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Gaining a non-competitive advantage

Posted 14 March 2016 · Add Comment

Chris Chesterman, senior associate and Rory Trust, solicitor, in the Projects Unit at Burges Salmon, look at how the MoD and industry can make the most of the Single Source Contract Regulations.

Above: Chris Chesterman (left) and Rory Trust (right).

The first year of the Single Source Contract Regulations has seen a hesitancy by industry to engage fully with the new regime. The aims of the regulations may still be achieved but it will take more than just time.

On 28 January, the Single Source Regulations Office (SSRO) - the independent regulator responsible for ensuring that taxpayers obtain good value for money in non-competitive defence contracts - published its first annual report. 

The report provides the SSRO’s account of its first year overseeing the MoD and industry’s compliance with the Single Source Contract Regulations (SSCR), the statutory regime introduced by the Defence Reform Act 2014 to reform single source procurement in the defence sector.  

Unfulfilled potential
The most striking finding in the SSRO's report is how few contracts have been caught by the regime: of 106 single source contracts awarded by the MoD since December 2014, just 18 were notified to the SSRO as qualifying defence contracts (QDCs) falling within the scope of the regulations. This has been perceived by many, with some justification, as a reluctance by industry to engage with the new regime. However, other factors have contributed to the low uptake. Most single source contracts fall below the qualifying threshold of £5m, and it was always to be expected that amendments or extensions to existing contracts (which only qualify by agreement) would depress the numbers in the short term. 

More significant are the low number of referrals made to the SSRO for opinions and determinations on matters affecting QDCs (just one issued opinion and one request for a determination), and the low level of agreed savings identified to date (just £100,000, although the SSRO states that it has identified a further £26m of 'potential' savings). The SSRO also reports that contractors have at times not provided it with sufficient information to enable it to assess compliance.  These findings seem to betray a hesitancy to engage fully with the SSRO, if not the regime as a whole.

Reasons to be cautious…
This hesitancy is not surprising. Most contractors now participating in the regime would admit that many of the reservations expressed before the introduction of the SSCR – such as a lack of political independence of the SSRO or the risk of continuous 're-opening' of price negotiations – have not materialised.  However, there remain significant uncertainties as to the application of the SSCR that continue to make full engagement a daunting prospect.

The greatest uncertainty concerns the definition of 'allowable costs' that form the basis of contract prices for QDCs. For costs to be allowable, the Act requires both the MoD and the contractor to be satisfied that they are "appropriate, attributable to the contract and reasonable in the circumstances". In doing so, they must 'have regard to' guidance published by the SSRO.  

The SSRO diplomatically reports that it has seen "differing levels of understanding of the Regulations and the SSRO's guidance among contractors and MoD staff."  In reality, the first edition of its guidance inevitably raised more questions than answers as to the allowability of certain costs, such as in relation to rework, overhead rates and contingency. 

More fundamentally, the simple wording of the Act creates a complex dynamic between the MoD, contractors and the SSRO that has yet to be settled.  In the first instance it is the contracting parties themselves who must be satisfied that costs are allowable, and sophisticated operators are understandably anxious to preserve their ability to negotiate freely. At the same time, there is a clear expectation that (in the SSRO’s words) “[The] guidance must be followed unless there are good reasons not to.”  The SSRO reports on compliance with the guidance by scrutinising reports submitted by contractors, potentially exposing those who do not share its interpretation.

There are similar uncertainties as to the profit rates available. In January 2016 the SSRO postponed its plans to introduce different baseline profit rates for different types of contract.  In relation to the adjustments to the baseline profit rate that must be applied to arrive at the profit rate for each QDC, there is not yet a sufficient body of data to allow the MoD and contractors to confidently predict the cost risk and capital servicing adjustments they will be able to negotiate. 

In some areas, it remains unclear what steps contractors must take to avoid incurring financial penalties for non-compliance.  For example, the SSRO has reported that contractors have misinterpreted the legislation on whether pre-existing subcontracts become qualifying subcontracts when they are subsequently amended.  Unfortunately, there are genuine ambiguities in the law in this area that cannot be eradicated simply by adhering to the SSRO's view.

If that were not enough, a host of other complexities exist that will take time to properly resolve, such as how to deal with sunk costs and profit payments when contracts become QDCs on amendment, how to price subsequent contract changes, and the use of provisional rates in contract pricing.

…and cautiously optimistic
Many of these uncertainties will subside as the regime matures. As more referrals are made to the SSRO and more opinions and determinations are published, a body of evidence will emerge clarifying the application of the SSCR and the guidance.  The SSRO intends to publish clarifications of the guidance, and the Secretary of State has already begun commissioning the SSRO to investigate and report on the knottier aspects of allowable costs.

This should be welcomed by industry as much as by the MoD. The sooner contractors become accustomed to the new regime, the sooner they can confidently develop their business, incorporate relations with the SSRO into their bid processes and contract management, mitigate non-compliance risk, and ensure their views are represented. The regime itself holds potential benefits for contractors, including opportunities to earn greater rewards and a more predictable and accountable customer. 

How soon this becomes a reality depends on all parties. If the MOD and contractors take a proactive approach to referrals, and an open and diligent approach to disclosure, the volume and quality of the guidance they receive will rapidly increase. If the SSRO continues to offer advice and support, and publishes knowledgeable and measured guidance and decisions that reflect the complexities of the affected contracts, it will encourage repeat business. In both cases, the opposite is also true.

Single source of truth
There is reason to be optimistic that the SSCR will achieve the stated aims of obtaining better value for money for taxpayers and fair and reasonable returns for contractors.  A harder truth is that these aims ultimately cannot be achieved through compliance alone. 

Enforcement certainly helps to diagnose inefficiencies and unfair returns but it cannot by itself cure the underlying performance issues that inflate prices in the first place, such as poor planning and resourcing, productive utilisation or supply chain management. At worst, an over-reliance on compliance to emulate competitive conditions may lead contractors to reject risk-based prices or walk away entirely. 

Wherever there is a commercial deal to be reached, the contract price must be balanced with a manageable allocation of risk, a well-designed incentivisation structure and practical remedies when things go wrong. If all these elements come together, the true measure of success will be in contract delivery rather than contract prices.



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