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Allocating and Managing Procurement Risks

by Bill Hearn

Prepared for The Canadian Institute’s Legal & Business Guide to Public Procurement

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The Canadian Institute’s Legal & Business Guide to Public Procurement:

ALLOCATING AND MANAGING PROCUREMENT RISKS

Bill Hearn* McMillan Binch LLP

Toronto, January 28, 2004

1. INTRODUCTION

A key part of any successful procurement is the identification, allocation and

management of risks. Effective solutions must address the legitimate and reasonable concerns of

both the issuer and the vendor.

In order to manage risk, it is important to systematically identify, analyze and

assess risks and develop plans for handling them early on. Responsibility should be allocated to

the party best placed to manage the particular risk in question. This may involve implementing

new practices, procedures or systems or simply negotiating suitable contractual arrangements. It

is also important to ensure that the costs incurred in risk management are commensurate with the

importance of the procurement activity and the nature and magnitude of risks involved.

The reputation of the parties, particularly the Government as issuer, is a vital

factor in the procurement process. Failing to honour the terms of a procurement agreement (or

worse, acting in bad faith) may deter other prospective vendors from dealing with the issuer and

thus may impair the issuer’s ability to attract quality responses to RFP’s in the future.

* This paper has been prepared with the assistance of Holly Agnew and Andrea Long, also of McMillan Binch LLP.

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2. TYPES OF RISKS

Broadly speaking, the implementation of a large, complex procurement project

gives rise to several types of legal risks, including:

(i) Direct Contractual Liability – liability of the vendor to the issuer

(or vice versa) for breach of the contract between them;

(ii) Third Party Liability – potential liability of the issuer and the

vendor to persons who are not parties to the contract (i.e., “third

parties”);

(iii) Early Termination – risks for the vendor as a result of termination

for convenience by the issuer and risks for the issuer in the event

the vendor prematurely terminates performance of its obligations

under the contract;

(iv) Limitation of Legal Recovery – risks that not all the losses suffered

by the issuer or the vendor as a result of a breach of the contract by

the other party to the contract will be legally recoverable from the

party in breach as a result of the application of legal principles

relating to the types of damages that may be recoverable for breach

of contract or as a result of the terms of the contract itself; and

(v) Strength of Vendor Covenants – risks associated with the

possibility that the vendor has, or will at some relevant time in the

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future have, insufficient assets to satisfy all of its legal obligations

to the issuer.

The main business risks in public procurements include:

(i) Project Design and Construction – delivering project on time and on budget and meeting technical and performance requirements;

(ii) Operation and Maintenance - exceeding established benchmarks for performance and continuous improvement;

(iii) Financial and Market – inflation, interest rate and foreign currency fluctuations, escalating insurance costs, etc.; and

(iv) Political – changes in law and government policy regarding project.

3. ALLOCATING RISKS

In large, complex procurements, it may be prudent for the issuer to develop a risk

register or matrix to help it identify these risks and to keep track of how the risks are allocated

and managed in the final contract.

In theory, risk-sharing dictates that there is a threshold of risk that a vendor will

not cross – i.e., when the risk outweighs the reward. In practice, there may be a vendor willing

to assume inordinate risk. However, the wider the risk and reward gap, the more inefficient the

project, and the more likely it is the project will fail. Therefore risk should be allocated to the

vendor in such a way that optimizes the project’s prospect for success.

In many instances, the issuer attempts to transfer all or substantially all of the risk

to the vendor. From the issuer’s perspective, this may appear advantageous (at least in the short

run) in terms of limiting liability. From the vendor’s perspective, it will require tactical

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manoeuvring to become a serious contender for the RFP without assuming all of the liability.

For non-mandatory terms in the RFP (i.e., terms that can be negotiated), this will likely involve

the use of “soft” language in the procurement proposal. Soft language prevents the vendor from

being tied to assuming all of the liability from inception, and leaves the door open to negotiate a

point in the future.

One fair and common way to allocate and manage the proper level of liability risk

a contracting party should bear is to tie the level of liability to the degree of responsibility and

control assumed. To have one party assume a greater degree of liability than is commensurate

with such party’s responsibility adds a degree of risk transfer that will probably affect the

economics of the transaction. If the issuer wishes to have the vendor assume liability for a risk

which the vendor does not control, there will be a significant price (i.e. risk premium) to be paid

for this, assuming the vendor is even prepared to assume the risk.

Methods of allocating risk are very specific to the nature of the procurement. For

example, a service contract may require specific benchmarks of service. The issuer may pass

risk to the vendor by stipulating that should a level of service not be achieved, the overall

compensation will be abated. Specifying service obligations, devising a pricing and payment

scheme, and including express contractual provisions that adjust risk allocation achieves a

balance that flexibly allocates risk.

4. MANAGING RISKS

Once the potential risks have been identified, a variety of options are available.

The risk may be accepted, it may be avoided, the likelihood of its occurrence may be reduced,

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actions may be taken to reduce the consequences of the risk and the risk may be transferred. The

method chosen to manage the risk will be specific to the transaction and the parties.

(a) Establishing Mechanisms to Monitor Performance

In complex, long-term procurements, it is important that the issuer establish at the

outset a clear mechanism to monitor contract performance on an ongoing basis. This mechanism

may be as simple as having regular meetings of the issuer’s and the vendor’s key operational

personnel.

Implementing formal reporting requirements may be an effective mechanism to

monitor risk. The Australian Government uses a risk management matrix (see slide in attached

powerpoint presentation) that specifies the source of the risk, the risk event and its impact on the

project. Beside this information, the risk’s likelihood of occurrence (almost certain, likely,

possible, unlikely, rare), consequences if it were to occur (severe, major, moderate, minor,

negligible) and the risk level (extreme, high, medium, low) are rated on a regular basis.

Ongoing monitoring of risk allows management to strategize foreseeable risk and

mitigate its potentially adverse affect on the procurement project.

(b) Establishing Performance Benchmarks

Where possible, the contract should establish performance benchmarks and a

means by which the parties can determine whether or not these benchmarks have been achieved.

Often, procurement contracts require the vendor to provide for “continuous improvement” of

increased service levels and reduced costs.

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Ongoing monitoring of performance will act as an early warning system for

potential breaches and will ultimately reduce the cost of performance and resolving disputes.

5. ENSURING EFFECTIVE REMEDIES

Remedies give the procurement contract its teeth. The promises in the contract are

not worth the paper they are printed on unless they are enforceable. To address different levels of

breach (relating to the character or severity of the breach), there should be different levels of

remedies. Remedies that are tiered in accordance with the level of breach provide effective relief

for the innocent party.

(a) Indemnities

(1) Claims By Third Parties and Contracting Party

The main purpose of an indemnity is to clearly stipulate the circumstances under

which one party to the procurement contract can pursue a remedy from the other party.

Typically, indemnity clauses specifically address the circumstances where one party to a contract

will be entitled to seek recovery and protection against liability arising from claims by third

parties due to the non-performance or negligence of the other party to the contract.

Indemnity provisions also typically reiterate the common law rule that the party in

breach of contract will pay an amount of money damages to compensate the other party for the

breaching party’s defective performance.

In the case of indemnities from the Crown as issuer, the bidder should ensure that

all statutory requirements to give effect to the indemnity have been met. For example, by section

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28 of the Financial Administration Act (Ontario), where the issuer is the Ontario government, the

issuer cannot enter into an indemnity unless it has obtained the written approval of the Minster of

Finance.

(2) Type of Loss

Indemnities may, by their express terms, address not only direct losses but also

indirect or consequential losses suffered by the innocent party. They may also specifically

require the indemnifying party to pay the innocent party’s legal costs, in defending a third party

claim or pursuing a claim against the breaching party.

The legal meaning of such terms as direct, indirect and consequential damage is,

at best, unclear despite their frequent use in commercial contracts. If the issue becomes relevant

in the course of a dispute, it is entirely possible that the vendor and the issuer will have different

views about what constitutes direct as opposed to indirect or consequential damage.

As a practical matter, no contractual definition of what kinds of damages are and

are not legally recoverable can be sufficiently specific to avoid all possibility of such disputes.

Words are simply not capable of being used with a sufficient degree of precision to achieve such

a result in all circumstances. Rather, there will often be room for some disagreement between the

parties to a dispute.

(3) Limitations On Liability

In complex, long-term procurement contracts, it is common for the liability of one

or both parties under the indemnification provisions to be limited either by reference to a

liquidated amount tied to the number of days the party is in default or to some other measure or

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by a cap on the maximum amount of liability a party may be required to incur. Some contracts

have both liquidated damage clauses and a cap on liability. By quantifying and capping

maximum liability, parties are able to estimate the amount of contingent liability they are

assuming and to make the appropriate adjustments in the overall contract price or take other

means to protect against risk of loss, such as purchasing insurance.

It is worth keeping in mind that whether the issuer agrees to or refuses to allow

limits on the vendor’s liability under the procurement contract is very likely to affect whether the

vendor will agree to accept any limits on the issuer’s liability. It is generally difficult for one

party to negotiations to demand such a limitation from the other party when it is not prepared to

accept a similar limitation itself.

(4) Contributory Breach or Negligence

Indemnities are usually subject to the exception that they do not operate to the

extent that the losses are due to the act or neglect of the party seeking indemnification. A party

should not be entitled to claim indemnification from another to the extent it is the author of its

own misfortune.

(b) Money Damages for Breach

(1) Primary Remedy

Generally speaking, the primary remedy at common law for breach of a

procurement contract is the monetary award of damages. The purpose of this award is to put the

innocent party in the same position as if the contract had been performed. In this way, the law of

contracts protects the reasonable expectations of the parties, or the “loss of the bargain”. This

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means that the innocent party will be entitled to damages which cover its out-of-pocket expenses

and its reasonable expectation interest (usually the anticipated profits over the term of the

contract). The law of contracts also protects the innocent party’s restitution interest and, in order

to avoid unjust enrichment, may require that monies be paid to the innocent party to compensate

it for any benefit it has conferred on the breaching party under the contract.

(2) No Punitive Damages

Generally speaking, the purpose of the law of contract is to compensate the

innocent party, not to punish the breaching party. Therefore, only in very exceptional cases will

the courts award exemplary or punitive damages for breach of contract.

(3) No Remote Damages

Another important principle in the awarding of damages is that of remoteness.

Of course, the innocent party is entitled to be put in as good a position as would have been

occupied had the innocent party received the performance promised. However, difficulties arise

when the breach of contract causes a loss or deprives the innocent party of some anticipated gain

from a separate transaction.

Indirect losses are usually only recoverable when they are reasonably foreseeable,

which the courts have held may be the case when, at the time the contract was made, the special

circumstances that gave rise to the indirect loss were known by the innocent party and

communicated to the breaching party.

(4) No Avoidable Damages

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A further restriction on recoverable damages lies in the principle that the innocent

party cannot recover for losses that could reasonably have been avoided. This is often described

as the duty to mitigate. For instance, if the breaching party fails in breach of contract to deliver a

machine essential to the innocent party’s business, the innocent party is expected to go into the

market and buy a substitute, not to let losses mount up for the lack of the machine.

(5) Liquidated Damages

Due to the difficulties inherent in ascertaining damages (such as remoteness) and

the legal costs of proving them, the parties can agree in the procurement contract in advance to a

genuine pre-estimate of damages for certain events of default. This pre-estimate could be

negotiated by the parties and expressed in the procurement contract as a specific amount or by

way of a formula. Such clauses are usually enforceable between commercial parties. However,

they will not be enforceable if they operate as a penalty. To be enforceable, the clause must be

reasonable, judged both at the time the contract was made and at the time it was breached. Again,

this is because, as a matter of contract law, the purpose of damages is to compensate the innocent

party, not to punish the party in breach.

(c) Security for Bidder’s Promises

For a procurement contract, the issuer will also need to consider whether it needs

more than just the promise from the vendor to pay the issuer damages when the circumstances

warrant. There are several ways the issuer can seek additional “security” to support this promise.

(1) Guarantees

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The issuer may want to have guarantees from the shareholders of the vendor,

particularly if the vendor does not have strong financial resources on its own. This can be quite

effective in circumstances where the shareholders do have substantial financial resources.

(2) Letters of Credit

The issuer could try to transfer certain financial risks from itself to a financial

institution by requiring that a letter of credit from a bank or similar financial institution be

delivered to it. Under a letter of credit, the bank promises to pay the issuer the face amount of the

letter of credit as soon as the bank is satisfied that the triggering event has occurred (e.g., notice

in writing from the issuer to the bank that the vendor has caused a loss and that the issuer is

entitled to compensation under the letter of credit).

A letter of credit can be expensive for the vendor to maintain depending on its

amount, the length of time it will be effective, and the circumstances under which it can be

called. The bank usually requires the vendor to keep on deposit with the bank or to provide other

security to backstop the bank in the event the letter of credit is called. Letters of credit can work

quite effectively, but the security the bank may require to support the issuance of the letter of

credit can be prohibitive to the vendor.

(3) Performance Bonds

Performance bonds are issued by certain insurance companies who participate in

this market. Under a performance bond, the insurance company promises the issuer that if the

vendor fails to perform the obligations under the procurement contract, the insurance company

will step in to cause the vendor or someone else to perform the vendor’s obligations under the

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contract. The typical performance bond usually gives the insurance company the right to pay an

amount as compensation in lieu of actually performing the relevant contract.

Performance bonds sound good in theory but usually are not that effective in

practice, particularly where the performance obligations are sophisticated and cannot be easily

substituted. It is also often difficult to negotiate the security that the insurance company will

want from the vendor as consideration for issuing the performance bond.

(4) Traditional Liability Insurance

Traditional liability insurance policies are also not particularly effective as the

primary solution to liability issues like those raised by the failure of the vendor to perform an

obligation under a procurement contract. For recovery under the vendor’s general liability

insurance policy, it would be necessary to prove to the insurance company (or court) that the

incident was an insured event under the policy and that the claimant (i.e., the issuer) is entitled to

the proceeds of the insurance. The claim process can be complex, slow and expensive. Liability

insurance policies are always needed for general liability concerns, but they do not usually cover

contractual liabilities.

(5) Non-Traditional Insurance

There are non-traditional insurance products or methods that are available and

could be designed to the particular facts of a large, complex procurement. For example, the

issuer and the vendor could agree in the contract that the vendor would establish directly or

through some form of specialized insurance product, a dedicated loss fund with a small portion

of each transaction under the procurement contract being allocated to the loss fund to be

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available in the event the issuer suffers a loss and wants to receive compensation. The exact size

and nature of the fund would depend on a variety of factors, circumstances, including the risk

and likely size of claims.

(d) Court Orders to Perform

The courts also have the power to order specific performance of a contract, but

will usually only do so if the subject matter of the contract is unique. For example, the court may

order delivery of the Mona Lisa under a contract of sale, but it would not order specific

performance of a contract for the sale of ordinary commercial goods.

The courts also have the power to order that a breach of contract be restrained.

Such an order (called an injunction) could apply to certain provisions of a contract – for

example, breach of confidentiality provisions – where an award in damages would not be

sufficient to protect the business interests of the innocent party.

Still, specific performance, whether by way of an order of the court to do

something or an order to refrain from doing something, is the exception. Generally speaking,

absent express provisions in the procurement contract to the contrary, specific performance is the

appropriate remedy only where an award of monetary damages would be insufficient.

(e) Termination

Another type of remedy for breach of contract (apart from damages and specific

performance) is termination. If a party breaches a term that is fundamental to the procurement

contract, the other party may terminate its obligations under the contract as well as any of the

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breaching party’s rights under the contract. Whether a term is fundamental or not depends on the

seriousness of the breach.

(f) Remedies Not Exclusive

A party’s remedies are usually not exclusive. Subject to not putting the innocent

party in a position better than would have been occupied had the contract been performed (by

way of double compensation), it is also within the court’s power to order a combination of

performance (albeit defective) and a monetary award. So too, the innocent party can terminate

the contract for cause and sue the breaching party for a monetary award of damages.

(g) Force majeure

Contracts for long-term procurement will often contain a force majeure clause,

which is designed to address circumstances which are beyond the control of the issuer or the

vendor (such as power blackouts, epidemics, acts of terrorism, floods, fires, ice storms, strikes,

etc.). Events that constitute force majeure may, depending on their duration, lead either to

termination of the procurement contract or suspension of the vendor’s provision of services for

some period of time. In either event, there would be risks to the issuer’s ability to have services

intended to be delivered pursuant to the procurement project provided during such events.

The issuer may wish to address what events will (and will not) constitute force

majeure for the purposes of the procurement contract. Even more importantly, the issuer may

wish to put in the contract that it has the right to provide services by some alternative means in

the event that the vendor ceases, temporarily or permanently, to provide services under the

contract. The issuer may wish to consider, as well, how and at whose expense it would be able,

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as a practical matter, to exercise any right to provide services by some alternative means, if the

need to do so were to arise.

(h) Right of Issuer to Terminate the Contract

In order to protect the issuer’s interest under the procurement contract, the

following provisions setting out circumstances in which the issuer may terminate the contract are

usually included:

(i) Termination Forthwith for Bankruptcy – In the event the vendor

becomes bankrupt, insolvent, etc., the issuer may terminate the

contract immediately. This right helps protect the issuer’s interest

vis-à-vis the vendor’s creditors;

(ii) Termination Upon Notice for Uncured Breach – The issuer should

also have the right to terminate the contract in the event that the

vendor breaches the agreement and, after a reasonable period of

notice to cure the default, fails to do so. Termination in this case

does not preclude the issuer from seeking a monetary award of

damages;

(iii) Termination Upon Notice for Fundamental Breach – The contract

could also go on to stipulate fundamental terms, the breach of

which entitles the issuer to terminate the contract without further

notice, opportunity to cure given to the vendor, etc.;

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(iv) Termination Upon Notice for No Appropriation by Parliament or

the Legislature – Where the government is the issuer, the

procurement contract should also be clear that the government is

entitled to terminate the agreement without further liability in the

event it is unable to appropriate the necessary funds from

Parliament or the Legislature, as the case may be. Such a clause

usually provides that the government will use its reasonable efforts

to obtain the appropriation sufficient to satisfy its obligations under

the agreement and when it fails to do so, will notify the vendor in

writing; and

(v) Termination Upon Notice for Convenience – Especially where the

issuer is the government, the procurement contract should also give

the issuer the right to terminate the agreement without cause, upon

a period of notice and with provisions sufficient to protect the

reliance interest of the vendor. For example, the issuer is often

required to at least reimburse the vendor its sunk costs. This is

usually referred to as a right to terminate for convenience. Such a

right gives the issuer the flexibility to cancel the project, with the

appropriate notice and compensation to the vendor, if, for example,

the project becomes obsolete or if there is a change in government

policy.

Notwithstanding the inclusion of these rights in the procurement contract, it is

usually the case that the issuer will not exercise the right of termination except in extreme cases.

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(i) Vendor’s Right to Terminate

The vendor may also have a right to terminate in certain circumstances (such as

material default by the issuer in performing its obligations or if there is a material reduction in

the scope of the project). In this case, the notice period would have to be sufficient to give the

issuer enough time to transfer the contract to an alternative service provider.

(j) Transition Obligations Upon Termination

In all cases of termination, the vendor must be obliged, by way of clear and

detailed transition provisions in the procurement contract, to work with the issuer and the new

vendor for a period of time and to facilitate the transfer of the procurement contract to the new

vendor. This provision will be particularly important in the termination for convenience

provisions. Practically speaking, however, these provisions may not be relied on when the issuer

has terminated the agreement by reason of the vendor’s breach.

As part of any transition provisions, the vendor should be required to deliver to

the issuer all computer hardware, computer software, material, equipment, records and other

property used to provide the services under the procurement contract.

6. RESOLVING DISPUTES

For long term, complex procurements, it is often desirable that the contract

specify a range of dispute resolution processes. This will maximize the likelihood that the parties

will resolve disputes effectively and efficiently during the course of the procurement

relationship.

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(a) Alternative Dispute Resolution vs. Court Proceedings

The term “alternative dispute resolution” or “ADR” is generally used to refer to

any dispute resolution process outside the scope of a traditional lawsuit and traditional courtroom

proceedings. There have always been alternative dispute resolution processes. However, in

recent times, these processes have gained in popularity and profile, and have, in some cases,

become mandated as part of a traditional lawsuit or as a preliminary step before traditional

litigation can proceed.

(b) Choice of Dispute Resolution Process

The most appropriate dispute resolution process depends upon a number of

factors, including the nature of the dispute, the desired degree of control by the parties over who

should resolve the dispute, the relationship between the parties and the stage of the dispute (e.g.,

is it a new problem or have there already been several attempts to resolve it?).

Traditional litigation may be the most appropriate process where it is important

for the issuer and for public policy reasons to have an open process and a decision that may serve

as a useful precedent for the future. On the other hand, if a decision by an independent third party

is required but the parties prefer to avoid the potentially negative publicity of open court

litigation, then it may be appropriate to have the matter resolved by private arbitration.

The various dispute resolution processes are not mutually exclusive. If the dispute

is not resolved by one process, the parties may agree to resort to another process.

(c) Models of Dispute Resolution

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There is a full spectrum of dispute resolution processes available. At one end of

the spectrum, negotiation, the parties have full control over the process and the crafting of the

solution. At the other end, litigation, a third party has the authority to impose a solution.

The first step in most dispute resolution processes is to formulate a statement of

the issues and facts as well as a list of relevant documents and other information. (This is known

as the “Evaluation Statement” in the “Early Neutral Evaluation” process). This information

should be provided to the persons evaluating the dispute.

Second, if information is to be provided to a third party or to the other party to the

dispute in the course of the alternative dispute resolution process, then a confidentiality

agreement is necessary. The agreement should state that all disclosures during the dispute

resolution process will remain confidential and cannot be used in any subsequent dispute

resolution proceeding, including arbitration and legal proceedings, without the consent of the

parties.

Various disputes resolution processes are described below. Negotiation has been

omitted as this term does not require explanation.

(1) Internal Resolution

It is frequently the case that persons who are involved at the hands-on operating

level may be involved in a dispute and may not have either the authority or broader perspective

to resolve the issue. Sometimes, emotions are also involved in causing deadlock.

It is often provided for in long term procurement contracts that, before any other

form of ADR is attempted, the matter in dispute be “delegated up” to senior officers within the

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respective organizations who have the authority to resolve the dispute and a mutual commitment

to try to make the overall relationship work.

(2) Early Neutral Evaluation

If the senior officers cannot resolve the dispute, it may be appropriate to appoint a

neutral third party to give an “expert opinion” on how the dispute should be resolved. The parties

choose a neutral third party, usually an experienced and respected expert in the field if the

dispute is technical in nature, or a lawyer if the dispute is one of contract interpretation.

The expert is provided with the Evaluation Statement prior to the “settlement

conference”. The disputants’ goal in this process is to obtain an objective opinion about the

merits of their respective positions.

The non-binding nature of early neutral evaluation may not always be appropriate

if one party is more interested than the other in a speedy and final resolution of the dispute.

(3) Fact Finding

A fact finding process may be helpful where facts are vague or in dispute.

A neutral third person or panel is appointed to determine the facts underlying the dispute and

usually to assess the reasonableness of the disputants’ positions given those facts.

The fact finder may be asked to produce a written report containing factual

conclusions and, if desired, recommendations. The report can be accepted as binding or non-

binding.

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Alternatively, the fact finder may be asked to produce a report for each disputant,

analyzing the strengths and weaknesses of their case.

Fact-finding is most useful in the early stages of a dispute before the disputants

become entrenched in their positions and unwilling to co-operate in any investigation that might

disclose facts detrimental to their respective cases.

A determination of the facts may allow the disputants to subsequently negotiate a

solution to their dispute on their own. If not, the parties may proceed to another dispute

resolution process.

Where the parties proceed to voluntary mediation, they have the option of

agreeing to make the fact-finding report available to the mediator. If they do so, the mediation

process is likely to be shorter.

If the parties ultimately proceed to litigation, any fact-finding report will be

admissible as evidence unless the parties have provided otherwise. There is a risk that parties

will use the fact finding process to discover the strengths and weaknesses of the other side’s case

and will then “argue the facts that are found to be most damaging” in subsequent litigation.

Consequently, it is often prudent for the parties to execute a confidentiality

agreement before beginning a fact-finding process. It should stipulate that all discussions, notes,

records and recollections provided to the fact finder or disclosed to the other side are confidential

and may not be used at trial, except by the party who provided the information. Similarly, the

confidentiality agreement should provide that any report by the fact finder may not be used at

trial, except with the consent of both parties.

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(4) Mediation

Mediation is a process that involves the appointment by the disputants of a

completely neutral third party to assist them in reaching their own mutually acceptable solution.

The ultimate goal is to produce a solution, recorded in a written contract, to which the disputants

agree.

Mediation is often included in a contract as the first “outside” ADR process, since

a mediator can be appointed relatively quickly, the process is relatively informal, and the parties

retain control over the proceedings.

(5) Mini-Trial

“Mini-trial” is a term used to describe a proceeding created by the parties, and

thus within their control, but which involves more formal presentations by each side. In a “mini-

trial”, lawyers usually make submissions to a panel of high-level representatives of the disputants

who typically have settlement authority.

After listening to submissions, questioning the lawyers and negotiating a solution,

the representatives may choose to enter into a binding agreement, if they have such authority. If

they do not have such authority, both sides must ratify any resolution. The panel may also

include a neutral third party who acts as an advisor/mediator/chairperson and who may or may

not be authorized by the parties to issue a binding decision if the representatives do not agree on

a solution.

The mini-trial process permits the disputants to find a creative solution, and is

usually speedier and less expensive than a traditional trial.

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(6) Arbitration

In a multi-stage dispute resolution process, arbitration is often used as the last

resort. Alternatively, arbitration is stipulated for particular issues. In either case, the arbitration

clause in the procurement contract must be carefully drafted since an agreement to submit a

dispute to arbitration is binding under provincial law.

A general arbitration clause (providing that the parties may submit disputes under

the agreement to arbitration) is usually not appropriate since it obliges the parties to submit any

and all disputes to arbitration, on the initiative of either of the parties. In such a case, the

obligation to arbitrate may only be avoided by mutual agreement.

The parties may stipulate in their contract a mechanism to appoint an arbitrator.

Where the disputants appoint the arbitrator or panel, they have the flexibility of choosing an

expert in the subject matter of the dispute, in contrast to litigation where the parties do not

choose the judge. If an appointment procedure is not specified in the contract, and the disputants

cannot agree, then the court may appoint the arbitrator, on application by a party.

Similarly, the parties may specify in the contract that particular rules of procedure

will apply, usually the rules of a designated arbitration institute. Where no such provision is

included in the contract and the parties do not otherwise agree on procedural rules, then the

procedural rules under applicable legislation, such as the Arbitration Act (Ontario), will apply,

supplemented by the rules of the particular arbitrator.

An arbitration decision is final unless the contract provides otherwise or unless a

party obtains leave from the court to appeal on a question of law. Thus, arbitration can be used as

MBDOCS_1235235.3 24

a substitute for litigation or in addition to litigation. However, given the relatively high cost of

arbitration, it is unusual for a procurement contract to provide for both arbitration and litigation

of an issue.

Arbitration is usually a relatively formal proceeding and, depending on the rules

adopted by the parties and the arbitrator, can be as lengthy as traditional litigation. The

arbitration process resembles traditional litigation insofar as it usually includes opening

statements, examination-in chief, cross-examination, re-examination, argument and reply. The

arbitrator can award damages, specific performance or an injunction.

If necessary, an arbitration decision may be enforced by a court in the same way

as a court order may be enforced. For example, a party may attempt to obtain an overdue

payment of a monetary award by requesting a writ of seizure and sale of the assets of the party

that owes the monetary award.

(7) Litigation

Traditional courtroom litigation is a formal process that in this province is

governed by the Ontario Rules of Civil procedure. Particular documents must be filed with the

court and delivered to the other side in order to commence a proceeding.

When both sides have completed their submissions, a judge or jury determines

whether or not the complaining party has proved its case, on a balance of probabilities, and is

entitled to the relief sought. The remedies that may be requested are limited, usually damages,

specific performance or an injunction (see discussion in next section).

MBDOCS_1235235.3 25

Litigation does not permit a party to claim remedies beyond those prescribed and

does not provide a forum wherein the parties can create their own solution.

If the defendant does not comply with the remedy ordered by the court,

enforcement mechanisms are available. Such mechanisms are relatively accessible and effective

in the case of a claim for monies owed by a party whose location is known and whose assets may

be seized.

Enforcement mechanisms may be more time-consuming and potentially less

effective where such assets are not available or where specific performance of contractual

provisions is sought.

7. SOME CURRENT ISSUES IN PROCUREMENT RISK ALLOCATION AND

MANAGEMENT

(a) Force majeure Clauses

(i) Introduction

As noted above, force majeure clauses allow parties to be excused from

contractual obligations when circumstances render performance substantially more difficult or

even impossible. However, the effectiveness of these clauses is dependant on their construction.

As a result of recent world events (including 9/11 and the outbreak of SARS), parties to a

procurement contract may face a real and substantial problem when performance under a

contract becomes impractical or unreasonable in the short term. Although such an event may not

allow a party to terminate a contract in its entirety, a properly drafted clause should provide for a

delay of performance.

MBDOCS_1235235.3 26

(ii) Elements of a force majeure

For a party to invoke the force majeure clause, it must be shown that:

• the failure was due to an impediment beyond the party’s control;

• the party could not reasonably be expected to have taken the impediment

and its effects upon the party’s ability to perform into account at the time

the contract was made; and

• the party could reasonably have avoided or overcome it or at least its

effects.

Upon the event of an enumerated trigger, the party relying on the clause must

prove the occurrence of the event has prevented, or at least hindered its ability to perform the

contract. Some of the situations where force majeure has been held applicable include failure to

supply electricity due to an unforeseen accident, strikes, unforeseen regulated pricing, and an

unforeseen change in market conditions. However, the applicability of the clause is highly

dependent on the construction of the contract and the context of the event that the party claims

justifies the use of force majeure.

Most contracts require the party claiming force majeure to notify the other party if

they intend to invoke force majeure. Once force majeure has been declared, performance under

the contract is excused, but only to the extent of the force majeure event and for only as long as

the force majeure event continues. Most clauses will provide for an extension of the term of the

contract for a reasonable period of time.

MBDOCS_1235235.3 27

(iii) SARS and force majeure

In the case of SARS, force majeure could be invoked as an “act of God”. Force

majeure, an “act of God”, was defined by Justice Dickson in Atlantic Paper Stock Ltd. v. St.

Anne-Nackawic as:

An act of God or force majeure clause . . . generally operates to discharge a contracting party when a supervening, sometimes supernatural, event, beyond control of either party, makes performance impossible. The common thread is that of the unexpected, something beyond reasonable human foresight and skill.

As an unanticipated epidemic beyond reasonable human foresight and skill that, at

least for a time last summer, paralyzed Toronto’s economy and lead to the suspension and

closure of many essential services, such as hospitals, it would appear that SARS could satisfy the

test outlined above.

(iv) Other recent instances of possible force majeure

Traditionally, there are some industries where it is more common to see force

majeure being invoked. There are a number of cases in the context of the natural resource

industry, due to the fact that the companies in this industry often operate in highly volatile socio-

political environments (such as in countries engaged in civil war). Force majeure cases are also

seen in the construction and transportation industries. For example, Northwest Airlines, citing a

decline in Asian traffic because of SARS, invoked force majeure to lay off employees without

notice. The airline used the same clause after the terrorist attacks on September 11, 2001 and at

the onset of the Gulf War.

MBDOCS_1235235.3 28

In Canada, Air Canada used force majeure at the onset of the Iraq war last year.

However, due to its subsequent application for protection from creditors, it is difficult to

ascertain whether or not its use of force majeure would have withstood judicial scrutiny.

Finally, there were instances last summer where Toronto group and convention

bookings were cancelled as a result of SARS. In many convention bookings, the force majeure

clause used the terms “illegal” and/or “impossible” and/or “inadvisable”. Thus, when the World

Health Organization declared it “inadvisable” to travel to Toronto, these parties had a reasonable

argument to invoke the force majeure clause.

(v) Considerations before enacting force majeure

Generally, the party wishing to rely on force majeure must make reasonable

efforts to correct the reason for such delay and give the other party prompt notice of any such

delay.

In addition to the above stated considerations, it is important to recognize the risks

involved if a contracting party were to pursue force majeure. If a contract does not explicitly

mention “disease” or “epidemic” as a trigger event, the party will have to rely on the broader “act

of God” or even the broader all-inclusive catch-all part of the clause. Consequently, the party

will be relying on the more ambiguous terms of the agreement. This ambiguity introduces

uncertainty as to how a court will decide in the event that the situation proceeds to litigation.

Ambiguity was an issue discussed in M.A. Hanna Co. v. Sydney Steel Corp. In

that case the Nova Scotia Supreme Court considered a boilerplate force majeure clause. The

court referred to “some broad phraseology” in the contract’s triggering events. This was a

MBDOCS_1235235.3 29

reference to the general catch-all language used in many boilerplate agreements. In that case, the

court concluded, “the broad wording of the clause creates an ambiguity which should, in this

case, be interpreted against the drafter.” As a result, it is necessary to identify the risk tolerance

of the contracting party before concluding that it would be in their best interest to pursue an

action of force majeure.

(vi) Recommendation

It is likely that the structure of currently employed force majeure clauses are

sufficient to adequately encompass recent world events such as 9/11 and SARS however this has

never been judicially tested. Accordingly, it would be prudent to use language that definitively

includes terrorist attacks and epidemics when drafting a force majeure clause where such an

event would impact the ability of either of the parties to carry their obligations under the

contract.

(b) Amertek: A Case Study

Governments in Canada may have a new obligation when negotiating public

procurement contracts that, until recently, only existed south of the border. In Amertek Inc. v.

Canadian Commercial Corp., the Ontario Superior Court of Justice held that the federal

government had a positive obligation to provide a private company with information critical to

the success of a procurement contract. In the United States, this obligation is known as the

doctrine of superior knowledge. The Amertek case has introduced this doctrine to Canada.

MBDOCS_1235235.3 30

(i) The Facts

In Amertek, two investors of a private company sued the federal government over

a procurement contract that left the company bankrupt. The case took 10 years to get to trial and

the judgement is more than 100 pages long (for a copy of the judgment, see 229 D.L.R. (4th)

419). In 1985, the Canadian Commercial Corporation (“CCC”) invited Amertek to bid on a

contract to design and produce 362 military fire trucks for the U.S Army. The contract had

already been awarded to a Quebec company, but the business’s financial difficulties had forced

CCC to find a new bidder. Inexplicably, even though CCC knew from its experiences with the

Quebec company that Amertek's bid price was too low, it advised Amertek to lower its price if it

wanted the contract. In addition, internal correspondence revealed that people at CCC had

questioned whether Amertek was even technically competent to perform the work. CCC did not

disclose this information to Amertek. Instead, it represented that the contract would be a

profitable one for Amertek. Amertek exhausted all of its assets performing the contract. The

Canadian government refused any restitution.

If Amertek had been fully informed of the inherent risks, it likely would never

have agreed to sign the contract. If CCC had been unable to find another private company to

manufacture the trucks, it is estimated that it would have been on the hook to the US government

for $18-20 million USD – the difference in price between the CCC contract and that of the next

highest available bidder.

(ii) The Doctrine of Superior Knowledge

The plaintiffs in Amertek argued, inter alia, that the government had violated the

doctrine of superior knowledge, a concept first developed in the US 40 years ago. This doctrine

MBDOCS_1235235.3 31

makes it clear that governments have a responsibility to fully inform bidders of all relevant

considerations before entering into procurement contracts. One of the underlying principles is

fair dealing -- the bidder cannot be expected to be responsible for risks that it did not fairly agree

to assume.

Governments are not typical issuers. In their paper, “Pre-Contractual Disclosure

Obligations of Government: The Doctrine of Superior Knowledge and Beyond”, Robert C.

Taylor and Stephen Thiele give three main reasons why governments should be treated

differently from their private sector counterparts:

1) a government, not because of its size or resources, but because it is a government which makes and enforces the law of the land, should be held to a standard of a [sic] fairness in its contractual relations with its citizens which includes the negotiation of contracts;

2) a government is often in possession of detailed or specialized information concerning products or services it is seeking which information would be of benefit to and is not available to prospective contracting parties; and

3) the government is possessed of various privileges and immunities which ordinary commercial entities do not enjoy.

In Amertek, after reviewing the US law on the doctrine of superior knowledge as

well as the plaintiff’s evidence, O’Driscoll J. of the Ontario Superior Court found that such a

duty exists in Canadian law, although he called it an “implied contractual duty”. O’Driscoll J.

concluded, “[T]he Government Defendants are liable to the Plaintiffs for breaching their implied

contractual duty to provide to the Plaintiffs the ‘vital information’ as defined earlier in these

reasons.” In the end, he awarded the plaintiffs $81 million including punitive damages. The

government is reportedly appealing this decision.

MBDOCS_1235235.3 32

(iii) Conclusion

The Amertek case appears to be an egregious example of a government abusing its

position in order to off-load liability onto a private company. However, it is important for all

government negotiators to be aware of the higher disclosure standard when entering into talks

with prospective bidders. What they don’t know could hurt you.

8. SUMMARY AND CONCLUSION

Identifying, allocating and managing risks is critical to the long term success of

any public procurement project. Care must be taken at the outset to strike the appropriate

balance.

There must be an equitable sharing of risks and rewards or else the procurement

project will be inherently inefficient, subject to an inordinate risk premium, and prone to failure.

Risks should be allocated to the party best able to manage them.

Generally, vendors are in the best position to manage the following risks:

1. project design and construction risks

- delivery of project on time and on budget

- meeting technical and performance requirements

2. operating and maintenance risks

- meeting and exceeding established benchmarks for performance

- consequences for failing to do so

MBDOCS_1235235.3 33

- incentives for continuous improvement

Typically, the issuer and the vendor share financial risks and market risks (such as

the risk of inflation, interest rate and foreign currency fluctuations, escalating insurance costs and

the risk that “users” revenue fails to develop).

Political risks are usually left with the issuer. Such risks include regulatory and

legislative change and future government decisions that have an adverse or discriminatory effect

on the procurement project. In this regard, the arrangements for termination of the contract by

the issuer (for convenience) cannot amount to expropriation without fair and adequate

compensation of the vendor’s investment or else the project is not bankable.

Taking the time to carefully identify, allocate and manage risks at the outset

provides a solid foundation to the procurement contract and to the relationship between the issuer

and the vendor for the duration of the project.

Giving the exercise short shrift (in order to accommodate near term political

agendas or artificial deadlines) is a false economy and parties (issuers and vendor alike) ignore

this simple truth at their peril.

Allocating and Managing Procurement Risks

By Bill Hearn*McMillan Binch LLP

*Holly Agnew and Andrea Long assisting

For The Canadian InstitutePublic Procurement Conference

Toronto, January 28, 2004

OUTLINE

• Identifying Risks• Allocating Risks• Managing Risks• Ensuring Effective Remedies• Resolving Disputes• Some Current Issues

– Force Majeure post 9/11, blackout and SARS

– Amertek

Definitions

• “Vendor” – the party bidding on

the procurement project (such as a private company or consortium)

• “Issuer”– the party issuing the

RFP (such as a government department, ministry or agency)

Identifying Legal Risks

• Direct Contractual Liability– Breach of contract between vendor

and issuer

• Third Party Liability– Liability to persons who are not parties

to the contract

• Early Termination– Risk for both vendor and issuer

Identifying Legal Risks

• Limitation of Legal Recovery– What is legally recoverable?

• Strength of Vendor Covenants– Will the vendor have sufficient assets to satisfy

its legal obligations to issuer?

Identifying Business Risks

• Project Design and Construction• Operating and Maintenance• Financial• Market• Political

Allocating Risks

• When does the risk overcome the reward?• The wider the risk and reward gap, the more

inefficient the project• Risk premium: the more risk to the vendor,

the higher the project cost to the issuer• Issuer – is the cost worthwhile? Or should

it take on the risk itself?

Vendor’s Perspective

• Must position itself as a serious contender for the contract without taking on all the liability

• “Soft Language” – prevents vendor from assuming all liability from inception

• Leaves door open to negotiation

Managing Risks• Options:

– Accept Risk– Avoid Risk– Reduce Likelihood of

Occurrence– Reduce Consequences

of Risk– Transfer Risk

Risk MatrixConsequences

HighHighModerateLowLowRare

ExtremeHighModerateLowLowUnlikely

ExtremeExtremeHighModerateLowPossible

ExtremeExtremeHighHighModerateLikely

ExtremeExtremeExtremeHighHighAlmost Certain

CatastrophicMajor ModerateMinorInsignificantLikelihood:

From: Australian Capital Territory – Government Procurement Board Risk Management Procurement Circular 2002/02

Sample Risk MatrixResponse Key

• Extreme = immediate action required• High = senior management attention

required• Moderate = management responsibility

must be specified• Low = manage by routine procedures

→For more info, see www.basis.act.gov.au

From: Australian Capital Territory – Government Procurement Board Risk Management Procurement Circular 2002/02

Managing Risks

• Establish Mechanisms to Monitor Performance– Regular meetings of both parties’ key

operational personnel– Formal reporting requirements

• Establish Performance Benchmarks– “Continuous improvement” clauses– Early warning system

Ensuring Effective Remedies

1. Indemnities• Claims by Third Parties and Contracting Party Type

of Loss• Limitations on Liability• Contributory Breach or Negligence• Vendor to ensure all statutory req’ts to give effect to

issuer’s indemnity have been met: e.g., s. 28 of Ontario FAA requires written approval of Minister of Finance to indemnity from Ontario government

Ensuring Effective Remedies

2. Money Damages for Breach• Primary Remedy• No Punitive Damages• No Remote Damages• No Avoidable Damages• Liquidated Damages

Ensuring Effective Remedies

3. Security for Bidder’s Promises

• Guarantees• Letters of Credit• Performance Bonds• Traditional Liability Insurance• Non-traditional Insurance

Ensuring Effective Remedies4. Court Orders to Perform

• Specific Performance• Only when subject matter is unique and monetary

damages would be insufficient

• Injunction• Helpful when damages would be insufficient to

protect business interests of innocent party

Ensuring Effective Remedies5. Force Majeure

• Addresses circumstances beyond the control of the issuer or the vendor

• May lead to termination or suspension of the vendor’s provision of services for a period of time

• Issuer may want to provide for alternative means of providing services in case of interruption due to events of force majeure

Ensuring Effective Remedies6. Right of Issuer to Terminate the

Contract • Termination Forthwith for Bankruptcy• Termination Upon Notice of Uncured Breach• Termination Upon Notice for Fundamental

Breach• Termination Upon Notice for No

Appropriation by Parliament or the Legislature

• Termination Upon Notice for Convenience

Ensuring Effective Remedies

7. Vendor’s Right to Terminate• Only in limited circumstances (i.e. material

reduction in scope of project)• Notice period must be sufficient to allow

issuer to find an alternative service provider

Transition Obligations upon Termination

• Vendor usually obligated to work with issuer and new vendor to facilitate the transfer of the procurement contract

• Not necessarily binding when the issuer terminates by reason of the vendor’s breach

• Vendor should be required to return all computer hardware, software, material, equipment, records and other property belonging to issuer

Resolving Disputes

• Internal Resolution• Early Neutral Evaluation• Fact Finding• Negotiation• Mediation• Mini-Trial• Arbitration• Litigation

Some Current Issues –Force Majeure

• Defining the Scope of Force Majeurepost 9/11, blackout and SARS– Should definition be expanded to include

acts of terrorism and epidemics?– Should time limits be included?– Doctrine of Frustration– Duty to mitigate

Some Current Issues –Force Majeure

• Examples:– Northwest Airlines – Air Canada– Group and Convention

Bookings in Toronto

Some Current Issues - Amertek

• Case decided by Ontario Superior Court of Justice in August 2003

• Facts:– The Canadian Commercial Corporation

(“CCC”) brokered a deal between the US military and a Quebec company to manufacture fire trucks

– Quebec company was unable to fulfill contract

Some Current Issues – Amertek

• CCC would have been liable to US government if it could not find a replacement

• CCC induced Amertek, an Ontario company, to undertake the contract even though CCC questioned whether Amertek had the technical competence

• Also, CCC convinced Amertek to lower its bid, even though it knew that the original amount offered was already too low

Some Current Issues – Amertek

• “Doctrine of Superior Knowledge”– Has been in existence in US since 1940s– Requires government to disclose all salient

details when negotiating public procurement contracts

– Based on fairness principle – companies cannot be expected to shoulder risks that they were not aware of at the time of contract

Some Current Issues – Amertek• “Breach of Implied Contractual Duty” --

Ontario Superior Court of Justice• Overlaps with fiduciary duty• Case is being appealed by the government

-- Court of Appeal may provide further development of doctrine in Canada

• Bottom line: Government must disclose all relevant facts of contract to potential vendors

SUMMARY AND CONCLUSIONS

• Identifying, allocating and managing risks is critical to long term success of any public procurement project

• Care must be taken at outset to strike appropriate balance

SUMMARY AND CONCLUSIONS

• Serves as foundation to procurement contract and relationship between issuer and vendor for duration of project

• Giving short shrift to this exercise at outset (e.g., to accommodate short term agendas or timelines) is a false economy

• Parties ignore this simple truth at their peril!

QUESTIONS & COMMENTS

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