2.33 Under the contract Defence Management is required to make the facilities available and to service these to specified standards. Appendix 4 summarises the performance regime on this contract. The regime was negotiated as a complete, inter-related package, where the use of warning notices plays an important part. Termination of a service sub-contract can occur if a warning notice has been issued for the relevant service for three consecutive months, and Defence Management can face termination of its own contract if, across all nine services, it receives 16 such notices in a 12 month period (Appendix 4 paragraph 9). These thresholds therefore provide a strong incentive for services to be delivered to the specified standards. The performance regime has proved effective, as catering performance has improved after the Department issued a warning notice in February 2001. Performance was not sufficiently poor for the Department to impose a financial deduction.
2.34 This emphasis on the use of warning notices, rather than financial deductions, is unusual. On other PFI deals we have examined the performance regime is structured in such a way that, when contractor performance in delivering the support services fails to meet the requirements of the contract, the first recourse open to a department is to levy financial deductions and then, if the performance is sufficiently poor, to take the first step which can eventually result in the contract's termination. Despite this, the College's underlying approach to dealing with poor contractor performance is consistent with guidance issued subsequently by the Treasury6.
2.35 The Department and Defence Management told us that they have succeeded in maintaining a good, open relationship with each other. Constant deductions to payments for poor service provision would substantially harm their relationship and might provide Defence Management with an incentive to walk away from the contract rather than to address any poor performance. Thus the performance regime had been designed to give Defence Management the opportunity to tackle poor performance in any one month without incurring financial deductions. If, however, Defence Management did not address its poor performance, then a further warning notice would be issued and financial deductions made.
2.36 In line with some other PFI contracts we have examined, there are limits on the deductions that can be made to the PFI fee for poor service delivery. The limits agreed on this contract are 20 per cent of the cost of each individual service, and 10 per cent in aggregate of all the elements of the PFI fee that relate to service delivery (Appendix 4 paragraph 6). These limits should provide Defence Management's sub-contractors with an incentive to perform well as their profit margins will be below these levels. Since the elements of the PFI fee that relate to service delivery total £8.3 million, the 10 per cent limit means that only 3 per cent of the total PFI fee of £26 million is at risk from poor service delivery. This low figure reflects the fact that, as a percentage of the PFI contractor's total costs, the costs of service delivery are low compared to the annual servicing of the finance raised for the construction of the facilities. The Department can also suspend all payments to Defence Management if service delivery is so poor that Defence Management is in default of the contract (Appendix 4 paragraph 7). In addition, virtually all of the PFI fee is at risk if Defence Management fails to make the facilities available (Appendix 4 paragraph 4).
2.37 For six months after contract signature in June 1998 Defence Management's shareholders received a higher level of protection than was usual if Defence Management's performance had been sufficiently poor for the Department to terminate the contract. On most PFI contracts, in the event of such contract termination, a department would have to pay its PFI contractor compensation. The purpose of this compensation is usually to ensure that a contractor's banks will receive at least some of their loans back in return for the assets reverting to the public sector. This protection can also be extended to the providers of any subordinated debt7 where these are not also shareholders in the PFI company. The subordinated debt on the College deal receives such protection. The original intention had been for this debt to be provided by Defence Management's bankers. However, as negotiations with these had been protracted, Defence Management's shareholders, Laing Investments and Serco Investments, had agreed to provide this debt in addition to their equity, on the understanding that they would quickly sell this debt on to an external third party. Laing Investments and Serco Investments then sold this debt on to Abbey National in December 1998.
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6 Standardisation of PFI Contracts (July 1999) paragraph 10.3.3.
7. Subordinated debt is an intermediate form of financing. It is usually unsecured and comes below bank and bond financing, but above equity, in ranking for repayment in the event of default.