Drafting the best possible outsourcing contract

Water and wastewater plants, many of which were built in the late 1970s and early ’80s with federal grant money, are now in need of capital improvements. In many situations, improvements are necessary to bring the plants into compliance with environmental regulations that have changed over the years.

Unlike in the 1970s, however, federal funding is not readily available, and local governments are faced with the unpopular prospect of raising taxes or user fees to cover necessary upgrades. Outsourcing presents an attractive financing alternative, although it, too, has controversial aspects.

Interest in municipal outsourcing was fueled by President Bush’s 1992 Executive Order on Infrastructure Privatization and President Clinton’s 1994 Executive Order on Principles for Federal Infrastructure Investments which directed federal agencies to work with state and local governments to reduce legal and regulatory barriers to privatization.

Moreover, a recent revision to the Internal Revenue Service guidelines allows public agencies to enter into 20-year contracts with private companies for projects financed with tax-exempt bonds, an expansion from the IRS’s previous five-year limit.

Why Outsource?

Successful outsourcing is based on the premise that the private company specializing can operate municipal water and wastewater facilities more efficiently and at a lower cost than can the public entity.

This can result in reduced user fees or at least prevent significant rate increases for taxpayers.

Depending on how the deal is structured, the local government may also receive an up-front cash payment, which can be used to reduce outstanding debt or finance capital improvements in other areas of municipal operation.

Private companies argue that their experienced personnel and better access to advanced technologies result in more efficient operations and a better environmental compliance record. This is particularly attractive, not only to smaller municipalities that cannot afford high-caliber personnel or cutting-edge technologies but also to those communities with chronic compliance problems.

Economies of scale also work to the benefit of the private company. A private company managing several treatment plants has more buying power which, in turn, means better pricing on treatment chemicals, capital equipment and supplies. Additionally, the municipality may realize a cost savings associated with a reduction in personnel. For instance, when Indianapolis, Ind., contracted out operation of its treatment plant in 1993, the total number of employees was reduced from 322 to 196.

Risks involved

Still, although work force reduction may be attractive when balancing a budget, it is a significant labor issue. Municipalities considering outsourcing should be prepared to address this issue on several different fronts, giving thought to political ramifications, labor negotiations and the outsourcing contract itself.

Outsourcing may also result in the loss of some level of services. For example, do municipal treatment plant employees serve as technical experts for the government on environmental issues? Do they provide consulting or educational services to treatment plant dischargers? Do they provide any type of disaster or emergency response function or assist in snow removal? Will the private company continue these roles? Will these services be lost? Will employees be summarily fired or kept on, thereby reducing the perceived benefits of outsourcing?

In addition, outsourcing may result in a municipality’s loss of control over its operations. A private company will likely be focused on the success of its treatment operations and may be unresponsive to the political needs – or broader needs – of the community. Outsourcing can be a viable solution for a municipality faced with increased operating costs or the need to make capital improvements, but the key is a clear understanding of the duties, responsibilities and risks assumed by each party and a contract that clearly reflects that understanding.

The Process

There are three basic outsourcing arrangements:

* A municipality may contract with a third party to operate its plant. For example, the wastewater treatment system serving Indianapolis is operated by a consortium under a contract with the city. Under an operating contract, the municipality maintains ownership of the treatment plant, but the outsourced company operates the plant. Variations on this arrangement are possible, depending on the scope of services the municipality wishes to outsource. For instance, the outsourced company may provide billing services in addition to operating the plant.

* A municipality may sell its existing treatment plant, in which case the company would both own and operate the plant. In 1995, the Miami (Ohio) Water Conservancy District closed a deal transferring both ownership and operation of its Franklin wastewater treatment plant to a private company. The asset sale was the first – and only – transaction of its kind to date. However, its apparent success may prompt more local governments to look at asset sales.

* A company may design, build, own and operate a wastewater treatment plant under a contract with a municipality. Build, Operate and Transfer contracts may contain provisions to transfer the plant back to the municipality at the end of the contract, which can exceed 20 years.

Making the right choice

Determining both short- and long-term goals is the first step in deciding whether to outsource. Then the sourcing relationship that will best achieve those goals can be identified. A clear, specific RFP should be drafted so that bids from outsourcing companies can be easily compared.

The pool of outsourcing companies should include well-established firms with significant experience in water and wastewater treatment operations as well as relative newcomers to the field. Company history, management structure, previous projects, financial information, company resources, quality assurance programs, technical expertise, personnel experience levels and relative stature in the market should be considered.

Each company’s proposal should include a discussion as to how it plans to manage the treatment system, and proposals should be compared to the stated goals and needs of the municipality.

Once the company has been chosen, a contract must be drafted that specifically sets forth the scope of services to be provided and states the responsibilities of each party. The company’s duties should be explicitly stated . Subcontracting should be avoided or limited. The contract should describe the facilities to be operated, including all major features, functions and design parameters.

Environmental Compliance

In outsourcing, local government officials are attempting primarily to reduce costs and divest themselves of environmental compliance responsibility.

Therefore, the environmental indemnification and pricing provisions of the contract are key and must be carefully negotiated and drafted.

Which party will be responsible for compliance and liable for violations must be negotiated between the parties as well as with the pertinent regulatory agency.

For example, under the federal NPDES regulations, when a plant is owned by one entity and operated by another, the operator must apply for the permit.

However, states can and do revise their regulations to require the owner to apply for the permit.

Indiana, for example, has done so. Yet, at least at present, the city of Indianapolis is listed as the NPDES permittee instead of its private partner. (The Indiana agency responsible for enforcing NPDES regulations is in the process of revising the permit and is considering listing both Indianapolis and the contract operator as co-permittee.)

Similarly, both the private owner/operator and the host municipalities are listed on the Franklin, Ohio, NPDES permit. In contrast, in Illinois, the owner is listed as permittee, regardless of the entity that is actually operating the treatment plant.

Listing the company as the sole permittee certainly achieves a municipality’s goal of distancing itself from environmental compliance responsibilities. However, state regulatory agencies have flexibility in identifying the permittee, and it is unlikely that many states will agree to a permit listing the company solely, in part because the company’s role as an operator may be transient.

Consequently, given the likelihood of continuing permit involvement, cities and counties must use a well-worded indemnification provision in the contract to protect themselves and achieve their goals.

The indemnification provision must be carefully drafted to define and cover any claims, causes of action and liabilities and losses that may arise and that have been assigned to the company. Liability for defense against actions, penalties and compliance costs related to enforcement actions should be assigned. Additionally, the local government can bargain for indemnification against its own negligence, but state law provisions limiting or striking “hold harmless” indemnity clauses that protect a party against its own negligence are sometimes ruled void.

To the extent possible, the municipality should also allocate the risk of criminal liability. Criminal liability for environmental violations is based on knowledge, which is typically defined by the courts as “general intent.” General intent means that a party knew it was dealing with a substance likely to be regulated and knew that it was discharging it. As with civil violations, the local government cannot avoid liability.

However, the contract should contemplate the possibility of criminal violations and assign responsibility for any fines or penalties.

Finally, OSHA liability should be considered. In the outsourcing context, workplace safety becomes a matter of whether the company or the local government is responsible. OSHA typically looks to the party in direct control of the workplace and the employees in determining which entity to cite for violations and will base its decision on a number of factors, including who supervises and controls the work, who is responsible for taking safety precautions at the job site and who owns the equipment. The contract, however, may allocate responsibility differently.

Pricing

Pricing is a significant contractual issue and one for which outsourcing companies are drawing fire. Some municipalities that have entered into outsourcing contracts are now finding themselves faced with unexpected capitalimprovement costs.

For instance, the outsourcing agreement may provide that capital costs over a certain level are extraordinary costs payable by the city. The outsourcing company may claim that certain costs are extraordinary costs, while the city claims that such costs are maintenance costs payable by the outsourcing company.

Hidden costs and related disputes can be avoided by clearly setting forth the pricing scheme in the contract. All contingencies and all assumptions on which the parties are relying should be stated. Improvements to be considered ongoing operation and maintenance and those to be considered extraordinary should be spelled out.

If a price increase is to be allowed over the life of the contract, or for significant changes in flow or loadings, a specific escalator clause should be included. Finally, the party responsible for utilities and other related costs must be identified.

Exercising Prudence

Outsourcing municipal wastewater treatment operations is a developing trend, touted by some as the answer to a municipality’s financing and environmental needs.

However, since most of the experience in this area is relatively recent, it is too soon to declare victory for the idea. Still, selecting the right company and drafting a contract that addresses the many environmental, pricing and technical issues can go far towards shaping the success of the process. The prudent government manager will carefully analyze local government operations, clearly define goals and proceed with the process only if its goals can truly be met by outsourcing.

Janine Landow-Esser is chair of the Environmental, Safety and Health Law Practice Group and Melissa Manuel is an attorney with Holleb & Coff, a Chicago-based law firm.