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final version of report
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Number of pages including this cover shoot: 19
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Final version. I have attempted to take on board comments wherever
Possible, but where they would cause controversy I have not done so.
Sarah
270-4456
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BA/POCL AUTOMATION PROJECT:
MINISTERIAL MEETING: 14 DECEMBER 1998
ISSUES FOR DISCUSSION
Is the ICL revised offer acceptable?
- In terms of the impact on the public sector, ICL, have moved £36-88m in NPV
terms (from £265-317m including the £80m contingency to £229m and no
contingency). But this still leaves a gap of £113m compared to the public
sector position at Corbett,
- in addition, ICL have now accepted considerable risk on volumes, and Fujitsu
have agreed to underwrite the financing of the project;
- the offer is acceptable to the Post Office who would meet the remaining gap
on its contracted services and: absorb increased prices for benefit payment
transactions without passing them on to BA;
- but ICL’s proposals for acceptance testing-are not acceptable to DSS/BA.
How does ICL’s new offer compare with fallback option?
- the fallback option is viable and offers marginally better value for money -
(NPV of £1.33bn v £1.31bn), but the difference is small compared to the risks
and uncertainties which surround the modelling, and on its own these figures
are not sufficient grounds for a decision; °
@ - and there are wider considerations ..
... impact of cancellation on ICL/Fujitsu, inward investment and PFI; possible ~
loss of confidence by subpostmasters; uncertainty over cost and feasibility of
fallback option until discussions with banks ...
.». as against the risk of further breach of contract by ICL (the project has
already slipped since the timetable was reviewed in October), and the wider
I policy agenda e.g. the potential for moving more quickly to a solution which
. reduced financial exclusion, and the potential to take advantage of the latest
technology with the fallback option
Decision: should the Government continue with the project (option 1) or
I terminate (option 3)?
(NB Option 2 - continuing with Horizon but without the Benefits Payment Card -
would depend on the cooperation of ICL and the Post Office. But it could emerge
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from Option 3, and might meet Government concerns about ICL/Fujitsu and the
impact on inward investment) :
‘Next steps
If the Government continues with the project
- should the Government push for further concessions by ICL in the next few
days, in particular on price and on acceptance criteria? How would the
* Government keep up the pressure on ICL - is there a case for issuing notice?
- should POCL be empowered to take forward the final negotiations to reach
heads of agreement, in consultation with BA?
+ how would the Government minimise tisk of further delay?
- what would the Govemment say publicly?
If the Government terminates the project ; -
- what legal notice should the Government serve on ICL - a notice to complete
ora 13 week notice? Advice of the Solicitor-General is that notice to complete
offers less risk, but depending on ICL’s reaction may not lead to specdy
termination. However, if Ministers’ unequivocal wish is to terminate the
contract, it would not be right to issue a notice to complete;
- what would the Government say publicly, in particular to reassure
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BA/POCL AUTOMATION.
INTERDEPARTMENTAL WORKING GROUP
FURTHER REPORT TO MINISTERS
11 DECEMBER 1998
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CONTENTS
1. Background2
2. The ICL offer3
3(i). The decision: the case for continuationS
3(ii). The decision: the case for termination8
(i). The way forward: continuation9
(ii). The way forward: termination10
Annex A: The ICL offer3
Annex B: Advice from the Law Officersn/a
Annex C: Presentational Strategyn/a
Annex D: letters from Neville Bain and Alistair Darlingn/a
Annex E: Cashflows from BA and POCL to ICLn/a
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1. Background
The BA/POCL automation project (known as “Horizon") has been under review
since the contractor, ICL Pathway, was placed formally in breach of contract in.
November .1997 by both POCL and BA, after a key contractual milestone was missed.
Following the failure of negotiations (the so-called Corbett discussions) to establish a
I commercial basis acceptable to Government for proceeding with the contract in
October, ICL were given a further period of two.weeks for them to make progress in
their discussions with the Post Office to develop a public/private partnership as a means
of enabling ICL to move further towards the public sector's position. ICL’s proposal for
the partnership was received on 9 November, along with’3 additional papers addressing
commercial, contractual and financing issues. ICL stated-they were prepared to accept
a loss of around £100m NPV (although we believe they expect to recover this with the
: income earned from the partnership with: POCL), but their commercial proposals
I involved a risk transfer that would have been entirely unacceptable to the public sector
j and would have effectively seen the public sector underwriting the whole deal. Ministers
concluded that ICL’s wider commercial proposals revealed insufficient movement on
their part, and a wide gap remained between the two sides.
I 2. The Chief Secretary therefore wrote to ICL on 20 November giving them a third
j and final period until 9 December to reach heads of agreement with the public sector.
ICL were told that they would have to make an offer which:
” demonstrated that they could secure adequate financing to take the * Project
forward without the public sector bearing unacceptable risk;
“ provided assurances that Fujitsu were standing behind the project;
a made an unequivocal move towards the public sector’s Position as proposed in
the earlier negotiations.
[—) 3. Ministers also agreed that they need to be in a position to implement the fallback
: options quickly ifn acceptable deal could not be struck by 9 December. The Chief
I Secretary therefore asked officials to prepare an exit strategy to the same timescale,
building on the work already completed on. the fallback options and including
presentational handling. A presentation to Ministers by the public sector parties on the
fallback option was held on 8 December. This demonstrated that there was a do-able
alternative, based on a move to ACT for benefit payments timed to fit the provision of a
banking capability across Post Office Counters.
4. Should Ministers decide to terminate, the exit strategy must be based on lawyers’
assessment of the strength of the public sector's case for termination. However there
are differences of view between the lawyers acting for the various parties on the route to
termination under the contract. The Chief Secretary therefore asked officials to
approach the Law Officers to resolve this difference of view. Lord: Falconer was also
asked by Alastair Darling to consider the issue.
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5. This report:
° provides an assessment of ICL’s “best and final offer” of 9 December;
° summarises the case for and against continuation;
.. sets out an exit strategy, taking.into account the advice of-the Law Officers,
should Ministers decide that ICL's offer is unacceptable.” ”
2. The ICL offer
6. Ministers agreed in early September that they would consider continuation with
the project provided an acceptable commercial deal could be struck between the public
sector and ICL, and that the offer provided VFM compared to the alternatives. The key
commercial obstacles to a deal identified in the subsequent negotiations have centred
on the overall NPV gap between the public sector and ICL; the level of risk transfer to
the public sector; and the acceptance testing process. _
a ICL wrote to the Chief Secretary on 9 December setting out its “best possible”
offer - on commercial arrangements, project funding and system acceptance (ICL's
letter as supported by 3 detailed Papers as before). The headline terms of the offer
include: © zs
” Commercial arrangements
confirmation that fraud risk will, as envisaged in the original contract, be
- borne by ICL (up to a limit of £200m over the life of the contract)
* . revised pricing, with greater volume risk taken by ICL (if volumes fall by
90% then ICL’s loss falls from -£118m to -£204m, whereas if volumes
increase by 10% then their loss reduces to -£32m) and the. burden of the
increases largely falling on POCL
* withdrawal of the previous Proposal for an £80m “contingency fund” to be
Se . ” funded by the public sector
. * anestimated loss to ICL of £118m NPV (£269m cash)
” Project funding
- : ICL, with Fujitsu support, funding the whole project, investing £600m (or
whatever is required) - although BA/POCL need to confirm this is a legally
binding guarantee.
an obligation on the public sector, if the contracts were terminated for
Pathway default, to buy the system at its economic value less appropriate
set off costs
. system acceptance : .
the sponsors’ giving up termination rights before full functionality for BA is
available and after limited testing of the system in a live environment
- guaranteed payments from the start of National Rollout
appointment by agreement of an Independent Expert to resolve
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acceptance disputes quickly; the Expert would be empowered to-make -
binding decisions for implementation without delay (subject to subsequent
arbitration or legal proceedings)
Below this headline level, the ICL offer envisages further discussions on the detail
although the ‘figures in the letter (representing their best offer) depend. on the
assumptions about pricing etc. in the supporting papers.
8. An overall NPV gap remains. ICL have moved their position of the 9 November
from a loss of between £75m and £103m (depending on the contingency) to a loss of
£118m on a central case, with no contingency. In terms of the impact on the public
sector, this represents a movement-of £36-88m NPV. But ICL have taken on more tisk
through the dropping of their request for higher volume guarantees. The public sector
(effectively the PO, since Ministers have already agreed that BA should not make
6 further concessions) would need to find a further £113m NPV to.close the gap, in
addition to the £116m NPV already offered relative to the Corbett base case.
9. On the other hand ICL have met the public sector's requirement that Fujitsu,
tather than the public sector, should stand behind the project as was the intention of the
Original PFI contract. ICL have confirmed verbally that the guarantee will be similar to -
~ .that provided for DTI for project Elgar and that this can be converted into a legally based
guarantee. Clearly BA and POCL would need to ensure that Fujitsu’s support for
Horizon was expressed in legally enforceable terms.
10, The proposals on acceptance testing are still unacceptable to the public sector
Parties as they stand. BA is rightly concerned about losing termination rights for a
system which needs to support 15 million claimants before adequate testing in a live
trial. But POCL believe that a way through can be found since, they argue, ICL have
accepted the principle that the system must be seen to work in live operation before it is
accepted. .
: [—} 14. A comparison of the 9 December offer with the 9 November offer and the Corbett
- proposals is set out in Annex C. .
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The parties’ response
142. The PO's view is set out in Neville Bain’s letter. to Peter Mandelson of 11
‘Dseember: Their view (endorsed by DTI) is that:
ICL has made major moves on a number of issues; in particular it has-
made clear its acceptance of funding, fraud and performance risks, which
substantially reduces the risk carried by POCL;
the commercial proposals, with no requirement for the public sector to pay
for a contingency fund, represent a move by ICL of £88m NPV;
the system will be seen to work in live operation before it is accepted;
the draft Partnership Heads of Agreement already agreed with ICL would’
offer real benefits (if finally signed off) in developing new services; and
overall that
the programme should go ahead with a -reaffirmed commitment by all
parties to its delivery.
13. The DSS/BA. view (confirmed by Alistair. Darling's letter to the cst of 11
December) is that:
. the commercial proposals make no material change to the November 9
proposal;
acceptance cannot be authorised until there has been a successful live
trial of the system and final responsibility for acceptance cannot be
delegated to an Expert;
* Fujitsu’s support of the project must include a legally enforceable
performance guarantee;
Ministers should stand back and weigh the wider issues in the balance -
the justification for continuation of the project against the wider policy
agenda - before reaching a decision;
overall, the proposals should be rejected.
*
14. The Horizon Programme Director has confirmed that a programme milestone will
be missed in December. This slippage to the programme timetable is likely to add
further delay, complicated by the Millennium, which will mean lost fraud savings and
additional administrative costs to BA.
3. The Decision :
15. The Key objectives against which a decision should be judged might be:
” to pay social security benefits in a way that is as cheap, efficient, fraud free and
convenient as possible, consistent with plans for welfare reform;
. to help to maintain a nationwide network of post offices in order to protect the .
accessibility of government services provided across PO counters;
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” to support integrated delivery of existing and new government services and
. information more generally taking full advantage of new technology, streamlining
e Government's dealings with citizens; ; ~
* to improve access to basic financial services, including banking services, for
poorer members of the community and the. socially excluded; 7
” to maintain -a thriving IT sector in the UK, in which ICL is a key player, while
ensuring that risks transferred through PFI projects do not end up with the
taxpayer; and - : . .
. against these objectives, to secure prudent use of taxpayers money.
> {i) The case for continuation
16. The case for continuation rests on three points:
” the acceptability of ICL’s offer relative to the alternative option;
” the possible impact on subpostmaster’s confidence and therefore the post office
network;
bd the impact on ICL and Fujitsu and the knock on consequences for the IT sector
and inward investment in the UK.
Is ICL’s offer acceptable relative to the alternative?
17, In judging whether ICL’s offer is acceptable, it is important to consider not only
how far they have moved from 9 November (see above), but also how their proposal
Compares to the fallback option.
- i) 18. The following table compares. the impact of continuation versus termination
(option 3) on the public sector! Option 1 has been revised to take into account the 9
December ICL offer (which requires a public sector. contribution of £113m NPV at 6%
teal); and the impact of the additional slippage in the programme on BA. BA.estimate
that the slippage of one and half months against the Corbett programme could result in
@ delay of six months because of BA’s year 2000 purdah (an additional cost to BA ©
against the base case of £110m NPV). Option 3 is based on KPMG's modelling, carried
Out in October.
1 The table does not show figures for option 2 - continuation without the Benefit
Payment card. This option would require [CL’s consent, and {s therefore not, strictly
Speaking, a choice available to Ministers (although it may be a desirable outcome of a
Negotiated settlement). . :
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4 ;Option'3:(withotit:floor)=
1.36
0.85
2.21
bi
OSS admin savings
DSS programme savings
Net impact on DSS
Net impact on POCL 0.73
Subsidy to subpostmasters 0.15
Horizon refresh costs -
additional payment to ICL -0.11 <j.
Overall NPV 1.31 1.33
19. Cashflows are shown in Annex E. The ICL revised offer would mean £1.7bn cash
over ten years would be paid to IcL (under, Corbett the cash payments would have been
£1.5bn).
ww
20. Insummary: -
” the figures suggest, as before, that the results are very close. The fallback option
now looks marginally better value. But there are still margins of error surrounding
the modelling - and in the case of option 3 these could not be resolved until the
public sector parties were able to enter further discussions with the banks;
“ there are significant risks surrounding all of the options which are not factored
into the figures. These would need to be managed.carefully.
The impact on the post office network
21. One of the key factors in the decision to try to find a way forward with the project
in September were Ministers’ concerns about the impact on the post office network. The
PO's ability to manage change in the'network and implement their commercial strategy
depends upon the confidence of both the subpostmasters and the PO's other clients in
e the future viability of the business (of which. a key factor is automation). An
* announcement that Horizon had failed would adversely affect expectations unless a
clear and deliverable plan was in place for an alternative. An earlier move to ACT would
also see the faster deterioration of POCL’s main source of income (since DSS/BA fund
paper-based methods of paying benefit).
22. There are clearly risks. But we believe that careful presentation, combined with
an agreed BA/POCL strategy for moving to ACT alongside (rather than ahead of) the
introduction of banking services in Post Office would mitigate (to some extent) these
risks, DSS, BA, POCL and DTI have held productive discussions about how to progress
the fallback option. These discussions, including further work by KPMG, have concluded
that there is a viable way forward. The challenge is to maximise the value for money to
Government through an integrated timetable - but until discussions/negotiations with the
banks are possible then we cannot further develop the costings or get a clearer picture
of the risks. All parties are fully committed to working together pro-actively to maximise
value for money.
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The impact on ICL/Fujitsu, the IT industry and inward investment
23. Loss of the project would be a major blow for ICL. Just how great would depend
primarily on the stance taken by Fujitsu, who have claimed that it could lead to the
collapse of ICL. However, it is possible given ICL's other work that merely ICL/Pathway
alone will be dissolved. Failure of the project would mean that ICL made a total loss of
£200m in 1998; it would destroy its prospects of flotation in 2000 and might lead Fujitsu
to divest itself of the company. Given the economic climate in Japan, Fujitsu’s attitude
may well have hardened. On a least bad scenario, cancellation would damage ICL's
reputation here and in its export market. °
24, The recent approach from Mr Naruto, Vice Chairman of Fujitsu and Chairman of
ICL, to. our Ambassador in Tokyo, Sir David Wright, suggests that cancellation could
have a serious effect on our relations with Fujitsu. Fujitsu has been a major inward
~~ investor in the UK, with over £700m invested in the last decade.
(ii) The case against continuation
25. The case against continuation rests on the following:
“ ICL have not moved sufficiently and there are further delays to the project (the
project is already 3 years late). But the PO (who would have to bear the bulk of
the further payments to ICL) have argued that they have a commercially viable
case under the proposals, and are prepared to bear the additional costs to
secure the deal; .
. the offer no longer appears to be VFM compared to the alternative - although the
results are still close and there are risks which are not reflected in the figures (for
- both routes); .
. the delay to a more modern and efficient benefit payment system. Paying
—) benefits. directly into bank. accounts which would fit with the Government's
welfare reform agenda, and would provide, in the view of the Social Exclusion
Unit, an“ extremely influential way of increasing people’s access to financial
services and reducing financial exclusion. There is also the fact that we would be
implementing the Benefit Payment Card at a time when alternative, more modern
solutions are available (such as Smartcard - although the PO have plans to
migrate to a Smartcard eventually);
. the public expenditure consequences for BA. It is likely that DSS/BA accounting
officers will require a formal Ministerial direction to continue with the project.
4, The Way Forward
{i) Continuation
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If Ministers decide, on the basis of the above, to continue with the project, then:
BA/POCL.will need to resolve their differences on ICL's acceptance proposals,
and-agree a way forward with ICL that is acceptable to all the parties;
there may also be a case for pushing for further concessions in the negotiations
to finalise heads of agreement (although this will carry risks, given ICL have said
this is their best possible offer). We would expect POCL to lead these final
negotiations, in close consultation with BA;
‘we envisage a low key statement to Parliament to end the uncertainty about the
project. A suggested statement is attached at Annex C;
we would need to think carefully about how to minimise the risks of further delay.
One important factor would be a strong renewed commitment from all the parties
concerned to make best endeavours to deliver the project. The parties have also
agreed that a restructuring of the contract with ICL after acceptance to remove
BA (who would become a customer of POCL) would be a useful step;
we also believe there is a case for issuing some form of notice to complete under
this scenario.
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{ii) Termination
27. If Ministers decide that the ICL proposals do not provide’ a way forward then
question arises as to what action to take. Lawyers acting for DSS and POCL have
disagreed on this. The Chief Secretary accordingly agreed that the Treasury Solicitor
should seek the advice of the Law Officers. A letter from the Legal Secretariat to the
Law Officers recording the Solicitor General's advice and a note from Treasury Counsel
(referred to in the advice) is at Annex B, and a letter from Lord Falconer to the Chief
Secretary on the legal issues is at Annex D.
28. The main options are:
a To serve a 3 month notice terminating the contracts;
@
b. To serve notice making time of the essence. This would give ICL/Pathway
the opportunity to complete the contract during the time specified in the
notice. The time specified in the notice has to be reasonable. The latest
advice from Slaughter and May advising POCL is that, given that the
operational trial is highly unlikely to be completed before 30" September
1999, the notice should run to October 1999. All Lawyers agree that the
period in the notice must be reasonable and that to serve notice which the
court holds to be unreasonable is a very undesirable outcome.
26. Law Officers’ advice draws attention to the additional legal obstacles if Ministers
were to choose option a. rather than option b. It runs the risk of the public sector parties
being held to be in breach of contract and thus liable for substantial damages which
could be in excess of £200 million:
” firstly. the public sector parties. right to terminate depends on a particular
a construction on the contractual documents. Whilst that construction is certainly
(—) arguable and may be upheld by a court, there is a considerable risk that it might
: not be; .
” secondly there is a risk that the public sector parties may be held to have waived
their right to terminate-based on the failure to reach contractual milestone in
November 1997;
thirdly it will be necessary for the public sector parties to show that ICL are in
default - ie that responsibility for delay substantially rests with ICL. Although the
public sector parties consider that they have good prospects of showing this,
there are inherent risks in predicting the outcome of litigation before all the
evidence is available.
27. The Solicitor General's views on the two options is that whilst option a. (if it
operates successfully) offers the quickest get out should Ministers be determined to
terminate the contract, it also carries the greater risk of ICL Pathway alleging breach of
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contract and engaging the public sector parties in uncertain expensive litigation. The
second option of serving notice making time of the‘essence is slower and deprives the
Public sector parties of the element of control, but it is legally safer. The Solicitor
General comments that a time of the essence notice will be seen, correctly, as giving
Pathway ‘a final chance to proceed according to contract. Ministers should therefore
only embark upon this course if they regard the performance of the existing contract as
a satisfactory outcome. If their unequivocal wish is to terminate, the Solicitor believes
that it would not be right to make time of the essence.
28. Under any notice making time of the essence, the performance would be of the
existing contract (although in the view of BA/DSS it will be difficult to establish beyond
doubt what that contract is) and not of any contract which might have been varied under
any discussions between the parties. It is therefore the performance of the existing
contract which Ministers need to assess as being a satisfactory outcome. There has
~ been considerable discussion between the public sector parties and their lawyers as to
what would actually happen if a time of the essence were served. The POCL view is
that, if the current discussions break down, ICL would not have the financial support to
- Continue performing the existing contract. They would therefore decide or be forced to
walk away from the contract. DSS view is that there can be no certainty about ICL’s
actions, faced with such a notice, except they will wish to act to maximise their
advantage and they might, for example, continue performance of the contract and later
sue the public sector parties. Whatever option is pursued, there is always the possibility
that ICL will sue the public sector parties for anticipatory breach alleging that the
Conduct of the public sector parties has made the performance of ‘the contract
impossible. The burden would however be on ICL to show this.
29. — Neither the Solicitor General nor Treasury Counsel have felt themselves in a
Position to speculate over what might happen if a notice. making time of the essence
.Were served.
6 30. ° Ministers are therefore invited to decide:
“ whether they wish to terminate the contract forthwith, by issuing a.3 month
notice, since this is the quickest route to achieve termination; but recognising that
this approach involves additional legal hurdles and carries greater risk of
litigation;
baa whether to issue notice that “time is of the essence”, setting a reasonable period
of up to 9 months for completion of the operational trial, on the grounds that this
is the safest route to termination; and in the expectation that ICL will either be
forced to terminate the contract themselves, or will complete the operational trial
on the basis of the existing contract to the deadline. In other words this option
gives ICL the opportunity (however likely or unlikely) to complete the contract on
the existing terms.
31. We envisage that the Chief Secretary would write to ICL in parallel, noting that
the public sector could not accept ICL’s offer and that discussions around a
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re-negotiation of the contract had ended.
32... Our preferred option at this point would be to seek:a negotiated settlement. But
this would depend on the reaction of ICL.
33. . At this stage, Ministers might also be attracted to the possibility of introducing into
the discussions with ICL option 2:- i.e. continuation without the benefit payment card.
This would offer some of the advantages of the fallback option 3 but would avoid the ©
adverse impact on Fujitsu and ICL. However, the PO do not favour this option. But
option 2 would require the-consent of ICL, so it is not, strictly speaking, a choice
available to Ministers at this stage.
34. Clearly Ministers would need to be ready once notice had been served to make a
public statement, in the event that ICL either issued writs or went to the press. The
statements would need to provide reassurance to benefit customers, subpostmasters,
Fujitsu and the IT industry. Draft statements are attached at Annex C.
@
35. BA/POCL will also continue to work up the fallback. option, in particular, once
notice has been served, by entering discussions with the banks.
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9. RESTRICTED - POLICY AND COMMERCIAL
WITHOUT PREJUDICE
ANNEX A: COMPARISON OF ICL 9 DECEMBER OFFER WITH CORBETT
PROPOSAL AND 3 NOVEMBER
NPV of additional £116m £265-317m
payment to ICL {including £80m
(relative to ‘core contingency
case’) provision, of which
£52m may have been
retumed)
@ ICLestimated NPV I £224m £75 -103m £118m
loss (depending on
shareout of
contingency)
RPI level before 6% 2% [5% .to 2006
Prices increase 2.5% from 2007]
Volume guarantees _I 75% 80% 75%
Funding Fujitsu underwrite Govt guarantees Ick FJ support ICL
refinancing borrowing funding project
(clarification of
enforceability being
sought)
i] Termination on Option to purchase Obligation to Obligation to
supplier default system on purchase system on I purchase system on
termination termination termination if it has
value
Termination by Cap on liability Capped at agreed Capped at agreed
Government borrowing+equity borrowingtequity
Termination rights I on successful after system test only I based on completion
given up... completion of . of acceptance tests
systems tests and (some to occur in live
live trial (Child running)
Benefit only)
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HM Treasury
14/12/98 14:51 PAGE ULUsSLS
TigncrAan
RESTRICTED - POLICY AND COMMERCIAL
WITHOUT PREJUDICE
Guaranteed
Payment
On acceptance and
rollout of all
contracted functions
On system test and
rollout (Child Benefit
only)
From 30 September
assuming successful
completion of live trial
Acceptance
requires... -
no more than 10
category 'B' faults
no more than 230
no more than 100
Independent Expert
to facilitate dispute
resolution
to make binding
decisions if no
agreement
to have decisions
implemented. Govt
can later seek
tedress
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