Common use of Introduction Clause in Contracts

Introduction. The deterioration of public finance and the increase in global competition have forced governments and public institutions to obtain “the best value for money” through the purchase of goods, works and services in the form of procurement contracts. Efficient public procurement contracts (henceforth PPCs) are thus emerging as a “core necessity for ... the public’s sector effectiveness in obtain- ing resources for social spending and/or lower taxes” (▇▇▇▇▇▇▇ et al., 2006). These contracts have recently recorded a rapid increase both in number and in value, reaching 16% of GDP in the EU, and around 20% in the United States.1 However, PPCs have both costs and benefits: their benefits (i.e. allocative and productive efficiency) can be quickly erased by the costs (i.e. inefficiency) which often arise from contractual incompleteness and all the issues that ensue therefrom.2 In this paper we specifically address the source of inefficiency which pertains to delays in PPC execution times3 by investigating the optimal penalty design which should provide the right incentive to prevent delays. Indeed, delays in de- livery dates in PPCs may negatively affect all the actors involved, i.e. they may determine direct costs for the procurer, lower firms’ profits (i.e. firms other than the contractor) and reduce consumers’ utility. The typical illustrative example in this regard is provided by a PPC for roadway resurfacing, rehabilitation and restoration: if these activities are undertaken in heavily urbanized areas, they may cause extreme traffic congestion and severe inconvenience to the travelling public and the business community. Thus, delays in the completion of these works prolong the negative impact on users (i.e. a social cost), and also cause overruns in the planned execution costs.4 There is evidence that delays in delivery dates have been particularly large and harmful in the recent Italian experience of PPCs. The data-base compiled by the Italian Authority in charge of controlling PPCs (Autorità per la Vigi- ▇▇▇▇▇ ▇▇▇ Contratti Pubblici di Lavori, Servizi e Forniture - AVLP ) records all contracts of a value between 150,000 and 15,000,000 euros awarded by munic- 1 Note that between 1995 and 2002 PPCs in the EU underwent a 31% increase in value (▇▇▇▇▇▇▇, et al., 2006: Ch. 1). See also: ▇▇▇▇://▇▇▇▇▇▇.▇▇.▇▇▇/▇▇▇▇/▇▇▇▇▇▇▇▇_▇▇▇▇▇▇/▇▇▇▇▇▇▇▇▇▇▇▇▇▇▇▇▇/▇▇▇▇▇_▇▇.▇▇▇ 2 The economic and engineering literatures give different explanations for the main issues arising in PPCs. Most of the economic analysis on this topic focusses on the information asymmetry concerning production costs between the supplier and the procurer (Laffont and Tirole, 1993), while engineering and construction managment analysis concentrates on the uncertainty which affects the contract after it has been signed and its effects on both the supplier and the procurer (▇▇▇▇▇▇▇▇▇▇▇, 1998). For an economic methodological discussion on contract incompleteness and unforeseen contingencies see Maskin and Tirole (1999). 3 In the economic literature on PPCs, delivery delays in contract execution are often con- sidered along with the issue of the supplier’s performance regarding contracted aims (i.e. quality). See on this: ▇▇▇▇▇ et al. (2006b). 4 Cost overruns in different procurement contracts have been investigated in the seminal paper by ▇▇▇▇▇▇ and ▇▇▇▇▇▇▇ (2001): they showed that cost plus contracts are better than fixed price contracts when the project carried out through the procurement is more complex. Focusing on fixed price contracts, Ganuza (2007) found that when the procurement market is more competitive, cost overruns are lower and decreasing with the design specification level. ipalities, local/regional public authorities and public firms. Our examination of this data-base highlighted that out of 43,863 fully exploited contracts in the period 2000-2006, about 32,731 had been completed with delays. For about 27,826 contracts, the delay contracted days ratio5 was always larger than 1, and it was higher, the greater the contract value (with a small slowdown in the trend for the more expensive contracts, see Table 1 below).6 Similar findings on the sustantial body of evidence on delays in the Italian PPCs have been recorded by other empirical analyses7 and call - primarily - for investigation into the effectiveness of the penalty rules currently adopted in such contracts. According to Italian law,8 the penalty fee in PPCs should be defined as a percentage - ranging between 0.03% and 0.1 % - of the total contract price for each day of delay in completion of the contracted works.9 Is there something wrong with the definition of these ranges? Answering this question should inform the decision on whether to insert a penalty rule in 5 This ratio has the following interpretation: for example, if 200 days are the ex-ante contracted time for the infrastructure’s execution and then its delivering occurs with 220 days of delay, the delay contracted days ratio results equal to 1.1. 6 These estimations and further analysis on the data-set are available from the authors on request. 7 See Bentivogli et al. (2007) and ANCE (2002). The former study reports interviews conducted with 32 local Contracting Authorities managing about 280 PPCs: only one third of these contracting authorities declared that the contract had been executed within the con- tracted time, or with very small delays. In the latter study, a detailed investigation conducted at regional level by ANCE ▇▇▇▇▇▇ Romagna highlights that of the 776 PPCs concluded in the period 2001-2002, more than 68% recorded delays and/or increases in cost execution. Similar results have been found at national level (see ANCE, 2005 and AVLP, 2005 ). 8 See Government Decree n◦ 163/2006 and D.P.R. 554/1999, art.117. 9 This penalty rule for Italian PPCs is determined in similar fashion in other countries; in regard to the US, ▇▇▇▇▇▇▇▇▇ et al. (1995, Table 6, p. 276) show that for PPCs in highway construction, the contracting authority usually sets penalties ranging from 0.03% to 0.3% of the contract value for each day of delay. the PPC and what its optimal design should be. Thus, the aim of this paper is twofold: first, to provide a theoretical and general framework in which to investigate how the inclusion of a penalty fee affects the contract value; second, to verify whether the penalty range currently adopted in the Italian legislation on PPCs correctly induces the contractor to avoid delays. Our starting point is that the inclusion of a penalty clause in a PPC gives the contractor - to some extent - the option of deciding the investment timing for the contract’s execution. Thus - in order to be effective - the penalty fee should consider the investment timing flexibility which, de facto, increases the supplier’s contract value. To correctly approach the issue, we propose a simple Real Option model which allows us to ascertain the value of investment timing flexibility induced by the inclusion of the penalty clause in the contract.10 Then, calibrating the model, we verify the range of penalty fees defined by the Italian legislation on PPCs: quite surprisingly, we find that this range indeed seems able to induce the contractor to respect the contractual execution time. This result sheds new light on the determinants of investment delays in PPCs which include explicit penalty rules, and it adds a new aim to our study because it leads to other cause-and-effect explanations specifically related to the enforce- ment of the penalty clause itself. Following results generally acknowledged in the incomplete contract literature, failures by the Contracting Authority (hence- forth, CA) to enforce the penalty clause can arise when: i) the contractor’s work execution time is non-verifiable11; ii) default by the contractor triggers costly and time-consuming litigation because the “quality” of the judicial system is unsatisfactory; iii) the court of law12 - to which the parties refer for settlement of the dispute on the penalty payment - reduces (or even does not enforce) the committed fee. The last two issues seem to play a major role in the Italian experience: indeed, ▇▇▇▇▇▇ et al. (2007) found that, in the data-set of Italian PPCs that they investigated, only in less than 5% of verifiable delays was the penalty enforced by the CAs. Moreover, with specific regard to elements deter- mining the low enforcement of penalties in Italy, it is a matter of fact that in the period 2004-2005 the average duration of an Italian civil trial was around 876 working days13 : this, if anticipated by the contractor, may well override the incentive provided by the penalty design. 10 As ▇▇▇▇▇▇▇ and ▇▇▇▇▇▇▇▇ (1985) and ▇▇▇▇▇▇▇▇ and ▇▇▇▇▇▇ (1985; 1986) highlighted in their seminal works, there is a close analogy between security options and investment timing flexibility. 11 “To ensure the contract enforceability, the court must first be able to verify that an agent has disobeyed the agreed clauses of the contract” (Laffont and Martimort, 2002, p.348). To our knowledge, since the seminal paper by ▇▇▇▇▇▇▇ and ▇▇▇▇▇▇▇ (1995), the analysis of the non-verifiability of quality aspects in procurement (and concession) contracts has been carried out - with differing emphases - by ▇▇▇▇▇ et al. (2004), Calzolari and ▇▇▇▇▇▇▇▇ (2006) and ▇▇▇▇▇▇▇ and ▇▇▇▇▇▇▇▇▇ (2007). 12 See ▇▇▇▇▇▇▇▇▇ et al. (2000) for discussion of the role of courts in enforcing contract clauses. 13 See the Corte Suprema di Cassazione (2007). Moreover, an old but impressive Report by the Commissione per la garanzia dell’informazione statistica of the Italian Government (2000, pp. 27-28) found that in the period between 1988 and 1997, the average time taken by the administrative (regional) courts to make a final ruling increased from 2617 to 4261 working days. We thus characterize our model to investigate how the CA’s ineffective en- forcement of a penalty rule would affect the extent of the optimal penalty. Accordingly, we assume in the model that the probability of enforcement is cor- related to a parameter identifying the “quality” of the judicial system (i.e. the average time taken to resolve disputes) and to the level of the penalty itself.14 Our calibration results show that the probability of penalty enforcement decreases both when i) the quality of the judicial system is low and ii) the civil court has high discretionality in reducing the penalty imposed. Specifically, the greater the level of the penalty that the CA would like to introduce in the contract, the lower the probability that it will be enforced by the court. This, in turn, calls for higher penalties - well beyond the range prescribed by the Italian legislation - to make the firm comply with the contracted execution time. However, if the degree of the court’s responsiveness to the penalty imposed by the CA is high, the latter will find it convenient to set the fee considered reasonable by the court. Finally, a caveat concerning our analysis should be mentioned. In principle, delays in the PPCs’ completion time weight differently on the contract value according to the procedure adopted in awarding it. Indeed, in the “negotiated” procedure, the contract value is directly agreed between the parties and includes an explicit trade-off between the contract value and the investment’s delivery time. Differently, in the “open” procedure, the investment’s execution time can itself be part of the successful bid, thus representing a strategic variable in the competition among bidders.15 Although our simple model refers in principle to PPCs awarded through the negotiated procedure because it assumes an ex- ogenous and fixed price contracted between the CA and the contractor, it is interesting that the Italian delays contracted days ratio seem not to be cor- related with the nature of the awarding procedure - see second part of Table 1 above. This suggests that our results could be reasonably extended to the Italian PPCs awarded through the open procedure as well. The rest of the paper is organized as follows. Section 2 presents a PPC basic model where a penalty fee is included. Section 3 presents an extension of the model which considers a simple and symmetric penalty/premium scheme where the contractor is punished/rewarded if it decides to delay/anticipate the delivery date. Section 4 concludes by providing a brief summary of our findings and policy implications. Finally, the Appendix contains all the proofs and shows how our framework can be used to define the optimal penalty in a concession 14 The enforcement of a penalty clause may also be ineffective (i.e. costly) in the case of “multiple contacts” between the CA and the contractor. Indeed, when the latter has (or expects to have) other ongoing (or future) procurements with the same CA and perceives the committed fee as highly punitive sanction, it may take revenge on the other ongoing (or future) PPCs. Our model does not specifically address this case. 15 Indeed, of the four EU procedures for procurement ("open procedure”, “restricted proce- dure”, “negotiated procedure”, and “competitive dialogue"), only the “open procedure” and - partially - the “restricted procedure” make the trade-off between the contract’s price and the delivery date explicit: the contractor makes a lower bid (i.e. asks for a lower price to execute the contract) if it can delay the construction time. For a survey on the current EU legislation on PPCs, see: ▇▇▇▇://▇▇▇▇▇▇.▇▇/▇▇▇▇▇▇▇▇/▇▇▇/▇▇/▇▇▇/▇▇▇▇▇▇.▇▇▇ setting.

Introduction. The deterioration of public finance and the increase in global competition have forced governments and public institutions to obtain “the best value for money” through the purchase of goods, works and services in the form of procurement contracts. Efficient public procurement contracts (henceforth PPCs) are thus emerging as a “core necessity for ... the public’s sector effectiveness in obtain- ing resources for social spending and/or lower taxes” (▇▇▇▇▇▇▇ et al., 2006). These contracts have recently recorded a rapid increase both in number and in value, reaching 16% of GDP in the EU, and around 20% in the United States.1 However, PPCs have both costs and benefits: their benefits (i.e. allocative and productive efficiency) can be quickly erased by the costs (i.e. inefficiency) which often arise from contractual incompleteness and all the issues that ensue therefrom.2 In this paper we specifically address the source of inefficiency which pertains to delays in PPC execution times3 by investigating the optimal penalty design which should provide the right incentive to prevent delays. Indeed, delays in de- livery dates in PPCs may negatively affect all the actors involved, i.e. they may determine direct costs for the procurer, lower firms’ profits (i.e. firms other than the contractor) and reduce consumers’ utility. The typical illustrative example in this regard is provided by a PPC for roadway resurfacing, rehabilitation and restoration: if these activities are undertaken in heavily urbanized areas, they may cause extreme traffic congestion and severe inconvenience to the travelling public and the business community. Thus, delays in the completion of these works prolong the negative impact on users (i.e. a social cost), and also cause overruns in the planned execution costs.4 There is evidence that delays in delivery dates have been particularly large and harmful in the recent Italian experience of PPCs. The data-base compiled by the Italian Authority in charge of controlling PPCs (Autorità per la Vigi- ▇▇▇▇▇ ▇▇▇ Contratti Pubblici di Lavori, Servizi e Forniture - AVLP ) records all contracts of a value between 150,000 and 15,000,000 euros awarded by munic- 1 Note that between 1995 and 2002 PPCs in the EU underwent a 31% increase in value (▇▇▇▇▇▇▇, et al., 2006: Ch. 1). See also: ▇▇▇▇://▇▇▇▇▇▇.▇▇.▇▇▇/▇▇▇▇/▇▇▇▇▇▇▇▇_▇▇▇▇▇▇/▇▇▇▇▇▇▇▇▇▇▇▇▇▇▇▇▇/▇▇▇▇▇_▇▇.▇▇▇ 2 The economic and engineering literatures give different explanations for the main issues arising in PPCs. Most of the economic analysis on this topic focusses on the information asymmetry concerning production costs between the supplier and the procurer (Laffont and Tirole, 1993), while engineering and construction managment analysis concentrates on the uncertainty which affects the contract after it has been signed and its effects on both the supplier and the procurer (▇▇▇▇▇▇▇▇▇▇▇, 1998). For an economic methodological discussion on contract incompleteness and unforeseen contingencies see Maskin and Tirole (1999). 3 In the economic literature on PPCs, delivery delays in contract execution are often con- sidered along with the issue of the supplier’s performance regarding contracted aims (i.e. quality). See on this: ▇▇▇▇▇ et al. (2006b). 4 Cost overruns in different procurement contracts have been investigated in the seminal paper by ▇▇▇▇▇▇ and ▇▇▇▇▇▇▇ (2001): they showed that cost plus contracts are better than fixed price contracts when the project carried out through the procurement is more complex. Focusing on fixed price contracts, Ganuza (2007) found that when the procurement market is more competitive, cost overruns are lower and decreasing with the design specification level. ipalities, local/regional public authorities and public firms. Our examination of this data-base highlighted that out of 43,863 fully exploited contracts in the period 2000-2006, about 32,731 had been completed with delays. For about 27,826 contracts, the delay contracted days ratio5 was always larger than 1, and it was higher, the greater the contract value (with a small slowdown in the trend for the more expensive contracts, see Table 1 below).6 Similar findings on the sustantial body of evidence on delays in the Italian PPCs have been recorded by other empirical analyses7 and call - primarily - for investigation into the effectiveness of the penalty rules currently adopted in such contracts. According to Italian law,8 the penalty fee in PPCs should be defined as a percentage - ranging between 0.03% and 0.1 % - of the total contract price for each day of delay in completion of the contracted works.9 Is there something wrong with the definition of these ranges? Answering this question should inform the decision on whether to insert a penalty rule in 5 This ratio has the following interpretation: for example, if 200 days are the ex-ante contracted time for the infrastructure’s execution and then its delivering occurs with 220 days of delay, the delay contracted days ratio results equal to 1.1. 6 These estimations and further analysis on the data-set are available from the authors on request. 7 See Bentivogli ▇▇▇▇▇▇▇▇▇▇ et al. (2007) and ANCE (2002). The former study reports interviews conducted with 32 local Contracting Authorities managing about 280 PPCs: only one third of these contracting authorities declared that the contract had been executed within the con- tracted time, or with very small delays. In the latter study, a detailed investigation conducted at regional level by ANCE ▇▇▇▇▇▇ Romagna highlights that of the 776 PPCs concluded in the period 2001-2002, more than 68% recorded delays and/or increases in cost execution. Similar results have been found at national level (see ANCE, 2005 and AVLP, 2005 ). 8 See Government Decree n◦ 163/2006 and D.P.R. 554/1999, art.117. 9 This penalty rule for Italian PPCs is determined in similar fashion in other countries; in regard to the US, ▇▇▇▇▇▇▇▇▇ et al. (1995, Table 6, p. 276) show that for PPCs in highway construction, the contracting authority usually sets penalties ranging from 0.03% to 0.3% of the contract value for each day of delay. the PPC and what its optimal design should be. Thus, the aim of this paper is twofold: first, to provide a theoretical and general framework in which to investigate how the inclusion of a penalty fee affects the contract value; second, to verify whether the penalty range currently adopted in the Italian legislation on PPCs correctly induces the contractor to avoid delays. Our starting point is that the inclusion of a penalty clause in a PPC gives the contractor - to some extent - the option of deciding the investment timing for the contract’s execution. Thus - in order to be effective - the penalty fee should consider the investment timing flexibility which, de facto, increases the supplier’s contract value. To correctly approach the issue, we propose a simple Real Option model which allows us to ascertain the value of investment timing flexibility induced by the inclusion of the penalty clause in the contract.10 Then, calibrating the model, we verify the range of penalty fees defined by the Italian legislation on PPCs: quite surprisingly, we find that this range indeed seems able to induce the contractor to respect the contractual execution time. This result sheds new light on the determinants of investment delays in PPCs which include explicit penalty rules, and it adds a new aim to our study because it leads to other cause-and-effect explanations specifically related to the enforce- ment of the penalty clause itself. Following results generally acknowledged in the incomplete contract literature, failures by the Contracting Authority (hence- forth, CA) to enforce the penalty clause can arise when: i) the contractor’s work execution time is non-verifiable11; ii) default by the contractor triggers costly and time-consuming litigation because the “quality” of the judicial system is unsatisfactory; iii) the court of law12 - to which the parties refer for settlement of the dispute on the penalty payment - reduces (or even does not enforce) the committed fee. The last two issues seem to play a major role in the Italian experience: indeed, ▇▇▇▇▇▇ et al. (2007) found that, in the data-set of Italian PPCs that they investigated, only in less than 5% of verifiable delays was the penalty enforced by the CAs. Moreover, with specific regard to elements deter- mining the low enforcement of penalties in Italy, it is a matter of fact that in the period 2004-2005 the average duration of an Italian civil trial was around 876 working days13 : this, if anticipated by the contractor, may well override the incentive provided by the penalty design. 10 As ▇▇▇▇▇▇▇ and ▇▇▇▇▇▇▇▇ (1985) and ▇▇▇▇▇▇▇▇ McDonald and ▇▇▇▇▇▇ (1985; 1986) highlighted in their seminal works, there is a close analogy between security options and investment timing flexibility. 11 “To ensure the contract enforceability, the court must first be able to verify that an agent has disobeyed the agreed clauses of the contract” (Laffont and Martimort, 2002, p.348). To our knowledge, since the seminal paper by ▇▇▇▇▇▇▇ and ▇▇▇▇▇▇▇ (1995), the analysis of the non-verifiability of quality aspects in procurement (and concession) contracts has been carried out - with differing emphases - by ▇▇▇▇▇ et al. (2004), Calzolari ▇▇▇▇▇▇▇▇▇ and ▇▇▇▇▇▇▇▇ (2006) and ▇▇▇▇▇▇▇ and ▇▇▇▇▇▇▇▇▇ (2007). 12 See ▇▇▇▇▇▇▇▇▇ et al. (2000) for discussion of the role of courts in enforcing contract clauses. 13 See the Corte Suprema di Cassazione (2007). Moreover, an old but impressive Report by the Commissione per la garanzia dell’informazione statistica of the Italian Government (2000, pp. 27-28) found that in the period between 1988 and 1997, the average time taken by the administrative (regional) courts to make a final ruling increased from 2617 to 4261 working days. We thus characterize our model to investigate how the CA’s ineffective en- forcement of a penalty rule would affect the extent of the optimal penalty. Accordingly, we assume in the model that the probability of enforcement is cor- related to a parameter identifying the “quality” of the judicial system (i.e. the average time taken to resolve disputes) and to the level of the penalty itself.14 Our calibration results show that the probability of penalty enforcement decreases both when i) the quality of the judicial system is low and ii) the civil court has high discretionality in reducing the penalty imposed. Specifically, the greater the level of the penalty that the CA would like to introduce in the contract, the lower the probability that it will be enforced by the court. This, in turn, calls for higher penalties - well beyond the range prescribed by the Italian legislation - to make the firm comply with the contracted execution time. However, if the degree of the court’s responsiveness to the penalty imposed by the CA is high, the latter will find it convenient to set the fee considered reasonable by the court. Finally, a caveat concerning our analysis should be mentioned. In principle, delays in the PPCs’ completion time weight differently on the contract value according to the procedure adopted in awarding it. Indeed, in the “negotiated” procedure, the contract value is directly agreed between the parties and includes an explicit trade-off between the contract value and the investment’s delivery time. Differently, in the “open” procedure, the investment’s execution time can itself be part of the successful bid, thus representing a strategic variable in the competition among bidders.15 Although our simple model refers in principle to PPCs awarded through the negotiated procedure because it assumes an ex- ogenous and fixed price contracted between the CA and the contractor, it is interesting that the Italian delays contracted days ratio seem not to be cor- related with the nature of the awarding procedure - see second part of Table 1 above. This suggests that our results could be reasonably extended to the Italian PPCs awarded through the open procedure as well. The rest of the paper is organized as follows. Section 2 presents a PPC basic model where a penalty fee is included. Section 3 presents an extension of the model which considers a simple and symmetric penalty/premium scheme where the contractor is punished/rewarded if it decides to delay/anticipate the delivery date. Section 4 concludes by providing a brief summary of our findings and policy implications. Finally, the Appendix contains all the proofs and shows how our framework can be used to define the optimal penalty in a concession 14 The enforcement of a penalty clause may also be ineffective (i.e. costly) in the case of “multiple contacts” between the CA and the contractor. Indeed, when the latter has (or expects to have) other ongoing (or future) procurements with the same CA and perceives the committed fee as highly punitive sanction, it may take revenge on the other ongoing (or future) PPCs. Our model does not specifically address this case. 15 Indeed, of the four EU procedures for procurement ("open procedure”, “restricted proce- dure”, “negotiated procedure”, and “competitive dialogue"), only the “open procedure” and - partially - the “restricted procedure” make the trade-off between the contract’s price and the delivery date explicit: the contractor makes a lower bid (i.e. asks for a lower price to execute the contract) if it can delay the construction time. For a survey on the current EU legislation on PPCs, see: ▇▇▇▇://▇▇▇▇▇▇.▇▇/▇▇▇▇▇▇▇▇/▇▇▇/▇▇/▇▇▇/▇▇▇▇▇▇.▇▇▇ setting.