Helen Randall: How commercial contracts go wrong

Shrinking budgets have put pressure on councils to be more commercial. Helen Randall provides a guide to the hidden dangers in commercial contracts.

Increasing financial pressures on most councils means they are now looking to make savings and increase revenue.  Ironically, many local authorities now find themselves in commercial and contractual arrangements which are unaffordable, fail to achieve savings targets, do not generate the anticipated revenue or are costly to terminate.  Why does this happen and what lessons can be learnt?

This usually comes down to one or more of five key issues:

• Lack of commercial acumen or knowing what represents the market for the particular type of contract in that sector;
• An ambiguous or over complex contract;
• An open ended variation mechanism;
• An overoptimistic business case;
• A rush to complete without resolving substantive commercial or operational issues.

Contractors’ daily business involves negotiating contracts in their service sector which gives them a keen understanding of precisely what terms are “on market” — not just price, but also what is normal for indemnity limits, compensation on termination, contractual remedies, TUPE, pension liability, warranties and KPIs. However, most authorities enter major partnerships, joint ventures, outsourcings or PPP-type arrangements much less frequently.

Trophies

Some of the worst deals have been reached without support from professionals with up-to-date market expertise because the lead negotiator has wanted a trophy on their CV or to save money on fees.  Authorities can bring negligence or misfeasance claims in such circumstances, never mind the career-limiting impact of an auditor or ombudsman enquiry.  Do ensure your lawyers and other advisors have up-to-date market experience and never be afraid to interrogate their advice.

Ambiguous contracts create misunderstanding which can lead to dispute.  Particularly, when money is tight or personnel or political control change.

Well drafted contracts can be negated by inconsistent specifications, payment and performance mechanisms or the contractor’s proposals. Contractors can conceal material in schedules which can cancel the protections in the legal contract terms. Review by the lawyer who drafted the contract is a worthwhile investment to ensure your deal will deliver what you envisage and will be flexible for exit if circumstances change.

A contractor’s profit margin can be derived solely through seeking variations to the basic contract.  To ensure the contract stays within budget, the variation clause should be both sufficiently flexible to cater for foreseeable changes and rigorous enough to ensure ongoing value for money. This is important for benefits realisation or profit sharing clauses where a savvy contractor can sometimes manipulate an authority to pay much more than the original projected contract estimate.  Supplements to the variation clause can be concealed in schedules in particular, the contractor’s proposals, so these should be reviewed carefully to ensure the contractual variation clause is not overridden.

Sellers

It is a cliché that every public authority wishes to be a seller not a purchaser.  It is a legal requirement for a local authority wishing to set up a commercial company to compile a business case including cash flow.  You should undertake market research (even where entering into a joint venture with a private sector partner) to ensure a realistic assessment of business volume.

To avoid unlawful state aid, public sector support to any trading company should be at full commercial rates. Just because a business is in the public or voluntary sector does not exempt it from state aid rules. There are some local authority businesses currently trading with the benefit of unlawful state aid which private sector competitors will one day challenge.  Unlawful state aid can result in the recipient’s insolvency and a penalty on the authority.  Therefore, do ensure your business case includes commercial costings for premises, staff and other benefits and take advice on exemptions which are intricate.

No deal could be better

Councils are of course controlled by politicians who want to win elections which are preceded by purdah periods.  However, the worst deals are those where one party is up against an immoveable deadline because they then lose their bargaining power. Take time to explain to politicians why sometimes no deal is better than a bad deal.  Do scrutinise the procurement timetable for over optimistic assumptions and factor in meaningful external consultation and internal briefings.

Many authorities close competitive dialogues too early and sacrifice the bargaining power afforded by the competition between bidders.  A better long term deal can be reached where dialogue is only closed once you are certain you have driven out as much detail as possible from your bidders.

On a positive note, many good commercial deals are signed by local authorities though, sadly, these rarely make the news.  Clear contract documents negotiated by a commercially astute team who is not afraid to ask the obvious question, or to take time to get the detail right, always pay dividends in terms of savings achieved, profits shared and costly disputes prevented.

Helen Randall, partner, Trowers & Hamlins LLP.