Confronting Environmental Pitfalls in Industry Downsizing and DoD Outsourcing and Privatization

Confronting Environmental Pitfalls in

Industry Downsizing and DoD Outsourcing and Privatization

James McAleese

INTRODUCTION

This article emerged from an environmental panel that I chaired at the National Security Industrial Association's (NSIA) recent Conference on Outsourcing and Privatization which was organized at the request of the Deputy Secretary of Defense. The purpose of our panel was to identify obstacles to the Department of Defense's (DoD) aggressive use of outsourcing and privatization and to propose solutions to remove such obstacles. Specifically, DoD is seeking to reduce its $93 billion annual Operations & Maintenance account to re-invest the net savings into its decimated Procurement accounts. While the majority of industry supports DoD's proposal to more aggressively use outsourcing and privatization to capture those savings, contractors face several pitfalls that must be negotiated to protect their bottom-lines while minimizing subsequent claims and disputes against the Government. In that light, Part I of this article addresses the potentially massive environmental liability which confronts contractors in any on-site outsourcing and privatization services, i.e. depot support, co-production and GOCOs, logistics, maintenance, remedial action contracting, and even generic "ash & trash" services.

Part II of this paper examines the environmental liability that contractors incur in consolidating their own facilities during discretionary downsizing or post-merger restructuring. Such remediation costs are potentially recoverable (1) as post-merger "external restructuring" costs from DoD, (2) from pre-existing insurance policies, or (3) by indemnification from the Government under a sister doctrine to the "Government Contractor Defense." Specifically, the original legislative intent for allowing contractor recoupment of post-merger restructuring costs from DoD was to leverage decimated RDT&E and Procurement accounts by maximizing contractor efficiency and utilization rates following the liquidation of underutilized facilities. That risk to the contractor's bottom line from facility closures is now being exacerbated by the current political controversy over restructuring costs as "corporate welfare" or "payoffs for layoffs." Such strong public concern to quash all appearances of corporate welfare magnifies the risk facing contractors' balance sheets. Another manifestation of such growing public concern is the almost-annual re-introduction of legislation to repeal contractor recovery for cleanup costs if the contractor is allegedly liable even in part for the contamination. Consequently, contractors face more environmental risk than ever before under either scenario of (1) on-site outsourcing and privatization, as well as (2) contractor facility closure and consolidation. In that light, this article assesses these risks and proposes "win-win" solutions to protect contractors' bottom lines while generating the critical savings that will enable DoD to recapitalize our weapons systems in today's balanced budget environment. While the original basis for this article was environmental liability in DoD outsourcing and privatization, it has been expanded to address liability across the government, e.g. Department of Energy (DoE), National Aeronautics & Space Administration (NASA), unless otherwise noted.

I. CONTRACTOR CONTAINMENT OF ENVIRONMENTAL LIABILITIES IN OUTSOURCING AND PRIVATIZATION

A. Parties must mutually clarify the government's liability for pre-existing contamination in outsourcing and privatization competitions

The Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA), 42 U.S.C. § 9601 et seq., was enacted in 1980 to empower the federal government to cleanup uncontrolled releases of hazardous substances into the environment. CERCLA established four classifications of "potentially responsible parties" (PRPs) on whom liability can be assessed for release or disposal of hazardous substances: (1) past, present and future "owners" of a contaminated facility; (2) "occupiers" at the time of a "release" or "threat of release" of a hazardous substance; (3) "arrangers" of the disposal of hazardous substances; and (4) entities that "accept" a hazardous substance for transport. From its inception, CERCLA has waived the sovereign immunity of the United States:

Each department, agency, and instrumentality of the United States (including the executive, legislative and judicial branches of government) shall be subject to, and comply with this chapter [i.e., CERCLA] in the same manner and to the same extent, both procedurally and substantively, as any nongovernmental entity . . . .

To give teeth to CERCLA, Congress imposed "strict" as well as 'joint and several" liability. This means that that all past, current and future "owners," are liable under CERCLA, regardless of whether they were responsible for the discharge, but that "operators," "arrangers," and "transporters" are liable only when they were acting in such capacity at the time of the "release" or "threat of release" of a hazardous substance. Consequently, "operators," "arrangers," and "transporters" cannot be held legally liable for pre-existing on-site contamination. Contractors must often operate on, or take possession of, federal property under outsourcing and privatization contracts prior to completion of the necessary on-site cleanup, which may require years. Unfortunately the complexity of determining when environmental liability attaches to on-site contractors is often misinterpreted by the Government and contractors alike, as meaning that the Government's blanket liability for its past and current ownership can practically and legally attach to all future contractors acting as "operators", "arrangers" and "transporters" in outsourcing and privatization contracts. Nothing could be further from the truth. When the express purpose of a contract could be for Remedial Action Contracting (RAC), the risks associated with RAC are self-evident to the contractor as the operator, arranger and transporter. But for all other non-RAC outsourcing and privatization contracts, the risk remains that an inadvertent "release" or inadvertent "threat of release" then triggers joint and several liability to all contractors which operate on the site. Because liability is strict, the burden of proof then falls on the contractor to demonstrate that it did not exacerbate the damage by additional release or "threat of release" after it began on-site operations. So, legally speaking, outsourcing and privatization contracts, operating on previously contaminated property, are technically excluded from liability for pre-existing contamination. However, as a practical matter, if DERA funds are exhausted at a site prior to cleanup being complete, the Government may order the hapless on-site contractor to conduct the remaining cleanup, with the right to sue the Government for indemnification later. So while it appears that the draft MOU will keep either DoD or DoE from precipitously passing its liability for pre-existing environmental contamination to innocent contractors subsequently operating on-site, that authority still resides with the Environmental Protection Agency (EPA) to identify "deep pocket" PRPs for the cleanup.

Consequently, the practical breadth of contractor exposure to CERCLA liability is staggering under outsourcing and privatization contracts. Further, because the statute gives only a circular definition of "operator" ("any person . . . operating such facility"), the courts have adopted an "actual control" test to determine whether "operator" liability should attach. Under that test, one contractor will be liable for contamination caused by another contractor if it exercised "substantial control" over that contractor. "Substantial control," in turn, is defined as "active involvement in the activities" of the offending corporation. Since the government does not have privity of contract with its subcontractors, only the prime contractor could qualify as having "substantial control," which effectively means that prime contractors could easily face "operator" liability for the environmental acts of their on-site subcontractors. This has obvious implications for sister contractors, Scientific, Engineering & Technical Assistance (SETA) contractors interfacing with on-site contractors, and joint venturers as well. Consequently, the allocation of pre-existing environmental liability and span-of-control for on-site operations must be negotiated with the customer in a fair and equitable manner prior to award of the outsourcing or privatization contract to minimize the probability of subsequent disputes and litigation among the contractor team.

To that end, contractors believe strongly that the government must clearly identify liability any existing contamination on the property for which the government is responsible, prior to award of outsourcing and privatization contracts. Contractors must recognize, however, that they may have to assume liability for the contamination that they themselves cause while operating on-site, while working to minimize risk that speculative "threats of release" will trigger joint and several liability for all current and pre-existing contamination. If contractors are arbitrarily forced to bear the cost of environmental cleanup for pre-existing conditions, conflict avoidance will be nearly impossible. Rather, impacted contractors will likely file claims and initiate lawsuits against the government for indemnification, as well as for compensation for delays. The implications of lost profits, lost time, needlessly expended legal fees, and dissipated customer goodwill are obvious, as hardware and service contractors are conveniently pressed into service as on-site RAC contracts while struggling to re-baseline disrupted on-site operations. All indications are that the government does not want to engage in interminable litigation with its contractors. That litigation and potential adverse judgments will inevitably diminish the widely projected 25-40% savings from outsourcing and privatization. Therefore, responsible government acknowledgment of responsibility for its pre-existing environmental liability, and contractors' vigilance in assuming responsibility only for legitimate post-takeover contamination, will enable the government to begin realizing those savings immediately. Moreover, contractors can then eliminate "pricing contingencies" that they must otherwise "bake" into their proposals as a matter of economic necessity, which will provide even greater savings for the government to bolster its Procurement accounts. Given that service contractors' profit margins are generally 7-9% on average, pre-award clarification of the government's environmental liability will effectively ensure that the contractor does not become a de facto insurance carrier for the government to off-load liability for its pre-existing environmental contamination.

Specifically, the environmental effects of the government's activities while previously on the land can be properly assessed through its environmental baseline survey. That survey should reveal much of the pre-existing contamination and many of the environmental threats that could trigger joint and several contractor liability under CERCLA. However, absent negotiated indemnification language, liability for such environmental threats and contributing contamination could still rest ultimately with the contractor under CERCLA's onerous liability standard. Thus, pre-contract indemnifications, or "global" indemnifications, must be vigilantly negotiated prior to contract execution. The parties must realize, however, that the time to conduct these global indemnifications is often lengthy because of site-specific eccentricities and complexities, such as authority of DoD, the EPA and state environmental agencies. Further, the parties must strive to accelerate their negotiations to mitigate the risk of (1) additional proposal preparation/evaluation costs, (2) lost opportunity costs, (3) retarded cashflow, (4) jeopardized financing/funding, (5) the fostering of an atmosphere of mutual suspicion, and (6) the re-manifestation of federal, state, local, and organized labor and DoD franchise political agendas. These negotiations are essential to protecting contractor investment and bottom-line growth, while generating desperately needed savings for the government to re-invest into its Procurement accounts. Similarly, contractors must be cognizant of their post-award due diligence requirements to identify additional inconsistencies or omissions in the government's initial baseline survey and to allocate such new-found liability accordingly.

Such post-award transition plans generate a tremendous return on investment for the contractor, given the historic explosion in environmental remediation costs on former DoD sites. Specifically, the Congressional Budget Office (CBO) just issued its report confirming the panel's belief that long-term savings from Base Realignment and Closures (BRAC) were running far below estimates, and had not been realized as quickly as intended. The CBO concluded that one of the principal reasons for the ongoing loss-posture was under-estimated environmental cleanup costs. Moreover, the impact of the estimating errors is still to be felt. As the CBO observed, DoD not only projected $56.7 billion in savings over a 20-year period, but had already incorporated those estimated BRAC net savings into planning for outlying-year budgets. If, as is most likely, the projected savings do not materialize fully, DoD "may have to redirect funds to pay the unanticipated costs or unachieved savings of BRAC actions, or it may have to request additional funding from the Congress."

Despite the Administration's long-term projections, all serious indicators, including the assumptions underlying the Quadrennial Defense Review, suggest a maximum DoD budget of $250 billion annually, at about its current level for Fiscal Year (FY) 1997. There is strong speculation that a fifth round of BRAC (BRAC V) will be undertaken in FY '99 or FY '00 to accommodate additional troop reductions and continue the bloated infrastructure reduction as well. Therefore, it is unlikely that DoD will be able to obligate scarce resources for non-value-added environmental indemnification, as opposed to the vital recapitalization of "geriatric" weapons systems. Given that the ultimate costs of cleanup are currently exceeding DoD estimates by a factor of almost 4:1, the average contractor can reasonably expect to find approximately $4 of pre-existing contamination once it is on-site for each $1 disclosed by DoD prior to award of the outsourcing or privatization contract. Absent clear and unambiguous indemnification agreements with the government, contractors can accept the government's estimates, but then they assume unbounded risk and basically become insurers to the United States for pre-existing contamination. Alternatively, contractors can price their proposals very conservatively, but then they will be non-competitive against organic government capability in outsourcing and privatization competitions. Additionally insurance may not be available because many insurers now routinely exclude environmental coverage from their Comprehensive General Liability (CGL) policies. Therefore, contractors must harness all of their corporate resources (e.g., contracts, legal) from the outset to protect the lean profit margins necessary to capture outsourcing and privatization business in the first place.

B. Civil false claims act must be amended to remove liability for environmental non- compliance as an obstacle to outsourcing and privatization

The civil False Claims Act (FCA) authorizes private citizens (relators) to bring civil actions ("qui tam" lawsuits) on behalf of the U.S. Government against contractors who "knowingly" submit false claims. As importantly, material omissions and other acts taken to avoid an obligation to pay money to the government, such as fines or penalties may also trigger FCA jurisdiction (reverse false claims). Civil liability for traditional false claims and "reverse false claims" includes fines of $5,000 to $10,000 per false claim, in addition to treble the amount of overpayment from the government, or underpayment by the contractor, in the event of reverse false claims. Several qui tam suits have been brought against companies for the violation of environmental laws. These claims are based on a contractor's assertion it its proposal that the contractor would not violate environmental requirements and that the contractor's subsequent violation of a specific environmental equivalent and its submittal of a bill for its services to its customer. For example, plaintiffs have brought suit alleging the contractors "false claim" (through its invoice) of environmental compliance. No lawsuits have yet been decided on "environmental false claims." However, treble damages for environmental reverse false claims could be computed as three times the amount of the penalty, fine, or other governmental lost revenue, which would have been assessed had the contractor's environmental non-compliance been disclosed. These would be in addition to the punitive fines and jail sentences triggered by the criminal False Claims Act and a host of redundant environmental statutes for environmental non-compliance or pervasive campaigns of concealment.

As a practical matter, qui tam suits are often brought by disgruntled former employees, such as personnel terminated in a contractor reduction-in-force. However, many courts also allow federal employees to file qui tam actions against contractors, where knowledge of the false claims arose in the course of their federal employment. In the case of DoD outsourcing and privatization, DoD employees are often "badged over" into the successful contractor's work force, under various right-of-first-refusal preferences for federal employees whose jobs have been outsourced or privatized. Those "inherited" employees will have gleaned substantial knowledge of the site as the former incumbent, and through their previous oversight of the public-private competition. They will also become intimately familiar with any weaknesses or deficiencies in the winning contractor's internal controls and decisionmaking processes following the transition. Almost all contractors will have to restructure that inherited work force to generate the widely projected 25-40% net savings from current DoD labor-intensive personnel structures and unwieldy compensation plans. This process will continue over the life of the contract as a direct function of employee learning curves, technology insertion, and contractor management experience on-site. Consequently, there is every indication that such ongoing "thinning" of the work force could trigger an surge in environmental qui tam suits by (1) contractor employees RIF'd to accommodate preferences for government employees, and (2) government employees subsequently RIF'd by contractors to enhance operational efficiency. Such hidden risk to the contractor's bottom line is further prolonged by the six-year statute of limitation for qui tam suits.

Consequently contractors must aggressively institute preventative measures prior to contract award. This may minimize unfounded environmental disputes, "nuisance" settlements, interminable legal fees for defense, program disruption, and lost customer goodwill. It is also essential that legal counsel develop well-defined post-award transition plans and compliance programs to ensure that the contractor's new business capture is maximized, while environmental threats are minimized.

II. CONTRACTOR RECOUPMENT OF ENVIRONMENTAL COSTS IN DOWNSIZING AND POST-MERGER RESTRUCTURING

A. Recovery from Insurance Companies and Assertion of the Environmental Government Contractor Defense

The other frequent scenario arises when a contractor (1) incurs environmental remediation costs in the course of downsizing or post-merger restructuring, or (2) is designated as a PRP as the "successor-in-interest" to a previously acquired company or business segment. In the case of downsizing or post-merger restructuring, facilities disposal costs can generally comprise as much as 50 percent of the restructuring charge, but should result in long-term cost-to-savings ratio of at least 2:1. In the case where the contractor is a former operator, i.e., tenant, or successor-in-interest, to a former tenant, there will be no long-term resultant savings because the contractor is merely discharging stale liability and will not receive any proceeds from land disposal or outlaying operational efficiency "on the shop floor." However, under either scenario, there are a number of vehicles which a prudent contractor can use to recover its costs. (Recoupment of post-merger restructuring costs is addressed below.)

In the default situation where the contractor is deemed a PRP as a successor-in-interest to a discharging former occupant of the contaminated parcel, it should aggressively pursue its predecessor-in-interest's former insurers for cleanup costs. This is in addition to examining its own CGL policies for potential coverage. Ordinarily, the predecessor's CGL policies do cover environmental cleanup. Generally, those policies contractually committed the predecessor's insurance companies to undertake the defense, provide indemnification, and cover damages and other expenses arising from environmentally based claims, including property damage, personal injury, and/or bodily injury claims. As long as the predecessor contractor complied fully with the terms and conditions of its insurance policies, successor contractors should be entitled to insurance coverage for all or part of those environmental costs, even if the predecessor subsequently became insolvent or declared bankruptcy. Contractors must be aware, however, that insurance companies began routinely excluding environmental coverage from CGL policies throughout the 1970s. Given that insurance companies have little incentive to voluntarily disclose coverage under old policies, contractors must be vigilant in meticulously sifting for those policies that are not already "tapped out."

Alternatively, contractors should consider seeking indemnification from the U.S. Government after exhausting contribution streams from the appropriate insurance policies and any other PRPs. As discussed above, the government is already liable under CERCLA for its activities as owner, operator, arranger or transporter. In addition, the government can also be liable for indemnification to its contractors for their environmental cleanup costs when its oversight activities become so pervasive that it exerts "considerable day-to-day control" over a contaminating contractor's operations.

B. Congressional Attacks Threaten Restructuring Cost Recoupment and Environmental Recovery by Contractors

The Congressional movement to eliminate external restructuring costs directly threatens recoupment of post-merger facility disposal and consolidation costs, which often comprise more than half of the restructuring costs generally incurred by contractors following major mergers. Specifically, much of those facility disposal costs are incurred in remediation and environmental cleanup. Post-merger restructuring cost recoupment was salvaged by congressional compromise in 1996, which required a savings ratio of at least $2 of savings per $1 of restructuring cost to be recouped from DoD for all future mergers. While past mergers were "grandfathered" by that compromise, legislation to repeal future recoupment of such costs has already been introduced in the 105th Congress, re-triggered by the recent explosion of mega-merger defense deals. It is well established that retroactive repeal of contractor authority to recoup post-merger restructuring costs by previously grandfathered contractors would likely incur multi-billion dollar liability under Winstar. If successful such prospective repeal would threaten the critical retirement of debt in future highly leveraged mergers, especially when the acquiring contractor commits to a tight debt retirement schedule to sustain market value of its stock. In the event of a retroactive repeal, it will be imperative for targeted contractors to satisfy the elements for a Winstar-based claim, since such liability would extend to include environmental costs incurred by contractors while disposing of redundant facilities. However, there are also strong congressional indications that prospective legislation to strengthen the 2:1 savings-to-cost rule could expand the definition of "costs" to include long-term environmental cleanup costs. In doing so, Congress would force contractors to generate exponentially greater savings to satisfy the heightened recoupment threshold. Therefore, contractors should carefully revisit all possibilities of contribution and indemnification from predecessor companies, insurance policies, as well as former government customers and former prime contractors that exercised substantial control over their operations.

C. New Bill Threatens Continued Allowability of Environmental Cleanup Costs

Contractors must similarly contend with proposed legislation to prohibit contractor reimbursement for cleanup costs incurred "at any facility owned or operated by the contractor or at which the contractor is liable in whole or in part for the environmental response action." The bill, which was re-introduced in the first week of the 105th Congress, would apply to all U.S. Government contracts. Moreover, it would apply not only prospectively to contracts in the future, but also retroactively to all existing contracts. This would be tantamount to an absolute prohibition on indemnification or payment under any circumstances, given that environmental liability by its very nature is strict, joint, and several. In other words, the threat to contractors' bottom lines if the bill is enacted into law cannot be underestimated: millions of dollars of otherwise allowable, reasonable, and allocable environmental cleanup costs will suddenly become expressly unallowable as a matter of law. Given the bill's lack of success when originally introduced last year, its fate this year remains uncertain unless it is swept up in the public concern as another form of "corporate welfare."

VI. CONCLUSION
As our panel of experts concluded, government and industry must strive together to eliminate current impediments to outsourcing and privatization. The government should assume immediate liability for pre-existing environmental contamination, while contractors should clarify discrete responsibility for any subsequent liability, segregable to their specific on-site operations. This will accelerate outsourcing and privatization to generate the critical savings for the decimated Procurement accounts. As a longer term goal, Congress should give serious consideration to amending the False Claims Act to eliminate redundant environmental whistleblower suits, while supporting the continued allowability of environmental costs as well as contractor recoupment of post-merger restructuring costs. In the interim, downsizing and merging contractors must also be vigilant to exhaust their legitimate rights against predecessors and insurers prior to bringing suit against the government for recovery of residual cleanup costs.

Please contact Katherine Madeira at (703) 917-8900 for the full briefing paper with corresponding endnotes and annotations.

This information is offered only for general informational and educational purposes. It is not offered as and does not constitute legal advice or legal opinions. You should not act or rely upon this information without seeking the advice of an attorney.

Last modified: May 2, 2001