John C. Person
Person & Craver LLP
Washington, D.C.

This paper reviews the recent contract reform and privatization initiatives of the Department of Energy and analyzes the impact that these and other Departmental initiatives are likely to have on the DOE contracting process. Additionally, this paper provides recommendations on additional reforms that would promote the special needs of the Department's performance-based contracting and privatization initiatives yet not upset the core requirements of federal procurement contracting.

This paper analyzes contractual risk allocation in the post-"Contract Reform Team" era of the Department of Energy's ("DOE" or "Department") program to clean up the nuclear, mixed, and hazardous wastes presently existing within the its Weapons Complex. This paper begins by identifying the risks that bear on DOE remediation contracting. The paper next covers the changes introduced by the final rule promulgated this past year to implement the Contract Reform Team recommendations. Third, in light of these first two considerations, this paper presents an analysis of DOE's privatization initiative and reviews its experience with that contracting mechanism to date.

This paper concludes with specific recommendations as to the use of contract terms and conditions to manage risk and maximize efficiency under the new, performance-based contracting regime espoused by DOE.

The DOE environmental remediation contractor faces several unique challenges and risks. First, the contractor often must remediate a non-homogeneous "toxic soup" of nuclear and mixed wastes. Second, the cleanup contractor must perform its work within the context of a Departmental culture that, until recently, has sacrificed contract efficiency and cost accountability in the name of Cold War secrecy. Third, the work takes place within the highly charged and politically driven "nuclear" environment, within which scheduling and cleanup commitments receive high visibility by anti-nuclear and environmental activists. As to this latter point, most of the DOE cleanup contracting work is performed in accordance with agreements entered into between DOE and others under which DOE is required, by compulsion of law, to meet certain cleanup milestones.

Taken together, these and other challenges and risks can produce an unacceptable level of contracting uncertainty unless they can be fully identified, quantified, and allocated to the appropriate party. Risks to be allocated by contract include: (1) on-site or third-party release of wastes; (2) penalties or fines assessed by the federal or state authorities for untimely or inadequate cleanup of wastes; (3) interface/interference by the Contracting Authority (e.g., DOE or an upper-tier M&O contractor; (4) willingness of Contracting Authority to provide level of interface and technical direction consistent with the underlying nature of the contract (minimal interface and direction for privatized contract; proportionately more involvement with cost-reimbursable contract); (5) work force composition and union recognition issues for privatized contracts; (6) definiteness of initial conditions and influent characterizations; (7) clearly enunciated cleanup standards; (8) risk of regulatory change.

These risks bear directly on a contractor's traditional responsibility for project completion, cost, schedule, and facility operability. The implementation of the final rule on contract reform, discussed immediately below, addresses these risks in part. Risks unique to privatized contracts are also discussed below.

On June 27, 1997, DOE issued as a final rule the contract clauses intended to implement the recommendations of the Department's Contract Reform Team. See 62 Fed. Reg. 34842. The issuance of that final rule is the culmination of a four-year effort begun by former Secretary of Energy Hazel O'Leary to replace inefficient contracting practices with a performance-based approach to contracting. Although the rule did not take effect until August 26, 1997, many of the affected contractors had "volunteered" over the months preceding the rule's promulgation to incorporate into their existing contracts comparable performance-based terms and conditions as a demonstration of their commitment to contract reform. The rule applies directly to Management and Operations (M&O) contracts, which are termed in the rule as "performance-based management contracts. See Preamble to Final Rule, 62 Fed. Reg. at 34834.

The key contract clauses affecting risk allocation that are addressed in DOE's mega-rule include: (1) performance-based contracting (DEAR 970.1001); (2) make or buy plans (DEAR 970.1507); (3) "prudent business judgment" standard for third-party liability; (4) pre-existing conditions (DEAR 970.5204-75; and (5) displaced employees (DEAR 952.226-24). These clauses operate as follows:

The cornerstone provision of DOE's "mega-rule"is DEAR 970.1001. There, DOE mandates that performance-based contracts be used in the Department's M&O contracts to the maximum extent practicable. Of particular importance in this clause is the definition of "performance-based" contracts, which are defined as:

This rule, set out in four conjunctive elements, goes to the very nub of the Contract Reform Team effort in that it clearly directs that work statements be framed in terms of "performance" specifications, and not as a "design" or "prescriptive" specifications. In that regard the rule goes on to provide that statements of work "should describe performance requirements and expectations in terms of outcome, results, or final work products, as opposed to methods, processes, or design". Id.

This rule signals a clear endorsement of the design-build contract delivery format, as with that model, the contractor is responsible for selecting the methods, processes, and designs to meet Department-prescribed performance requirements. By extension, this rule also favors privatized contracts, in that a privatized contract is necessarily built upon a design-build contract structure. This rule represents a simple and forceful statement of the Department's unqualified support of contract reform.

Subsequent to the issuance of the "mega-rule", DOE issued two guidance documents to tighten-up the implementation of the incentive and performance-based features of DEAR 970.1001. Acquisition Letter ("AL") No. 97-08, dated December 8, 1997, provides specific guidance on: (1) developing performance objectives; (2) selecting the appropriate contract type; and (3) developing incentives. Of interest, AL 97-08 recognizes that while many performance-based contracts may be structured generally on cost-reimbursable pricing, the procuring authorities should package work scopes within that pricing framework so as to allow for "other than cost type contracting" (i.e., firm, fixed price). Additionally, the guidance document provides direction on developing multiple incentive fee arrangements, for which an incentive fee component would apply to objective performance requirements and an award fee component would apply to subjective performance requirements. The companion guidance document, AL 97-09, also issued on December 8, 1997, establishes the framework for the implementation of cost reduction incentives ("CIRs"). AL 97-09 provides criterion for both the preparation and acceptance of CIRs, as well as for the distribution of shared savings.

In accordance with DEAR 970.1507, contractors are required to submit make-or-buy plans that are designed to provide supplies or services "on a least-cost basis, subject to program specific make-or-buy criteria". With respect to the development of program-specific make-or-buy criteria, the rule goes on to provide that the cognizant DOE program office is to establish such criteria after due consideration of a number of factors, including contractor diversity, work force displacement and restructuring, and collective bargaining agreements. See DEAR 970.1507-2. The contract clause to be inserted into all performance-based contracts is set out at DEAR 970.5204-76. That clause requires that the contractor characterize work items as "must make", "must buy", or "can make or buy", and submit such plans for approval, along with the accompanying backup, within 180 days of contract award.

In reconciling the comments to the proposed rule, the Department stated that it expects wide site-to-site variance in the precise requirements of make-or-buy plans, and in acknowledgement of that, refused to be overly prescriptive in drafting the regulation. See Preamble to Final Rule, 62 Fed. Reg. at 34848. The Department also defended its departure from the FAR make-or-buy provision, noting that the DOE-contractor generally is closer and longer-term than ordinary Government-contractor relationships due to the close, long-term relationships that typically characterize DOE contracts. Id. at 34848.

To the extent that a contractor recommends that a particular requirement be "bought" pursuant to its make-or-buy plan, the contractor is essentially creating a second tier of performance-based or privatized contracts, all of which would be predicated on the design-build platform. A potential impediment to the success of this program is the extent to which the Department-generated make-or-buy criteria are inconsistent with overall economic efficiency. On this score, the Department has left the door open for affected constituencies to help shape the make-or-buy criteria that, in turn, dictate the contents and objectives of the make-or-buy plan.

One of the most significant requirements of the "mega-rule" is DOE's heightening of the threshold for reimbursement of costs arising from third-party liability. Prior to the promulgation of this rule, the threshold for reimbursement of such costs was the FAR-based standard set out in the "Litigation and Claims" clause that the costs not be a product of "willful misconduct or lack of good faith" on the part of contractor management personnel. Third-party liability is now addressed in the new clause DEAR 970.5204-31, "Insurance - Litigation and Claims". In addition to barring reimbursement for costs arising from willful misconduct or lack of good faith of managerial personnel, the new clause bars reimbursement when the liability is caused by failure of the company's management personnel to exercise prudent business judgment.

The prudent business judgment standard is specifically defined in the final rule as failure to act in the same manner as a prudent person in the conduct of a competitive business. This significantly stepped-up standard of care required of contractors presents a new risk; however, this new risk should be capable of full absorption by proper in-house compliance planning and training. With respect to fines or penalties levied against a contractor, the final rule establishes a "rebuttable presumption" that such costs are to be disallowed.

The rule requires that the clause included at DEAR 970.5204-75 be included in all performance-based contracts. That clause, in turn, absolves the contractor from civil liability due to the existence of a preexisting condition. As noted in the preamble to the rule, the Department intends to place a reasonable duty on the contractor to inspect site conditions, but that duty is not absolute. In this regard, the preamble goes on to provide that a contractor will not be precluded from recovering costs resulting from or related to preexisting conditions merely because the inspection failed to discover the condition.

This rule is helpful in allaying contractors'concerns over environmental liability that could otherwise attach to "owners" or "operators" of an environmental facility under the environmental statutes.

DOE's "mega-rule" also implements Section 3161 at DEAR 926.71, et seq. That section provides that Department employees, at all levels and tiers, are to be given hiring preference where the Department determines that a change in the workforce is necessary. The clause to be included in performance-based contracts is set out at DEAR 952.226-74.

In the preamble to the final rule, the Department stated that Section 3161 displaced worker preferences are separate and distinct from contractor make-or-buy requirements, in that Section 3161 requirements extend to all DOE contractors and subcontractors, regardless of make-or-buy considerations. See Preamble to Final Rule, 62 Fed. Reg. at 34851.

Presented in this section of the paper is a brief review of ongoing privatization projects, along with a discussion of several recurring problems associated with this innovative contracting form. Before turning to specific projects, however, to address precisely what is embraced by the "privatization" contracting form. The term "privatization" means many things to many people. For example, "privatization" has been interpreted to embrace outsourcing, divestiture, deregulation, or asset transfer. Of late, the term has been interpreted by the Department as applying to ordinary firm, fixed-price construction contracting. For purposes here, however, the term "privatization" refers to a "project finance"-based model whereby private contractors design and build facilities to treat waste streams on a through-put, unit-priced basis. Typically, such an arrangement guarantees the privatized contractor a minimum processing quantity. This "take-or-pay" agreement serves as the cornerstone upon which the contractor is able to secure financing to undertake the work. Traditionally, this contracting form has been used extensively for infrastructure projects such as electric power, water, and waste treatment facilities.

To date, the Department has embarked on a number of privatization projects. One shining example of privatization has been the Hanford laundry contract. Other privatization projects that have proceeded successfully, at least on a tentative basis, have been Phase I (Part A) of the Hanford Tank Waste Remediation System ("TWRS") and the Advanced Mixed Waste Treatment ("AMWT") at the Idaho National Engineering and Environmental Laboratory ("INEEL").

Not all has been going well on the privatization front, however. The privatized project getting most of the publicity at present is the "Pit 9" cleanup at INEEL. In October 1994, the contractor for this project, Lockheed Martin Advanced Environmental Systems ("LMAES"), was awarded a $200 million fixed-price contract to perform the remediation of Pit 9, which had served as a radioactive waste disposal pit. Midway through performance, however, LMAES walked off the project, seeking $257 million for its performance through June 1997. As reported in a recent GAO report, the project is at least 26 months behind schedule and no retrieval or processing of wastes has begun. See Department of Energy's Project to Clean Up Pit 9 at Idaho Falls is Experiencing Problems, GAO/T-RCED-97-180, July 28, 1997. LMAES reportedly has stopped work and filed a claim in the amount of $257 million for costs incurred through June 1997. Additionally, DOE has been fined approximately $1 million by state and federal regulators. LMAES contends that DOE and its M&O contractor improperly administered the contract and interfered with LMAES' performance, and that the estimates of the types and amounts of materials in Pit 9 were substantially changed. DOE has countered that LMAES claimed in its technical proposal that its technologies were sufficiently robust to be able to handle almost any type of waste that might be discovered at the site. Additionally, notes DOE, its high level of day-to-day involvement was necessitated by LMAES' demonstrated lack of knowledge on nuclear safety issues.

This ongoing dispute is both highly instructive from a "lessons learned" standpoint, as well as pivotal concerning the future of privatization. First, while it is unclear at this early point as to the relative merits of the dispute, it appears that LMAES' allegation that DOE's 7,000 design comments were excessive does suggest improper micro-management by DOE. Second, it appears that DOE's contention that its high level of involvement was necessitated by safety concerns may be overstated. Third, the fact that the Pit 9 contents were characterized only by analysis of the existing contents and not by a manifest-by-manifest review of the individual contributions to the pit suggests that any characterization on which the contractor based its treatment system is inherently uncertain. This factor alone should have counseled DOE to use some pricing form other than firm fixed pricing.

Finally, and most importantly, this dispute has triggered Congressional scrutiny as to DOE's contracting abilities and weighed heavily in Congress' five-fold reduction in DOE's FY 1998 budget request for $1 billion for privatized projects. Further concerning Congress'wariness over DOE's contracting abilities, the House included in Sec. 302 of the FY 1998 Energy and Water Appropriations bill (H.R. 2203) a provision that prohibits deviations from the FAR unless the Secretary of Energy grants, on a case-by-case basis, a waiver to allow for such a deviation. Such waivers, in turn, are made subject to Congressional approval before they can be made final. This provision is reflected in the Act as signed into law. See Pub.L. 105-62, effective October 13, 1997. However, in the acquisition letter issued to implement this provision, the Department appears to be preserving the status quo as to its discretion to deviate from FAR-based provisions. See AL 98-02, dated January 26, 1998.

Based on the foregoing discussion of DOE's "mega-rule" on Contract Reform, and on the privatization experience logged to date (especially on the Pit 9 project), several specific recommendations emerge that would apply to performance-based contracts generally, including privatized contracts:

• Relative to choice of pricing models, the Department should view its options as extending beyond the bipolar choices of cost reimbursement or firm fixed-price contracting. Multiple-award task order contracting, which allows for the issuance of either cost reimbursable or firm fixed-price task orders, has been employed successfully on other federal facility cleanups, and certainly recommends itself where the initial conditions or influent characterizations for portions of the work cannot be stated with certainty. Indeed, as pointed out above, recently issued AL 97-08 would appear to encourage the use of firm fixed-price task orders wherever feasible, even under an umbrella cost-reimbursable pricing arrangement.
• Clearly and carefully define the nature and level of involvement, interface, and direction between the upper-tier contractor (whether it be DOE or the M&O contractor) and the cleanup contractor. In the continuum from a cost-reimbursement contract to a privatized contract, DOE's involvement should modulate from significant to minimal. This involvement should be particularized even further in pre-award discussions with potential offerors (e.g., numbers of design reviewers, scope of design review, etc.), and should become a central feature of an ongoing "partnering" relationship between the Department and its contractors. This may be the only objective way to change the DOE's culture from a cost-reimbursable, M&O mindset, to a fixed price, performance-based mindset.
• Make a speedy and clear transition from DOE oversight to NRC oversight on nuclear safety issues. Too often in the past, DOE, under the guise of nuclear safety, has exceeded its nuclear safety mandate and has required contractors to absorb additional costs on non-safety related matters in response to a perceived nuclear safety deficiency.

Following below are specific recommendations for improving contractual risk allocation and efficiencies for privatized contracts. The ultimate objective of these proposed recommendations is to strike a more balanced risk profile so as to encourage a high level of participation by project finance lenders:

• When treating and/or disposing of discrete waste streams or contamination areas, limit use of the privatized form to situations where: (a) the influent wastes can be fully and accurately characterized; (b) the cleanup standards can be clearly articulated; (c) the technology has been fully demonstrated (e.g., risk of technological failure is remote); (d) the risks of contract performance can be assigned in an equitable manner; and (e) the project presents a risk allocation profile acceptable to the project finance lending community.
• Establish a recognized standard of operations independent from the "Default Termination" standard. The FAR-based "Default Termination" should continue to have application for a privatized project for those activities taking place prior to the commencement of facility operations. Upon commencement of operations, however, the "Default Termination" clause could be the subject of uneven or arbitrary exercise, and could result in unfair contractor treatment (i.e., loss of facility investment costs). Accordingly, upon start-up of the treatment phase of the project, the "Default Termination" clause should yield to a more flexible and predictable standard, such as the "Prudent Business Judgment" test as enunciated in DEAR 970.5204-31 relative to liability for third-party claims. Such a standard has been judicially interpreted and is well understood in the industry. In an analogous setting, the "Prudent Utility Practices" ("PUP") has worked well as the standard for liability for power plant operators in the electric utility industry.
• Establish an "Operating Committee" for privatized operations that includes the site-based Contracting Officer as well as plenary involvement from a regionally or Headquarters-based Director of Privatized Contracts. This would sensitize the Department to the different considerations governing the design/construction of a facility versus the operation of that facility.
• Develop as an Acquisition Letter or as an implementing regulation a standardized privatization contract, based on a standard "take-or-pay" contracting format. At present, the privatized contracting terms are "force-fit" into a standard set of procurement terms and conditions.
• Apart from implementing Section 3161 (see DEAR 926.71) and the Service Contract Act, the Department should adopt an affirmative position of transparency with respect to union recognition. Market forces should govern this issue, without any direction, whether express or implied, from DOE.

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