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Contract Indexation Vs. Contracting Authority’s Economic Prudence in Poland

Contract Indexation Vs. Contracting Authority’s Economic Prudence in Poland

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An economic crisis is definitely upon us. Factors such as inflation, reduced availability of raw materials and skyrocketing material prices and costs triggered by, among other things, the armed conflict in Ukraine and sanctions imposed on the Russian Federation, are having a direct impact on performance of contracts and their profitability. Among those hardest hit in these circumstances are parties to public procurement contracts.

The first response to the emerging problems came in March 2021 when the Public Procurement Office (PPO) published its position on indexation of contractual remuneration, allowing contracts adversely impacted by the conflict in Ukraine to be amended pursuant to Article 455(1)(4) of the Public Procurement Law (PPL) where (i) the contract does not have an indexation clause or where (ii) its indexation clause is insufficient to restore the proper economic balance between the contractual parties. The contract amendment mechanism proposed in the PPO’s opinion is also to apply to contracts being performed under the previous version of the PPL .

In July 2022 the PPO’s position was endorsed in an opinion published by the General Counsel to the Republic of Poland (GCRP) which, when referring to the admissibility of amending public procurement contracts, adopted a broader perspective and also dwelt on economic prudence [Polish: gospodarność] (expenditures) of the contracting authority.

In a further development, the indexation of certain categories of contracts was regulated in the Act of 7 October 2022 on amendments to certain laws with the view to simplifying administrative procedures for citizens and entrepreneurs (Journal of Laws of 2022, item 2185) which, as of 10 November 2022, amended the PPL, among other legislation. We will not be discussing this latter piece of legislation, as it lies outside the ambit of the current publication.

1. The principle of economic prudence

While the concept of economic prudence [gospodarność] invoked in its opinion by the GCRP is used by economic and legal scholars, it has never been defined in any piece of legislation. In discussing it, we must thus rely on doctrinal positions.

To begin with, from the linguistic viewpoint, ‘economic prudence’ manifests itself in sound (competent) and thrifty management, while ‘management’ is used to mean the handling of resources and means or deciding on how to use what one has at one’s disposal. Also, "we describe as acting with economic prudence anyone ... who — when handling finances — makes proper use of money to attain a set objective.". Thus, in linguistic interpretations, economic prudence is skillful decision-making in the use of what one has at one’s disposal, including in the thrifty management of the available resources and means, while at the same time pursuing a specific goal.

Secondly, as is noted in the literature, economic prudence in spending public funds was referred to by the legislator in Article 44(3) of the Public Finance Act and is immensely important from the practical viewpoint. This regulation requires public spending to be purposeful and thrifty, geared to the achievement of the best possible results from the outlays made and to optimal selection of the methods and means serving to achieve the envisaged objectives.

Thirdly, legal scholars have elevated economic prudence to the status of a principle of law that merits legal protection. As a rule, principles of law are expressive of values which the legislator considers particularly weighty and would like to see respected when applying standards other than principles of law. They serve to stake out goals that must be pursued. In case law, the principle of prudent management is construed as tantamount to the principle of rational management. To quote the Supreme Court: “According to this principle, a goal is attained to the greatest extent possible when acting so as to achieve this goal as much as possible with the given outlays (the rule of greatest effect) or to expends as little resources as possible to achieve a given level of goal attainment.”. It is also assumed that the designates of the principle of prudent management are purposefulness, economy and effectiveness.

Finally, it should be noted that prudent management ranks highly — alongside purposefulness, diligence and legality — among the criteria for proper management of public property set forth in constitutional law, since appraisal from the viewpoint of prudent management is one of the key elements of the legal model of operation of the Supreme Audit Office. Seeing this distinction made between the respective criteria of prudent management and legality, one has to construe the former as distinct and ‘extra-legal’ in nature. At the same time, legal scholars view prudent management in terms of a qualitative (rather than formal) assessment criterion, and this because when some specific sphere of an entity's operations is looked into, the appraisers focus on how good a job this entity made in utilizing the resources available to it, grading the entity’s ability to perform in a certain desired way. The model for such operations calls for the employment of specific means, exclusively to the extent essential to achieve the set goal, and the audit is meant to determine whether or not just the right amount of resources was used to accomplish the given task.

2. Mismanagement

It can be inferred, a contrario, from the foregoing that we have imprudent management (mismanagement) when an entity deviates from the proposed model of operation and uses more than the amount of resources found to be essential to achieve the envisaged objectives.

Another view being expressed is that imprudent management consists in making irrational business decisions while disregarding or misapplying the rules of economic balance.

Also worth noting, as an aside, is that the legislator, faced with the widespread incidence of mismanagement, moved to counteract practices of this sort by penalizing imprudent management under Article 296 of the Criminal Code. This offense is also referred to as ‘criminal mismanagement’.

3. Position of the GCRP

In the cited opinion, the GCRP made it clear that the additional expenditures to be incurred by the contracting authority as a consequence of the contract being amended must be in line with the provision of Article 17 of the PPL and the principles implied by the Public Finance Act, with the additional money to be spent frugally, purposefully and effectively.

In deciding to amend the contract, the contracting authority has its own interests in mind (seen as an element of the broader public interest), which is to be furthered by due performance of the contract. Accordingly, the cost-effectiveness of a contract amendment must be appraised on a case-by-case basis, taking into account all the circumstances relevant to the contracting authority's interest and all the scenarios likely to unfold in the perceived circumstances. Examples of such scenarios include a contractor declaring bankruptcy, rescission of a contract for reason of the contractor ceasing to perform it, and situations when the procurement procedure must be repeated. Circumstances such as these can in the final analysis substantially increase the cost of carrying out a given project.

However, as has been emphasized, when scenarios likely to come to pass in certain circumstances are reviewed, it may transpire that a refusal to increase a contractor’s remuneration in a situation warranting contract amendment would in fact qualify as mismanagement, especially when the contractor is in a position, if only potentially, to successfully seek an increase in remuneration under rebus sic stantibus clauses in its contract.

This position is important when one considers that contracting authorities are wary of taking any action that might expose them to charges of mismanagement. In practice, contracts are amended and contractors’ remuneration increased only once this is sanctioned by a valid court ruling. Meanwhile, the PGRP has made it very clear that groundless refusal to modify (increase) remuneration due to a contractor may also constitute an instance of mismanagement. Hence, if the tests for an increase in remuneration are met, a refusal to conclude the relevant annex to the contract or the mere exposure to high litigation costs would be interpreted in terms of mismanagement.

4. Settlement

It is important to note that what we are dealing with here is a mechanism similar to the one we see when public finance entities seek settlements in disputes concerning the performance of public procurement contracts.

Article 594(3) of the PPL provides that Article 54a of the Public Finance Act applies, the latter requiring provisions of the Public Finance Act to be applied directly to settlements concerning remuneration due under civil law agreements entered into by public finance entities. What can be inferred from the latter regulation is that public finance entities may enter into settlements in disputes over amounts due under civil law agreements if they conclude that the consequences the settlement is likely to have for that entity, the State Treasury or the relevant local government authority, as the case may be, are preferable to the likely consequences of court or arbitration proceedings.

As can be seen from the explanatory memorandum to the law adding Article 54a to the Public Finance Act, the legislator created an explicit legal basis for public entities to enter into settlements, having realized that no such powers have specifically been provided for in the public funds management system. The main intention underlying this amendment of the law was to allay the concerns of contracting authorities that they could face liability for breach of public finance discipline if they opt for an amicable resolution of a dispute — concerns that in practice often hold contracting authorities back from seeking settlements. At the same time, the legislator wanted to encourage public entities to act more rationally, "as do private entities which enjoy the actual power to choose how to end a dispute (whether through litigation or amicable settlement) after reviewing all the likely consequences, not only legal, but also economic.”.

In order to conclude a settlement, the contracting authority must review each specific case, taking into account all the attendant circumstances (in particular the legitimacy of the disputed demands, the feasibility of satisfying them, the likely outcome of the dispute, and the expected duration and costs of court or arbitration proceedings), focusing primarily on whether or not the consequences of the settlement are beneficial for itself (or the State Treasury or local government authority, as the case may be).

While in practice the contracting authorities continue to be wary of settlements with contractors, the application of Article 54a of the Public Finance Act serves to safeguard the basic principles of public spending, including the principle of purposeful and frugal spending. As noted in the literature, exclusive reliance on just the overriding criterion of conformity with the law (legality) is often likely to lead to situations that will be perceived as irrational or inconsistent with the requirements of frugal economy.

Consequently, if sufficient reasons exist for a settlement, the contracting authority's refusal to settle may be seen as a violation of these principles, a point already made in an earlier position published by the GCRP. This view was reiterated in the opinion on contracts indexation when the PGRP pointed out that the conclusion of a settlement in a dispute over the contractor's demand may be considered — in the circumstances set out in Article 54a of the Public Finance Act — as not only permissible but indeed called for in light of the principles of public funds management, and especially in light of the principle of purposefulness and efficiency of spending.

5. Public finance discipline

However, what makes the possibility of concluding a settlement agreement different from the possibility of amending ('indexing') public procurement contracts is the explicit indication of the legal basis according to which the execution of a binding settlement of a disputed civil law receivable does not constitute a breach of public finance discipline.

As already mentioned, in this case a settlement is admissible if a written appraisal is provided confirming the positive consequences thereof. At the same time, it is equally important for this appraisal to be of sufficient ‘quality,’ by which is meant here compliance with the due diligence standard. If this quality is achieved, culpability is excluded, which in turn means that no one will be held liable for a breach of public finance discipline. Thus, if the appraisal of the consequences of the settlement is performed with due diligence, the contracting authority has no reason to fear any charges of a breach of public finance discipline.

Turning now to economic prudence in the context of permissible indexation of public procurement contracts, it must be pointed out — relying on the case law of the Main Adjudication Committee [Główna Komisja Orzekająca] reviewing cases of public finance discipline breaches — that actions cannot be reviewed from the viewpoint of breaches of public finance discipline based on the general regulation governing the principle of operation, because in this kind of review actions are not appraised in terms of their purposefulness of from the point of view of economic prudence. The Adjudication Committee lacks the powers to consider actions taken by the alleged offender in terms other than culpability, for example from the viewpoint of economic prudence or purposefulness. Reviews of the latter kind remain within the purview of Regional Boards of Account [Regionalne Izby Obrachunkowe]. Thus, assessments as to whether a particular contract amendment was or was not done in a manner consistent with economic prudence do not belong in procedures to determine liability for breaches of public finance discipline.

It would therefore appear that in this case entities may be held liable for breaches of state financial governance rules resulting from contract indexations under Article 17(6) of the ABPFD, which stipulates that an amendment to a public procurement contract made in violation of public procurement regulations represents a breach of public finance discipline. That said, an offense of this kind will have been committed if the authorized person undertaking it effectively amends the concluded contract and the amendment is of a material nature, as referred to in Article 454 of the PPL.

However, as follows from the position taken by GCRP in the mentioned opinion, in order to properly perform a contract as intended where external circumstances arise that were not originally anticipated, the contracting authority may amend the contract as necessary under Article 455(1)(4) of the PPL (or the equivalent article in the previous version of the PPL) which provides for an exception to the prohibition on making material amendments to public procurement contracts under Article 454 of the PPL. Thus, Article 17(6) of the ABPFD will not apply in this case.

6. Summary

Contracting authorities, as bodies of public administration, significantly impact the operation of the country’s economic system. Their actions should be marked by a high degree of economic prudence, such attitude requiring a broad perspective to be taken, extending to considerations of rationality and purposefulness.

Developments impacting economic processes in a major way that were not foreseeable in the award of contract stage (such as an armed conflict or pandemic breaking out) and therefore cannot be considered ordinary contractual risks, warrant remuneration indexation. Such indexation is often justified and in fact may be a downright must in light of the law since, as the GCRP pointed out, a refusal to increase the contractor’s remuneration in a situation where contract amendment is admissible amounts to mismanagement.

In view of this, the position expressed by GCRP must be seen as important. What follows from it is that not only improper spending of public funds may be deemed economic imprudence (mismanagement), but also an unjustified refusal to amend a contract where grounds exist for amendment. It is to be hoped that this approach will go a long way to alleviating the concerns of contracting authorities that remuneration increases will automatically trigger allegations of economic imprudence (mismanagement) and persuade more of their number to take advantage of the available indexation mechanisms.

By Dominika Markowicz, Associate, Dentons

Poland Knowledge Partner

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