Some thoughts on Carillion's liquidation and systemic risk management in public procurement

REUTERS/Simon Dawson

The story that was developing over the weekend finally broke as Carillion plc has gone into compulsory liquidation. Carillion is one of the largest contractors of the UK public sector and holds a very large number of contracts for a range of infrastructure and services projects. The immediate concern of the UK government will now be how to ensure continuous provision of those services (which include catering and cleaning services for schools and hospitals), and finding ways to ensure completion of the ongoing infrastructure projects, possibly through 'bringing them in-house' or re-nationalising the contracts--although it seems a reasonable to question whether there is capacity in the civil service and in local government to manage such a volume of complex outsourced contracts.

However, that is not the focus of this post. In my view, one of the aspects that should not go unnoticed in this crisis is that the public sector had had information pointing towards Carillion's increasingly dire financial situation for a while. Indeed, as The Guardian reports, "Carillion ran into financial difficulties last year after issuing three profit warnings in five months and writing down more than £1bn from the value of contracts. It has debts of about £1bn and a £600m pension deficit, and is being investigated by the Financial Conduct Authority over announcements made between December 2016 and July 2017." Very clear information about Carillion's severe financial difficulties was in the public domain in November 2017, and the first of the three consecutive profit warnings had been issued as early as July 2017.

Here, I offer some thoughts on the share of responsibility that could arise for UK contracting authorities due to poor management of the systemic risk created by the accumulation of contracts on Carillion's hands, including some awards completed after Carillion published information of its financial difficulties (for example, a 4-year £84mn contract for energy maintenance and repair services for public housing in the Belfast region in November 2017). The UK Government should not be able to decline all responsibility, as it was informed and monitoring the situation. Indeed, The Guardian reported three months ago that "The government, one of [Carillion's] major customers, said it was being kept informed. 'We remain supportive of their ongoing discussions with their stakeholders and await future updates on their progress,' the Cabinet Office said". 

Domestic public procurement law (in particular, reg. 58 of the Public Contracts Regulations 2015) empowers contracting authorities to monitor the economic and financial standing of tenderers before they award contracts. It is explicitly stated that "Ratios, for example that between assets and liabilities, may be taken into consideration where the contracting authority specifies the methods and criteria for such consideration in the procurement documents, but such methods and criteria shall be transparent, objective and non-discriminatory" (reg.58(10) PCR2015). It has been long standing UK Government policy to assess the financial risk implicit in the award of a contract due to the economic and financial standing of the would-be contractor. Currently, the relevant guidance to that effect is in the Procurement Policy Note on 'Supplier Financial Risk Issues' of 2013, which requires contracting authorities, as part of a regular procurement exercise, to "Assess the risk to public sector business and/or public money which would result if a potential provider bidding for a contract were to go out of business during the life of the contract, or have inadequate financial resources to perform the contract".

There is no question, then, that contracts recently awarded to Carillion should be under suspicion of potential shortcomings in the assessment of its economic and financial standing. Of course, this may be complicated due to the certainly complex corporate structure in which the industrial conglomerate is organised, but the fact that self-certification has been operative in the UK since 2016 (at least in theory), raises important questions as to the ability of contracting authorities to carry out effective monitoring of tenderers' capabilities and the financial risk implicit in contracting.

On that note, it should also be recognised that the monitoring of the contractor's economic and financial standing is largely limited to procurement phases prior to conclusion of the relevant contract. This raises a more important point concerning the difficulties in managing systemic risks that derive from the accumulation of public contracts in the hands of a single supplier (however it is divided internally), which require a more complex and decentralised policy requiring effectiveness of the policies facilitating SME participation in procurement, which certainly remains an unresolved issue in the UK and in other EU jurisdictions. Given that large public sector contractors subcontract very significant volumes (if not the majority) of the works and services to SMEs, important questions should be raised as to the effective value for the public sector of allowing for the intermediation of such 'public contract brokers'.

In my view, this is reflective of the continued erosion of public sector capability to manage and oversee contracts (big and small), which requires 'ready-made' bundled contractual solutions. If the situation is to be reversed, in my view, governments should make a clear commitment to invest in the required skills and resources to ensure that the provision of important public services and the development of strategic infrastructure is not affected by systemic risks that go unnoticed or are unmanageable once realised. This is not a legal problem, but mainly a political issue that requires committing the required level of funding in rebuilding the capacity that the public sector has lost. Given pressures in other areas (such as direct NHS funding), this is certainly a big ask. But, unless the public sector re-skills itself, not only the management of crises, but the regular operation of public services will continue to be dependent on the ups and downs of the private market--where undertakings, however big, are not too big to fail.

Some thoughts on recent ECJ case law at ERA's annual conference on European Procurement Law

One more year, it has been a pleasure to participate in ERA's Annual Conference on European Public Procurement Law, and to exchange views with practitioners and policy-makers about recent developments and future challenges in this important area of EU economic law. It has also been an honour to contribute to the celebrations of ERA's 25 years of good work towards improving our knowledge of EU law.

This year, I was invited to provide some critical remarks on recent case law of the ECJ in some areas of practical relevance and, in particular, on case law concerning:

1. the rules on subcontracting and teaming or consortium bidding,
2. the rules on contract modification and termination; and
3. the scope of the concessions Directive.

My main remarks concentrated on

1. the difficulties of keeping the right balance between preserving the maximum possible procedural flexibility to ensure participation in tenders by groupings of economic operators (loosely defined) and allowing the contracting authority to scrutinise the technical and economic standing of joint bidders--while ensuring that competition rules are respected and the supreme and directly effective provisions of the TFEU (notably Art 101) are enforced at all levels of procurement activity;
2. the challenges in adapting a commercially-oriented approach to the adjudication of disputes at execution phase where the risks of discriminatory or anti-competitive procurement are largely absent; and
3. the limited advances made so far in fine tuning the definition of a concession contract, in particular in cases not involving relatively straightforward instances of improper use of the label 'concession' (such as using it to refer to licences or authorisations), or not involving the need to differentiate the scope of application of the rules in what is now Dir 2014/23 and competing frameworks, such as the Services Directive or the Transport Regulation.

The slides I used appear below. The presentation was recorded and will soon be available (keep an eye on @how2crackanut for details).

Impact of the ECJ’s jurisprudence in practice (ERA March 2017) from Albert Sanchez Graells

CJEU ignores commercial reality and sets unjustified contractual boilerplate requirements for contractual modifications (C-549/14)

In its Judgment of 7 September 2016 in Finn Frogne, C-549/14, EU:C:2016:634, the European Court of Justice (ECJ) issued guidance on the requirements (and constraints) derived from the principle of equal treatment in situations where the difficulties in the performance of a contract are such that the contracting authority decides to settle its early termination in a way that implies a material amendment to the initial contract. This case is relevant in the early stages of the new rules on contract modification and termination in Articles 72 and 73 of Directive 2014/24. However, the compatibility between the Finn Frogne Judgment and these new rules raises several questions.

In Finn Frogne, and according to the rather limited facts given in the Judgment, the dispute concerned the contract for the supply of a global communications system common to all emergency response services and for the maintenance of that system for several years, which was awarded after a competitive dialogue. The execution of the contract was subsequently delayed due to difficulties for which neither the contracting authority nor the supplier accepted responsibility (in the terms of the ECJ, both parties disagreed "as to which party was responsible for making it impossible to perform the contract as stipulated", para 10), which eventually led them to enter into a settlement involving the reduction of the contract and each party waiving all other rights arising from the original contract (para 11).

The main point of contention was that the settlement not only included the supply of equipment initially covered by the original contract (a radio communications system), but also the sale of two central server farms which the contractor had itself acquired with a view to leasing them to the contracting authority in performance of the original contract (paras 11 and 19). The settlement was the object of a voluntary ex ante transparency notice and subsequently challenged by a third party.

The legal issue in front of the ECJ was "in essence, whether Article 2 of Directive 2004/18 must be interpreted as meaning that, following the award of a public contract, a material amendment cannot be made to it without a new tendering procedure being initiated, even in the case where the amendment is, objectively, a type of settlement agreement, with both parties agreeing to mutual waivers, designed to bring an end to a dispute with an uncertain outcome, which arose from the difficulties encountered in the performance of that contract" (para 27). Or, in simple terms, whether settling the disputes that had made the commercial relationship between the supplier and the contracting authority non-viable in a way that implied a substantive amendment of the initial contract breached the principle of equal treatment and the obligation of transparency.

In Finn Frogne, the ECJ first took the opportunity to clarify its case law in pressetext (C‑454/06, EU:C:2008:351) and in Wall (C‑91/08, EU:C:2010:182) in the sense of emphasising that a material reduction of the scope of a public contract is equally caught by the restrictions on contract modification as a material extension of the scope of that contract. The reasons for this are as follows:

an amendment of the elements of a contract consisting in a reduction in the scope of that contract’s subject matter may result in it being brought within reach of a greater number of economic operators. Provided that the original scope of the contract meant that only certain undertakings were capable of presenting an application or submitting a tender, any reduction in the scope of that contract may result in that contract being of interest also to smaller economic operators. Moreover, since the minimum levels of ability required for a specific contract must ... be related and proportionate to the subject matter of the contract, a reduction in that contract’s scope is capable of resulting in a proportional reduction of the level of the abilities required of the candidates or tenderers (C-549/14, para 29).

This makes logical sense and is generally linked with the discussion of the division of contracts into lots and how to manage volume-related restrictions of competition for public contracts. However, in the context of a contractual settlement aimed at terminating the commercial relationship between the original (larger) provider and the contracting authority, this would lead to the conclusion that, in a case of breakdown of the commercial relationship implicit in all public contracts, "the principle of equal treatment and the obligation of transparency imply that a contracting authority cannot consider entering into a settlement to resolve the difficulties arising from the performance of a public contract without this automatically giving rise to the obligation to organise a new tendering procedure relating to the terms of that settlement" (para 24), which the referring court considered problematic.

Indeed, in my opinion, taking this position would create situations where the contracting authority is simply in a catch 22 by having to either remain committed to a non-functioning contractual relationship that is not allowing it to perform its public functions to which the contract is instrumental, or having to spend significant funds in the creation of an alternative commercial relationship that may not be the best solution for its needs--particularly if there are economies to be had from preserving part of the original contract or the preparatory actions which the parties had already undertaken in view of its performance.

Regardless of this clear practical difficulty, the ECJ considered that

neither (i) the fact that a material amendment of the terms of a contract results not from the deliberate intention of the contracting authority and the successful tenderer to renegotiate the terms of that contract, but from their intention to reach a settlement in order to resolve objective difficulties encountered in the performance of the contract nor (ii) the objectively unpredictable nature of the performance of certain aspects of the contract can provide justification for the decision to carry out that amendment without respecting the principle of equal treatment from which all operators potentially interested in a public contract must benefit (C-549/14, para 29).

Consequently, it stuck to its previous line of case law in Succhi di Frutta (C‑496/99 P, EU:C:2004:236) whereby any material modification of a public contract requires a new tender (para 38), but placed significant emphasis on the fact that

Although the principle of equal treatment and the obligation of transparency must be guaranteed even in regard to specific public contracts, this does not mean that the particular aspects of those contracts cannot be taken into account. That legal imperative and that practical necessity are reconciled, first, through strict compliance with the conditions of a contract as they were laid down in the contract documents up to the end of the implementation phase of that contract, but also, second, through the possibility of making express provision, in those documents, for the option for the contracting authority to adjust certain conditions, even material ones, of that contract after it has been awarded. By expressly providing for that option and setting the rules for the application thereof in those documents, the contracting authority ensures that all economic operators interested in participating in the procurement procedure are aware of that possibility from the outset and are therefore on an equal footing when formulating their respective tenders (C-549/14, para 37, emphasis added).

Ultimately, the ECJ ruled that

Article 2 of Directive 2004/18 must be interpreted as meaning that, following the award of a public contract, a material amendment cannot be made to that contract without a new tendering procedure being initiated even in the case where that amendment is, objectively, a type of settlement agreement, with both parties agreeing to mutual waivers, designed to bring an end to a dispute the outcome of which is uncertain, which arose from the difficulties encountered in the performance of that contract. The position would be different only if the contract documents provided for the possibility of adjusting certain conditions, even material ones, after the contract had been awarded and fixed the detailed rules for the application of that possibility (C-549/14, para 40, emphasis added).

In my view, the Finn Frogne Judgment must be criticised, at least for two reasons.

First, because it is very difficult to coordinate with the functional approach of Art 72 (and to some extent, 73) of Directive 2014/24 and gives excessive deference to the creation of contractual modification mechanisms. Strictly on the coordination aspect, it is worth stressing that Art 72 seems to be concerned with extensions of the contractual object, but not with its reduction (Art 72(4)(c)), and with qualitative or technical changes that would have allowed other tenderers to participate (Art 72(4)(a)). In the Finn Frogne case, there would have seemed to be more reason to challenge the content of the settlement on the basis that it changed one of those conditions (sale rather than lease of the central server farms) rather than on the change of overall value of the contract. 

Moreover, it is worth stressing that Art 72 also provides significant leeway for the modification of contracts up to 50% of their value (per modification, without a maximum cap) where a diligent contracting authority could not have foreseen the circumstances leading to the need for the contractual modification. Implicitly, the ECJ seems to indicate that every diligent contracting authority needs to foresee the possibility of the commercial relationship breaking down (which may be fair enough), but it also goes on to require a full contractual regulation of how such termination of the contractual relationship needs to unfold.

In that regard, it must be stressed that the requirements for the inclusion of "general" contractual review clauses foreseen in Art 72(1)(a) demands them to be "clear, precise and unequivocal", which may or not be coincidental with the ECJ's requirement for the contractual arrangements to fix "the detailed rules for the application [of] the possibility of adjusting certain conditions"--and which may not be (feasibly) applicable to "termination through settlement" clauses, whereby the parties must necessarily engage in negotiations.

In my view, the ECJ has fallen in the same problematic assumption of the possibility to design "perfect contracts" explicitly and exhaustively regulating all consequences of their (un)foreseeable non-viability or imperfection that also affects the provision in Art 72(1)(a) of Dir 2014/24 [for criticism, see A Sanchez-Graells, Public procurement and the EU competition rules, 2nd edn (Oxford, Hart, 2015) 428], but with the aggravating factor of not acknowledging that they may also be totally ineffective in scenarios where the commercial relationship is broken and, consequently, the parties need to settle, mediate, arbitrate or litigate those consequences regardless of the prior inclusion of such contractual clause.

The second reason why the Finn Frogne Judgment needs to be criticised is because it does not make any effort to attempt to distinguish between settlement conditions that remain strictly within the scope of the original contract and, consequently, only entail its partial enforcement (in its own terms) from settlements which include substantive changes in either their scope or the conditions for (partial) performance. While the first imply a consolidation of the effects already (de facto) created by the original contract, the latter seem to indicate the appearance of different needs of the contracting authority and/or different ways of satisfying them by the supplier. And, in my opinion, while the latter may justify the imposition of strict restrictions and (depending on the circumstances and the proportionality of the requirement) a new tender, the former do not seem to warrant such an approach.

These are issues that will necessarily arise again in litigation concerning the termination of contracts under the combined effect of Arts 72 and 73 of Directive 2014/24 and I would hope that the ECJ will adopt a more analytically rigorous approach when that happens because following the path started in Finn Frogne does not make commercial sense.

Delays in public procurement and liquidated damages (Dosi & Moretto, 2015): a further justification for new rules on modification and termination

In their recent paper, 'Procurement with Unenforceable Contract Time and the Law of Liquidated Damages' [(2015) 31(1) Journal of Law, Economics & Organisation 160-186], Cesare Dosi and Michele Moretto of the University of Padova find an interaction between the rules on liquidated damages for time overruns in public procurement and the (risky) bidding behaviour of tenderers.
 

More specifically, considering a scenario of insufficient (negative) incentives to meet time commitments due to suboptimal liquidated damages, they demonstrate that "[t]he inability to force sellers to meet their contractual obligations determines their bidding behavior. Conversely, bidding behavior alters the incentive to meet the contract time. In particular, by placing more aggressive bids, all bidders may become potential violators of the contractual agreement, and the more the bidders and/or the higher the expected cost volatility [of relevant inputs], the higher the probability of breach."

In my view, their general findings are interesting in themselves in the design of liquidated damages clauses to be included in procurement contracts. But, more importantly, their findings also stress a key justification for the new rules on contractual modifications and contract termination in Arts 72 and 73 of Directive 2014/24, which need to serve to actually empower contracting authorities to enforce the terms of the original contract as awarded. In economic terms and from this perspective, these rules deserve both criticism and praise.

In terms of contractual modification, and from the perspective of creating red lines that enforce time commitments, the rules in the new Directive can be criticised because Art 72 does not specifically address the issue of modification of deadlines for the execution of the contract--which is left to the residual clause in Art 72(1)(e) "modifications [that], irrespective of their value, are not substantial", in relation to 72(4)(a) "the modification introduces conditions which, had they been part of the initial procurement procedure, would have allowed for the admission of other candidates than those initially selected or for the acceptance of a tender other than that originally accepted or would have attracted additional participants in the procurement procedure". This sets a very difficult standard when it comes to interpret whether a deadline is essential and its modification is, consequently, "substantial" to the contract overall. This restricts the possibility to limit time-related negotiations between contractors and contracting entities during the term of the contract and perpetuates a problem that ultimately depends on domestic rules in the Member States.

Secondly, in terms of contract termination, that criticism is carried over to the rules in art 73, as one of the main causes for contractual termination is derived from an infringement of Art 72. However, it is also worth stressing that there is the possibility to create  causes for termination other than those expressly established by the Directive, for instance, to strengthen the consequences for contractors to miss contractual deadlines. In that regard, it is interesting that Art 73 is open ended and could create regulatory space for Member States to develop effective time-related termination rules (eg imposing contractual termination for breach of predetermined contractual milestones). 

Moreover, it is also interesting to note that Art 57(4)(g) Dir 2014/24 allows contracting authorities to exclude operators "where the economic operator has shown significant or persistent deficiencies in the performance of a substantive requirement under a prior public contract, a prior contract with a contracting entity or a prior concession contract which led to early termination of that prior contract, damages or other comparable sanctions". This would, again, increase the impact of failing to meet contractual deadlines. And, overall, it would counter one of the issues raised by Dosi & Moretto in their model: "[t]he inability to force sellers to meet their contractual obligations", which in turn would "determin[e] their bidding behavior" in a less risky way, so that they make sure ex ante that they can comply with contractual deadlines and the overall risk of non-compliance is reduced.