Friday 17 April 2015

Offsets: Evolution and Legal Challenges Affecting its Success

The Indian Defence Procurement Procedure (DPP) has been under evolution since its first iteration in 2005 and can be best witnessed through the evolution of offsets. The DPP clearly establishes offsets as the desired path to eventually reduce India’s reliance on international vendors and the international political interference which usually accompanies strategic procurementThere are some legal issues, which are creating challenges for the industry and need to be examined.

The evolution of offsets
The 2005 DPP required a vendor to either directly purchase, or provide market access or create new markets for products, components and services from any Defence Public Sector Undertaking (DPSU) or the Ordnance Factory Board (OFB) as its offset obligation. It is notable that the term services remained unexplained. The 2005 DPP also allowed foreign direct investment in an Indian PSU for defence industrial infrastructure through equity participation.

The 2006 iteration was a significant step forward which removed the ambiguous concepts of providing market access and creation of new markets and instead provided for vendors to directly purchase or execute export orders for products, components or services from either a DPSU, OFB or any private defence enterprise operating under an industrial license. It also clarified the scope of services to include maintenance, overhaul, up-gradation, life extension, engineering, design, testing, defence related software or quality assurance services; permitted FDI in private Indian defence industries and in organisations engaged in defence research & development and established the Defence Offset Facilitation Agency as a regulator and facilitator for foreign vendors.

The 2008 DPP was a further step forward which introduced the concept of banking of offset credits. The 2011 DPP showed sensitivity to vendor concerns and expanded the list of eligible products to include the categories of homeland security and civil aerospace products. The inclusion was welcome, in light of the continued international concerns with respect to the qualitative aspects of products being manufactured by the Indian industry and the ability of the Indian industry to absorb technology.

Subsequently the Ministry of Defence (MoD) also issued the Offset Revision Guidelines on 1 August 2012. The Guidelines refined certain concepts and were a clear intent of how the Indian MoD wanted to proceed for acquiring key technologies.
The biggest conceptual change which the Guidelines introduced were the introduction of investment in kind. Paragarph 3.1 (c) of the Guidelines explains investment in kind as documentation, training and consultancy required for full transfer of technology (ToT). The Guidelines also explained that investment in kind could also be made by providing machinery and equipment.

The Guidelines were formally incorporated under the DPP with its 2013 iteration. The 2013 DPP took another significant step forward by introducing the concept of multipliers for investments/ purchases from Micro Small Medium Enterprises (MSMEs) and transfer of technology to Defence Research & Development Organization (DRDO). Subsequently, MoD issued a notification in May 2013 suspending the services component of offset contracts.

The evolution of the philosophy of offset has been closely watched by the world community and while the forward strides in expanding the scope of achieving offset obligations have been welcome, there are significant issues which need to be addressed to make offsets successful. The following section of the article attempts to articulate some of these issues which have both legal and commercial implications for vendors.

Legal challenges affecting the success of the scheme
The present FDI norms only permit investment up to 26%. The restriction has been universally criticized as it gives OEMs restricted operational rights and a disproportionate amount of control to Indian offset partners. The limited equity participation raises significant issues from the OEM perspective on aspects pertaining to quality control, protection of OEMs intellectual property and management issues. While the issue has been actively discussed at various governmental levels, the stasis in implementation continues to be a major stumbling block for OEMs looking to invest in critical technologies.

The discontinuation of investment in the services sector has been a significant backward step. The restriction on services would hit most OEMs who are required to provide simulators, training services and maintenance as part of their contracted obligations. Though no formal rationale for taking the step has been extended by the MoD, the probable reason may have been the abuse of the services route, in which case the emphasis should have been on instilling checks and balances and not an indefinite suspension of the option. Alternatively, the MoD, through Defence Offsets Facilitation Agency (DOFA), could evaluate each investment in services on a case to case basis.

The present regime imposes an obligation on the vendor to adhere to timelines for fulfilling its obligation without imposing responsibilities on the DPSUs to respect the timelines. In the event the delays are caused due to the scope apportioned to the DPSU, the only recourse which would remain with the OEM would be limited to seeking liquidated damages from the DPSU which assuming it agrees to pay, may or may not be sufficient to compensate the OEM for the punitive damages it may be liable to pay under the offset scheme Further, in the event the vendor seeks to enforce damages through courts, the process may derail the entire transaction and cause substantial losses to the OEM’s program.

The issues around transfer of technology are multiple and complex. The DPP places considerable emphasis on transfer of technology. In such a scenario, the valuation of the technology becomes a critical issue. The DPP provides detailed guidelines of the qualitative parameters which constitute transfer of technology, but does not provide any process for valuation of the technology or weightage for how sophisticated it might be.

An argument in favour of MoD’s position, would be that the price at which the goods may be purchased would include the value of technology and hence the same should not be given additional weightage. The authors believe that this is a myopic view. The DPP covers complex multi-year procurements with emphasis on the transfer of core technologies and therefore a weightage needs to be given to the technology a vendor may be willing to transfer. This may also prove to be an incentive to OEMs to bring the latest bleeding edge products to the table.

The present mechanism of technology transfer provides negligible protection to the intellectual property of a vendor. For example, technologies transferred to DRDO can be used by DRDO to build products and freely export them. In case DRDO collaborates with another international defence research & development organization for further refining of the technology, it would result in a vendor losing commercial opportunities in other countries along with the ownership of its intellectual property. This may also lead to a situation where an Indian DPSU may be able to offer the same product to another country cheaper than what the OEM may be able to offer.

In conclusion, it may be submitted that though the policy intention behind offsets remains progressive, there is a need to review it to iron out the various legal concerns and issues. A clear policy and implementation mechanism would help in removing the regulatory and commercial ambiguities and also help the forces to upgrade on schedule. Further, India could also take a leaf from the international practices being followed in other countries such as Australia and South Korea which have significantly gained from offsets by setting up transparent systems and an investor friendly climate. A dithering policy and legal regime would not only increase the procurement cost but would also result in considerable delays and possibilities of disputes in investing in the Indian defence sector.

Editor’s note: The authors represent Khaitan & Co law firm in Defence Practice. Their views may be in line with those of their clients.



No comments: