Risky Business | Article

Negotiating the Minefield of Liability

Man at computer with crash helmetAn up-and-growing suburban community decides it has outgrown its wastewater treatment plant. A reliable private-sector firm is chosen to design, build and operate a new one. A year after the plant is completed and operating, hundreds of cases of people getting viral infections from contaminated drinking water crop up. One person actually dies. Who is to blame?

The above situation is a hypothetical one, but the issue of how liability is addressed in an outsourcing agreement is very real. The ultimate goal of any outsourcing arrangement is mutual satisfaction. The outsourcing entity hopes to acquire a higher level of performance in a particular aspect of its business that was not attainable in the past and be cost effective while doing so. The outsourcer leverages its expertise and economies of scale in the hopes of meeting the client’s expectations and making a profit in the process. But it doesn’t always work out that way.

Government outsourcing can be as risky as a high-wire act. Entrusted with the enormous responsibility of properly dispensing millions of taxpayers’ dollars, the government agent must take every opportunity to be as cost-effective as possible in supplying services. All this must be accomplished in an environment full of politics.

In outsourcing, risk is measured in terms of liability. Adrian Moore, who tracks government outsourcing for the Reason Public Policy Institute, says that when a government agency is contemplating outsourcing, it must consider how it will indemnify itself against whatever risks or liabilities that are associated with it: blown deadlines; shoddy workmanship; poor service; breach of the public trust.

Liability and the RFP

Moore sees a couple of big issues that must be addressed at the outset of any public-private partnership. First is the request for proposal, or RFP. He says that government agencies too often complete this initial phase of a potential outsourcing relationship without addressing liability. “They wait until they’ve selected a vendor and then the subject comes up,” Moore explains. “And that’s a mistake because sometimes the vendor is not willing to accept the risk you want them to.” If the vendor refuses to indemnify the project to the satisfaction of the client, the client may have to resort to dealing with its second choice, wasting valuable time and energy in the process. Clearly a best practice would be to get indemnification against risk spelled out in the RFP, which would obviate any potential disputes between client and outsourcer.

Secondly, many government agencies are not experienced enough to accurately define and quantify risk. Government personnel typically are not trained in risk assessment. They do not work in the world where the various instruments of managing liability—letters of credit, different kinds of insurances, and corporate guarantees, for instance—are common. “They are just not familiar with these methods,” Moore says. “You talk to most public-sector contract managers and they think of liquated damages and performance bonds. Those are the two mechanisms that everyone in the public sector is familiar with. But there’s actually a whole host of mechanisms that are used out there in the private sector that governments don’t know about or understand.” In most cases, a consultant may be hired to provide the needed expertise.

Using the Proper Tool Properly

Though a public-private partnership may be worth hundreds of millions of dollars, there is more than just economics at stake—the well being of hundreds of thousands of citizens may also be at risk. Governments need to shield themselves from being held liable for undesirable results that can be traced back to the private sector partner. According to Moore, among the three types of liability-protection instruments mentioned above—letters of credit, insurance, and corporate guarantees—corporate guarantees seem to be the most popular. With a corporate guarantee, the government agency is indemnified against liability by the outsourcer’s financial net worth (or balance sheet) rather than just the value of the project. Therefore, governments tend to favor the companies with greater net worth, a kind of “bigger is better” philosophy. For example, if the project is to build and operate a $50 million sewage plant, the $3 billion company would probably get the bid over the $500 million company. However, Moore is critical of this type of logic. “Governments will want the $3 billion company instead of the $500 million company even if, on a lot of other measures—performance history, better bid, better customer satisfaction rating—the smaller company looks better.” The reason for such an approach is usually political. Within city or state governments, a huge corporate guarantee is an excellent selling point in winning support to get a project privatized.

Deciding Who Does What

The nature of the outsourcing agreement between municipality and private company can have a huge impact on how to determine liability should something go awry. Let’s say the city enters into a DBO (design, build, operate) agreement with a company to replace its sewage facility. The outsourcer is responsible for everything having to do with the new plant, including maintenance (if enough money is built into the contract). If anything goes wrong at any time, from design to construction to operation, the private company is liable, pure and simple. However, if the city decides it only needs to outsource the operation of the plant, things can get sticky. The city may have a budget crunch and need to cut costs by decreasing maintenance of the equipment in the sewage plant. As a result, the pumps begin to malfunction and the plant starts operating at a substandard level. Eventually public outcry about river contamination leads to an EPA inspection and, subsequently, a huge fine is levied against the city for environmental violations. Does the agreement adequately address who is responsible?

Privatization of government operations can be a very complex issue. It takes critical analysis to figure out what the risks are and come up with an effective means of managing those risks so that neither party is liable for incidents outside of their control.

Lessons from the Outsourcing Primer:

  • Good risk management starts with governments requiring that private sector bidders address the issue of liability in the RFP.
  • The company that offers the largest guarantee may not necessarily be the best choice for the job.
  • Critical risk analyses should adequately protect governments from risks they cannot control.


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