The Defence Reform Act 2014 (supported by the Single Source Contract Regulations 2014 No 3337) ("the Act") sets out a new statutory framework for single-source contracts, covering pricing and transparency. As single source procurement contracts form around 45% of the UK Ministry of Defence's (MOD) procurement budget, this new framework will have a significant impact on companies contracting with the MOD.

The purpose of the Act

The Act seeks to crystallise into legislation and guidance the practice and expectations of the MOD and its previous voluntary arrangements, such as the non-legally binding system of "Yellow Book". Yellow Book dealt with profit and overhead cost, but failed to address the poor commercial leverage position of the MOD or provide incentives for efficiency.

What are the changes?

  • The creation of a new executive non-departmental public body, the Single Source Regulations Office ("SSRO"). The SSRO is an independent arms-length regulator set up to manage and monitor single source procurement. It has a duty to issue legally binding decisions in response to referrals from the MOD or contractors as either opinions (on proposed defence contracts) or determinations (on existing defence contracts). The grounds for a valid referral are specified in the Single Source Contract Regulations 2014 and include, for example, appropriate profit rate calculation adjustments and the extent to which certain costs can be treated as allowable.
  • The onus of proof for establishing if a cost is an allowable cost has shifted from the MOD to the contractor. Previously the MOD had to show that a cost was unnecessary, extravagant or wasteful for it to be excluded. The contractor will now have to satisfy the MOD (and the SSRO on a reference) that the cost is appropriate, attributable to the contract, and reasonable in the circumstances.
  • The Act includes detailed requirements for contractors setting out the various reports to be provided. The information in those reports includes the contract pricing statement, the contract reporting plan, the notification report, reports on overheads and forward planning, quarterly reports for contracts above £50 million and an annual profile of estimated costs and cost implications of key risks/opportunity events.
  • From 1 April 2015, the baseline profit rate will be 10.6%, a 0.1% reduction from the 2014 rate. The Secretary of State for Defence has accepted the baseline profit rate and capital servicing allowance for 2015 recommended by the SSRO. The baseline profit rate is paid to defence contractors by the MOD in single source defence contracts. It is the starting point for determining the contract profit rate to be applied in the contract pricing formula after a series of adjustments have been made, which could include:
  • a cost risk adjustment (reflecting the risk of actual allowable costs differing from estimated allowable costs);
  • an adjustment to ensure that profit arises only once on allowable costs under the contract (in relation to the price payable under any group subcontract);
  • an SSRO funding adjustment (zero until 31 March 2017);
  • an incentive adjustment (if determined by MOD but not to exceed 2%); and
  • a capital servicing adjustment (to provide an appropriate and reasonable return on fixed and working capital employed by the primary contractor for the purposes of the contract).

To which contracts does the Act apply?

The Act applies to qualifying defence contracts ("QDC") and qualifying sub-contracts ("QSC").

A QDC is a contract under which the MOD procures goods, works or services for defence purposes from another person. "Defence purposes" means for the purposes of defence (whether or not in the UK) or related purposes. It must have a value of £500,000,000 if entered into before 31 March 2015 or £5,000,000 if entered into after 31 March 2015. This is a significant change and will capture more contracts.

A QDC is a contract not excluded by the Regulations. Excluded contracts are contracts with Governments outside the UK, contracts under the framework of an international co-operative defence programme, contracts for the acquisition of land, the management or maintenance of land or buildings, or contracts relating to intelligence activities.

In conclusion

The aims of the Act are to achieve a new governance regime for qualifying defence contracts, supported by the SSRO, under which industry will receive a fair and reasonable price on single source work; and the tax payer will be protected and achieve good value for money.

It will be interesting to see how both the MOD and contractors respond to the Act. Watch this space.