A “Work In Progress” – The Evolving U.S.-India Defense Supply Relationship

Robert S. Metzger and Sanjay J. Mullick
India’s transformation as a rising power has been accompanied by significantly increased defense expenditures. Late in February 2011, the Indian Government announced a nearly 12% increase in the defense budget. Of the total defense budget of approximately $36 billion (Rs 164,415 crores for fiscal 2011-12), capital acquisition is to receive 42%, or about $15 billion (Rs 69,199 crores). India may spend as much as $80 billion over the next five years on defense capital acquisition. Homeland or “internal” security represents an additional market opportunity. India is strongly committed to a policy of “indigenization” and self-reliance. In order to satisfy the requirements of the Indian military, and to obtain desired transfer of technology (“ToT”), however, a sizable portion of the defense capital acquisition budget will continue to involve purchases from foreign original equipment manufacturers (“OEMs”).

India makes capital acquisitions of defense equipment via the “Defence Procurement Procedure” (“DPP”), first released publicly in 2006 and subsequently revised periodically. The latest revision was announced by India’s Ministry of Defence (“MOD”) on January 1, 2011. Within the same month, on January 25, 2011, the U.S. Department of Commerce, Bureau of Industry and Security, issued a rule formalizing the first set of U.S. export reforms specific to India. February 2011 marked Aero India 2011, the 8th international aerospace exhibition held by India. Some 675 companies from over 30 countries were in attendance. Since Aero India, the U.S. was disappointed with the exclusion of the two American fighters, the F-16 and F/A-18, from India’s pending $11 billion Medium Multi-Role Combat Aircraft (“MMRCA”) competition. On the other hand, in early June India announced an intention to purchase ten Boeing-made C-17 cargo aircraft for $4.1 billion. Finally, towards the end of June, the U.S. Senate Armed Services Committee requested the Department of Defense to submit a report later this year assessing the current state of U.S.-India security cooperation and recommending ways to enhance it, including possible sale to India of the F-35 Joint Strike Fighter.

The confluence of these events makes this an opportune moment to assess and reflect on the challenges involved in India defense procurement and to forecast the opportunities that can lie ahead for U.S.-India defense and strategic trade if the right steps are taken.

A.Suitability of the U.S. Foreign Military Sales Procedure.
Thus far, the majority of U.S. defense sales to India have been accomplished as government-to-government foreign military sales (“FMS”) rather than as direct commercial sales (“DCS”) between a U.S. supplier and the Government of India (“GOI”). Though Boeing’s sale of P-8I maritime aircraft was a DCS sale, FMS has been used by the GOI to make major purchases of U.S. systems, such as the C-130J and, recently, the C-17.

India has reservations about FMS, however. A principal objection is that FMS does not comport with competition requirements of the DPP requiring bids be made on a firm fixed-price basis. Ordinary FMS procedures, in contrast, contemplate an “offer and acceptance” procedure which begins with a Letter of Request (“LOR”) from the government intending to make a purchase. A LOR may request only Price & Availability (“P&A”) data or a formal, ready-to-execute sales offer in the form of a Letter of Agreement (“LOA”). A P&A response is only an estimate of approximate costs and projected availability. An FMS sale is concluded only if there is an LOA, but the LOA itself normally does not contain a firm, fixed price, as the final price for an FMS purchase typically is not known until some time after execution of the LOA, i.e., after the USG negotiates the corresponding supply or service contract with the U.S. supplier.

The DPP also requires tendering companies to commit to a technical field evaluation phase before selection, a procedure not contemplated in the FMS process. Further, a crucial element of any GOI procurement from a foreign source is satisfaction of offset measures. The USG assumes no obligation to administer or satisfy any offset requirements – in FMS deals or otherwise.

There are countervailing considerations which favor FMS, even though aspects of FMS are difficult to align with the DPP requirements General FMS policies recognize that “foreign nations often compete weapon systems procurements.” A competitive solicitation of a foreign government is treated as a LOR triggering the FMS case process. The U.S. response can be a combination of programs (a “hybrid”) which include FMS and DCS elements (and international cooperative agreement as well). Hence, one or more U.S. companies can respond to a solicitation under the DPP using a combination of FMS (for supply of defense articles) and DCS (for training, support equipment, and other services). Offset obligations are independently executed between the purchasing government and the supplier.
Concern as to whether FMS is “competition” reflects largely issues of alignment of U.S. systems to Indian requirements – not differences in philosophy. One objective of “competition” is to assure a public buyer it is paying a reasonable price. Here, the FMS structure is satisfactory. FMS acquisitions are to be conducted under “the same acquisition and contract management procedures” that the U.S. uses for its own acquisitions. Moreover, price and cost justification is required for FMS contracts using the “same principles” as for other U.S. defense contracts. These rules are both well developed and rigorously enforced. Arguably, in FMS purchases, the GOI has a much higher degree of assurance as to the fairness of price, the assurance of delivery of goods at the contract price, and the integrity of the offering process, than realistically can be obtained through a procurement done entirely within the DPP framework.

Another criticism goes to fees and charges that accompany FMS cases. Depending on the particulars, categories of such charges can include an “administrative surcharge,” a “contract administration services (CAS) surcharge,” or a “logistics support charge,” among others. Again, there are reasons behind the U.S. approach which are mutually advantageous rather than self-serving of U.S. interests. And, these charges reflect the real costs of activities which the USG performs for the benefit of a foreign customer.

The USG considers the “support of U.S. origin defense articles critical to the success of the Security Assistance program.” The U.S. prefers a “Total Package Approach” (“TPA”) intended to assure FMS purchasers that they sustain as well introduce new equipment. The TPA includes elements such as training, technical assistance, initial and follow-on support. Considering well-publicized problems that the GOI has experienced with military articles supplied from countries, notably Russia, the commitment of government-backed support has high value. Even so, the USG requires that a “complete sustainability package” must be offered to the purchaser, but purchase of that package is not required.

Actually, therefore, the “hybrid” FMS mechanism presents the GOI with an opportunity to have both the “direct” relationship that it (or the Indian Armed Forces) may desire with the supplier while also having the confidence in a USG contract with the American supplier. An FMS sale does not mean that the foreign purchaser is isolated from the transaction. FMS customers are “encouraged” to participate with U.S. acquisition personnel in discussions with industry to develop technical specifications, establish delivery schedules, identify special warranty or other requirements unique to the FMS customer, and review prices of varying alternatives, quantities and options as needed to make price-performance tradeoffs.

Of great concern for India is the application of export controls and whether goals of transfer of technology can be accomplished. As a matter of policy, U.S. export controls apply equally to FMS as to DCS. However, the USG may determine to sell certain types of more sensitive equipment and technology, such as a new or complex system or service, only through FMS. (A transaction can combine FMS-only and DCS elements.) When the USG executes a response to an FMS LOR, it is the USG which is responsible to coordinate and secure necessary export approval. In practice, this can work faster, and with higher assurance, than when defense supplies services are sold through DCS and a private contractor must secure export authorization. As to transfer of technology, U.S. FMS policies encourage foreign manufacture of U.S. equipment when it is advantageous to assist in maintaining the purchaser’s defense industrial base or in improving general defense capabilities by collaboration.

Taken as a whole, there are objective benefits to India from the FMS process and its employment in combination with DCS. While FMS is not ideally aligned with the DPP, fundamental objectives are substantially similar. It behooves both the USG and the GOI, as well as prospective commercial partners from both countries, to anticipate and work through alignment issues. The USG has mechanisms to facilitate U.S. participation in international competition. These include the coordination of actions necessary to comply with U.S. law as well as working with the foreign government. Both countries would benefit from an initiative to identify recurring issues in the application of FMS to the full scope of prospective GOI requirements, so that recommended practices and representative solutions may be developed in advance of future procurements.

B.Effectiveness of India’s Defence Procurement Procedure
U.S. firms have encountered considerable frustration and delay in attempting to secure business through the DPP. The strengths of the DPP, a rule-driven mechanism, include predictability, regularity and transparency. It provides an objective reference to the requirements and expectations of the MOD and of the process used to establish requirements, secure authorization for acquisition, and then to conduct procurement. Ultimately, however, the effectiveness of a procurement system is measured by whether it succeeds in accomplishing contract award and whether the end user acquires supplies and services which conform to its requirements. In this regard, some of the DPP’s rigors have worked against its effectiveness. One recent article suggested that the GOI has accomplished “more than 70%” of its major defense acquisitions through means which proceed outside the formal procurement process of the DPP, such as inter-government agreement and “fast track” procedures.

The DPP is a “single stage, two-bid” system which posits that there are multiple sources available for a fully developed product for which at least two competitive bids can be obtained. The evaluation method is price-determined, assuming satisfaction of technical requirements. For a procurement to succeed under the DPP, it is best that each specified step, process, and action proceed exactly as prescribed. In the real world, however, this rarely occurs. Thus, the DPP has proven unwieldy, if not unsuited, to situations as have actually emerged while an acquisition is in process, where one or another event is outside the “frame” expected by the DPP.

The preference for formal competition is so strong that it has proven difficult for the MOD to proceed to make an award unless it has two fully compliant tenders under a DPP procurement. Several authorities are available under the DPP to allow for procurement in other than multiple bid situations. These include DPP ¶ 69 (“Single Vendor Situation”), DPP ¶ 71 (“Inter Government Agreement”) and DPP ¶ 73 (“Procurement on Strategic Considerations”). Indian officials have proven wary of using these authorities, however, perhaps out of undue concern that flexible administration of the DPP will expose them to charges of favoritism or corruption. Recent history includes an example of cancellation of a solicitation long in the gestation, for a compelling military requirement, where one competitor decided it would prefer to scuttle the acquisition rather than lose the competition. For its own sake, India needs better measures to avoid and address this situation.

On procurements conducted under the DPP, where bids are deemed to satisfy the technical requirements, a low bidder (the “L1”) is selected for contract negotiation only on the basis of bid price. This also is vulnerable to manipulation – “gaming” – by a potentially unscrupulous bidder. In several reported competitions, the realism of low bids has come into question. In one competition, it is understood that the MOD made “adjustments” to an unrealistically low bid which caused the ostensible “L1” to become the higher priced (and losing) “L2” bidder. The authority for such adjustments, in the DPP, is obscure at best, though the experience demonstrates the need for common sense flexibility in administration. In the U.S., in contrast, price “realism” may be a selection criteria. Bids can be disregarded, or unfavorably reviewed, if the proposed price is not realistic.

The DPP today does not allow for consideration of life cycle costs, though these are obviously most important in understanding the total cost of an acquisition. Nor does the DPP allow for the selection decision to reflect qualitative discriminators such as higher performance and greater mission suitability. No credit is given for exceeding the specifications enumerated in a tender document. In the U.S., acquisition of complex articles and systems usually are acquired through a “best value” approach, in which the source selection authority also considers non-price factors such as better technical performance, lower performance or cost risk, and better past performance credentials.

Moreover, the DPP is poorly suited for acquisitions that call for design and development. It is very difficult for vendors to offer anything other than existing, “off-the-shelf” hardware. This means that when India procures via the DPP it is largely limited to acquisition of what others have already built. The result favors defense public sector undertakings (“DPSUs”) for developmental work and frustrates private sector engagement.

C.Realistic Prospects To Satisfy Offset Requirements
Demands for offsets appear to be the “norm” in international acquisition of defense supplies or services from foreign sources. For India, questions of implementation and administration have importance because a successful foreign seller to India is required to enter into binding contractual obligations for offset commitments which are co-terminus with the period of performance of the main contract.

India’s offset requirements reflect important national policies. Where India purchases from a foreign source (“Buy-Global” or “Buy and Make”), offsets must equal or exceed 30% where the indicative cost of the procurement exceeds approximately $66 million (Rs 300 crores). In certain acquisitions, such as the MMRCA competition, the offset requirement is greater still. The DPP Amendment of 2009, released on November 2, 2009, added an acquisition category for “Buy and Make (Indian)” where RFPs would be released only to Indian firms. Such firms could partner with foreign OEMs, but this procurement category requires a minimum of 50% indigenous content.

Concerns exist as to the ability of Indian industry to “absorb” the offset commitments already made and those which will accompany future foreign purchases. India formerly was very restrictive in classification of transactions qualifying for offset credit. The DPP 2008 allowed discharge of offset obligations only through direct purchase of, or executing export orders for, “defence products and components manufactured by, or services provided by, Indian defence industries, i.e., DPSUs, the Ordinance Factory and private defence industry.” As implemented by DPP 2008, offset obligations could be discharged by direct purchase of services provided by Indian defense industries.

DPP 2011 is a welcome step. It enlarges qualifying “services” to also include testing of products and includes “training services and training equipment, e.g., simulators.” DPP 2011 also eliminated the prior requirement that offsets be “direct” to the defense sector and expands the categories of “eligible” offsets to include internal security and civil aerospace. The expansion of transactions eligible for offset satisfaction represents real progress, but a number of issues left unresolved present opportunities for further clarification and improvement.

Retroactive Application: The ostensible position of the MOD is that the revised offset rules of DPP 2011 apply only to contracts awarded on RFPs issued after the effective date of the new rules. This position might be revisited. As a matter of policy, if the expanded scope of offsets for “new” contracts serves the national interests of India, then the same interests should be served by allowing the policy to apply retroactively, albeit selectively. There are three principal considerations: first, the general interest of the GOI in achieving the industrial objectives of offset rules; second, the specific interest of the GOI in assuring vendors of different size within India that they have real opportunity to participate in offset work; and third, the proposition that “fairness” to OEM competitors should discourage liberalizing offset requirements once a competition has been concluded. Since the offset rules exist for the benefit of the GOI, and confer no rights enforceable by private parties, it should be within the sound discretion of Government officials to take prudent actions in the application of these rules to achieve their fundamental purposes. Hence, for illustration, it would seem appropriate for the GOI to allow application of the DPP 2011 rules to contracts awarded after issuance of the 2011 rules but under RFPs released beforehand.

Credit for Technology Transferred: Today, the DPP does not give any offset credit for accomplished ToT per se, as offset satisfaction is purely a function of cash value of purchased eligible supplies or services, irrespective of technical content. Critical defense and dual-use technologies have “leverage” value after receipt, in that some technologies will enable greater industrial exploitation or have higher job-producing consequences than others. In addition, certain technologies may be comparatively more important for India to acquire from the standpoint of its security objectives. Offset credit should be awarded as promised technology is delivered, and for especially valuable technology the MOD should apply a “multiplier.” That this serves India’s national objectives—of indigenization and technology development—is self-evident. It also serves the interests of India’s foreign sales partners, by affording additional means to perform their contractual offset obligations.

Allow Greater FDI:DPP 2011 allows offset credit for foreign direct investment (“FDI”) in Indian industries “for industrial infrastructure for services, co-development, joint ventures and co-production of eligible products and components” as well as for certain organizations involved in R&D. Today, investment in the defense industry is capped at 26%, reflecting concerns about sovereignty over the national defense industrial base. India will be more successful, in achieving ToT and the ultimate goal of indigenization, if the ceiling is increased, even to 49%, if not more. There are many and serious business considerations which discourage U.S. and other foreign firms from joint venture participation with a 26% cap on FDI. Control over transferred technology, assurance of proper use, and controls on unauthorized dissemination are hard to accomplish from a minority ownership position. Similarly, U.S. firms see minority ownership as making it more difficult to assure compliance with the myriad of U.S., Indian and other national anti-corruption laws.

Enhanced Administration:The DPP 2011 revisions, as concern offsets, are accompanied by many questions of interpretation and application. The MOD should enhance the resources of the Defence Offsets Facilitation Agency (“DOFA”) and clarify its authority to resolve issues of offset application, evaluation, and compliance. DOFA also should establish a collaborative mechanism to receive supplier inputs. DOFA should actively monitor performance of offset contracts, assess the state of capacity absorption, and evaluate and report on the successful implementation of offset arrangements. Today, for all its ambitions, there is little evidence that the offset program has succeeded in bringing high-tech jobs and new industries to India. Having a real-time knowledge base of the functionality of its offset requirements and flexibility in adaptation and application of the rules benefits India. No one benefits, in contrast, from rigid adherence to rules if the consequence is defeat of these important national objectives. Offset rules can be amended and subjected to appropriate exception in a fashion that is transparent and which considers the expectations of all interested parties.

D.Overcoming the “Trust Deficit” Prompted by U.S. Export Controls
U.S. export controls serve important policy objectives but their operation has proved slow and uncertain, causing frustration to India as a prospective purchaser and sometimes resulting in exclusion of U.S. suppliers from opportunities for which they offer superior products and technology. Following nuclear tests in 1998, the U.S. imposed sanctions on both India and Pakistan which included termination of foreign military sales and revocation of licenses for commercial sale of any item on the U.S. Munitions List. These sanctions—not forgotten by contemporary India decision makers—severely impacted U.S.-India defense cooperation. Collectively, the result has been called a “trust deficit,” which still besets the U.S.-India defense relationship.

In 2011, the U.S. has announced three major export reforms favoring India. Just as India’s DPP 2011 represented real progress in some areas, but insufficient accomplishment in others, the 2011 export measures are a step in the right direction, but do not yet achieve enough.

  • The U.S. has removed several defense and space-related entities from the Entity List: Bharat Dynamics Limited, and the remaining subordinates of Defense Research and Development Organization (“DRDO”) and the Indian Space Research Organization. The Entity List consists of organizations the U.S. Government has determined are involved in or pose a risk of developing weapons of mass destruction. License requirements continue to apply to an entity removed from the Entity List, but there is no longer a general bar on exports, even if items are not sensitive technology.
  • The U.S. has also realigned India in its country groupings, removing it from Country Groups D:2, D:3 and D:4, and adding it to Country Group A:2. This reflects U.S. treatment of India on par with close allies and may facilitate cooperation and partnerships in the commercial space sector, such as space launch vehicles. Addition of India into Country Group A:2 places it into the list of Missile Technology Control Regime (“MTCR”) member states, though India is not formally an MTCR member. This will not remove the existing requirement for a license to export items controlled for missile technology reasons (which applies to all countries except Canada).
  • President Obama has also announced U.S. support for India’s full membership in the four multilateral export regimes: the Nuclear Suppliers Group, Missile Technology Control Regime, Australia Group, and Wassenaar Arrangement.
  • The 2011 export reform initiatives were taken by the U.S. Department of Commerce. Further actions will be required of the Departments of State and Defense. State has a key role, as its jurisdiction encompasses export licensing under the International Traffic in Arms Regulations (“ITAR”), which is the responsibility of the Directorate of Defense Trade Controls. Other key actors on the U.S. side include the Defense Technology Security Administration, which administers technology release policies, and the Defense Security Cooperation Agency, responsible for security cooperation and security assistance and, specifically, for FMS sales.

    What India seeks is advance assurance of the technology it will receive, in fact, should it make a contract award for the benefit of or to a U.S. company. Today, it is very difficult for the USG to coordinate among the various interested and assigned agencies and render such assurance. Such doubts affect the willingness of India to consider FMS sales, the eligibility of U.S. firms to make direct sales under the DPP, and the credibility of U.S. firms as prospective partners for industrial cooperation. For U.S. companies to effectively partner with the private sector in India, or work with India’s public sector defense establishment (e.g., DRDO), the U.S. must take positive and specific acts to overcome the lingering concern that U.S. companies cannot give to the GOI, or to industrial partners, positive and timely assurance on technology release. This may require efforts that are “exceptional” in their design for India’s specific needs.

    Further India-specific export reforms should be possible. For example, the Commerce Department has indicated it is prepared to remove certain export controls on India that currently are in place on the basis of “Regional Stability” or “Crime Control” reasons. Such controls affect items such as explosives detection equipment and night vision equipment, i.e., homeland security or “internal security” items, which the DPP has now made eligible for offset credit. The convergence of reforms on both the U.S. and Indian side has the potential to catalyze strategic trade between the two countries. However, for the U.S. to take such further steps, reciprocal action on India’s part will be necessary. India may need to tighten its own controls on retransfer. Iterative progress on so-called “enabling” bilateral agreements such as the Communications and Information Security Memorandum of Agreement (known as “CISMOA”) will encourage further U.S. actions.

    At a high level, U.S. policy has elevated the importance of both the strategic and commercial relationship with India. From a practical perspective, however, these favorable developments are less than fully recognized by the actual bureaucratic machinery that processes export license applications. For the “strategic partnership” sought by the U.S. to have value to India, the U.S. must demonstrate a consistent pattern of timely technology transfer approvals and deliveries. Doubts as to whether the U.S. is a reliable supplier can be put to rest only by real world results.

    Indian officials acknowledge that the DPP is a “work in progress” and they appear genuinely receptive to constructive criticism and new ideas. Certain measures should be taken with some immediacy. The defense capital acquisition process takes a long time to reach fruition, and is subject to unpredictable delays and detours and sometimes fails to result in contract award. Vendors incur considerable expense in preparing for competition, in making offset arrangements, and in committing to the field trials which India requires on a “No Cost No Commitment” basis. Vendors will invest and accept the results of a fair competition. But they will not participate if RFPs only occasionally lead to contract award and after interminable delays.

    Another issue is how to reconcile India’s enormous public sector defense industry, and the political and economic interests it represents, with the proposition that private sector engagement must increase if India is to achieve defense self sufficiency. There is conflict between the announced objectives to increase private sector involvement and preservation of the prominence of DPSUs. A challenge is to demonstrate through successful “public-private” partnerships that mutually advantageous alliances can be achieved. The autarky which India seeks may require determined national promotion of private sector opportunities and active management of DPSU expectations and roles.
    The U.S. has responsibilities as well. These include additional planning and coordination to improve the suitability of FMS as a means by which India can contract with U.S. The U.S. must continue efforts to clarify and simplify its export control regimes, and on a bilateral level must take additional steps to recognize the importance of India as regional power with whom it shares many political and geo-strategic interests. These measures, however, must be respectful of India’s sovereign interests and well-demonstrated aversion to a bilateral relationship which compromises India’s political independence and military autonomy.

    Robert S. Metzger is a shareholder at Rogers Joseph O’Donnell,Washington, D.C. and San Francisco, CA, and may be contacted at rmetzger@rjo.com.
    Sanjay J. Mullick is counsel at Pillsbury Winthrop Shaw Pittman LLPWashington, D.C., and may be contacted at sanjay.mullick@pillsburylaw.com


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