMENT (ACQUISITION) COST OF DEFENSE ITEMS SOLD FROM THE DOD STOCK FUND INVENTORY UNDER A COOPERATIVE LOGISTICS SUPPLY SUPPORT AGREEMENT?

ANSWER: REPLACEMENT COST.

III. EXPLANATION:

WE HAVE NO DOUBT THAT THE SALES IN QUESTION FALL SQUARELY WITHIN BOTH THE TERMS AND INTENT OF SECTION 21, THUS REQUIRING THE CHARGING OF THE REPLACEMENT COSTS OF THE ITEMS SOLD. THE TRANSACTIONS WERE CLEARLY SALES OF ITEMS FROM STOCK FUND INVENTORY, AND DUE TO THE VERY NATURE OF STOCK FUNDS THE ITEMS WERE INTENDED TO BE REPLACED. WE THEREFORE DO NOT AGREE WITH DOD'S CHARACTERIZATION OF THE TRANSACTIONS AS SECTION 22 PROCUREMENT FOR CASH SALES, THUS REQUIRING THE CHARGING OF THE PROCUREMENT COSTS THEREOF.

THERE IS SOME QUESTION WHETHER DOD COULD PROPERLY ENTER INTO A COOPERATIVE LOGISTICS SUPPLY SUPPORT AGREEMENT (CLSSA) UNDER THE AUTHORITY OF SECTION 22. THAT SECTION APPEARS TO CONTEMPLATE THE EXISTENCE OF SPECIFIC, IDENTIFIABLE DEFENSE ITEMS, WITH THE UNITED STATES ACTING ON BEHALF OF THE FOREIGN CUSTOMER IN PROCURING THE ITEMS FROM A DEFENSE CONTRACTOR. CLSSAS DO NOT RELATE TO SPECIFIC, IDENTIFIABLE ITEMS BUT RATHER A COMMITMENT BY THE FOREIGN CUSTOMER TO PURCHASE CERTAIN TYPES OF ITEMS FROM THE DOD STOCK FUND AT SOME TIME IN THE FUTURE. IN ANY CASE, THERE ARE OTHER MORE COMPELLING REASONS WHY WE QUESTION DOD'S POSITION.

FIRST, WE FIND NO BASIS FOR DOD'S CONTENTION THAT THE SUBJECT SALES TRANSACTIONS WERE IN FACT SECTION 22 PROCUREMENT FOR CASH SALES. TO THE CONTRARY, NEARLY ALL AVAILABLE REFERENCES INDICATE THAT THE TRANSACTIONS WERE CONSIDERED AS SECTION 21 SALES. THE AGREEMENTS EXECUTED BETWEEN THE UNITED STATES AND THE FOREIGN COUNTRIES DO NOT SPECIFICALLY IDENTIFY WHETHER THEY CONSTITUTE SECTION 21 OR SECTION 22 TRANSACTIONS. AS DOD POINTED OUT, HOWEVER, THE SALES TRANSACTIONS WERE CARRIED OUT PURSUANT TO CLSSAS, AND THE DOD MILITARY ASSISTANCE AND SALES MANUAL FLATLY STATES THAT SUCH ARRANGEMENTS ARE GOVERNED BY SECTION 21: FN3

"(7) FOREIGN MILITARY SALES ORDER (FMSO) NO. 1 - *** THIS TYPE OF ASSISTANCE APPLIES TO CASH PAYMENT FOR A FMSO NO. 1 SUPPLY SUPPORT ARRANGEMENT AUTHORIZED BY SECTION 21 OF THE ARMS EXPORT CONTROL ACT AND DESCRIBED IN DOD INSTRUCTIONS 2000.8 AND 2140.1. (8) FOREIGN MILITARY SALES ORDER (FMSO) NO. 2 - *** THIS TYPE OF ASSISTANCE APPLIES TO CASH PAYMENT FOR A FMSO NO. 2 SUPPLY SUPPORT ARRANGEMENT *** SECTION 21 OF THE ARMS EXPORT CONTROL ACT AND DOD INSTRUCTIONS 2000.8 AND 2140.1 APPLY."

CONSISTENT WITH THE ABOVE, DOD IMPLEMENTING INSTRUCTIONS (FORMERLY DOD INSTRUCTION 2140.1, NOW FMS FINANCIAL MANAGEMENT MANUAL 7290.3-M) CLEARLY INDICATE THAT CLSSAS ARE IN THE NATURE OF A SECTION 21 SALE FROM STOCK: FN4

"70201 GENERAL

"SECTION 21 OF THE ACT AUTHORIZES THE SALE OF DEFENSE ARTICLES FROM STOCK TO ELIGIBLE FOREIGN GOVERNMENTS AND INTERNATIONAL ORGANIZATIONS. THESE SALES INCLUDE ALL SALES OF ITEMS FROM DOD INVENTORIES, WHETHER DELIVERED FROM STORAGE OF FROM PROCUREMENTS WHICH WERE INITIATED TO MAINTAIN ADEQUATE DOD INVENTORY LEVELS. *** PROCUREMENTS SPECIFICALLY FOR FMS REQUIREMENTS (EXCLUDING COOPERATIVE LOGISTICS SUPPLY SUPPORT ARRANGEMENTS) WILL NOT BE CONSIDERED A SALE FROM STOCK. "70202 SALES PRICE OF NONEXCESS MATERIEL

"A. NONEXCESS DEFENSE ARTICLES ARE ASSETS APPLICABLE TO THE APPROVED FORCE ACQUISITION OBJECTIVE AND APPROVED FORCE RETENTION STOCK OF ALL DOD COMPONENTS AS DEFINED IN DOD DIRECTIVE 4100.37 (REFERENCE (8)). ALSO INCLUDED IN THE NONEXCESS CATEGORY ARE ARTICLES PROCURED IN ANTICIPATION OF MILITARY ASSISTANCE OR SALES REQUIREMENTS AS A RESULT OF COOPERATIVE LOGISTIC SUPPLY SUPPORT ARRANGEMENTS, OR PURSUANT TO A MILITARY ASSISTANCE OR SALES ORDER."

SECOND, DOD'S CONTENTIONS THAT STOCK FUND SALES UNDER CLSSA ARRANGEMENTS ARE PRICED AT PROCUREMENT (I.E., ACQUISITION) COST IS INCONSISTENT WITH DOD'S ESTABLISHED PRICING POLICIES AND PRACTICES. AS STATED IN SECTION 707 OF FMS FINANCIAL MANAGEMENT MANUAL 7290.3-M (WHICH PERTAINS SPECIFICALLY TO CLSSAS), FOREIGN CUSTOMERS ARE TO BE CHARGED THE ESTABLISHED STANDARD PRICE OF STOCK FUND ITEM SOLD, JUST LIKE ANY OTHER DOD STOCK FUND CUSTOMER. THE STANDARD PRICE IS DETERMINED AT THE TIME THE ITEM IS DROPPED FROM INVENTORY, WHICH MAY BE ENTIRELY DIFFERENT THAN THE ORIGINAL PROCUREMENT OR ACQUISITION COST OF THAT ITEM. IT IS ALSO RELEVANT TO NOTE THAT THE CHARGING OF THE STANDARD PRICE IS INTENDED TO RECOVER (AMONG OTHER THINGS) AN AMOUNT NECESSARY TO REPLACE ANY STOCK ITEMS SOLD, WHICH DIRECTLY CONTRADICTS DOD'S CONTENTION. FN5 PARAGRAPH 70202 OF THE SAME MANUAL STATES:

"*** THE ESTABLISHED STANDARD PRICE INCLUDES INFLATION, INVENTORY SHRINKAGE, AND OBSOLESCENCE FACTORS WHICH ADEQUATELY ASSURE RECOUPMENT OF THE MONIES NECESSARY TO PROCURE REPLACEMENT ITEMS ***."

FN1 "MILLIONS IN LOSSES CONTINUE ON DEFENSE STOCK FUND SALES TO FOREIGN CUSTOMERS," AFMD -81-62, SEPTEMBER 10, 1981.

FN2 THE REASON WHY SECTION 21 REQUIRES THE CHARGING OF THE ESTIMATED REPLACEMENT COST OF THOSE STOCK ITEMS THAT ARE INTENDED TO BE REPLACED IS BECAUSE THE EFFECTIVE COST TO THE UNITED STATES IN ANY SUCH SALE IS THE AMOUNT NEEDED TO PURCHASE A REPLACEMENT ITEM. IF A CUSTOMER IS CHARGED ANYTHING LESS THAN THE REPLACEMENT PRICE OF THE ITEM, THE UNITED STATES IS ABSORBING THE DIFFERENCE BETWEEN THE SALE PRICE AND THE REQUIRED REPURCHASE PRICE. IN THE CASE OF THE DOD STOCK FUND, THE NET RESULT OF ANY SUCH REDUCED PRICING IS THAT THE FUND MUST RECEIVE FINANCING ELSEWHERE IN ORDER TO PURCHASE REPLACEMENT ITEMS, EITHER FROM OTHER STOCK FUND CUSTOMERS OR THROUGH DIRECT APPROPRIATIONS.

FN3 PARAGRAPH 3.B. OF CHAPTER G (FINANCIAL PROCEDURES).

FN4 THE CITED REFERENCES APPEAR IN SECTION 702, WHICH COVERS SECTION 21 SALES FROM STOCK. IN CONTRAST, THE INSTRUCTION PERTAINING TO SECTION 22 SALES (SECTION 703) IN NO WAY MENTION OR OTHERWISE INDICATE THAT CLSSAS ARE COVERED THEREIN.

FN5 AS MENTIONED EARLIER, ONE OF THE REASONS WE HAD CITED FOR DOD'S FAILURE TO CHARGE REPLACEMENT COSTS IS DOD'S FAILURE TO UPDATE THE SALES (STANDARD) PRICE OF STOCK FUND ITEMS.