Introduction

The Defence Reform Bill (Bill) – currently at committee stage in the House of Lords - is intended to implement some of the proposals for reform that were made in two recent White Papers: Better Defence Acquisition and Reserves in the Future Force 2020. The Bill is divided into three parts:

  • the arrangements for reforming Defence Equipment and Support (DE&S);
  • the legal framework for ‘single source contracts’ (that is, contracts which are not subject to a legal obligation to be let pursuant to a competitive process); and
  • measures to strengthen and support the Reserve Forces in order to support their further integration with Regular Forces as part of Future Force 2020.

The debates on the reform of DE&S and the future role of the Reserve Forces have received more attention in the mainstream media – particularly given the well-reported decision by the Secretary of State not to pursue the GOCO competition to its conclusion.

The debate on the reform of the single source contract framework is more complex and more a practical question of ‘how’ the reforms will be implemented rather than ‘why’ the system might be in need of reform. Such contracts represent approximately 40% by value of those let by the MoD in recent years and yet – by comparison with many proposed amendments to Parts 1 and 3 – this part of the Bill (Part 2) appears to have received much less attention in debate and proposed amendments.

The current system is reliant upon an increasingly out-dated and non-legally binding framework (known as the ‘Yellow Book’), which is implemented by the appropriate DEFCONs in contracts with MoD. These require the pricing of such contracts to be implemented by the parties in accordance with the Yellow Book, and for them to submit their disputes on such pricing for determination by the Review Board for Government Contracts.

Arguably, the current system places most of the negotiating power with the contractor. In his Review of Single Source Pricing Regulations, published in October 2011, Lord Currie of Marylebone summarised the potential for wastefulness arising from both “inefficiencies in MoD procurement processes” and “inefficiencies on the side of industry and from skilful deployment of the Yellow Book to secure returns that, although within the regulations, have not been appropriate”.

It is in that context that Part 2 of the Bill has been drafted. It provides for a regulatory framework for single source contracts, to be called the Single Source Contract Regulations (SSCR), and will establish a new non-departmental public body, the Single Source Regulations Office (SSRO), to oversee that regulatory framework. The SSCR and SSRO are explored in more detail below but, in summary:

  • the SSCRs do not represent a “sea-change” in the way such contracts are priced – the applicable principles are still good value for money for MoD and a fair and reasonable price for the contractor (albeit without the explicit comparability principle, as before);
  • however, moving the system from an informal (albeit highly technical) basis to a statutory basis is a significant change to the underpinning infrastructure – reflected in, amongst other things, the fines for which contractors may be liable as a result of “actionable contraventions” of the SSCRs;
  • the new regime appears to give greater scope for the MoD to re-open the pricing provisions of contracts by referring them to the SSRO for determination;
  • the new regime imposes significantly increased reporting requirements on contractors and sub-contractors throughout the lifetime of the contract (with the sanctions referred to above); and
  • the new regime moves the responsibility for adjudication away from a Review Board seen as a joint MoD/industry body to an SSRO which, while independent and with the potential for industry representatives, is seen by some as potentially more open to influence by the MoD as customer.

More detail on the SSCR and SSRO

EU law requires most government contracts to be procured via an open and competitive process. However, there are exemptions to such procurement rules where (i) a country considers it to be necessary for national security reasons or (ii) only one supplier is capable of supplying the goods or services in question. The advanced and specialist nature of some defence equipment, its sensitivity and the need to preserve industrial and technological capabilities in the UK for strategic reasons combine to necessitate the continued practice of placing certain contracts without competition. Over the last five years single source procurement contracts have averaged £6bn per annum and the MoD estimates they are likely to remain a significant proportion of MoD procurement spending in the future.

The Bill provides the framework for the SSCR and an overview of what the regulations will contain. The explanatory notes to the Bill suggest that the SSCRs are likely to come into force on 1 October 2014 (the Relevant Date) but this is not yet confirmed. The SSCRs are not yet in public circulation but drafts are being discussed between the MoD and relevant parties (with a new draft expected during March 2014).

Only a ‘Qualifying Defence Contract’ (QDC) and certain related sub-contracts (see below) will be subject to the provisions of the new framework. The basic criteria for a primary contract (ie a contract directly between MoD and a contractor) to be considered a QDC are as follows:

  • it is a contract under which the Secretary of State for Defence (SoS) procures goods, works or services for defence purposes (defined as any contract which SoS enters into);
  • it is above a specified value threshold set in the SSCR (currently £5m); and

either

  • it was entered into on, or after, the Relevant Date and is not the result of a competitive process; or
  • it was entered into before the Relevant Date not as a result of a competitive process, and was amended on or after the Relevant Date where the SoS and primary contractor agreed it should be a QDC; or
  • (whether entered into before or after the Relevant Date) it is a competitive contract amended on a non-competitive basis after the Relevant Date where the SoS and primary contractor agree that it should be a QDC.

The following contracts are exempt from being a QDC:  those with a foreign government, within the framework of a cooperative international defence programme, for the acquisition of land (or its management or maintenance) or for the purposes of intelligence activities.

The SoS will also have a broad power to exempt contracts from QDC status on a case by case basis.

The SSCR also covers sub-contracts (and other contracts down the supply chain) if they are necessary for the performance of QDCs, are awarded on a non-competitive basis and have a contract value above £25m – such contracts are treated as QDCs for the purposes of the SSCR. This poses particular challenges for primary contractors, as are discussed below (see Industry Opinion and Commentary).

The key provisions of the SSCR cover (in relation to QDCs):

  • how the price payable will be determined, in line with a pricing formula, which will base the price on a set of allowable costs uplifted by a contract profit rate;
  • how the pricing formula will be adapted for four contract types, (1) firm price contracts, (2) fixed price contracts and (3) cost-plus contracts and (4) TCIF contracts;
  • the requirements for contractors to keep records for the purposes of auditing costs, pricing, performance and sub-contracts;
  • the obligations upon contractors (and sub-contractors) to deliver reports on QDCs to the SoS, the content of such reports and the timeframe for delivery; and
  • a general obligation on contractors to notify the SoS when they become aware of any matter likely to have a material impact on the cost, price or performance of a QDC.

The Bill will establish the SSRO, which will replace the existing Review Board for Government Contracts but will have a much greater remit than the current Review Board. The SSRO will act as the regulator, with a duty to ensure that the new framework delivers value for money for the MoD while also providing contractors with a fair and reasonable price. Initial set-up costs will be met by the MoD and ongoing costs will, broadly, be split evenly between the MoD and deductions from payments made to contractors under the contracts that are let.

Broadly, the functions of the SSRO will be to:

  • advise the SoS on setting key rates in pricing contracts (eg the baseline profit rate);
  • issue guidance on allowable costs under QDCs, any contract profit rate steps, reports and the amount of any penalties for non-compliance;
  • make determinations on certain matters on referral by the SoS or contractors (generally as outlined in the bullet above but with a wide scope for matters raised by the SoS);
  • keep the framework under review at set intervals (3 years after inception and every five years thereafter - a departure from the current practice of annual review by the Review Board) and propose changes to the SoS; and
  • maintain records of QDCs and their duration, monitor contractors’ compliance with their reporting obligations and analyse reports and other information provided by contractors.

The Bill will also establish a compliance regime for the new framework. For most contraventions, the penalty will be a fine, using a tariff and up to a maximum amount set in separate regulations. However, failing to notify the SoS of any relevant event relating to a QDC or providing a misleading report will have no upper limit. The penalty will be calculated as if the contravention were a breach of the QDC itself and will be made in accordance with the general law of contract in England and Wales. There will also be a criminal offence of disclosing protected information.

Industry Opinion

When giving evidence to the Public Bill Committee, ADS raised certain issues and concerns regarding the SSCR and SSRO. The most material of these were:

  • the lack of political independence in the SSRO. ADS submitted that the Bill appears to allow the MoD (as customer) to control the SSRO (as regulator);
  • the broad power granted to the SoS to exempt contracts from QDC status should be, as far as possible, defined in a transparent manner. ADS argued that failure to do so may place UK suppliers at a disadvantage in the international market place (ie if international suppliers require the SoS to exempt them from the SSCR – or to purchase on a “FMS” basis - as the price of doing business with them);
  • the new regulations (with their ongoing ability to “re-open” price agreements and sums paid) will create uncertainty over contract price with possible adverse consequences for shareholder value, boardroom confidence to invest and the international perception of the UK as a good place to do business;
  • a failure to maintain the comparability principle currently used, which links the profit allowance on single source contracts to the average profit earned by a reference group of companies listed on the London Stock Exchange, and replacing it with the test of what is a “fair and reasonable price” may undermine suppliers’ willingness to participate in single source procurement and invest in the UK;
  • the regulations may place a heavy burden on subcontractors and SMEs and the scope of the application of the regulations should be tightly defined; and
  • although ADS supports the restrictions on disclosure of information, protection of suppliers’ information should be further strengthened by including an additional criminal offence of failure to protect suppliers’ information (beyond the currently proposed offence of disclosing information provided under the SSCR).

Concerns have also been raised by potential primary contractors about the scope of the compliance regime, which may see them responsible for the acts or omissions of sub-contractors that are in breach – particularly in relation to information security. This is one issue that potential primary contractors must consider carefully when sub-contracting work under the new framework. In particular, given the criminal liability that could arise on disclosure of protected information, all contractors will need to be meticulous in negotiating contractual provisions regarding the transfer and use of data and information. Further, it has been suggested that the subjective judgements that will be required of the SSRO, as opposed to the more certain formulae currently used, create fertile grounds for dispute.

Political Opinion

The concerns raised in the political sphere broadly echo those raised by industry. Although expressing that her party “broadly supported” the proposals, Alison Seabeck, the Shadow Minister for Defence, echoed the concern raised by ADS regarding “the level of power that the Secretary of State will have over this ‘independent body’”. Further, James Arbuthnot, Chair of the House of Commons Defence Select Committee, expressed a concern that if the new framework did not apply to overseas contractors, it may “create an incentive for UK defence contractors to move abroad”.

Further Commentary

Other material issues for contractors (particularly prime contractors) to consider include:

  • the greater level of reporting required by the SSCR should not be underestimated:  it will likely put significantly greater obligations on contractors and their supply chain;
  • the conceptual move from a voluntary regime (albeit more often than not observed) to a statutory and mandatory one will create very different negotiation dynamics;
  • the greater obligations the SSCR imposes could see some industry participants (particularly those further down the supply chain for whom defence is non-core) choose to divert resources away from the defence field and into other sectors where returns are greater and compliance requirements less onerous (restricting competition and, paradoxically, increasing MoD’s costs);
  • existing pricing models which rely on lower upfront costs compensated by greater support fees will need to be revisited in a world where there is less certainty of obtaining those follow-on contracts and where the fees which they (and the initial supply contracts) produce are more open to review during and after their term;
  • the SSCR seem likely to accommodate less well than the Yellow Book those contracts which are partially competed and partially sole source;
  • the guidance on how the SSRO will interpret the requirement for “appropriate, attributable and reasonable” allowable costs and a “fair and reasonable price” will be critical but is not expected until after the new regime comes into force;
  • certain other key terms and concepts remain uncertain, such as the “authorised person” and “relevant records”, but their definition will be important for the practical implementation of the SSCR; and
  • there is a danger that the SSCR drive industry participants to new corporate or physical arrangements so as to separate their businesses which fall within the regime from those which do not (to avoid any cross-subsidisation within the group); it is also possible that bidders will consider foreign and/or special purpose vehicles to seek to fall outside the regime or refine their cost base.

Conclusion

The committee stage in the House of Lords (a line by line examination of the Bill) started on 3 February 2014 (with the report stage due on 24 March 2014). Although the passage of a bill and any possible amendments necessarily cannot be predicted, it is felt that substantial changes are now unlikely. Nonetheless, the concerns raised by industry do suggest that there is particular disquiet about the regulation of the new framework by a body that, it appears, may be insufficiently independent of the SoS and, more generally, about ambiguities that could expose contractors to the risks of lower returns, uncertainty and disputes. We look forward to seeing the extent to which these nettles are grasped by the Lords and in revised drafts of the SSCR.