Lessons to learn in options and competition

"The issue before this Court is whether the prices for the … options for 2010 and 2011 could be privately renegotiated by the parties or whether such a renegotiation required public, competitive bidding."

This quote from a Pennsylvania court opinion last year cuts to the heart of a fundamental tool used in government contracts. We all use options. Indeed, many jurisdictions have limitations on multi-year contracts that require the use of options. Typically, governments assess price reasonableness of options before exercising them. But can price terms be renegotiated?

For federal procurement practitioners, the balancing of the need for contract modifications against competition policies is a recurring issue. But in my experience a challenge against option exercises on a competition grounds was unusual.

This article looks at the Pennsylvania case and some lessons that can be derived from it. The article also introduces some federal standards for evaluating modifications and explains why federal practice may be relevant.

Pennsylvania's option analysis

The Pennsylvania case arose out of a waste services contract. [Hanisco v. Township of Warminster, 41 A.3d 116 (Pa. Cmwlth. 2012)] The contract had been awarded effective Jan. 1, 2005. The contract had a five-year term with options for two one-year extensions. The options were priced using a unit price (based on the number of households).

In the fall of 2009, before the expiration of the contract, a public hearing before the supervisors was held and the waste services contract discussed. The supervisors noted that neighboring towns were paying less than the option price for similar trash and recycling services. At the meeting, it was suggested that advertising for a new waste hauling contract should be postponed until a meeting with the incumbent contractor scheduled the following day. The supervisors authorized advertising for new bids if the meeting did not result in an acceptable reduction in the option price.

At the meeting, the contractor agreed to freeze the rates near current-year prices. The township and contractor executed an amendment that left the option-year prices the same in the contract but established a "rebate" that would reflect the agreed reduction. The supervisors voted to approve the amendment that exercised both of the option years in exchange for the rebate. In all, the modified contract options achieved a 10 percent reduction in price.

Hanisco, the plaintiff, lived in the township and filed a complaint claiming that the township should be enjoined from exercising the options and required to engage in competitive bidding for a new waste services contract. The trial court denied the request for injunctive relief, and Hanisco appealed.

The township argued that the amendment was a supplement to the existing contract, not a new contract. The township maintained that once a public contract has been lawfully awarded in accordance with competitive bidding, a lower price may be negotiated. The appellate court held against the township, however, concluding that "the decision not to advertise its waste services contract for competitive bidding has prevented the parties from knowing whether greater savings could have been achieved had the contract been rebid."

One judge wrote a lengthy dissenting opinion. The dissenting judge emphasized that the scope of work and frequency of waste collection services stayed the same: only the price was reduced. The dissent reviewed other Pennsylvania precedent as well as precedent in other states and applied a different legal standard than the majority opinion. The dissent reasoned that the modifications were not new undertakings and not "material" because they were not of such a magnitude that they undermined the goals of competitive bidding.

Federal standards on "scope" issues

What is "materiality" in the context of a modification? Federal bid protest decisions provide guidance about when "scope" has been materially changed by an amendment. The Hanisco dissent applied reasoning closer to the federal analysis.

Some state courts — Colorado and Arizona are examples — will consider federal precedent in matters peculiar to public procurement where there is little state judicial precedent. Sometimes contract law principles arising out of private commerce provide little guidance. For example, whether the formalities of an option exercise are adequate to create a binding obligation can be resolved using normal contract formation principles. Federal precedent would not be particularly helpful. On the other hand, the application of competition policies to contract modifications is unique to public procurement, and courts might be willing to consider the way that federal courts analyze the issue.

The federal standard for assessing the materiality of modifications looks at the expectations of competitors. The General Accountability Office, the federal agency that decides the lion's share of federal bid protests, considers whether the modification would have materially changed the field of competition. Similarly, the United States Court of Federal Claims (the court having jurisdiction over federal bid protests) has described the test this way: "If the court concludes as a matter of law that the modification was contemplated in the original procurement and the type of work, quantity, performance period, and costs have not substantially changed," the requirements for competition are not implicated. [Ceradyne v. United States, 103 Fed.Cl. 1 (2012)] Note the importance placed on original solicitation language.

Drawing lessons from Hanisco

What lessons that can be learned from Hanisco? Case law in the various states will differ of course. And some courts are more likely than others to consider judicial precedent outside the state. You need to view this issue in the context of your state laws and local ordinances/policies, meaning your lawyers should be involved.

When faced with case law like that in Pennsylvania, attorneys look for facts that meaningfully distinguish their situations, that is, reasons that a court should not apply the holding in the case. Here are some facts that might be a basis for distinguishing Hanisco (even in Pennsylvania) and point the way to best practices in states that follow this line of analysis.

• Avoid structural changes to contract pricing mechanisms. The plaintiff argued that negotiation of a "rebate" and the private negotiations between the contractor and township created a new contract. It is unclear from the opinion why this amendment structure was used. Along with the unusual, contemporaneous exercise of both one-year options, the creation of a rebate mechanism may have made this contract modification appear more like an entirely new contract. Avoid fundamental revisions to the payment structure in the original contract.

• Include price adjustment provisions in the solicitation and contract. The court noted that the "renegotiation of price was not contemplated by the original contract." Consider using economic price adjustment or renegotiation provisions in solicitations. In the absence of a relevant economic price adjustment index, include a solicitation provision that permits the agency to request renegotiation where market information suggests availability of reduced pricing. Modification of option prices by amendment then more clearly become contract administration actions, matters not typically addressed in bid protests.

• Analyze the document option price. One good practice is that required by the Federal Acquisition Regulations: a market analysis prior to option exercise. In Hanisco, other townships had unit prices 33 percent lower than the original option prices. However, the dissent pointed out that the prices may not have been an "apples to apples" comparison because other townships had different frequency and range of pickup services. If there are circumstances that account for differences between option prices and more favorable costs derived from other market information, explain them in a memorandum placed in the procurement file.

Final thoughts

It is important to have the ability to fashion contract administration tools like options that adapt the contract to changing markets and still promote competition policies. Sensitivity must be shown, however, to how competition policies and efficient contract administration can sometimes collide. Providing for these mechanisms up-front in the solicitation improves the chances of a court's approving of their use.

Richard Pennington, CPPO, C.P.M., J.D., LL.M. is an NIGP Individual Member and NIGP Instructor. After federal procurement law practice as an Air Force judge advocate, he served as an assistant attorney general (procurement and contract law and litigation)and State Purchasing Director for the State of Colorado.