December 5, 2001
The purpose of this report is to report publicly to Council as directed by it.
It is recommended that this report be received for information.
At its meeting on December 4, 2001, Council had before it a confidential report, dated November 29, 2001, from the Chief Administrative Officer and the City Auditor. Council directed that staff provide a public report setting out information pertaining to the subject computer leasing contract between the City and MFP Financial Services (“MFP”).
The following constitute the facts forming the background of the investigation.
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.
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, 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 some of 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.
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.
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 PST 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 the City was under the impression 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 5 ½ years. Some other equipment in the restructured lease schedules now has a term of either 5 years or 5 ¼ years.
This restructuring did have a financial impact. The total obligation of the City increased.
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%. 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 to 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. 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 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%.
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 lifespan 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.