Designing Sound Defence Offset Policies
(Source: Institute for Defence Studies and Analyses; issued April 17, 2015)

By Sandeep Verma
‘Fools rush in where angels fear to tread’ could well be an apt adage in the context of the rolling out of offsets and related counter-obligations in defence procurement rules worldwide. There has been a steadily growing clamour in many countries for imposing such requirements in big ticket government contracts. This has happened despite the fact that only a handful of the more than 100 countries that now impose such obligations in defence and civil acquisition programmes have been able to intelligently use offsets to invigorate domestic hi-tech production and manufacturing.

Notable among these are the United States (direct offset requirements through “Buy American” and “little Buy American” provisions), Israel (mixed offsets as industrial cooperation), South Korea (mostly direct offsets), Canada (as industrial and regional benefits), Turkey (mixed offsets) and now Malaysia. In this commentary, these countries are referred to as ‘The Smarter Lot’ in terms of the design of sound offset policies.

For most other countries, ‘offsets for domestic industry development’ appears to be a merely convenient rhetoric. They have ignored the serious potential for the abuse of domestic offset partners, for instance as willing conduits to shroud fraudulent transactions in a manner that stays ‘compliant’ with anti-(foreign) bribery regulations such as the Foreign Corrupt Practices Act (FCPA) in the US and the Anti-Bribery Act (ABA) in the UK by exploiting a variety of ingenuous loopholes that are intrinsically embedded therein.

It may therefore be useful for policymakers to explore the core question of ‘What Really Makes Offsets Tick?’ This would help develop an objective analytical framework based on certain sound policy principles repeatedly noticed in offset regulations of ‘The Smarter Lot’. It would further help them to stay clear of the seven ‘original sins’ (discussed below) that a poorly-designed offset policy may entail. For obvious reasons, the development of an objective framework for offset policy analysis would be a more useful and consistent alternative to anecdotal and response-based country rating systems that are presently employed for analysis and comparison of national defence procurement regimes.

The First Original Sin: Offset Credit by Transaction Value, Not by Domestic Value-Addition

It does not take much common sense to figure out that tying the successful discharge of offset obligations to minimum domestic content is the foremost requirement for sound offset policy design. This can be done either in specific terms as in the US, Canada and Turkey or in graded terms as in Israel and South Korea. That is because a central policy objective for offsets is to enhance value-addition in the domestic industry and economic environment, rather than making domestic offset partners simply outsource contracts placed on them by foreign vendors to the principal foreign entities or to the foreign supply chain partners.

The Second Original Sin: Allowing a Free Run for “Indirect” Offset Transactions

It is equally unsurprising that ‘The Smarter Lot’ insists on a higher element of direct offset transactions. This entails indigenisation within the product or service being supplied (as in the case of the US), or at the very least through the imposition of maximum percentage limits on indirect transactions that are allowed to qualify towards offset discharge. These could be in the form of caps on technology transfer, imported capital equipment, and other-than-supplies indigenisation as is the case in South Korea.

The Third Original Sin: Qualifying ‘In-Scope’ RFP Activities towards Offset Discharge

This loophole in offset policy design creates a double whammy benefit for participating vendors by allowing them to count as eligible what is anyway required mandatorily under the scope of the prime supply contract, thus violating the ‘additionality’ and ‘causality’ principles cardinal to sound offset policy design. As an example of the practice among ‘The Smarter Lot’ countries, South Korea explicitly forbids the execution of mandatory RFP requirements by prime vendors to be counted towards discharge of their offset obligations.

The Fourth Original Sin: Offset Contracts that go on Forever

Avoiding this sin is more of a practical consideration for policymakers and procurement practitioners. If an offset discharge period is too long compared to the time for supplies, then neither a vendor nor officials involved in procurement/ offset approvals would have any realistic or professional stakes in the development of sound offset contracts. As an associated requirement, sound policymaking may also require ‘balancing’ of offset contracts—where the quantum of offset obligations broadly follows the percentage payments for supplies under the main contract. In Israel, for instance, a default rule is that the offset contract is coterminous with the main supply contract.

The Fifth Original Sin: A “Hands-Off” Approach to Domestic Offset Partner Selection

On paper, adopting a hands-off approach with the choice of selecting a domestic offset partner being left entirely to a foreign vendor comes with two associated practical problems. Firstly, a foreign vendor would naturally opt for the weakest or the most unscrupulous domestic partner rather than a worthwhile domestic player, thus defeating the policy objective of developing a strong domestic industrial base. Secondly, such provisions allow unscrupulous procurement officials to actually choose their ‘favourite’ entities as domestic partners in tandem with willing foreign vendors, even as they continue with the pretence of maintaining complete probity in supplier selection. As a matter of contrast, the South Korean offset practice requires the close association of government agencies with the selection of domestic partners and formulation of offset contracts.

The Sixth Original Sin: Unbridled Third-Party Transactions

This design mistake occurs when third-party transactions, i.e., transactions between entities that are not parties to the main procurement contract, are allowed as an unbridled element in offset contracts, without ensuring adequate oversight and control from procurement officials. Such practices create adverse effects such as de-risking prime suppliers from anti-bribery investigations in case of integrity abuses, while also destroying in the process the ‘additionality’ and “causality” principles that are otherwise considered as absolutely essential ingredients of a sound offset policy. It is therefore no wonder that Canada, for instance, carefully checks for additionality elements before allowing any vendor claim to be treated as an eligible offset transaction.

The Seventh Original Sin: When in Doubt, Destroy the Fundamentals

Offset guidelines may not always work to equal effect in every procurement case or for every importing country. It is after all a country’s negotiating capacities in public procurement that eventually determine the extent to which it can successfully leverage its procurements for developing its domestic industrial base. These include a strong determination on the part of its executive leadership, the administrative capabilities of its acquisition workforce, and the value and importance of an instant procurement case to external suppliers.

‘The Smarter Lot’ therefore tends to reduce or increase the quantum of offset obligations on a case-to-case basis rather than allowing deviation or dilution of the structural elements of offset policy guidelines. Reducing the percentage of offset obligations when faced with practical problems is a superior policy alternative to diluting the ‘ fundamentals’ of offsets, as the latter can serve as unsavoury precedents for other procurement cases and vendors. This can damage consistency and predictability in the application of guidelines as well as permanently harm the negotiating positions and strengths of national procurement teams.

Conclusions

Some plausible elements of a sound national offset policy discussed above could hopefully serve as useful pointers to a better design of effective offset policies. These would be of particular interest to any developing country that seeks to achieve intended effects in terms of invigorating its domestic industry. Otherwise, a bad offsets framework may well end up enhancing integrity abuses through complex, non-transparent and multi-layered corporate transactions that tend to usually underpin transnational offset contracts.

To make matters worse, poor or careless policy design can also embed a network of compromised domestic business entities, which over time can work to lobby and prevent their national governments from undertaking any meaningful reform of offset guidelines.


The author is a civil servant and holds an LLM degree from The George Washington University Law School, Washington D.C. Views expressed do not reflect the official position or policy of the Government of India or any of its departments or agencies. This brief has been prepared for reading and classroom discussions by IAS officers at a mid-career training programme at LBSNAA, Mussoorie for exploring the intersection of law, procurement and public policy in government programme design and implementation.

Views expressed are of the author and do not necessarily reflect the views of the IDSA or of the Government of India.


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