Session 2 Discussion Paper
Licensed Production Overseas: Time for a New Control Initiative?

Ian Davis (BASIC)

What is known about licensed production

Licensed production overseas[1] and licensed manufacturing agreements are increasingly common in many commercial fields, from the music industry to pharmaceuticals. This discussion paper is concerned with military-related licensed production overseas with a particular emphasis on small arms and light weapons (SALW).[2]

Licensed production in defence manufacturing has been operating since the late nineteenth century, but there has been a rapid increase in the number of companies and countries producing arms since the Second World War, and especially in the post Cold War era. This can partially be explained by the creation of more states, the privatisation of arms manufacturing, and increased globalisation of production. In addition to the traditional arms manufacturers (i.e. the former Soviet Union, the United States, Eastern and Western Europe) other regions are increasingly manufacturing arms and their components, especially SALW. Africa, for example, has seen a doubling in the number of small arms producing firms in the 1990s.

What is not known

There is very little comprehensive information available in the public domain either in North America or Europe on the numbers or details of licensed production agreements. This is largely due to the 'commercial confidentiality' of such agreements. The UK Select Committee on Defence, for example, noted in a recent report that: "There is not as much information available on the subject as we would have wished". In particular, the economic consequences for developing countries arising from licensed production agreements are not well known. Such agreements (especially in relation to major defence contracts) are increasingly popular seemingly because of the economic benefits that accrue to all parties - but is this really the case, however? Are licensed production agreements the most appropriate and efficient means for satisfying legitimate needs of security and defence in developing countries?

Scope of licences

When a licence to manufacture a weapon system or weapons-related components is granted the scope of the licence must be defined. The 'licensor' can place restrictions on the 'licensee's' right to use the licensed property in three main respects: subject matter; territory; and improvements. In most cases the licensee pays royalties to the licensor, as a lump sum payment, annual fixed sum payments, fixed sum per unit produced, a percentage of the selling price of the product, or any combination of these methods.

The regulatory dilemma

The main regulatory dilemma is the ease by which licensees can export weapons produced under licence to third countries in violation of the original licence agreement. Even when the host government of the licensing company makes an effort to implement and enforce adequate controls (for example through placing ceilings on production or restrictions on export or end-use) licensed production overseas agreements are liable to be breached with a subsequent loss of control. Control can also break down when the licensee adapts the initial weapon, in effect producing entirely unauthorized copies of the same or very similar weapons under a new name. For example, most current production of AK-47's takes place 'unlicensed', and as such (with more than 160 derivatives of the AK series), presents a particularly virulent form of proliferation. Licensed production agreements, combined with inadequate state controls on small arms in most countries, contribute to the massive proliferation and misuse of such weapons. In many instances these arms are manufactured by countries that would not be permitted destinations for arms exports because of their poor human rights record or concerns about sustainable development.

Current regulatory practices: two options

Option 1: Controlling the physical transfer of components or technology

Under this option, governments (such as the UK Government) seek to control licensed production by controlling the materials and parts required to implement a licensed production agreement, rather than controlling the agreement itself. There are two pitfalls with this approach. First, individual components or technology transfers required for licensed production may not appear controversial in isolation, but may do so when considered in the context of a licensed production agreement as a whole. Moreover, some individual components or services may not be subject to controls. Second, once a licensed production deal has been established and all the machine tools, blueprints and other components have been transferred to the licensee, the government (and to some extent, the original licensing company) loses control of the licensed production process.

Option 2: Controlling licensed production agreements

In overseeing the scope and content of the actual license, the state has the option of influencing the level and terms of the restrictions, as set out above. The main area of concern is to safeguard against re-export or re-transfer to an end-use, end-user or destination not previously authorised in the contract. In the case of the United States, for example, a non-transfer and use certificate is a condition of granting a license for all defence articles, including manufacturing licenses and technical data. This certificate is binding on the foreign end-user. If the foreign end-user is not a government agency (for example, if the transfer is to an overseas manufacturer), the US authorities may also insist on a guarantee from the government of the end-user that the end-use of the licensed article will be verified. If the value of the contract exceeds $50 million, the US State Department must notify Congress before the agreement is approved.

Violation of these provisions can lead to the original license being revoked and/or the imposition of sanctions. Simplified procedures apply to US transfers to NATO countries, Australia and Japan, where re-export or re-transfer may be undertaken under certain circumstances without the prior written approval of the US Office of Defense Trade Controls.

Regional and multilateral controls on licensed production

While explicit controls on aspects of licensed production can be found in the national legislation or administrative regulations of a number of states, harmonisation of such controls has not been widely discussed at either the regional or international levels. In terms of multilateral control mechanisms, only a few general provisions for regulating defence manufacturing can be found. One regional agreement that does contain explicit language on controlling licensed production is the OSCE Document on Small Arms and Light Weapons. The last EU Code of Conduct Annual Report also made reference to LPO.[3]

Potential policy responses by the EU-US

1. The US and EU governments could support research to better understand licensed production in general and examine how other industries have dealt with controlling this phenomenon.

2. Existing proliferation concerns strongly suggest that effective control of the ultimate use of equipment manufactured or technology transferred through licensed production overseas requires explicit Government authorisation of the production agreement itself, as is the case in the United States, Germany and Sweden. All EU Member States could adopt Option 2 controls on licensed production.

3. The US and EU could set out clear and consistent enforcement principles on licensed production, including strengthened provisions for end-use monitoring of such agreements. The most effective system would include provisions whereby an end-use certificate takes the form of a legally binding contract which contains a list of proscribed uses and a prohibition on unauthorized re-export, and which grants governments explicit authority to revoke licences where end-use understandings are broken.

4. The US and EU could explore mechanisms for enhancing internal company compliance procedures in relation to licensed production.

5. EU member states could press for EU-wide (and EU-US) harmonisation of controls on licensed production agreements, with a minimum requirement for control mechanisms requiring prior licensing approval from companies seeking to establish licensed production facilities overseas. The criteria for such government authorisation, and the end use control systems could also be harmonised at the EU-level and be as stringent as for direct exports.

6. The EU and US could take a leadership role in promoting effective international control of licensed production of SALW and in establishing clear commitments and processes for taking forward international action in this area. In particular, the EU and US could promote a review, at the first biennial meeting in July 2003, of national approaches to controlling licensed production with a view to establishing best practice and developing effective national, regional and international controls.

7. EU member states could call for a study group within COARM to draw up objective criteria for assessing the economic consequences of licensed production agreements in less developed countries, especially in relation to the application of Criterion Eight in the EU Code of Conduct on Arms Exports.

8. The EU and US could support a number of regional case studies on the impact of a range of licensed production overseas agreements on human security and sustainable development in the recipient states and the impact on regional arms control arrangements.