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1999 September and November Report of the Auditor General of Canada

September and November 1999 Report—Chapter 27

Case Study 27.1—NATO Flying Training in Canada

Background

The NATO Flying Training in Canada (NFTC) program is an undergraduate and postgraduate military pilot training program offered by the Government of Canada, in co-operation with industry, to NATO and other nations seeking affordable military flying training solutions. NFTC is viewed by National Defence as a co-operative approach to training military jet pilots, based on a partnering between government and industry. Canadian and NATO air force pilots will provide the flying instruction. The industry team, led by Bombardier Inc. Defence Systems Division, will provide the aircraft, training simulators, training material, airfield and site support services, aircraft maintenance services and other services. Under the terms of the contract, the military fighter pilot training program will be made available to the Canadian Forces as well as to the military air forces of other nations who choose to participate. Since the NFTC project was initiated prior to the implementation of the ASD program, it is not being managed under the ASD management framework.

In addition to the primary objective of developing a cost-effective pilot training program, NFTC is supposed to achieve a number of other benefits. These are:

creating employment;
keeping the base at Moose Jaw open;
demonstrating the capabilities of Canada's aerospace industry; and
making a significant contribution to NATO.

Officials also informed us that National Defence had insufficient capital funds to renew its training aircraft fleets. One of the ways to combat the "rust out" of the existing fleet was to implement a service contract that required annual installment payments.

In 1996, National Defence obtained Cabinet approval to enter into a 20-year, $2.8 billion sole-source contract with Bombardier Inc. to provide support to the NTFC. The legal relationships underlying this arrangement are complex and interdependent. The flight training will take place at Canadian Forces Base Moose Jaw and the base in Cold Lake. The government has licensed the use of these bases to Milit-Air Inc., an independent non-profit organization incorporated for the sole purposes of the flight-training program. The organization is not subject to control by either Canada or Bombardier Inc. Milit-Air Inc. will purchase the planes, flight simulators and other equipment with the proceeds of a $720 million bond offering. Bombardier Inc. has been appointed Milit-Air Inc.'s agent for the negotiation and purchase of the equipment. In addition, Milit-Air Inc. has granted Bombardier Inc. the right to use the facilities at the bases for flight training. By way of a separate agreement, Milit-Air Inc. has leased the equipment to Bombardier Inc. Under the Canada Services Agreement, Bombardier Inc. provides certain ground-based training and maintains the planes, equipment and base facilities; Canada pays tuition fees.

The tuition fees payable by Canada comprise several components: transition fees, firm fixed fees, firm fees (covering maintenance of aircraft and administration of premises), variable fees (covering life-sensitive spares, consumable spares and engine overhauls) and reimbursable costs (oxygen and petroleum). The firm fixed fees are payable semi-annually for 20 years, whether or not Canada trains the full number of pilots it is entitled to under the agreement. However, the agreement allows Canada to sell some of its unused pilot training to other countries. The firm fixed fees are sufficient to cover the semi-annual payments of principal and interest that Milit-Air Inc. is required to make to its bondholders. Bombardier Inc. has assigned its right to receive the tuition fees to a Collection Trustee. Once the Collection Trustee receives the tuition fees from Canada, the rental payments owed by Bombardier Inc. to Milit-Air Inc. for the planes and equipment are deemed to have been paid. The Trustee then pays to the Bondholders' Trustee the portion of the firm fixed fees equal to the principal and interest due on the bonds. The remainder of the firm fixed fees is held for the benefit of Milit-Air Inc. to cover its reasonable normal operating expenses. The other components of the tuition fees are paid to Bombardier Inc. for services rendered under the Canada Services Agreement.

If the Canada Services Agreement is terminated, Canada is obliged to assume Bombardier Inc.'s rights and obligations under the lease agreement for the planes and equipment and to continue the rental payments for the equipment. These payments will, in turn, continue to provide the means for Milit-Air Inc. to meet its obligations to the bondholders.

Most of the training will take place at Canadian Forces Base Moose Jaw, Saskatchewan and some will occur at the base in Cold Lake, Alberta. According to the Department, the role of the Canadian military will consist mostly of conducting the flying training, overseeing the contractor support, managing the training content and standards, running the air traffic control and providing site services at Cold Lake. Bombardier Inc. will be responsible for the provision and support of aircraft and simulators, ground school training, classroom training systems and site maintenance services at Moose Jaw. This commercial option is similar to a number of others under the ASD program, which was developed to move various internally provided support services to the private sector when it makes business sense to do so.

About $1.3 billion of the contract funds will be used to acquire flight simulators and a new fleet of 42 military training aircraft to replace National Defence's existing fleet of Tutor aircraft that, according to departmental studies, could have been refurbished and made to last until the year 2015. The remaining $1.5 billion will be used by the Bombardier-led industry team to maintain the aircraft and the simulators, manage the base in Moose Jaw, and provide ground school instructors. National Defence will provide the overall management of the NFTC program as well as the flight instructors. The first flight instructors were to start training in the third quarter of 1999.

We reviewed the NFTC contracting process, using the following criteria:

the contract awarding process should meet the requirements of the government contracting policies and regulations for integrity, openness and fairness;
the pricing methods should provide best value; and
the financing and contracting arrangements should be appropriate.

The contract was awarded without competition

We reviewed the rationale for awarding the contract without competition and the events leading to the contract award, to determine if National Defence and Public Works and Government Services Canada had complied with the government's contracting policy and regulations. We found that the decision to award the contract without following the normal bid solicitation process for government contracting was not adequately justified.

Our review of NFTC contract files indicated that the sole-source decision was based on the following factors:

The Bombardier Inc.-led team included all of the companies that had bid as prime contractors on a 1991 contract to supply pilot training services at Portage-la-Prairie. Bombardier Inc. was awarded that contract because it was the lowest bidder.
The proposed industry team was the only one that indicated a "committed interest" in the NFTC program.
The deadline imposed by NATO for submission of a proposal precluded a competitive tendering.
The availability of a competing pilot training program in the United States, and concern among NATO nations about the costs of contracted-out pilot training compared with their domestic costs, created incentives for Bombardier Inc. to keep training costs down.

Those reasons for awarding the contract without soliciting competitive bids do not meet the conditions specified in the Government Contracts Regulations. In the fall of 1994, Bombardier Inc. proposed the idea of a National Defence/industry collaboration to establish a NATO flying training program. This led to the submission of an unsolicited proposal containing a business case in December 1994. The NATO deadline for the submission of offers to host flying training was 1 February 1995, which was later revised to 1 May 1995. The deadline for submitting a fully costed proposal was June 1996. While it is probably true that the time between the receipt of the unsolicited proposal and NATO's deadline was insufficient for the government to tender the project, "making a deal" does not match the definition of urgency in contract regulations.

During the course of our audit, officials told us that the benefits to be gained by the deal meant that competitive tendering was not in the "public interest". This does not conform to the criteria that define "public interest" in contracting policy.

Officials also told us that because they were satisfied that all Canadian companies qualified to bid were already part of the Bombardier-led consortium, a non-competitive contract was equitable. In addition, they pointed out that the government's intention to pursue NATO participation through a sole-source contract was highly publicized and that no other company came forward. A document we examined did indicate that another firm had expressed some interest.

We remain concerned about the equity of these practices. It cannot be stated with certainty that no other competitor would have come forward, possibly as part of a consortium including a foreign firm. In addition, publicity may discourage competition by making it appear that the government has made its decision.

Finally, officials argue that because Cabinet directed that a sole-source contract be let, no compliance problem exists. However, a directed sole-source contract of this nature must comply with the regulations. If it does not fall within the permitted exceptions, an order-in-council is needed to authorize the transaction. No such order-in-council was sought or obtained.

In public statements, National Defence has stated that "partnering" is a good strategy for a contract of this nature, involving a large, complex project. However, the Government Contracts Regulations make no provision for partnering, and the terms of this contract do not indicate that it is a partnership in a legal sense. Moreover, the term "partnering" is an elusive term now being used as a catch-all to describe almost any activity involving government and non-government organizations. We found that there are no clear policies or guidelines on how such arrangements should be set up and managed.

The profit markup in the NFTC contract is not consistent with current guidelines or supported by adequate analysis of contractor's risks

In the event of a sole-source contract, Public Works and Government Services Canada's profit policy and guidelines are supposed to establish the level of profit awarded to a contractor. The NFTC contract includes a profit markup of about $200 million over 20 years. This markup was arrived at through direct negotiations between Public Works and Government Services Canada and Bombardier Inc. Public Works and Government Services Canada officials told us that the profit policy and guidelines are not designed for a project of this magnitude, complexity and period of performance, nor for a complex financing arrangement of this nature. They also stated that the profit markup that was negotiated with Bombardier was justified by the "material" and "substantial" risks assumed by the contractor. However, they could not provide us with the detailed calculations and risk assessments they used to arrive at the profit markup included in the contract. According to officials of both departments, the NFTC program will provide the government with valuable benefits through the transfer of significant risks to the contractor over the next 20 years. Although departmental documents show the departments' estimate of contractor risk to be between $360 million and $460 million, they had no calculations to support this. They estimate that the risk exposure to the contractor relates to the following:

the quantity and adequacy of the aircraft required for the program;
future increases in aircraft and infrastructure operating costs;
failure to obtain the expected number of foreign participants; and
environmental risks.

We expected that the two departments would comprehensively assess the risks being transferred to the contractor and estimate the value to the Crown of that risk transfer. We were unable to establish that this had been done.

Public Works and Government Services Canada informed us that it hired an outside consultant to review the risk elements in this program. We note that the external consultant could not perform a comprehensive review of all the risks involved in the NFTC program since, at the time of his review, the agreements had not been finalized. Therefore, in our opinion the review was not sufficient to provide assurance that there is an equitable sharing of risks under the contract. Public Works and Government Services officials indicated to us that the risks of poor performance by the contractor were sufficiently moderated and managed by the provisions contained in the Canada Services Agreement. Nevertheless, the payment by Canada of $1.3 billion in firm fixed fees is unconditional and irrevocable under the terms of this agreement, even if the contractor fails to perform. However, if Bombardier is replaced there is a provision in the contract that guarantees access to and use of the equipment for the period of the contract.

In response to our audit, National Defence officials prepared a risk summary in late September 1999 that attempted to quantify the value of the risks transferred to the contractor. While this summary clearly identified the major risks, it did not assess their probability of occurrence and their overall financial impact. As a result, it is not possible to establish the correlation between the value of the risks and the profit markup that was negotiated in the NFTC contract.

According to information provided to us by National Defence officials, Bombardier Inc. faced the risk of not recovering $103 million of its costs if Canada were to be the only participant in the program. Based on current commitments by foreign countries, this amount has now been reduced to between $15 million and $30 million. Moreover, Bombardier maintains that it will earn its forecast profits only if the full, expanded program is achieved. It would therefore appear that the risk associated with insufficient foreign participation has now been mitigated. However, the other risks mentioned above remain.

It should be noted that if the NFTC program expands beyond its current level and National Defence agrees to such an expansion, the Department is committed to paying for the additional aircraft and equipment that will be required. These costs would be recovered from the additional revenues from foreign participants. According to National Defence officials, if the program were to expand beyond its current capacity there would be significant financial benefits to both the Crown and the contractor, because the fixed costs of the program would be shared among a greater number of participants.

The chosen financing arrangements increase some risks

The NFTC program is the first example of "innovative" financing for a major National Defence capital project. This financing arrangement requires the contractor to supply most of the equipment and capital needed to provide support services. However, the Department is irrevocably committed to making the required payments to acquire the aircraft, simulators and other related assets.

The Department of Finance had suggested in late May 1997 that the Department consider purchasing the equipment directly and supplying it to the contractor as government-supplied equipment. In response, National Defence prepared an analysis of industry financing compared with government financing of the NFTC assets. We found that this analysis was not complete and that it was performed at a point when it was impractical to make any changes to the financing arrangements, since there would not have been enough lead time to purchase the equipment and have it in place by the end of 1999,

The financing structure also posed additional risks to the government. Officials took steps to reduce the risks by including certain safeguards in the agreements with Bombardier Inc. and Milit-Air Inc. but not all risks could be circumvented. The main risk identified by Public Works and Government Services Canada is that if Milit-Air Inc. were ever to become insolvent, National Defence would face the drastic consequence of losing its access to the planes while continuing to pay the firm fixed fees. Therefore, should Milit-Air Inc. incur an expense of a type that the Department was not obligated to reimburse, National Defence would nevertheless, as a practical measure, be forced to inject the necessary funds into Milit-Air Inc. to keep it solvent. Public Works and Government Services Canada has assessed the likelihood of the occurrence of such expenses as very small. It notes, however, that their impact could be high. Officials told us that they have taken action to mitigate this risk.

The unique financing arrangements are also causing problems with the acquisition of the Raytheon T6-A aircraft and related technical data. The U.S. Department of State has serious concerns about a private company, Milit-Air Inc., owning military aircraft. It is concerned about Canada's ability to control the transfer of information and the use and resale of aircraft owned by Milit-Air Inc. The two governments have been working on a solution, and it is expected that the Canadian government will be providing the necessary assurances shortly. However, the issue is not yet completely resolved.