Defence Reform Bill

Written evidence from ADS (DR 04)

The UK Defence Industry employs over 300,000 people – directly and through the supply chain. The UK is the second largest defence exporter in the world and is highly skilled, with 59 per cent of workers holding a university degree or equivalent. It is research intensive, investing 8 per cent of annual sales revenue in research and development.

Overview of Key Issues

Industry recognises that reform of defence acquisition and the Reserve Forces is necessary. Defence reform has four objectives – to ensure that our Armed Forces have the equipment and support they need; that the taxpayer receives value for money; that suppliers receive a fair return allowing them to invest for the future; and that there is predictability for industry.

UK industry supports reform of single source contract pricing and reporting, but the provisions in Part 2 (Single Source Contracts) present significant concerns. ADS’s submission therefore focuses principally on Part 2 of the Bill.

Part 1 – Defence procurement:

· There is inadequate protection for suppliers’ IP and commercially sensitive information (Clauses 7 and 8). IP is critical to the success of the UK Defence Industry and the Bill must consider proper safeguards or risk a loss of business confidence.

· MOD should communicate the metrics it intends to use to assess the GOCO and DE&S+ options even if it chooses not to define them in legislation.

Single Source Contracts:

· The lack of political independence in the SSRO (Single Source Regulations Office) (Clauses 13 and 39; Schedule 4). The Bill appears to allow the customer (MOD) to control the regulator (SSRO). The checks and balances in the Pharmaceutical Price Regulation Scheme (PPRS) could be used as a basis for developing similar arrangements tailored to defence requirements.

· Subsection 7 of Clause 14 allows the Secretary of State to exempt any Qualifying Defence Contract from the new regulations. Industry recognises that there will be occasions when it will be necessary to exempt a contract. However, the circumstances and criteria when an exemption can be granted should be defined in a transparent manner. Failure to do so may place UK suppliers at a disadvantage in the international market place.

· The new regulations will create uncertainty over contract price (Clauses 18, 20, 21 and 23) with possible adverse consequences for shareholder value, boardroom confidence to invest and the international perception of the UK as a good place to do business.

· A failure to maintain the comparability principle, which links the profit allowance on single source contracts to the average profit earned by a reference group of companies listed on the London Stock Exchange, in Clauses 17 and 18 may undermine suppliers’ willingness to participate in single source procurement and invest in the UK.

· The regulations may place a heavy burden on subcontractors and SMEs (Clauses 27 to 29) and ADS would ask that the scope of application of the regulations is defined.

· ADS supports the restrictions on disclosure of information in Clause 37 and Schedule 5, but protection of suppliers’ information could be strengthened by amending Schedule 5 to include an additional criminal offence of failure to protect suppliers’ information. There should be a requirement for the MOD and SSRO procedures for protecting suppliers’ information to be subject to audit by an independent third party to demonstrate their efficacy, replicating the responsibilities of a Data Controller under the Data Protection Act.

Reserve Forces:

· Clause 43, Subsection 4, which extends the circumstances under which the Reserve Forces can be deployed, will place a greater burden on employers, particularly SMEs employing Reservists with unique skill-sets. Greater clarity is required on what appeals process will be put in place to protect employers.

Part 1 – Defence Procurement

1. Inadequate protection of suppliers’ IP and commercially sensitive information (Clauses 7 and 8; Schedule 2)

1.1. A willingness to invest in the R&D creates "hard IP". This, in addition to "soft IP" (e.g. unique business models), are factors that explain the UK Defence Industry’s global success. Elements within the consortia bidding for the GOCO contract will at times inevitably compete, both in the UK and abroad, with companies not bidding for the contract. The Bill must provide safeguards to ensure UK industry IP is protected. Sanctions should be put in place to deter IP infringement, deliberate or otherwise.

1.2. Clauses 7 (Restrictions on disclosure or use of information) and 8 (Intellectual property rights) secure the Secretary of State new legal rights to disclose IP and commercially sensitive information currently held by MOD. This will include private and commercially sensitive information to which MOD has been given access outside of a contractual obligation in circumstances where the owner has had a reasonable expectation that MOD would hold it in confidence and not disclose it to a third party.

1.3. Clause 7 gives effect to Schedule 2, which allows the Secretary of State to disregard confidentiality obligations under any defence procurement contract where it is "necessary or expedient" under Clause 1, which sets out the arrangements for providing defence procurement services. Clause 8 allows MOD to disregard the rights of owners of work protected by copyright or database rights. Disclosures are not required to be under conditions of confidentiality.

1.4. Clauses 7 and 8 take rights away from the disclosing party or copyright owner without any right to objection and without compensation.

1.5. ADS has serious concerns about the proposed provisions in Clauses 7 and 8. We recommend that, in the case of copyright, the existing Crown user rights under the IPR DEFCONS should be preserved. [1] Clauses 7 & 8 should therefore be removed from the Bill.

1.6. Clause 37 in Part 2 of the Bill gives effect to Schedule 5, which creates a criminal offence of disclosing protected information. Part One does not include a corresponding provision.

1.7. A lack of sufficient safeguards may undermine MOD’s ability to be an intelligent customer. Industry trusts MOD and is willing to give it access to its IP and commercially sensitive information. Without stringent safeguards, that confidence will be lost and companies may become unwilling to share their information with MOD. The consequence would be a more transactional relationship between MOD and industry.

1.8. Part 1 should provide stronger safeguards to protect suppliers’ IP and private and commercially sensitive information. A new clause should be introduced in Part 1 to provide for a criminal offence of failure to protect, or prevent the unauthorised use of, suppliers’ protected information.

2. Communicating the metrics used to assess the performance of GOCO / DE&S+ (no applicable Clause)

2.1. ADS recognises that the detail defining the function and purpose of the proposed GOCO will be contained in secondary legislation.

2.2. MOD may not wish to enshrine in legislation the criteria by which the success of the new contracting entity will be assessed. However, MOD should communicate the metrics to both industry and Parliament. ADS suggests that metrics might include: value for money; a reduction in the length and cost of bidding processes; greater stability in the funding and direction of the equipment budget; and increased staff skills and expertise.

2.3. Given that the GOCO will be awarded a contract of up to nine years, it is not clear how the contracting entity will be incentivised to take longer-term considerations into account. MOD should clarify the balance it seeks between short-term priorities (e.g. reducing the cost of the bidding process) and longer-term ones (e.g. maintaining critical capabilities).

Part 2 – Single Source Contracts

3. A lack of political independence in the SSRO (Single Source Regulations Office) (Clauses 13 and 39; Schedule 4)

3.1. The Bill gives the Secretary of State significant power over the SSRO, which risks a perverse situation in which the customer (MOD) holds substantial influence over the regulator (SSRO). The Secretary of State will appoint the Chair of the SSRO (Schedule 4, Subsection 1) and can remove any board member from office on certain grounds (Schedule 4, Subsection 4). Clause 39 gives the Secretary of State broad powers to repeal the new single source contract regulations and abolish the SSRO.

3.2. The checks and balances within the Pharmaceutical Pricing Regulation Scheme (PPRS) could be used as a model for developing a set of similar arrangements. For example, the PPRS states that parties must attempt to resolve differences by negotiation before initiating the dispute resolution process; whilst an industry body is involved in the selection and appointment of the chairman of the panel established to adjudicate on disputes.

3.3. Industry will fund up to 50% of the running costs of the SSRO through deductions from the price payable under single source contracts without having a say over the body’s outputs. The amount of funding will be determined each year by the Secretary of State on the advice of the SSRO and taken from payments made to contractors (see step 4 of the contract profit rate under Clause 17).

3.4. The cost of the current Yellow Book arrangements is approximately £270k per annum. The expected annual cost of the SSRO is £4m. MOD should communicate the value of this significant increase.

3.5. Past precedent demonstrates that the cost of non-departmental public bodies (NDPB) tends to increase over time. ADS recommends that Clause 19, which sets out the process for determining the SSRO funding adjustment, is amended to ensure that the SSRO gives due consideration to how the burden of potential cost growth of the SSRO should be shared to ensure that overall profit margins are not adversely affected.

3.6. Schedule 4 requires amendment to enhance the impartiality and independence of the SSRO by:

3.6.1. Ensuring that Industry is represented on the SSRO Board by allowing for a proportion of the Board’s members to be nominated by an industry body in accordance with the procedures laid down by the Office for the Commissioner for Public Appointments, as in the case of the Technology Strategy Board and the Advisory, Conciliation and Arbitration Service.

3.6.2. Giving Parliament and/or an appropriate select committee an opportunity to scrutinise appointments of executive and non-executive members of the SSRO.

3.6.3. Ensuring that industry’s contribution to the SSRO running costs reflects up to 50% of the cost of reviewing the profit formula periodically , creating and amending the Single Source Cost Standards , Single Source Contract Regulations and calculating the baseline profit rate annually.

3.6.4. Requiring that SSRO committees have a majority of members who are not members or employees of the SSRO.

3.7. The regulations made under Part 2 should also be subject to external consultation. The Bill should be amended to ensure that, before making any regulations, the Secretary of State consults an industry body and any other bodies and persons he thinks fit; and has regard for the consultation responses by laying a report of the results and his conclusions before Parliament.

3.8. The SSRO should also be obliged to consult externally when it undertakes its periodical review of Part 2 of the Bill and the accompanying regulations and require the Secretary of State to have regard for the consultation responses by laying a report of the results and his conclusions before Parliament.

4. Defining the circumstances in which the Secretary of State may exempt a Qualifying Defence Contract/Sub Contract from the regulations (Subsection 7 of Clause 14)

4.1. It is of great concern to industry that the Bill does not state whether the regulations will apply universally, i.e. to overseas as well as UK suppliers. Subsection 7 of Clause 14 allows the Secretary of State to exempt any single source contract from the new regulations. Industry recognises that there will be occasions when it is necessary to exempt a contract from the regulations. However, the circumstances in which an exemption can be granted and the criteria against which an application for an exemption is assessed should be clearly defined. Failure to include these measures may create an unlevel playing field in which it will be easier for overseas suppliers to obtain an exemption. UK companies may subsequently be disadvantaged.

4.2. Exempting overseas suppliers from the stringent monitoring and compliance regulations provided for in Clauses 23 to 26 and Clauses 30 to 33 respectively places an additional cost burden on UK suppliers and their supply chains, putting them at a competitive disadvantage in international markets. Overseas suppliers may fare better under the new regime than UK counterparts because their contracts are more likely to be exempt from the regulations. Single source contracts awarded as follow-on contracts to those placed as a result of competition are particular concerns (e.g. spares, support and Through Life Support contracts).

4.3. ADS notes that the Secretary of State may delegate his decision-making powers on exemptions to the new operating entity, which could have consequences for the accountability of decisions.

4.4. The Bill must define the circumstances when a Qualifying Defence Contract/Sub Contract can be exempted from the regulations and the exemption process must be transparent.

5. Improving predictability over contract prices and profit (Clauses 18, 20, 21 and 23)

5.1. Directors require a high degree of predictability over cost, price, and contract risks and obligations when approving tenders, authorising their submission and accepting contracts. They must be certain that the price will ensure a fair and reasonable return to shareholders for the risks taken.

5.2. The Bill may undermine predictability by allowing the SSRO to adjust the final price of a contract and monitor and adjust contract prices through a new reporting regime which gives MOD a general audit right and places a responsibility on suppliers to demonstrate that a cost is "appropriate, attributable and reasonable". The uncertainty may have unintended consequences for shareholder value, group decisions on where to invest, and the perception in the wider market place that the UK is a good place to invest.

5.3. The sense of ambiguity is heightened by the absence of any obligation for MOD to respond, accept or approve cost and pricing data provided to it within a specific timescale.

5.4. The legislation should contain an obligation for MOD and contractor to disclose to each other all facts likely to affect the agreed price of a contract. It should also require that the disclosures must be made at or before the price for the contract or amendment was agreed, and in sufficient time to allow the other party to assess and evaluate the information disclosed.

5.5. As it stands, the logical end-point of the new regime will be for a supplier to refer its own contract to the SSRO at the start of a contract in order to gain greater confidence over price and profit. MOD should make clear the purpose of the proposed new operating model and explain what assessment it has made of potential unintended behavioural consequences of the new regime.

5.6. The final Bill must recognise the restrictions on publicly-listed companies and their subsidiaries when providing certain information under Stock Exchange regulations. Clause 25 should be amended to read that "single source contract regulations must disapply a requirement [of the Bill]…to the extent that compliance with the requirement would…contravene a relevant restriction." This would make mandatory the disapplication of the regulations when compliance with the requirement would breach legislation or private law.

5.7. Boardroom predictability over price needs to be enhanced by amending the Bill to:

5.7.1. Define the specific types of information that will be covered by the new regime.

5.7.2. Limit the number of times, and the timeframe in which, MOD can challenge a contract price.

5.7.3. Define how a cost will be determined to be ‘appropriate, attributable and reasonable’.

5.7.4. Define the grounds on which a challenge to a contract price may be made.

5.8. Clause 21 states that the regulations may provide for adjustments to the total price, without stating a purpose or criteria for those adjustments. This creates uncertainty for the supplier on the total price of a contract. The Clause should be amended to define the purpose for regulations on final price adjustment of qualifying defence contracts.

5.9. Clarity over contract price could be improved by restricting the timeframe in which a contractor may be asked to show that the criteria for an allowable cost has been met in relation to a particular cost. As drafted, the Bill enables the Secretary of State to ask the contractor at any time to demonstrate that a cost is an allowable cost. Given that the purpose of the Bill concerns the pricing of certain contracts, the period during which a request may be made should be limited to the period before a price is agreed or before overhead rates are agreed (Clause 20, Subsection 4).

6. Improving business confidence by setting the basis on which profit is determined (Clauses 17 and 18)

6.1. The current Government Profit Formula and Associate Arrangement determines the Baseline Profit Allowance (BPA) and equates to the average profit earned by companies listed on the London Stock Exchange. In practice, the profit allowance on UK single source contracts is broadly similar to the profit earned for performing similar work in other countries such as the US, Canada and France.

6.2. The Bill does not define how profit allowance will be determined. Yet profitability is an important consideration when a board decides whether to bid for a contract. The consequent impact on profitability may undermine boardroom confidence in bidding for contracts.

6.3. Large defence contractors operate globally. An adverse change in profit earned from UK single source contracts in comparison to overseas contracts may undermine willingness to invest in the UK. The final profit formula should avoid encouraging suppliers to construct complex contract structures that have the net effect of offshoring the delivery of UK single source contracts.

6.4. ADS recommends that Clause 17 be amended to enshrine the comparability principle and tie the BPA calculation to profit earned by wider UK industry.

7. Fair application of the regulations to subcontractors and SMEs (Clauses 27 to 29)

7.1. SMEs are a vital part of the UK Defence Industry. Their flexibility and innovation provide great value to the Armed Forces and to the primes which they supply. ADS supports MOD’s efforts to ensure that SMEs have more opportunities to become suppliers.

7.2. A significant proportion of MOD contracts are non-competitive: in 2011/12, 63% of the total number of new MOD contracts (4,598) were single source; 40% of the total value of MOD contracts were single source. In 2011/12, 285 companies were paid £50m or less by MOD; 87 companies were paid over £50m. [2] A significant volume of contracts were therefore of relatively low value.

7.3. Primes may encounter significant practical difficulties in applying the new single source contract regime to their own suppliers. It is possible to envisage a situation in which a single source subcontractor, for whom defence work represents a small part of their business, declines a contract due to the onerous nature of the new regime. This has the potential to cause disproportionate disruption in supply chains and MOD programmes.

7.4. The burden placed on companies by the new regime may also act as a barrier to entry for SMEs seeking to enter the UK defence supply chain or as a disincentive to remaining in the market.

7.5. The current drafting of Clauses 27 and 28 suggests that the regime is likely to apply to all single source subcontracts. The Bill should be amended so that the regime only applies to subcontracts of a significant value (for example, above £50m) providing goods, services or works directly for a qualifying defence contract.

8. Improving the protection of suppliers’ commercially sensitive and confidential information (Clause 37; Schedule 5)

8.1. IP and sensitive commercial information is critical to business success. Information received by MOD and the Single Source Regulations Office (SSRO) must be treated with care and appropriate penalties must be in place.

8.2. The increased totality of information to which MOD and the SSRO will have access under the new regime will be more sensitive than that disclosed previously to MOD. The detail, volume and regular reporting of information will have an aggregating effect making it ‘super-sensitive’.

8.3. ADS supports Clause 37 and Schedule 5, which create a criminal offence of unauthorised release of protected information.

8.4. The Bill requires a deliberate act before unauthorised disclosure of information becomes a criminal offence. Greater assurances are required to demonstrate that commercially sensitive information received by MOD under the new regime will be held securely. Schedule 5 should be amended to include a criminal offence of failing to protect suppliers’ information, which would mirror the provisions in the Data Protection Act 1998.

8.5. The Bill requires amendment to ensure that the internal procedures of MOD and the SSRO for protecting information from unauthorised disclosure are subject to external third part audit, replicating the responsibilities of the Date Controller under the Data Protection Act 1998.

8.6. Further work is required to define the categories of information that will be protected by the provisions of the Bill, as this is currently unclear.

Part 3 – Reserve Forces

9. Supporting employers of Reservists by improving the transparency of the deployment and appeals processes (Clause 43)

9.1. From primes to SMEs, the UK Defence Industry has a close relationship with the Armed Forces including the Reserves. Industry recognises the increased future role of Reserves and supports the principles of the provisions in the Bill.

9.2. Clause 43, Subsection 4 places a greater burden on employers of Reserve Force members by allowing Reservists to be deployed for any purpose for which Regular Forces may be used. Subsection 6 extends the maximum duration of service for members of the Reserve Forces.

9.3. Increased demands on the Reserve Forces may impact SMEs employing Reservists with unique skill-sets. Reservists are most likely to be mobilised for deployment during times of conflict, at a time that is by its very nature busiest for the UK Defence Industry. A paradox therefore exists whereby defence SMEs may lose valuable employees in times of conflict when they must step up production. Greater clarity is required as to what steps will be taken to support SMEs in these circumstances and what appeals process will be put in place to protect employers. A mechanism is required to enable a compromise agreement to be reached on the restricted availability of certain Reservists in key SME jobs. The existing appeals process may prevent flexible arrangements.

10. Sponsored Reserves

10.1. The Bill does not mention Sponsored Reserves. ADS would support an explanation of what implications Part 3 of the Bill has for the role of Sponsored Reserves within the Reserve Forces. The Defence Reform Bill is an opportunity to provide a link between the Reserve Force and the Whole Force Concept designed to provide more integrated and efficient provision of defence capability.

About ADS

ADS is the trade organisation advancing the UK Aerospace, Defence, Security and Space industries. Farnborough International Limited (FIL), which runs the Farnborough International Airshow, is a wholly-owned subsidiary. ADS has offices in England, Scotland, Northern Ireland, France, and India. ADS comprises over 900 member companies within the industries it represents, of which over 850 are small and medium enterprises (SMEs). Together with its regional partners, ADS represents over 2,600 companies across the UK supply chain.

August 2013

[1] Current MOD IPR policy follows Government policy. For contracts funded by MOD, ownership of IP arising from the con tract is owned by the developer; however, MOD takes rights to use the IP itself or have it used by others for the purpose of government contracts free of charge. This allows the IP to be exploited more readily. DEFCON is the term used for MOD def ence con ditions. DEFCONs are standard form conditions of contract which are referred to in MOD invitations to tender and purchase contracts.

[2] Figures sourced from DASA Defence Statistics 2012.

Prepared 4th September 2013