The Modbury Hospital Contract (the Contract¹⁴⁸) was first signed on 3 February 1995. It was substantially amended and re-executed on 19 August 1997. Amendments were necessary, inter alia, because of matters raised by Healthscope Ltd (Healthscope). These included the possibility of the termination of the Management Agreement due to the continued losses and Healthscope's inability to satisfy the conditions precedent in the Project Agreement due to the unavailability of the site to construct the private hospital.

The Contract price agreed by Healthscope as at 3 February 1995 was allegedly not sufficient to enable it to support the long term completion of the Contract. The decision was taken by the Executive Government that, on the basis of the information available to it, the Government would be acting against the public interest in not proceeding with the proposed amendments.

In my opinion, this matter raises a number of issues that are instructive of potential problems that can arise in the contracting out of the responsibility for the delivery of important governmental functions and hence it has a wider public sector significance. It emphasises the importance of pre-contractual and post-contract execution of due diligence. It also illustrates the importance of ensuring clarity and completeness in the contract documentation so the contract document, as the instrument that governs the relationship, is adequate to deal with the various issues that arise during the course of the contractual relationship.

The bottom line outcome of the re-negotiated Contract for the Modbury Hospital is that, notwithstanding changed funding arrangements with a continuing discount on the Casemix Funding Model, the 1997 amendments provide financial benefits to Healthscope in the form of more money for the provision of the same service activity as was intended at the time of the original agreement.

This commentary on the Contract considers matters associated with the contractual relationship and the contract process and management¹⁴⁹. The decision to amend the Contract is a policy decision that was made by the Executive Government taking into account, inter alia, reports by independent consultants, Coopers & Lybrand.

As a general principle, where a contractual relationship has been undertaken, it can be expected that the parties will honour and discharge their respective responsibilities and undertakings. Not all contracts work out as intended and in some cases the expected benefits may not eventuate for one or all of the parties. This situation is not, in itself, a basis for amending a contractual relationship¹⁵⁰.

It has been agreed by all the parties that the relevant Modbury Hospital Contract be amended. As it has also been agreed by the Government and Healthscope that the original and amending contracts will be disclosed, the public accountability of government in undertaking these contractual commitments will be satisfied.

During the two years of the Contract prior to the 1997 amendment, differences arose between the contracting parties over a number of ambiguities in the original Management Agreement.

There were also a number of substantial matters where different opinions regarding the aims and interpretation of the Management Agreement arose and where there was continuing negotiation. For example, while the South Australian Health Commission (SAHC) believed that certain pre-existing contracts between the Government and other service providers should be novated to Healthscope, the Management Agreement did not explicitly provide for this, and the Government was forced to continue to make payments under these pre-existing contracts.

Further, Healthscope considered that it should be funded on the basis of the same principle as other public hospitals, but, because the Management Agreement did not provide for this, SAHC refused to provide funds on this basis and, in my opinion, properly so.

Substantial problems appear to have occurred because the amount of money the parties had agreed would be paid to Healthscope under the Management Agreement was allegedly insufficient to allow Healthscope to make a profit.

Healthscope appears to have experienced great difficulty in resolving these important areas of difference. In its 1996-97 Annual Report, Healthscope noted in relation to the Modbury Contract:

Issues escalated to the point where the Government was presented with the option of 'losing' the Management Agreement or paying more for it than had originally been intended and approved. Healthscope also asserted that as certain conditions precedent in the Project Agreement had not been met, it was not obliged to build the Modbury Private Hospital.

The difficulties in the relationship between Healthscope and the Government eventually resulted in Coopers & Lybrand being engaged by the Government to produce certain reports. These reports were entitled 'Post Implementation Review of the Modbury Public Hospital Management Agreement', dated June1997; 'Benefits Assessment of Proposed Amendments to the Modbury Public Hospital Management Agreement', dated June 1997; and 'Benefits of Modbury Hospital Agreement to June 1997' (the reports).

The reports identified a number of key deficiencies in the contract management process and in the original Management Agreement itself. These included the fact that:

• there was no statement of shared aims and values in the Contract, as part of the preamble, which might have assisted in the resolution of matters arising after commencement;
• the mechanisms for meetings to discuss and resolve issues were inadequate. The parties to the Management Agreement appeared to have assumed that the Management Agreement said all that needed to be said;
• there was no clear relationship between the quantity and type of services to be provided and the amount paid under the Management Agreement;
• non-typical base periods were used as benchmarks for activity targets. This caused difficulty for Healthscope in meeting those targets¹⁵¹;
• the Management Agreement contained inconsistent bases to measure in-patient activity, which meant that the two parties used different criteria to measure performance against the contract specifications;
• the Management Agreement was completed hastily which resulted in a number of problems, such as inconsistencies, obvious omissions such as the failure to novate existing service contracts (with the result that the Government was required to make most of the payments under these), and inadequate due diligence of the type and age of equipment to be handed over to Healthscope.

To this, in my opinion, should be added the following substantive deficiencies:

• the Management Agreement did not provide any guarantees of Healthscope's performance. In my opinion, bank guarantees, charges over assets, or other guarantees should have been obtained;
• the Management Agreement did not provide for termination (for convenience) of the Contract;
• the internal government processes relating to the review of the Contract did not identify the deficiencies in the Contract.

In addition to deficiencies in the terms of the Contract and its formation, certain deficiencies in the Government management of the Contract are, in my opinion, for the reasons discussed herein, evident.

Where performance of a contract is subject to conditions precedent it is important to ensure that the conditions are achievable and the contract is managed in an appropriate manner so that both parties expressly acknowledge that the conditions are met on time.

With respect to the conditions precedent of the Project Agreement, the SAHC advised Audit that:

In the context of commercial contracting it is common for the parties to carry out a due diligence. In the course of such a due diligence, legal advisers acting for the parties identify all conditions precedent and conditions subsequent to the performance of the contract and ensure they are achievable and have been satisfied. One assumes that, in the event such a process had been undertaken in the case of the Contract, the fact that a condition precedent was not able to be satisfied would have been promptly identified and possibly rectified.

As a consequence of inadequacies in the initial Contract, and the relationship difficulties indicated above, the Government was in a situation whereby it had limited options open to it. As stated, it has now agreed to substantial amendments.

PRE-CONTRACTUAL PROCESSES

The Coopers & Lybrand reports also identified certain deficiencies in the pre-contractual processes carried out in the case of the Management Agreement. These deficiencies were of a financial nature, ie the failure to properly identify and value equipment, and the 'failure' to select an average year against which to benchmark patient activity levels (which were linked to payments to Healthscope). The use of a year, as a benchmark, in which patient activity was abnormally high made it difficult for Healthscope to meet targeted activity levels although it must be acknowledged that the Contract was negotiated with these terms having been agreed by Healthscope and there can be no criticism of SAHC in this regard.

POST-CONTRACTUAL MANAGEMENT

The amendments proposed to the Contract not only ensured that Healthscope receives more money, but has the potential, should certain events occur, to shift some of the financial risk back to the Government (for example the decision to amend was based upon calculations of the Net Present Value (NPV) of the amended contract over a extended period of time). The extent that the 'assumptions' underlying the NPV calculations prove erroneous, the benefit to Government may be less.

Having regard to the 'accountability', 'public law' and 'administrative law' elements that must be taken into account in the negotiation of government contracts, in my opinion, the Crown Solicitor should be engaged to review the adequacy of these matters in those government contractual arrangements where the contractor is providing a service to the public that immediately prior to the contract was provided by the Government. This would necessitate the Crown Solicitor's involvement at the time of the formulation of the contractual objectives and his/her continuing involvement throughout the negotiation process.