New Contract Guidance for Government IT Projects

Government IT procurement policy in the UK underwent a fundamental change in July 2003 when HM Treasury announced in its policy paper, PFI – Meeting the Investment Challenge,[1] that the UK government would no longer be using PFI to finance IT procurement (the 2003 Policy). The Treasury however did not immediately provide detailed guidance on a replacement financing and payment mechanism or unveil a replacement contract that would be used for IT procurement.

For the last 18 months there has been some confusion in the private sector as to the specific impact of the new policy. In November 2004 the Office of Government Commerce clarified the new regime by releasing both a detailed policy document and also Model Contracts for government IT procurement.

Why the decision was made in 2003 to stop PFI for IT

The key characteristics of PFI (ie long-term contracts, large-scale projects and no upfront capital costs to government) are not well-suited to the procurement of IT for the following reasons:[2]

• the fast pace of change in the sector makes it difficult for the public sector to define the outputs it requires in a long-term contract

• regardless of whether it is in the private or the public sector, experience has shown that the larger and more ambitious the IT project the more likely it is to strike major problems

• the high level of integration of IT infrastructure into the other business systems of the procurer makes it difficult to delineate areas of responsibility between the procurer and the contractor, and so makes an appropriate sharing of risk more difficult both to discern and enforce; and

• the lack of a market for third-party finance.

The last factor is particularly significant. A downtown in the IT sector in the 1990s, together with the bad publicity that was generated when several of the early (very large and very ambitious) government IT projects ran into serious difficulties, has meant that a thriving market for third-party finance for IT PFI projects has never developed. This effectively precluded most small and medium-sized IT contractors from bidding for the larger PFI IT projects as they could not afford to finance months or even years of development until they started receiving service charges during the operational phase.

The government hopes that by moving away from PFI for IT procurement it will encourage shorter and more flexible contracts that will allow a wider range of contractors to bid. It should also increase the chances of success and reduce the costs of failure.

Overview of the new Decision Map Guidance

Parts 1 to 3 of Version 2 of the Decision Map Guidance for Procurement (the Decision Map) are of general application to any type of project. Part 4 relates specifically to IT projects.[3]

Part 4 is divided into 10 modules. The content of those modules should not come as a surprise to experienced practitioners as they reflect the position that is usually adopted by a sophisticated IT customer with significant bargaining power. The philosophy underpinning all of the new guidance is the attainment of value for money whilst at the same time transferring risk to the contractor where this is commercially sound.

Decision Map II refers to the two model contracts for IT Procurement -the Services Contract and the Supply Contract.[4] They are drafted as relatively complete contracts rather than being merely a bank of some of the clauses that could be used. Guidance is provided in Part 4 of the Decision Map Guidance on completing the schedules to the Model Contracts and also the drafting of additional clauses that may be needed for more complex projects.[5]

The Services Contract will be used for long-term contracts where the government is contracting for outputs. The Supply Contract will be used for shorter contracts where the government is contracting for inputs, ie where the contractor will provide certain deliverables, but will not be responsible for their operation (unless there is also a maintenance agreement).

The features of the new Model Contracts that will be of greatest interest to government authorities and private sector IT contractors are discussed below.

Specific contract issues

• Warranties

Government will in general not provide any warranties as to the state of affairs prior to the commencement of the contract. Instead the contractor will have sufficient opportunity to conduct due diligence.[6] Consequently the contractor will need to ensure that it notifies the government of any aspect of the operating environment that is not suitable for the provision of the proposed solution. The contract should include the costs and details of dealing with those issues.[7]

• Sharing the fruits of IPR exploitation

Consistent with the value for money ethos, the government will be content with a perpetual and royalty free licence for software, rather than outright ownership. It realises that the contractor is the best person to exploit the IP and is likely to charge a premium if it is required to transfer all IPRs relating to the contract to the government. Provided the government has the required licence there is no reason for it to pay a premium to own the IPR unless there are other policy considerations (eg national security).

Contractors will be less pleased to learn that the government will require a reduced contract price and/or a share in the licensing revenue if the contract will result in the development of bespoke software that has the potential for further commercial exploitation.[8]

• Delays

Regardless of the party which is at fault, the Services Contract obliges the contractor to deploy promptly all additional resources and take all reasonable steps to eliminate or mitigate the consequences of the delay.[9] This is part of the government’s “fix it first and argue later” approach.

If the fault is due to the contractor, it is liable to pay delay penalties. In addition there may not be any corresponding adjustment of the contract period. The shortening of the operational period will also reduce the contractor’s total profit as fewer service charge payments will be made by the government.

• Step-in rights

Government will have comprehensive step-in rights both as an alternative and as a pre-cursor to termination. Contractors are likely to resent such interference and that resentment will no doubt be exacerbated if the government exercises the right via a third party.[10] Such third parties will in most cases be a competitor and contractors will need to take steps to avoid revealing valuable IPR or in the worst case scenario being replaced as the contractor.

The same issues will also arise as part of the Escalation Process as the government can require the contractor to work with another supplier/contractor in a designated capacity.[11]

Step-in rights are less likely to be required under the Supply Contract as there is no ongoing service delivery to manage.

• Exclusion of Liability

Contractors will be pleased that the exclusion of liability for indirect, special or consequential losses and for loss of profit or expected turnover will apply to both parties to the contract. Contractors will not be as pleased to learn that carve-outs from this exclusion will allow the government to recover damages arising from any of the following:

• additional administrative costs, wasted expenditures and management time and third-party costs;


• loss of anticipated government revenue/savings; and


• loss or degradation of data.[12]

The Model Contracts make provision for financial caps for most types of liability as the government realises that, if it fails to do so, the contractor will need to increase the contract price to reflect the increased risk. The financial caps do not however apply to claims by the government under the indemnities provided by the contractor in respect of IPRs, VAT liabilities or employees.[13] In addition, the government may require an indemnity for loss of data due to a breach of the contractor’s obligations or contravention of the Data Protection Act 1998 or the Freedom of Information Act 2000.[14]

The use of service credits and delay payments as the exclusive remedy will apply only to less serious breaches.[15]

• Supply chain rights

Under the Model Contracts the government will have a contractual right to do all or any of the following:

• pre-approve all sub-contractors,


• pre-approve all material changes or terminations of all sub-contracts; and


• terminate the main agreement in the event of a change of control of a material sub-contractor.[16]

In all material sub-contracts the contractor is also required to:

• preserve the government’s rights under the Contracts (Rights of Third Parties) Act 1999;


• ensure it can assign, novate or transfer its rights to the government; and


• ensure it, the government or a third party nominated by the government can step-in to the sub-contract.[17]

The most intrusive aspect of the government’s supply chain rights are the provisions relating to competitive terms. [18] If the government is able to obtain from any sub-contractor or any third party more favourable terms with respect to the supply of goods, software or services used by the contractor, the government may require the contractor to match those terms. Alternatively the government can enter into a direct agreement with the sub-contractor or third party. If the government enters into a direct agreement for the supply of the relevant item then it will require a reduction in the service charges. The contractor will only be permitted to offset any unavoidable costs in respect of the substituted item, including any licence fees on early termination.

• Transitional arrangements following termination

Under the Services Contract, the government and the replacement contractor will have the right to access information relating to the services and the contractor personnel for up to 12 months following termination.[19] The standard wording permits the contractor to recover the reasonable costs of providing that access. The prior consent of the government must be obtained to remove or replace key personnel during the exit management period.[20]

Both the contractor and the government are required to comply with the Exit Plan annexed to the Services Contract. A model exit plan is not included but Module 8 in Part 4 of the Decision Map Guidance sets out the government’s view in relation to key issues concerning access to personnel, price, payment and adherence to performance standards.

Under the Supply Contract, the government has a number of options following termination.[21] If it occurs prior to the acceptance tests being passed by the contractor, the government may retain the contractor’s technical solution documentation for its own use or for a third party to use. Alternatively it can return the technical solution documentation and obtain a refund of any charges that it has paid. If termination of the Supply Contract occurs after acceptance, the government may require the contractor at its own expense to remove the deliverables and refund all the charges paid by the government.[22]

• Freedom of Information Act

To enable the government to comply with the Freedom of Information Act 2000 (the FOIA) the model contracts impose obligations on the contractor to provide information and assistance. Contractors will understandably be anxious to ensure that their commercially sensitive information and IP is not divulged to a third party who has made an FOIA request to the government.

The Act contains a number of absolute and qualified grounds for the government to refuse to provide information in response to an FOIA request.[23] However the exact ambit of those exceptions has yet to be tested by the courts. This means that there is the potential for such sensitive information to be revealed. To allay contractor concerns, the contract contains a schedule in which to list the documents which the parties agree contain “Confidential Information of the Contractor that is genuinely commercially sensitive, and may therefore be exempted”.

This solution provides only superficial protection to the contractor. Inclusion on the list will not of itself stop the government from disclosing the information without first notifying the contractor or obtaining its consent.[24] Contractors would no doubt prefer the contract to oblige the government to give at least one week’s prior notice to the contractor of any intended disclosure of a listed document.

The new payment regime

The model contracts do not contain the detailed contractual provisions for the new payment regime. Instead detailed guidance is provided in Module 10 of Part 4 of the Decision Map Guidance. The key features of the Guidance include the following:

• The payment structure in the Services Contract

The new payment model will include both milestone payments and service charges. Milestone payments will generally be paid during the application design and development phase and service charges will be paid during the operational phase.

Under the new system, the contractor may recover the cost of providing the asset (or at least a substantial portion of it) prior to the commencement of the operation of the service. Contrast this with pure PFI where the government will never pay directly for the underlying assets; under PFI the contractor’s costs of providing the assets are indirectly paid by the government over the life of the contract via the service charges.

Milestone payments will generally reflect the actual costs the contractor has incurred in delivering the value received by the government up to that point in time. Unless they are made after Authority to Proceed, they will not include the contractor’s profit margin. This is to ensure that the contractor is incentivised during the subsequent operational phase of the contract as some of its project return will be at risk during that period due to the threat of service credits being incurred due to sub-standard performance.

There will be two critical payment points in the Services Contract, both of which will usually attract milestone payments:

(i) “Authority to Proceed” – this is the point when the project goes live (ie the point at which the contractor is authorised to roll out the solution that has been developed); and

(ii) The “Contract Performance Point” – this is the point when the contract is fully operational. This will occur some time after Authority to Proceed, when the system has been accepted and rolled out and all the services envisaged are being provided under the contract. Contractors will push for the Contract Performance Point to occur as early as possible because after that point the government will lose the ability to claw back any milestone payments.[25]

The largest payment will be made on Authority to Proceed. Earlier payments could be made, for instance for a design deliverable, but this would only be on the basis of value provided.

Phased payments are permitted prior to the attainment of a milestone only if the following exceptional circumstances exist:

(a) there is greater than 12 months between milestones;

(b) by reducing the need for the contractor to obtain commercial financing of its working capital requirements, the contractor is able to reduce the price charged to the government;

(c) the phased payments are paid in arrears; and

(d) all the phased payments are covered by a letter of credit from the contractor’s bank. The letter of credit must be for the full amount of all the phased payments and will allow the government to claw back the full amount if the milestone is not reached.

Service charges will be subject to service credits and deductions.

All of the types of payment will be linked to the contractor demonstrating attainment of performance criteria specified in the contract. The intention is to demonstrate that, if the contract were terminated at the point of payment, the government would still have received value.

• The payment structure in the Supply Contract

Ideally the contactor’s technical solution will be agreed before the award of the contract and will be annexed to the contract as a schedule. The key payment date under the Supply Contract will be the “Acceptance Date”. This will occur once the contractor has satisfied the acceptance tests detailed by the parties in Schedule 6.1 to the contract. On the Acceptance Date the government will pay the contract price and receive title to the assets.

There may also be some contractor charges for support services following acceptance but this will occur only where there is a maintenance agreement.

Prior to the Acceptance Date the government can terminate the contract for any reason and reject the technical solution. It will also be entitled to a refund of all the money it has paid to the contractor. Alternatively the government can choose to retain the proposed technical solution and implement it itself or via a third party.[26] Note however that both termination and compensation payments may need to be paid by the government to the contractor if termination is for convenience (see below).

• Termination Payments

Under the normal PFI model, termination rarely occurs as termination costs are high. This is because the contracts are for long periods and termination payments usually include an element of loss of profit for the remaining contract period as well as compensating the contractor for its financing costs. However, as a result of the new payment structure in the Service Contract, at any given time in the contract lifecycle the contractor will have recouped the majority of its actual costs of development and deployment. As a result, the Model Contracts contain a right for the government to terminate not just for contractor breach but also for convenience.[27]

If the contract is terminated by the government for convenience, the contractor will receive a Termination Payment which is aimed at reimbursing the contractor for any of its unrecovered costs.[28] In addition, if less than 12 months’ notice is given, the contractor is entitled to a Compensation Payment which should not exceed the contractor’s return for the following 12 months.[29] If more than 12 months’ notice is given, the contractor is not eligible for a Compensation Payment. Both payments will be calculated in accordance with a pre-agreed formula annexed to the contract.

No compensation is payable if termination is due to the contractor’s default, but the government may choose to purchase some of the contract assets.

• Value for Money Mechanisms

The various value for money mechanisms that should be incorporated into the Services Contract include efficiency savings, gain share, open book accounting (this may extend to the contractor’s key affiliates and sub-contractors), audit rights and benchmarking. Those mechanisms are unlikely to be applicable to a Supply Contract as it will be of shorter duration.

• Financial Models

The new guidance will require standard calculation and presentation of information as to costs and marking-up of prices. The objective of the financial model is to provide full transparency as to the calculation of the bid price. The contractor will have few, if any, financial secrets. As discussed earlier, the commercial sensitivity of that information will raise issues for the contractor under the FOIA 2000.

The government requires both the contract and the sub-contracts to permit the Comptroller and Auditor General ( or an equivalent body such as the Audit Commission) access to the parties relevant accounting records. The contractor and its contractors and sub-contractors will also be obliged to disclose any information required pursuant to the National Audit Act 1983.[30] The contractor will not however be entitled to be paid for the costs and expenses incurred in compliance with those obligations.

Conclusion

Taxpayers will be relieved to see that the government has learned from mistakes that have been made in the past in both public and private sector IT contracts. The Decision Map Guidance and the Model Contracts have recognised that leaving any element of the services description to be defined post-contract is one of the biggest causes of problems in IT projects.[31] The requirements must dictate the solution rather than the reverse.

IT contractors will in general welcome the new payment scheme as it is a step back from the strict PFI ethos of placing as much of the project risk as possible on the contractor. PFI was not suited to SMEs in the IT sector as they struggled to survive without payments during the development phase and third-party finance was difficult to obtain. Both the government and SMEs in the IT sector will be hoping that the new policy will provide a more workable solution.

Whilst in general the Model Contracts are reasonable in a commercial sense, there will still be a number of points that contractors will seek to negotiate. The major issues for contractors will be the new payment structure, the increase in termination rights for the government, the extensive step-in rights and the competitive pricing powers. The FOIA 2000 will also pose a real challenge for contractors as the new Model Contracts require the contractor to provide a detailed plan of the technical solution and also have complete transparency in the financial records relating to the project. The Act potentially makes all of this extremely commercially sensitive information available to any party who makes an FOIA request. In dealing with all of these issues, the government will need to weigh up the convenience of inflexibly complying with the Model Contracts against the added cost this may lead the contractor to include in the price.

Ultimately, however, the success or failure of future government IT projects will depend upon whether the relevant government authority possesses or has access to the experience and resources to manage the project properly after the contract has been signed. In the new Guidance the government has benefited from the input of experienced private sector consultants and distilled this into a “how-to” contracting manual that recognises the specific challenges posed by a major IT procurement. This will hopefully only be the start of an ongoing process of enhancing the skills base within government. Putting in place contract guidance is an important step, but the main challenge will be developing and disseminating best practice within the public sector.

Mark Turner is a partner and Dominic Callaghan an Australian qualified solicitor in the IP/IT department at the London office of Herbert Smith.

© December 2004, Herbert Smith