KEY ELEMENTS AND BENEFITS OF OUTSOURCING

Successfully outsourcing chemical and wastewater management services (CWMS) involves balancing three key elements. Each of these elements must be addressed in carefully structured contracts negotiated among the manufacturing entity and service providers. These elements are: (1) transforming the chemical supply chain and replacing or insulating existing suppliers from their traditional roles as commodity sellers; (2) outsourcing, to the extent possible, water, wastewater, solid waste and recycling systems, to relieve the manufacturer of a non-core business and allocate risk and responsibility to more technically competent experts; and (3) aligning motivations of manufacturer and service provider to reduce costs and consumption, thereby optimizing efficiency, performance and safety. The contractual relationships governing CWMS must provide for each of these three components if such outsourcing is to achieve the goals of reduced costs and improved performance.

In the standard chemical supply chain, neither manufacturer nor chemical supplier is properly motivated to reduce chemical usage. Although manufacturer may pursue such strategy if it leads directly to cost controls, performance improvements or greater efficiency, without more, supplier cannot benefit from this approach and therefore will not support such efforts. To transform this dynamic, chemical suppliers must break from their traditional product-sales and product-servicing role and diversify as more integrated service providers. As integrated service providers, chemical suppliers could encourage CWMS users to purchase lower volumes of chemical materials to produce more efficient usage and supply chain management. The innovative supplier can thereby replace commodity sales revenue with fees for management services and technical expertise to benefit directly from this transformation.

However, this change in suppliers’ orientation is not easily accomplished when chemical suppliers are economically motivated to promote increased sales of product and naturally averse to incurring new risks of environmental liability and employee transfers. Accordingly, a neutral third-party, nonprofit organization like Chemical Strategies Partnership (CSP) (http://www.chemicalstrategies.org/) can greatly enhance the argument for CWMS by specifying how chemical suppliers may convert and diversify their expertise to benefit from decreased consumption of chemicals by manufacturers (adding value to manufacturer’s production process).

Fortunately, as CSP demonstrates, the innovative manufacturer profits from CWMS by helping the manufacturer reduce chemical usage, but also by reducing chemical waste and limiting handling risk. In addition, CWMS can improve overall operating performance when more efficient chemical usage and system improvements introduced by the creative chemical supplier are integrated into other parts of the manufacturing process. A technically competent and diversified supplier who is prepared to diversify and sell services along with chemical materials can reap such tangible economic benefits. Finally, the overall reduction of chemical waste and mitigation of associated risks benefits the environment, and therefore provides additional intangible social and marketing benefits for both manufacturer and supplier.

Successful outsourcing of CWMS relieves the manufacturer of peripheral business activities that detract from the manufacturer’s ability to perform its basic manufacturing process. This may involve only incremental parts of the overall manufacturing process, but can effect a transfer of significant responsibility for a sensitive and costly part of the manufacturing process. The optimal allocation between manufacturer and service provider places risk and responsibility on the party who is most capable of managing such risk, however, service provider must now be compensated for such risk, and manufacturer must therefore understand the true cost of carrying the risk today to justify such expense. In one extreme, manufacturer may desire to make a complete transfer of responsibility from the manufacturer to a more competent technical supplier. On the other hand, parties must recognize and accept the challenge of transferring total responsibility along with risk in a short period of time. This may lead to a partial or gradual transfer of risk to supplier, with manufacturer retaining any risk of failure attributable to pre-existing conditions broadly defined.

The potentially difficult challenge of transferring risk to the service provider can be mitigated by a gradual transfer of responsibility, by use of third party insurance and recognition of pre-existing liabilities. Contractual responsibility or complete risk of failure can be further limited because the manufacturer retains title to any waste product released from the facility and the manufacturer remains primarily obligated on all governmental permits and for any spill or release to the environment attributable to such broadly defined pre-existing conditions. In addition, the parties can make advantageous use of any available insurance to further limit the risks of liability. In the process of drafting and carefully negotiating contracts that (i) limit the initial scope of work to be done by the manufacturer, (ii) specify ongoing obligations of the service provider, (iii) include a generous definition of pre-existing conditions, and (iv) recognize the legal and practical limitations of transferring liability for spills or releases of hazardous chemicals into the environment and for third party claims, both parties may learn more about the scope of existing risks. With a better understanding of existing risks, and a trial period of services or consulting on limited projects, the parties develop a working relationship that supports a process of specifying further tasks toward a goal of effecting a comprehensive transfer.

The incremental benefits of reducing costs of chemical materials purchased may justify the trial period or gradual transfer, and thereby allow for the expanding opportunities of a comprehensive CWMS. This cost reduction usually comes from service provider’s economies of scale, exercising its broader purchasing power and expertise in procurement management over a specified range of chemical products and gases, which can be demonstrated by CSP, for example. The service provider may then offer further economic benefits to the manufacturer by providing chemical management and wastewater treatment on an expanding scale.

CONTRACTING TO SUCCESSFULLY OUTSOURCE CWMS

A successful CWMS contract requires a workable system of sharing information between the manufacturer and an integrated service and product supplier. This means exchanging potentially sensitive information about the existing manufacturing process, including baseline cost structures, chemical compositions and consumption statistics, together with other proprietary information or trade secret technology. Accordingly, a first step in developing any contractual relationship is to define the terms of confidentiality in a non-disclosure agreement (NDA). The terms of confidentiality can be further refined within a negotiated CWMS contract to continue the process of sharing such competitive information, accommodating the expansion of an incremental agreement as discussed above, and allowing the service provider to better understand and participate in the overall manufacturing business.

There are several steps to create binding legal obligations in the outsourcing of CWMS. After the NDA, manufacturers and service providers may use a letter of intent (LOI) or memorandum of understanding (MOU) to outline the general terms of a proposed transaction. The initial contracts may then evolve into a more formal request for proposal (RFP), with a form of CWMS contract attached as part of the RFP, leading to final contract negotiations. Each of these steps provides an opportunity for the parties to share information about each party’s goals, including objectives and limitations, together with technical information and some indication of the manufacturer’s employees likely to be transferred under CWMS. Creating legal obligations carefully and systematically by increments allows the parties to establish a process of communication and trust, creating a binding contract entered into with planning, due diligence and balanced negotiations.

Each LOI, MOU and RFP is unique and subject to the circumstances of particular negotiations. These documents are not prone to any definitive form or characterization of the legal relations created thereby. The LOI and MOU usually contain a statement that denies any binding contractual obligation by signature thereon, deferring to a process of due diligence and further negotiation before legal obligations exist by signed, definitive documentation. Conversely, the LOI and MOU may create binding legal contracts, commonly limited to issues like confidentiality, responsibility for fees, and requirements to cooperate, deliver documents and allow inspections, but possibly more. The manufacturer and service provider should therefore work closely with experienced legal counsel to manage the process of contract formation and to ensure a balanced approach to achieving their respective needs.

SOME CONTRACTING ISSUES OF PARTICULAR CONCERN

Statement of Work, Pricing, and Performance. Within the CWMS contract, there are certain, potentially contentious areas warranting special attention. First and foremost, as discussed above, the statement of work and pricing must reflect the manufacturer’s realistic objectives and compensate the service provider for its technical competence and any true risk allocated to the service provider. This transfer of risk may include environmental risk as discussed above, and also risks related to managing employees transferred from manufacturer to service provider as part of the CWMS.

To outsource CWMS, the manufacturer must establish an objective system to measure a contractor’s performance and properly motivate contractor to accomplish the stated goals of reducing costs and consumption, and optimizing efficiency, performance and safety. Such a system also involves sharing of computer tracking data to eliminate inventory and correct the supply chain and waste management systems. The statement of work should therefore specify these goals and the contract itself must provide a plan for exchanging necessary information. Such exchange involves shared access to computer tracking systems, transfer of management, operations and maintenance responsibility, and a system of comparison to baseline definitions of pre-existing conditions, including baseline costs, operating conditions and system deficiencies. Entering into a contract that specifies such clearly established performance goals allows both parties to better understand their new rights and obligations, and objectively to determine the success or failure of CWMS.

In addition, the manufacturer may consider a method of sharing economic benefits with the service provider by carefully monitoring individual cost items comprising CWMS, establishing minimum guarantied savings to meet the manufacturer’s expectations. Beyond these minimum cost-savings, the service provider can share in the economic benefits by “gainshare” or other method of promoting cost savings. The sharing of economic benefits resulting from CWMS can justify the allocation of responsibility, risk and legal obligations incurred by the service provider for the benefit of manufacturer. On the other hand, manufacturer receives comfort from its ability to terminate the contract and find a replacement service provider in the event of contractor’s breach.

Labor Issues. With respect to the transfer of employees from the manufacturer to the service provider in CWMS, the first issue to consider is whether the consent of a union or other collective bargaining unit is required. If the transfer overlaps with union jobs, the terms of collective bargaining need to be carefully reviewed and factored into negotiations in the early stages of an LOI and accounted for in drafting the RFP. A protracted negotiation with a union over whether and how to transfer employees to the service provider will also affect the overall timing of CWMS. Regardless of the existence of a union at the manufacturer’s site, however, any transfer of personnel raises sensitive performance and morale issues requiring careful attention from both manufacturer’s and service provider’s human resources departments early in the CWMS process. These labor issues usually involve a myriad of local and national laws, including mandatory notice periods and possibly a consultation process, all affecting timing and terms of any proposed transfer.

In the United States, for example, the Worker Adjustment and Retraining Notification Act of 1988 (WARN Act) applies directly to the transfer of employees on the federal level, commonly triggered by CWMS. The WARN Act refers to plant closings or mass lay-offs affecting the lesser of 50 employees and one-third of the workforce. The purpose of the WARN Act is to protect the workers through a mandatory 60 day advance notice period imposed on the existing employer. As a consequence, if the required advance notice is not given to the employees, the new employer will be liable to the affected employees for back pay and benefits. To avoid WARN Act consequences in CWMS, service providers are encouraged to offer employment to all affected employees (often with signing bonuses) on substantially equivalent terms as previously offered by the manufacturer. Concurrently, the manufacturer should terminate all employees and pay-off accrued vacation and personal time-off balances before effecting a complete transfer. Additionally, all parties to a CWMS contract under US law should represent and warrant to “at will” employment status, while outside of the US, the “at will” contract may not exist.

CONCLUSION

The benefits of CWMS are clearly achievable and the opportunity is enhanced by proper contract drafting that understands the objectives of supply chain management within the parameters of realistic allocation of risk. The CWMS contract, if structured correctly, provides for economic, environmental and social benefits because the manufacturer and service provider have developed a system for sharing information to permit a realistic valuation of the transfer. To facilitate this process of CWMS development, goals must be clearly defined by the manufacturer and presented in a manner easily understood by and accessible to the service provider. This allows for the proper assessment and pricing response requested in the RFP. These goals, expectations and limitations should then be documented through the process of incremental CWMS contract formation, with special attention to the proper allocation of risk and responsibility for economic, social, employment and environmental impact.

Anders E. Stenstedt is a partner in the firm’s global finance and infrastructure practice group, located in the San Francisco office, with expertise in international transactions, project development and finance with emphasis on private sector participation (PSP) in public infrastructure. In addition, Mr. Stenstedt has a range of experience in complex structured finance and in evolving areas of infrastructure development, project finance and the private public partnership (PPP).

For more information on this article, please contact Anders Stenstedt at (415) 268-6646 or anders@mofo.com.