My Say: Truths and untruths about terminating government contracts

This article first appeared in Forum, The Edge Malaysia Weekly, on August 23, 2021 - August 29, 2021.
My Say: Truths and untruths about terminating government contracts
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There seems to be much misinformation regarding the fallout from cancellation of contracts by the government. Undoubtedly, cancellation of any contract is a serious matter, and such action should be taken only after careful consideration of the costs and benefits. Such vital deliberations should be grounded in clarity and truths, however, rather than myths and fears. So, here are some of the realities.

Untrue: That the sovereign rating of the country will drop with government cancellation

If contractual termination by the government is in accordance with contractual provisions, coupled with payment of appropriate compensation, the country’s sovereign rating should not be affected.

There are many examples where nations have done just this with no impact on their ratings, including most recently in the US with regard to the Biden administration’s consideration of terminating the border wall contracts. That debate centres around better use of state funds and environmental concerns versus the approximately US$3 million-a-day idling costs paid to contractors and the questionable effectiveness of cross-border control. Similarly, in June, the UK Cabinet Office in a guidance notice conceded that the time was right for public-sector clients to discuss contract terminations, reversing advice in April to help contractors and suppliers with such contracts through the Covid-19 pandemic. Throughout the consideration of contract termination in these examples, the impact on sovereign ratings was not even raised.

Lawful termination by a government should not be confused with a country defaulting or unilaterally changing contractual terms, both of which can have disastrous effects and affect sovereign ratings. For example, Argentina’s decision in 2019 to extend its loan maturity resulted in the S&P slashing the country’s long-term credit rating by three notches to CCC-, relegating the credit to the lowest level of junk debt.

The Malaysian government has never defaulted on a contract in this manner and, thus, lawful termination, or restructuring, should not be feared for these reasons.

True: The contractual basis for termination is important to determine compensation/damages

In government contracts, the standard grounds for termination are mutual agreement, national interest, contractor default, force majeure, corruption and unlawful or illegal activities.

Thus, contract provisions protect the interests of the contractor and should ensure fair compensation for completed works, reflecting the negotiated agreement (save for the case of termination on the bases of corruption and unlawful or illegal acts where the issue of fairness takes a different tone). Fair payment would typically include the value of all works completed; the cost of materials ordered for the works (which have been delivered or for which the contractor is legally liable to accept delivery); any expenditure reasonably incurred and not covered by other payments; and the cost of protection works and removal of equipment and site facilities further to termination.

Where there is termination for corruption and unlawful or illegal activities, the government should give immediate notice and may activate the performance bond and/or forfeit the performance guarantee sum. The government may also be entitled to all losses and expenses, including any incidental costs incurred from such termination, and the contractor would not be entitled to any form of losses, including loss of profit.

Untrue: Contractors will not bid for future projects if the government cancels contracts

Typically, the focus of terminated contractors has been to maximise compensation and, thus, disputes typically centre around quantum. In many cases, governments settle these disputes without resorting to court or arbitration. Only in rare cases would the contractor challenge termination because, typically, the contractor would fear potential blacklisting. Thus, challenge would occur only if the contractor argued wrongful termination and inadequate compensation (inability to recover or account for all/actual legitimate costs).

Thus, contractors would not refrain from bidding for government projects because of any fear of termination. Rather, it is fear of lack of good governance and unethical tender processes that is more likely to prompt a decision to refrain. The cost of preparing large international tenders runs into seven- or eight-digit figures and contractors will not invest in the process when there is concern that the tender will not be evaluated fairly or is a ruse (namely, that the client has already decided to whom the tender will be awarded). A good example of a fair tender process is found in the Large Scale Solar (LSS) tenders by the Energy Commission. The process attracted many local and international bidders, with LSS 4 attracting 138 bidders to show prices as low as 17.68 sen/kWh, baffling industry pundits. With the resulting lower energy costs, the beneficiaries have been consumers/public.

True: Terminating a foreign G2G contract should not ruin international relations with a counterparty country

Similarly, if the contractors have little to fear from contractual termination, then their host country governments should have little cause for concern regarding international relations (barring special circumstances). For example, the recent termination of the KL-Singapore High-Speed Rail (HSR) agreement saw Malaysia paying RM320 million to Singapore for costs incurred by the latter. In a joint statement, it was said “both countries remain committed to maintaining good bilateral relations, and cooperating closely in various fields, including strengthening the connectivity between the two countries”. The termination process was professional and amicable. Both countries abided by their respective obligations and kept open the possibility for future collaboration as reinforced by the Singapore Transport Minister’s comment that Singapore remained willing to discuss future proposals on the HSR or similar projects with an open mind. (A new HSR project could recoup some of the compensation paid to Singapore if, inter alia, the works and designs previously undertaken could be reused at least partially, if not fully.)

True: Termination is an arduous process with many potential pitfalls

The termination process includes issuing a termination notice, securing of the site, equipment and facilities, and, where appropriate, retendering for project completion. The drawbacks of termination include:

• Project delay;

• Increased project costs due to the retender exercise. The project’s appeal might also be diminished for prospective bidders because of reduced scope;

• Risk of site abandonment by contractor, failure to ensure proper protection of the completed works and loose materials (already paid for by government), resulting in loss or damage;

• Refusal by contractor to remove all its temporary buildings, tools and equipment;

• Potential legal and contractual claims by contractor(s), subcontractors and suppliers leading to arbitration or litigation; and

• Potential industrial relations claims by terminated contractor personnel.

True: Termination should be a last resort, occurring only if its benefits outweigh the above costs

Government should terminate a contract only as a last resort and only when there are compelling justifications that show tangible benefits to the taxpayers/public, and such benefits greatly outweigh the costs of termination. Renegotiation could offer a viable alternative in some circumstances if the project is considered as required. Two recent high-profile examples of local mega projects where the government opted to renegotiate rather than terminate are:

(1) MRT2, where the government and MRT Corporation executed two revised agreements with the contractor MMC-Gamuda (MMCG) for the latter to deliver and be responsible for the design, execution and completion of the project on a turnkey basis instead of on the previous Project Delivery Partner (PDP) model. This resulted in savings of RM8.82 billion — from RM39.35 billion to RM30.53 billion (22.4% savings). Factors that contributed to this tremendous cost savings were: conversion to a turnkey contract; rationalisation in the allocation of reimbursables; contingencies and provisional sums; postponement of some stations; and scope rationalisation for mechanical and electrical works; and

(2) LRT3, where the project cost was reduced by 47% from RM31.65 billion to RM16.63 billion (RM15.02 billion savings), through renegotiations between the government and MRCB-George Kent JV. The main factors leading to this reduction in cost were: scope reduction/rationalisation; extending the completion date to 2024; and contract restructuring from a PDP model to a “fixed price” turnkey contract.

The revision of these projects gained international headlines for smart, transparent and general good governance, with kudos given to the government for its action.

Conclusion: Truth

Realistically, cancellation of any contract should be considered only as a last resort, when all other remedies have failed. The decision to do so must be professionally analysed and guided (preferably with independent and expert advice), and weighing the pros and cons (including to the economy and community). Indeed, if the government’s contract terms and relevant parties’ relationships are unworkable, ending both may provide a healthier solution for all parties while, importantly, protecting the public and national interests for generations to come.

Datin Shalini Ganendra is a lawyer who is currently a Visiting Fellow at Oxford University

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