January 21, 1997. Document from GPO Access, GAO Documents at:
http://www.access.gpo.gov/su_docs/aces/aces160.shtml

-----------------------------------------------------------------------

Defense Industrial Security: 
Weaknesses in U.S. Security Arrangements
With Foreign-Owned Defense Contractors 
(Chapter Report, 02/20/96, GAO/NSIAD-96-64).

Pursuant to a congressional request, GAO reviewed security arrangements
used to protect sensitive information from foreign-owned U.S. defense
contractors that perform on classified Department of Defense (DOD)
contracts.

GAO found that: (1) security arrangements are intended to protect
foreign-owned U.S. defense contractors from undue foreign control and to
prevent foreign owners' access to classified information; (2) there are
54 foreign-owned U.S. defense contractors operating under security
arrangements, such as voting trusts, proxy agreements, and special
security agreements; (3) although such companies are not permitted
access to classified information due to the risk of foreign control, DOD
authorized access to 12 of 33 special security agreement companies; (4)
each foreign-owned U.S. defense contractor must have a visitation
agreement with its parent company to protect against foreign owners'
unauthorized access to classified information; (5) individuals contacted
by the parent company are required to report on the technical
discussions that took place under visitation agreements; (6) U.S.
citizens are selected for the boards of directors of foreign-owned U.S.
defense firms to protect against undue foreign control and unauthorized
access to classified information; and (7) most trustees feel they have
limited oversight roles and do not actively check on the implementation
of security policies or engage in management issues, and some appear to
have conflicts of interest.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  NSIAD-96-64
     TITLE:  Defense Industrial Security: Weaknesses in U.S. Security
             Arrangements With Foreign-Owned Defense Contractors
      DATE:  02/20/96
   SUBJECT:  Department of Defense contractors
             Foreign corporations
             Proprietary data
             Classified records
             Computer security
             Information disclosure
             Technology transfer
             Conflict of interest
             International trusteeships
             Intelligence gathering operations
IDENTIFIER:  B-2 Aircraft
             F-22 Aircraft
             F-117 Aircraft
             DOD Industrial Security Program
             Advanced Technology Bomber
             United Kingdom
             Switzerland
             Sweden
             France
             Netherlands
             Germany
             Worldwide Military Command and Control System
             D-5 Missile
             DOD Special Access Acquisition Program
             FBI National Security Threat List Program

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Cover
================================================================ COVER

Report to Congressional Requesters

February 1996

DEFENSE INDUSTRIAL SECURITY -
WEAKNESSES IN U.S.  SECURITY
ARRANGEMENTS WITH FOREIGN-OWNED
DEFENSE CONTRACTORS

GAO/NSIAD-96-64

Defense Industrial Security

(463831)(705103)

Abbreviations
=============================================================== ABBREV

  CEO - Chief Executive Officer
  CIA - Central Intelligence Agency
  DIA - Defense Intelligence Agency
  DIS - Defense Investigative Service
  DOD - Department of Defense
  FBI - Federal Bureau of Investigation
  FOCI - foreign ownership, control, or influence
  FSO - facility security officer
  ISR - Industrial Security Regulation
  MOA - memorandum of agreement
  NISPOM - National Industrial Security Program Operating Manual
  SCA - security control agreement
  SSA - special security agreement

Letter
=============================================================== LETTER

B-265628

February 20, 1996

The Honorable Floyd Spence
Chairman
The Honorable Ronald V.  Dellums
Ranking Minority Member
Committee on National Security
House of Representatives

This is an unclassified version of a classified report issued to you
in 1995.  This report discusses security arrangements known as voting
trusts, proxy agreements, and special security agreements that are
used to protect sensitive information when foreign-owned U.S.
defense contractors perform on classified Department of Defense
contracts.  Our review was in response to a request from the former
Chairman and Ranking Minority Member, Subcommittee on Oversight and
Investigation, House Committee on Armed Services.  In chapter 4 of
this report, we recommend improvements in trustee oversight of
information security and additional controls to prevent potential
trustee conflicts of interest.

We are sending copies of this report to the Chairman and Ranking
Minority Member, Senate Committee on Armed Services, and the
Secretary of Defense.  Copies will also be made available to others
upon request.

Please call me at (202) 512-4587 if you or your staff have any
questions concerning this report.  Other major contributors to this
report are listed in appendix II.

David E.  Cooper
Associate Director,
Defense Acquisition Issues

EXECUTIVE SUMMARY
============================================================ Chapter 0

   PURPOSE
---------------------------------------------------------- Chapter 0:1

Since the mid-1980s, development, production, and marketing of weapon
systems has been increasingly internationalized through
government-sponsored cooperative development programs and various
kinds of industrial linkages, including international subcontracting
and teaming arrangements, joint ventures, and cross-border mergers
and acquisitions.  Foreign companies have acquired many U.S.  defense
companies and have legitimate business interests in them.  The U.S.
government allows such foreign investment as long as it is consistent
with U.S.  national security interests.  Some foreign-owned U.S.
companies are working on highly classified defense contracts, such as
the B-2, the F-117, the F-22, and military satellite programs.

The Federal Bureau of Investigation and intelligence agencies have
reported that foreign intelligence activities directed at U.S.
critical technologies pose a significant threat to national security.
According to these agencies, some close U.S.  allies are actively
trying to obtain U.S.  defense technologies through unauthorized
means.  To reduce the national security risks of foreign control over
companies working on sensitive classified contracts, the Department
of Defense (DOD) requires controls known as voting trusts, proxy
agreements, and special security agreements (SSA).

Concerned that a major U.S.  defense contractor could be acquired by
foreign interests, the former Chairman and Ranking Minority Member,
Subcommittee on Oversight and Investigation, House Committee on Armed
Services (now the House Committee on National Security) asked GAO to
review voting trusts, proxy agreements, and SSAs.  GAO reviewed the
structure and implementation of the agreements intended to protect
classified information from unauthorized disclosure to foreign
interests and to reduce the risk that foreign control could adversely
affect the companies' performance of classified contracts.

   BACKGROUND
---------------------------------------------------------- Chapter 0:2

The government has drafted the National Industrial Security Program
Operating Manual (NISPOM) to replace the DOD Industrial Security
Manual and various agencies' industrial security requirements.  The
section dealing with foreign ownership, control, or influence
contains many provisions on voting trusts, proxy agreements, and SSAs
that are similar to provisions in the DOD Industrial Security
Regulation (ISR).  The ISR will continue to apply in its current form
until it is amended to reflect the NISPOM.

The ISR and NISPOM require a company to obtain a facility clearance
before it can work on a classified DOD contract.  To obtain a
clearance, a U.S.  defense contractor that is majority foreign-owned
must first accept a voting trust, proxy agreement, or SSA to insulate
it from its foreign owners.  With one of these agreements in place,
some foreign-owned U.S.  defense contractors have access to some of
the most highly classified information, such as Top Secret and
Sensitive Compartmented Information.\1 The Defense Investigative
Service (DIS) administers DOD's Industrial Security Program and is
required to conduct compliance reviews of defense contractors
operating under voting trusts, proxy agreements, and SSAs.

The agreements call for (1) installing one or more foreign
owner-selected, DOD-approved, cleared U.S.  citizens on the company's
board of directors for management oversight and (2) limiting contact
between the U.S.  company and representatives of its foreign owners.
The trustees, proxy holders, or SSA outside directors (collectively
referred to as "trustees" in this report) are to represent DOD's
interests by ensuring against unauthorized access to classified
information and company actions that could adversely affect
performance on classified contracts.  Under the ISR and the NISPOM,
voting trusts and proxy agreements must provide the trustees with
complete freedom to act independently from the foreign owners, and
trustees are to exercise responsibility and management prerogatives
for the cleared U.S.  companies.  ISR and NISPOM requirements for
SSAs are less specific and allow a higher potential for foreign
control.  Normally, SSA firms are not supposed to be cleared for Top
Secret, Sensitive Compartmented Information, Special Access Programs,
and certain other categories of classified information.  The ISR and
most implementing agreements were not intended or designed to protect
unclassified export-controlled information.

--------------------
\1 Special Access Programs, Restricted Data, and Communications
Security are also among the most highly classified categories of
information that foreign-owned U.S.  defense firms have access to on
some DOD contracts.

   RESULTS IN BRIEF
---------------------------------------------------------- Chapter 0:3

The security arrangements GAO reviewed were not intended or designed
to deny foreign owners the opportunity to pursue legitimate business
with their U.S.-based companies working on classified contracts.
Rather, they were designed to insulate these companies from undue
foreign control and influence and to prevent foreign owners' access
to classified information without a clearance and a need to know.
Fifty-four companies operate under voting trusts, proxy agreements,
and SSAs.  GAO reviewed the controls established in 13 of these
companies and a company operating under a unique security arrangement
called a memorandum of agreement.  The structure and implementation
of the agreements at most of the 14 companies GAO reviewed permitted
some risk of foreign control, influence, and unauthorized access to
classified data and technology.  GAO did not determine whether
unauthorized access to classified data or technology actually
occurred.  GAO observed the following:

  Thirty-six percent of SSA companies were granted exceptions to
     restrictions on their access to the most highly classified
     information.

  Visitation agreements permitted numerous visits, many occurring
     under contracts and export licenses for military and dual-use
     products, between the foreign owners and the U.S.  defense
     contractor.

  Most trustees performed little oversight and, at four companies,
     some trustees appeared to have conflicts of interest.

   PRINCIPAL FINDINGS
---------------------------------------------------------- Chapter 0:4

      THROUGH EXCEPTIONS, SSA
      FIRMS GAIN ACCESS TO
      OTHERWISE PROSCRIBED DATA
-------------------------------------------------------- Chapter 0:4.1

The ISR and NISPOM allow each SSA to be tailored to the individual
company, but SSAs have some common elements that allow foreign owners
to exercise a high degree of control over the U.S.  firms.  For
example, SSAs allow the foreign owner to have a representative (an
"inside director," often a foreign national) on the U.S.  firm's
board of directors.  Although inside directors do not hold a majority
of votes on the board, their views about the company's direction on
certain defense contracts or product lines reflect those of the
owners.  In addition, unlike voting trusts and proxy agreements, most
SSAs allow foreign owners to replace any member of the board of
directors of the U.S.  company for any reason.  Under new boilerplate
SSA language DOD provided to GAO, DIS will have to approve such a
removal.

Because SSAs allow greater potential for foreign control than the
voting trust and proxy agreement, SSA firms cannot work on Top Secret
and other highly classified contracts, except when DOD determines it
to be in the national interest.  At the time of GAO's review, at
least 12 of the 33 SSA companies were working under exceptions to
this restriction on at least
47 contracts that required access to Top Secret, Special Access, and
other highly classified information.

      A HIGH DEGREE OF CONTACT
      OCCURS UNDER VISITATION
      AGREEMENTS
-------------------------------------------------------- Chapter 0:4.2

To address the risk of foreign parent\2 firms' personnel gaining
unauthorized access to classified information, the ISR requires each
voting trust, proxy agreement, and SSA company to draw up a
visitation agreement.  Under the ISR, the visitation agreement is to
generally restrict and limit visits between personnel of the U.S.
defense contractor and its foreign parent firm, except for
trustee-approved visits relating to regular day-to-day business
operations pertaining to purely commercial products or services.
DOD-approved visitation agreements that permitted a high number of
visits pertaining to military and dual-use products and services.
Often these visits occurred under approved export licenses for
specific products and technologies.  These licenses and a large
number of contracts between the U.S.  defense contractors and their
foreign owners allowed considerable access to the U.S.  facilities.
In several cases, GAO observed hundreds of visits and long-term
visits with personnel at technical and other levels of the companies.

A primary tool for trustees and DOD to monitor visitation by foreign
owners' representatives is post-visit reporting.  Post-visit
reporting requires the individuals contacted by the foreign
representatives to report the substance of the discussions that took
place.  With few exceptions, the contact reports GAO examined
identified only the individuals involved and the title of the program
they discussed, without providing any detailed information on
technical discussions that may have occurred.

In 1993, DOD eliminated separate visitation agreements and included
visitation controls in each voting trust, proxy agreement, and SSA.
The new NISPOM does not address visitation control agreements or
procedures.  According to DOD, when the ISR is amended to reflect the
NISPOM, it will retain a requirement for visitation approval
procedures.

--------------------
\2 The business arrangements between U.S.  firms and their foreign
owners may take a variety of forms, including a parent-subsidiary
relationship.  This report uses those terms in general way to
indicate affiliation rather than as a description of the exact legal
relationship between specific U.S.  and foreign entities.

      LITTLE TRUSTEE OVERSIGHT;
      SOME HAVE APPEARANCE OF
      CONFLICTS OF INTEREST
-------------------------------------------------------- Chapter 0:4.3

The foreign owner selects and DOD approves cleared U.S.  citizens to
be placed on the boards of directors of foreign-owned U.S.  defense
contractors to guard against undue foreign influence over company
management and to ensure against unauthorized access to classified
information.  At a few of the 14 companies GAO reviewed, the trustees
were more actively involved in company management and security
oversight than at the other companies.  At some companies, the
trustees maintained their responsibility for approving all visits by
representatives of the foreign owners, as required in the visitation
agreements.  The more active trustees also interviewed a sample of
technical staff who had been contacted by the foreign owners to
determine the parameters of their discussions, questioned potentially
adverse company business conditions caused by exclusive arrangements
with the foreign parent, and attended business meetings at the
company more often than quarterly.  In most cases, however, the
trustees delegated nearly all aspects of visitation oversight to the
foreign-owned company's facility security officers, who generally
lacked substantive knowledge of the company's business affairs or
defense programs.  Most trustees viewed their role as limited to
ensuring that the company had policies designed to protect classified
information and attending scheduled quarterly meetings at the
company.  These trustees did not actively check on the implementation
of the security policies or remain engaged in company management
issues.  DOD security officials suggested that some trustees needed
to take a more active oversight role.

GAO also found situations at four companies that had the appearance
of conflicts of interest among some DOD-approved trustees.  For
example, at two companies under proxy agreements, DOD-approved
trustees also held positions as chief executive officers at the
foreign-owned companies.  As proxy holders, these individuals were
paid up to $50,000 annually to protect DOD's security interests,
while as chief executive officers they were paid over $100,000 for
exercising their fiduciary duty and loyalty to the foreign-owned
firm.  GAO observed other cases giving the appearance of conflicts of
interest (see ch.  4).

   RECOMMENDATIONS
---------------------------------------------------------- Chapter 0:5

GAO recognizes that some security vulnerabilities cannot be fully
eliminated, nor would the costs and benefits warrant trying.  Still,
GAO's findings indicate some improvements to information security
could reasonably be made at firms operating under voting trusts,
proxy agreements, and SSAs.  In chapter 4, GAO makes a number of
recommendations to the Secretary of Defense that will improve trustee
oversight of information security and recommends additional controls
designed to prevent potential trustee conflicts of interest.

   AGENCY COMMENTS AND GAO'S
   EVALUATION
---------------------------------------------------------- Chapter 0:6

In commenting on a draft of this report, DOD generally agreed with
most of the report, but disagreed on some matters.  For example, DOD
agreed that visitation agreements give foreign owners a high degree
of access to the facilities and personnel of foreign-owned U.S.
defense contractors, but stated that this access is consistent with
applicable U.S.  law and regulation.  GAO believes such frequent
contact, often at the technical and engineering levels, can increase
the risk.

DOD indicated classified and export-controlled unclassified
information is sufficiently protected at firms operating under SSAs.
However, GAO points out that DOD established restrictions on SSA
companies' access to certain levels of classified information since
there is a higher degree of risk assumed under SSAs.  Despite the
risk of the foreign owners' control or dominance of the U.S.  defense
contractors' operations and management, 36 percent of SSA companies
were granted exceptions to restrictions on their access to the most
highly classified information.

While acknowledging that some trustees need to be more actively
involved, DOD disagreed with GAO's statement that trustees at most of
the companies reviewed did little to ensure that company management
was not unduly influenced by the foreign owners or that the security
controls were being properly implemented.  As GAO noted, trustees at
two firms reviewed were actively involved in company management and
security oversight.  However, GAO also reported that in the majority
of the cases, the trustees saw their role as limited to ensuring that
the company had policies to protect classified information, and their
performance in this role was limited to attendance of four meetings a
year.  Following a 1993 survey of foreign-owned U.S.  defense
contractors, the Defense Intelligence Agency and DIS concluded that
trustees that were the most successful in fulfilling their
responsibilities were those that established procedures that allowed
them to independently monitor and assess the implementation of the
security agreements.  They also concluded that trustees who primarily
depended on management of the cleared facility to implement and
monitor the security controls were less successful.

DOD stated that it generally agreed with the thrust of the
recommendations in this report, but did not agree that the specific
actions GAO recommended were necessary, given DOD's efforts to
address the issues involved.  DOD said it had addressed these issues
by educating, advising, and encouraging the trustees to take
corrective actions.  However, DOD and GAO have both seen instances in
which this encouragement has been rejected.  Because of the risk to
information with national security implications, GAO believes that
requiring, rather than encouraging, the trustees to improve security
at the cleared foreign-owned defense contractors would be more
effective.  Therefore, GAO continues to believe its recommendations
are valid and believes they should be implemented to reduce the
security risks.  (See app.  I.)

INTRODUCTION
============================================================ Chapter 1

In the last decade, weapon systems have increasingly been developed,
produced, and marketed internationally through government-sponsored
cooperative development programs and a variety of industry linkages.
These linkages include international subcontracting, joint ventures,
teaming arrangements, and cross-border mergers and acquisitions.
Also, the Department of Defense (DOD) and other agencies have shared
certain highly classified information with allied governments.  U.S.
government policy allows foreign investment as long as it is
consistent with national security interests.  Foreign companies from
many countries have acquired numerous U.S.  defense companies and
have legitimate business interests in them.  Some of these
foreign-owned companies are working on highly classified defense
contracts, such as the B-2, the F-117, the F-22, and military
satellite programs.

Recognizing that undue foreign control or influence over management
or operations of companies working on sensitive classified contracts
could compromise classified information or impede the performance of
classified contracts, DOD requires that foreign-owned U.S.  firms
operate under control structures known as voting trusts, proxy
agreements, and special security agreements (SSA).  Each of these
agreements requires that the foreign owners select and DOD approve
cleared U.S.  citizens\1 to be placed on the board of directors of
the foreign-owned company to represent DOD's interests by ensuring
against (1) foreign access to classified information without a
clearance and a need to know and (2) company actions that could
adversely affect performance on classified contracts.

--------------------
\1 Voting trustees, proxy holders, and outside directors under SSAs
are collectively referred to as "trustees" in this report.

   GOVERNMENT REQUIRED SECURITY
   CONTROLS
---------------------------------------------------------- Chapter 1:1

In February 1995, the government issued the National Industrial
Security Program Operating Manual (NISPOM) to replace the DOD
Industrial Security Manual and various agencies' industrial security
requirements.  The NISPOM's section dealing with foreign ownership,
control, or influence (FOCI) contains many provisions on voting
trusts, proxy agreements, and SSAs similar to those in the DOD
Industrial Security Regulation (ISR).  The ISR will continue to apply
in its current form until it is amended to reflect the NISPOM.

Both the ISR and NISPOM require a company to obtain a facility
clearance before it can work on a classified DOD contract and
prescribe procedures for defense contractors to protect classified
information entrusted to them.  DOD's policy provides that a firm is
ineligible for a facility clearance if it is under FOCI.  However,
such a firm may be eligible for a facility clearance if actions are
taken to effectively negate or reduce associated risks to an
acceptable level.  When the firm is majority foreign-owned, the
control structures used to negate or reduce such risks include voting
trusts, proxy agreements, and SSAs.

The Defense Investigative Service (DIS) administers the DOD
Industrial Security Program and is required to conduct compliance
reviews of defense contractors operating under voting trusts, proxy
agreements, and SSAs.  This oversight function requires a DIS
security inspection of the cleared facility every 6 months and an
annual FOCI review meeting between DIS and the trustees of the
foreign-owned firm.  These reviews are aimed at ensuring compliance
with special controls, practices, and procedures established to
insulate the facility from foreign interests.

      VOTING TRUSTS
-------------------------------------------------------- Chapter 1:1.1

Under a voting trust agreement, the foreign owners transfer legal
title to the stock of the foreign-owned U.S.  company to U.S.
citizen trustees.  Under the ISR and NISPOM, voting trusts must
provide trustees with complete freedom to exercise all prerogatives
of ownership and act independently from the foreign owners.  Under
the ISR and NISPOM, five actions may require prior approval by the
foreign owner:

  the sale or disposal of the corporation's assets or a substantial
     part thereof;

  pledges, mortgages, or other encumbrances on the capital stock of
     the cleared company;

  corporate mergers, consolidations, or reorganization;

  the dissolution of the corporation; or

  the filing of a bankruptcy petition.

Under the ISR, the trustees were to act independently without
consultation with, interference by, or influence from the foreign
owners, but the NISPOM allows for consultation between the trustees
and foreign owners.

      PROXY AGREEMENT
-------------------------------------------------------- Chapter 1:1.2

The proxy agreement is essentially the same as the voting trust, with
the exception of who holds title to the stock.  Under the voting
trust, the title to the stock is transferred to the trustees.  Under
the proxy agreement, the owners retain title to the stock, but the
voting rights of the stock are transferred to the DOD-approved proxy
holders by a proxy agreement.  The powers and responsibilities of the
proxy holders are the same as those of the trustees under a voting
trust.  From a security or control perspective, we saw no difference
between the voting trust and the proxy agreement.  DOD and company
officials stated that from the companies' perspective, the difference
between these two agreements is largely a tax issue.

      SPECIAL SECURITY AGREEMENT
-------------------------------------------------------- Chapter 1:1.3

The third type of control structure for majority foreign-owned firms
is the SSA.  Unlike a voting trust or proxy agreement, the SSA allows
representatives of the foreign owner to be on the U.S.  contractor's
board of directors.  This representative, known as an inside
director, does not need a DOD security clearance and can be a foreign
national.  In contrast, outside directors are U.S.  citizens and must
be approved by and obtain security clearances from DOD.  Under DOD
policy, outside directors are to ensure that classified information
is protected from unauthorized or inadvertent access by the foreign
owners and that the U.S.  company's ability to perform on classified
contracts is not adversely affected by foreign influence over
strategic decision-making.

Because SSAs allow the foreign owners a higher potential for control
over the U.S.  defense contractor than proxies or voting trusts,
firms operating under SSAs are generally prohibited from accessing
highly classified information such as Top Secret and Sensitive
Compartmented Information.  However, DOD can grant exceptions to this
prohibition and can award contracts at these highly classified levels
if it determines it is in the national interest.

      VISITATION AGREEMENT
-------------------------------------------------------- Chapter 1:1.4

The ISR required a visitation agreement for each voting trust, proxy
agreement, or SSA.  This agreement was signed by

  the foreign owners,

  the foreign-owned U.S.  firm,

  the trustees, and

  DOD.

The visitation agreement was to identify the representatives of the
foreign owners allowed to visit the cleared U.S.  firm, the purposes
for which they were allowed to visit, the advance approval that was
necessary, and the identity of the approval authority.  In 1993, DOD
eliminated visitation agreements as separate documents and
incorporated visitation control procedures as a section of each
voting trust, proxy agreement, and SSA.

   AGREEMENTS ARE NEGOTIATED AND
   VARY
---------------------------------------------------------- Chapter 1:2

Voting trust agreements, proxy agreements, SSAs, and their attendant
visitation agreements are negotiated between the foreign-owned
company and DOD.  Although DOD has boilerplate language that can be
adopted, according to a DOD official, many cases have unique
circumstances that call for flexible application of the ISR
provisions.  DOD's flexible approach leads to negotiations that can
result in company-specific agreements containing provisions that
provide stronger or weaker controls.  Generally, the foreign owners
negotiate to secure the least restrictive agreements possible.

DOD has approved more lenient visitation agreements and procedures
over time.  A DOD official explained that DOD's flexible approach to
FOCI arrangements and the resulting negotiations have probably caused
the visitation controls to become relaxed.  Each negotiated
visitation agreement that relaxed controls became the starting point
for subsequent negotiations on new agreements as the foreign-owned
companies' lawyers would point to the last visitation agreement as
precedent.  We recognize the need to tailor the agreements to
specific company circumstances and to permit international defense
work, but the lack of a baseline set of controls in the agreements
made DIS inspections very difficult, according to DIS inspectors.

   AGREEMENTS WERE NOT DESIGNED TO
   PROTECT UNCLASSIFIED
   EXPORT-CONTROLLED TECHNOLOGIES
---------------------------------------------------------- Chapter 1:3

Almost all the foreign-owned U.S.  firms we reviewed possessed
unclassified information and technologies that are export-controlled
by the Departments of State and Commerce.  DOD deemed some of these
technologies to be militarily critical, such as carbon/carbon
material manufacturing technology and flight control systems
technology.  Many classified defense contracts involve classified
applications of unclassified export-controlled items and
technologies.  The ISR and most agreements were not designed to
protect unclassified export-controlled information.  As such, DIS
does not review the protection of unclassified export-controlled
technology during its inspections of cleared contractors.  In fact,
the U.S.  government has no established means to monitor compliance
with and ensure enforcement of federal regulations regarding the
transfer of export-controlled technical information.  In light of
what is known about the technology acquisition and diversion
intentions of certain allies (see ch.  2) and the high degree of
contact with foreign interests at foreign-owned U.S.  defense
contractors (see ch.  3), enforcement of export control regulations
is important.  The new NISPOM reflects this concern and requires
trustees in future voting trusts, proxy agreements, and SSAs to take
necessary steps to ensure the company complies with U.S.  export
control laws.

   FIFTY-FOUR FIRMS OPERATE UNDER
   VOTING TRUSTS, PROXY
   AGREEMENTS, OR SSAS
---------------------------------------------------------- Chapter 1:4

As of August 1994, 54 foreign-owned U.S.  defense contractors were
operating under voting trusts, proxy agreements, or SSAs.  Six of
these companies operate under voting trusts, 15 under proxy
agreements, and
33 under SSAs.  These 54 firms held a total of 657 classified
contracts, valued at $5.4 billion.  The largest firm operating under
these agreements (as measured by the value of the classified
contracts it held) is a computer services company that operates under
a proxy agreement and held classified contracts valued at $2.5
billion.  The foreign owners of the
54 firms are from Australia, Austria, Canada, Denmark, France,
Germany, Israel, Japan, the Netherlands, Sweden, Switzerland, and the
United Kingdom.  Currently, three of the companies are wholly or
partially owned by foreign governments.

   OBJECTIVE, SCOPE, AND
   METHODOLOGY
---------------------------------------------------------- Chapter 1:5

Our review was conducted at the request of the former Chairman and
Ranking Minority Member, Subcommittee on Oversight and Investigation,
House Committee on Armed Services (now the House Committee on
National Security).  Our objective was to assess the structure of
voting trusts, proxy agreements, and SSAs and their implementation in
the prevention of unauthorized disclosure of classified and
export-controlled information to foreign interests.  We did not
attempt to determine whether unauthorized access to classified or
export-controlled data/technology actually occurred.  Rather, we
examined the controls established in the ISR, the draft NISPOM, and
the agreements' structures and the way they were implemented at each
of 14 companies we selected to review.

We discussed security issues involving foreign-owned defense
contractors and information security with officials from the Office
of the Deputy Assistant Secretary of Defense (Counterintelligence,
Security Countermeasures and Spectrum Management); DIS; and
information security officials from the Air Force, the Army, and the
Navy.  We also discussed the performance of Special Access and
Sensitive Compartmented contracts by foreign-owned companies with an
official from the office of the Assistant Deputy Under Secretary of
Defense (Security Policy).  To obtain information on the threat of
foreign espionage against U.S.  defense industries, we interviewed
officials and reviewed documents from the Central Intelligence Agency
(CIA), Defense Intelligence Agency (DIA), and Federal Bureau of
Investigation (FBI).

In selecting the 14 companies for our judgmental sample, we included
5 companies\2 that were wholly or partially owned by foreign
governments.  We selected the nine additional foreign-owned firms on
the basis of (1) the sensitivity of the information they held, (2)
agreement types, (3) country of origin, and (4) geographic location.
One company we reviewed operated under a voting trust, five operated
under proxy agreements, and six operated under SSAs.  In addition,
one firm transitioned from an SSA to a proxy agreement during our
review, and we found that another firm operated under a different
control structure, a memorandum of agreement (MOA).  Table 1.1 shows
the countries of ownership and agreement type of the companies we
reviewed.

                               Table 1.1

                  Ownership and Agreement of Companies
                            Reviewed by GAO

Country of
foreign ownership                               Agreement type
----------------------------------------------  ----------------------
United Kingdom                                  SSA

United Kingdom                                  SSA

Switzerland                                     SSA to proxy

Sweden                                          Proxy

France                                          Proxy

United Kingdom                                  Proxy

France                                          Proxy

United Kingdom                                  SSA

Netherlands                                     Voting trust

United Kingdom                                  SSA

France, Germany, and Italy                      MOA

France                                          SSA

United Kingdom                                  Proxy

United Kingdom                                  SSA
----------------------------------------------------------------------
This judgmental sample reflects the distribution of agreement type
and country of ownership of the 54 companies operating under voting
trusts, proxy agreements, and SSAs.  However, due to the small size
of our sample and the nonrandom nature of its selection, the results
of our review cannot be projected to the universe of all companies
operating under these agreements.

We were initially told that an aerospace company operated under an
SSA, and selected the company for our sample based on foreign
government ownership of companies that are its partial owners.  We
subsequently learned that the company operated under a unique
arrangement--an MOA .  Because of the foreign government ownership
component and the sensitivity of the information accessed by this
aerospace company, we retained the company in our sample.  When we
present statistics in our report on the number of companies operating
under voting trusts, proxy agreements, and SSAs and the number of
contracts they hold and the contracts' value, this company is not
included in those numbers.\3 However, we include the company in the
discussions of control structures and their implementation (see chs.
3 and 4).  In those instances, we specifically refer to the MOA.

We compared the agreements of the 14 companies to each other and to
boilerplate agreements provided by DIS.  We also examined the
agreements' provisions to determine if they met the requirements of
the ISR, the regulation in force at the time.  We examined the
visitation approval procedures and standard practice procedures
manuals at the companies we reviewed to determine how the companies
controlled foreign visitors and their access to the cleared
facilities.  We also interviewed company management, security
personnel, and the company trustees to determine how they implemented
the agreements.  To assess implementation of the agreements, we
reviewed annual company implementation reports, board of directors
minutes, defense security committee minutes, visitation logs,
international telephone bills, and various internal company
correspondence and memorandums.  To assess trustee involvement, we
interviewed trustees and reviewed visitation approvals, as well as
trustee meeting minutes, which showed the frequency of meetings,
individuals' attendance records, and topics of discussion.  We also
discussed each company's implementation of the agreements and its
information security programs with the cognizant DIS regional
management and inspectors and reviewed their inspection reports.

--------------------
\2 Two of these five companies no longer operate under SSAs.  One of
them was sold to American interests, and the other no longer performs
on classified contracts.

\3 At the time of our review, the aerospace company operating under
an MOA held 10 classified contracts valued at approximately $1.0
billion.

      ACCESS LIMITATION
-------------------------------------------------------- Chapter 1:5.1

During our review, we had limited access to certain information.
Foreign-owned contractors were working on various contracts and
programs classified as Special Access Programs or Sensitive
Compartmented Information.  We were told by an official from the
Office of the Assistant Deputy Under Secretary of Defense (Security
Policy) that in some instances, it is not possible to acknowledge the
existence of such contracts to individuals who are not specifically
cleared for the program.  As a result, we may not know of all
foreign-owned firms involved in highly classified work.

DOD provided written comments on a draft of this report.  The
complete text of those comments and our response is presented in
appendix I.  We performed our review from August 1992 through
February 1995 in accordance with generally accepted government
auditing standards.

ESPIONAGE THREAT AND INFORMATION
AT RISK
============================================================ Chapter 2

Some close U.S.  allies actively seek to obtain classified and
technical information from the United States through unauthorized
means.  Through its National Security Threat List program, the FBI
National Security Division has determined that foreign intelligence
activities directed at U.S.  critical technologies pose a significant
threat to national security.  As we testified before the House
Committee on the Judiciary in April 1992, sophisticated methods are
used in espionage against U.S.  companies.\1 Unfortunately, the
companies targeted by foreign intelligence agencies may not know--and
may never know--that they have been targeted or compromised.

The Joint Security Commission was formed in 1993 at the request of
the Secretary of Defense and the Director of Central Intelligence to
develop new approaches to security.  The Commission examined (1)
policies and procedures regarding foreign ownership or control of
industrial firms performing classified contracts and (2) the national
disclosure of classified information to permit export and
coproduction of classified weapon systems.  In its February 1994
report, the Commission wrote the following:

     "The risk in each of these situations is that foreign entities
     will exploit the relationship in ways that do not serve our
     overall national goals of preserving our technological
     advantages and curtailing proliferation.  These goals generally
     include keeping certain nations from obtaining the technical
     capabilities to develop and produce advanced weapon systems and
     from acquiring the ability to counter advanced US weapon
     systems.  In cases where U.S.  national interests require the
     sharing of some of our capabilities with foreign governments,
     security safeguards must ensure that foreign disclosures do not
     go beyond their authorized scope.  Safeguards must also be
     tailored to new proliferation threats and applied effectively to
     the authorization of foreign investment in classified defense
     industry and the granting of access by foreign representatives
     to our classified facilities and information."

Contractors owned by companies and governments of these same allied
countries are working on classified DOD contracts under the
protection of voting trusts, proxy agreements, and SSAs.  These
companies perform on DOD contracts developing, producing, and
maintaining very sensitive military systems, and some of them have
access to the most sensitive categories of U.S.  classified
information.

--------------------
\1 Economic Espionage:  The Threat to U.S.  Industry (GAO/T-OSI-92-6,
Apr.  29, 1992).

   INFORMATION AT RISK
---------------------------------------------------------- Chapter 2:1

Contracts requiring access to classified information at the levels
shown in table 2.1 have been awarded to foreign-owned U.S.  defense
contractors.

                                    Table 2.1

                         Levels of Classified Information

Acronym       Classification
------------  ------------------------------------------------------------------
C             CONFIDENTIAL: Information, the unauthorized disclosure of which
              could reasonably be expected to cause damage to the national
              security.

S             SECRET: Information, the unauthorized disclosure of which could
              reasonably be expected to cause serious damage to national
              security.

TS            TOP SECRET: Information, the unauthorized disclosure of which
              could reasonably be expected to cause exceptionally grave damage
              to the national security.

SAP           SPECIAL ACCESS PROGRAM: Program imposing "need-to-know" or access
              controls beyond those normally provided for access to
              Confidential, Secret, or Top Secret information.

WNINTEL       WARNING NOTICE -INTELLIGENCE SOURCES AND METHODS INVOLVED

SCI           SENSITIVE COMPARTMENTED INFORMATION: Information bearing special
              controls indicating restricted handling within present and future
              intelligence collection programs and their end products.

RD            RESTRICTED DATA: Information concerning (1) design, manufacture,
              or utilization of atomic weapons; (2) the production of special
              nuclear material; or (3) the use of special nuclear material in
              the production of energy.

FRD           FORMERLY RESTRICTED DATA: Information removed from the Restricted
              Data category upon joint determination by the Department of Energy
              and DOD. For purposes of foreign dissemination, however, such
              information is treated in the same manner as Restricted Data.

CNWDI         CRITICAL NUCLEAR WEAPON DESIGN INFORMATION: Top Secret Restricted
              Data or Secret Restricted Data revealing the theory of operation
              or design of the components of a thermonuclear or implosion-type
              fission bomb, warhead, demolition munition, or test device.

COMSEC        COMMUNICATIONS SECURITY: Information concerning protective
              measures taken to deny unauthorized persons information derived
              from telecommunications related to national security and to ensure
              the authenticity of such communication.

NOFORN        NOT RELEASABLE TO FOREIGN NATIONALS
--------------------------------------------------------------------------------
The following are examples of some sensitive contract work being
performed by the 14 foreign-owned U.S.  companies we reviewed:

  development of computer software for planning target selection and
     aircraft routes in the event of a nuclear war (a Top Secret
     contract);

  maintenance of DOD's Worldwide Military Command and Control System
     ((WWMCCS) - the contract was classified TS, SCI, and COMSEC
     because of the information the computer-driven communications
     system contains);

  production of signal intelligence gathering radio receivers for the
     U.S.  Navy;

  production of command destruct receivers for military missiles and
     National Aeronautics and Space Administration rockets (to
     destroy a rocket that goes off course);

  production of carbon/carbon composite Trident D-5 missile heat
     shields; and

  production of the flight controls for the B-2, the F-117, and the
     F-22.

Some of the contracts these foreign-owned U.S.  companies are working
on are Special Access Programs.  Due to the special access
requirements of these contracts, the contractors could not tell us
what type of work they were doing, what military system the work was
for, or even the identity of the DOD customer.

Some of the contracts performed by companies we examined involve less
sensitive technologies.  For example, one company we visited had
contracts requiring access to classified information because it cast
valves for naval nuclear propulsion systems, and it needed classified
test parameters for the valves.  Another firm operating under an SSA
is required to have a Secret-level clearance because it installs
alarm systems in buildings that hold classified information.

In addition to classified information, most of the 14 foreign-owned
companies we reviewed possessed unclassified technical information
and hardware items that are export- controlled by the State or
Commerce Departments.  DOD deemed many of these technologies to be
militarily critical.

   U.S.  INTELLIGENCE AGENCIES
   IDENTIFIED ECONOMIC ESPIONAGE
   EFFORTS OF CERTAIN ALLIES
---------------------------------------------------------- Chapter 2:2

Reports and briefings provided during 1993 by U.S.  intelligence
agencies showed a continuing economic espionage threat from certain
U.S.  allies.\2 Eight of the 54 companies operating under voting
trusts, proxy agreements, and SSAs and working on classified
contracts are owned by interests from one of these countries.  The
following are intelligence agency threat assessments and examples
illustrating this espionage.

--------------------
\2 "Economic espionage" was defined in a 1994 U.S.  government
interagency report as "government-sponsored or coordinated
intelligence activity designed to unlawfully and covertly obtain
classified data and/or sensitive policy or proprietary information
from a U.S.  Government agency or company, potentially having the
effect of enhancing a foreign country's economic competitiveness and
damaging U.S.  economic security."

      COUNTRY A
-------------------------------------------------------- Chapter 2:2.1

According to a U.S.  intelligence agency, the government of Country A
conducts the most aggressive espionage operation against the United
States of any U.S.  ally.  Classified military information and
sensitive military technologies are high-priority targets for the
intelligence agencies of this country.  Country A seeks this
information for three reasons:  (1) to help the technological
development of its own defense industrial base, (2) to sell or trade
the information with other countries for economic reasons, and (3) to
sell or trade the information with other countries to develop
political alliances and alternative sources of arms.  According to a
classified 1994 report produced by a U.S.  government interagency
working group on U.S.  critical technology companies,\3 Country A
routinely resorts to state-sponsored espionage using covert
collection techniques to obtain sensitive U.S.  economic information
and technology.  Agents of Country A collect a variety of classified
and proprietary information through observation, elicitation, and
theft.

The following are intelligence agency examples of Country A
information collection efforts:

  An espionage operation run by the intelligence organization
     responsible for collecting scientific and technologic
     information for Country A paid a U.S.  government employee to
     obtain U.S.  classified military intelligence documents.

  Several citizens of Country A were caught in the United States
     stealing sensitive technology used in manufacturing artillery
     gun tubes.

  Agents of Country A allegedly stole design plans for a classified
     reconnaissance system from a U.S.  company and gave them to a
     defense contractor from Country A.

  A company from Country A is suspectecd of surreptitiously
     monitoring a DOD telecommunications system to obtain classified
     information for Country A intelligence.

  Citizens of Country A were investigated for allegations of passing
     advanced aerospace design technology to unauthorized scientists
     and researchers.

  Country A is suspected of targeting U.S.  avionics, missile
     telemetry and testing data, and aircraft communication systems
     for intelligence operations.

  It has been determined that Country A targeted specialized software
     that is used to store data in friendly aircraft warning systems.

  Country A has targeted information on advanced materials and
     coatings for collection.  A Country A government agency
     allegedly obtained information regarding a chemical finish used
     on missile reentry vehicles from a U.S.  person.

--------------------
\3 Report on U.S.  Critical Technology Companies, Report to Congress
on Foreign Acquisition of and Espionage Activities Against U.S.
Critical Technology Companies (1994).

      COUNTRY B
-------------------------------------------------------- Chapter 2:2.2

According to intelligence agencies, in the 1960s, the government of
Country B began an aggressive and massive espionage effort against
the United States.  The 1994 interagency report on U.S.  critical
technology companies pointed out that recent international
developments have increased foreign intelligence collection efforts
against U.S.  economic interests.  The lessening of East-West
tensions in the late 1980s and early 1990s enabled Country B
intelligence services to allocate greater resources to collect
sensitive U.S.  economic information and technology.

Methods used by Country B are updated versions of classic Cold War
recruitment and technical operations.  The Country B government
organization that conducts these activities does not target U.S.
national defense information such as war plans, but rather seeks U.S.
technology.  The motivation for these activities is the health of
Country B's defense industrial base.  Country B considers it vital to
its national security to be self-sufficient in manufacturing arms.
Since domestic consumption will not support its defense industries,
Country B must export arms.  Country B seeks U.S.  defense
technologies to incorporate into domestically produced systems.  By
stealing the technology from the United States, Country B can have
cutting-edge weapon systems without the cost of research and
development.  The cutting-edge technologies not only provide superior
weapon systems for Country B's own use, but also make these products
more marketable for exports.  It is believed that Country B espionage
efforts against the U.S.  defense industries will continue and may
increase.  Country B needs the cutting-edge technologies to compete
with U.S.  systems in the international arms market.

The following are intelligence agency examples of Country B
information collection efforts:

  In the late 1980s, Country B's intelligence agency recruited agents
     at the European offices of three U.S.  computer and electronics
     firms.  The agents apparently were stealing unusually sensitive
     technical information for a struggling Country B company.  This
     Country B company also owns a U.S.  company operating under a
     proxy agreement and performing contracts for DOD classified as
     TS, SAP, SCI, and COMSEC.

  Country B companies and government officials have been investigated
     for suspected efforts to acquire advanced abrasive technology
     and stealth-related coatings.

  Country B representatives have been investigated for targeting
     software that performs high-speed, real-time computational
     analysis that can be used in a missile attack system.

  Information was obtained that Country B targeted a number of U.S.
     defense companies and their missile and satellite technologies
     for espionage efforts.  Companies of Country B have made
     efforts, some successful, to acquire targeted companies.

      COUNTRY C
-------------------------------------------------------- Chapter 2:2.3

The motivation for Country C industrial espionage against the United
States is much like that of Country B:  Country C wants cutting-edge
technologies to incorporate into weapon systems it produces.  The
technology would give Country C armed forces a quality weapon and
would increase the weapon's export market potential.  The Country C
government intelligence organization has assisted Country C industry
in obtaining defense technologies, but not as actively as Country B
intelligence has for its industry.  One example of Country C
government assistance occurred in the late 1980s, when a Country C
firm wanted to enter Strategic Defense Initiative work.  At that
time, the Country C intelligence organization assisted this firm in
obtaining applicable technology.

      COUNTRY D
-------------------------------------------------------- Chapter 2:2.4

The Country D government has no official foreign intelligence
service.  Private Country D companies are the intelligence gatherers.
They have more of a presence throughout the world than the Country D
government.  However, according to the 1994 interagency report, the
Country D government obtains much of the economic intelligence that
Country D private-sector firms operating abroad collect for their own
purposes.  This occasionally includes classified foreign government
documents and corporate proprietary data.  Country D employees have
been quite successful in developing and exploiting Americans who have
access to classified and proprietary information.

The following are examples of information collection efforts of
Country D:

  Firms from Country D have been investigated for targeting advanced
     propulsion technologies, from slush-hydrogen fuel to torpedo
     target motors, and attempting to export these items through
     intermediaries and specialty shipping companies in violation of
     export restrictions.

  Individuals from Country D have been investigated for allegedly
     passing advanced aerospace design technology to unauthorized
     scientists and researchers.

  Electronics firms from Country D directed information-gathering
     efforts at competing U.S.  firms in order to increase the market
     share of Country D in the semiconductor field.

      COUNTRY E
-------------------------------------------------------- Chapter 2:2.5

Intelligence community officials stated that they did not have
indications that the intelligence service of Country E has targeted
the United States or its defense industry for espionage efforts.
However, according to the 1994 interagency report, in 1991 the
intelligence service of this country was considering moving toward
what it called "semi-overt" collection of foreign economic
intelligence.  At that time, Country E's intelligence service
reportedly planned to increase the number of its senior officers in
Washington to improve its semi-overt collection--probably referring
to more intense elicitation from government and business contacts.

The main counterintelligence concern cited by one intelligence agency
regarding Country E is not that its government may be targeting the
United States with espionage efforts, but that any technology that
does find its way into Country E will probably be diverted to
countries to which the United States would not sell its defense
technologies.  The defense industry of this country is of particular
concern in this regard.

It was reported that information diversions from Country E have
serious implications for U.S.  national security.  Large-scale losses
of technology were discovered in the early 1990s.  Primary
responsibility for industrial security resides in a small staff of
the government of Country E.  It was reported that this limited staff
often loses when its regulatory concerns clash with business
interests.  The intelligence agency concluded that the additional
time needed to eradicate the diversion systems will consequently
limit the degree of technological security available for several
years.  The question suggested by this situation is, if technology
from a U.S.  defense contractor owned by interests of Country E is
transferred to Country E, will this U.S.  defense technology then be
diverted to countries to which the United States would not sell?

ASSESSMENT OF CONTROL STRUCTURES
============================================================ Chapter 3

Foreign ownership or control of U.S.  firms performing classified
contracts for DOD poses a special security risk.  The risk includes
unauthorized or inadvertent disclosure of classified information
available to the U.S.  firm.  In addition, foreign owners could take
action that would jeopardize the performance of classified contracts.
To minimize the risks, the ISR and NISPOM require voting trusts and
proxy agreements to insulate the foreign owners from the cleared U.S.
defense firm or SSAs to limit foreign owners' participation in the
management of the cleared U.S.  firm.  The ISR also required
visitation agreements to control visitation between foreign owners
and their cleared U.S.  firms.  The new industrial security program
manual does not address visitation control agreements or procedures.
DOD eliminated separate visitation agreements in favor of visitation
procedures in the security agreements themselves.

In May 1992, a former Secretary of Defense testified before the House
Committee on Armed Services that under proxy agreements and voting
trusts, the foreign owners of U.S.  companies working on classified
contracts had "virtually no say except if somebody wants to sell the
company or in very major decisions." He indicated that for the
purposes of the foreign parent company, proxy agreements and voting
trusts are essentially "blind trusts." Further, he testified that a
number of companies were "functioning successfully" under SSAs.

Of the three types of arrangements used to negate or reduce risks in
majority foreign ownership cases, SSAs were the least restrictive.
Accordingly, SSA firms pose a somewhat higher risk associated with
classified work.  The ISR and the NISPOM generally prohibit SSA firms
from being involved in Top Secret and other highly sensitive
contracts, but allow for exceptions if DOD determines they are in the
national interest.  SSA firms we reviewed were working on 47
contracts classified as TS, SCI, SAP, RD, and COMSEC.  In addition,
we observed that ISR-required visitation agreements permitted
significant contact between the U.S.  firms and the foreign owners.

   HIGHER DEGREE OF RISK WITH SSA
   STRUCTURE
---------------------------------------------------------- Chapter 3:1

Unlike voting trusts and proxy agreements, which insulate foreign
owners from the management of the cleared firm, SSAs allow foreign
owners to appoint a representative to serve on the board of
directors.  Called an "inside director," this individual represents
the foreign owners and is often a foreign national.  The inside
director is to be counterbalanced by DOD-approved directors, called
the "outside directors." The principal function of the outside
directors is to protect U.S.  security interests.

Inside directors cannot hold a majority of the votes on the board,
but because of their connection to the foreign owners, their views
about the company's direction on certain defense contracts or product
lines reflect those of the owners.  Depending on the composition of
the board, the inside director and the company officers on the board
could possibly combine to out vote the outside directors.  In
addition, unlike voting trusts and proxy agreements, the SSAs we
examined allow the foreign owner to replace "any member of the [SSA
company] Board of Directors for any reason." DOD recently provided us
with new boilerplate SSA language that will require DIS to approve
the removal of a director.

Foreign owners of SSA firms can also exercise significant influence
over the U.S.  companies they own in other ways.  For example, at two
SSA firms we examined, the foreign owners used export licenses to
obtain unclassified technology from the U.S.  subsidiary that was
vital to the U.S.  companies' competitive positions.  Officers of the
U.S.  companies stated that they did not want to share these
technologies, but the foreign owners required them to do so.
Subsequently, one of these U.S.  companies faced its own technology
in a competition with its foreign owner for a U.S.  Army contract.

      SSA FIRMS WORKING ON
      CONTRACTS REQUIRING ACCESS
      TO TOP SECRET, SPECIAL
      ACCESS, AND OTHER SENSITIVE
      INFORMATION
-------------------------------------------------------- Chapter 3:1.1

Because of the additional risk previously mentioned, companies
operating under SSAs are normally ineligible for contracts allowing
access to TS, SAP, SCI, RD, and COMSEC information.  However, during
our review,
12 of the 33 SSA companies were working on at least 47 contracts
requiring access to this highly classified information.

Before June 1991, DOD reviewed an SSA firm to determine whether it
would be in the national interest to allow the firm to compete for
contracts classified TS, SCI, SAP, RD, or COMSEC.  New guidance was
issued in June 1991 requiring the responsible military service to
make a national interest determination each time a highly classified
contract was awarded to an SSA firm.  We found only one
contract-specific national interest determination had been written
since the June 1991 guidance.  According to DOD officials, the other
46 highly classified contracts performed by SSA companies predated
June 1991 or were follow-on contracts to contracts awarded before
June 1991.  Since information on some contracts awarded to SSA
companies is under special access restrictions, DOD officials may be
authorized to conceal the contracts from people not specifically
cleared for access to the program.  We, therefore, could not
determine with confidence if the requirement for contract-specific
national interest determinations was carried out.

      ONE COMPANY OPERATES UNDER
      AN ALTERNATIVE AGREEMENT
-------------------------------------------------------- Chapter 3:1.2

One company performs on contracts classified as TS, SCI, SAP, RD, and
COMSEC under an alternative arrangement called an MOA.  The MOA (a
unique agreement) was created in 1991 because the company has
classified DOD contracts and, although foreign interests do not hold
a majority of the stock, they own 49 percent of the company and have
special rights to veto certain actions of the majority owners.

Normally, under the ISR, minority foreign investment in a cleared
U.S.  defense contractor required only a resolution of the board of
directors stating that the foreign interests will not require, nor be
given, access to classified information.  DOD did not consider the
board resolution appropriate for this case, partially because of the
board membership of the foreign owners and their veto rights over
certain basic corporate decisions.  The company board of directors
consists of six representatives appointed by the U.S.  owners and one
representative for each of the four foreign minority interests.  Any
single foreign director can block any of 16 specified actions of the
board of directors.  These actions include the adoption of a company
strategic plan or annual budget as well as the development of a new
product that varies from the lines of business set forth in the
strategic plan.  In addition, any two foreign directors can block an
additional 11 specified actions.  These veto rights could give the
foreign interests significantly more control and influence over the
U.S.  defense contractor in certain instances than would be permitted
in an SSA.  In 1991, DIS objected to an agreement less stringent than
an SSA because of the veto rights of the foreign directors and,
unlike an SSA, an MOA does not require any DOD-approved outside
members on the board of directors.  However, the Office of the Under
Secretary of Defense for Policy determined that the company would not
be under foreign domination and that the MOA was a sufficient
control.

DOD reexamined the MOA during a subsequent (1992) foreign investment
in the company and made some modifications.  Although the MOA does
not provide for outside members on the board, it does require
DOD-approved outside members on a Defense Security Committee to
oversee the protection of classified and export-controlled
information.  The first version of the MOA did not give the outside
security committee members the right to attend any board of directors
meetings.  Under the revised (1992) version of the MOA, the outside
security committee members still do not have general rights to attend
board meetings; however, their attendance at board meetings is
required if the foreign interests are to exercise their veto rights.
Also, the first version of the MOA did not require any prior security
committee approval for representatives of the foreign interests to
visit the cleared U.S.  defense contractor.  The newer version
requires prior approval when the visits concern performance on a
classified contract.\1

--------------------
\1 The 1995 NISPOM now requires a Security Control Agreement (SCA) in
cases where minority foreign owners are represented on the board of
directors.  The SCA is more stringent in some respects than the MOA,
and is essentially an SSA for cases of minority foreign investment.
For example, the SCA requires that outside directors be placed on the
company's board of directors.

   VISITATION AGREEMENTS GIVE
   FOREIGN OWNERS A HIGH DEGREE OF
   ACCESS
---------------------------------------------------------- Chapter 3:2

Unlike the new NISPOM, the ISR required the foreign owners of a
cleared U.S.  defense contractor to be segregated from all aspects of
the U.S.  company's defense work.  The ISR provided the following:

     "In every case where a voting trust agreement, proxy agreement,
     or special security agreement is employed to eliminate risks
     associated with foreign ownership, a visitation agreement shall
     be executed .  .  ."

Further:

     "The visitation agreement shall provide that, as a general rule,
     visits between the foreign stockholder and the cleared U.S.
     firm are not authorized; however, as an exception to the general
     rule, the trustees, may approve such visits in connection with
     regular day-to-day business operations pertaining strictly to
     purely commercial products or services and not involving
     classified contracts."

The visitation agreements are to guard against foreign owners or
their representatives obtaining access to classified information
without a clearance and a need to know.

At all 14 companies we reviewed, visitation agreements permitted the
foreign owners and their representatives to visit regarding military
and dual-use products and services.  The visitation agreements
permitted visits to the U.S.  company (1) in association with
classified contracts if the foreign interests had the appropriate
security clearance and (2) under State or Commerce Department export
licenses.

The large number of business transactions between the U.S.  defense
contractors and their foreign owners granted representatives of the
foreign owners frequent entry to the cleared U.S.  facilities.  Eight
of the
14 firms we reviewed had contractual arrangements with their foreign
owners that led to a high (often daily) degree of contact.  In one
case, the U.S.  company sold and serviced equipment produced by the
foreign firm, so the two firms had almost continual contact at the
technician level to obtain repair parts and technical assistance.
During a 3-month period in 1993, this company approved 167 extended
visit authorizations.

At one SSA firm we reviewed, 236 visits occurred between the U.S.
firm and representatives of the foreign owners over a 1-year period,
averaging about 7 days per visit.  At a proxy company, there were 322
approved requests for contact with representatives of the owners
during a 1-year period; 94 of the requests were blanket requests for
multiple contacts over the subsequent 3-month period.  Not all
foreign-owned defense contractors had this degree of contact with
representatives of their foreign owners.  One SSA firm had only 44
visits with representatives of its foreign owners during a 1-year
period.

Some visitation agreements permitted long-term visits to the cleared
U.S.  companies by employees of the foreign owners.  Five companies
we reviewed had employees of the foreign owners working at the
cleared U.S.  facilities.  In a number of these cases, they were
technical and managerial staff working on military and dual-use
systems and products under approved export licenses.  One company
covered by a proxy agreement had a foreign national technical manager
from the foreign parent firm review the space and military
technologies of the U.S.  defense contractor to determine if there
were opportunities for technical cooperation with the foreign parent
firm.  At another firm we reviewed, representatives of the foreign
partners are permanently on site.  At yet another company, a foreign
national employee of the foreign parent company worked on a computer
system for the B-2 bomber and had access to export-controlled
information without the U.S.  company obtaining the required export
license.

      LACK OF POST-VISIT REPORTING
      REQUIREMENTS
-------------------------------------------------------- Chapter 3:2.1

Post-visit contact reports are the primary means for DIS and the
trustees to monitor the substance of contacts between the
foreign-owned U.S.  contractor and representatives of its foreign
owners.  Such records should be used to determine if the contact with
representatives of the foreign owners was appropriate and in
accordance with the ISR and the visitation agreement.  Some
visitation agreements do not require employees of the U.S.  firm to
document and report the substance of the discussions with employees
of the foreign parent firm.  At three of the firms we reviewed, the
only record of contact between employees of the U.S.  company and the
foreign owners were copies of forms approving the visit.  However, at
other foreign-owned U.S.  defense contractors, post-visit contact
reports were available for DIS to review when it inspected the firms
and when DIS held its annual agreement compliance review with the
foreign-owned companies.

      TELEPHONIC CONTACTS NOT
      CONTROLLED
-------------------------------------------------------- Chapter 3:2.2

The ISR, the NISPOM, and most of the visitation agreements we
reviewed do not require telephonic contacts between the U.S.  defense
contractor and representatives of its foreign owners to be controlled
and documented.  One of the firms covered by a proxy agreement
documented 1,912 telephonic contacts between the U.S.  company and
representatives of its foreign owners for a 1-year period.  After
examining telephone bills at other companies, we found 1 SSA company
had over 550 telephone calls to the country of the foreign owners in
1 month.  Company officials said these calls were primarily to
representatives of the foreign owners.  In contrast, our review of
telephone bills at another SSA company showed only 47 telephone calls
to the country of the foreign owners during 1 month in 1993.

If an individual intends to breach security, it would be easier to
transfer classified or export-controlled information by telephone,
facsimile, or computer modem than it would be in person.  Documenting
telephone contacts would not prevent such illegal activity, but might
make it easier to detect.  During our review, DIS also recognized
this and asked companies to establish a procedure for documenting
telephonic contacts with representatives of their foreign owners.

      NATIONAL INDUSTRIAL SECURITY
      MANUAL HAS NO REQUIREMENT
      FOR VISITATION AGREEMENTS
-------------------------------------------------------- Chapter 3:2.3

We were initially told the NISPOM section dealing with foreign
ownership, control, and influence would replace the FOCI section of
the ISR.  The new manual does not address visitation control
agreements or procedures to restrict visitation between the cleared
U.S.  defense contractor and representatives of its foreign owners.
Instead, it appears to allow unlimited visitation.  However, in its
comments on our report, DOD stated that the ISR will be retained and
revised to reflect the NISPOM.  DOD also said that the revised ISR
will require visitation approval procedures, but instead of separate
visitation agreements, these procedures will be incorporated into
each voting trust, proxy agreement, and SSA.

   CONCLUSIONS
---------------------------------------------------------- Chapter 3:3

Under the ISR and the new NISPOM, majority foreign-owned facilities
cleared to perform classified contracts must enter into agreements
with DOD to negate, or at least reduce to an acceptable level, the
security risks associated with foreign ownership, control, and
influence.  Voting trusts and proxy agreements are designed to
insulate cleared U.S.  defense firms from their foreign owners.  SSAs
limit the foreign owners' participation in company management.  None
of these security arrangements is intended to deny U.S.  defense
contractors the opportunity to do business with their foreign owners.
However, the frequent contact engendered by legitimate unclassified
business transactions can heighten the risk of unauthorized access to
classified information.  Also, existing visitation agreements and
procedures permit a high degree of contact.  Often this contact is at
the technical and engineer level where U.S.  classified information
could most easily be compromised.  The draft NISPOM does not address
visitation controls, but DOD has stated that a visitation approval
procedures section will be included in the revised ISR.

ASSESSMENT OF CONTROL
IMPLEMENTATION
============================================================ Chapter 4

At a few of the 14 companies we reviewed, DOD-approved trustees were
actively involved in company management and security oversight.  At
most of the companies, however, the trustees did little to protect
classified or export-controlled information from access by foreign
owner representatives.  At proxy agreement companies, we observed
cases where foreign owners were exercising more control than the ISR
allowed and foreign-owned U.S.  defense firms whose independence was
degraded because of their financial reliance on the foreign owners.
We also observed that some DOD-approved trustees appeared to have
conflicts of interest.  Finally, DIS did not tailor its inspections
of these foreign-owned facilities to specifically address FOCI issues
or the implementation of the control agreements, but has recently
promulgated new inspection guidelines to address these issues.

   LITTLE INVOLVEMENT BY TRUSTEES
   IN SECURITY OR COMPANY
   MANAGEMENT OVERSIGHT
---------------------------------------------------------- Chapter 4:1

Some DOD-approved trustees were more actively involved in management
and security oversight than others.  For example, at some companies,
the trustees retained, and did not delegate, their responsibility for
approving all visits by representatives of the foreign owners as
required in the visitation agreements.  The more active trustees also
reviewed post-visit contact reports and interviewed a sample of
technical staff who met with the foreign owners' representatives to
ascertain the substance of their discussions, questioned potentially
adverse business conditions caused by arrangements with the foreign
parent, and attended business meetings at the company more often than
quarterly.

At most of the companies we reviewed, however, the trustees (or proxy
holders or outside directors) did little to ensure that company
management was not unduly influenced by the foreign owners or that
the control structures in the security agreements were being properly
implemented.  Instead, they viewed their role as limited to ensuring
that policies exist within the company to protect classified
information.  At six of the firms we reviewed, monitoring the
security implementation and the business operations of the company by
the trustees ranged from limited to almost nonexistent.  In only two
of the firms did the trustees appear to be actively involved in
company management and security oversight.

The need for trustee oversight of the business management of
foreign-owned companies was highlighted at one SSA firm we examined.
At this company, the foreign owners exercised their SSA powers to
replace two successive director/presidents of the U.S.  company.  The
first claimed he was terminated because he attempted to enforce the
SSA.  The second president contested his dismissal because the
outside directors were not given prior notice of the owners' intent
to replace him.  The owners stated that in both cases, poor business
performance was the cause for termination and, in these cases, the
outside directors agreed.  Nevertheless, outside directors need to
remain actively involved in monitoring the companies' business
management to ensure that foreign owners exercise these powers only
for legitimate business reasons and not for reasons that could
jeopardize classified information and contracts.

Implementation and monitoring of the information security program was
usually left to the facility security officer (FSO), an employee of
the foreign-owned U.S.  company.  At the companies we reviewed, a
variety of personnel served as FSO, including a general counsel,
secretaries, and professional security officers.  In any case, the
FSO often performed the administrative functions of security and
lacked the knowledge to determine the proper parameters for the
substance of classified discussions, given a cleared foreign
representative's need to know.  This limitation and the FSO's
potential vulnerability as an employee of the foreign-owned company
pose a risk without active trustee involvement.

Another potential problem associated with trustees relinquishing
implementation and monitoring responsibilities to the FSO was
illustrated at an SSA firm we reviewed.  At the SSA firm, the FSO
wanted to establish a new security procedure, but was overruled by
the president of the foreign-owned U.S.  defense company.  In this
instance, the FSO had enough confidence in the outside directors to
go to them and complain.  The outside directors agreed with the need
for the new control and required its implementation.  In this case,
the outside directors led the officials of the foreign-owned firm to
believe that the new security measure was an outside director
initiative.  If the circumstances and individuals had been different,
the FSO might have lacked the confidence to seek the assistance of
the outside directors.

At the foreign-owned companies we reviewed, trustees were paid
between $1,500 and $75,000 a year.  In return for this compensation,
the usual trustee involvement was attendance at four meetings
annually.  Typically, one of the trustees is designated to approve
requests for visits with representatives of the foreign owners.  This
additional duty involves occasionally receiving, reviewing, and
transmitting approval requests by facsimile machine.

The ISR requires that a trustee approve visitation requests.
However, in most of the firms we reviewed, trustees only directly
approved visits between senior management of the U.S.  firm and the
foreign parent firm.  The FSO approved visits below this senior
management level, including visits with the technical and engineering
staff; the trustees only reviewed documentation of these visits
during their quarterly trustee meetings, if at all.  In addition,
when required, most post-visit contact reports lacked the detail
needed for the trustees or DIS to determine what was discussed
between the foreign-owned company and the owners' representatives.
Trustee inattention to contact at the technical level is of
particular concern, since that is where most of the U.S.  defense
contractor's technology is located, not in the board room where
senior management officials are found.

Trustees rarely visited or toured the foreign-owned company's
facility to observe the accessibility of classified or
export-controlled information, except during prearranged tours at the
time of their quarterly meetings.  The trustees also rarely
interviewed managerial and technical staff to verify the level and
nature of their contact with employees of the foreign parent firm.
Government officials suggested that trustees at two companies involve
themselves in a higher degree of monitoring.  Some flatly refused and
stated that they have held important positions in government and
industry and feel that it is not their role to personally provide
such detailed oversight.

The ISR requires that proxy holders and trustees of voting trusts
"shall assume full responsibility for the voting stock and for
exercising all management prerogatives relating thereto" and that the
foreign stockholders shall "continue solely in the status of
beneficiaries." However, as an example of minimal proxy involvement,
at one proxy company the three proxy holders only met twice a year.
Only one of the three proxy holders was on the company's board of
directors, and the board had not met in person for 4 years.  All
board action was by telephone, and the board's role was limited to
electing company officers.  The proxy holders' were minimally
involved in selecting and approving these company officials.  The
parent firm selected the current chief executive officer (CEO) of the
company and the proxy holders affirmed this selection after
questioning the parent firm about the individual's background.  The
FSO was required to approve all visits to this firm by employees of
the foreign parent rather than the proxy holders as required by the
ISR.

At the company we reviewed operating under an MOA, the Defense
Security Committee consists of four company officials and the three
outside members.  These outside members visited the company only for
the quarterly committee meetings.  The president of the company, who
is also the security committee chairman, set the meeting agenda and
conducted the meetings.  Further, his presentations to the outside
members usually focused on current and future business activities
rather than security matters.  Any plant tours the outside members
received were prearranged and concurrent with the quarterly meetings.
There were no off-cycle visits to the company to inspect or monitor
security operations.

   FOREIGN OWNERS ACTED IN
   CAPACITIES BEYOND THAT OF
   BENEFICIARY IN PROXY FIRMS
---------------------------------------------------------- Chapter 4:2

To eliminate the risks associated with foreign control and influence
over foreign-owned U.S.  defense contractors, the ISR requires that
voting trust and proxy agreements "unequivocally shall provide for
the exercise of all prerogatives of ownership by the trustees with
complete freedom to act independently without consultation with,
interference by, or influence from foreign stockholders."

Further,

     "the trustees shall assume full responsibility for the voting
     stock and for exercising all management prerogatives relating
     thereto in such a way as to ensure that the foreign
     stockholders, except for the approvals just enumerated, [sale,
     merger, dissolution of the company; encumbrance of stock; filing
     for bankruptcy] shall be insulated from the cleared facility and
     continue solely in the status of beneficiaries."

However, at one of the proxy firms we reviewed, the foreign owners
acted in more than the status of beneficiaries.  The proxy firm's
strategic plan and annual budget were regularly presented to the
foreign owners for review.  At least once the foreign parent firm
rejected a strategic plan and indicated that it would continue to
object until the plan specified increased collaboration between the
proxy firm and the foreign parent firm.  At another time, the foreign
owners had employees of this U.S.  firm represent them in an attempt
to acquire another U.S.  aerospace firm more than 10 times the size
of the proxy firm.  Although decisions on mergers are within the
rights of the foreign owners, during this acquisition effort,
officers and employees of the U.S.  defense contractor were operating
at the direction of the foreign owners.  In this case, because the
parent firm directed staff of the proxy firm, it clearly acted as
more than a beneficiary, the role to which foreign owners are limited
under the ISR.

Another proxy firm has a distribution agreement with its foreign
owners that restricts the proxy firm to marketing electronic
equipment and services to the U.S.  government.  In addition, the
agreement will only allow the proxy firm to service hardware that is
used on classified systems.  Although this distribution agreement was
approved by DIS at the time of the foreign acquisition, it controls
the strategic direction of the proxy firm.  The proxy firm reported
to DIS that it is important for the survival of the U.S.  company to
be able to pursue business opportunities that are currently denied by
the distribution agreement.

   SOME FOREIGN-OWNED FIRMS ARE
   FINANCIALLY DEPENDENT ON
   FOREIGN OWNERS
---------------------------------------------------------- Chapter 4:3

The ISR states that a company operating under a proxy agreement
"shall be organized, structured, and financed so as to be capable of
operating as a viable business entity independent from the foreign
stockholders." During our review, we saw examples of firms that
depended on their foreign owners for financial support or had
business arrangements with the foreign owners that degraded the
independence of the proxy firm.

The president of one company operating under a proxy agreement told
us that his company was basically bankrupt.  His company is financed
by banks owned by the government where the parent company is
incorporated.  The company's foreign parent firm guarantees the
loans, and two of the government banks are on the parent firm's board
of directors.  The foreign owners paid several million dollars to the
U.S.  company to relocate one of its divisions.  According to
officials of the U.S.  company, they could not otherwise have
afforded such a move, nor could they have obtained bank loans on
their own.

Another proxy firm had loans from the foreign owners that grew to
exceed the value of the proxy firm.  One proxy holder said the
company would probably have gone out of business without the loans.
Even with the loans, the company's financial position was precarious.
It was financially weak, could not obtain independent financing, and
was considerably burdened by making interest payments on its debt to
the foreign owners.  During our review, a DIS official acknowledged
that DIS should have addressed the risk imposed by this indebtedness.

   SOME TRUSTEES HAVE APPEARANCE
   OF CONFLICTS OF INTEREST
---------------------------------------------------------- Chapter 4:4

Under the ISR provisions, voting trustees and proxy holders "shall be
completely disinterested individuals with no prior involvement with
either the facility or the corporate body in which it is located, or
the foreign interest." At one of the companies we reviewed, a proxy
holder was previously involved as a director of a joint venture with
the foreign owners.  These foreign owners later nominated this
individual to be their proxy holder.  He withheld the information
about his prior involvement from DIS at the time he became a proxy
holder.  After DIS became aware of this relationship, it concluded
that this individual was ineligible to be a proxy holder and should
not continue in that role.  Thereafter, the Assistant Secretary of
Defense for Command, Control, Communications, and Intelligence wrote
to the company about irregularities in proxy agreement
implementation, such as allowing the foreign owners prerogatives that
were not allowed under the proxy agreement.  However, he did not
address the appearance of a conflict of interest, and the individual
has remained as a proxy holder.

This same proxy holder is also now the part-time CEO of the
foreign-owned U.S.  defense firm and received an annual compensation
of approximately $272,000 (as compared to the $50,000 proxy holder
stipend) for an average of 8 days' work per month in his dual role of
CEO and proxy holder.  This appears to be a second conflict of
interest:  as CEO his fiduciary duty and loyalty to the foreign-owned
company takes primacy; as proxy holder, his primary responsibility is
to protect DOD's information security interests.

In addition, at this company, the conflict between the proxy holders'
responsibility to DOD and their perceived fiduciary responsibility
was illustrated during a DIS investigation into possible violations
of the proxy agreement.  Citing their fiduciary responsibility, the
proxy holders refused to allow DIS investigators to interview
employees without company supervision.  The Assistant Secretary of
Defense for Command, Control, Communications, and Intelligence found
this action to be contrary to the firm's contractual obligations
under its security agreement with DOD.

The company just discussed is not the only one where a proxy holder
also holds the title of CEO.  At another firm, the proxy holder's
salary as CEO is approximately $113,000 (as compared to the $22,000
proxy holder stipend).  Again, there appears to be a conflict of
interest because of the CEO's fiduciary duty and loyalty to the
foreign-owned company, and his responsibility to protect DOD's
information security interests.

At another proxy firm, the lead proxy holder owns a consulting firm
that has a contract with the foreign-owned U.S.  company.  In this
case, there appears to be a conflict of interest because as proxy
holder, his primary responsibility is to protect the information
security interests of DOD, but as a consultant to the foreign-owned
firm, it is in his interest to please the foreign-owned company.

At another firm, the agreement requires that the outside members of
the security committee be independent of the foreign investors and
their shareholders.  The French government owns 12-1/4 percent of
this U.S.  company.  Even though the outside members of the security
committee are to protect classified and export-controlled information
from this foreign government, one outside member created the
appearance of a conflict of interest by representing a French
government-owned firm before DOD in its efforts to buy another
cleared U.S.  defense contractor.  This outside member also created
the appearance of a conflict of interest when his consulting firm
became the Washington representative for a French government-owned
firm in its export control matters with the State Department.

Finally, the ISR does not expressly require that outside directors
serving under an SSA comply with the independence standards
applicable to voting trustees and proxy holders.  The reason for this
omission is not clear.  However, all of the SSAs we reviewed stated
that individuals appointed as outside directors can have "no prior
employment or contractual relationship" with the foreign owners.
Since the outside directors perform the same function as voting
trustees and proxy holders in ensuring the protection of classified
information and the continued ability of the cleared U.S.  company to
perform on classified contracts, it seems reasonable that they should
also be disinterested parties when named to the board and should
remain free of other involvement with the foreign owners during their
period of service.

   DIS INSPECTIONS DID NOT FOCUS
   ON FOREIGN OWNERSHIP ISSUES
---------------------------------------------------------- Chapter 4:5

DIS inspectors told us that their inspections of foreign-owned U.S.
defense contractors vary little from the type of facility security
inspections they do at U.S.-owned facilities.  Their inspections
concentrated on such items as classified document storage, amount and
usage of classified information, and the number of cleared personnel
and their continuing need for clearances.

During the time of our review, DIS developed new guidelines for
inspections of foreign-owned firms by its industrial security staff
to specifically address foreign ownership issues.  They call for the
inspectors to examine issues such as changes to the insulating
agreement, business relationships between the U.S.  company and its
foreign owners, foreign owner involvement in the U.S.  company's
strategic direction, the number and nature of contacts with
representatives of the foreign owners, and the number of foreign
staff working at the facility.  These guidelines were promulgated in
September 1994.

DIS is beginning to implement the new inspection guidelines.
According to DIS officials at the regional and field office levels,
before they use the new guidelines, they must educate the inspection
staff on foreign ownership issues as well as how the issues should be
addressed during their inspections.  They also said that implementing
these new inspection procedures would probably double the length of
an inspection at the foreign-owned facilities.

Currently, DIS must inspect each cleared facility twice a year, but
it is having difficulty maintaining this inspection schedule.
Industrial security inspectors are responsible for around 70 cleared
facilities, and inspections at some larger facilities take a number
of days.  Doubling the inspection time at the foreign-owned
facilities under the new guidelines might require some realignment of
DIS resources.  According to DOD officials, DIS inspections will
occur no more often than annually under the NISPOM.

   RECOMMENDATIONS
---------------------------------------------------------- Chapter 4:6

We recommend that the Secretary of Defense develop and implement a
plan to improve trustee oversight and involvement in the
foreign-owned companies and to ensure the independence of
foreign-owned U.S.  defense contractors and their trustees from
improper influence from the foreign owners.  As part of this effort,
the Secretary should make the following changes in the implementation
of the existing security arrangements and under the National
Industrial Security Program.

1.  Visitation request approvals:  The trustees should strictly
adhere to the ISR visitation agreement provision that requires them
to approve requests for visits between the U.S.  defense contractor
and representatives of its foreign owners.  This duty should not be
delegated to officers or employees of the foreign-owned firm.

2.  Trustee monitoring:  The trustees should be required to ensure
that personnel of the foreign-owned firm document and report the
substance of the discussions they hold with personnel of the foreign
parent firm.  The trustees should review these reports and ensure
that the information provided is sufficient to determine what
information passed between the parties during the contact.  The
trustees should also select at least a sample of contacts and
interview the participants of the foreign-owned firm to ensure that
the post-contact reports accurately reflect what transpired.

3.  Trustee inspections:  To more directly involve trustees in
information security monitoring, the trustees should annually
supervise an information security inspection of each of the cleared
facilities.  The results of these inspections should be included in
the annual report to DIS.

4.  FSO supervision:  To insulate the FSO from influence by the
foreign-owned firm and its foreign owners, the trustees should be
empowered and required to review and approve or disapprove the
selection of the FSO and all decisions regarding the FSO's pay and
continued employment.  The trustees should also supervise the FSO to
ensure an acceptable level of job performance, since trustees are
charged with monitoring information security at the U.S.  defense
contractor.

5.  Financial independence:  To monitor the financial independence of
the foreign-owned firm, the annual report to DIS should include a
statement on any financial support, loans, loan guarantees, or debt
relief from or through the foreign owners or the government of the
foreign owners that have occurred during the year.

6.  Trustee independence:  To help avoid conflicts of interest for
the trustees, require them to certify at the time of their selection,
and then annually, that they have no prior or current involvement
with the foreign-owned firm or its foreign owners other than their
trustee position.  This certification should include a statement that
they are not holding and will not hold positions within the
foreign-owned company other than their trustee position.  It should
be expressly stated that these independence standards apply equally
to voting trustees, proxy holders, and outside directors of firms
under SSAs.

7.  Trustee duties:  The selected trustees should be required to sign
agreements acknowledging their responsibilities and the specific
duties they are required to carry out those responsibilities,
including those in numbers 1 through 4.  The agreement should provide
that DOD can require the resignation of any trustee if DOD determines
that the trustee failed to perform any of these duties.  This
agreement should ensure that the trustees and the government clearly
understand what is expected of the trustees to perform their security
roles.

   AGENCY COMMENTS AND OUR
   EVALUATION
---------------------------------------------------------- Chapter 4:7

DOD stated that it generally agreed with the thrust of our
recommendations in this report, but did not agree that the specific
actions we recommended were necessary, given DOD efforts to address
the issues involved.  DOD said it had addressed these issues through
education, advice, and encouragement of trustees to take the desired
corrective actions.  We and DOD have both seen instances in which
this encouragement has been rejected.  Because of the risk to
information with national security implications, we believe that
requiring, rather than encouraging, the trustees to improve security
oversight would be more effective.  Therefore, we continue to believe
our recommendations are valid and believe they should be implemented
to reduce the security risks.

DOD's comments and our evaluation are presented in their entirety in
appendix I.

(See figure in printed edition.)Appendix I
COMMENTS FROM THE DEPARTMENT OF
DEFENSE
============================================================ Chapter 4

(See figure in printed edition.)

(See figure in printed edition.)

(See figure in printed edition.)

12-14.

15.

(See figure in printed edition.)

(See figure in printed edition.)

(See figure in printed edition.)

(See figure in printed edition.)

(See figure in printed edition.)

(See figure in printed edition.)

27-30.

(See figure in printed edition.)

30-32.

(See figure in printed edition.)

32.

(See figure in printed edition.)

(See figure in printed edition.)

34-37.

(See figure in printed edition.)

(See figure in printed edition.)

(See figure in printed edition.)

(See figure in printed edition.)

38-40.

(See figure in printed edition.)

(See figure in printed edition.)

(See figure in printed edition.)

(See figure in printed edition.)

(See figure in printed edition.)

(See figure in printed edition.)

The following are GAO's comments on the Department of Defense's (DOD)
letter dated April 14, 1995.

GAO COMMENTS

1.  We have revised the draft report to reflect DOD's comments on the
National Industrial Security Program Operating Manual (NISPOM), the
Industrial Security Regulation (ISR), and visitation agreements.

2.  Lawyers negotiating a new agreement may have significant
experience with foreign-owned firms operating under these agreements.
Five of the 14 firms we reviewed used the same lawyer.  Further,
visitation agreements signed before 1993 demonstrate a trend toward
loosening controls.  For example, an older visitation agreement
associated with a proxy agreement stated:

     "As a general rule, visits between the Foreign Interest and the
     cleared Corporation are not authorized; however, the Proxy
     Holders may approve visits in connection with regular day-to-day
     business operations pertaining strictly to purely commercial
     products or services and not involving classified contracts or
     executive direction or managerial matters."

In contrast, the comparable provision in a newer visitation agreement
associated with a proxy agreement was less limiting:

     "As a general rule, visits between representatives of the
     Corporation and those of any Foreign Interest, are not
     authorized unless approved in advance by the designated Proxy
     Holder."

According to DOD's comments, baseline visitation controls were
developed in 1993.  At that time, visitation agreements ceased to
exist as separate documents.  The visitation controls are now a
section of the voting trust, proxy agreement, and special security
agreement (SSA).  The terms of each agreement type continue to be
negotiable.

3.  The acquisition of a U.S.  defense contractor by a foreign
interest can present a higher degree of risk to export-controlled
information than other international involvement.  In international
cooperative programs and joint ventures, the U.S.  firm maintains an
arms-length relationship with the foreign interests.  That is not the
case with foreign ownership, when the foreign owner has control or
influence over the U.S.  firm and access to the U.S.  contractor's
facilities.  The risk of control and influence inherent in foreign
ownership is justification for DOD's special foreign ownership,
control, or influence (FOCI) controls.  However, the controls used to
protect unclassified export-controlled information are limited.
Although some of the newer SSAs we reviewed required the protection
of export-controlled information, most of the agreements did not.
Further, as we reported and DOD acknowledges, the Defense
Investigative Service (DIS) does not review the protection of
unclassified export-controlled information.  In fact, there is no
established means for the U.S.  government to monitor compliance and
ensure enforcement of federal regulations regarding the transfer of
export-controlled technical information.

4.  None of the six SSAs we reviewed required DIS to approve the
replacement of directors.  However, the requirement is included in
boilerplate SSA language that DOD told us it plans to use in the
future.

5.  The terms of the distribution agreement were not revised.  After
negotiating with the proxy holders, the foreign owners agreed to a
more liberal, "case-by-case" application of the distribution
agreement.

6.  DIS oversight did not bring these two cases to light.  In both
instances, DIS was notified about these situations some time after
they occurred.  In the first case, DIS was given an anonymous
allegation and then pursued it vigorously.  In the second case, the
proxy holders brought the complaint to DIS, and DIS monitored the
proxy holder negotiations with the foreign owner.

7.  Trustee approval of visitation requests need not be onerous.
This duty is typically carried out by a designated company trustee
and involves the occasional receipt, review, and transmittal of
approval requests by facsimile machine.  Further, at the companies we
reviewed, the trustees' time was not consumed ensuring the economic
health of the company.  The usual trustee involvement was their
attendance at four meetings a year.  In making this recommendation,
we do not intend to discourage distinguished individuals from
accepting appointments as trustees, but rather believe that it would
be in the best interest of DOD to encourage individuals who are
interested in being proactive trustees to accept these positions.

8.  Our recommendation is not that the trustees supervise "each
inspection effort" at the company, but that they supervise an
inspection of each of the company's facilities annually.  We believe
it is a minimal requirement for the trustees to visit each of the
company's facilities once a year to personally assess security.

9.  The cited March 1995 "policy change" is a positive step, but this
new approach is not documented in any DOD regulation, directive, or
policy memorandum.  Its only documentation is in the DOD-approved
implementing procedures for one recently signed SSA.  Further, our
recommendation calls for trustee approval of all decisions regarding
the facility security officer's (FSO) pay and continued employment
and for trustee supervision of the FSO.  Although voting trustees and
proxy holders may be currently empowered to review and approve or
disapprove the FSO's selection, they are not required to do so and
could delegate this responsibility.

10.  Any involvement the trustees have with the foreign owners after
their initial certification may not be reported to DOD unless the
trustee in question heeds the advice of DIS to report such
activities.  We believe an annual certification, which should not be
onerous, will prevent inadvertent disclosure omissions.

11.  The "Acknowledgement of Obligations" portion of the FOCI
agreements is too broad and general to clearly identify the trustees'
responsibilities in carrying out their security role.  Trustees'
certification of acknowledgement of the broad and general obligations
cited in the FOCI agreement will do little to ensure that trustees
will play an active role in security oversight.  Further, although
DIS educational efforts may encourage some trustees to pay greater
attention to the security aspects of their role, we feel that the
agreement we are recommending will provide baseline performance
criteria for all trustees.

12.  Following their 1993 survey of foreign-owned U.S.  defense
contractors, the Defense Intelligence Agency (DIA) and DIS reported
the following:

     "Most agreements are silent on the authority of the DOD to
     terminate the arrangement or to dismiss a Proxy Holder, Trustee
     or outside director.  While DIS is normally a party to Special
     Security Agreements, it is not a party to proxy or trust
     agreements and therefore lacks standing to intercede when
     appropriate."

While DIS is a party to SSAs, if faced with outside directors who are
not performing their security duties, the only means for DIS to force
corrective action would be to terminate the agreement, thereby
causing the company to lose its clearance, and halting all the
company's work on classified contracts.  Our recommendation is a more
moderate way of removing a nonperforming trustee than revoking a
company's clearance and terminating its classified contracts.  We
modified our recommendation in recognition of DOD's comment that the
shareholder must remove a trustee director.

MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix II

James F.  Wiggins
Davi M.  D'Agostino
Peter J.  Berry
John W.  Yaglenski

Norbert Trapp
Arthur Cobb

Odilon Cuero
Allen Westheimer

Eric L.  Hallberg
Deena M.  El-Attar

Cornelius P.  Williams
Robert R.  Tomcho

*** End of document. ***
