Too big to fail: outsourcing in the public sector and the Carillion collapse

One lesson most people took away from the banking crash in 2008 was that no organisation should become too big to fail.

The financial crisis put the very nature of British governance and society under the microscope, with its over-reliance on massive financial institutions.

A similar outcry followed the collapse of Carillion, a leading government contractor which was involved in some of the biggest public infrastructure projects in the country.

The Scottish Building Federation argued that the public sector’s default position of ‘big is better’ locks small to medium enterprises out of the competition, and also puts the public sector at risk if the giant is felled.

Stephen Kemp, SBF president and managing director of Orkney Builders, said the collapse of Carillion was “an important lesson for government that, when it comes to awarding public sector work, big is by no means always best”. 

A damning report from two House of Commons select committees, published last week, found that Carillion directors prioritised executive bonus payouts and dividends for shareholders as the firm neared collapse.

They put Carillion’s demise down to  “recklessness, hubris and greed” among directors who put their own financial rewards ahead of all other concerns ­– including pension payments which they allegedly regarded as “a waste of money”.

Frank Field, who chairs the Work and Pension Committee, said: “Same old story. Same old greed. A board of directors too busy stuffing their mouths with gold to show any concern for the welfare of their workforce or their pensioners.”

In a joint statement with business committee chair Rachel Reeves, the pair called for a complete overhaul of Britain’s corporate governance regime.

“British industry is too important to be left in the hands of the likes of the shysters at the top of Carillion,” Field said.

Phil Bentley, CEO of Mitie – whose contracts include maintenance of the Scottish Parliament – said the liquidation of Carillion has “raised fundamental questions” about the outsourcing industry. 

He warned of a “challenging” year ahead for the company, which has had a series of CEOs in recent years, after it made statutory losses in 2017 and shares fell to their lowest level for nearly 13 years in March this year.

Other outsourcing companies including Interserve and Capita are also under pressure.

Interserve, which employs about 80,000 people worldwide, is expected to accumulate a net debt of £600m in the first half of 2018 – insisting the margins on UK Government contracts are too tight to make a profit.

Capita lost 47 per cent of its share value on 31 January after a new CEO announced a profits warning, a £700m rights issue and a cost-cutting and disposals programme.

The reason for the plight of the outsourcing giants has split down the old ideological divide. 

Right-wing libertarians blame the public sector for squeezing hard-working businesses until the pips squeak, while left-wing statists have piled the onus on corporate bosses who put short-term dividends before long-term sustainability.

The reality, according to Oxford University economist Simon Wren-Lewis, lies somewhere in between.

“There are either ‘private good, public bad’ people or ‘public good, private bad’ people,” he wrote on his blog Mainly Macro.

“Carillion…did not go bust because of privatisation of public services, unless you think the government should build its own hospitals or roads. 

“If anything, it shows that those contracting out public contracts were getting a good deal.”

Wren-Lewis acknowledged that the UK Government does have questions to answer over the collapse of Carillion, particularly over why it continued to award contracts after a profit warning, its lack of oversight, and its failure to ask questions about the pay-out of large dividends in a company with an underfunded pension pot.

But he insisted outsourcing can save money, pointing out that part of Carillion’s difficulty was that the margins on public works are so tight that there is little wriggle room when things go over budget.

Executive pay at Carillion was about the same as the salaries awarded to public sector managers as the company tried to keep costs down to compete for public contracts.

But there are only so many corners a company can cut before its standards and balance sheet are whittled to a stump, while increasingly austere governments are reluctant to sign contracts that hand outsourced companies a blank cheque.

As Wren-Lewis observed: “In truth, the public sector is much better at stopping managers using their monopoly power to be paid over the odds than the private sector appears to be.”

However, it takes a good lawyer to write good contracts which prevent private firms taking public money and running with it – and good lawyers costs money. 

Some think money could be saved by sacking the lawyers and bringing the contracts in house, where they will be overseen by public figures who (should) put taxpayers’ money before private dividends.

It doesn’t always work like that, though, as Glasgow City Council’s experience with ALEOs (arm’s length external organisations) demonstrated. The council has wound up several of its ALEOs since 2011 following an outcry over councillors awarding themselves additional payments of more than £250,000-a-year for sitting on the ostensibly external boards, following the age-old tendency of nationalised industries to descend into cronyism.

However, as bad as ALEOs were, the few thousand pounds councillors were creaming off the top to supplement their relatively low incomes paled in comparison to the hundreds of thousands – or even millions – corporate executives take in bonuses and dividends.

Roger Barker, head of corporate governance at the Federation of Small Businesses, said it was “highly inappropriate” for Carillion to relax the rules in its bonus structure in 2016 which previously allowed the company to clawback bonuses in the event of corporate failure.

“It does no good to the reputation of UK business when top managers appear to benefit in spite of the collapse of the organisations that they are responsible for,” he said.

Unions, predictably, proclaim that the collapse of Carillion demonstrates the “perils of privatisation”.

Rehana Azam, GMB national secretary, said it showed “the complete failure of a system that has put our public services in the grip of shady profit-making contractors…who answer to shareholders, not patients, parents and service users in our public services.”

Tim Roache, GMB general secretary, said Carillion is just “the tip of the iceberg”.

“Continued privatisations have mortgaged our future and services that we all rely on to profiteering companies,” he said.

But investors, equally predictably, insist the pendulum has swung too far to the left and say the public sector is not paying a fair price for its infrastructure.

Mark Baxter, managing director of Galliford Try Investments, said the last three large Scottish infrastructure projects – the M8 upgrade, the Aberdeen bypass and the Queensferry Crossing – have been “unmitigated disasters” for the contractors involved.

“UK-wide, the construction and infrastructure industry turned over about £80 billion last year and lost £1 billion, collectively, and that is not sustainable” he told the Scottish Parliament’s Economy, Jobs and Fair Work Committee.

“Carillion has gone to the wall, not solely on the back of the bypass project, and Lagan Construction is also struggling. 

“The contract types that we have been signing have moved the risk too much to one side, on which the risks are possibly not understood or known…the public sector has got a bargain, which is great, but that is not sustainable.”

Galliford Try was one of three joint venture partners to form the Aberdeen Roads Ltd (ARL) consortium on the £745m Aberdeen bypass – alongside Balfour Beatty and Carillion.
Economy Secretary Keith Brown insists the Aberdeen bypass remains on track, and 90 per cent of Carillion’s former employees will be taken on by the remaining contractors.

However, ARL has warned that the project is running behind schedule, citing the cumulative effects of weather events on the project, such as Storm Frank in 2015, and delays to the timing of public utility diversions.

It is seeking to recover “substantial costs” from the government for the delays, Brown told parliament in March, revealing an insight into the often fraught relationship between government and its private sector contractors.

“Disputes are not unusual in contracts of this nature and we are working with ARL to understand the basis of its claim,” Brown said.

“An additional complicating factor has arisen from the collapse of Carillion, one of the joint venture partners. 

“As would be expected in such a situation, Carillion’s liquidation has had significant impacts across the UK. 

“The delivery of projects such as the Royal Liverpool Hospital and the Midland Metropolitan Hospital has been significantly impacted.”

In contrast, the Aberdeen bypass contract “made provision” for the collapse of one of the partners – indicating the Scottish Government at least had an inkling that all was not well with the subcontracting sector.

The contract made the remaining construction partners, Balfour Beatty and Galliford Try, “jointly and severally liable for the delivery of the project”.

The Scottish Government may have been able to contain the fire with its prudent contract negotiations, but the structural damage the collapse of Carillion has caused to the wider subcontracting sector may yet bring the house down.

Carillion’s demise increased Galliford Try’s cash commitments on the Aberdeen bypass by more than £150m – and Baxter insists they won’t get burned again.

“The public sector got more asset for its money than it paid for,” he said.

“It is a good deal, but it is not sustainable in the long term…because Carillion went bust, and if we all keep going bust, we will have 43,000 people unemployed.

“The private sector should not have taken on the contracts at those prices. The contract form is not sustainable going forward, and we will not be doing such projects again. Going forward, we will not do large infrastructure projects with a fixed-price, lump-sum contract, because the risks and the rewards do not tally up. 

“So the private sector was stupid and the public sector has done well on those contracts, but that is not sustainable for the industry.”
Subcontractors are clearly concerned that they are being given a raw deal by the public sector, but it’s not as simple as poor innocent contractors being stung by stingy politicians. 

Robin Fallas, a partner at MacRoberts LLP which provides external legal services to Scottish ministers, outlined some of the underhand tactics and hidden charges some contractors have employed to secure public contractors.

Some of the hidden charges would even make budget airlines’ blush – such as “product use price gaming” which involves tendering a low bid with a contract that doesn’t specify how much goods and services should cost, so that contractors can subsequently charge exorbitant prices later.

One roads contractor charged “multiple thousands of pounds to pick up a dead deer”, and had wildly varying charges for paving stones ranging from 1p for the cheapest and £10 for the second option – and they will invariably insist on the most expensive option once the ink on the contract is dry. 

“They might say, ‘the 1p paving stone is not going to work there so you’ll need the £10 one’,” Fallas told a Holyrood conference on effective contract management.

“Unless you have very stringent monitoring of that there is scope for it to end up being a lot more expensive than you thought.”

Contractors also try to catch out public bodies who might not be up to speed with building regulations by discounting unsuitable products in their opening bids.

Fallas cited an example of a contract to replace windows which offered a discount on unsuitable solutions, in the knowledge that the public body would have to procure the most expensive window to meet the regulations.

“The contractor says, ‘They never use that type of window so I’ll put that one down as £5, but there’s a window that they have to use – which they haven’t realised – which I’ll put in at £40 and I’ll win on that basis’,” explained Fallas.

Disputes inevitably arise when the public body realises it has been stung, but contractors also use non-disclosure agreements which prevent other public bodies learning from these mistakes.

“I have seen two huge contracts terminated in the last few years and one of them has an absolute non-disclosure agreement around it,” said Fallas.

However, lawyers recently dismissed suggestions by Labour MSP Neil Findlay that private companies actually go into public sector contracts fixing for a fight.

Fenella Mason, a partner at Burness Paull, told the Scottish Parliament’s Delegated Powers and Law Reform Committee: “I am not sure that I would say that parties go into a contract intending to have a dispute, but they probably go into one without putting enough money into it. 

“If there is not enough money in the contract, people will end up in a dispute. They will be desperate for more money, so they will not price any risks that are inherent in the job.”

Iain Drummond, a partner at Shepherd and Wedderburn, agreed that money is at the root of the current outsourcing crisis, rather than a breakdown in trust between the public and private sectors.

“People in the industry are talking about two particular issues, the first of which is how tight the margins are,” he said.

“With margins at between one per cent and three per cent, even a fairly minor problem can eat up the margin for the contractor, so they have to find some way of making it back.

“The other problem is the lack of attention to design and planning. Everything is done in such a rush now that the temptation is often to skimp on those aspects. 

“Construction is, apart from anything else, a complex business. There will be problems, and it will be difficult to sort them out when the margins are so tight. 

“Contractors would say that, in the olden days, when margins were better, they were able to resolve difficulties with their clients and perhaps allow some of the margin to be swallowed for the sake of future relationships. However, that sort of thing is much more difficult at the moment.”

He suggested that the collapse of Carillion was a product of “overoptimistic bidding” in an extremely competitive market.

So what is to be done? Should public bodies pony up and pay contractors a fair day’s pay for a fair day’s work, as the libertarian privateers recommend – with all of the implications for the public purse that would entail? Or, should public bodies turn their backs on privatisation and bring all public works in house – potentially politicising infrastructure spending even more and running the risk of party cronyism in the rush for top jobs?

The solution – as ever – is probably somewhere in the middle.

Fallas said that public bodies are growing increasingly wise to the gaming tactics of some contractors, which is good news for the public purse, and that public bodies are also willing to shell out to realistic and responsible bidders, which means they will pay fair if contractors play fair.

“I have seen a huge contract where there were two bids for £5 million, one for £7.5 million, and one for £10 million, and during technical compliance it was decided that the £10 million bid had to be accepted,” he told delegates at the Holyrood conference.

“The authority were delighted to be going with the £10-million bid because they were convinced that the other three were just at it, and they were really glad that they were able to pin down the technical aspects that they were not meeting.”

The message is clearly that the outsourcing industry could have a bright future if contractors behave themselves and adopt more transparent tactics.

Public bodies should also open their eyes, put their hands in their pockets and realise that if a deal looks too good to be true – it probably is.