South Korea cancels F-16 upgrade deal with BAE Systems: Pentagon

By Andrea Shalal WASHINGTON (Reuters) - The U.S. government on Wednesday said it had cancelled, at the request of South Korea, early work by the U.S. unit of Britain's BAE Systems on upgrades for 134 F-16 fighter jets after a spike in the projected $1.7 billion cost of the arms deal. The unusual move, announced by the Pentagon's Defence Security Cooperation Agency, paves the way for South Korea to pursue a similar upgrade deal with Lockheed Martin Corp , the warplanes' original manufacturer. Sources familiar with the matter said preliminary talks between South Korea and Lockheed would begin on Thursday. Seoul's decision raises questions about the ability of non-original equipment makers like BAE to compete in the market to upgrade thousands of F-16s in use around the world. BAE was the first non-OEM to win a competition to upgrade F-16s. South Korea in October said it could cancel the project and seek a different contract after the U.S. Air Force told Seoul the projected cost of 1.75 trillion won ($1.7 billion) could rise by 800 billion won. BAE said it remained convinced that it could have done the work "in an efficient and cost-effective manner. "Unfortunately, the programme was impacted by Korea's strict budget limitations and the U.S. Air Force's conservative approach to the overall programme cost," said spokesman Brian Roehrkasse. BAE said it learned of Seoul's decision on Wednesday and would now assess when to send layoff notices to 205 affected employees. The Air Force had already halted some work on the project last week. U.S. officials said the Air Force increased its cost estimate after the U.S. government determined the sensitivity of equipment involved meant the contract could not be negotiated by BAE directly with Seoul as a direct commercial sale, and should be handled as a government-to-government foreign arms sale. Such sales are generally more expensive and broader in scope to ensure that the requesting country has the needed training, spares, infrastructure and other equipment to operate the new weapons, said one U.S. official, speaking on background. U.S. officials said they told the Seoul government two years ago that there was a substantial risk that the projected cost would rise to cover the "total package approach." After a detailed calculation, the Air Force concluded this past summer that the overall deal would cost South Korea between $2.1 billion and $2.4 billion, versus initial estimates of around $1.7 billion, the officials said. The officials said Seoul's decision did not change the U.S. government's confidence in BAE as a contractor. In Seoul, South Korea's defence contract agency said work by BAE has been suspended but talks were still ongoing between the two governments to reach a final conclusion. "I understand that, if the conditions we're seeking are not met by BAE Systems or the U.S. government, we could be looking at other options, that's what has been mentioned," Defence Acquisition Programme Administration Spokesman Kim Si-cheol said. U.S. officials said South Korea told Washington it wanted to cancel the deal on Oct. 29. Seoul faces "sizeable" termination fees for ending the contract "for convenience," they said. BAE executives repeatedly said they were willing to perform the work under the terms of the firm, fixed-price contract initially proposed. Part of the cost increase was due to changes in the scope of work, but the Air Force also increased its cost and "risk reserves," said sources familiar with the programme. U.S. officials said the cost estimates were based on historical data and detailed discussions with South Korea and BAE. They denied any "risk reserve" was added. Vice Admiral Joe Rixey, who heads the Pentagon agency, said South Korea remained a vital ally and valued foreign military sales customer. U.S. officials said no talks had begun with an alternate provider and it could take four to six months before any such deal was agreed to and Congress was notified. Lockheed said it felt it was uniquely qualified as the original manufacturer and design authority to provide "best value" to potential F-16 upgrade customers. (Reporting by Andrea Shalal; Additional reporting by Joyce Lee in Seoul; Editing by Ros Krasny, Sandra Maler and Leslie Adler)