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Is Sovereign Guarantee Comfort An Enabler For Liberalisation Of Foreign Investment In The Indian Defence Sector?

The Indian defence opportunity is immense, it will now be up to the new government to further smoothen the road ahead.

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India has been reaching new heights and milestones every year in the defence sector and, now more than ever, it has become crucial to strengthen the Indian defence sector by modernising the defence capabilities and reducing reliance on imports. Since 2000, no substantial foreign investments have been made in the Indian defence sector, and due to the volatile nature of the defence industry, the need for cutting-edge technological development in defence mechanisms has become very important.

Under the Draft Defence Production Policy, 2018, there is a proposal to further liberalise foreign direct investment (FDI) in the defence sector permitting FDI upto 74% under the automatic route, in niche technology areas. If the proposal is brought into effect, then foreign players would be able to acquire a controlling stake in an Indian entity engaged in niche technology areas in the defence sector without the approval of the Indian Government.

While, FDI in the defence sector is heavily regulated across the world including in the United States of America, Russia, Japan, France and Germany, these countries have a very evolved defence industrial base. Hence, these countries have either imposed certain restrictions on foreign participation or have not permitted acquisition of control or have mandated the requirement of the approval of the government for acquisition beyond a certain percentage. 

Due to the highly skewed import to indigenisation ratio of India’s defence needs, India’s proposal to grant a foreign stakeholder a right to hold a controlling stake in an Indian entity engaged in the defence sector without the approval of the Government would significantly change the dynamics of the Indian defence industry in the world, considering that there are no precedents in other jurisdictions of such a move.

Given this backdrop, it would be important to analyze the consequences of providing a controlling stake to a foreign stakeholder in an Indian entity engaged in the defence sector and certain counter protective measures that would be critical in mitigating potential risks. 

Controlling stake in the India defence sector: Concerns and advantages

Currently, under the extant foreign exchange laws in India, FDI in the defence sector is permitted upto 100%, but the approval of the Government is required for FDI beyond 49%, which would depend upon the nature of the investments that are “likely to result in access to modern technology or for other reasons to be recorded”. However, the conditions for obtaining the approval of the government for FDI beyond 49% have not been explicitly set out and the government has the prerogative to approve each investment on a case to case basis. The lack of clarity with respect to the conditions that may be imposed by the Indian Government has resulted in a regulatory black box, and it appears that this has made foreign investors hesitant to acquire a controlling stake in an entity in the Indian defence sector. 

Under the proposal to further liberalise FDI under the automatic route, one of the advantages of providing a foreign stakeholder a controlling stake in an Indian entity engaged in the defence sector is technological advancement. It would not be incorrect to assume that, subject to the control of the Indian entity, the foreign stakeholder would be more inclined to share technical know-how and information with the Indian subsidiary as they would be able to manage and control the dissemination of such information.

However, greater responsibility and control is naturally accompanied with greater accountability. If a foreign stakeholder obtains a right to nominate majority directors on the board of directors of the Indian entity, such nominees would have the power to make decisions of the Indian investee entity. Therefore, such nominees of the foreign stakeholder can be held accountable for any failure to meet their supply obligation or any deficiency in the quality of the defence equipment manufactured by the entity and sold to the Government of India.

Having said that, for any reason, if there is any adverse impact on the continuous supply of defence platforms / sub-systems by the Indian subsidiary of the foreign entity to the Armed Forces, it may become a cause of concern for the Government. In light of this, we have recommended a sovereign guarantee or a letter of comfort that may be considered by the Ministry of Defence, Government of India whilst liberalising FDI in the defence sector.

Genesis of Sovereign Guarantees and Letters of Comfort

A sovereign guarantee is a guarantee for discharging the liability or obligation of a third party from the government of a nation to the government of a foreign nation, which is legally enforceable and binding in nature. A letter of comfort is akin to a sovereign guarantee, but it is not legally enforceable in a court of law. A letter of comfort from the foreign Government may be considered as a moral obligation in the eyes of the public and any default thereof may become a matter of international embarrassment for the foreign country. 

The power to issue a sovereign guarantee and letter of comfort usually emanates from the Constitution of a country. As a matter of fact, the Government of India has the power to issue such guarantees under Article 292 of the Constitution of India. 

It is not novel for India to obtain a letter of comfort or a sovereign guarantee from a foreign state, as can be gathered from media reports, a letter of comfort was given by the French Government under the Rafale Deal and a sovereign guarantee was given by the Russian Government under certain other defence deals. However, it would be advisable to peruse the provisions of the Constitution of the foreign countries to ensure that such guarantees / letter of comfort are intra vires the Constitution of the foreign countries. Having said that, it is evident that this requirement would put an additional obligation on the foreign OEM, however, since all the foreign investment transactions through FDI are from a long-term perspective, Government of India can seek this additional comfort to ensure continuity of supplies even in times of national / political / economic crisis.

One important factor that will help facilitate this is the exponentially improving relations between the foreign countries (with defence technologies) and India. This may further be strengthened basis the international relations and the existence of bilateral treatises between the nations. 

Since the issuance of sovereign guarantees or letters of comfort is confidential in nature and details of issuance of any such guarantee to the Government of India backing the performance of a foreign entity are not available on public domain, we have only seen such guarantees forming a part of inter-governmental agreements or contracts with foreign government for foreign military sale of defence equipments. However, the viability of such safeguard mechanisms has not been tested for investments under the FDI route. 

Conclusion 

The Government of India should consider a progressive approach to enhance FDI in the defence sector resulting in prospective transfer of technology which would be invaluable to the Indian defence sector. As such, granting a controlling stake in Indian entities to foreign investors seems to be the need of the hour, but such rights should be intertwined with checks and balances. 

Hence, if a foreign investor can produce a Sovereign Guarantee or Letter of Comfort, the Ministry of Defence should consider liberalising the FDI norms beyond 50% under automatic route with such safeguard mechanisms. The Indian defence opportunity is immense, it will now be up to the new government to further smoothen the road ahead.

Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.


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Bhavin Gada

The author is Partner, Economic Laws Practice (ELP)

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Soumya Shanker

The author is Senior Associate, Economic Laws Practice (ELP)

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Mehak Gupta

The author is Associate, Economic Laws Practice (ELP)

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