(Paul Krugman - 2008 Nobel Prize for Economics)
Performance based contracts could play a major role in boosting Australia's flagging productivity. However, the High Court's decision in Andrews v ANZ threatens the future of this innovative form of contracting in Australia.
While the reasons for Australia's productivity crisis are varied and complex, there is consensus that innovation is key to the solution. The 2012 Australia in the Asian Century White Paper asserted that:
"most of what is required to lift Australia's productivity is in the hands of individuals...It will emerge through innovation in business processes within firms and more sophisticated relationships among firms...".1
PERFORMANCE BASED CONTRACTING - A LEGAL INNOVATION
Performance Based Contracts, or PBCs, are a recent innovation that encourage contractors to boost their productivity. A PBC is structured to motivate the contractor to achieve particular outcomes, rather than simply performing individual activities. They are generally used for services contracts but can be adopted for the supply of goods.
The principal pays the contractor according to whether they meet pre-agreed targets usually measured by KPIs. This aligns principals and contractors so that, instead of a contractor working to minimise costs to increase its profits, both principal and contractor work together towards a common outcome.
Where the agreed outcome is achieved, the contractor receives positive remuneration. Where there is a performance failure, there may be an abatement to reflect the contractor's poor performance.
PBCs have been used successfully in Australia by government and the private sector.
The Department of Defence is encouraging more PBC type arrangements and has set out clear guidelines in a draft paper, Managing Contractor Performance under Productivity and Performance Based Contracts (The PPBC Handbook).
PBCs have been endorsed by COAG in the delivery of health services and they have also been used in major infrastructure project and services contracts.
PBCs are not unique to Australia. They are also used extensively in the United States and the European Union.
A POSSIBLE STUMBLING BLOCK
While PBCs could play an important role in kick starting Australia's productivity growth, the High Court of Australia's decision in Andrews v ANZ may prove to be a stumbling block.
Ostensibly, the Andrews case was about bank fees, however the decision could have ramifications for contracts more broadly. In Andrews, the High Court unanimously held that contractual breach is not necessary to enliven the doctrine of penalties.
This suggests that any secondary fee, which is found to be out of all proportion to the primary loss suffered, may be considered a penalty and hence be unenforceable. This would include a large abatement in a PBC levied as a result of a failure by a contractor to deliver a primary service.
Due to the potential unenforceability of contractually agreed abatements, care will be needed in structuring the incentive and abatement regimes commonly used in PBCs.
Fundamental to PBCs is the ability to create incentives for good performance by punishing a contractor for poor performance. However, this mechanism to achieve performance may now be unenforceable. This has implications both at the pre-contractual negotiation stage and at the performance stage.
At the pre-contract stage, parties now need to consider whether the abatement regime being agreed to will be enforceable. Effectively the parties are forced to guess how tolerant a court will be in balancing their right to contractual freedom with equitable principles. The parties are left to reconcile setting an abatement level that is large enough to influence performance yet not so large that it becomes unenforceable. This creates uncertainty which may mean PBCs are less attractive.
Significant issues also arise at the performance stage. Where an abatement is set aside and the only recourse for a principal is to prove its actual loss, contractors may find it more profitable to fail to perform an obligation to the agreed level. This effectively creates incentives to underperform in contracts.
This issue is particularly acute in PBCs, because frequently the contract price of PBCs are higher than that for traditional contracts. Contractors price the risk of potential lost revenue from abatements. If there is uncertainty as to whether the abatement is enforceable, then the principal may not be getting value for this risk transfer, which rather defeats the intent of the contract.
CAN THIS RISK BE MINIMISED?
On the whole abatements accrue over time and escalate for persistent failure. Two practical measures a principal might take to discourage challenges are, first, to ensure that any abatements arising are deducted regularly to avoid a sizeable unpaid amount accruing that might tempt a contractor to challenge it. Secondly, jeopardising the contractor's revenue stream by the addition of a right to terminate on unfavourable terms to the contractor, if the abatement regime is declared unenforceable, should discourage a challenge.
1 Australia in the Asian Century White Paper (2012) Chapter 4.2.
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