Supplementary memoranda submitted by the
Ministry of Defence (19 February 2003)
The Committee would like to have details of defence
budget changes made in anticipation of the DERA PPP, as well as
the funds received by the MoD (or the Treasury) in connection
with the establishment of QinetiQ and those funds expected to
flow from the strategic partnership with Carlyle.
2. In anticipation of the PPP receipt MoD
received a credit of £262 million to the defence budget in
FY 01/02. The size of this credit did not represent an estimate
of the value of the company. MoD will repay this advance in stages
as it receives the proceeds from the initial and subsequent transactions.
Proceeds above this £262 million will be available to fund
further investment in Defence.
3. When QinetiQ was vested as a plc in July
2001 it was required to purchase its assets from the MoD. At this
point there was no means to establish the market value of the
business, and the price paid for the assets was based on their
net book value (£495 million) as shown in QinetiQ's accounts.
It is important to note that this figure does not reflect the
value of QinetiQ as an ongoing business nor, given the very specialised
nature of many of QinetiQ's assets, does it reflect their potential
sale value on the open market, which is likely to be substantially
lower. When QinetiQ purchased its assets, MoD had the option to
accept payment entirely in shares, or as a combination of shares
together with an obligation (in the form of an interest bearing
loan note) to pay MoD directly in cash at a future date. Following
advice from its bankers MoD chose to accept the latter option,
on the basis that injecting an element of debt creates additional
commercial disciplines on management to scrutinise cashflow and
capital expenditure. Consequently, at vesting MoD received interest
bearing loan notes for £150 million and 100%. of QinetiQ's
shares, which at that point had a nominal face value of £345
million. As the value of shares varies in accordance with both
trading prospects and liabilities this structure has the additional
advantage of giving MoD greater assurance of the size of the PPP
proceeds.
4. Based on this capital structure and the
terms of the deal agreed with The Carlyle Group the PPP receipt
consists of the following:
| Source | Amount (£m)
| Cumulative proceeds to MoD |
| Partial loan repayment from QinetiQ (£50m + £2m interest) in February 2002.
| £52m | £52m |
| Partial loan repayment following debt refinancing by Carlyle (£40m + £9m interest)
| £49m | £111m |
| Cash payment by Carlyle for QinetiQ equity stake (amount to be determined in completion accounts)
| £40-50m | £151-161m
|
| Final loan repayment from QinetiQ (contingent on sale of properties at Chertsey and Aquila)
| £60m | £211-221m
|
| Proceeds from sale of MoD's remaining shares in QinetiQ probably within 3-5 years. Value depends on company's performance but likely to be hundreds of £Millions
| Not yet known | Not yet known
|
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QinetiQ's chief executive indicated that the cost of any future
redundancies might eventually be paid for indirectly by the MoD
in the overhead charges subsumed in the prices of the contracts
it places with QinetiQ. To what extent will the MoD be able to
vet such charges?
6. QinetiQ is subject to the same arrangements applied
to MoD's other external suppliers. In calculating their charges
to MoD, any contractor engaged in work to which the government
profit formula applies is entitled to include a proportion of
their overheads within their costs. Redundancy costs can be included
as part of the allowable overheads. The Pricing and Forecasting
Group (PFG) within the Defence Procurement Agency would investigate
the overall claim (including the redundancy element) and agree
with the Company whether the costs are fair and reasonable. The
PFG has the right to inspect the company's accounts and disallow
claims if it is not satisfied that they are legitimate.
In earlier inquiries by the previous Defence Committee, the
MoD had indicated that QinetiQ would not be permitted to engage
in "defence manufacturing". QinetiQ witnesses indicated
last month that under its compliance regime procedures it would
seek MoD approval for all defence work, but what is the MoD's
policy on this previously undecided issue?
8. Defence manufacturing within the UK supply chain is
the activity that is most likely to create an unmanageable conflict
of interest with QinetiQ's role as an impartial adviser to MoD.
For this reason, Ministers have consistently made it clear that
there would be a general prohibition on the involvement by QinetiQ
in such work. It is difficult to arrive at a simple definition
of defence manufacturing so we have adopted a pragmatic approach.
There is a "black list" of items that QinetiQ cannot
manufacture (guns, artillery, fighter aircraft etc) and then a
"grey list" of items where manufacturing work requires
specific approval from MoD customers (this includes items which
might have both a military and civil application). MoD retains
the right to waive this prohibition under certain circumstances,
for example where this is the best route for meeting an Urgent
Operational Requirement. All work within QinetiQ, regardless of
whether it involves manufacturing activities, is subject to the
overriding principles of the compliance regime and if there is
any potential for conflict of interest then MoD customer approval
is required.
The Committee would like to have details of those cases where
intellectual property rights have been disputed by companies;
including the firms involved, the areas of technology involved
and the steps the MoD is taking to resolve these disputes
10. Prior to the vesting of QinetiQ as a plc MoD carried
out an extensive exercise to identify and remove any IP which
could not be held by the company when it ceased to be part of
the Department. During this exercise, known as the Records Audit
and Segregation Process (RASP), over 160,000 Records were examined.
In the 18 months since vesting the MoD has received 3 challenges
where contractors have disputed intellectual property rights and
these are described below.
11. Smiths Group plc raised a concern which was
of a general nature and contained no specific examples. MoD has
corresponded with the Company to allay their general concerns.
12. Advanced System Architecture Ltd. After investigation
of the challenge, MoD confirmed that it did indeed have the right
to pass the IP to QinetiQ. ASA Ltd were told this and we have
had no further approaches from them. Only one item of IP is still
retained by QinetiQ in conjunction with a specific MoD programme.
13. Rolls Royce have raised an issue about the
fate of 500 "Grey Books". These were documents jointly
authored by MoD(DERA) and Rolls Royce relating to the Gas Turbine
engine research programme. The IP was jointly owned by MoD and
Rolls Royce but the contracts did not allow MoD to disclose the
information contained in the document without the permission of
Rolls Royce. The current situation is:
(a) The "Grey Books" date back over a number
of years.
(b) Of the 500 "Grey Books" held by DERA before
the vesting of QinetiQ, a significant number are believed to have
been destroyed or sent to archives in the Defence Records Office
as the information was no longer needed.
(c) The RASP process identified a number of "Grey
Books" still within DERA and MoD customers were asked to
adjudicate as to whether these could be retained by QinetiQ. The
results of this adjudication were subsequently challenged by Rolls
Royce.
(d) After 1 July 2001, further Grey Books were destroyed
and 78 were returned to Rolls Royce by QinetiQ. A further 29 are
in the process of being returned. An exercise following the challenge
from Rolls Royce has identified only 3 further "Grey Books"
held by QinetiQ. These relate to continuing contracts where the
work is being done in conjunction with Rolls Royce. This information
has been passed to Rolls Royce and we are awaiting a response.
(e) The focus of the current discussions is whether MoD
or QinetiQ can prove that documents were destroyed or archived
as claimed.
(f) There is no suggestion that QinetiQ has illegally
exploited the IP contained in these documents or that Rolls Royce
has suffered any form of loss.
14. We continue to work with QinetiQ and Rolls Royce
to resolve the issue and a meeting is planned for next month between
all parties to discuss whether any further measures can be taken.
What input did Ministers and MoD officials, respectively, have
in QinetiQ's consideration of salaries, bonuses, share-options
and other aspects of the company's remuneration packages ?
16. Staff salaries and bonuses are entirely a matter
for the company. The salaries and bonuses of the most senior staff
are subject to approval by the Remuneration Committee of the QinetiQ
Board. MoD currently sends observers to meetings of this committee,
but does not have voting rights.
17. The design of the share scheme that will be put in
place as part of the transaction was the result of detailed negotiations
between MoD Officials and Carlyle. QinetiQ's management provided
advice on the design of the scheme, but were not directly part
of the decision making process. The scheme meets the Government's
objective to allow for participation by all of QinetiQ's staff.
It takes account of the need to provide the correct levels of
incentives to grow the business whilst still providing value for
money to the taxpayer. The scheme was approved in detail by Ministers.
DSTL's chief executive's evidence [QQ147-153] described the
benefits of DSTL being subject to the commercial disciplines that
executive agencies are given. What is the MoD's rationale for
DSTL being a trading fund, rather than simply an executive agency?
19. Dstl was established specifically to conduct work
that could not easily be transferred to the private sector. Therefore
its targets and corporate plan differ from those generally applied
to MoD Trading Funds. In particular, Dstl is not required to seek
to grow its external commercial business. However, MoD still believes
that Trading Fund status offers a number of real benefits in terms
of incentivising Dstl to meet MoD's requirements effectively.
The funding mechanism for Dstl was reviewed in 2002 and HM Treasury
agreed that the existing Trading Fund arrangement was appropriate
and should continue. As is normal for all Trading Funds, Dstl's
status will be reviewed at appropriate intervals, and the review
will take account of the effectiveness and efficiency of the relationship
as well as examining Dstl's performance against its targets. MoD
considers Trading Fund status to be the most appropriate financial
regime for Dstl because:
(a) The disciplines associated with Trading Fund status
have a proven record within Dstl and its predecessor organisations
for increasing value for money in the delivery of MoD's Science
and Technology services. The ability of customers to withhold
payments, provides considerable incentive to staff to satisfy
customers' requirements. There is also considerable pressure from
customers to reduce costs.
(b) It provides Dstl's management with appropriate freedoms
to fulfil their remit to provide MoD with capabilities in areas
that can not easily be transferred to the private sector. This
allows more flexibility in capital expenditure for site rationalisation,
development of facilities, and the terms and conditions of employment.
(c) It provides sufficient freedom to operate in the commercial
market to the limited extent that MoD believes is appropriate.
Dr Moonie indicated that the defence research budget was likely
to fall over the next 10 years. By how much is the budget anticipated
to fall ?
21. MoD's current financial plans, which extend over
the next four years, assume that annual expenditure on defence
research will show little variation in the short-term. Over a
longer period we would expect that research competition and initiatives
such as Defence Technology Centres will increase efficiency and
could produce savings in the costs of individual items of research.
The total size of the research budget will continue to vary in
response to MoD's requirements for science and technology. Dr
Moonie's intention was not to suggest an absolute fall in the
MoD research budget, but to highlight the problem of having a
relatively static budget while the frontiers of knowledge are
constantly expanding.
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