By Constance Hornig

Consolidation among private-sector waste haulers has left many local governments' MSW revenue base dependant on one or two major companies. Communities have been disappointed to find that performance bonds did not provide timely or full recompense. If their haulers declare bankruptcy, the communities might be stranded as an unsecured creditor. This article discusses how to avert and remedy haulers' credit risks to better ensure stable cash flow and consistent and reliable MSW services.

Performance Bond Caveats: Don't Secure Illusory Protection

Performance bonds have become notoriously difficult to liquidate, seldom if ever providing timely cash flow due to surety contest or their preference for substituting performance rather than paying money.

1. Size the cash flow to cover your fees as well as substitute service costs and reprocurement. Often performance bonds are not sized logically, but comparatively, by looking at requirements in other municipalities' contracts or solid waste codes. However, such loose comparisons could result in overbonding or underbonding since it is not apparent from the face of a contract agreement or code text what the gross rates are or how long it would take the other community to replace a defaulting hauler.

A more logical basis for sizing the performance bond requires at least three steps:

• Determine the amount of average monthly service costs and franchise, administrative, or other fees.
• Estimate how long it would take for a new substitute hauler to take over services of the nonperforming hauler. Ask: How long does it take under provisions of the collection contract (i) for municipality to perform service or (ii) for breach to ripen into default, and noticed default to allow termination?
• Project the costs that municipality would incur to enforce the terms of the contract (or terminate it) and reprocure substitute services.

The sums of these amounts arguably should be covered by a performance bond, if the hauler collects rates and charges.

(1) Substitute service costs. But if you, the municipality—not the hauler—collect the rates for service, you have the cash flow to hire a substitute hauler. You would not need to draw on the performance bond to pay the substitute hauler. (However, you must do a cash-flow analysis under your contract, taking into consideration, for example, whether contractor is compensated in arrears or in advance and whether you have the right to offset substitute service costs from amounts owed contractor.) You could consequently downsize the performance bond.

(2) Lost franchise, contract administration, and other solid waste fees. Although municipalities often justify procuring a performance bond to protect themselves against lost fee revenues in event of contractor default, it is not clear that performance bonds would cover that loss.

For example, franchise fees are conceptually an obligation paid by the franchisee for the privilege of conducting the franchised business, and they are payable from revenues and receipts of the franchisee. They are not obligations of the customer. If a hauler defaulted and the municipality consequently did not pay the hauler, then there would be no receipts or revenues upon which to pay the franchise fee. Performance bonds only cover contractual obligations. If the hauler owed no money under its franchise agreement, arguably the performance bond would not cover the loss.

As another example, if customer fees that the hauler collects on your behalf are commingled with hauler's money, they might be frozen by the hauler's trustee in bankruptcy. Worse, the trustee could "claw back" as preferences fees paid to you during the 180 days preceding the bankruptcy.

Consequently, if the hauler collects fees, try to secure a flow of funds whereby the hauler must deposit those fees separately in an account held in trust for your benefit.

In addition, provide in your collection contracts for compensatory damages payable in event of default in an amount equal to the franchise and other fees payable during the preceding 180 days. That contractual obligation would then be payable from performance bond proceeds.

(3) Reprocurement Costs. You can draw upon a performance bond to get reimbursement of the your costs of reprocuring a contract terminated for contractor default and for incremental substitute service costs, only if the contract obligates the contractor to pay those reimbursements. These reprocurement reimbursements should be structured as compensatory damages payable upon termination. (And of course these payment obligations should be specifically stated to survive the termination of the contract.)

2. Secure the most advantageous form of performance bond. Sureties naturally prefer bond forms that give them defenses. Propose your own (for example, the AIA form).

Municipalities generally find it more acceptable to allow a substitute general contractor to complete construction and equipping in accordance with clear and specific plans and specifications than it is to have a substitute operations contractor provide service over a term of years . . . even a decade. You might have chosen an original contractor that meets you standards of environmental good citizen, diversion ethics, lack of litigiousness . . . or that is not vertically integrated and therefore is not in direct competition with the your own solid waste facilities or service contracts. The surety might not have the same criteria. Don't approve a bond form that gives the surety the right to take over performance. The surety might even take over the job and use the defaulting contractor!

Require a form of bond that gives you the option of option reprocuring the work and drawing on the performance bond for the excess cost.

3. Consider a letter of credit in lieu of performance bond. In addition to downsizing the performance bond to reflect your ability to apply municipality-collected rates, you might consider switching from a performance bond to a letter of credit for the balance of reimbursement costs, such as lost franchise fees, reprocurement, or incremental substitute service costs.

Performance bonds best back construction and equipping contracts, not service agreements. Bond sureties prefer to provide substitute contractors and complete performance rather than pay out money. (The surety "blow the bond penalty"—i.e., the monetary amount of the bond—and the bond agent may lose his commission applied by the surety from a halfback account.) But anecdotally, many county counsel, city attorneys, and risk managers report that liquidating performance bonds is slow and fraught with argument.

Haulers dislike letters of credit because they may have to disclose them as a contingent liability on their financial statements. They often allege that the cost of securing a letter of credit is greater than the cost of securing a comparable amount of performance bond. But by downsizing the bond amount, the cost of the letter of credit may nevertheless be less than the cost of procuring a larger-size bond, and it is more liquid. A letter of credit would likely provide more immediate cash, especially if you control the draw. The municipality could get money and argue later whether or not the draw was justified by contractor default.

Hauler Billing Caveats: Don't Become an Unsecured Creditor in Event of Hauler Bankruptcy

There are several disadvantages of allowing the hauler to bill customers (and conversely, there are corresponding advantages to providing municipal billing). Disadvantages include the following:

(1) You might lose control of the purse strings. If you collect the money and pay the hauler service fees, you can offset damages or other amounts the hauler owes you. This becomes increasingly valuable as state-of-the art collection contracts and franchises include lists of liquidated damages for service breaches (missed collection, collection outside of permitted hours, failure to timely submit reports, and so on).

(2) You are forced to rely on third-party instruments (e.g., performance bonds) to fund service in event of hauler default. If you don't collect the money, you don't have ready cash flow to hire secure substitute service if your contract hauler is subject to strikes, labor slow-downs, or just general defaults. Waste is putrescible, and you need fast solutions. Liquidating performance bonds is not a quick fix.

(3) If the hauler becomes bankrupt, you might lose funds. Not only the money that the hauler has collected from customers to compensate the hauler its service costs but also any fees that it has collected on your behalf would become part of an estate in bankruptcy. You might be in the position of an unsecured creditor.

(4) You might expend significant costs to audit hauler financial records. If the hauler collects rates, you might find it necessary to incur the expense of auditing its financial records to ensure that it is properly billing customers in accordance with contracted or regulated rates and that it is properly remitting fees payable to you. (For example, franchise fees may be payable as a percentage of gross receipts, which must be verified. This can be onerous where a hauler's routes and records commingle your residents and businesses on which hauler owes you fees with other jurisdictions'.)

Municipal billing: The municipality can hire the hauler as a billing agent. You might provide for billing as part of property-tax assessments, in conjunction with invoicing other utilities, or with your own billing staff. But to secure the advantages of direct billing, you do not necessarily have to hire municipal employees. You can hire your hauler to be your billing agent.

Variations on billing service exist. The hauler might keep customer subscription and service records and provide you merely with invoicing data. Or it might provide a third-party billing contractor, such as a water utility, with the data. (The hauler also handles customer complaints.) Or it might also send out bills and record receipts but forward customers' checks to you for deposit.

Parent Guaranties & Financial Covenants Caveats: Support Indemnifications With Financial Creditworthiness Tests

You want assurance that your contractors have access to sufficient capital to fully and timely perform contracted services, pay damages in the event of contract breach, and honor indemnification covenants. In particular, indemnities are worth only as much as the contractors' applicable insurance coverage and available credit. In evaluating indemnities' worth, your must try to ascertain the likelihood that your contractor will be able to fund the indemnity from either insurance proceeds or cash.

In instances of underinsurance or lack of insurance coverage, contractors' creditworthiness or financial strength (or that of a guarantor—perhaps its parent corporation—which guaranties the subsidiary services provider's service), if and when called upon to fund the indemnity, increases in importance.

But frequently large contractors required to provide parent guaranties offer the guaranty of a regional company and not the ultimate parent or holding company that is rated and files its audited financial statements with the SEC. Make certain that you know the financial strength or your guarantor.

And consider establishing financial tests to ensure that your guarantor remains creditworthy throughout the term of your contract. This is an area where municipalities are breaking new ground. Lenders and banks providing letters of credit, by contrast, routinely require borrowers to maintain certain levels of financial creditworthiness, measured, for example, by financial ratios. Municipalities to date generally have not required similar tests, either for dearth of financial sophistication or lack of funding necessary for that contract development, oversight, and administration. An alternative, simpler requirement for large companies might be maintaining specified bond ratings on their debt.

In summary, consider direct billing either yourself, through a third-party contractor such as a utility company, or through hiring your hauler. Thereby control the purse strings through offset rights, reduce the size of your performance bond, and preserve your fees in event of contractor bankruptcy. Better yet, secure a letter of credit in lieu of a performance bond. If you do rely on a performance bond, review the surety's defense rights and ensure that it cannot substitute contractors. Only accept a parent guarantor with audited financial statements. Impose financial tests to ensure continuing creditworthiness.

Constance Hornig, Esq., heads her own law firm in Los Angeles, CA. Janet Martin, senior director in the public finance department of Fitch Ratings in New York, NY, contributed to this article.

MSW - September/October 2003