25 May 2009

Alliance contracting in Defence

In AWD: who is building those ships? I raised some queries about the nature of the AWD Alliance. In particular, I asked whether we have a genuine alliance contract of a type that would be recognised by industry, or is ASC yet again in effect a prime contractor that will be held to its contract, notwithstanding intervention by the Commonwealth in the way the contract is implemented?

The idea of moving away from the traditional buyer-seller model for major defence procurement projects has been around for over a decade, and it certainly has its attractions. One of the drivers of the acrimony between the then Defence Acquisition Organisation (DAO) and the Australian Submarine Corporation (ASC) was the fact that there was a fixed price contract for delivery of the six Collins Class submarines, a problem made worse by the fact that Defence budgeted only 2.5% for contingency, whereas a contingency provision of 5% would be typical of a standard building construction project, and contingency provisions for civil engineering type projects would be higher. For a contract to do something that has never been done before, one which involves very complex systems integration in a very rapidly changing technological environment, contingency of 15-20% would appear to be a minimum reasonable provision.

The combination of the fixed price contract and the wafer thin contingency provision proved toxic in relation to the Collins class submarine project. ASC was a profit making private company (albeit with a proportion of Australian Government ownership) and had a powerful incentive to treat all new issues as variations to the contract. Defence would have to go back to Cabinet for any additional funds for the project and thus had a powerful incentive to insist that all matters arising were the responsibility of ASC within the terms of the fixed price contract.

What was really needed was a mature and realistic approach to the fact that this was a major developmental project which was inherently risky, and a willingness upon the part of Government to be a little less unyielding in dealing with problems as they arose; we needed more “jointness” in our approach to this challenging national project. It is very difficult to estimate how long it will take, or how much it will cost, to do something that has never been done before.

At the same time as the Collins project was being brought to completion the Howard Government conducted a review of defence and industry policy, which was published in June 1998 as the Defence and Industry Strategic Policy Statement. This statement noted (p. 25) that partnering had become increasingly common in the private sector, where it had been found to reduce cost and schedule overruns, encourage innovation and make risk more manageable. It suggested that partnering could produce similar benefits for Defence, with the stipulation that partnering required that each side be able to place trust in the other.

Addressing the 1998 Defence Procurement Conference on the day of the Statement’s launch, the then Minister for Defence Industry, Science and Personnel, the Hon. Bronwyn Bishop, said:

A critical aspect of the government's new approach will be the introduction of partnering. Partnering is about taking a more integrated, team approach. It is about long-term relationships, transparency and communication. Partnering is based on sharing both risks and rewards. We need to share some element of risk because we know that risk can pay off in substantial improvements in schedule and costs. We also know there is no such thing as a risk free environment. But this requires a change of culture.

The previous Government seemed to think that you could transfer risk onto a contractor and do so for free. This concept was and remains nonsense - for any risk transfer a heavy premium was paid by Defence and the taxpayer.

The government's concept of partnering and sharing risk will be introduced across Defence within the broad framework provided by a Partnering Charter. This will improve the ability of Defence and industry to work together more closely while ensuring probity and accountability is not diminished in the new relationship. The charter will then underpin the development of the new culture in Defence that regards industry as integral to the nation's security.

There was no mention of alliance contracting in either the Statement or the Minister’s speech.

This was perhaps wise because on 28 November 2001 the Australian Government Solicitor published some Commercial Notes that identified some substantial issues to be considered by Government agencies in considering whether to enter into an alliance contract. It is worth reproducing the AGS’s advice in full:


Since the changes to the Audit Act and Regulations in 1989, Commonwealth agencies have been free to pursue in their procurement 'value for money' by the most effective means. Accordingly, considerations such as quality, fitness for purpose and capacity to deliver can be considered as well as price. Even so, the focus has generally been very much on the item (or service) to be delivered.

Now, with the advent of alliancing, one of the criteria for selection is a bidder's ability to operate successfully within an alliance relationship. If it is considered that the project demands an alliancing process, then it is reasonable that the bidder's ability to deliver through that process should be the subject of assessment. However, besides making it clear that this ability is a selection criterion, the method of making the assessment must be reasonable and conducted fairly.

Alliance workshops are a usual part of the assessment process and, as these will involve more interaction than normal between principals and bidders, particular care must be taken to ensure fairness. To ensure equality of opportunity and consistency of assessments, considerable preparation is required, including rehearsal, planning of the positions to be taken and training of participants. It is inadvisable to include actual output from the workshops in the evaluation as it will be difficult to distinguish the bidder's input from that of the principal.

No Fixed Price

One of the fundamental elements of an alliance project is that contractor participants will be paid on a cost plus basis. Although their fee will be at risk if key performance indicators (including coming in at or below the target costs) are not met, it is true to say that costs are in fact not fixed. There will therefore be no definite price fixed when the preferred tenderer is chosen. Although this has been criticised, in our opinion it is not necessarily contrary to the requirement to seek best value for money.

The Commonwealth Procurement Guidelines (September 2001) set the test of value for money as whether 'the best possible outcome has been achieved taking into account all relevant costs and benefits over the whole of the procurement cycle.' The justification for using a cost plus payment method must be tested exhaustively against this, including an assessment of the real advantage a so called 'fixed price' would have in the context of the variations to price likely to be necessary during the particular project if a fixed price were used.

Alliance Board, Alliance Teams and IPTs

The principal normally will be involved with other alliance participants on the Alliance Board, the Alliance Management Team and Integrated Process Teams (IPTs). A number of important issues arise from this involvement. First, it will be necessary to ensure that each representative has the necessary (actual) authority from their respective organisations to do what is required of them. It will also be necessary to state clearly what the limits of that authority are, and to make sure that any financial functions allocated to a contractor comply with the requirements of the Financial Management and Accountability Act 1997.

Secondly, there is a risk that the close cooperative relationships on the board and those teams could be regarded as giving rise to a 'fiduciary relationship'. This would introduce considerable problems for government representatives as it would raise questions about whether they could use their position or knowledge to the disadvantage of another alliance participant. That is, there could be a conflict between their obligations as representatives (employees) of the Commonwealth and their personal obligations as members of the board or team. While in principle, a fiduciary relationship could be expressly excluded, there is still the danger that a court would see such a relationship as arising in the particular circumstances or from actions of the parties.

Thirdly, IPTs are increasingly widely used in relationship contracts (that is, not only in those considered to be 'alliance projects'). The difficulty here is in establishing precisely where the dividing line between the responsibilities of the principal and contractors lies. The involvement of a principal's representative in the work of an IPT could well result in the principal being unable (that is, 'estopped') from holding the contractor responsible for the consequences of a joint decision. Even in projects governed by traditional contracts, where there is little involvement of the principal in detailed management of the project, it has often been difficult to establish who was properly responsible for defects, because of some action by the principal. Where the principal is involved in everyday decision making through being represented on IPTs, that difficulty will be magnified. At the very least, it will be important to spell out carefully what the respective responsibilities are and to keep a careful record of the deliberations of IPTs. (There will of course be less need to identify clearly who decided what where the contractor is largely relieved of direct liability for breach of contract, as is the case in many alliance contracts.)

In a typical alliance contract, both parties are taking on unusual liabilities - the principal, for cost overruns and lack of precise specifications and the contractors in respect of their profit (and corporate overhead) being at risk, as well as sharing management of the contract with the principal.

Alliancing is neither suitable nor necessary for many projects and involves considerable expense for the principal both in the selection process and ongoing. These matters merit careful consideration before a decision is made to proceed with alliancing.

In short, it is difficult to select alliance partners fairly, there can be no meaningful sense that costs are fixed, and most compellingly in my view, the Commonwealth could be estopped from holding the contractor responsible for decisions in which it (the Commonwealth) participates.

The Defence Materiel Organisation seems to have appreciated the difficulty because the 2004 version of the Defence Procurement Policy Manual (DPPM Version 5.0, 2004 Update 5.6), after making clear that “Partnering” is to be distinguished from Alliance Contracting, has this to say about Alliance Contracting:

301 This chapter is currently under review. If you require advice on project alliancing please contact the Contracting Help Desk through the Contracting Policy intranet website at [intranet web page address].

302 Advice from General Counsel, Defence Materiel Organisation must be obtained on any alliance contracting proposal. The CEO Defence Materiel Organisation, or the relevant Divisions Head, must approve any use of project alliancing methodology in a Defence Materiel Organisation contract.

It is clear that DMO never resolved the conceptual difficulties involved to the point where it could publish any sort of in-principle guidance on alliance contracting because the latest version of the Defence Procurement Policy Manual (DPPM Version 6, Update 6.6, effective from 7 January 2009) has this to say about Alliance Contracting:

4.3 Project Alliancing

This Chapter was deleted as part of DPPM Version 6.0 Update 6.5.

In spite of these conceptual difficulties the Howard Government decided to enter into the Air Warfare Destroyer Project on the basis of a project alliance, as this 27 May 2004 Joint Media Release on Naval Shipbuilding by Defence Minister Robert Hill and Finance Minister Nick Minchin makes clear:

Tenderers for the AWD contract will be asked to bid on the basis of an alliance relationship with the Commonwealth. An alliance contract will reflect all of the key commercial principles that will govern the relationship and will rely on providing incentives to the parties to minimise costs.

So the Howard Government decided to embark on its biggest shipbuilding adventure yet, on the basis of having a learning-by-doing project governance adventure at the same time – one based on a model its defence procurement agency found it so difficult to describe that the generic alliancing principles have not to this day been published.

We get a further sense of the inherent difficulties with the model from a paper published in March 2007 by Mr Grant Hensley of Tenix Aerospace and Defence, reviewing and making recommendations about the alliance type arrangement which was developed for the through-life support of the AP-3 Orion, known as the ‘P-3 Accord’. Hensley makes the revealing comments that:

The origin of the P-3 Accord started with the selected parties jointly engaged under the ASDEFCON sole-source process to develop a proposed “pure alliance” model.

In February 2005, the “pure alliance” was dismissed by the CEO DMO due to objections on the use of “no blame” and “alliance”. The proposed model was amended to include risk allocation to each Participant and replace the “pure alliance” concept of risk sharing. A hybrid / modified alliance model was subsequently proposed and eventually known as the current P-3 Accord model with signing of the MA on 09 November 2005.

This seems to lie on the direct trajectory from the first thoughts about alliancing to the current internally inconsistent situation with the Air Warfare Destroyer Alliance, noted in AWD: who is building those ships?, under which we supposedly have an alliance in which gains and losses are shared, but it is the responsibility of “industry” to bring the project in on time and within budget. DMO seems to want to participate in the decision making but avoid any responsibility for the consequence of those decisions, a position that seems highly problematic in view of the problems foreseen by the AGS in November 2001.

The situation is rendered all the more unsatisfactory by the fact that the systems integrator, Raytheon, was chosen under a separate Request for Tender by the Commonwealth, not by ASC as prime contractor. The ostensible gain and loss sharing alliancing arrangement could have the consequence that the taxpayer owned shipbuilder could present a fully built and fitted out fleet of ships to DMO and yet see its profit reduced to zero by inability of the alliance partner that is responsible for the inherently risky systems integration to perform its obligations under a separate contract. Why this would represent a reduction of the taxpayer’s risk is difficult to see.

Given the universally recognised need for trusting relationships for alliance contracting to succeed, one has to wonder whether the current environment is right for that:

- Relations between DMO and ASC are reportedly poisonous – see Submarines: Chairman ASC to Prime Minister, Submarines: do we need an arbitrator? and Submarines: the management consultants' review. What could be more hostile than the customer putting in a customer selected management consultant to review the service provider’s performance?

- Following the events described in the above posts the CEO of ASC announced that he was leaving the company.

- The Government has published a Defence White Paper with very ambitious savings targets, to which DMO will be expected to make a contribution.

- DMO holds itself out as an organisation that can control the cost and timeliness of major defence acquisition projects and through-life support – see for example Defence Materiel: DMO gunning for efficiency?

- The Government has published rigid parameters for the growth of the defence budget, and everyone knows that any cost overruns with the Air Warfare Destroyers will have to be met by reduced expenditure elsewhere.

This does not sound like a propitious environment for the establishment of a genuine alliancing framework: when it comes to the crunch DMO is bound to behave more like aggrieved customer than risk-sharing ally.

It is to be hoped that the Government will give a lot more thought to this model before it embarks on the construction of the projected fleet of twelve submarines.

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