MFP Settlement Staff Report 3
November 29, 2001
Review of the Computer Leasing Contract between the City of Toronto and MFP Financial Services
This report sets out the findings of a review of the City’s business relationship with MFP Financial Services Ltd. (MFP) of Mississauga Ontario. It is the final report of a three-month review into the nature of the City’s contractual relationship for leasing computer hardware and software. It includes an examination of the role of staff in making a number of key changes to the arrangements with MFP and the impact of those changes.
Financial Implications and Impact Statement
The financial implications of this report can be addressed from existing budgets.
- The Chief Administrative Officer lead a comprehensive strategy to significantly enhance the City’s business processes, accountability, transparency, and human resource competencies. That strategy should include, but not be limited to, the recommendations below.
- A steering committee of appropriate senior staff work with the CAO to support the development and implementation of the strategy.
- The Chief Administrative Officer put in place stringent standardized life cycle management rules for the management of City contracts by September 2002. A central component of those rules should be a project charter template for all large acquisition and contract projects. The project charter should clearly delineate accountability for all aspects of the contract life cycle.
- The Chief Administrative Officer, with the assistance of the City Solicitor, develop written policies and procedures on contract changes. The policies should specify when changes to existing contracts require Council approval, further financial analysis, legal review, or the issuance of a new RFP or RFQ.
- Where possible, all future contracts be designed and negotiated to protect the City’s interests should priorities or needs change. Therefore, contracts should, wherever possible, include review processes, re-negotiation windows, cancellation provisions, and full or partial exit provisions.
- The Chief Administrative Officer and Commissioner of Corporate Services develop a contract management centre of excellence in Corporate Services I&T Division using existing funds and 2001 under-expenditures. The centre should include highly skilled technical experts and all necessary resources to assess, issue, review, manage and evaluate major contracts. The centre should include, at a minimum, expertise in financial analysis, contract law, and negotiation. The staff of the centre should have, or be working towards, nationally or internationally recognized professional qualifications in contract management. The business processes of the centre should similarly reflect or fully adopt international standards for contract management. The centre should be implemented early in 2002.
- The Chief Administrative Officer, in consultation with the City Auditor, report to the Audit Committee in the spring of 2002 on a strategy to undertake ongoing ‘value for money’ audits of major contracts and outsourced services.
The Chief Administrative Officer ensure that the City’s approved conflict of interest policy is fully implemented, and that all levels of management ensure that there is rigorous and consistent application and compliance. The opportunity for conflict of interest can be created by the contractor. Therefore the city’s conflict of interest policy should be included with requests for proposal and quotations.
In May of 2001 the Chair of Audit Committee raised concerns that the City’s contract with MFP had been used in a way that 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 by legal staff of the issues raised by the Chair of Audit committee. This culminated in a meeting of City purchasing and legal staff on July 23rd, 2001 to examine this issue. At that meeting legal staff presented a preliminary position that City staff did not have the authority to use the MFP lease beyond a $43 million threshold approved by Council in 1999.
The next day, 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 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 dramatic increases in the effective interest rates. As well, the initial review revealed significant 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, because of possible audit implications, 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. At the same time all documentation related to the MFP lease was collected by Finance and I&T staff and consolidated in the office of the City Solicitor.
In the early weeks of the review, it was further apparent that there were questions about key decision points related to the lease. It was evident that current and former City staff had made decisions and authorized changes to the lease that had significant financial implications. It was therefore necessary to undertake a review of staff decisions that would require interviews of current and former staff. It was determined by the acting CAO that there were, at that point, two key elements of the review; an analysis of the financial implications of the lease; and an analysis of the staff behaviour in relation to the lease. The Acting CAO engaged the services of KPMG to ensure that the review of staff behaviour was done in a strictly objective manner.
It also became necessary to contract with external legal advisors. In March of 2000, a member of the City Solicitor’s staff issued a letter to MFP, at MFP’s request, stating that certain agreements with MFP had been duly authorized by the City, the persons executing the agreements were authorized to do so, and the agreements were legal, valid and binding agreements of the City. Because legal staff had to be interviewed in the course of the interview, the City Solicitor felt that external legal advice was needed to ensure the appearance of objectivity.
On the advice of both City and external legal counsel, in order to protect the City’s options, the City has not paid any amounts owing MFP since the beginning of the review. Certificates acknowledging receipt of delivered computer equipment have also not been signed by the City. No new business has been undertaken with MFP. As a result of not paying lease payments the City may be subject to late payment penalties and interest on late payments.
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. More recent meetings have been held with MFP to examine compensation to the City for amounts believed by the City to be owing. The City is of the position that it is immediately owed certain amounts by MFP. The results of these discussions will be the subject of another report.
There are a number of major areas of focus arising from the review. Each major finding is examined individually.
RFQ and Report to Council
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. Some bidders linked their future rate to government bond yields. MFP had a much more general statement that future rates would be set “.to reflect changes in technology and the prevailing market conditions which includes the underlying base interest rate.”
The report to Council in July of 1999 failed to mention that the rates quoted in the responses to the RFQ, and on which the analysis was done and MFP recommended, were only in effect for 90 days, after which they could change. An early draft of the report did conclude that leasing was the lower cost option “assuming leasing rates remain at the existing level for future periods.” This important caveat was edited out of the final version, apparently by the former Chief Financial Officer.
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.
MFP was recommended based on the 90-day lease rate that was substantially lower than the other bidders. The implicit effective interest rate of the MFP proposal was 4.6%, which was lower than the City’s cost of borrowing. Most of the other bidders had an effective interest rate of approximately 9%. However, as stated above, the report failed to mention that the MFP rate was only valid for 90 days and was then subject to change, as were the rates quoted by the other companies.
Five year initial lease term
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 leases from three to five years appears to have been initiated by the former Chief Financial Officer in order to reduce annual lease expenditures and thereby reduce annual budget pressures. However, 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, and on which Council made its leasing decision. The new implicit interest rate was 6.5%. 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.
Many City staff suggested that a motion moved by a former member of Council, the former Budget Chair, at the Policy and Finance Committee meeting in July of 1999, constituted approval for staff to extend the term of the lease. The motion, which was subsequently approved by Council, generally suggested that staff take steps to ensure that “.the terms and conditions of the lease be flexible enough to ensure that the life span of the computer equipment is extended beyond three years.”
In the opinion of the City Solicitor, this motion does not grant staff the authority to extend the term of the lease to five years, only to take such steps to acquire or otherwise retain equipment that might have a useful lifespan beyond three years. The City Solicitor argues that a motion that allows for a lease beyond three years would fundamentally negate the premise of the base report. That report, the analysis on which the report is based, and the council decision are entirely predicated on a three year lease term.
Sale Lease Back of previously purchased equipment
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 was not properly authorized, and should have been approved by Council. In addition, specific transactions undertaken during the sale leaseback were undertaken by staff who lacked the appropriate authority.
Many staff indicated when interviewed that there was an implicit understanding that a sale leaseback would be a component of the lease arrangement from the outset.
The review also identified problems with the manner in which the City was compensated for the sale leaseback. The $23.5 million was not immediately paid to the City when the transaction occurred, but was held by MFP, some of it for 18 months. Two lump sum payments were made to the City, one for $4.2 million in May of 2000, and one for $4.7 million in May of 2001. The remainder of the amount owed by MFP to the City was used to offset lease payments due to MFP by the City. The lost interest to the City as a result of this delay in payment is approximately $460,000. Recovery of this amount is now the subject of discussions with MFP. In addition, 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.
Lease Restructuring of July 2000
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. City staff generally stated that the change was initially suggested by MFP as an administrative convenience. The former Chief Financial Officer stated that there was an assumption that this was an administrative change only and had no financial impact. The review suggests that the restructuring was approved by the former Chief Financial Officer.
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. This represents a financial impact to the City of $2.7 million, all of which is profit for MFP. 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).
No financial analysis was done by City staff of the restructuring. The restructuring was not approved by, or reported to, Council.
Total Amount Under Lease
Council approved the leasing of $43 million of computer equipment for three years at an effective interest rate 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.
In the opinion of the City Solicitor, there is no Council authority to lease more than $43 million of computer equipment.
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.
As part of the review of staff behaviour, KPMG was specifically asked to consider whether there was evidence of staff impropriety in relation to the contract. KPMG has concluded that there is no evidence that staff profited from the transaction.
However, there are conflict of interest issues. Senior City staff accepted hockey tickets and meals from MFP before the issuance of the RFQ, and after the contract was signed. The former Chief Financial Officer accepted ‘less than 12’ hockey tickets from the company, and traveled on a chartered aircraft to a hockey game in Ottawa. The former Chief Financial Officer has produced a cancelled cheque made out to a senior executive of MFP for $700 to offset the cost of that trip.
The electronic schedule calendar of the former Executive Director of Information and Technology indicates that he had a number of lunch meetings scheduled with representatives of MFP. Correspondence from MFP indicates the former Executive Director of Information and Technology had a longstanding relationship with MFP dating from his previous employment with the provincial government.
In addition, the former Executive Director of Information and Technology, former Chief Financial Officer, and Director of the Y2K Project posed for a photograph in the 2000 MFP annual report. The same testimonial appeared on the company’s website, and provided statements of endorsement of the company. The website photo and endorsement were removed from the company website in July of 2001 at the request of the acting CAO.
In the opinion of Ross Dunsmore of Hicks Morley, Barristers and Solicitors, who was the solicitor involved in training staff respecting the conflict of interest policy, “.the conduct of the former Chief Financial Officer violated her contractual duty to recognize and avoid circumstances giving rise to the appearance of conflict of interest. The formal policy of Council itself is quite strict. Employees may not accept favors. This would certainly cover hockey tickets and meals. However, the policy has been administered by degree, so that receipt of sporadic favours has been permissible. Unfortunately, with hindsight the number of favors coming from one company in this case goes over the acceptable line. The perception is that MFP engaged the former Chief Financial Officer in a conflict, the result of which she did not scrutinize certain dealings as scrupulously as she might have otherwise. Certainly, some of the problem falls at the feet of MFP who enticed the city employee, but the former Chief Financial Officer should have acted differently.”
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. The following sets out the key impacts.
The total impact to the City of the changes in lease terms and rates is $13.5 million dollars. This amount is the difference between leasing $80.5 million of computer equipment at 4.6% for three years, and the current lease lengths and rates.
However, 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. There are also likely to be operational impacts in attempting to extend the life span of the City’s desktop computers to five and a half years. The City will reach a point where newer business applications will not run on the current computers.
The analysis by KPMG and Mr. Dorbeck, indicates that in addition to the amounts above, as a result of the restructuring of July 2000 the City will pay $2.7 million more to MFP than it would have had the leases not been restructured. In addition, the City has suffered $460,000 of lost interest arising from delayed repayment of the sale leaseback interest, and is owed an additional $100,000 by MFP as a result of other technical errors. The City may also be owed additional interest of approximately $430,000 as a result of an unusual payment structure of one of the larger software leases.
The City owes MFP approximately $7.5 million in lease invoices that remain unpaid starting in June 2001. Interest on these payments is estimated to be $374,000. MFP claims that an additional one million is owed in respect of interest on lease schedules that have not yet been signed by the City and various other claimed late lease payments.
The handling of the leasing contract with MFP represents a major accountability failure with serious financial implications for the City of Toronto. The failure was not caused by one single factor, but by several.
- The report to Council authorizing the leasing arrangement with MFP was seriously flawed. It failed to provide Council with the necessary information to make a fully informed decision. In particular, the report failed to mention that the payment rates would change every 90 days for new leases.
- MFP’s rate setting provision was vague. Concerns raised by one finance staff member about the vagueness of the provision were not pursued.
- There was no clear acceptability framework set out for managing the contract. As a result staff repeatedly assumed, incorrectly, that other staff were undertaking necessary financial reviews of changes to the contract.
- Staff had little experience with leases and the complex financial analysis and contractual arrangements that are associated with leasing.
- The agreement was undertaken in the context of Y2K, during which large spending decisions were being made rapidly, and normal purchasing requirements had been modified.
- Staff used the contractual documents provided by the company, that were complex and likely structured to the company’s advantage, without comprehensive review or negotiations.
- Changes were made to the lease and schedules with little or no financial impact analysis.
- Finally, it is reasonable to believe that the extra-professional social relationship key staff had with MFP may have compromised their objectivity, and therefore their ability to exercise proper due diligence.
While the issues raised above represent a serious concern, it must be stressed that the City’s responsibility for this problem rests with a very small number of senior individuals, some of whom have since left the City. The majority of staff who were involved in administering the contract did so in good faith and with appropriate professionalism. The vast majority of staff in Finance and Corporate Services I&T had little or nothing to do with the contract.
Finally, the findings of this report are in many cases consistent with the findings of the reports by the City Auditor and CAO on the use of consultants. There are common themes and issues in both this report and the report on consultants. There are common causes, and many cases the same senior staff played key roles. Through 1999 and 2000, and particularly through the Y2K project, the City entered into a number of agreements with the private sector some of which were poorly structured, improperly analyzed, managed sloppily, inadequately documented, and questionable in scale and scope. A separate report recommends a review of Y2K spending.
This report makes no excuses for those lapses. The recommendations of this report and the report from the CAO on the use of consultants are intended to form a comprehensive strategy to ensure that these sorts of problems never occur again. However, the necessary changes must be made by staff. This means that the staff in Finance and Corporate Services and I&T need the full confidence and support of Council as new business processes are developed and implemented. In order to move forward it is absolutely essential that City staff who must implement these improvements receive the full support of all members of Council.