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.

The Boeing Deal and the Future of U.S.-India Defense Trade

Amy Hariani
On June 6, 2011, the Government of India announced its purchase of ten C-17 Globemaster III airlifters from Boeing for $4.1 billion. Some hail this announcement as a pivotal turning point in the U.S.-India defense trade relationship, while others say that it is simply one more step in the right direction for increasing defense trade ties between the two nations. Like those in the latter group, Timothy J. Roemer, U.S. Ambassador to India, said, “[f]or India, the [Boeing] sale adds strategic and humanitarian muscle to its defense needs” and that the sale will sustain 23,000 jobs in America. Ambassador Roemer also indicated that the Boeing contract would strengthen political and economic ties between the United States and India and lead to enhanced cooperation on security issues.

Nothing is more telling of a deep and solid partnership than the sharing of defense technology and sale in defense goods. But the strategic and economic alliance that the United States has enjoyed with India is a relatively new relationship and it will surely continue to experience setbacks as the relationship matures. As the friendship between the United States and India matures, and the U.S.-India defense trade grows, it is important to understand the objectives of both countries and how each ally might fulfill the other’s expectations for defense security and cooperation.

THE TURNING POINTS IN THE U.S.-INDIA DEFENSE TRADE RELATIONSHIP

In order to understand the current relationship between the United States and India, it is critical to examine the historical relationship between the two countries. During the Cold War, India aligned itself with Russia and the United States aligned itself with Pakistan. In 1991 these alliances began to shift with the easing of India’s foreign investment restrictions and the end of the Cold War. Throughout the 1990s, India experienced impressive economic growth as New Delhi continued to loosen restrictions on foreign trade and investment. Many credited Finance Minister Manmohan Singh for India’s dramatic growth during this time. As a result of his financial reforms, Mr. Singh became popular with the Indian electorate and was elected Prime Minister in 2004 as a member of the popular Congress Party.

In the early 2000s, Prime Minister Singh and President George W. Bush were quick to form a friendship, especially as President Bush was looking for allies in the region to assist with the U.S. War On Terror and to counter the ever-impending economic threat of China. U.S.-India relations continued to grow and, by July 2005, Prime Minister Singh and President Bush concluded a global partnership and framework agreement to share U.S. nuclear technology. The U.S.-India Civil Nuclear Cooperation Agreement, or the 123 Agreement as the agreement is sometimes called, was seen as a watershed agreement and a turning point for U.S.-India defense trade. After completing the 123 Agreement, the United States and India continued to deepen their friendship and reliance on each other. India wanted access to nuclear technology, and the U.S. wanted to sell it to India. Although India promoted the 123 Agreement as a means of meeting the country’s substantial energy needs, India was simultaneously complaining to the United States that it also was concerned about its security, particularly with respect to nearby neighbors China and Pakistan.

President Barack Obama continued to deepen the U.S.- India defense trade relationship by visiting India in the first half of his current term. During his November 2010 visit, the U.S. President announced his plans to boost trade with India. In so doing, President Obama said he would make “‘fundamental reforms’ to the export controls that guide trade between the two countries….[including] removing several Indian space and defense companies from the entities list, which identifies firms that manufacture products with dual civilian and military purposes and makes it more difficult for them to trade with the United States.” President Obama’s announcement thus concluded another turning point in the U.S.-India defense trade relationship.

To facilitate increased defense trade with India, the U.S. Department of Commerce announced in January 2011 that it was easing export controls on U.S. goods to India by issuing a regulatory Final Rule. The stated objectives of the Final Rule were to realign U.S. export policy toward India to reflect the strategic partnership between the two countries and to expand U.S.-India cooperation in civil space, defense, and other high-technology sectors. Among the changes made in the Final Rule were to remove nine Indian space and defense organizations from the Department of Commerce’s Entity List (a list of foreign end users involved in proliferation activities). Coincident with the issuance of the Final Rule, Commerce Under Secretary Eric L. Hirschhorn stated that the United States would support India’s full membership in the four multilateral export control regimes: the Wassenaar Arrangement, the Nuclear Suppliers Group, the Australia Group, and the Missile Technology Control Regime. By February, 2011 it appeared that there were few obstacles that could stop the growth of the U.S.-India defense trade.

On April 28, 2011, however, the relationship that was otherwise humming along was provided a jolt when the Government of India decided to rule out both of the U.S. companies (Boeing and Lockheed Martin) competing for an $11 billion fighter-jet supply contract for the Indian Air Force (IAF Contract). The exclusion of the U.S. companies from the $11 billion deal – and subsequent awarding of the IAF contract to an EU-based defense supplier – was widely viewed as a setback for the Obama Administration and the ability for India to create a truly meaningful defense relationship with the United States. Ambassador Roemer went so far as to announce that he would resign his post the day after the United States lost its bids to the IAF Contract. While Ambassador Roemer stated that he was leaving India for personal reasons, many in the defense community linked the two events as more than a coincidence. Whatever disappointment existed at the time of the IAF Contract announcement, however, quickly disappeared. In fact, shortly after the IAF Contract announcement, Boeing admitted that it still believed that India presented enormous market opportunities.

Boeing was right, because on June 6, 2011 the U.S. defense trading relationship with India regained its footing when the Government of India awarded Boeing the C-17 Globemaster III contract. Many hailed the contract as evidence that the United States and India were on the path to long-term trade in defense goods. Ron Somers, president of the U.S.-India Business Council (USIBC), stated that the contract was a “testament to India’s appreciation of U.S. technology and confidence in the U.S. as a long-term defence sales partner. This largest-ever Indian purchase of U.S. defence technology, we hope, will be just the beginning of much more to come.” According to news reports, “[o]nce these planes are delivered, India will possess the largest fleet of Globemaster III after the United States.” Ambassador Roemer stated that the deal would “further strengthen the strategic ties between the U.S. and Indian armed forces, leading to enhanced cooperation for a safer and more secure region and world.”

FOR GEOPOLTICAL AND FINANCIAL REASONS, TRADE IN DEFENSE GOODS IS IMPORTANT TO INDIA AND THE UNITED STATES

While commercial trade between the United States and India has progressively improved since the opening of India’s economy in 1991, trade in defense goods signals a new turning point in the U.S.-India partnership. The Boeing C-17 aircraft deal represented the first U.S. military aircraft purchase in India’s history. Although India would like access to enhanced military technology, the United States must remember that India cautions itself against aligning too closely with any single country. In addition, India is currently negotiating a free trade agreement with the European Union and announced on May 12, 2011 that it was entering into Free Trade Agreement negotiations with Australia. Although Free Trade Agreements with the EU and Australia would likely require several years to conclude, these negotiations should signal to the United States that deepening U.S.-India ties run parallel to India’s efforts to develop defense cooperation and trading partnerships with other allies around the world. Therefore, the United States must remember that while India may want defense technology, it does not necessarily need it from the United States.

India must also recognize that the United States demands certain expectations from its relationship with India. The United States is relying heavily on India to fulfill President Obama’s National Export Initiative to double U.S. global exports within five years. Consequently, India should recognize that the United States is relying on India’s promise to boost U.S. exports by purchasing defense and nuclear items from the United States. India should understand that if it fails to perform on its promises, the United States may instead look to other developing nations to promote U.S. exports. India’s delay in living-up to its promises is now evident by India’s nuclear liability law, which has effectively stalled the sale of civilian nuclear technology to India and rendered the 123 Agreement meaningless at the moment. India should seek to understand the U.S. motivations in partnering with India and be honest about its ability to fulfill the American expectations of that partnership.

THE U.S.-INDIA DEFENSE TRADE RELATIONSHIP WILL CONTINUE FOR MANY YEARS TO COME

The trading relationship between the United States and India will continue to grow and prosper as the countries further develop their relationship. But India will not rely on the United States alone to support it defense needs. India will use a multi-ally approach to build its defense arsenal by relying on the United States, the European Union, and other trading partners. As long as the United States understands that India is not going to align itself only to the United States and that India will continue to look out for what is best for India, the trading relationship in defense goods between the two countries will grow and prosper, albeit with setbacks along the way, for years to come.

Amy Stanley Hariani is an associate in the international trade group at King & Spalding LLP, with a particular focus on trade issues with India. She advises in import and export compliance, trade remedies, market access issues, and cases before the World Trade Organization. She can be reached at ahariani@kslaw.com or amyjstanley@gmail.com.

Highlights of Indian Tax Proposals in Finance Bill, 2011

By Aseem Chawla, Aurica Bhattacharya, and Priyanka Duggal

On February 28, 2011, India’s Finance Minister, the Honorable Pranab Mukherjee, unveiled the Finance Bill, 2011, which would make a number of significant changes in Indian tax law.  The changes proposed in the Finance Bill, 2011 also aim in facilitating the introduction of the planned Direct Taxes Code (“DTC”) and the Goods & Service Tax (“GST”).

The DTC proposes to introduce a modern and lucid direct tax legislation scheme aligned with internationally accepted best practices.  In addition, the proposed GST represents an ambitious plan to subsume most indirect tax legislation, including but not limited to the central excise, service tax, and value added tax.

Direct Tax Proposals

With respect to direct taxes, the Bill proposes a marginal increase in the basic exemption limit for individual taxpayers.  While the rate of surcharge would be reduced from 7.5% to 5%, the proposed increase in the minimum alternate tax from 18% to 18.5% could hurt industries, particularly those eligible for tax holiday incentives.  The Bill also extends the applicability of minimum alternate tax to include hitherto exempt special economic zone developers and units.  Furthermore, special economic zone developers would be subject to a tax at the rate of 15% on dividends distributed to their shareholders.

The Bill also seeks to introduce an alternate minimum tax on limited liability partnerships.  The proposal to tax foreign dividends received by an Indian company from a subsidiary of the foreign company at an incentivised rate of 15% over the present corporate tax rate would encourage outbound investments.

The Bill also introduces a number of administrative and substantive measures to counter tax abuse and reduce tax avoidance, such as extending the transfer pricing regime to transactions by residents with parties located in notified offshore jurisdictions.  It also proposes to mandate the filing of annual information by the liaison offices of foreign entities in India.

Indirect Tax Proposals

The Bill has made an effort to streamline the provisions of all indirect tax laws by eliminating various exemptions and aligning duty structures, in order to increase taxation of goods and services.  The ultimate objective is a smooth transition to GST. Since the proposed GST envisages a single rate of tax for all indirect tax laws, provisions have been introduced to align duty structures of various laws.  For example, the concessional excise duty rates and central sales tax rates have been fixed at 5%.  Currently, the Value Added Tax (“VAT”)/sales tax on many goods in most states is also 5%.  Basic customs, excise and service tax rates remain at 10%.  130 items that were hitherto exempt are now taxable under the excise tax at the rate of 1%.

One of the most important changes made under the service tax laws is the introduction of “point of taxation rules,” which would change the basis of tax collection from receipt basis to accrual basis, consistent with the existing  provisions of excise and sales tax laws.

The service tax net has also been expanded with the introduction of new taxable services, such as services rendered by restaurants serving alcohol and short term accommodation provided by hotels   In addition, the scope of many services has been expanded, including healthcare, legal, air travel, and life insurance.  Of note, the scope of legal services that are taxable has been considerably expanded.

In a nutshell, the Finance Minister has reaffirmed his commitment to introduce the Direct Taxes Code and the Goods & Service Tax, which, if passed, would bring an unprecedented change in the fiscal policy regime.  The proposals seek to further simplify and improve voluntary tax compliance and at the same time, deter tax evasion and take serious measures in situations where unethical practices have been followed.  For the moment, the big bang tax reforms are being eagerly awaited.

Mr. Aseem Chawla is the practice leader, and Ms. Aurica Bhattacharya and Ms. Priyanka Duggal are associates with the tax practice group at Amarchand & Mangaldas & Suresh A. Shroff & Co in New Delhi. They can be contacted at aseem.chawla@amarchand.com; aurica.bhattacharya@amarchand.com; and priyanka.duggal@amarchand.com.

Navigating Defense Procurement Challenges in India

Robb Fipp, Rina Singh, David Stevens

Rising Chinese military power, ongoing tensions with Pakistan, and the creeping obsolescence of Indian military hardware are creating opportunities for Western defense corporations to aggressively enter a market in which they have long played relatively marginal roles. India, the world’s largest arms importer as the recipient of nine percent of international arms transfers between 2006 and 2010, has increased its 2011 defense budget an additional 11.59 percent to $36.03 billion. According to the Stockholm International Peace Research Institute, Russian companies accounted for 82 percent of India’s 2006-2010 imports, but Western firms are poised to make substantial inroads as the Indian government seeks to expand and upgrade its arsenal with cutting-edge technologies. Israel has already developed into a key source of advanced missile systems, and France’s Dassault and the European Aeronautic Defence and Space Company (EADS) are the finalists in the $11 billion Medium Multi-Role Combat Aircraft (MMRCA) tender to replace India’s aging fleet of Soviet-era MiGs. While lingering suspicion of US ties to Pakistan has complicated the positioning of American companies, steady improvements in Indo-US diplomatic relations and recognition of India as a strategic regional partner are likely to bolster market access for US firms.

Despite these shifts, penetrating the Indian defense market remains as difficult as it is potentially rewarding. This article provides an overview of the core challenges that Western defense companies face, along with guidance on how to manage a number of central issues and risks in the Indian defense procurement process. As in many emerging markets, successful entry and operation is contingent on robust information collection permitting companies to identify key decision-makers and credible local partners, monitor their standing with major stakeholders, and track the actions of competitors. The nature of the defense sector, where decision-making can be particularly opaque and secretive, heightens the indispensability of such an approach.

Challenges of the Indian Procurement Process
Entrants into India’s defense sector must overcome a range of bureaucratic, regulatory, and political obstacles that demand patience, vigilance, and a clear understanding of local practices and dynamics. Indian governmental decision-making tends to be lumbering, opaque, and subject to corrupt practices that potentially skew the playing field against Western firms bound by the US Foreign Corrupt Practices Act (FCPA) and similar national and transnational statutes. In addition, while the Indian government has opened procurement to international participants, it remains committed to the development of an indigenous defense industry through local production and technology transfer requirements that necessitate careful management and negotiation.

Defense Procurement Decision-Making

India’s vast and complex bureaucracy impedes streamlined decision-making, and contending interests among the multiple participants in the defense procurement process can subject decisions to particularly lengthy delays. The MMRCA tender is a case in point of the potential for start-and-stop progress. The Indian Air Force (IAF) submitted Requests for Information (RFI) to a range of international defense companies in 2004 but then took three years to issue Requests for Proposals (RFP). Despite projections of delivery in 2011, the government has yet to select a vendor.

Competing sets of actors can potentially enter the process at a number of different stages, exposing defense procurement to incongruent or rival agendas and to shifting criteria that may contribute to tender delays. While the armed services or intelligence agencies typically play leading roles in the evaluation and testing phases, Ministry of Defense (MoD) civil servants with little or no background in technical defense matters often shape RFPs. Particularly for large-scale projects, ultimate purchasing decisions often take place at the cabinet level or within the office of the Prime Minister. In the course of a typical procurement cycle, the basis for decision-making thus often evolves from potentially unrealistic criteria established by functionaries to technical criteria established by professionals, and then on to considerations subject to political and diplomatic pressures. Particularly at this final stage, vested interests can shift the basis of vendor selection away from objective performance to contenders’ political influence and outreach efforts.

Large-Scale Defense Project Procurement Cycle and Key Decision-Makers

Competition and Corruption
India’s emergence as a major market for arms and defense technology has intensified competition for military tenders, reinforcing incentives to capitalize on the underlying opacity of decision-making by resorting to bribery and to bending or breaking regulations regarding the use of agents well-positioned to broker sales. In addition, Western companies may face an uphill battle against Russian and Israeli competitors whose established relationships with procurement officials may tilt tenders in their favor.

Despite a general crackdown on corruption in India, bribery remains a potentially significant factor in the defense sector, where the specialized nature and secretive handling of tenders creates opportunities for vendors to attempt to influence the process through illicit means. As discussed above, the selection procedures on which acquisition decisions depend often are shrouded in mystery or subject to unexplained shifts that underscore the degree to which small groups of officials can shape a tender’s procedural course and outcome. Western companies find themselves at a potential disadvantage as enforcement of India’s own anti-bribery statutes is inconsistent and not all international competitors are subject to the same anti-bribery statutes—such as the FCPA—in their home country or other jurisdictions.

Western defense suppliers entering a complex new market typically hire agents to assist them in minimizing their competitive disadvantages and winning audiences with key figures and bureaucratic entities. In the Indian context, however, reliance on agents can create more problems than it solves. Many former MoD personnel who offer their services as agents served during periods when corruption was an inescapable element of nearly all major acquisition decisions. This background may lead them to rely on a similar approach on behalf of their new employers, with or without the latter’s knowledge or permission, requiring close monitoring of their actions in order to minimize FCPA exposure.

Indian MoD rules further complicate the task of locating suitable agents by prohibiting the payment of success fees to those who assist in winning tenders. This raises the expense and competition involved in hiring agents with proven track records, or pushes companies to hire them in ways that circumvent the standing rules and create potential vulnerability to subsequent tender disqualification. Companies seeking to stay safely within MoD guidelines often are left with a selection of relatively junior agents typically less effective in advocating for projects with key constituencies.

Technology Transfers
Upgrading the technological sophistication of the country’s armaments to compete with regional rivals, including both China and Pakistan, is at the heart of India’s current defense expansion and opening to international defense suppliers. As retired Air Marshal Padamjit Singh Ahluwalia, the former head of India’s Western air command, has explained, “The Soviet Union gave equipment and transferred technology to India at subsidized costs and ensured a steady flow of material free from sanctions in time of conflict.” On this basis, it emerged as India’s preferred supplier. “After the break-up of the Soviet Union, however, the Russians began demanding hard cash for all sales at a time when they were losing their ability to compete with the West technologically. Because it has to pay cash, India now feels that it should shop around for the best technology possible.”

Yet merely providing advanced weaponry is not sufficient to win major defense tenders, as India also seeks access to underlying technologies to maintain and develop its indigenous arms industry. As a result, international defense suppliers seeking to enter India face significant technology transfer requirements that have evolved into key tender selection criteria. Beginning with the MoD’s 2005 Defense Procurement Policy (DPP), suppliers have to meet a 30-percent offset requirement for all defense orders over $66.6 million in value; for the MMRCA RFP, the MoD raised the requirement to 50 percent. Offset conditions often place foreign companies in a position where commercial success depends on transferring sensitive technologies to Indian partners with few or no intellectual property protections, confronting suppliers with difficult choices and underscoring the importance of selecting trustworthy local manufacturing partners. In addition, US or other government prohibitions on the export of certain technologies can limit the tender competitiveness of firms subject to these restrictions.

Keys to Successful Navigation

Successful navigation of the Indian defense sector requires adapting to the local environment. This includes developing a nuanced understanding of Indian decision-making in conjunction with the ability to constrain the activities of competitors through local institutions. Rigorous due diligence of potential partners and agents is also vital to compete effectively while minimizing the danger of running afoul of the FCPA.

Engage Early and Prepare for a Lengthy Process

For companies seeking to enter India’s defense sector, patience is a necessity. Tenders rarely adhere to their initial schedules, and companies must be prepared to stay the course over a long—and potentially elastic—period subject to delays, shifts in criteria, legal proceedings, and retendering. Early engagement in the tender process is key, particularly in the stage between the RFI and the RFP. Companies that wait for the RFP have missed a significant window of opportunity to develop pivotal relationships, gauge or stimulate demand, and shape RFP requirements.

Use Local Regulatory Bodies to Ensure a Level Playing Field

The Indian defense market is potentially conducive to corruption, but companies need not sit back and allow less ethically constrained competitors to capitalize. When there are grounds for concern, companies can petition Indian regulatory and investigative bodies, including the Central Vigilance Committee (CVC) and the Central Bureau of Investigation (CBI), to examine suspicious proceedings. After losing a 2007 Indian military tender for 197 light attack helicopters, US-based Bell Helicopter protested vociferously that EADS had benefitted from preferential treatment. With the backing of the US government, Bell eventually succeeded in bringing its case to the CVC, leading to the retendering of the contract on the grounds that EADS agents had engaged in improper activity and that the company had used a civilian helicopter model in test flights, biasing the trials decidedly in its favor.

Identify Qualified Indian Partners
Partnering with capable and trustworthy Indian companies can reduce international defense suppliers’ reliance on potentially problematic local agents while also facilitating the task of meeting offset requirements. Allowing Indian partners to take a leading role in tender bids naturally strengthens their competitiveness and appeal to Indian authorities. Locating credible local counterparts, however, requires detailed checks on candidates’ technical backgrounds, political connections, and legal and business track records, including indications of their involvement in corruption. Confidence in the competence and trustworthiness of local partners should alleviate some concerns that accompany the transfer of sensitive technologies. Many of the same considerations hold true when companies opt to engage local agents to advance their tender prospects. Due diligence service providers who are familiar with the local lay of the land and have access to independent sources of information can vet potential agents to ascertain their professionalism, effectiveness, political positioning, and potential implication in unethical conduct.

Breaking the Indian Code

Following a long period of relative exclusion, Western suppliers are at an early stage in the process of establishing their brands and mastering the Indian procurement process. While several companies have developed toeholds, there are no indications that any has truly deciphered the Indian puzzle or developed a strong basis of support among key decision-making constituencies. Even within Western companies that have succeeded in winning contracts, business units continue to grapple with the task of translating individual successes into a winning formula. The market remains relatively open and will reward those with the patience and adaptability to meet its challenges.
All authors are affiliated with Veracity Worldwide, a political risk consultancy focused on emerging markets, including the Indian defense sector.
Robb Fipp, Partner and Managing Director, is based in Singapore and can be reached at rfipp@veracityworldwide.com. Rina Singh, Managing Director, is based in New Delhi and can be reached at rsingh@veracityworldwide.com. David Stevens, Associate Director, is based in New York and can be reached at dstevens@veracityworldwide.com.

A Call for India to Join the OECD Convention on Combating Bribery and UN Convention Against Corruption

By Anupama Jha

India has been rocked by a series of corruption scandals in the recent past.  The loan bribery case, the telecom license row, and the commonwealth games corruption scandal, are just a few of the bribery schemes that have embarrassed the ruling party, rattled economic markets, and shocked the public conscience.  Then there is the story about the Indian Ambassador in Washington who wrote to the Indian Prime Minister about how some American companies paid huge kickbacks to government officials in India, either to procure contracts or expedite registrations.  A common thread in all these cases is the involvement of the private sector.  It has become so pervasive that the general public has started blaming the policy of economic liberalisation for the rising corruption in the country.  Politicians are hand in glove with private sector companies in order to maximise their chances of being re-elected.  The pay to play scheme is well known – companies bribe politicians with campaign cash, who in turn award the firms government contracts.

The Prevention of Corruption Act (“PCA”) does not expressly punish corrupt acts of private parties, except to a limited extent under Section 9, which addresses persons who accept gratification to influence a public servant in the conduct of an official act, and Section 12, which addresses persons who abet bribery.  However, there is no direct provision prohibiting a private person from offering a bribe or engaging in other corrupt practices.  This is especially significant in cases of “collusive corruption,” where the private person may offer a bribe and the public servant may actually reject the bribe.  The PCA also does not contain any provision to address cases where Indian citizens engage in corrupt activities with a foreign public official. These are a few of the shortcomings in the law that must be corrected to bring India’s anti-corruption laws in line with international standards.  To add to the problem, there are inordinate delays in the prosecution of public servants against whom complaints have been made.

The U.S. Foreign Corrupt Practices Act (“FCPA”), on the other hand, prohibits the payment of bribes to foreign officials for the purpose of obtaining or retaining business. Recently, however, the U.S. Chamber of Commerce  advocated loosening the rein on  subsidiaries of multinational companies, saying, “A parent company’s control of the corporate actions of a foreign subsidiary should not expose the company to liability . . . where it neither directed, authorized, nor even knew about improper payments.”  At a time when multi-national companies often have thousands of subsidiaries worldwide, the U.S. Chamber’s position will subject the law to much ridicule.

Transparency International has always maintained that clean business is good business.  There are several examples around the world illustrating why poor business ethics costs investors and stakeholders dearly.  No doubt, corruption adds to the cost of doing business.  We find multinationals operating in developing countries encourage corruption, and thereby undermine development and deepen poverty.  This may eventually lead to markets in emerging economies on which companies from the West so heavily rely to collapse.

Supply side corruption by transnational companies translates to economic, political, social, and cultural divide among people, and has far reaching negative consequences.  The Maoist insurgency in India, which has grown recently and covers 40,000 square kilometres across Central and Eastern India, is just one example of what corrupt practices by companies can do.  Money that could be spent on developing the social infrastructure, eradicating poverty and empowering the poor (who could be the next potential market for multinationals) goes into the hands of few individuals making them richer and increasing the rich-poor divide.  Corruption of this sort also disadvantages domestic firms and distorts decision making in favour of projects that benefit few rather than many.  Transnational corruption normally happens on a grander scale compared to domestic corruption, making it a substantial obstacle to development or security of the country.  When funds from the domestic budget or foreign aid get diverted as corruption proceeds in foreign banks, the country is deprived of the multiplier effect of the productive expenditure.

The Organization for Economic Co-operation and Development’s (“OECD”) Anti-Bribery Convention and the United Nations Convention against Corruption (“UNCAC”) are compelling companies to develop new anti-bribery policies and review existing ones. India is not a member of OECD but was granted “observer” status in 2006.  India has not ratified UNCAC.  It’s time for India to became a member of the OECD convention and ratify UNCAC.  These conventions would provide India with mutual legal assistance, and allow it to trace, freeze and confiscate assets.  The central goal of UNCAC is to promote international cooperation in the fight against corruption.  If India ratifies UNCAC, it will assume obligations but will also be afforded many valuable opportunities for affecting cooperation to combat corruption.  The OECD convention, although not legally binding, provides a consensus among the 28 member countries for a uniformed approach to fight corruption and creates a strong platform for cooperation.

Anupama Jha is Executive Director of Transparency International, India and may be contacted by email at anupama.jha@gmail.com.

Enacting Whistleblower Protection Legislation in India

By Priyanka Sharma

It is often said that no culture is immune from corruption.  Unfortunately, there may be individuals in all societies who might improperly leverage their positions of authority, demanding financial or personal favors in order to do work they are supposed to do by virtue of their authority.  Irrespective of the degree of coercion involved, the fact remains that bribery fosters a culture of impunity and rampant corruption undermines the functioning of public institutions.  The ripple effect of this culture is then felt in many aspects of both public and private life.

Whistle-blowing or the act of exposing wrongdoing, fraud or corrupt practices in an organization or situation, has been seen as one of the few strong measures to combat corruption.  The social censure that such whistle-blowing entails for the wrongdoer seemingly operates as a check or deterrent for future improper conduct. A whistleblower can be a person who works for the government and reports misconduct within the government or it can be an employee of a private company reporting corrupt practices within the company.

India still does not yet have legislation to protect whistleblowers.  By exposing corruption among their superiors, whistleblowers face the possibility of direct or indirect punishment.  This could be retaliation, including termination, lack of advancement and promotion, and even a threat to the whistleblower’s safety or life.

Proposals & Past Efforts

Harassment and victimization of whistleblowers in India, especially by superiors in their own organizations, have led to calls for laws to protect whistleblowers.  At the request of the then Central Vigilance Commissioner, Mr. N. Vittal, in August 1999, the Law Commission of India prepared a report on “Public Interest Disclosure Bill” [179th Report of the Law Commission of India].  A draft Public Interest Disclosure (Protection of Informers) Bill, 2002 was then circulated in January 2003.  There was no further progress on the matter until November 2003, when Mr. Satyendra Dubey was murdered after exposing corrupt practices prevalent in the National Highways Authority of India (“NHAI”).  The incident led to widespread media outrage and impetus for the enactment of a whistleblowers bill.

In May 2004, the Government of India passed a Resolution on Public Interest Disclosure & Protection of Informers and authorized the Central Vigilance Commission (“CVC”) as the ‘Designated Authority’ to receive written complaints for disclosure of any allegation of corruption or misuse of office and to recommend appropriate action.  The CVC then issued a Public Notice (through an Office Order) stating that its jurisdiction would be restricted to any employee of the Central Government or to any corporation established by or under a Central Act, government companies, and societies or local authorities owned or controlled by the Central Government.   Consequently, personnel employed by the State Governments and activities of the State Governments or its Corporations would not come under the purview of the CVC.  It also stated that the CVC would have the responsibility of keeping the identity of the complainant secret.

Current Proposal

The Office Order and the Public Notice are still in force.  In 2006, however, the draft Public Interest Disclosure Bill was updated and renamed The Whistleblowers (Protection in Public Interest Disclosures) Bill, 2006.  It was introduced in the Rajya Sabha (Upper House of the Parliament of India) on March 3, 2006.

The Bill has undergone several changes over the last few years based on public comment.  The latest version of the Bill, named The Public Interest Disclosure and Protection to Persons Making the Disclosures Bill, 2010 (“Bill”), was introduced in the Lok Sabha (House of the People), Parliament of India on August 26, 2010.  The Bill is yet to be notified as a statute.

A Brief Summary of the Bill

The purpose of the Bill is (a) to establish a mechanism to receive complaints alleging corruption or willful misuse of power or willful misuse of discretion against any public servant; (b) to inquire / cause an inquiry into such disclosure; (c) to provide adequate safeguards against victimization of the person making such complaint.

The Bill defines “Public Interest Disclosure” as a complaint made by any person relating to: (a) an attempt to commit or commission of an offence under the Prevention of Corruption Act, 1988; (b) willful misuse of power or willful misuse of discretion by virtue of which demonstrable loss is caused to the Government or demonstrable gain accrues to a public servant; and (c) an attempt to commit or commission of a criminal offences by a public servant.  The term “public servant” has been defined in the Bill as any employee of the Central or State Governments, or any corporations established by or under any Central/State Act, any government companies, societies or local authorities owned or controlled by the Central/State Governments, and such other categories of employees as may be notified by the Central/State Governments from time to time.

The Bill envisages that any public servant or any other person including any non-governmental organization may make a public interest disclosure before the Competent Authority.  The Competent Authority, in relation to any public servant employed with the Central Government or any Central Government Authority, is the Central Vigilance Commission or any such authority that the Central Government specifies by way of a Notification.  In the case of State Government employees, the Competent Authority is the State Vigilance Commissioner or any other authority as specified by the State Government by way of a Notification.

Further, the Bill also makes it necessary that any disclosure made under the Act is made in good faith and the person making the disclosure is required to make a personal declaration stating that he/she has reasonable belief that the information disclosed by him/her and the allegation contained therein is substantially true.  Furthermore, in order for action to be taken on a public interest disclosure, it is necessary that the identity of the complainant/public servant is included in the complaint.

After ascertaining from the complainant/public servant whether he/she was the person or public servant who made the complaint, the Competent Authority shall conceal the identity of the complainant unless the complainant has himself/herself revealed his/her identity to any other office or authority while making the disclosure in the complaint or otherwise.  Thereafter, an inquiry into the disclosure shall be made by the Competent Authority.

For the purposes of an inquiry under the Act, the Competent Authority has been granted the powers of a civil court (while trying a suit) in respect of the following matters:

  • Summoning and enforcing the attendance of any person and examining him/her under oath;
  • Requiring the discovery and production of any document;
  • Receiving evidence by affidavits;
  • Requisitioning any public record from any court/office;
  • Issuing commissions for the examination of witnesses or documents;
  • Such other matters as may be prescribed.

Proceedings before the Competent Authority shall be deemed to be judicial proceedings.  While exercising powers of a Civil Court, the Competent Authority must ensure that the identity of the complainant is not revealed or compromised.  Importantly, the Bill mandates that the Central Government shall ensure that no person/public servant who makes a disclosure under the Act is victimized by initiation of any proceeding or otherwise on the ground that such person/public servant has made a disclosure or rendered assistance in an inquiry under the Bill.  If any person is victimized or is likely to be victimized, he/she may file an application to the Competent Authority seeking redress in the matter.  The Competent Authority may then issue suitable directions for protection of such person.  Such directions can be issued to the concerned public servant, or public authority, and any other government authority, including the police.

If officials required to aid an inquiry into the public interest disclosure upon the request of the Competent Authority obstruct the inquiry by delaying the furnishing of a report on the matter which is requested for by the Competent Authority, such official(s) shall, as per the provisions of the Bill, be liable to pay a penalty up to Rupees Two Hundred and Fifty for each day of delay.  However, the total amount of the penalty shall not exceed Rupees Fifty Thousand.

Disclosing the identity of a complainant negligently or in bad faith is punishable with imprisonment for a term up to three years and a fine up to Rupees Fifty Thousand.  Making a negligent, incorrect, false, or misleading disclosure is punishable with imprisonment for a term which may extend up to three years and also to fine which may extend up to Rupees Fifty Thousand.

Conclusion

While the Bill is a big leap forward in relation to protection of whistleblowers in India, there are still some ambiguities.  For instance, while the Bill proposes to protect the identities of those who make a public interest disclosure, protection to such complainants is proposed to be provided only after a complaint or a query is filed under the Right to Information Act, 2005, in which the complainant/applicant must disclose his/her identity.  Such protection may not only be too late but also insufficient, since the risk of information leaks may be high.  While it is commendable that the Bill requires suitable action to be taken by the Competent Authority to prevent a complainant from being victimized, it does not expand on what this suitable action shall consist of or address the consequences of inaction.  There also aren’t many robust provisions to deal with the issue of accountability of the Competent Authority in the process of conducting an inquiry.  In most cases, the chosen Competent Authority of the CVC is the Central Bureau of Investigation, which may not be independent from the body under inquiry itself – the Government.  There is therefore the need to provide for more autonomy and objectivity in the process if meaningful protection to whistleblowers is the ultimate goal.  Hopefully, such loopholes will be plugged before the Bill is finally notified as a statute.

Priyanka Sharma is a partner with Dua Associates in Delhi, India.  She has been a member of the Bar Council of Delhi since August 2001 and can be contacted at priyanka@duaassociates.com.

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.

CRITICAL BARRIERS TO GREATER US-INDIA DEFENSE TRADE
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.

    CONCLUSION
    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