Licensed manufacture: The key to survival for SRDP companies?

In the wake of efforts by the Senate Committee on National Defense to amend Section 53 of the Government Procurement Reform Act to give the President the power to negotiate modernization-related acquisitions (see here), supporters of local defense industry players sought to campaign the Office of the President to use that power to instruct the DND to buy from local defense manufacturers.

But with only two years remaining in the Aquino administration, such a move would be the kiss-of-death for the object of such a blatant act of patronage. Any such selection would, in essence, be a political decision thus firmly associating that company with the outgoing administration. This in turn gives the succeeding administration a very strong incentive to overturn the decision — if only to show the country that Malacanang was under new management.

Given the state of the local defense industry, virtually all players are vulnerable to the following two excuses for reversing the “anointment” of a preferred supplier:

  • Qualification for suppliers. Normal bid invitations include a protection against fly-by-night suppliers that stipulate that “bidders should have completed, within five (5) years from the date of submission of bids, a contract similar to the project. With all Philippine defense companies still in an embryonic state, this virtually disqualifies all local players
  • Commoditized products. Unless the preferred company were manufacturing the world’s only light saber — it really wouldn’t take much for spin doctors to question the selection. Regardless of the technical merits of company’s design, there are virtually no locally produced defense articles that are sufficiently unique to merit being singled out for a negotiated purchase, in lieu of other potentially cheaper imported alternatives

Even if a new administration upholds the previous President’s decision, these violations would still give SIGNIFICANT fodder for any political operator who wants to stir controversy. The company that benefited from presidential selection could then be in the unenviable position of becoming a tool for political leverage, or worse . . . impeachment.

Dealing with SRDP barriers

To deal with these omnipresent barriers to SRDP, defense companies could lobby for a change in the rules-of-the-game. The industry could ask Congress to amend procurement rules and make them more favorable to local production. This, however, is a time consuming approach with an uncertain outcome. Furthermore, such amendments have the potential for unintentionally weakening the protections that the current law was meant to implement in other procurement areas (e.g., routine purchases for schools, hospitals, etc.)

This is NOT the only option for the defense industry.

Despite the challenges presented in both the previous (RA 7898) and current (RA 10349) AFP modernization law cited earlier in this article, both actually contain substantial pro-SRDP provisions namely the following:

Sec. 10. Self-Reliant Defense Posture Program. — (a) In implementing the modernization program, the AFP shall, as far as practicable, give preference to Filipino contractors and suppliers or to foreign contractors or suppliers willing and able to locate a substantial portion of, if not the entire, production process of the term(s) involved, within the Philippines.

(b) In order to reduce foreign exchange outflow, generate local employment opportunities and enhance technology transfer to the Philippines, the Secretary of National Defense shall, as far as feasible, incorporate in each contract/agreement special foreign exchange reduction schemes such as countertrade, in country manufacture, co-production , or other innovative arrangements or combinations thereof.

(c) The AFP likewise ensure that in negotiating all applicable contracts or agreements, provisions are incorporated respecting the transfer to the AFP of the principal technology involved as well as the training of AFP personnel to operate and maintain such equipment or technology.

The spirit of the law is clearly in favor of SRDP. But the AFP modernization law does not actually direct the AFP to buy locally. It merely encourages it to do so, and with a very ambiguous caveat: “as far as practicable”.  Given the state of the manufacturing industry, there is a significant disconnect between the intent of that section and practical implementation. The law does not lay out a plan for how to develop local defense industries to the point where it would be practical to source equipment from them. Prototypes should not be mistakenly equated with a production-ready design, or production capacity.

These two mandates: “buy local” and “buy only mature products” appear totally contradictory. After all, how can the AFP buy mature products from an immature local defense industry? A potential answer: license-production of existing weapon systems in the Philippines.

What is licensed manufacture?

The following is an excerpt of a document prepared by an organization that monitors the growth of the international arms industry.

Licensed production is where a company’s product is manufactured under contract by a company in another country. At its simplest, parts purchased from the vendor are assembled in the buyer country; at its most advanced, a weapon’s design, along with the expertise of engineers, is purchased and the equipment built in its entirety in the buyer country.

The document above cites India as an example of a country that insists on licensed production of weapons as a pre-condition for acquiring them from foreign vendors. Russia, Israel, France, and the United Kingdom have all complied with India’s demands to secure that regional power’s business. It is worth noting that India’s procurement policy is the same model espoused by Section 10 of the AFP modernization law. Other countries have adopted a similar approach.

Tim Huxley described in his book Defending the Lion City how Singapore uses a point-system for selecting weapon systems, with contracts awarded to options garnering the highest score. Special additional points are awarded to prospective suppliers that include locally-produced content thus ensuring success for companies that enter into partnerships with Singaporean companies. This strategy has resulted in in-country production of components for Singaporean F-16 multi-role fighters and CH-47 Chinook heavy lift helicopters.

The South Korean aerospace industry benefited greatly from licensed production of 120 KF-16 multi-role fighters. The US Department of Defense notified Congress of the South Korean request for local production in 1991, and a mere ten years later, the first South Korean supersonic aircraft, the T-50 Golden Eagle, took to the air. It was arguably no accident that the Golden Eagle was developed in partnership with Lockheed Martin, the manufacturer of the F-16 from which South Korea obtained the production license.

Incentive to license

The existing legislative framework offers local defense companies a host of under-utilized tools. In addition to Section 10 of the AFP Modernization Law shared above, prospective SRDP entrants also have Republic Act 5183 working in their favor. This law prohibits the Philippine government from sourcing items from companies that aren’t majority Filipino owned. This means that any foreign vendor seeking to sell its wares to the AFP needs to establish arrangements with Philippine business entities, which will then be responsible for representing the vendor in public biddings and similar engagements.

The following partnerships have been outcomes of this representation requirement

Philippine company   Foreign companies represented   Acquisition project
Aeromart Commercial & Industrial Corp Marsh Aviation (USA) Service Life Extension Program (SLEP) for OV-10 Bronco aircraft
Aerotech Industries Philippines Alenia (Italy) Supply SF-260 training aircraft for the Philippine Air Force
Firepower Defense Contractors Rheinmetal Denel Munition Pty Ltd (Germany)
Denell Pty Ltd (South Africa)
Companhia Brasilera de Cartuchos (Brazil)
Supply of various small arms munitions for the Philippine Army and general purpose bombs for the Philippine Air Force
Urban Industrial Corporation Arcus Co. (Bulgaria)
Kompanija Sloboda A.D. (Serbia)
Supply of 40mm grenade launcher ammunition and artillery rounds for the Philippine Army

This law virtually ensures that a Filipino company will be involved in any acquisition — with the exception of government-to-government deals. While the companies that have thus far emerged have been mere middle-men that lacked manufacturing capacity, Philippine defense companies could potentially use this law as a catalyst for licensing talks, thus forging an enduring production partnership instead of just a representation relationship.

Arguably, this law was meant to entice manufacturing  investments to the Philippines. Having defense industry players leveraging the law for licensed production would use the law the way it was intended.

This approach has the following advantages:

1. Existing laws can be used without any changes. This means that this course of action is available today

2. There would be no need to curry political patronage since this simply requires the law to work as written and intended. Although ensuring DND buy-in of the concept would still be necessary, as would an SRDP roadmap.

3. The two-countries rule AND the minimum requirement for deal sizes are both satisfied since the Philippine company would leverage those characteristics of their foreign partner

Once this joint venture is established, and wins bids for AFP contracts, the Philippine company would then be completely justified in claiming to have had experience with sizeable government contracts, thus satisfying the minimum deal-size requirement. A status that it could not have achieved on its own. Furthermore, the company could leverage its status as a licensed manufacturer of an established company to sell its own products both domestically and overseas.

Plan of action

How could this all play out? Ultimately that would depend on the nature of the equipment that will be manufactured, the capacity of the Philippine company (which would determine the capital expenditure required), the requirements of the foreign entity, and the export controls of the foreign company’s country of origin.

Philippine companies may also have to come to grips with the fact that they can’t advance on their own and may need to form a consortium of companies with complementary capabilities. This would potentially cut down on capital expenditures, since the consortium would take advantage of the investments already made in equipment and production space, and enhance the resulting entity’s competitiveness as well as credibility as manufacturing partner.

The following simplistic plan of action should, at a high-level, should cover the process in broad strokes:

1. Select a foreign manufacturer whose products are already in use by at least two foreign countries — or at least the country of origin. This would satisfy the requirements of the AFP Modernization Law

2. Enter into a representation agreement with this manufacturer in accordance with RA 5183

3. Enter into a licensing agreement with this manufacturer to have THEIR products manufactured at the Philippine company / consortium’s manufacturing facilities

4. Take part in a bid invitation, and submit a bid that reflects the savings made possible by local manufacture

Conclusion

Instead of leveraging their design portfolios, local defense companies should consider to looking to their manufacturing prowess instead, and enter into licensing arrangements with existing players. This approach would not only allow it to tap into the admittedly small Philippine defense market, it could also launch it into the world stage, where the bulk of the defense dollars are to be sourced anyway.

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Author’s note: This article is based on the opening message of what eventually became a productive, well-received, email conversation with the founder of a prominent player in the Philippine defense industry. Details of that discussion are being kept private as per request. But the substance of the proposal is shared here.

This post was also posted on the Timawa.net forum here.

ERRATA: The following bullet point was removed from the main article because the IRR of the AFP Modernization law actually exempts local companies from this rule: Section 1 of the revised AFP Modernization Law re-affirmed Section 4 sub-paragraph b of the original modernization law, RA 7898, that explicitly stipulated that “no major equipment and weapon system shall be purchased if the same are not being used by the armed forces in the country of origin or used by the armed forces of at least two countries”. This is pretty much a deal breaker for patronage-based SRDP. Any administration looking to establish its anti-corruption credentials could very easily resort to reversing the “hand-out” for a quick win.

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