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MEMORANDUM
TO: Board Members FROM: John Roberts
ce: Richard Dykes
Kevin Williams
Stuart Sweetman
DATE: 2\ May 1999
[SUBJECT: HORIZON -
Ihave managed to brief the Non Executive Directors today on the background to the
current Horizon situation. I mentioned to them that we had produced a draft Board
paper while all this was going on, a copy is enclosed.
It’s not fully up-to-date as events continue to move very quickly but it probably gives
the best background briefing that is currently available.
Neville, who is currently in America, has said that if'a direction is given to the Board
by the Government, he would want to have a Board meeting to consider it before
responding. I have asked our Secretary’s office to contact your offices to see when
you might be available-in person or on the phone at any time on Monday.
If we do need to meet, we will confirm this as soon as we possibly can.
AIR2105954
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POB (99) o/s
POST OFFICE BOARD
THE FUTURE FOR HORIZON
Purpose and Background
1.
The purpose of this paper is to
¢ update the Board on the progress of negotiations on the future of the
Horizon programme since the last Board meeting on 27 April 1999
¢ decide the Post Office’s view of the way forward as Ministers are meeting
imminently, following HMT meetings with ICL, and as a consequence
there is a real possibility that the Post Office will be given direction by the
Secretary of State for DTI to enter into new contracts with ICL.
The timetable for the discussions has been driven by Fujitsu's insistence to
the Prime Minister (7 April 1999) and other Ministers since, for new legally
binding Heads of Agreement (the “Agreement”) given the imminence of
publishing their report and accounts and the consequences of declaring a
massive provision for sunk costs (c300 million) could have in these.
Situation Report
3.
At the beginning of March 1999 Ministers agreed that, under the leadership
of Steve Robson, HMT, a solution (Option B) should be sought that would
meet a number of conditions set out at Annex I.
Intensive negotiations have continued with ICL on this solution. The original
front runner to meet these claims was an option known as ‘B1’, which would
have done so by creating new POCL bank accounts, with a PO Smartcard, for
all beneficiaries. Terms were negotiated with ICL by POCL. together with a
POCL proposal to Government for the necessary matching funding and
revenue. However this option has been rejected by Government as
providing value-for-money”, and ICL were advised of this by the Chief
Secretary of HMT last week.
“not
Since then, HMT (backed by DSS) have driven forward a new option (known
as “B3”) as a way of salvaging something from ICL’s work to date as an
alternative to termination. We were not involved in developing this option.
Its key characteristics are:
allcontracts are between POCL and ICL up to 2005/06 on a turnkey basis
rather than PFI
¢ Benefits Agency would withdraw the payment card and replace it with
bar-coded order books nationally (OBCS) instead (rather than by a
smartcard, for example)
there would also be an early move by DSS to force customers to have
benefits paid through the banking system (but no universal method to
withdraw cash at post offices)
¢ settling ICL past claims would be wrapped up in ICL’s future charges to
POCL
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¢ a public/private sector parmership between POCL/ICL to be incorporated
HMT on 19 May 1999 put a variant of this deal to ICL to also include ICL
having a right to the £150m settlement or cancellation figure from the public
sector if final contracts around this option could not be completed within
three months (there are a number of important conditions and risks still left
open which need proper completion in final agreements).
The Parties’ Positions
7.
10.
1.
12.
From the outset, the Post Office has made it clear that to enter into any
agreement it would need to be commercially and strategically acceptable to
the Board. The Chairman wrote to the Secretary of State reminding him of
this (27 April 1999) and has this week (18 May 1999) set out our position on
“B3‘ to him, including meeting the commercial tests by which the Board
would judge options. This letter is at Annex II. So far no reply (or any verbal
assurances) from Government has been given to the fundamental issues he
raises.
The Board's fundamental position is that it has agreed to support Option A
(our approved way forward), and until another acceptable option is agreed
the Post Office will continue to honour its existing contracts on Horizon, and
will expect others to do so too (both BA and ICL). This is also in line with our
agreed contingent litigation strategy in line with our best legal advice.
All Ministers seem to have removed both ‘Option A’ and Option ‘BI’ from
the table (despite Option A clearly being best value for money even by
HMT's own analysis), and would seem to prefer to avoid termination.
Funding of the Post Office, within the public sector, around options seems to
bea second order issue for them.
DSS and Benefits Agency’s drivers continue to be withdrawal from ICL
contracts and the payment card, avoided costs of settling the past with MCL,
and an ACT timetable as fast as possible.
Fujitsu and ICL appeared to have given up hope that any deal involving
future contracts with DSS/BA (even on a migrated basis such as Option A)
will work. They remain determined to claw back their sunk costs to date, as
well as having guaranteed income streams for the future (in order to avoid a
large accounting provision), or they will sue under termination.
HMT seem to be driving towards some sort of deal with ICL to avoid a
potentially messy termination situation to meet Ministers’ wishes, and would
see termination taking the course of a negotiated settlement at a risky and
early stage (despite our best legal advice to the contrary). They have neither
included us in many of their approaches to ICL and have ignored our
comments when they have requested them, nor have dealt with our
considered requests around the consequences of these approaches on the Post
Office.
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Analysis of Option B3
13.
4.
15.
16.
17.
Itis clear that, unless the relevant key issues are assured by Government this
option, as it now stands, fails the Chairman’s tests of commercial
acceptability to us.
The Chairman's letter (at Annex II) sets out the key issues and the scale of the
cash funding and income POCL would need (in excess of £2.5 billion) to get
us back to what the Board thought was acceptable under Option A (which
itself produced a marginally positive NPV). If these finances were not made
available, the Post Office could find itself consuming much of its balance
sheet reserves, and/or effectively having to give priority to this investment
ahead of our other strategic programme to an extent that could badly
undermine the Post Office’s overall commercial direction. There are clearly
fundamental White Paper issues associated with this too. That is already
delayed chiefly because of Government indecision on Horizon, and itis
possible that some of Governments promises around investment freedoms,
EFL regime, and balance sheet restructuring may fall too depending on
Horizon’s outcome.
The impact is even more severe on POCL. The turnkey nature of ‘B3’ would
bring new immediate significant liabilities onto its balance sheet that will
exceed its net assets. POCL’s strategy, and vision, recently agreed by the
Board, would probably be irreparably damaged by the sudden and severe
loss of benefits business, a severe reduction in its wholesale cash business,
the lack of a new card base to develop its new markets and services (eg
“Government Gateway’ and ‘Network Banking’). In addition, it would be
contracted to having an IT infrastructure that will not be optimal as its
business requirements are likely to change following the BA Payment card
service being stripped out from the design. POCL will also be faced witha
loss of confidence in its marketplace and the consequential need to re-shape
its network much more rapidly than envisaged. It will need to review its
strategy, including facing the real prospect of managed decline.
There will also be an increased risk of procurement challenge from other IT .
supplier because of the extent of the change in scope, and the non PFI nature,
of the new deal. :
There will be a flow-through adverse impact on other POCL stakeholders.
The CWU and NFSP (both of whom have been very active to date in lobbying
Ministers against termination or “salvage” solutions such as B3) would no
doubt work hard against an option that destroyed Post Office value or create
great uncertainty about the network. Some POCL clients would also be badly
damaged by BA-related business loss, either through less footfall (eg
Camelot, or the Utilities) or less cash provisioning (eg Girobank).
Comparison with Other Options
18.
Annex III shows the comparison of options, as we understand them,
including Option A and termination.
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Itis very difficult to be firm about these, given the lack of complete
understanding we have been given, the softness of the costings, the absence
of revenue streams, and the range of the risks.
There are various scenarios, of course, that could flow from either ‘B3’ or
termination, given the uncertainty that either represents. Under ‘B3’ the loss
of prospective new business, alongside the certainty of losing core business,
has wide ranges, as do the network consequences. Under termination, there .
is both the outcome of the litigation risk with ICL to consider (ranging from
£+200m to -£334m for the public sector as a whole), as well as the strategic
choices the Board would face for POCL. These include whether or not to
automate at all and “cash cow” the business or whether to reduce the
network and automate to a much smaller scale, or whether to continue to ty
to find alternative automation for the whole network which would be
transacting significantly less business in the medium term. Either option will
require another strategic review for POCL, taking some months, whilst
interim operational contingency arrangements (already planned) are put into
effect. Nonetheless, best estimates have been made for comparison purposes.
The scale of additional funding required under termination scenarios
requested of POCL to HMT for modelling purposes is not very different from
that for ‘B3’ (but would exceed it if the ACT timetable was to start even
earlier then B3 as HMT have suggested as a variant - say in 2001).
Choices facing the PO Board
20.
21,
Unless the assurances sought by the Chairman are immediately met, the
option being vigorously and urgently pursued by HMT with ICL, does not
look acceptable. Under these circumstances, the Secretary of State has a
general power to “direct” the Post Office Board.
In essence the Secretary of State would have to direct us by meeting two tests:
that there is a general “defect” in the way the Post Office has reached its
decision on how the Post Office or POCL in particular should be run
and that the “remedy” he is directing is the right one to put right that
defect.
In this case, it is likely that he will be implying that the PO Board has failed to
manage the social needs the network represents and that the B3 deal, by
entering into ICL contracts to do that, will “save” the network.
We know that DTI lawyers have been working on the format of the direction
based upon these arguments and the powers given under the Post Office Act.
We have tested our own legal advice with Queen’s Counsel. Annex IV isa
of Counsel's opinion. Counsel has unequivocally stated that the
legal basis of the direction is invalid and would be “susceptible to judicial
- review proceedings”. Essentially, the Secretary of State only has a power to
direct us generally, rather than direct us to enter into specific arrangements.
Moreover, it is not at all clear that entering into this contract with ICL would
bea “remedy” to the network issue at the heart of why he wants to direct us
in this instance. We have advised DTI of the legal difficulties they face in
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going down this route. We should also note Counsel's view that the Post
Office, as a public sector body, may itself be open to challenge for taking into
account a factor that may be invalid in reaching a decision on this matter.
24, Besides, we are asked to run the Post Office on a commercial basis, and not
essentially for social needs. The commercial consequences of entering into
these new ICL contracts, with their certain costs long term, without any
contracts or final commitment of equal status, about the necessary revenue
steams is clearly wholly uncommercial. Moreover, that is against the
background both of an existing set of contracts we are prepared to honour
(but others, including DSS, are not), or another option ('A) which we were
prepared to back.
25. Ifa direction is proven to be legally justifiable, and given to us, the Board has
no option but to comply. The direction must then be published in the Report
and Accounts to indicate that this was a Government and not a Board
decision.
26. Insuch circumstances, the Post Office would need to give POCL Directors
indemnity in some way against the financial or other consequences that
could bring.
Next Steps Under B3 ‘
27. If B3 was to proceed the key next steps would be:
© operationally wind down the benefit payment card service, contractually
with DSS, and operationally in the trialed post offices
© attempt to complete the relevant contracts in three months with ICL
¢ turn the (hopefully) commitments if given, from Government about
_ POCL's income and funding into a set of contracts
* POCL to review its business strategy and plan in the light of the above
¢ decide a communication plan (internally and externally) taking into
account the Board’s stance about direction.
Summary
28. The Board is invited to:
(@) _ agree that B3, as matters stand, is unacceptable commercially and we should
refuse to enter into contracts with ICL until terms to the Post Office are made
acceptable as set out in the Chairman’s letter annexed.
(b) _ note the position on possible “direction” by the Secretary of State
(c) note that Option A remains our preferred way forward (and is the best value
for money for Government)
(@) __ note that we require both ICL and BA to honour existing contracts until
another option is agreed.
21 May 1999
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ANNEXES
Original aims of Option B from Ministers
Chairman’s letter of 18 May 1999 to Secretary of State outlining current
Office Position on options
Financial analysis of comparison of options
Counsel’s opinion and draft DTI wording of the direction
Post
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ANNEX 1
Original ‘Option B’ aims agreed by Ministers.
A commercial arrangement between ICL and POCL, backed by DSS/BA that would
enable electronic payments of benefits at Post Offices using a smartcard;
involve mass conversion of order book holders, to this method;
build a system capable of developing other new services and, in line with HMT’s drivers,
should be cost effective for the public sector as a whole;
should not destabilise Option A (Horizon with the benefit card), or prejudice termination
rights against ICL
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Since we last met, discussions have continued on Option B3 with your officials and
the Treasury as you requested.
We have now reached a point where I think it is important that I restate The Post
Office position on the various options available. First of all, we continue to believe”
that Option A is the right way forward, are still prepared to honour all current
contracts, and believe that it is the only option that meets the Prime Minister’s
requirements as set out by Jeremy Heywood on 11 May 1999.
It is a matter of considerable regret to us that this option, we are told, is now off the
table, as is Option B1, which is not seen by Ministers as value for money.
Our team has continued therefore to work on B3 against the background of the tests
required by the Post Office Board and which I set out to you in my letter of 27 April
1999. For ease of reference they are appended at Annex A.
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~*~ pRIvATE & CONFIDENTIAL ANNEX «LD
& els - + :
DR NEVILUR RAIN
Chairman
148 Old Street
Lunn
URGENT - BY FAX & BY HAND fer ony
- 18 May 1999
The Rt Hon Stephen Byers MP
Secretary of State
Department Trade & Industry
1 Victoria Street
LONDON
SW1H 0ET
Horizon
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PRIVATE & CONFIDENTIAL ei
; (2)
We still have not had from Government a precise definition of B3 as it affects The
Post Office, However, our understanding is that under this option we would
effectively be buying assets and an operating service from ICL under a schedule of
fixed payments but without either the vital underpinning commitments associated with
continued and automated benefit payments at post offices (at least, to anything like
the levels of business and timescale under our existing agreements, or even Option A).
Nor would the fundamental components for developing our new markets, for example,
acard issued widely to many millions of our customers, be available.
‘We have now been asked to set out the terms under which B3 might become
acceptable to us and in order to consider this, we have attempted to estimate the
minimum income and cash funding profiles the Post Office would need from
Government. These are shown at Annex B. In the light of them, we would therefore
require the following:
™ A guarantee that Government would provide this minimum income and cash
funding additional to that envisaged under the proposed White Paper (without such
a’guarantee we would face serious balance sheet issues, including immediate
liabilities to ICL that could exceed POCL’s assets).
m An ACT timetable which would start in 2005.
™ A firm commitment by Government to use the new B3 infrastructure extensively
for existing and new services, including the possible use of anew smartcard for
such services.
m Even ifthe 3 points above are met, there are a number of other significant issues
outstanding which would require around 3 months work before any unconditional
agreement could be signed with ICL.
Without these commitments, a large part of our core business, e.g, benefit payments,
would be removed without the certainty of means to replace it with significant new
business. In such circumstances it would be impossible for us to sustain the current
nationwide network,
As a result, B3 does not appear to The Post Office to meet the tests I set out and thus
provide an acceptable commercial case to which the Post Office Board could agree.
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Rank
PRIVATE & CONFIDENTIAL : eT
(3)
Termination of the contracts and an honouring of commitments to automate post
offices produce a similar set of direct and indirect consequences for The Post Office.
Again we would need very significant funding similar to that described for B3, and the
other financial and customer issues would also apply, together with payment for
alternative automation of post offices. Compared to Option A, as matters stand,
termination does not meet my commercial tests.
In addition as I said to you at our meeting on 6 May, we must also consider in the
event of termination:
impact of litigation including who holds the zing;
™ communication;
™ honouring both Government’s and our commitment to automating the Counters
network;
@ the approach to be taken to sub-postmasters,
I hope this letter gives you a very clear statement of where The Post Office stands.
DR NEVILLE BAIN
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PRIVATE & CONFIDENTIAL . Anes
Cx)
Annex A
COMMERCIAL TESTS
Is the case a commercial one with fairly balanced risks? In other
words one that gives a positive NPV at an appropriate discount rate.
Can the funds be generated in such a way that they do not
prejudice other planned Post Office activities (which may have
a much better return)?
What is the impact and timing of the costs on The Post Office
and POCL Profit & Loss accounts? In particular the Board will
need to consider if the proposal can be accommodated by Post
Office Counters Ltd without technically bankrupting this
business.
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P&L:
P&L AND FUNDING REQUIREMENTS
PRIVATE & CONFIDENTIAL
POCL require the following additional income stream:
f a
Annex B (4 s)
Year I 99/0 I 00/0 I 01/0 I02/0 I 03/0 I 04/0 I 05/0 I 06/0 I 07/0 I 08/0
0 1 2 3 4 5 6 7 8 9 -
£m 66} 21{ 131 96{ 128I 382] 530] 412] 241] 159
Cashflow:
Additional to the above (and excluding interest), POCL require the following funding
from Government:
Year [99/0 [00/0 [01/0 I 02/0 [03/0 I.04/0 I 05/0 I 06/0 I 07/0 I 08/0
0 1 2 3 4 5 6 7 8 9
fm 101I 244
The repayment profile of such funding (net of interest) will be as follows:
Year I 99/0 I 00/0 I 01/0 [02/0 I 03/0 I 04/0 I 05/0 I 06/0 I 07/0 08/0
0 1 2 3 4 5 6 7 8 9
im 61 62 65 66 56 20
These numbers are at outturn prices and are indicative only, and will need to be
revised in the light of final agreements. They reflect the terms of the “counter offer”
being put by HMT to ICL on the evening of 17 May 1999. -
Nate & Rs, Ghro 2a Prams OT G2) far FORA vue GB efter OTe
HAT ded We ICL 4 14 Mond,
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Annex DIT
These numbers are indicative and will need to be revised in the light of final agreements
Financial Summary
In NPV terms the current options have the following NPVs when compared to Option A
(including POCL's latest view of Network Banking and Government Gateway):
Absolute NPV (at 12%)
(Outturn)
ém £m
Option B3 as at 17 May 1999: (2,485) (1,112) worse than A
Option B3 as at 20 May 1999: (2,516) (1,139) worse than A
Option C termination (first cut):
© automation
(ACT 01/02 to 02/03): (2,698) (1,153) worse than A
© automation
(ACT 03/04 to 04/05): - (2,102) ( 849) worse than A
None of these options include the consequences on network size, costs and pace of change.
Other options yet to be evaluated fully would include understanding the impact of not
automating post office at all (with different ACT timescales). Early scoping of these would
suggest that such options, none of which are better than A, are an improvement on the above.
However, there is still a great deal of uncertainty around the impact that such a plan would
have on both income and footfall, and hence network size and shape.
‘NB: Option A worse than
Business Plan: ( 567) ( 203)
NB: These numbers are indicative only and.can be used for comparative purposes only.
A revised view of Annex B to the Chairman's letter which explains the income and cash
funding requirements POCL would need based upon our best understanding of HMT's latest
offer to ICL of 20 May 1999 follows:
IN STRICTEST CONFIDENCE
P&L AND FUNDING REQUIREMENTS
P&L: POCL require the following additional income stream:
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Year 99/00 00/01 01/02 02/03 03/04 04/05 05/06 06/07
07/08
08/09
09/10
Original 66 21 131 96 128 382 530 412
241
159
163
‘Amended following reconciliation to KPMG model:
Revised: I 89] 68] 177] 140 I 136] 219 I 357I 589 I
260 I
147]
162
View based on latest Treasury "offer" (20 May 99)
Revised: I 121 I 68 I 177] 140 I 136 I 219 I 557 I 589 I
260 I
147
162
Cashflow: Additional to the above (and excluding interest), POCL require the following funding from Government:
Year 99/00 00/01 01/02 02/03 03/04 04/05 05/06 06/07
07/08
08/09
09/10
Original 101 244
Amended following reconciliation to KPMG model:
Revised: I 56 I 217 I [ I I I I 5]
View based on latest Treasury "offer" (20 May 99)
Revised: _ I 56 I 217 [ i] I [ I I al
The repayment profile of such funding (net of interest) will be as follows:
Year 99/00 00/01 01/02 02/03 03/04 04/05 05/06 06/07
07/08
08/09
09/10
Original 61]. 62 65 66 56 20
‘Amended following reconciliation to KPMG model:
Revised: I I I 59 I 60] 60 I 15] 21 I 0]
36]
27]
View based on latest Treasury "offer" (20 May 99)
Revised: _I I I 39] 60] 60] 15] 21 I O1
36]
27]
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Notes:
1, These income and cashflows represent the necessary payments and funding required by
POCL to return it to the same position as under option A.
2. Main amendments included:
© changed replacement assumptions,
© ICL prices already outtumed,
e latest assumptions on volume.
- To be consistent with KPMG we have included an additional year.
}. These numbers exclude risks.
. Possible accounting consequences:
¢ POCL would need to capitalise some £480m (plus irrecoverable VAT),
¢ assuming no impairment of assets and without funding, POCL would have a
deficiency in assets in the financial year 2004-5,
¢ under FRS 11 and without funding, POCL would need to write down the assets to
avalue on which the return was acceptable. Given no return this would mean that
we would write them down to zero. In addition, there could be an argument that
all the business assets are permanently impaired and the remaining POCL assets
should be written down as well. In this case, POCL could have a deficiency of
assets within months of the new contract. If POCL's property assets have a
market value independent of POCL business, then this could delay deficiency for
up to two years.
Upw
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SLAUGHTER AND MAY
35 Basinghat Street, London FC2V SDB + Telephone +44 (0)171 600 1200 + Fax +44 10)171 600 2289
Telex 883486 and 888926 + LOE and COE Box Not!
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John Roberts, CBE,
The Post Office,
148 Old Street,
London EC1V 1HQ.
Dear John,
Dousent mnser CAI1410103
Yon tolerenee
in reply pane quote JRT
wraer sect we 0171 710 3162
2ist May, 1999
Horizon
Catherine and I have been for a consultation with James Goudie QC on the
question of whether a direction under Section 11 of the Post Office Act in the form of
DTI Solicitor’s draft would be valid.
His advice was unequivocal. Any direction under Section 11 has to be of a
general cHaracter. The direction to conclude a particular agreement is of a specific and
not a general character. Furthermore, Counsel could not conceive of any alternative
way of wording the direction which would make it general.
Any direction to sign the agreement would therefore be invalid. The Secretary
of State's decision to issue the direction would be susceptible to judicial review
proceedings. In addition, the Post Office would be open to challenge as a public body .
for taking into account a factor (i.e. the invalid direction) which it should not have
taken into account in reaching a decision which it would not have reached but for that
factor.
Lack of generality was the main factor making the direction invalid. There were
also other concerns, such as the fact that the Secretary of State would need to have
reasonable grounds for concluding that there was a defect in the general plans or
arrangements of the Post Office for exercising any of its powers. In addition, the
direction would have to be designed to remedy that defect.
tonoon Panis anuasets
Incarone HONG Kon
new von
=e
vn
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,
John Roberts, CBE, 2 ‘isc May, 1999
We will supply an approved written note of Counsel's advice in due course.
ae I
mn
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Ashi
POST OFFICE
the Post Office Act 1969
Whereas it appears to me that there is a defect in the general plans or
arrangements of the Post Office for exercising its powers insofar as they relate
to the future of its wholly-owned subsidiary, Post Office Counters Limited:
Now, therefore, in exercise of the powers conferred on me by section 11(2) of
the Post Office Act 1969, after consultation with the Post Office, I hereby direct
the Post Office [to exercise its powers in relation to Post Office Counters
Limited so as best to secure a network of post offices as a public service in the
United Kingdom and in particular] to conclude an agreement in the form
attached to this direction, subject only to such amendments as may be agreed
by me.
One of Her Majesty’s Principal
May 1999 Secretaries of State
TOTAL P.
@2