PFI contracts: are service points regimes subject to good faith?
30 September 2015
In Portsmouth City Council v Ensign Highways  EWHC 1969, 14 July 2015, the High Court held that there was no implied duty on a public body to act in good faith when exercising its discretion under a service points regime in a long-term PFI contract. It had only to exercise its discretion honestly and on proper grounds, and not in a manner that was arbitrary, irrational or capricious. Service points regimes are a common feature of long-term PFI contracts and this case is the second (following Mid Essex Hospital Services NHS Trust v Compass Group  BLR 265) to make clear that no obligations of good faith will be implied into their operation.
In 2004, Portsmouth City Council (PCC) entered into a 25-year public finance initiative contract (the PFI Contract) with Ensign Highways Ltd (Ensign) for the long-term rehabilitation, maintenance and operation of PCC's highway network. The PFI Contract was split into two phases. During the first five years Ensign was required to bring the highway infrastructure up to a defined standard, and in the second 20-year phase Ensign was to be responsible for the maintenance and cyclical renewal of the highway.
Mechanism for penalising breaches
The PFI Contract contained a mechanism which allowed PCC to penalise Ensign for breaches. The mechanism allowed PCC to award service points for certain "default events" by Ensign. The Contract specified a "Maximum Event Value" of between 1 and 10 points for each such default event. If Ensign accrued certain numbers of service points in a 12-month period PCC could take certain actions, up to and including a right for PCC to terminate the PFI Contract if Ensign accrued 250 service points in a 12-month period.
Up until the end of 2013, the service point regime operated to both parties' satisfaction. PCC treated the Maximum Event Value as a maximum, and awarded less than the maximum number of service points for less serious examples of particular default events. PCC also assessed and awarded service points on a monthly basis. However, from the beginning of 2014, PCC began awarding the Maximum Event Value for every default. It also stored up and "ambushed" Ensign with many months' worth of accrued service points. Ensign referred PCC's new practices in awarding service points to expert determination, which found that PCC had acted in bad faith, without mutual co-operation and unfairly. PCC applied to the High Court for declarations on the proper interpretation of its rights and obligations with regard to the award of service points under the terms of the PFI Contract.
The High Court faced two questions. First, whether the service points mechanism gave PCC a meaningful discretion in the awarding of service points. Second, to what extent was PCC constrained in exercising that discretion?
Was there a discretion in awarding service points?
This question turned on whether the heading "Maximum Event Value" connoted the top of a range of service points that could be awarded for a particular default, or a fixed number of service points to be awarded for each type of default. Edwards-Stuart J followed the approach to the interpretation of a contract in Rainy Sky v Kookmin Bank  1 WLR 2900, namely to look for and adopt the interpretation that most accords with commercial common sense. Applying that approach, he found that the heading "Maximum Event Value" connoted the top of a range of service points that PCC had a discretion to award, and were not fixed tariffs.
Accordingly, the service points regime gave PCC a meaningful contractual discretion.
Should the discretion be exercised in good faith?
Ensign argued that PCC must exercise that discretion in good faith. Ensign relied on clause 44 of the PFI Contract, which was concerned with the parties' obligations in assisting PCC to comply with its "best value" duty under s3 of the Local Government Act 1999. That clause required PCC and Ensign to "deal fairly, in good faith, and in mutual co-operation with one another and Interested Parties". Ensign argued that this contractual duty of good faith applied to all of the parties' dealings under the PFI Contact. It also argued that the long-term nature of the PFI Contract put it within the class of relational contracts identified by Leggatt J in Yam Seng Pte Ltd v International Trade Corp  1 All ER (Comm) 1321, into which a duty of good faith may be implied.
PCC contended there is no general duty of good faith in English contract law and that there was nothing in the PFI Contract that stated that the good faith obligation had a wider ambit than clause 44. PCC also noted that there were further express duties of good faith or obligations to use reasonable endeavours in other clauses of the PFI Contract, indicating that the parties had not intended there to be any overarching duty to deal in good faith in all aspects of the PFI Contract, but only in certain specific clauses. It argued that the exercise of its discretion was only constrained by an implied term that it must "be taken on proper grounds and for proper purposes, and without dishonesty or deceit."
Edwards-Stuart J agreed with PCC that the obligation to act in good faith in clause 44 of the PFI Contract did not apply to the rest of the PFI Contract. In doing so he relied on the decision of the Court of Appeal in Mid Essex Hospital Services NHS Trust v Compass Group  BLR 265, which declined to read a more widely drafted contractual obligation to act in good faith as applying to specific provisions of a PFI contract concerning a comparable service points regime, and declined to apply the Yam Seng analysis to that PFI contract.
However, Edwards-Stuart J declined to find that the term to be implied in relation to the exercise of PCC's discretion to award service points was that contended for by PCC. Instead he applied the line of authorities culminating in Socimer International Bank Ltd v Standard Bank London Ltd  1 Lloyd's Rep 558 (that had also been considered by the Court of Appeal in Mid Essex) to find that the discretion conferred on PCC was constrained by an implied term that it would "act honestly and on proper grounds and not in a manner that is arbitrary, irrational or capricious".
Comment: Service points regimes (often referred to as service default points or service deficiency points) are a common feature of long-term PFI contracts and we now have two major decisions on their application. In Mid Essex the Court of Appeal declined to imply a term into the clause, empowering the NHS Trust to award service points on the basis that it interpreted the clause as setting out precise rules for calculating how many service points were incurred, and therefore there was no meaningful exercise of discretion; the NHS Trust either applied the contractual provisions correctly or it did not and there was no need to imply a term to give the clause effect. By contrast, Edwards-Stuart J in this case found that the relevant service points regime did confer discretion on PCC, and that the exercise of that discretion was constrained by the standard implied term from case law as to the exercise of a contractual discretion. In both cases the courts declined to find that the relevant public authority was under any obligation of good faith. The case law is now reasonably clear that:
a. where a service points contractual regime is precisely set out in the relevant PFI contract, no term need be implied as to the operation of that regime, as there is no true discretion whose exercise needs to be constrained;
b. where the operation of a service points regime confers a meaningful discretion on the public body, a term will be implied into the PFI contract that the discretion must be exercised honestly, and not arbitrarily, irrationally, or capriciously; and
c. a duty of good faith is unlikely to be read into the operation of a service points regime unless the express words of the contract are clear that the public body must act in good faith in the exercise of its obligations under that regime.
By their nature PFI contracts set out a long-term relationship between two parties in a significant degree of detail. The interpretation of a PFI contract will dictate whether and the extent to which investors will receive a return on their capital investment in an asset; lenders will be repaid amounts they advanced to build or renew an asset and service providers will be paid for their services. These cases on service points can be equally applied to the exercise of other discretions under PFI contracts.
Before the High Court, Ensign sought to rely on evidence that had been given by a number of employees of PCC in the expert determination proceedings as to the practical operation of the contract. It argued that, although evidence as to the performance of a contract is ordinarily inadmissible as an aid to its interpretation, such evidence ought to be admitted here as evidence of what would constitute commercial common sense in the operation of such contracts. The evidence that PCC employees had operated the service points regime on the flexible basis Ensign contended for was ultimately one factor in the Court's decision that the heading "Maximum Event Value" connoted the top of a range of service points and were not fixed tariffs. Whilst Mr Justice Edwards-Stuart was cautious in relying on this evidence, his judgment may be a useful tool for parties in interpretation disputes where their counterparty has changed position and is arguing for the contract to be interpreted in a manner contrary to how it has performed it to date.
The conclusions that investors, lenders and public bodies that are (or about to become) parties to PFI contracts should draw from this new case law are set out below:
a. normal rules of contractual interpretation
continue to apply and views of Lord Hoffmann in AG for Belize v Belize
Telecom  UKPC 10 amongst other cases were referred to – that is,
interpretation involves discerning the meaning that the contract in question
would convey to a reasonable person having all the background knowledge which
would reasonably be available;
b. the terms of a contract are extremely important and the courts will be reluctant to interpret them in a manner that departs from the intention of the parties or commercial/business common sense. It is critical therefore that the service points regime is analysed from both a legal and commercial perspective;
c. it is important for a service points regime to be drafted properly. The judge criticised the drafting as the schedule in question did not provide for a timetable in accordance with which service points may be issued. The lack of one in this case allowed PCC to award service points cumulatively so that they could be imposed in a manner which proved to be overwhelming for Ensign;
d. if the PFI contract contains a negotiated set of points awardable for each default, it is important to clearly state whether the points awardable for each default are in the nature of a fixed tariff or a range capped at the specified number and if a maximum cap how particular events would result in deductions at below the maximum;
e. if the intention of the parties is to apply an umbrella duty of good faith in all dealings between the parties (or in the application of a performance regime), then the contract must explicitly state this so that courts will otherwise refrain from implying such a duty into cherry-picked clauses; and
f. the court also criticised the drafting of the disputes procedure to be followed in relation to default events that were not specifically assigned a Maximum Event Value or when different authorities are empowered to award a quantum of service points. It is imperative that such procedures be detailed and unambiguous as otherwise the court will interpret them to accord with commercial business sense, which may not align with the original intention of the parties.
Clearly the overarching lesson for PFI contractors contracting with public sector bodies is that they should be aware that if a right is reserved contractually to the public sector to do something, then they should price bids and ensure they have drafted contractual provisions on the assumption that those rights will be exercised. Warm words of partnership and collaboration during a bid process count for very little in the cold light of a court room.