Increasing Foreign Direct Investment in the Defence Sector: Security Concern or Strengthening India’s Defence?

Vandana Shroff and Ashish Jejurkar

Until May 2001, the Indian defence sector was closed to private players and was considered to be an exclusively governmental function. In May 2001, the Government of India, issued Press Note 4 (2001 Series) permitting foreign direct investment (“FDI”) of up to 26% in the defence sector with prior approval of the Foreign Investment Promotion Board (“FIPB”). This press note reflected a new policy of liberalization for participation by the foreign manufacturers. However, this cap has remained unchanged for a decade.

The debate in relation to the FDI cap in the defence sector was reinvigorated in May 2010, when the DIPP issued a Discussion Paper setting out the pros and cons in relation to increasing the FDI cap in the defence sector (“Discussion Paper”). The Discussion Paper, the first of several discussion papers put forth by the DIPP on important topics for public discussion, raised strong arguments for increasing the FDI cap in the defence sector from 26% to 74%, and stated that liberalizing the FDI cap to 100% would be desirable.

Existing Regulatory and Policy Framework

FDI of up to 26% in the defence sector is permitted with prior approval of the FIPB. At present, the defence industry is subject to industrial licensing requirements under the Industries (Development & Regulation) Act, 1951. Additionally, the guidelines for production of arms and ammunition which have been notified vide Press Note 2 (2002 Series), sets out, inter alia, the following conditions:

  • Applications for a license shall be considered and a license shall be issued by the DIPP, in consultation with the Ministry of Defence. Cases involving FDI, in contrast, shall be considered by the FIPB;
  • Management of the applicant company should be in Indian hands. Majority representation on the Board, as well as the Chief Executive role of the company, should be allocated to resident Indians;
  • A three year “lock-in” period is applicable for transfer of equity shares of an Indian defence company from one foreign investor to another foreign investor. Any such transfer would be subject to prior approval of the FIPB;
  • The Government retains the right to verify the background of foreign vendors and their domestic promoters, including their respective financial standing and credentials in the global arms and ammunitions market. Preference is to be given to original equipment manufacturers or design establishments, companies with an established supply record with the Armed Forces, Space and Atomic Energy sector, and/or companies with an established R&D base;
  • The relevant licensing authority would be required to satisfy itself of the adequacy of the net worth of the foreign investor, taking into account the category of weapons and equipment proposed to be manufactured;
  • No purchase guarantee is to be given by the Ministry of Defence;
  • Capacity norms for production are to be included in the license based on the application and the recommendations of the Ministry of Defence looking into the existing capacities of similar and allied products;
  • Purchase preference and price preference may be given to public sector organizations as per the guidelines of the Department of Public Enterprises;
  • Adequate safety and security procedures must be put into place by the licensee, which remain subject to verification by authorized Government agencies; and
  • Arms and ammunitions manufactured are to be sold primarily to the Ministry of Defence or other Government entities under the control of the Ministry of Home Affairs and State Governments, with the prior approval of the Ministry of Defence, and not to any other country or person or entity. Export of manufactured items is subject to relevant policy and guidelines applicable to ordinance factories and defence public sector undertakings (“PSUs”). Non-lethal items would be permitted for sale to persons or entities other than the Central or State Governments with the prior approval of the Ministry of Defence.

Moreover, the Defence Procurement Policy provides, inter alia, for an offset policy. An “offset” is essentially an agreement in which a foreign purchaser, usually a developing country government, requires the contractor (usually a foreign supplier) to agree to purchase a predetermined level of components from subcontractors located within the purchasing nation, or to fulfill other portions of the contractor’s international purchasing requirements from firms within that nation, or even to assist that nation in selling its unrelated products to third parties. The policy stipulates that all contracts awarded to foreign vendors worth over INR 3 billion would carry an offset obligation of a minimum of 30% of the value of a defence purchase. The offset obligations of a foreign defence supplier can be satisfied in any of the following ways under the Defence Procurement Policy:

  • direct purchase of components or goods manufactured or supplied by local Indian companies in the defence sector, or execution of export orders of goods or services manufactured or supplied by local Indian companies in the defence industry;
  • FDI in Indian companies/organisations engaged in the defence industry and defence R&D; or
  • credits earned for satisfying offset obligations at an earlier date which have been “banked” may be discharged against future contracts.

Given that India is one of the largest importers of defence equipment and makes large purchases from foreign suppliers, these purchases would result in offset obligations for the foreign suppliers, resulting in a greater interest in FDI in the defence sector by these foreign suppliers. Additionally, due to the high level of defence spending in India, the defence sector could also prove to be a potentially major revenue source for foreign defence equipment suppliers. Nevertheless, the defence sector remains one of the most heavily regulated and closed sectors in view of its sensitive nature.

Private Participation and FDI in the Defence Sector under the Current FDI Framework

Most defence equipment manufacturing in India is still conducted by the ordinance factories set up in the 1960s and a handful of defence PSUs, such as Hindustan Aeronautics Limited, Bharat Electricals Limited, Bharat Dynamics Limited, and Garden Reach Shipbuilders & Engineers Limited, to name just a few. Private participation and FDI in the defence sector under the existing FDI policy framework are not very significant. The Tata group, Mahindra & Mahindra, Larsen & Toubro and Godrej & Boyce are some of the private sector firms that carry the status of Raksha Udyog Ratna (“RUR”), which enables these firms to bid for defence contracts and manufacture defence equipment. RUR status enables these firms to receive the same treatment as defence PSUs, which include certain benefits such as substantial government financial investment (up to 80%) for design, development and manufacture of defence products, including fighter aircraft, tanks and warships.

There have been exceptions to the 26% cap, such as India’s joint venture with Russia to manufacture BrahMos missiles, where the Ministry of Defence obtained a special dispensation from the Cabinet to enable the Russian contractor, NPO Mashinostroyenia, to hold a 50% equity stake in Brahmos Aerospace Private Limited. Hindustan Aeronautics Limited and a French company, Snecma, have also been permitted to form a 50-50 joint venture for the manufacture of aircraft engines. However, the Ministry of Defence recently rejected certain other proposals, such as for a 49% foreign equity in a joint venture between Mahindra Defence Systems and UK-based BAE Systems, and a separate proposal for a joint venture between Larsen & Toubro and European EADS. Overall, the exceptions for allowing FDI beyond 26% have been few (only in the case of joint ventures with PSUs), and obtained only at the discretion of the Government.

A number of joint ventures in the defence equipment manufacturing space have been announced. Tata Advanced Systems Limited has signed a memorandum of understanding with Lockheed Martin Aerostructures for the C-130 aircraft produced by Lockheed. Another Tata Company, Tata Industries Limited, had formed a joint venture with Boeing Company in 2008 to manufacture defence-related aerospace components in India. Indian aerospace firm Axis Aerospace and Technologies (AAT) and Russian defence exporter FGUP Rosoboronexport have also signed an agreement creating a joint venture focusing on avionics for the Indian Airforce’s front line Sukhoi SU-30 and MiG-29 fighter jets, as well as military helicopters such as the Kamov Ka 27.

The Case for Increasing the FDI Cap: From Import Dependence to Indigenous Manufacturing and Exports

In the decade between the time FDI and private participation were first permitted in the defence sector and the date of the Discussion Paper, FDI inflows in the sector amounted to only Rs. 7 million. This low investment figure provides a clear indication of the failure of current FDI policy to attract sufficient foreign investment in the defence sector. However, India is one of the largest users and importers of conventional defence equipment, ranking among the top ten countries in the world with respect to defence expenditure. The cumulative defence budget for the financial year 2006-2007 was USD 20.11 billion. According to the Discussion Paper, nearly 70% of India’s expenditure (by value) for defence procurements is allocated to imports and only the remaining 30% can be allocated to domestic production. The majority of domestic production is met either through ordinance factories or defence PSUs, rather than from private manufacturers. Additionally, even in cases of domestic manufacturing, a large component of defence sub-systems is imported, with the domestic PSU acting merely as systems integrators. Therefore, India remains highly dependent on imports. Moreover, indigenous R&D has not kept pace with present-day warfare requirements. Suppliers are keen to sell their own products from abroad rather than localize production of their defence equipment in India. However, offset obligations do allow for some portion of the purchase price for foreign defence equipment to be distributed back into India. Ordinance factories and PSUs have been unable to modernize their facilities and have not kept up with advances in technology.

In terms of the Companies Act, 1956 (“Companies Act”), every shareholder has a right to vote on every resolution placed before the company and his voting right on a poll is in proportion to his share of the paid–up equity share capital of the company. There are essentially two types of resolutions which can be passed at a general meeting of the shareholders of a company – an “ordinary resolution” and a “special resolution.” An “ordinary resolution” is a resolution where the votes cast by members in favour of the resolutions exceed the votes cast against such resolution. A “special resolution” is a resolution where the votes cast by the members in favour of the resolution cannot be less than three times the votes cast against such resolution. Generally, matters which are more critical to a company, such as liquidation, merger, etc. are required to be passed by a “special resolution.”

With a 26% interest, foreign investors can only have blocking rights with respect to special resolution matters, such as amendment of charter documents, liquidation, mergers, etc. The foreign investor can exercise control only if it has more than a 50% stake. Thus the current defence sector FDI cap of 26%, which provides only blocking rights to the foreign investor, deters original equipment manufacturers from investing in India or from transferring technology to the relevant Indian partner. To increase foreign participation, increasing the FDI cap to at least 51% will serve to attract foreign investment.

The stated objective of the Government of India has been to “reverse” this trend of import dependence and ensure that India can meet at least 70% of its defence requirements through indigenous manufacturing. Given the capital-intensive nature of the defence industry, it may take a long time for domestic companies to acquire modern technologies without the additional capital provided by FDI. As a result, manufacturing within India, with full transfer of state of the art technology, is preferable to importing the equipment from foreign companies. Additionally, in view of the significant amount of defence spending, decreasing the import dependence on foreign equipment suppliers would also amount to large savings in foreign exchange for India.

Concerns Regarding Increase in FDI Cap

The Discussion Paper acknowledged the special sensitivities inherent in the defence sector, and accordingly recommended that the views of the Ministry of Defence be taken into consideration prior to any policy being passed by the DIPP. However, according to certain news reports, the DIPP’s proposal has not been viewed favourably by the Ministry of Defence. In its Discussion Paper, the DIPP specifically noted the following concerns regarding a potential increase in FDI cap in the defence sector:

  • Ordinance factories and defence PSUs may be rendered obsolete in the face of competition from global weapons manufacturers;
  • Ownership and control of firms operating in a critical and highly sensitive industry may be passed on to foreign hands, thereby increasing India’s dependence on foreign investment and foreign companies in relation to manufacture its defence equipment;
  • Availability, reliability and maintenance services of supplies during times of war;
  • Transfer of critical equipment, design or source code to other players / countries which may have adverse interests to India;
  • Export of defence equipment manufactured in India to other players / countries which may have adverse interests to India; and
  • Internal security of particular factories or other locations where arms or ammunition are manufactured.

The Discussion Paper addressed each of these concerns:

  • The ordinance factories and defence PSUs currently lag behind the technology curve and have proved inadequate in meeting India’s defence requirements. Collaborations with domestic manufacturers with FDI may ensure modernization of the ordinance factories and defence PSUs. The Discussion Paper also notes that in areas where the ordinance factories and defence PSUs are capable of meeting the requirements, the government need not award licenses in such areas.
  • In view of the widespread dispersion of weapons manufacturers across nationalities, the danger of dependency on a particular nation’s weapons manufacturers may be unfounded.
  • Availability, reliability and maintenance services of supplies could be ensured by the Government’s retention of certain expropriation powers in cases of national security.
  • The danger of transferring critical information to other players / countries poses greater concern in the case of importation from foreign suppliers, because the Government is comparatively better suited to controlling FDI with respect to domestic manufacturers than importation from foreign suppliers.
  • The danger of exporting equipment to entities inimical to Indian interests may be addressed by export controls, which a number of Western countries such as the United Kingdom utilize.
  • Internal security concerns may be addressed by ensuring adequate safeguards and security requirements.

The Way Forward: Suggestions on the Policy Change

The Parliamentary Standing Committee on Defence on “Indigenisation of Defence Production – Public Private Partnership” expressed the view that the possibility of increasing the FDI limit to 49% in the defence sector should be examined by the Government after keeping in mind the fact that national interest must reign supreme in defence-related matters. A number of developed nations such as the United States and the United Kingdom have permitted FDI of up to 100% and have included adequate safeguards to address their national security concerns. Safeguards which are being used by various countries include:

  • all procurements from the U.S. defence industry must be approved by the U.S. Government and published if the procurement value exceeds a defined amount;
  • Foreign military sales in the U.S. are routed through the U.S. Department of Defense itself;
  • In the US, industry bodies provide for a forum for exchange of information between the government and private participants and advise the government on national security related issues concerning the defence industry;
  • Production and technical certifications and standards for the defence industry are used by various countries including India; and
  • Satisfaction of offset obligations through FDI by foreign firms enhances the domestic defence industry. A vibrant domestic defence industry reduces dependence on foreign suppliers and creates employment for the domestic population. Many countries including Australia, Austria, Belgium, Brazil and Canada have offset policies (though the US is formally against any offset policies and labels it as an unfair trade practice).

It is essential for India to revise its FDI policy by increasing the FDI cap to attract greater foreign investment in the defence sector. It would be an ineffectual policy change, if upon liberalization of the sector, the Government were to limit the FDI cap to 49%, because the main reason for lack of FDI in the sector has been that a relatively low percentage holding does not provide adequate amount of control.

Vandana Shroff is a Senior Partner and Ashish Jejurkar is a Partner at Amarchand & Mangaldas & Suresh A. Shroff & Co. and they specialize in corporate law, mergers and acquisitions, and private equity. They may be contacted by email at vandana.shroff@amarchand.com and ashish.jejurkar@amarchand.com.

Advertisements

Leave a Reply

Please log in using one of these methods to post your comment:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

w

Connecting to %s