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Post Carillion insolvency: what next

Projects portrait1The collapse of Carillion this week has thrown up a range of issues for local authorities and other public bodies. David Kilduff, James Mills and Kate Webster chart a way forward.

With the news of Carillion – a company responsible for delivering a large number of public infrastructure and services contracts from building HS2 to serving school dinners – entering liquidation many public sector organisations (as well as private) must work out how they deal with the collapse. It provides a timely reminder to authorities to consider the risks associated with outsourced contracts and their contingency plans to deal with such situations.

Service continuity will be uppermost in the concerns and the solution will need to balance this imperative with compliance and propriety concerns. Authorities' actions must avoid creating additional problems and risks which can be mitigated if not avoided with carefully planned response.

David Lidlington, Cabinet Office Minister has publicly stated that some services will be taken in-house whereas others will be transferred over to other operators "in a managed, organised fashion". But how will this actually work in practice? This is a complex area in which at one end of the spectrum authorities have obligations to residents and clients and at the other face obligations touching on risks arising from a myriad of aspects including employment, asset transfer, supply chain and commercial issues including IP and data elements.

The Official Receiver has been appointed as liquidator of Carillion and a liquidator has the power to reject or disclaim a contract which is deemed to be a burden on the company. This can have far reaching implications, particularly for counterparties.

Generally, a liquidator has the power to disclaim onerous property (i.e. property that has become a burden) by giving notice, at any time. Onerous property has a broad definition under the insolvency legislation and encompasses an unprofitable contract; any other company property that is unsaleable; is not readily saleable or such that it may give rise to a liability to pay money or perform any other onerous act.

A contract may be defined as unprofitable if the future obligations it imposes would prejudice the liquidator's ability to realise the company's assets and make a distribution to creditors. However, it is important to note that a contract is not unprofitable just because a liquidator thinks that a better deal could have been achieved or it is financially disadvantageous - so the nature and cause of the detriment will have to be examined in detail.

Importantly, a disclaimer only terminates a contract's liabilities that arise after the disclaimer, in other words, the power cannot be used to deny a right or liability which has already arisen although the value of any financial claim is clearly circumscribed by the value realised in the liquidation and the priority afforded to certain creditors over others. On this basis, undoubtedly there is much uncertainty created for public bodies that have contracts with Carillion as to whether or not a liquidator will choose to exercise its power to disclaim unprofitable contracts. Therefore one option for a public body (or other interested party), is to serve a notice on the liquidator requiring him or her to make a decision, usually within 28 days, as to whether or not a particular contract will be disclaimed. It may not where the liquidator sees a viable basis for disposing of those contracts to a new contractor by way of assignment or novation. That will also depend of course as to whether the authority has its own right to determine the contract in the event of an insolvency.

Termination

Authorities need to understand their legal rights, remedies and responsibilities. Typically outsourcing, PPP and public services contracts will contain a right to terminate upon an insolvency event.

In more complex contracts the authority may have rights to keep the suppliers and subcontractors to the insolvent company in place for a period of time to ensure continuity in service provision and allow it to make a decision as to whether it will either appoint a replacement contractor, have the supply chain deliver services to it in lieu of the insolvent contractor or perhaps take the services back in house. Contractually these rights will flow from 'collateral warranties' or 'direct agreements' if the authority is not to make a short term award of contract as a matter of urgency.

A key concern for the authority in larger contracts in the first two instances is that where it steps in to the shoes of the contractor it may find that it has accrued sizeable debts and liabilities to its sub-contractors, in which case the authority may be required to take on these debts and liabilities (usually only those that have been fully disclosed by the sub-contractor). There is also a risk that the sub-contractor may look to re-negotiate the risk allocation in the sub-contract and the authority will need to assess whether any modified terms comply with the EU Rules.

On termination or expiry of public contracts, the services will usually either be performed by a (new) contractor or provided in-house by the authority. Public contracts should contain provisions covering termination consequences including the transfer of assets, employees (pursuant to TUPE), pensions, IP and data. However in situations like this the benefit of contract terms dealing with such matters (e.g. warranties and indemnities on accurate disclosure of liabilities) are as worthless as the insolvent company itself. For this and other reasons the authority may consider setting up a new company to provide the balance of the services keeping it at arm's length from the authority and allowing it time to determine a longer terms strategy.

If, having taken the contract in-house (whether onto the authority payroll or via an authority owned company), the authority wishes to outsource then this will likely involve an OJEU compliant tender process under the EU Rules. This may make some authorities query whether it wouldn't be better simply to transfer the contract to another (solvent) contractor at the outset. On the other hand where the services are taken into a company controlled by the council then it will have certain advantages as a Teckal company for the authority to award it further work.

Transferring the contract to a new contractor

The Cabinet Office has suggested that contracts will be transferred to other providers "in a managed and organised fashion" and the Guardian reported that "contracts were drawn up so that if Carillion failed, other contractors would take over its responsibilities." Whilst touched on above, transferring to a new contractor is not particularly straightforward under the EU Rules.

EU Rules state that a change of contractor is a substantial modification that requires a new tender process. There is an exemption to this rule where a new contractor replaces the old one if:

  1. The replacement follows corporate restructuring, including takeover, merger, acquisition or insolvency; and
  2. The new contractor fulfils the criteria for qualitative selection in the original tender process; and
  3. There are no other substantial modifications to the contract.

These conditions do not make a transfer to a new contractor particularly straightforward. First, the recitals to the EU directive suggest that the contractor should be able to undergo structural changes (including those arising from insolvency) during the currency of the contract. This suggests that the drafters of the EU Directive had more in mind changes to the contractor driven by the administrator rather than the authority selecting an alternative contractor. However, authorities should bear in mind these second and third conditions if an administrator is seeking to change the contractor. The second condition will require the authority to perform "a qualification stage" with this alternative contractor using the original qualification questions. Lastly, the alternative contractor may be reluctant to take on the risk allocation in the existing contract but a modification to this to make it more palatable may well fall foul of EU Rules as a substantial modification to the original contract.

If the insolvent contractor is delivering the contract in a joint venture then the authority may want to explore whether it could transfer the entire contract to the remaining contractor. This is likely to be more straightforward. The Court of Justice decided in 2014 that a bidding consortium could be replaced with a single entity that was part of the consortium provided that the single entity met the qualification criteria for the contract. It therefore seems arguable that competition would not be distorted if the contracting parties were reduced in number provided the initial qualification criteria were met and there were no other material modifications such as the level of guarantees and similar surety obligations.

Some public contracts may contain provisions which permit the funders to auction off the contract where the existing contractor is subject to insolvency (e.g. PFI) or exit and hand the project back to the authority. However, it will require a review of the exact drafting to determine whether or not these provisions would meet the requirements of the EU Rules for "clear, precise and unequivocal review clauses".

If an authority were to drive a novation of the contract to an alternative contractor outside of the above exemption without an OJEU advertised procurement then the next question would be whether it complied with one of the grounds for direct awards in particular, whether this was "strictly necessary where, for reasons of extreme urgency brought about by events unforeseeable by the contracting authority, the time limits for the open or restricted or competitive procedure with negotiation cannot be complied with".

Insolvency may seem an obvious unforeseeable event and there may be circumstances where authorities could use this but it is far from clear cut. Differing judicial views might be expected depending on whether the novated contract had 6-9 months left to run or whether it was a complex PFI contract with another 10 years left. At the core of the EU Rules is the principle objective of ensuring the free movement of services and the opening-up to undistorted competition in all the Member States. The distortion of competition is likely to be a key consideration in determining whether a novation complies with the EU Rules or not.

Pension liabilities

Another issue to consider in the wake of the liquidation of the Carillion Group, is employer pension schemes. Setting aside complications with the application of TUPE for now (see below), any new contractors wanting to take on Carillion's employees and fulfil their contracts will face the cost of providing pensions schemes; yet the type of scheme which must be provided will depend on the status of the workers. Broadly speaking, if the new contractor takes on any workers from Carillion who used to be employed in the public sector, then they will have to keep providing a defined benefit scheme comparative to what the employee received in the public sector, which can be an expensive benefit. In contrast, if the new contractor takes on employees who were never in the public sector then then will not have to provide a defined benefit scheme to those employees and the pension costs will be much lower. Any defined benefit pensions deficit relating to Carillion will generally be left behind without the new contractor having to pick up the tab. One option might be for authorities to take the services Carillion provided, like the provision of school meals for example, back in-house along with the staff but authorities will also need to consider the pension implications of such a move in detail and the procurement position of other public bodies who may also have been provided services by that workforce and whether such contracts could properly continue in the medium term.

Employees

When you are dealing with a change of contractor under normal circumstances, the transfer of undertakings legislation (known as TUPE) may apply to employees. Broadly speaking, under TUPE any employees who are assigned to the services being provided would transfer from the outgoing contractor to the new contractor on their existing terms and conditions and their existing length of service would be preserved. Those employees would also enjoy certain protections against (i) unfair dismissal related to TUPE; and (ii) changes to their terms and conditions.

However, TUPE's rules are different where the outgoing contractor's assets are being liquidated which is the case with Carillion. The key differences include:

  1. the employees of the existing contractor will not automatically transfer to the new contractor;
  2. employees whose employment is terminated will not be able to claim automatically unfair dismissal under TUPE, although their dismissals could still be deemed 'unfair' for other reasons;  
  3. certain employee liabilities (including up to 8 weeks' unpaid arrears of wages) will be met by the government's National Insurance Fund – the types of liabilities that an employee can claim from the Fund depend on whether or not their employment has been terminated; and
  4. the new contractor has more flexibility to agree changes to terms of employment with any retained employees, provided that those changes are made with the intention of safeguarding employment by ensuring the survival of the business. These changes are subject to certain requirements, including the requirement to agree the changes with appropriate representatives of the employees.

Don't forget that the requirements to inform and consult with appropriate representatives of employees still apply to TUPE transfers, even if the situation involves liquidation. Failure to comply with this requirement can itself lead to awards of up to a maximum of 13 weeks' gross pay per employee by an Employment Tribunal and both the outgoing and new contractors can be liable for such awards. Therefore employment issues require careful consideration.

Next steps

The right course of action for any Authority will ultimately be to balance commercial pressures and the need to continue delivering services within the regulatory requirement of the EU rules on procurement and domestic legislation. While Authorities directly affected by the Carillion collapse take urgent advice, its insolvency is a reminder to all Authorities to check and take expert advice on their existing contracts as well as their plans for future contract awards and procurements and ensure they are prepared for the unexpected.

David Kilduff is a partner and head of the Energy, Infrastructure and Government Group, James Mills is a trainee solicitor and Kate Webster is a director at Walker Morris LLP - for advice on this topic please feel free to contact them. The firm's specialist Employment, Pensions and Insolvency Teams would also be happy to assist you with any of the issues raised.

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