December 20, 2001
The purpose of this report is to recommend approval of the Minutes of Settlement as recommended by external legal counsel and to advise Council on the public disclosure of the reports leading to the resolution of outstanding issues with MFP.
It is recommended that Council approve the Minutes of Settlement as recommended by the City’s external counsel, Mr. Alan Lenczner, and upon approval of the Minutes of Settlement authorize the public release of the attached backgrounder, the backgrounder being in essence the contents of the prior in camera report, dated November 29, 2001, pertaining to the facts of the City’s review of the MFP Financial Services computer leasing contract modified to delete any information pertaining to staff behavior which is the subject of ongoing investigation as directed by Council.
At its special meeting on December 20, 2001, Council will be considering a confidential report from external legal counsel on a proposed settlement with MFP Financial Services (“MFP”).
It is appropriate that upon approval of the Minutes of Settlement that the prior in camera report, dated November 29, 2001, setting out the facts contained in the City review of the computer leasing contract be publicly released subject only to the deletion of information which could pertain to staff behaviour which is subject to ongoing investigation as directed by Council.
The following constitute the essential facts forming the background of the City’s review of the MFP computer leasing contract as contained in an in camera report, dated November 29, 2001, from the City’s Chief Administrative Officer and the City Auditor.
In May of 2001 the Chair of Audit Committee raised concerns that the City’s contract with MFP exceeded the original intent and approvals of Council. Specifically, the Chair of Audit Committee argued that Council had not approved the use of MFP as a vendor of record beyond very specific Y2K related purchases.
In May of 2001, the Acting Executive Director of Information Technology initiated a review of the issues raised by the Chair of Audit committee.
On July 24th, 2001, City staff became aware of media reports about the City of Waterloo’s contract with MFP Financial Services. The reports suggested that the City of Waterloo was initiating legal action against MFP in relation to alleged changes in the interest rates implicit in their contract. A report in front of Toronto City Council recommending MFP as the successful bidder in an RFP to lease City photocopiers was referred back to staff at the request of the acting CAO.
City Financial Planning staff undertook a preliminary review of the implicit effective interest rates arising from the City’s contract with MFP. This initial analysis suggested that there had been increases in the effective interest rates. As well, the initial review revealed inconsistencies between the original Council approval and the current arrangements with MFP.
The acting CAO created a working group to undertake a thorough analysis. The working group included the Commissioner of Corporate Services, the City Solicitor, and the Acting Executive Director of Information Technology. In addition, the City Auditor was requested to participate in the review. City Council was informed by a memo from the Acting CAO that a review was underway and that the results would be reported out to the appropriate committee of Council.
It quickly became apparent that the City lacked the technical expertise to properly analyze the highly complex lease documents and schedules, particularly because the schedules to the lease had changed on a number of occasions. On the advice of the City Auditor, an external lease expert, Mr. Greg Dorbeck of Pivotal Technologies, was contracted to undertake an examination of the lease.
It was determined by the acting CAO that there were two key elements of the review; an analysis of the financial implications of the lease; and an analysis of staff decision making and management systems in place in relation to the lease. The Acting CAO engaged the services of KPMG and external legal advisors to ensure that the review was done in a strictly objective manner.
Throughout the review, weekly or semi-weekly meetings of the review team were held with the external experts. During the course of the review all available documents were collected, but it quickly became apparent that many of the key decision points related to the lease had little or no supporting documentation.
A series of meetings have been held with MFP, both to obtain documents relevant to the review, and to discuss some of the findings. It should be stated that MFP has been very helpful in agreeing to meet with the City and its external advisors and in providing documents and records.
There are a number of major areas of focus arising from the review.
In early 1999 staff were exploring financing options for the large-scale computer acquisitions anticipated for Y2K. Leasing was recommended as an approach because it reduced the initial capital outlay and stabilized year to year payments and budgets. To this end, an RFQ was issued on May 31 of 1999 to solicit bids for computer leasing. Six companies bid on the RFQ.
The RFQ did not request an effective interest rate, only a payment rate quoted as an amount per $1,000 of purchase value. The rate to be quoted in bids was for the first 90 days only of a three-year lease (the rate quoted would apply to the duration of all leases entered into during the 90-day period). Respondents were also required to include in their submissions a description of the mechanism for setting the lease rates beyond the initial 90 days.
The contract with MFP was signed after the 90 day period expired. It is important to note that, consistent with the RFQ requirements, all respondents to the RFQ quoted rates that were only valid for 90 days and that all could have changed their rates after that period.
The various contractual documents constituting the business arrangements with MFP are numerous and complex. The master contract with MFP was reviewed by outside legal ‘as to form’ only. Most of the equipment leased is included in a number of equipment schedules that are sub-documents of the master lease. In total, the City has entered into 15 equipment schedules with MFP, three of which have since been terminated and re-written.
With two exceptions, the initial leasing schedules were not for three years as approved by Council, but were for longer terms, most commonly five years. The extension of the lease term increased the total financial cost to the City over the term of the agreement.
In addition, when the initial lease was signed in October of 1999 for five years, the rate of interest implicit in the lease payments was significantly higher than the interest rate implicit in MFP’s bid for the first 90 days and on which Council made its leasing decision. This also increased the City’s total financial obligation. There is no evidence that any analysis was undertaken of the financial impact of extending the lease term or the new payment rate.
Between January 1999 and the signing of the first equipment schedules with MFP, the City purchased a large amount of computer equipment and software in preparation for Y2K. In the fall of 1999, staff initiated a sale and lease back transaction of this equipment with MFP. All of the previously purchased equipment was sold to MFP and leased back by the City. Additional equipment was purchased by the City and sold to MFP and leased back through 2000. In total, $23.5 million dollars of equipment was sold to MFP and subsequently leased back to the City.
There is no mention of a sale leaseback in the RFQ or the report to Council. In the opinion of the City Solicitor, the sale leaseback should have been explicitly approved by Council.
City staff failed to collect from the federal government a GST rebate due the City worth approximately $1.8 million. Staff are now attempting to recover the rebate.
In the summer of 2000 a number of the leases were restructured and, in the course of this restructuring, the term of some leases was extended beyond the initial five year period. The review indicates that there was an assumption that this was an administrative change only and had no financial impact.
During the restructuring, equipment was resorted into five new schedules. All printers were placed in one schedule, laptops in another, etc. As a result of this lease restructuring, the majority of the equipment in the restructured lease schedules now has a term of 5½ years. Some other equipment in the restructured lease schedules now has a term of either 5 years or 5¼ years.
This restructuring did have a financial impact. The total obligation of the City increased. Moreover, the restructuring failed to take into account payments that had already been made by the City on the equipment placed into the restructured lease. The payments which result in this additional cost to the City will arise at the end of the lease term (i.e., the final additional payments to be made 2005).
Council approved the leasing of $43 million of computer equipment for three years at an effective interest rate for the initial 90 day period of approximately 4.6%. However, the City is currently leasing $80.5 million in assets from MFP. Virtually all computer equipment acquired by the City in 2000 and 2001 was leased from MFP. The review found that there was a pervasive belief across finance, purchasing and I&T staff that the MFP lease was to be used exclusively for computer leasing, and that this was appropriately approved.
The Council direction from July 1999 directed that the former Chief Financial Officer and former Executive Director of Information and Technology report back on future or additional leasing opportunities. There have been no subsequent reports.
The calculation of the financial impact to the City is complex because it is a factor of both lease rate changes, changes in the length of the lease term, and other factors. In addition the precise financial impact is contingent on the City making a decision, as yet unmade, on whether to buy out the computer equipment at the end of the lease. Moreover there are several possible baselines against which to measure the impact to the city.
Comparing the City’s current obligation to the rate proposed in the original MFP lease is problematic. It was understood by MFP and city staff from the outset that the rates would change during the course of the lease and would not remain fixed at 4.6%. This fact was, however, not reported to Council. The Council report can therefore leave a reader with the erroneous impression that the initial rate would remain fixed for the duration of the lease term.
It is also important to note that the initial purchase/lease analysis was based on MFP’s proposed lease rate with an implicit effective interest rate of 4.6%. At the current lease rate, the purchase/lease analysis may not hold.
There are possible future financial impacts for the City related to the lifespan of the equipment under lease. The current leases require that the City continue to pay for most of the City’s computer infrastructure into 2005. While every attempt will be made to maximize the lifespan of the computer equipment purchased in 1999, some elements of that infrastructure do not have a five to six year lifespan. Some network devices, servers, storage devices (particularly those that operate 24 hours a day) typically have short lifespans and will have to be replaced or upgraded before 2005, in some cases in 2002-3. That means that the City will inevitably find itself in a position of continuing to pay for some equipment that has been replaced and disposed of.