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I have 2 different games going on playing the Allies in both of which the Germans invaded Spain (which seems to be the norm these days). In the 1st game the Germans did a preliminary air bombardment 1st to damage some units and then launched the ground assault. In the 2nd game the Germans just attacked with everything at once. In both games the Germans took Spain easily. But in the 1st game the undamaged Spanish survivors retreated to Gibralatar and the damaged units showed up in the WA build que in England. So at least the WA got something from Spain's collapse.

However, in the 2nd game all the undamaged and damaged Spanish units were completely destroyed as having no place to retreat. I didn't understand why the difference until I read section 8.2 of the Rules Manual which says "any Neutral Territory owned by an attacked Neutral that survives the initial onslaught (the attacker fails to conquer the Neutral) will automatically join the opposing side. In other words, in the 1st game Spain and the units located there became WA immediately after the air bombardment and were therefore able to retreat to WA Territory and production centers after the 2nd attack by ground units. However in the 2nd game where there was no preliminary air attack 1st and Spain was taken on the "initial onslaught" the defeated units never got the chance to join the WA.

I personally think this is silly, but since it is the rule the lesson is "When attacking neutrals that have a connection to an enemy territory or production center be sure to conquer them on your 1st attack."

Very good point. One additional tip to add. After an unsuccessful first attack, not only do the remaining units join the allies they are instantly upgraded to the tech level of the WA. This can mean that the surviving units may get a significant bump in their tech levels making a second attack even harder. So I echo your point - it is best to wipe out a neutral country in a single attack, don't try to soften them up.

yeesh... this is a weird caveat

I think its a bug! It should be if they survive the first TURN of attack. Not just the first air strike.
BTW the Axis AI regularly does this in Yugoslavia! They flunk the first attack, then pour Militia in and take gross losses! Terrible thing to witness...

Aren't most the the neutral forces militia?

Militia might be able to retreat, but there is no worry about them inheriting a tech upgrade.

There's a seperate rating for Neutral units (even for Carriers & such, lol!) I think they're a little lower than WA units, and at any rate can't be upgraded.
Spain, Turkey & Yugoslavia, and Switzerland for that matter, start with Infantry, not Militia.