Peter Kitson, Lee Ranford and Thomas Bond unpick the factors that contributed to Carillion’s downfall and saw the company go into liquidation rather than administration.
The news of Carillion’s collapse has surprised many, despite three profit warnings since last July.
The reality is that Carillion has been living on borrowed time for months. The company had exhausted ordinary lines of commercial credit, pushed its lenders to the limit and relied on expensive reverse-factoring arrangements to keep projects moving. Carillion’s appeals to creditors were unsuccessful and ultimately it was left with no option but to file for insolvency.
Unusually, Carillion (the public limited company, along with various subsidiaries) immediately entered compulsory liquidation rather than administration (which is much more common).
Administration
The purpose of administration is to (1) rescue the company as a going concern or (if not possible) (2) achieve a better result for the company’s creditors than could be had by winding the company up or (if neither of those is possible) (3) realise some or all of the company’s property to make a distribution to secured or preferential creditors. Given the condition of Carillion’s balance sheet, it seems that there was no viable way to achieve any of those purposes through administration.
Often a company trades throughout administration; either to an orderly winding up after realising stock and other assets or until the unprofitable parts of the business are ditched and the remaining elements return to financial health and leave administration. The very point of a trading administration is that the administrators take control of the business; Carillion’s projects are simply too big and too complicated for that to be manageable. Carillion’s business spans numerous sectors and its performance is reliant on third parties including the substantial chain of subcontractors in the construction industry and the intricate relationship between Carillion’s employees and the various companies in which they operate in the facilities management business. Trading that business in administration would be an enormous task.
The most simple reason administration was not viable, though, is that there were no elements of the business worth salvaging; the only available assets were contracts with unsustainable profit margins.
It is often a commercial reality that when a company fails there is a new corporate vehicle waiting in the wings, usually under the control of the existing managers, ready to acquire contracts and assets, free of the old company’s debt. This is known as a “pre-pack”. The pre-pack allows those managers to start afresh, but it seems that despite having hundreds of high-profile contracts, none was sustainably profitable. In the circumstances, given the political fallout, any pre-pack would have attracted significant criticism.
Official receiver
The official receiver is acting with support from “special managers” at PwC. Those special managers are appointed under a statutory power, but the exact scope of their role is determined by the court documents under which they are appointed.
The special managers will manage distinct aspects of the liquidation, but are ultimately subject to the direction and control of the official receiver. That ensures that there is central and consistent control of Carillion’s sprawling businesses and that essential parts of the business, linked to public sector work, can be managed in accordance with the public interest.
The official receiver’s involvement will also help to manage costs. The reality is that there aren’t sufficient realisable assets to pay the administrator’s fees incurred by any of the large accountancy firms. The official receiver can rely on support from PwC while handling various aspects in-house, to try to keep a handle on cost (albeit at the tax payer’s expense). With PwC taking on limited responsibility, the risks it faces (and therefore its operating costs in handling aspects of the liquidation) are lower.
Inevitably, it will be some time before all the reasons behind Carillion’s collapse can be understood. Irrespective, however, of the specific contracts and decisions that may be found liable for Carillion’s liquidation, the market conditions in which Carillion operated should not be ignored.
Public contracts and procurement
In relation to public sector work, those conditions are hugely influenced by the operation of the Public Contracts Regulations 2015 and other legislation importing EU procurement directives into UK law. Aimed at allowing potential bidders in any European country to compete for contracts awarded elsewhere in Europe, these regulations require public bodies to award substantial contracts through prescribed procurement processes.
Contract award decisions must be made on the basis of objective evaluation criteria, which are disclosed in advance. With few exceptions, any post-tender negotiation is prohibited. The regulations also make it difficult for authorities to insist on quality standards that are higher than those required by law.
In addition, the regulations provide aggrieved tenderers with the right to claim damages and sometimes even to require the concluded contract to be set aside.
Alongside limited resources and expertise in public bodies, these regulations contribute to a risk-averse approach to procurement. In many cases, energy and resources can appear to be devoted to avoiding challenge rather than to ensuring that procurement outcomes deliver the authority’s aims and reflect the needs of service users.
Comparative pricing
One example of that approach is the widespread use of comparative pricing models. Typically, complex contracts of the type which Carillion was interested in are awarded to the “most economically advantageous tender”. That requires an evaluation of price and qualitative factors, which are combined to produce an overall tender score for each bidder.
Even for complex contracts, most authorities adopt a comparative approach to price evaluation. The lowest-priced compliant tender is awarded the maximum score and all other bidders’ scores reflect the extent to which their price is higher. For strained procurement officers this approach has two main advantages. First, the “best price” is determined by the market rather than by the authority in advance. That requires fewer upfront resources and also helps to control challenge risk.
Secondly, the comparative model tends to produce large differences between bidders. Large differences between tenderers – especially established by reference to objective pricing – help significantly to reduce the risk of challenge.
In practice, however, comparative price models tend to disproportionately favour tenderers submitting the lowest price, irrespective of the weightings given to price and quality.
Assuming that 50% of the available marks are allocated to quality, qualitative marks for a competent group of tenderers would usually be clustered around 35-40%. That is partly because any inexperienced or under-qualified applicants would have been de-selected prior to tender stage. Setting out evaluation criteria in advance and the obligation to treat all bidders equally also contribute to uniform quality marks.
Another contributor is that bids are generally prepared by specialist business development teams, and all bidders are working at risk.
Consequently, it is often difficult for tenderers to distinguish themselves from their competitors on the basis of their qualitative submissions.
By contrast, comparative pricing models typically produce large disparities between tender submissions, especially between the lowest-priced tender and the remainder of the field. Returning to our example, the lowest-priced tenderer will receive the maximum 50 marks, something which is almost impossible to achieve on a qualitative evaluation. Secondly, if the second-lowest price is 10% higher, that tender will receive 45 marks – that difference is probably sufficient to outweigh any disparity in quality marks. Any bidder that is 20% higher is effectively out of the running.
This combination of uniform quality scores and comparative pricing models is endemic in public procurement. Public bodies, tenderers and their advisers all recognise that public procurement processes disproportionately deliver contracts at very low profit margins.
The 2015 Regulations strengthened public bodies’ rights to investigate and exclude bid prices which are “abnormally low”. Here again, comparative pricing models are popular because – the logic goes – any bid price which is significantly below the mean average is worthy of investigation. The problem arises when all bids are equally low. It would be a very confident public body which would exclude three cheaper bids to award to the sustainably priced bid in fourth place.
A failed business model
Of course, price competition is desirable for public contracts. The impacts, however, of a disproportionate focus on price and a reliance on minimum quality standards should not be underestimated. Whether through high-profile collapses such as Carillion, failed procurements, reduced services or even through the impacts of inadequate health and safety standards, public services are inevitably affected.
Carillion was undeniably busy and good at winning work, but it seems that that came at the expense of profitability. That is clearly an unsustainable business model and doesn’t fit squarely with the recent rhetoric about profiteering contractors. The reality may be that the price sensitivity of public contracts created a problem that Carillion could not trade out of and caused Carillion to become ever more reliant on public work, which simply compounded the problem.
Main image: © Tony Hall/REX/Shutterstock
Peter Kitson is a partner in the construction team, Lee Ranford is a partner and Thomas Bond is an associate in the insolvency team at Russell-Cooke LLP
