Allowable Costs under the Single Source Contract Rules: Costs for work undertaken at risk before entering into a defence contract

By Dr Luke Butler, Lecturer in Law (University of Bristol Law School).

38611963In an earlier blog, I introduced the Defence Reform Act 2014 (DRA), the Single Source Contract Regulations (SSCR) and the Single Source Regulations Office.[1] Collectively, these regulate the pricing of defence contracts awarded by the Ministry of Defence to a single source contractor. It is recalled that contractors can recover certain “Allowable Costs” incurred under a Qualifying Defence Contract (QDC) if they are appropriate, attributable to the contract, and reasonable in the circumstances (the so-called “AAR test”).[2]

But what if, ahead of the agreement of the contract, work relating to the contract is undertaken at risk pursuant to an “intention to proceed” (ITP) arrangement?[3] Unless the ITP fulfills the requirements for a legally binding contract, it cannot itself constitute a QDC.[4] This leaves the question whether this kind of pre-contractual work can constitute an Allowable Cost recoverable under the QDC once the QDC is in place.

On 26 October 2016, the SSRO gave a formal Opinion on this question in response to a joint referral by the MOD and contractor.[5] In giving its Opinion, the SSRO operated on two assumptions: (1) that there were no contractual obligations between the MOD and the contractor in respect of the work covered by the referral question; and (2) the MOD had not instructed the contractor to undertake this pre-contractual work.[6] It is also notable that neither party were in dispute over the issue, suggesting the referral was simply for clarification than to affirm a particular view. [7] Further, in commencing work prior to the agreement of the contract, the contractor accepted that there was a risk that costs incurred may not meet the AAR test should a contract be signed.[8]

This blog sets out the SSRO’s Opinion before offering just some observations on its developing jurisdiction.

SSRO’s Opinion

Ultimately, the SSRO opined that costs incurred at risk prior to entering into the contract may be Allowable once the contract is in place.[9] This is subject to such costs meeting the AAR test, having regard to the SSRO’s Single Source Cost Standards, before they are included in the price of the proposed QDC.[10] The SSRO noted that the lack of a specification in this case prevented an assessment or determination at this stage of whether the AAR test was met.[11]  If a QDC is subsequently entered into, the MOD and the contractor will need to review these costs against contractual obligations to decide whether the costs can be classified as necessary to fulfil the requirements of the contract.[12] The SSRO appeared to identify the following arguments supporting its reasoning.

Pre-contract costs incurred at risk can be attributable to the contract

Firstly, the SSRO opined that there is nothing inherent in whether the cost is “attributable to the contract” under the AAR test which excludes costs that are pre-contract and at risk.[13]

Contract pricing formula does not limit the date on which a cost can be incurred

Secondly, the SSRO indicated that the DRA/SSCR pricing formula (one element of which is Allowable Costs)[14] provides that an Allowable Cost may be as estimated at the time of agreement, or the estimated amount subsequently adjusted according to specified indices or rates, or actual costs as determined during or after the contract completion date.[15] In other words, there was no limitation regarding the date upon which a cost may be incurred in order for it to be considered an Allowable Cost once the contract is in place. This appeared to be further supported by the Single Source Cost Standards which indicate that its Guidance applies to both estimated and actual costs and that costs incurred in advance of a contract becoming a QDC may also be subject to the regime.[16]

 Guidance supports costs incurred at risk as being Allowable Costs

 Thirdly, the SSRO “draws attention” to certain statements in its Single Source Cost Standards “in so far as relevant” as to whether costs incurred at risk are AAR. As will be discussed below, the inference to be drawn is that relevant issues include: whether a cost was expected to be incurred (in determining whether appropriate); whether it is necessary for the fulfilment of the QDC and whether there was a causal relationship with the contract (in determining whether attributable); and whether it is congruent (in determining whether reasonable). Further, it was reasoned by analogy that the Single Source Cost Standards also provided that bid costs, which by definition have to be incurred pre-contract and at risk, may be Allowable, if properly evidenced.[17] In addition, the SSRO indicated that it considered such a question in its SSRO Answers publication and the SSRO’s May 2016 Newsletter.[18] There it was indicated that work undertaken relating to an ITP may be genuinely at risk and not strictly subject to the DRA/SSCR at the time when it is carried out; however, when incurring costs at risk, contractors should remember that if those costs are later to be incorporated into the price of a QDC, then they will become subject to this regime.[19]

Evidential limitations in making this assessment remain

This blog confines itself to just a few observations. At the outset, it must be acknowledged that, as permitted by its referrals guidance, the Opinion was only published as a summary in recognition of issues of “commercial sensitivity” for the parties.[20] It is, therefore quite possible that issues raised here will be elaborated in a full Opinion. However, this still leaves the broader question of the extent to which commercial confidentiality will impact a full understanding of the reasoning. It is also open to speculate whether the SSRO is receiving the necessary information from parties on which to reach an informed Opinion. It is recalled that the SSRO had to work on certain fundamental assumptions regarding information that most would consider important, for example, regarding the contractual status of prior work in the instant case. It is further recalled that the SSRO were unable to assess whether costs met the AAR test due to lack of specification.[21] Yet, the SSRO itself indicates that it reviewed written evidence; it is unclear whether it did, or should have, obtained more detailed information by other means as permitted under its referrals procedure.[22]

Framing the issues relative to the criteria and vice versa

Whilst, in theory, all three AAR critiera are equal, it is arguable that the SSRO placed particular emphasis on the relevance of the “attributable” criterion in determining whether costs incurred at risk are Allowable Costs. This is evidenced by the weight attributed to it in the Opinion and elsewhere, for example, the Newsletter. The greater emphasis on the “attributable” criterion is understandable. If asked: why is a pre-contractual cost at risk not allowable?, the overriding sense would be because such costs do not have their origins in the contract i.e. they are not attributable per se. However, this highlights the potential for reasoning to focus disproportionately on one criterion to the exclusion of other criteria. It may also give the (false?) impression that the attribution criterion is more easily satisfied than others. Parties might well agree or reluctantly concede that a cost is attributable but fundamentally disagree as to whether it is appropriate and reasonable. It is also reminded that the question as asked was whether such costs “may represent” an allowable cost, indicating that there was no particular emphasis placed by the parties on one criteria or the other. This raises a broader question about how the SSRO deals with questions as stated and whether there is a case for greater clarity in the requests stated.

Uncertainty in applying the criteria

It is also notable that whilst the SSRO intimated that costs incurred at risk may meet the AAR criteria, it stopped short of indicating how the language of the criteria applies specifically to a cost incurred at risk. As indicated above, this may be due to the fact that the SSRO did not receive sufficient specification to conduct this assessment. It is also emphasised that it is for the parties to prove that a cost is Allowable. Notwithstanding, the SSRO might have indicated how the AAR criteria applied in principle specifically to costs incurred at risk even if it could not indicate how such criteria apply to such costs on the facts of a particular case.[23]

As indicated above, parties are simply left to infer which statements in the criteria might apply to costs incurred at risk being those that touch on the relationship between the costs and the contract. This also means that there is some uncertainty in their interpretation. For instance, when is work undertaken “genuinely at risk”? When is such a cost “necessary for the fulfilment of the QDC”? Any lawyer knows that references to causation (i.e. a “causal relationship” between the cost and the contract) open up a minefield of enquiry. It may also imply notions of remoteness that may be difficult to assess. For instance, the Opinion simply states that costs incurred at risk “prior” to entering into the contract may be allowable.[24] Therefore, there is still considerable uncertainty as to how these criteria apply notwithstanding that it is for the parties to prove. If it were considered necessary to issue guidance on what constitutes a “direct” or “indirect” cost to clarify uncertainty, what does this mean for pre-contractual costs incurred at risk?

Awareness of what should be relevant in justifying the Opinion

The SSRO indicates that its Opinions and certain of the documentation on which it relies are not legally binding. However, the SSRO should be cautious about what sort of documentation it relies on if it wishes to develop a coherent series of decisions or even a loose system of precedent. To illustrate, since its inception, the SSRO has produced multiple publications in successive versions, so many that only dedicated experts are able to keep track. It is almost inevitable that over time, inconsistencies and discrepancies between statements and interpretations between documents will arise. The SSRO has already been confronted with concerns about statements in its statutory guidance.

Yet, the SSRO in its latest Opinion appears to identify Q and A documents (SSRO Answers) and Newsletters alongside its formal guidance as “relevant guidance”. Citation of relevant SSRO publications is useful as general context; however it is of questionable use in aid of the interpretation of what are legal rules: the AAR test, for example. A host of more general issues arise.

Firstly, what is the provenance, if any, of a particular document and when is a document relevant or not? To give an extreme example, can reliance be placed on statements made in speeches given by the SSRO Chair at industry events (Chatham house rules)? The SSRO can hardly object if parties seek to rely on draft documents, older versions and other sources to aid interpretation if the SSRO does not give a clear indication of what is relevant.

Secondly, there is a risk that statements made at one point may subsequently affect Opinions and Determinations expressed at a later point (what about documentation issued in the interim between an Opinion and Determination?).

Thirdly, there are questions about the utility of documents such as Newsletters and SSRO Q and A answer documents as aids to interpretation generally. The SSRO May Newsletter identified the costs incurred at risk issue as one raised by industry and addressed through its SSRO Answers. If this was intended to clarify matters and prevent or reduce the possibility of referrals for Opinions, it did not prevent parties in the present case from seeking an Opinion on a matter of principle.

In short, there is enough concern applying the formal guidance. The SSRO might be advised to stick to it. Further, with the greatest respect, it also looks odd referring to Newsletters in formal opinions.

Pre-contractual costs at risk = value for money: risky hypothesis?

One final thought, the SSRO emphasises not once but twice its general obligation under Section 13(a) DRA that in carrying out its statutory functions, the SSRO must aim to ensure that good value for money is obtained in government expenditure on QDCs.[25] The SSRO’s Opinion is an indication that it sees the recoverability of costs incurred at risk as Allowable Costs as contributing to the attainment of this objective. Yet, at no point does it justify its reasoning in reference to Section 13(a). As a matter of general principle, does the recognition of such pre-contractual costs incurred at risk contribute to the achievement of good “value for money”?  What is clear is that the SSRO’s Opinion now brings within the orbit of assessment another aspect of “risk” in the form of pre-contract costs.

I welcome views as to whether, on balance, this represents a positive or negative move in a risk-averse industry. As ever, I can be contacted via the blog space or in confidence at: Luke.Butler@bristol.ac.uk.

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[1] https://legalresearch.blogs.bris.ac.uk/2016/08/singling-out-defence-procurement-contract-pricing-under-the-single-source-contract-regulations/.
[2] Section 20(2) DRA.
[3] MOD Guidance has historically cautioned against the use of such arrangements given that risk is not contractually defined; however, anecdotal evidence suggests they appear to be fairly common in practice.
[4] As the SSRO May 2016 Issue 7 Newsletter has observed: “However, not all ITP arrangements are entirely at risk and a contract may in fact arise in some cases, depending on the particular circumstances. This will be where the required elements for a contract exist: an offer, acceptance, consideration, intention to create legal relations, and certainty of terms. Such ITP contracts may be a QDC or QSC if the other requirements for a QDC or QSC are present.”
[5] Pursuant to Section 35(3)(b) DRA which authorises the SSRO to give an opinion on a proposed QDC. See SSRO Opinion, Opinion on Allowable Costs arising from work undertaken at risk, 26 October 2016. Dates concerning referral, receipt and acceptance of referral are not stated in the Opinion.
[6] Opinion, para.2.5.  With regard to the scope of the referral, the SSRO also proceeded on the basis that the contractual relationship for payments between the contractor and any sub-contractors in respect of pre-contract works was outside the scope of the referral. Ibid., para.2.4.
[7] Opinion, para.2.3. It is not clear what, if any, effect the fact of it being contested would otherwise have on the Opinion.
[8] Opinion, para.2.3. In most cases, it would seem logical that a party seeking to recover costs would  argue that such costs were Allowable Costs. However, there may exceptionally be good reasons why a contractor may not want such costs to be recoverable.
[9] Opinion, para.2.6.
[10] Opinion, para.2.7 and para.2.13. Section 20(1) DRA provides the power under which the SSRO issues guidance about determining whether costs are Allowable under a QDC. Section 20(3) provides that, in deciding whether a particular cost meets the AAR test, the Secretary of State (or an authorized person) and the primary contractor must have regard to the guidance (the Single Source Cost Standards). The parties agreed in evidence that this was the proper basis for assessment. Opinion, para.2.11.
[11] Opinion, para.2.8.
[12] Opinion, para.2.9.
[13] Opinion, para.2.12.
[14] The statutory pricing formula = (Contract Profit Rate x Allowable Costs) + Allowable Costs: see Section 10 DRA and Regulation 15 SSCR (outlined my previous blog).
[15] Opinion, para.2.12 citing Section 15 DRA and Regs.10(1), 10(4)-(11) SSCR.
[16] Opinion, para.2.12 also referring to para.2.15 citing Single Source Cost Standards, para.6.4.
[17] Whilst understood, the analogy to bid costs is open to question. For instance, it is not necessarily the case that bid costs are always incurred pre-contract; bid costs can be incurred under contract. Further, it is not always the case that a winner recovers bid costs even if properly evidenced.
[18] Opinion, para.2.17 citing: https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/557176/SSRO_Answers_30_September_2016.pdf, para. 4.13 and Newsletter (n 4).
[19] Ibid.
[20] Opinion, para.2.1.
[21] Opinion, para.2.8.
[22] Opinion, para.1.3.
[23] The SSRO itself indicates that whilst it is not a full Opinion, it purports to outline the “key principles which emerge”. Opinion, para.2.1.
[24] Opinion, para.2.12.
[25] Opinion, para.1.4 and para.2.12.

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