Summary: The anniversary of the collapse of Carillion is a reminder to customers to review contracts with outsource providers to ensure that all necessary safeguards are in place to protect against the negative impact of such provider insolvency. Has your business learnt the lessons from Carillion? What contractual safeguards should you use and what other steps can you take to help mitigate the impact should the worst happen?

The next Carillion? Do you have the right safeguards in your outsourcing contracts to protect your business?

The reported predicament at Interserve is just the latest to strike Britain’s struggling public sector outsourcing market following the spectacular collapse of Carillion in 2018. Now with commentators warning of the risk of another systemic failure in this sector, the New Year is the time to look again at your contracts to ensure you have the safeguards and practical measures in place to protect against the negative impact of such provider insolvency.

We are aware that certain contracts (including with Carillion) which were let under the Private Finance Initiative (PFI) have replacement mechanisms built in, but this blog focuses on non-PFI service arrangements involving the public and private sector.

Has your business learnt the lessons, either directly or otherwise, from Carillion? What contractual safeguards can you include in your outsourcing contracts and what other steps can you take to help mitigate the impact should the worst happen?

Do you have sufficient oversight and the information you need?

It may seem obvious, but customers need to understand the risks associated with their outsourcing arrangements, along with market conditions affecting their outsource providers and the financial health of their providers. This way, customers can ensure not only that they are carrying out appropriate monitoring of the financial viability and performance of the provider during the term of the contract, but also that they know who could if practical step in to the contract in the event of severe difficulties, and how such interim arrangements will work. And in the worst case, customers need to know how and to whom to migrate the outsourced services in a terminal situation.

Contracts must enable the customer to monitor the financial standing and resilience of the provider from before appointment and throughout the term of the contract. While there is often a focus at the tender stage on financial vetting, it is important that this continues to ensure that any apparent financial difficulties facing a provider are picked up sooner rather than later.  

The contract should therefore require the provider to create and regularly maintain in a transaction “library” or depository (to which the customer must always have access):

·               details of all material staff, their roles and responsibilities on an anonymised basis due to data protection restrictions, 

·               service delivery locations,

·               all material sub-contractors and key contacts and staff in them, along with any supply chain proprietary rights that will be needed by the customer or an alternative provider to maintain continuity of service,

·               all key assets used to provide the services,

·               service and other asset and operational risk registers, 

·               details of central office functions performed by a provider group company, and

·               operations manuals and performance records and standards,

all in the event that the customer or a replacement provider needs urgently to take over service delivery as seamlessly as possible.

To support this requirement, the contract should contain robust audit rights to allow the customer and its appointed representatives to access the provider’s information about the services, including financial data, and to verify that information on an ongoing basis. 

In addition, there should be detailed governance procedures involving both parties’ senior stakeholders that require regular service and contractual meetings, with relevant agenda items specified, including regular provider financial health reviews.

There should also be ongoing obligations on the provider to supply at specified times, and in any event when required in certain conditions by customer senior executives, specified management information that includes all the above operational and financial data.

Of course, having the right contractual provisions is only one part of the equation.  Customers must be prepared to exercise their contractual rights to monitor the operational and financial viability of their providers. And then, if necessary, to take appropriate action.

Can you step-in?

Most well-drafted outsourcing contracts now contain a right for the customer or an interim provider to step in if a specific set of circumstances arise, such as a force majeure event, a serious breach of contract by the provider (falling short of a material breach), regulatory interventions, or in the event of the insolvency of the provider. We suggest that customers consider widening those circumstances, to include substantiated or justified concerns about the financial viability of the provider or even known market conditions threatening that viability.

In practice, is it actually worth stepping in? 

The right to step in often seems like an attractive option to customers. Customers hope it will allow them to take over the provider’s obligations or appoint an interim provider to ensure that disruption to service recipients is kept to a minimum and that critical services are delivered. However, most step-in right clauses permit the customer to stop payment to the provider during any period of step-in. The reality is that this could be the final event that tips the provider over the edge into a formal insolvency procedure and yet the customer is not going to wish to pay both the provider and an interim provider during any step-in period just to avoid this. 

Timing is also an issue our clients have experienced with step-in rights. Depending on the stage of financial difficulties the provider is in, even if the provider could withstand a period of non-payment, there may not be the time to implement the step-in process before the provider’s financial difficulties worsen or it enters into a formal insolvency procedure.

It is still best practice to include step-in rights for the customer so that it has the option to use them if appropriate, but careful consideration should always be given when deciding whether to exercise them and in many cases the customer may want to look to a more final remedy straight away.

How quickly can you terminate if there are signs of trouble?

Termination for provider insolvency is a standard provision in outsourcing contracts. What is important is ensuring it covers all the different corporate insolvency procedures, broadly: liquidation, administration, receivership, and voluntary arrangements.  The rights to terminate for insolvency should also apply in advance of the provider actually being put into the formal insolvency process.  

Secondly, this termination right could extend to the customer having the right to terminate where the insolvency events apply not just to the provider with whom the contract has been entered into, but also in relation to a parent company (whether or not a parent company guarantee has been given) or other key group company.  This is because many outsourcing groups structure their businesses so that certain subsidiaries provide specific services and/or act as the prime contracting entity for the wider business.  

Finally, any termination right should also cover the insolvency of a guarantor where a guarantee is provided under the outsourcing contract.

In practice, when should a customer terminate?

Once a customer has decided it wishes to exit the arrangement, it is even more important in a financial distress scenario to consider when it will exercise such right. While it may seem like the best option is to make as speedy an exit as possible, this may not be the most prudent option where service continuity is key. For those customers that are regulated, most regulators require any termination of the outsourcing to be without detriment (or as minimal as possible) to the continuity and quality of its provision of services to end users. This will require a period of handover by the staff at the provider to the customer or its replacement provider.

Where a supplier has entered into terminal insolvency proceedings (e.g. liquidation),  although TUPE will apply, it will not trigger the transfer of employees. Therefore, on termination of the contract, employees will not automatically transfer. No staff transferring to the customer or new provider means that there are no staff to handover or provide knowledge transfer to ensure a continuity of service. This is a situation some of our clients found themselves in with Carillion. Customers may therefore wish to consider delaying formal termination for a period of time, while it considers offering existing staff or key personnel of the provider new roles at the replacement provider or customer, so that it has the staff needed to assist in the handover and minimise disruption to the services on a disorderly exit.

Do you have a contingency plan?

In a speech he delivered to the Business Services Association in November 2018, Cabinet Office Minister David Lidington announced that several government service providers had agreed to prepare “living wills” to ensure continued service delivery in the event they suffer financial difficulties. He explained that after the Carillon collapse the government “did not have the benefit of key organisational information that could have smoothed the management of the liquidation” and added that for future contracts “by ensuring plans can be quickly put in place in the very rare event of supplier failure, we will be better prepared to maintain continuity of critical public services, to minimise the potential impact on critical national infrastructure and to ensure a smooth transition to new service providers should the need arise”.  The “living wills” are part of a range of measures the UK government hopes will transform public procurement.

So what really is a “living will” or resolution plan?  Essentially it is a contingency plan that sets out what would happen in the event the provider becomes insolvent. It would set out how the outsourced services can be secured and continued in the event of the provider’s failure, to allow the government time to transfer the services to a new provider or take them in-house. The government has yet confirm what the “living wills” should contain, but they are being jointly developed by the industry and government subject matter experts.

As a matter of good practice, such a concept could equally be applied outside the government outsourcing market. If a living will proves too difficult to negotiate, the contractual exit plan and related procedures - now standard in good outsourcing contracts - which focus on the wherewithal to ensure an orderly handover of services following the early termination or expiry of the contract - could be expanded to cover a handover in disorderly circumstances, such as provider financial distress in anticipation of insolvency. This also ensures the plan is contractually enforceable and is tailored to a specific contract, something yet to be confirmed in relation to living wills. It is important to note that a contractual exit plan for an orderly handover on its own won’t be sufficient in a financial distress scenario, as the plan will take too long to implement and will envisage staff being available to handover and transfer knowledge over a period of time.  Don’t forget to regularly review these contingency plans and ensure that they are updated during the term of the contract to take account of any changes in services, operating procedures, service delivery, assets, or staff.

Where possible, outsourcing contracts should provide flexibility when unexpected or certain anticipated circumstances, such as financial distress or insolvency, arise.  The above are just a few examples of how you can achieve this flexibility.

The collapse of Carillion may have been a year ago now, but it is not too late to apply the lessons learnt to your own contracting practices and to ensure that our recommended provisions – or something similar - are included in future outsourcing contracts, particularly as 2019 looks set to be another volatile year in the public sector outsourcing and wider financial markets.