Angelica Hymers 30 January 2018

The key to sustainable contracting

Carillion, one of the UK’s largest construction companies went into liquidation in January. It is understood that the cause of Carillion’s problems were unprofitable contracts and unpaid work.

Profit margins in the construction industry can be very low, driven down by pressure from customers and competition between contractors and this means that it does not take much to tip the balance between running a sustainable business and ruin.

For many in the public sector the collapse of Carillion will be the trigger to reassess their tendering processes and approaches to contract management. In particular, many will wish to understand how to avoid granting contracts to potentially unstable contractors, and how to reduce the risk that a contract becomes unprofitable for a contractor, which, even if it does not cause them financial problems on this magnitude, can result in a contractor wishing to terminate a contract early.

Here are our top tips for sustainable contracting:

Due diligence is vital

For above threshold contracts, use a selection questionnaire (SQ) or ask suitability questions to do some due diligence on a potential contractor’s financial position. The Cabinet Office standard SQ contains a range of questions which enable you to consider a contractor’s economic and financial standing, including their accounts, statements of profit and loss, financial position and cash flow.

You can also require bank letters outlining the bidder’s current cash and credit position, and require a minimum level of annual turnover. Of course, this will not always give you the complete picture, but you can ask additional questions where these are proportionate and linked to the subject matter of the contract. For example, you could ask for credit checks or other supporting financial information.

The right price isn’t always the lowest

It may be, in some circumstances, for example very standardised items where quality is not so much of an issue. But usually you will need to achieve a balance between price and quality and in those circumstances a very low price can be a bad sign – perhaps the contractor hasn’t properly scoped the work or they are aiming to use a low price to win the work but then add extra charges later.

There is a process prescribed by regulation 69 Public Contracts Regulations 2015 to follow when you receive a tender with a price that could be ‘abnormally low’. You must ask the contractor to explain why the price is so low and assess the reason given – only if the evidence given by the contractor to explain their pricing does not account for the low costs can you exclude their tender. There are some other specific rules around this which should be considered if the circumstances arise.

Don’t impose punishing sanctions through KPIs

Often, disputes will arise between a customer and contractor because the contractor feels it is being unfairly punished by KPIs which are too strict or too strictly applied. Where KPIs become a sanction, this can easily damage a commercial relationship and may even prompt a contractor to terminate a contract. It is worth bearing in mind that performance regimes should be stretching but achievable and that a clause which amounts to a penalty may be unenforceable.

Get the right balance between quality and price

Even if the price is not abnormally low, too heavy a focus on price may result in contractors submitting bids which give them a very low profit margin or are indeed unprofitable. You may find that in these circumstances, very small changes can mean that the contractor will decide to stop providing the services and terminate the contract rather than continue to perform a loss making contract. This may result in significant disruption for the customer, who may well need to re-procure a contractor very quickly.

Whist it is not for a customer to ensure that contractors include sufficient profit in their bids, things may be eased by appropriately balancing your award criteria between quality and price, as well as maintaining discussions with your contractors should circumstances change.

Seek guarantees

In some circumstances, you may want to seek a guarantee that a contractor will fill its obligations under a contract, or if it does not, that someone else will do so in its stead.

Guarantees can be useful where you have concerns about the financial position of a contractor but you are aware that it has a more stable parent or group company. If you are seeking a guarantee, you will need to carry out some due diligence on the guarantor to ensure that the guarantee is worthwhile. However, this can be a very useful tool if you are dealing with SMEs’ and startups.

Adhere to payment terms

The failure of customers to pay, on time or at all can cause significant problems for contractors. Many contracting authorities are obliged to make payment under their public contracts within 30 days from the date of a valid and undisputed invoice. This obligation extends down the supply chain, and public contracts must include provisions requiring payment within 30 days, timely verification of invoices, and provisions which impose these requirements on subcontractors. These terms will be implied into any public contract which does not contain them. In each financial year, contracting authorities must publish on the internet statistics showing the authority’s compliance with this requirement in the preceding financial year.

Manage poor performance

Often contracting authorities complain that they know that a particular contractor isn’t very good, but they will win the procurement process anyway. It can be very frustrating when you know that company X will put in a great tender but perform a contract badly. Luckily, this is provided for in the procurement rules. You may exclude bidders from participating in your procurement where they have 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 the prior contract, damages or other comparable sanctions’ (regulation 57(8) PCR 2015). This is a relatively high threshold to meet, and demonstrates the importance of good contract management.

Often public bodies will not performance manage a bidder, sometimes to maintain a relationship and sometimes because they don’t know that their contract allows them to do this. Whilst relationships are important, if penalties have not been applied then you cannot exclude a bidder you know will not perform well from future contracts. Exercise caution when using this provision – it isn’t clear whether the application of service credits, for example, would be sufficient to be described as damages (probably not) and what other comparable sanctions might be is also difficult to envisage.

In any event it is always important to have well designed and used contracts to ensure that contract performance is maintained, and this is especially important if you have suffered poor performance in the past.

Contract management is crucial

You should involve your contract managers at the pre-procurement stage so that you can ensure that those who will be responsible for the contract understand how it works in practice. Appropriate provisions should be included in the contract to ensure that there are controls by which you can monitor supplier performance and manage contract risks.

As discussed above, poor contract management can limit your ability to exclude poorly performing providers from future procurements, so where appropriate, penalties such as service credits, liquidated damages and termination should be used.

Angelica Hymers is a solicitor in the public sector team at Browne Jacobson.

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