The O&M Agreement

Dan Elias, Esq.
abridged from article in ICMA

The O&M Agreement is an integral part of every public/private partnership structure including a concession/lease type structure, the sale of municipal assets or just simply the operation and maintenance of a municipal system by a private operator.

The O&M Agreement must address a variety of complex issues, including but not limited to:

  • asset management maintenance and care,
  • the municipality’s concern over the apparent loss of control over the privatized system,
  • the potential impact on the existing labor force,
  • continued regulatory compliance in the face of changing regulations,
  • compliance with the provisions of the Internal Revenue Code,
  • compliance with USEPA guidelines governing public/private partnerships, etc.

In order to ensure the success of the public/private partnership the O&M Agreement should

  • Allocate risks among the public and private partners in an efficient manner.
  • Ensure the provision of quality service by the system operator throughout the term of the agreement.
  • Provide an efficient framework for addressing changes that will inevitably occur during the term of the agreement.

There are common risks to every public/private partnership, whether such partnership involves the construction of new facilities, or just simply the privatization of existing facilities either through a concession/lease type arrangement, the sale of municipal assets or the operation of municipal facilities by a private firm. Investment bankers and project lenders typically group these risks into the following categories:

Permit Risks – Who is responsible for obtaining and maintaining permits, including:

  • Construction Permit
  • Operations Permit

Design and Technology Risks – Who is responsible for design and/or technology flaws?

Construction Risk – Who is responsible for completing construction activities according to plans, within budget and on time?

Operations Risk – Who is responsible for the day to day operation of the system?

Economic/Financial Risks – Is there and will there be a sufficient income stream to pay for all expenses and debt service?

Force Majeure (casualty and business interruption) – Insurance proceeds can provide the funds necessary to rebuild. However, is it possible and necessary to insure the expected income stream derived from operations?

The O&M Agreement

As stated above, the O&M Agreement must address a variety of complex issues. The following is a summary of the salient terms that should be included in each such agreement.

Agreement Term – consideration should be given to the correlation between the term of the agreement and the contract price. A longer term allows the contract operator to amortize the costs associated with the procurement of the agreement, any concession fees paid, capital investments made or to be made, costs associated with the transition of the existing labor force, etc. over a longer period of time.

In addition, to the extent that the privatized system has been financed through the sale of non-private activity tax exempt bonds which remain outstanding, or should the parties have any plans to finance any additional capital improvements through the sale of non-private activity tax exempt obligations, the Internal Revenue Code’s safe harbor provisions for qualified management contracts should be considered. These provisions limit the term of the agreement and have different impacts on the fee structure depending on the term of the agreement.

Early Termination Option A municipality may bargain for an early termination option. This early termination option may be used as tool to terminate the private operator as a result of unsatisfactory service without requiring the municipality to allege and prove a default. It may also be used as a tool to maintain a competitive price. The parties may also wish to negotiate a limited guaranteed term so that the contract could not be terminated without cause prior to that time.

Scope of Services – This provision should specify whether operator is to provide all labor, tools, equipment, consumables and utilities, or simply just labor (or maybe even just management services in the form of a project supervisor) in connection with any or with all of the following services:

  • The operation and maintenance of the privatized system (including the operation and maintenance of all distribution and/or collection systems).
  • Billing, collection and customer service functions.
  • Industrial Pre-treatment Program management.
  • Street Department operations or any other operations handled by the Department of Public Works.
  • Management of any Capital Improvement Programs and/or the design and construction of any capital improvements.
  • System studies and analyses such as line televising work, inflow and infiltration studies, etc.

Use of Existing Tools and Equipment – A typical O&M Agreement should allow the operator to use all existing tools, equipment and vehicles dedicated by the municipality for the operation and maintenance of the privatized system. In turn, the operator should agree to return all such equipment in good condition with normal wear and tear excepted.

Performance Guarantees – An operator should guarantee compliance with all applicable laws, including without limitation, all existing permits, environmental, health and safety regulations. Performance guarantees may include specific odor guarantees. However, such performance guarantees are typically subject to the following limitations:

  • The design and physical capabilities of the privatized system.
  • The failure of the municipality to update and enforce its Industrial Pre-treatment Program in compliance with applicable law.
  • The delivery and/or acceptance of untreatable water and/or wastewater at any of the system facilities given the physical and/or design constraints of the facilities despite the operator’s reasonable treatment efforts.
  • The occurrence of any disabling event beyond the reasonable control of the operator, such as extreme weather conditions.
  • A change in law including, a change in any of the existing permits, or a change in any applicable environmental, health and/or safety regulation. To the extent that the municipality retains ownership rights to the privatized system or is the sole user of the system, the municipality should be responsible for the payment for all costs including capital expenditures and increased operations and maintenance expenses necessary to comply with the change of law.

Inspection and Review – It is typical for the operator to provide the municipality with monthly and annual operating reports in sufficient detail so as to enable the municipality to evaluate the operator’s performance under the O&M Agreement. In addition, the municipality should have the right to inspect any of the system facilities and audit operator’s records at any time upon reasonable notice.

Maintenance Functions and Expenses – The operator’s maintenance responsibilities typically include all preventive and predictive maintenance functions in compliance with manufacturers’ instructions for service and care and in conformity with good engineering practice. Maintenance functions should also include groundskeeping, cleaning of buildings and equipment and landscaping.

The distinction between the repair and replacement of equipment and capital expenditures for which cost the municipality is typically responsible (as the owner and/or sole user of the privatized system) is in many agreements arbitrary and vague. The distinction is made based on the consideration of such factors including cost, the extension of service life, etc.

Base Operating Fee – The O&M Agreement should clearly delineate the list of services included in the base fee. It is also common to adjust the base fee on an annual basis to account for inflation. Payments are typically made in equal monthly installments either in advance or in arrears.

Permits and Permit Renewals – It is typically the system’s owner (i.e. typically, the municipality) that bears ultimate responsibility for procuring and maintaining the permits necessary to allow for the operation of the system. Most O&M Agreements provide for the operator’s assistance in the procurement and renewal process.

It is important to note a recent trend requiring system operators to be named as additional permit holders. I have negotiated several agreements where the municipality insisted on naming the private operator as an additional permit holder on the municipal NPDES permit. I believe that the desire to include the system operator as a permit holder is mostly symbolic. This is true because in many jurisdictions an operator is legally accountable for permit violations whether or not the operator is named as a permit holder. In fact, in many jurisdictions the definition of the "owner" of a system includes an operator for environmental compliance purposes.

Other Fees and Expenses – As the privatized system’s owner and/or sole user, it is typical and customary for the municipality to reimburse the operator for the costs associated with the following:

  • Capital improvement programs;
  • additional capital expenditures and operating expenses necessitated by change of law, the occurrence of any disabling event, or a casualty; and
  • Additional capital expenditures and operating expenses necessitated as a result of changes in baseline conditions (including changes in baseline flows and/or loads) or incurred as a result of a requested addition to the scope of services.

All such additional fees typically include a predetermined percentage allocation towards the operator’s overhead and profit.

Compliance with Tax Regulations – To the extent that the privatized system has been financed through non-private activity tax exempt obligations, the O&M Agreement must meet the threshold of the safe harbor provisions for qualified management contracts. These provisions vary with the term of the contract and allow for a term of up to 20 years. For example, with respect to a 20 year agreement the Internal Revenue Code provides the following:

  • The term of the Agreement cannot exceed a period of time longer than either twenty (20) years or eighty percent (80%) of the useful life of the system; and
  • Eighty percent (80%) of the annual fees to be paid under the Agreement must be in the form of fixed fees. It is important to note, however, that costs incurred by the operator as a result of the occurrence of any of the events specified in Section 10 above (excluding any profits derived by the operator) which are paid by the municipality will generally not be considered as a part of the variable cost portion of the annual fee.

EPA Privatization Guidelines – Generally speaking, the privatization of any system that has been financed in whole or in part through a grant program or through a revolving fund loan program may require USEPA approval to the extent that the agreement involves a lease/concession type payment or the sale of assets. The USEPA review is primarily focused on the financial impact caused by the privatization effort on the system’s ratepayers.

Existing Labor – This is probably the most difficult issue to address. There is not a single answer that will fit every situation and I do not profess to have a solution. In negotiating this issue, the parties should recognize the costs of maintaining staff levels and benefits, recognizing a collective bargaining agreement and/or requiring the operator to negotiate a new agreement with the local union.

Indemnification – Typically, an O&M Agreement will require the operator to indemnify the municipality for breach of agreement and for operator’s negligence. On occasion, the municipality is asked to provide a reciprocal indemnity

Default and Termination for Default – The O&M Agreement should provide each party with a termination right as a result of the other party’s breach following notice and a reasonable opportunity to cure. In addition, it is typical to include a provision that a party shall not be terminated for default so long as such party is continuing to take diligent steps to cure the default provided, however, that the default is ultimately cured within a specific set maximum period of time.

Termination for Uncontrollable Circumstances – Either party should have the right to terminate the agreement if its’ purpose has been frustrated as a result of a casualty or other natural disasters provided that the system is not and could not be re-built within a reasonable period of time..

Insurance – The operator should be required to maintain, at a minimum, general liability, automobile liability and workers’ compensation insurance and name the municipality as an additional insured and certificate holder. The municipality should also consider whether an errors and omissions policy or pollution liability policy is appropriate. The municipality, if it remains the owner of the privatized system, should maintain all property and structures liability insurance, flood and fire insurance including coverage for vandalism and malicious mischief for the insurable value of the system.

Performance Bonds, Payment Bonds, Project Guarantees, Letters of Credit – The municipality should insure the financial and contractual ability of the operator to faithfully discharge its obligations, especially if the operator is a special purpose entity formed specifically for the underlying project. However, due consideration should be accorded to the costs associated with such requirements. Due consideration should also be provided to the liquidity of any guarantee instrument furnished by the operator. For example, a performance bond will typically cost a worthy entity anywhere between 0.25% - 0.75% of the face amount of the bond annually. In comparison, a letter of credit may require the operator to maintain a line of credit with the issuing bank at some fixed annual cost plus pay for the cost for maintaining the letter of credit itself (for a total average of anywhere between 2% - 5% per annum).

Disputes – Disputes requiring the exercise of engineering judgement and involving an amount, if any, below a certain threshold should be resolved either by arbitration or by an impartial panel of engineers. All other disputes that cannot be resolved by the parties can and should be prosecuted before the appropriate State or Federal Court.

I add a word of caution on the enforceability of an arbitration clause in this context. In a recent case litigated by my staff, a municipality was able to obtain injunctive relief and to stay the arbitration process. The municipality was able to successfully argue that the issues arising under my client’s O&M Agreement directly related to public health and welfare. The municipality further argued that, as a matter of law, such issues should not be resolved by arbitration.

Dan Elias

Dan Elias is a practicing attorney who specializes in project finance and in structuring and negotiating public/private partnerships. His specific areas of expertise include counseling municipal and industrial clients on a variety of project agreements, including deign/build construction agreements, solid waste/sludge hauling and disposal agreements and management agreements for the operation and maintenance of water, wastewater, solid waste and waste-to-energy facilities.

Dan Elias, Esq.
411 Theodore Fremd Ave.
Suite 102
Rye, NY  10580

phone: 914-925-0000
fax:      914-925-9344