By Constance Hornig

This is the second in a series of articles that identify issues frequently raised in negotiating and drafting MSW service contracts. Collectively these articles will constitute a practical contracts manual that describes approaches that MSW service providers and local governments can take to share risk and reward - and reach a mutually satisfactory agreement. (To read our first article please click here.)

Liquidated Damages or Performance-Based Compensation?
Liquidated damages express the understandable desire for performance accountability and contract enforcement flexibility. Often I hear local governments' MSW administration staff express desire to assess "penalties" on their contractors for underperformance or contract breaches. In collection contracting, customer-service problems, such as missed collection, noise, and litter, rank high on their list of accountability (e.g., for each failure over 15 instances in a calendar year to pick up refuse on the regulatory scheduled collection day: $25). In a landfill operating agreement, it might be contractors garnering many notices of violation from a regulatory agency. In a recyclables processing agreement, it might be high residue levels. Not only is it understandable to want accountability, it is practical, realistic, and flexible to craft remedies short of the most drastic one - contract termination, which is likely to be subject to expensive contest in court or arbitration.

But liquidated damages cannot penalize the contractor. But you cannot penalize a contractor in the context of a contract, where the local government is acting like a private party in reaching an agreement with another private party. You can only impose fines and penalties in the context of regulation, such as a solid waste ordinance or chapter of the local municipal code, where the local government is wearing its regulatory hat. Furthermore, regulation usually prescribes protocols of proof, hearing, and contest rights to determine breach or violation of code or ordinance and assessment of fines or penalties.

Liquidated damages, which express contract parties' best guesstimate as to amounts of damages at the time they execute their agreement, often are challenged by a contractor as tantamount to penalties that are void and unenforceable. You might have noticed long prefatory language justifying liquidated damage provisions that recite why it is difficult to quantify those damages and therefore justifiable to project or estimate them in advance and asserting that they are not penalties.

In lieu of liquidated damages, consider performance-based compensation. From a local government's perspective, penalties or liquidated damages generally are not intended to raise money for the public fisc but rather to grab the contractor's attention and focus it on remedying a service problem. And of course money is one of the quickest and surest ways of ensuring attention. This can be achieved not only through assessing liquidated damages payable out of the contractor's pocket but also by structuring an increase (bonus) or decrease (fee reduction) in contractor's compensation, payable out of customers' rates or the local government's MSW program budget (e.g., a landfill operator's compensation might increase if it keeps notices of violation for litter beneath specified, stepped occurrences each calendar year; a hauler's compensation might be decreased for each failure over specified instances in a calendar year to pick up refuse on the regularly scheduled collection day). Performance-based compensation might circumvent potential challenges to liquidated damages, claiming they are void and unenforceable as penalties.

Some Control and Structuring Considerations
Whether you choose damages or fee reductions, control the purse strings. If you pay your haul contractor from rates collected on your utility bill or collected through property taxes or if you compensate a facility operator from tipping fees, then you control the purse strings and can either pay bonuses or offset compensation reductions/liquidated damages. Of course, you must carefully draft your budget to anticipate the maximum possible bonus payments in excess of the MSW administrative and other program costs you are obligated to fund. (In communities where you collect franchise or other fees from your hauler, you can structure your bonuses or compensation reductions by increasing or decreasing the franchise fee that the contractor pays.)

On the other hand, if your contractor collects rates or tipping fees and compensates itself therefrom, you face the administrative challenge of ensuring that the contractor pays itself the proper bonuses or deducts the correct pay reductions/damages. You will be in a stronger position if you can access a letter of credit to pay yourself fee reductions/damages than to seek judicial enforcement - perhaps in small claims court - of a contractor's payment obligation. (To retain control of the purse strings without incurring the cost and possible bureaucratic headache of doing customer billing yourself, consider hiring your contractor to be your billing and collection agent and remit collected fees to you. You can then pay - or offset - a contractor's compensation with a check you cut payable from the rates or fees.)

Also consider the payment trigger and schedule. Especially in sole-source negotiations, contractors will naturally express worries about mismeasurement and proof of breaches (e.g., collection customers might be notorious for lying about missed collections that are really late setouts). Local governments often counter: Truth evidences itself in fact patterns (e.g., the same customer routinely calls about missed collections and that home was the sole stop omitted on a route, or an entire street was clearly missed). To reflect this uncertainty, agreements may structure the monetary damage/compensation schedule to allow for a specified number of breaches prior to assessing liquidated damages or reducing compensation (e.g., for each occurrence over five instances during any calendar year of collecting during unauthorized hours). In addition to allowing a number of initial "free" breaches, agreements may schedule initially lower amounts of damages/compensation decreases that incrementally grow with increased incidence of occurrence (e.g., for noise emissions in excess of specified levels during compaction, $50 for one to five breaches, $100 for six to 10 breaches, $200 for 11–15 breaches, and $500 for each breach in excess of 15 breaches in any calendar year).

When establishing the amount of damages or fee reductions, consider degree of contractor control, fiscal or political stakes, and misconduct. The degree of uncertainty or contest is also relevant to setting the amount of damages/compensation reduction.

First, is the breach under a contractor's relative control, such as submitting reports and timely responding to local government correspondence? If so, in addition to allowing fewer free breaches, the levels might be set higher (e.g., failure to provide documentation for review or to obtain any approval, consent, or other permission of the local government required under the contract, including failure to timely submit general customer correspondence and promotional material, news releases, and so on: $300 for each failure per customer or each day prior to retraction or correction of misinformation identified by local government). To prevent disputes over missed collections, you might require that the contractor's driver document a failed setout by calling in the dispatcher or customer-service representative for timed recordation or to take a dated photograph.

Second, are the fiscal or political stakes high? For example, if you have a contract for processing recyclables at a particular facility, your hauler's failure to deliver collected recyclables to the designated facility might result in your incurring damages to the facility owner or paying excessive per-ton rates under a put-or-pay agreement.

Third, is the breach related to misconduct like dishonesty? For example, if you have a contract for disposing of solid waste at a particular facility, your hauler's delivery of waste collected outside the boundaries of your jurisdiction might result in your paying tipping fees for another community's waste. Commingling or inaccurately reporting waste origins might carry significant damage/compensation reduction consequences.

Paying or offsetting money invites contest, so prescribe a dispute resolution protocol. In a competitive procurement, you might be able to prescribe a protocol that allows for final resolution of a dispute by an intragovernmental official or body, such as a contractor's appeal of an MSW contract administrator's assessment to a city manager or the elected body. If you do not have the negotiating leverage to secure that relatively inexpensive protocol, nevertheless consider specifying the selection of a third party (e.g., an MSW engineer or a procurement consultant) to finally resolve the dispute. (Remember that arbitration under general American Arbitration rules is not well tailored and might be unduly expensive for resolving these disputes that could involve public health and require injunctive relief. The arbitrator is likely to be a lawyer or a retired judge with no MSW administration experience who would have to hire an MSW expert. And payment of damages/reduced compensation probably turns on facts, not issues of interpretation of contract language or law.)

Effectuate damage/compensation reduction through detailed customer- service recordkeeping and reporting requirements. Often one of the goals of contracting for MSW service rather than to provide municipal service might be to reduce public staff time and payroll. Collection contracts, for example, might obligate a hauler to compensate the local government for the direct costs plus prescribed mark-up of staff time spent on a specific complaint or complaints in the aggregate over a specified period of time. Therefore it is often the outsourcing intent that a contractor handle all complaints; ideally the local government does not have to devote resources to handling them.

But almost the entire scheme of damages/performance-based compensation is based ultimately on customer complaint and resolution. Therefore it is important that the contract not only prescribe complaint recordation but give you access to those records, either immediately on-line or at a local contractor's office. You should secure the right to audit customer records locally.

Cross-check to ensure that listed damages and compensation are tied to specified contractor performance obligations. Sometimes lists of damages/compensation (e.g., return of a cart to within 10 ft. of where it was picked up) do not relate to any prior articulated contractual performance obligation (e.g., a general obligation to pick up carts at the curb). To facilitate enforcement, make sure the damages/compensation schedule reflect breach of a specified obligation.

Over the course of a midterm to long-term agreement, adjust the amounts of damages/compensation. This is easy if your basic rates of compensation are adjusted by a consumer price index or other bundle of indices.

Reduce the Likelihood of Successful Challenges to Liquidated Damages
Because rates or tipping fees might not tolerate an incremental charge to cover bonuses or the momentum of tradition, you may choose to structure your fiscal disincentives as liquidated damages rather than reduced compensation.

Negotiate liquidated damage provisions. Bilateral negotiation by informed parties represented by counsel reduces the likelihood that courts will sustain a contractor's challenge of liquidated damage provisions. If you are renewing or extending an existing contractor or entering into a new contract with an existing contractor, you can negotiate those damages. Recite and document those negotiations. If you are procuring a new agreement through competitive procurement, you may attach the proposed form of contract to your request for proposals; proposers lose evaluative points if they take exception to the contractor provisions, including liquidated damages. (Under some bidding laws, bidders cannot take exception to the contract terms.) Although opening the proposed agreement to negotiations interjects a qualitative element into proposal evaluations, consider reserving proposers' rights to negotiate the liquidated damage provisions in order to strengthen your case against subsequent challenge.

Draft acknowledgments. Similarly, reduce risk of invalidity by documenting the parties' negotiations and consideration for the damages. For example, assert the reasons motivating the procurement (e.g., improved service quality and increased customer satisfaction) and affirm the importance of consistent and reliable services to you and customers. Chronicle the considerable time and expense incurred in procuring the contract. Cite reliance on a contractor's representations as to its experience and expertise. Assert that service breaches represent a loss of bargain. Ensure that the contractor acknowledges that quantified standards of performance are necessary and appropriate to guarantee quality, consistent, and reliable service. State that if the contractor fails to meet service obligations, you will suffer damages in subjective ways and in varying degrees of intensity that are incapable of measurement in precise monetary terms and that it is and will be impracticable and extremely difficult to ascertain and determine the value thereof. Include examples, such as customers' inconvenience, criticism, and complaint; anxiety, frustration, potential political pressure, lost elected body, and staff time; deprivation of the benefits of the agreement; and loss of bargain.

In addition, agree that if the contractor breaches the contract, urgency of protecting public health and safety may necessitate your entering into emergency or short-term arrangements for services without competitive procurement at prices substantially greater than under the existing contract, and the monetary loss resulting therefrom is impossible to quantify precisely. Further agree that remedies for breach and default, including termination, are at best a means of future correction and not necessarily remedies that make you whole for past breaches and defaults.

In sum, the parties should specifically agree that liquidated damages represent a reasonable estimate of the amount of damages, considering all of the circumstances existing on the date they entered into the contract, including the relationship of the sums to the range of harm that the local government reasonably could anticipate and anticipation that proof of actual damages would be costly or inconvenient. Conclude with confirmation like the following: "In signing this agreement, each party specifically confirms the accuracy of the statements made above and the fact that each party had ample opportunity to consult with legal counsel and obtain an explanation of this liquidated damage provision at the time that this agreement was made." Specifically recite negotiations (e.g., "Contractor and local government have negotiated this section subsequent to contractor's submission of a proposal to provide services").

Substitute compensatory damages where possible. Compensatory damages, unlike liquidated damages, require proof and quantification of loss. This involves more administrative staff time when a contractor breaches a contract and the loss is incurred but might be less subject to judicial challenge as a penalty. So, for example, if a haul contractor breaches its obligation of delivering recyclables to a processing facility, in lieu of or in addition to liquidated damages, you might prescribe compensatory damages, including reimbursement of any damages you owe to the processing facility, incremental haul and processing costs (as applicable under cost-plus-fee methodology), and your costs of securing specific performance of the delivery obligation.

In conclusion, consider substituting performance-based compensation or compensatory damages for liquidated damages to minimize possible judicial challenges by your contractor claiming that liquidated damages are unenforceable penalties. Budget and/or set rates and tipping fees to fund compensation bonuses. Pay your contractor so that you can offset damages or fee reductions. (If you do not collect rates, hire your contractor as a billing and collection agent.) Alternatively, draw on a readily accessible and liquid letter of credit. When establishing damage or compensation bonuses/damages, consider trigger, timing, and amount as they relate to contractor control and (mis)conduct and fiscal and political stakes. Prescribe as simple and inexpensive a dispute resolution procedure as possible, as well as recordkeeping and reporting requirements. If you cannot implement performance-based compensation, negotiate liquidated damage provisions where possible and make certain you recite detailed acknowledgments to support enforcement.

Attorney Constance Hornig represents local governments in MSW contract procurement.

MSW - January/February 2004