Management of payment mechanisms in PFI/PPP schemes by the public sector has generally become more active in recent years. Amongst the many factors at play are balancing proper management and application, and avoiding the potential threat to the workings of a long term relationship, by excessive or aggressive management.

The purpose of payment mechanisms

Payment mechanisms provide a basis for monitoring and incentivising an agreed level of performance in long term service contracts. Where service provision falls below a defined standard, the mechanism can apply points and/or payment deductions, the accumulation of which, over an agreed threshold, might ultimately lead to termination of the contract.

Some payment mechanisms are well drafted - they define the required performance standards objectively and unambiguously; they allow a period to rectify performance failures to avoid knee jerk payment deductions; to encourage speedy rectification of breached performance standards, they employ ratchet mechanisms to increase the original deduction level at agreed intervals; they state clearly at what point in time points and deductions will be allocated, and they calibrate points/deductions to reflect the standards to be achieved.

Others are not so objective or comprehensive - leaving those tasked with managing the mechanism to make decisions without contractual direction.

Both scenarios can be problematic.

Unintended results

The more certain mechanism may produce results which were not intended. For example, some performance standards include reporting requirements. Operatives on the ground may fail to report, for example, installation of a fire alarm. Executives reviewing self-reporting paperwork provided by the operating company, may be unaware that the alarm has been installed. Months later they become aware that installation has taken place. The alarm is being properly operated and maintained, but the points/deductions for failure to report its installation have ratcheted up to a substantial sum - hundreds of thousands of pounds - it is possible! If no cap on the extent to which the ratchet can be applied has been agreed, then the Authority is perfectly within its contractual right to make the deduction.

Ambiguously drafted payment mechanisms may tempt practices which were not originally intended, but arguably might be allowed within the contract wording. For example, a mechanism which does not specify the regularity at which the Authority should calculate points and report them to the contractor, might encourage "ambushing" - rather than report on a monthly basis to give the contractor time to rectify on a rolling basis, points are accumulated over a longer period (say four to six months) leaving little time for multiple rectification issues, and investigation of events long-since past.

Increasingly we are seeing payment mechanism disputes being referred to mediation or alternative dispute resolution processes. Those which cannot be settled are beginning to reach the courts. One issue that has become the crux of a number of cases is whether those managing payment mechanisms have an obligation to act in good faith.

Good faith in payment mechanisms?

There is no general concept of good faith in English law; if good faith is to be relied upon, the contract must expressly set out the scope of the obligation, and when it will apply. If there is no express contractual provision, then the party suffering at the hands of extreme implementation of a payment mechanism, will ask the court to imply a good faith obligation into the contract wording.

The Mid Essex case1 was the first to look at good faith in the context of a payment mechanism. In that case the contract was apparently well drafted - on the occurrence of objectively defined events, the awarding authority did not have to exercise any discretion as to when or how many points applied. In the event, substantial deductions were made by the awarding authority, and the contractor argued that good faith wording in the contract should be applied to the manner in which deductions had been calculated and awarded. The judge held that the express obligation of good faith, was not sufficiently broad to cover operation of the payment mechanism, and that (as the contract included precise rules on how to operate the payment mechanism) there was no requirement to imply a good faith obligation. Beatson LJ explained -

"In a situation where a contract makes such specific provision, in my judgment care must be taken not to construe a general and potentially open-ended obligation such as an obligation to ‘co-operate’ or ‘to act in good faith’ as covering the same ground as other, more specific, provisions, lest it cut across those more specific provisions and any limitations in them."

The payment mechanism in the Portsmouth case2 did require exercise of discretion in its application - the awarding authority had to apply points within an agreed range, depending on the gravity of the performance default. In some cases, where there was a breach of the service specification, but no performance standard was directly relevant, the number of points to be awarded had to be decided by reference to defined performance standards of equivalent seriousness. The judge therefore distinguished the facts from the Mid Essex case, and agreed that a term should be implied. He declared that the following wording should be implied into the contract:

"When assessing the number of Service Points to be awarded under clause 24.2.1(c) of the Agreement, [the Authority's] Representative is to act honestly and on proper grounds and not in a manner that is arbitrary, irrational or capricious."

His reasoning partly derives from "The Product Star” case [1993] 1 Lloyd’s Rep 397, in which Leggatt LJ said:

“Where A and B contract with each other to confer a discretion on A, that does not render B subject to A’s uninhibited whim. In my judgment, the authorities show that not only must the discretion be exercised honestly and in good faith, but, having regard to the provisions of the contract by which it is conferred, it must not be exercised arbitrarily, capriciously or unreasonably. That entails a proper consideration of the matter after making any necessary enquiries. To these principles, little is added by the concept of fairness: it does no more than describe the result achieved by their application.”

The judge in the Portsmouth case was equally reluctant to include a concept of fairness in his implied term as, in the context of payment mechanisms, he felt it might introduce threshold risk. He described this as follows:

"It may be helpful if I give an example to illustrate the point. Suppose that [the contractor] has accumulated 197 Service Points within a 12 month period and [the Authority] is aware of an Event of Default which carries a maximum of 5 Service Points. Assume that, viewed objectively, the breach is a fairly serious one - probably justifying 3 or 4 Service Points. In my view, when deciding the number of Service Points to award, [the Authority] would be under no obligation to consider the wider implications for [the contractor]of an award of 3 or 4 Service Points for the breach, rather than an award of, say, just 2 Service Points - which would prevent the 200 point threshold being crossed. It may well be that [the Authority] might, when deciding whether or not to issue a notice under clause 24.2.1, take into account the fact that the breach is likely to justify an award of 3 or 4 Service Points and the consequences for [the contractor] which that would entail. But as the decision in the Mid Essex case makes clear, that is a decision whether or not to exercise a contractual right, not a decision that involves a balancing exercise. The introduction of a duty to act fairly when awarding Service Points might be taken as introducing wider considerations going beyond the circumstances of the breach. Whilst I do not suggest that such an interpretation would be correct, it seems to me preferable to avoid using language that might create uncertainty or, at least, provide scope for dispute."

One of the reasons, there is no concept of good faith in English law is that the English courts are keen to support the autonomy of commercial entities. So, for example, the adversarial nature of pre-contract negotiations is acknowledged, and each party is entitled to pursue his (or her) own interest, so long as s/he avoids making misrepresentations.

Although acting honestly is an implied term of any contract:

"…it never has been the law that a person is only entitled to enforce his contractual rights in a reasonable way." Lord Reid - White & Carter (Councils) Ltd v McGregor [1962] AC 413.

And:

"…Motive is disregarded as irrelevant. A person who has a right under a contract or other instrument is entitled to exercise it and can effectively exercise it for a good reason or a bad reason or no reason at all. " Pearson LJ, Chapman v Honig [1963] 2 QB 502, 520

Business efficacy is key. In Barclays v Unicredit [2014] EWCA Civ 302, at first instance, Popplewell J stated:

"…the question is not whether the decision is justified but whether the decision is one which might be reached by a reasonable man in the circumstances; and the decision maker is entitled to take into account his own commercial interests, in preference to those of the other party, and normally to their exclusion."

In that case, early termination of a guarantee by Unicredit was permitted, if Barclays chose to consent. Any consent had to be provided "in a commercially reasonable manner". Barclays’ only commercial reason for entering into the guarantee was to profit from the transaction through its fees. Without the ability to protect and preserve profits by means of the exercise of its discretion, the discretion would have little purpose for Barclays. Barclays therefore required five years fees, as a condition to its consent. Unicredit objected.

The Court of Appeal held that Barclays was acting in a commercially reasonable manner. Longmore LJ held that the appropriate standard was that of Wednesbury unreasonableness – namely, to be considered unreasonable it had to be so unreasonable that no reasonable person, acting reasonably, could have made it.

"It is not easy to express a test for commercial reasonableness for the purpose of this (let alone any other) contract but I would tentatively express it by saying that the party who has to make the relevant determination will not be acting in a commercially reasonable manner if he demands a price which is way above what he can reasonably anticipate would have been a reasonable return from the contract into which he has entered and which it is sought to terminate at an early date."

Deductions running into hundreds of thousands of pounds for failure to notify installation of a fire alarm are "way above" what would have been reasonably anticipated (when negotiating a payment mechanism) as proper incentivisation for a contractor to keep its employer in the loop about fire prevention measures. To charge such an amount for that type of default might be described as perverse, but following Mid Essex if the contract allows the deductions to be made, then they are incontrovertible.

So does the implied term drafted by the judge in the Portsmouth case serve a useful purpose? It is not "arbitrary" to ratchet points in accordance with a contractually agreed mechanism, but it seems "irrational" (not logical or reasonable) to apply excessive ratcheted deductions, when breach of a performance standard has caused no substantive loss. To do so might ultimately frustrate the entire project, if a thinly capitalised SPV has not established reserves to cover such an eventuality. The judge's approach therefore seems to incorporate the Wednesbury reasonableness approach adopted in the Barclays case. When the judge refers to "proper grounds", does he mean solely the express mechanisms set out in the contract, or the wider considerations referred to for "relational" contracts in the Yam Seng case3?

"While it seems unlikely that any duty to disclose information in performance of the contract would be implied where the contract involves a simple exchange, many contracts do not fit this model and involve a longer term relationship between the parties [to] which they make a substantial commitment. Such “relational” contracts, as they are sometimes called, may require a high degree of communication, cooperation and predictable performance based on mutual trust and confidence and involve expectations of loyalty which are not legislated for in the express terms of the contract but are implicit in the parties’ understanding and necessary to give business efficacy to the arrangements. Examples of such relational contracts might include some joint venture agreements, franchise agreements and long term distributorship agreements."

Yam Seng seems to acknowledge that achieving business efficacy in a "relational" long term service contract, requires different disciplines to those required for achieving business efficacy in a broader commercial background as in the Barclays case, where the parties cannot take each other's commercial interests into account, because they do not know what they are. In a PPP context where a thinly capitalised special purpose vehicle has been set up, and a detailed financial model (negotiated by key project participants) shows the income stream required to provide the life blood which will determine whether the project survives or fails, is it reasonable to impose points/deductions which are so huge that the SPV will almost certainly topple, and lenders will seek to call in their loans? In Mid Essex, the court disallowed substantial deductions, on the grounds that express clauses had been misinterpreted. But if express terms allow that course of action, would the courts allow good faith provisions, express or otherwise, to override the mechanism?

This is a developing area of the law, which the PPP/PFI market is expected to follow with interest. In the meantime, well drafted good faith provisions along the lines of the implied term used in the Portsmouth case, which clearly apply to administration of the payment mechanism, are to be advised. A contractual acknowledgement of the basis on which the contract was structured - ie as a limited recourse public private partnership, with payments crafted to create value for money and sustainable returns - will help to establish the "relational" nature of the contract. Payment mechanisms are intended to incentivise, not punish. Behavioural directions, such as those found in partnering arrangements, may also encourage the courts to apply good faith obligations, not only to fill gaps where there is no express contractual provision, but also to temper perverse application of express terms.

In the meantime, for those who are party to one of the UK's 900+ PFI schemes and other outsourcing arrangements (many of which will feature a form of payment mechanism), parties will want to ensure a balance between management of the mechanism and their long term relationship.