Defence Briefing - December 2014

The Defence Reform Act 2014 and the Single Source Contract Regulations – A new way for the MOD to drive a harder bargain?

The Defence Reform Act 2014 (DRA) creates a new statutory framework, called the Single Source Contract Regulations (SSCR) and a new public body, called the Single Source Regulations Office (SSRO).

The SSRO has been established to oversee the regulatory framework for single source contracts.

The MOD, as a public authority, is required under EU law to procure goods and services via an open and competitive process. Single source contracts are awarded directly to a contractor without such a process taking place. These awards are only permitted in particular circumstances. The exceptions relevant to defence contracts are:

• where it is considered necessary for national security; or
• when there is only one supplier capable of supplying the goods or services in question.

A high proportion of military contracts in the UK are procured on a single source basis; the value of such contracts is estimated at around £6 billion per year. The purpose of the new legislation is to drive value for money for the MOD even when a competitive tender is not used.

The DRA will have wide reaching effects on those contracts that are caught by the regime, including:

• price negotiations conducted on a statutory basis, leading to less flexibility;
• an increase in reporting requirements; and
• penalties on contractors for non-compliance.

Defence contractors will need to adapt to the new pricing and reporting regime, and pay close attention to the guidance being given by the SSRO.

Which contracts will this apply to?

Qualifying defence contracts are:

• between the Secretary of State for Defence and a primary contractor;
• valued at £5 million or more; and
• not the result of a competitive process.

The DRA will also apply to qualifying defence sub-contracts which are:

• necessary to enable the performance of a qualifying defence contract;
• valued at £25 million or more; and
• not the result of a competitive process.

The result of these limits is that the majority of contracts and sub-contracts entered into by SMEs will not be directly affected by the SSCR.

How will this affect price negotiations?

Price negotiations have previously followed a voluntary code of conduct. The SSCR will result in negotiations being made under a statutory basis.

Contracts will be priced in line with a simple pricing formula that bases the price on allowable costs uplifted by a contract profit rate.

Allowable costs are determined against one of six methods (firm pricing method, fixed pricing method, cost-plus pricing method, estimate-based fee pricing method, volume-driven pricing method or target pricing method).

The contract profit rate is calculated by subjecting a baseline profit rate (which the draft documents suggest will initially be set at 10.7%) to adjustments for various factors, including the level of risk and the cost of capital.

 
This is likely to lead to less flexibility in price negotiations than was previously the case, and for the need for contractors to be very transparent with their cost information.

How will reporting requirements change?

There will be reporting requirements on contractors under the SSCR.

A contract reporting plan must be provided by a contractor within one month of entering into a qualifying contract. This plan will include a timetable of reporting obligations that will then need to be followed.

For contracts valued at £50 million or more, contractors must provide quarterly reports which will include, among other information, detailed estimates of incurred and forecast costs.

What about sub-contractors?

If a prime contractor sub-contracts out a portion of their contract, and that sub-contract is valued at more than £25 million, then the sub-contractor can expect the price negotiations and reporting requirements to be caught under the new regime. The prime contractor can also expect to negotiate and review the pricing of the sub-contract using the new pricing rules.

What are the penalties for non-compliance?

Failure to provide all the information required by the SSCR could result in the name of the supplier being made public, and could also result in a fine.

What is the impact on SMEs?

The SSCR are designed to minimise the burden on SMEs. The £5 million threshold for contracts and £25 million for sub-contracts should keep the majority of SMEs outside the new regime.

Larger single source suppliers will be required to produce an annual SME report, which must describe how they have encouraged SMEs to enter into their supply chains using the sub-contractor procurement process. This emphasis on SMEs may result in an increase in the use of SMEs by the larger suppliers.

What will the SSRO do?

The SSRO is an executive non-departmental government body created under the DRA with a responsibility for regulating single source procurement by MOD.

SSRO will have responsibility for reviewing the standard profit rate used in pricing the contracts and sub-contracts, publishing reporting templates, keeping the SSCR under review and will also act as the appeal body for civil penalties under the SSCR.