Defence Offsets undergo First Audit Scrutiny

Defence Offsets undergo First Audit Scrutiny

(Global Defence Offset Review June 2013)

Major General Mrinal Suman, AVSM, VSM, PhD

The defence offset regime in India is characterised by secrecy and a total absence of transparency. Understandably, certain aspects of the defence contracts cannot be made public and have to be assigned suitable security classification. However, there is no justification in according the same security classification to the associated offset contracts as they have no security implications. 

Offsets can generally be termed as formal arrangements of trade with inbuilt contractual obligations wherein a foreign supplier undertakes specified programmes with a view to compensate the buyer as regards his procurement expenditure and outflow of resources. In other words, the supplier undertakes measures to generate benefits for the economy of the buyer country. Offsets can also be called as trade arrangements with reciprocity clauses to provide some sort of relief to the buyer to help him pay for the purchases. The negotiated package consists of the primary contract and the compensatory offset contract. 

As the focus is always on the main defence contracts, offset contracts attract peripheral public interest. Due to their long-term spread and the complexities of the process, very few experts carry out appraisal, evaluation and efficacy-ascertainment of various offset programmes. Lack of understanding and absence of public interest make offsets highly vulnerable to corrupt practices.

Despite the fact that the Ministry of Defence (MoD) introduced offsets in 2005, very little information is available in the public domain about the offset contracts signed and their progress. MoD has been very wary of sharing any data. It is not known if any offset programme has been successfully completed and the accrual of envisaged benefits validated. As a matter of fact management of offsets remains shrouded in utmost secrecy so far. 

Report No 17 of 2012-13 (Air Force and Navy) of the Comptroller and Auditor General of India (CAG) is the first official appraisal of the performance of offsets in India’s defence contracts. Therefore, it is of immense interest as it gives the observers a glimpse of the obscured world of offsets.

MoD had concluded a total of 16 offset contracts worth Rs 18,444.56 crore and India should have received offset inflows of Rs 5543.33 crore at the time of compilation of the CAG report.

The Report is Highly Disconcerting

The CAG report is based on the test audit of the financial transactions carried out during the period 2010-11 and early part of 2011-12 as well as those which came to notice during the earlier years, but were not included in the previous reports.

Unfortunately, the report does not cover all facets of offset management. It had a very limited agenda and confined itself to ascertaining the following two aspects only:-

·  Whether the provisions of the Defence Procurement Procedure (DPP) were duly adhered to?

·   Whether a proper mechanism was in place to monitor the implementation of offset contracts?     

Some of the major observations made by CAG have been discussed in the following paragraphs. 

a)    Non-Equity Foreign Direct Investment was Accepted against Offsets

 
Foreign Direct Investment (FDI) is one of the specified routes for the fulfillment of offset obligations.  It is allowed in two areas – one, in Indian defence industries for industrial infrastructure for services, co-development, joint ventures and co-production of defence products; and two, in Indian organisations engaged in research in defence R & D as certified by the Defence Offset Facilitation Agency (DOFA). Non-equity investment (investment in kind) was not an acceptable route for the fulfillment of offset obligations.

CAG has observed that the foreign vendors had been allowed to discharge their offset obligations by supplying equipment worth Rs 3410.49 crore as investment in kind. More worrisome is the fact that there was no value addition in India. Although there is no ambiguity in the interpretation of the term direct, its scope was unfairly tweaked. It was a patently erroneous and mischievous act of transgression. Inexplicably, this was done despite the repeated assertions of the Defence Acquisition Council (DAC), the overarching authority under the Defence Minister that the foreign investment had to be direct to claim offset credits.

CAG noticed that M/s Boeing was allowed to establish a Transonic Wind Tunnel test facility at the Defence Research and Development Organisation (DRDO) in the form of investment in kind. The company was allowed to claim 90 per cent offset credit for the initial setting up of the facility and 10 per cent for subsequent purchase of testing services from the Indian offset partner (IOP).

The case of the offset contract concluded in January 2009 with M/s Boeing for the procurement of P-8(I) maritime aircraft was found to be more intriguing. The vendor was allowed to provide offsets worth Rs 750 crore in the form of safety, reliability and air worthiness seminars; establishment of fire finder classrooms; transfer of metallurgy and hydraulic laboratory facilities; composite manufacturing assembly/tooling; mobile broadband; friction stir welding; and aero structures tools and processes. Under DPP, none of the above activities is eligible for offset credits as there is no value addition in India.

DPP did not allow investment in simulators against offset obligations. Furthermore, DAC had clarified the issue in December 2010 and February 2011 that only purchase of simulator services (to the extent of value addition in India) by the vendor from the IOP would be eligible for offset credits. Despite instructions to the contrary, MoD allowed a number of foreign vendors to supply vendors against their offset obligations. CAG has pointed out four such cases.

One, M/s Boeing was being allowed to submit claims for offset credits against the supply of training simulators for P 8(I) aircraft. Two, M/s Lockheed Martin has been offering weapon training simulators worth Rs 619.59 crore as offsets against the sale of C-130J Hercules transport aircraft. Three, two mission based simulators worth Rs 460.56 crore were being transferred to India by M/s Rosoboronexport against their offset liability in the sale of medium lift helicopters. Finally, a simulator centre has been provided by M/c RAC MiG worth Rs 100.38 crore against the contract for the upgradation of MiG 29 aircraft.

b)    Foreign Companies Allowed as Indian Offset Partners

DPP stipulates that IOP shall, besides any other extant regulations in force, also comply with the guidelines/licensing requirements for the defence industry issued by the Department of Industrial Policy and Promotion. While opening the defence industry to the private sector in May 2001, the Government allowed 26 percent FDI. Therefore, there is no ambiguity in the provision that IOP must not have more than 26 percent FDI.

There is a sound reason for the above qualification. The aim of offsets is to facilitate flow of compensatory financial resources into India. In case IOP has higher FDI holding, a large proportion of such funds will get repatriated abroad, thereby defeating the very purpose of demanding offsets and incurring related cost-penalty.

CAG noticed that, in total breach of the specified selection criteria, MoD accepted some companies with more than 26 per cent of foreign holding as IOP. It highlighted three cases. M/s Prescient Systems and Technologies Private Limited, a foreign company, was approved as IOP in the offset contract for the upgrade of MiG 29 aircraft.

More shocking is the case of the offset contract for the procurement of Low Level Transportable Radar signed with M/s Thales. MoD accepted M/s Thales International India as IOP whereas the company is a hundred per cent subsidiary of M/s Thales, Singapore and M/s Thales, Hong Kong. It means that no benefits would accrue to the Indian industry as all gains would be repatriated back to M/s Thales, albeit through an indirect route.  Such an arrangement made a mockery of the concept of offsets.

Similarly, in the offset contract for the procurement of fleet tankers for the Indian Navy with M/s Fincanteri, M/s Wartsila India Ltd and M/s Johnson Pumps Ltd were approved as IOPs. M/s Wartsila is a subsidiary of M/s Wartsila Global which holds 96 per cent of its stock while M/s Johnson Pumps is a subsidiary of a foreign company called M/s SPX Flow Technologies, Sweden. Therefore, both these firms were ineligible to be listed as IOPs.

c)    Absence of Effective Monitoring Mechanism

Despite the fact that offsets carry enormous financial ramifications and are susceptible to dishonest manipulations in execution, Indian policy makers have failed to grasp the criticality of keeping a close eye on their implementation. Monitoring of offsets has been treated in a highly cavalier and slapdash manner.

As per DPP, the Acquisition Manager was the nodal authority to monitor implementation of offsets. He was to be assisted by DOFA and the Offset Monitoring Cell (OMC). As the division of their respective responsibilities had not been spelt out, the guidelines were obscure, imprecise and muddled.

CAG observed that due to the shortage of necessary manpower and the absence of established procedures, OMC was not able to discharge monitoring functions effectively. For that matter, OMC admitted to CAG that it was not clear about the type of assistance it was required to render to the Acquisition Wing. Further, OMC had no mechanism in place for independent verification of the claims made by the vendors in their quarterly reports. It chose to rely totally on the facts and figures submitted by the vendors.

Shockingly, many vendors chose to ignore submission of periodic reports of progress made. MoD admitted that in the offset contract for C-130J Hercules aircraft, the vendor neither provided copies of the offset contracts to OMC nor submitted the required quarterly reports despite repeated requests.

As is apparent, India has failed to put a system in place for overseeing offset programmes and ensuring their successful completion. The whole process has been left to the sincerity and diligence of the vendors. MoD has no option except to accept the progress reports submitted by them.

d)    Non-recovery of Penal Charges

DPP mandated that if a vendor failed to fulfill the offset obligations in a particular year, a penalty of 5 percent of the value of the unperformed offset obligation was to be levied. In addition, the unfulfilled offset value was to be carried forward to the subsequent year. The said penalty was required either to be paid by the defaulting vendor or recovered from the bank guarantee of the main contract or deducted from the amount payable under the main contract.

While 13 of the 16 contracts reviewed had not reached a stage for the levy of such a penalty, CAG observed that MoD had failed to recover penalty charges worth Rs 3.06 crore from the defaulting vendors in two contracts on account of unfulfilled offset obligations.  The vendors were M/s IAI Israel (Rs 2.04 crore) and M/s Lockheed Martin (Rs 1.02 crores). Worse, when queried, MoD failed to provide satisfactory replies to CAG.

The Way Forward

Offsets do not come for free and entail considerable cost penalty. Hence, it is essential that maximum benefit is drawn from every offset programme. All successful offset programmes have certain common well-defined characteristics – deliberate and purposeful selection to fulfill a pressing technological/economic need; detailed planning to facilitate smooth and coordinated implementation; and close supervision and continuous monitoring to ensure timely completion. As is apparent from the CAG report, India has failed on all accounts.

According to the CAG report, the benefits of offsets could not be reaped to the extent envisaged due to the lack of uniformity in interpretation of the extant offset provisions; acceptance of foreign investment in kind with no value addition; selection of ineligible IOPs; and an ineffective monitoring mechanism.

Even the drafting of offset contracts is being carried out in an inept manner. Shockingly, in the offset contract with M/s Fincanteri, Italy for procurement of fleet tankers, the work was held up after achieving 52 per cent progress. No penalty charges could be imposed on the vendor due to non-inclusion of year-wise schedule of implementation in the contract.

Being the first audit of offsets, CAG limited itself to a few salient aspects only. Even then, the report is highly disturbing and alarming. It shows that the whole gamut of offset activities is being handled in a highly amateurish, casual and ad hoc manner. Worse, decisions are being taken in total disregard of the laid down policies. India’s defence offset regime is in a mess with confusion reigning supreme. 

India must inject transparency in all offset activities. Details of every offset contract should be available in the public domain. Periodic progress reports along with details of penalties imposed, if any, should be made public. Deficiencies and corrective measures taken should also be made known to all. At the end of every offset programme, fully collated data should be published indicating the degree of achievement of the laid-down objectives. 

Media coverage and public awareness are essential to ensure that the vendors fulfill their obligations diligently. Most foreign vendors are big defence conglomerates and dread bad publicity that impacts their reputation. They are unlikely to default when under public scrutiny.

Finally and more importantly, transparency is the most potent antidote for the virus of corruption and misconduct. India’s inefficient offset regime with lax monitoring system is highly vulnerable to corrupt practices. Crafty foreign vendors and their fraudulent Indian partners can easily connive to shortchange the country. The Indian defence acquisition regime is already mired in controversies and accusations of financial improprieties. It can ill-afford to let offsets degenerate into cesspools of corruption and dent its reputation further. *****