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Carillion: were profit warnings grounds to exclude?

18/01/2018
On 14 January 2018, Carillion Plc, the second largest construction company in the UK went into liquidation. Carillion had issued three profit warnings in 2017, yet during this period the government continued to award the company lucrative contracts.

On 14 January 2018, Carillion Plc, the second largest construction company in the UK went into liquidation. Carillion had issued three profit warnings in 2017, yet during this period the government continued to award the company lucrative contracts. These included £1.3bn of HS2 contracts awarded in July 2017, a week after Carillion had issued a profit warning noting a deterioration in cash flow.  Carillion issued a second profit warning at the end of September 2017 and about five weeks later was awarded a £62m contract with Network Rail.

Media and political commentators have criticised the government for continuing to award contracts to Carillion in these circumstances, suggesting that once concerns about Carillion's profitability had been made public, Carillion should have been disbarred from further contract awards. 

But some have questioned whether this is something that the government would have been legally entitled to do.

ITV News Political Editor, Robert Peston, commented on Facebook on 16 January that: "A member of the cabinet said to me yesterday, in all seriousness, that it would have been “illegal” for the government and public-sector bodies to have rejected bids from Carillion for government contracts in the second half of last year, when it was very publicly warning that its profitability was far less than it had been expecting and almost the entire City of London knew it was in serious difficulties."  

He goes onto express his view that the minister in question was "spinning like a political whirling dervish to cover up incompetence or worse" because "it is inconceivable that officials are banned from factoring into their contract-awarding decisions the balance-sheet strength or weakness of the bidding companies - or whether the successful bidding company is going to be alive long enough to deliver on the contract."

Mr Peston is of course right in a general sense.  The government is entitled to take into account the financial standing including the balance sheet strength or weakness of bidders for public contracts, both at the point of admission to a procurement procedure and prior to contract award.  It is also common for larger contracts to include provisions specifically dealing with what happens where the contractor falls into financial distress, including termination or set-in rights. 

However, as is often the case with procurement law (and law, in general, come to that) matters are not that simple.  This blog considers the constraints that government is under when considering financial standing of bidders in public procurements in the light of Carillion's demise.

Financial standing in public procurement

Exclusion based on insolvency

Helpfully enough, the public procurement rules provide that a contracting authority may exclude a bidder from a procurement procedure where the bidder is bankrupt, insolvent or subject to winding up proceedings.  Under insolvency law, a company is insolvent where it is "unable to pay its debts as they fall due" (cash flow insolvent) or the value of the company's assets is less than its liabilities (balance sheet insolvent).

Although a profit warning that notes a deterioration in cash flow ought to have raised concerns, it would not necessarily be an indicator of insolvency. The government might have done more financial due diligence on Carillion, or tried to protect itself contractually, but under the public procurement rules, it is unlikely to have been able to exclude Carillion from participating in a procurement on the grounds of insolvency, based on profit warnings alone.  It could of course exclude Carillion on those grounds now, but that is not much help!

Exclusion and selection based on economic and financial standing

Unsurprisingly insolvent companies rarely bid for public contracts, so the more usual way in which the financial health of bidders is taken into account is through the selection criteria for admission to the procurement.

Under the public procurement rules, contracting authorities may impose requirements to ensure that economic operators (i.e. bidders for contracts) possess the necessary economic and financial capacity to perform the contract and can require proof of the economic operator's financial standing.  In particular, contracting authorities may require economic operators to:

(a) have a minimum yearly turnover, including a certain minimum turnover in the area covered by the contract;

(b) provide information on their annual accounts showing the ratios, for example, between assets and liabilities; and

(c) have an appropriate level of professional risk indemnity insurance.

This list is not, however, exhaustive.

Contracting authorities are specifically allowed to look at balance sheet ratios provided that they disclose the methods and criteria for assessment of ratios are transparent, objective and non-discriminatory and are disclosed to bidders in the tender documents.

The rules do not preclude measures of financial standing based on profitability provided that they are proportionate and relevant to the contract being tendered.  It would in our experience be unusual for profitability measures to be used to the exclusion of other measures of financial strength, such as turnover or balance sheet ratios.

Where minimum levels of financial standing must be met in order to participate in a procurement and be awarded a contract, those minimum levels must be determined by the contracting authority at the outset and disclosed to bidders. 

If financial standing requirements are too stringent, this can be a barrier to entry to government contracts, especially for SMEs and there has perhaps been a trend in recent years to reduce such barriers.  For contracts of the scale that Carillion was bidding for, however, financial standing is likely to have been an important factor.

In the case of Carillion, all this points to a simple truth: assuming that Carillion was not in fact insolvent at the time it was awarded the contracts last year, the government's ability to exclude Carillion on financial health grounds would have depended on the rules and criteria set by the government itself in each procurement in which Carillion was bidding.

If, for example, the financial standing criteria were assessed merely on the basis of turnover, it is quite possible that Carillion, as a large listed company, would have continued to meet the threshold even as its financial position worsened. More sophisticated measures based on balance sheet ratios might have picked up the deterioration but a judgment would need to be made in each case based on the terms of the procurement whether that deterioration was sufficient to warrant exclusion.

Hindsight is a wonderful thing, not afforded sadly to those who design procurement procedures, and the insolvency of major government contractor is an exceptional occurrence.  It is entirely possible therefore that the financial standing tests set out for the contracts which Carillion was awarded in 2017 simply did not give the government the possibility to exclude.  (It is also of course possible that they did but the government chose not to exclude them – but that is another story!)

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