Here Comes Trouble

Overcharging on offender tagging contracts could be the tip of the iceberg as the public sector starts to investigate its long-term contracts. Paul Jarvis considers the implications for the PFI world, and whether it has learnt the lessons of the past

In July this year, private firms G4S and Serco were caught apparently overcharging the Ministry of Justice for criminal offender tagging contracts.

Many of the alleged incidents go back a significant period, and were only brought to light as part of a major examination of the contracts conducted by the justice department.

The findings have sent some in the PFI industry scurrying back to their contracts, checking that they are complying – and what their liabilities might be if it turns out they’re not. “These weren’t PFI contracts but effectively there is little difference: there is the service element,” says one consultant. “NOMS [the National Offender Management Service] went through these contracts to find the issues and officials are doing the same in PFI contracts.”

And it’s not only in the justice sector. Both at national and local level, there is a determination to cut the cost of contracts with the private sector, and with the squeeze being put on councils across the land, local authority deals are as likely as any to face scrutiny.

In this context, PFI deals are likely to be viewed as the same as any other contract with the private sector – except that the perception remains that PFI has proved bad value for money.

“The public sector is going to want its pound of flesh,” warns Liz Jenkins, a partner with law firm Clyde & Co. “There is a perception from the Commons public accounts committee and others that the public sector is paying too much. So to the extent to which they are able to get nasty, they might try to do that.”

This approach is in some ways part of government policy, through its drive to make savings on operational PFI projects. In June, the government finally launched its PFI code of conduct, designed to provide both the public and private sectors with guidelines on how to ensure a contract is performing to its optimum standard.

Its creation may empower public sector parties to get their contract out of the drawer, dust it off and make sure it is properly applied.

“The public sector has to be tougher,” says Tim Care, partner at law firm Bond Dickinson. “Not necessarily more aggressive, but they just need to make sure the contract is properly checked and applied.

“Some clients have found that paying someone for two days a week to manage the contract will more than repay the cost of employing them.”

He points out that, where contracts have been applied more rigorously by the public sector – in a fair way and in the spirit of the partnership – things have been found and dealt with quickly. “A lot of clients have put a lot of effort into looking at their contracts over the past 12 months and in so doing a number of things have cropped up, for example RPI uplift calculations have in some cases been wrong.”

On the other hand, it has long been feared that some authorities may see the creation of the code as carte blanche to begin imposing a series of penalties that will squeeze out the savings that they need, without having to spend large sums renegotiating the contracts.

“PFI type contracts are very hard to renegotiate because of financing requirements and where they are thought to be costly there is some anecdotal evidence that public authorities are monitoring contracts harder in order to demonstrate better value for money when service standards slip,” says Graham Beal, partner at financial consultancy Ernst & Young.

In July, it was reported that the Isle of Wight’s highways PFI contractor, Island Roads, could face financial penalties because the councillor in charge felt the standard of grass cutting has been unacceptable. While such things may have been overlooked in the past – particularly at the start of a new partnership – they are much more closely monitored today.

This can quickly escalate, warns Beal. “Where trust between the contractual parties has broken down, you sometimes see large teams on both the public and private sector sides checking everything against each other. Often this is not the spirit under which such contracts were negotiated or how monitoring regimes were intended to operate.”

Care suggests that the voluntary code will have little effect either way here. “You are not going to get people who haven’t done it already suddenly doing it, and it’s not going to resolve the issues of people making false assumptions because they haven’t looked at the contract.”

Although the public sector might want to get ‘nasty’ on contracts where they feel cheated, it is far from certain that they really have much clout. G4S and Serco quickly agreed to repay any overcharging in the tagging case, no doubt in part because they were dealing with a major procurer in the form of central government. Would a facilities management provider on a relatively small health or local authority PFI deal be quite so inclined to move, especially as their margins are often wafer thin to begin with?

“There is the age-old problem that a contract is a contract,” says Jenkins – but admits that it can be hard for the private sector to ignore pressure coming from one of the largest employers and procurers in the form of central government.

Experts have suggested that at least part of the problem in the Serco and G4S cases is around the interpretation of the contracts.

That could be a significant issue for PFI contracts, assuming that the public sector is now planning to apply the code of conduct rigorously and insist that clauses are interpreted in a way that is beneficial to both sides. “Historically, the contractor has interpreted the contracts, so this could open a Pandora’s Box,” warns one technical consultant.

Not everyone is convinced that the Serco/G4S situation is analogous with PFI, though. “Where the private sector is only the delivery agent, it will only be as good as the information it is given,” says one adviser. “With a lot of PFI contracts, the private sector is managing and is in control of the asset, and the interface with the public sector is much less.”

Nonetheless, the potential for disputes remains. “Difficulties occur if the specification is vague, because the charging will often follow that,” says Care.

“On some of the NHS acute hospital contracts, we have almost gone into full-blown disputes over what the payment mechanism means,” adds one lawyer.

“Early contracts in particular were not clear.” Jenkins warns that a more aggressive approach from the public sector could result in more contracts ending up in dispute and needing legal action to sort them out. “But does that really help?” she asks. “Ultimately, you have to have a relationship in these contracts.”

“Some PFIs have a three-month look back period covering contract interpretation issues,” says the technical consultant. “But not all of them do.”

Even where that look back period is in place, the public sector can always fall back on standard contract law if it genuinely feels there has been a breach. “I have seen some schemes where overpayment has been spotted a year or so after the event, and that has generally been dealt with quite quickly and easily,” says Care.

“[But] it would be more difficult if the relationship is already strained.” Gerry Askew, commercial director at facilities management provider SGP, agrees that if the public sector starts to look closely into where deductions and penalties should have been made, there is a danger that ad hoc arrangements, where trade-offs have been agreed informally, will be overlooked.

He has plenty of experience of working with public sector clients who had little knowledge of the contract, which can be a difficult time for a partnership. “One of the PPP buildings we work on has over 164 individual key performance indicators. It is no wonder then that when someone new joins the client team there is a period of learning about the contract,” he explains. “Of course after a few months they have usually familiarised themselves with the specifics and are in tune with the terminology, the decision making process and the metrics.”

So has the industry learnt the lessons of the past, and will contracts signed since the government launched its operational review of PFIs two years ago prove to be more transparent and less risky?

Askew suggests that contracts are now more transparent than in the past – but says this has been mainly down to improvements in monitoring technology and skill levels on both sides, rather than anything to do with the code of conduct.

“Standardisation means there is more certainty,” adds Jenkins. “But if you look at Building Schools for the Future, waste and housing PFIs, none closed easily despite standardisation.”

Care agrees that standardisation has helped up to a point. “Standardisation will never solve all the problems. There will always be project-specific issues. “Some standard documents have been appalling,” he continues. “But where they have caught up with the issues being seen on the ground, these are better.”

One technical adviser who has worked on a number of recent deals is more concerned, however. He warns that there are plenty of vulnerable projects being signed today that are ripe for the public sector to force deductions once they are in full swing.

His fear is that authorities, under pressure to make savings in operational contracts and to cut their revenue spending, will bring in financial consultants with the intention of going through projects with a fine toothcomb to see where deductions and penalties can be applied.

“There are questions around how well the payment mechanisms are being drafted at the moment,” says the adviser.

If problems do begin to arise within contracts, and penalties start to be applied retrospectively, it may be argued that the premise of self-monitoring on which many of these contracts have been based, has failed.

One direction to avoid these issues in future, however, might be to move away from the formal structures of PFI (or PF2) altogether, suggests Cathy Ley, partner at law firm Fladgate. She says the use of structural special purpose vehicles (SPVs), like the local asset-backed vehicle, might prevent such problems in future.

“That may give advantages because all parties can sit down as the board members of the SPV and respond to market conditions, for example, together,” she explains.

For those schemes already in existence, however, it looks like there will be some difficult discussions ahead as the public sector ups its game. As Care suggests, the private sector will need to respond to that and recognise it is now dealing with a more intelligent client.