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 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. 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. 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 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. 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. 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. 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. 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. 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. 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. 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.