Privatizing Better: Representing Nonprofit Service Providers Contracting with the Government

by Peter Manzo, Former Executive Director, Center for Nonprofit Management

This article originally appeared in Clearinghouse Review Issue 35, pp. 666 - 673 (Jan.-Feb. 2002)

I. Public Interest Lawyers and Nonprofit Transactional Legal Needs

Throughout the country, nonprofit and neighborhood organizations attempt to address the needs of their communities directly by serving individuals and sponsoring projects to improve their communities. They provide child care, primary medical care, job training and counseling, and referral services to low-income people, and they build and rehabilitate affordable housing, renovate deteriorating commercial buildings, help local residents start and manage new businesses, and much more. In doing so, they are involved in business, albeit not for profit, and they require the same level of business law representation as for-profit companies. All of the community-building efforts cited above involve transactional legal tasks, from incorporating a nonprofit charitable organization and seeking tax-exempt status, acquiring land through a lease or purchase and syndicating interests in low-income housing tax credits, to forming joint ventures.

Transactional legal advocacy differs from litigation, obviously, in that the attorney's role is to help the client pursue a goal by reaching agreement with other parties on a mutually acceptable exchange.² This is precisely the kind of assistance needed by nonprofit entities seeking creative solutions to pressing problems. Unfortunately, without a resource for finding free representation from a legal services organization or a pro bono program, getting legal assistance is "catch as catch can" for most nonprofit groups. Most simply do not have the money to pay an attorney, and further, unless they find an attorney through a board member or other haphazard contact, they do not know where to find competent, experienced legal assistance. As a result, most smaller nonprofit groups forge ahead without legal assistance, often running catastrophic risks.

By representing charitable organizations, public interest attorneys can improve the quality of life for low-income and disadvantaged people. Besides advocating on behalf of nonprofit clients in particular matters, public interest transactional attorneys can work within private-public coalitions on broader issues; the attorneys have knowledge of the law of public benefit organizations and the ability to bridge diverse constituencies such as neighborhood residents, local government, and business and civic groups.

The transactional legal needs of community groups are well suited also to the use of volunteer attorneys from the private bar, perhaps more so than with civil rights litigation matters. In many cases, private bar volunteers can bring resources otherwise unavailable to public interest attorneys and their clients. Affordable housing projects, for instance, require attention from real property, tax, and corporate and securities attorneys. By leveraging efforts of volunteer transactional attorneys, public interest attorneys can serve far more clients.

For the broad range of community groups to find the help they need, public interest lawyers should partner with private bar attorneys to coordinate efforts to match volunteers with needy nonprofit entities. In many cities across the country, bar associations and legal services groups are organizing themselves to address this problem. For example, Public Counsel in Los Angeles brings together the Los Angeles County and Beverly Hills bar associations to sponsor pro bono transactional representation for nonprofit entities. At the national level, organizations such as Power of Attorney, the American Bar Association National Legal Aid and Defender Association partnership called "A Business Commitment" and the Pro Bono Institute support such programs and encourage private attorneys to get involved.³

II. Potential Issue Conflicts

Public interest attorneys representing nonprofit entities may confront issue conflicts when the interests of a charitable organization client conflict with the interests of a class of clients the legal services program also represents. For example, legal services organizations may represent low-income tenants or people who use services provided by homeless shelters, and may feel they cannot assist nonprofit affordable housing and homeless service providers with designing or enforcing eviction policies.⁴ Another potential conflict situation would be a dispute regarding eligibility for services or treatment of an individual or family by a service provider similar to the kind of adverse situation that would arise if the government itself provided the service. Still another area of conflict may be the employment practices and labor policies of the nonprofit, including resistance to unionization drives.

Unpleasant as evicting tenants, disqualifying people seeking services, terminating employees, and even resisting unionization may be, nonprofit charitable organizations are business enterprises and their directors and officers owe a fiduciary duty to the organization and to the public to ensure that they pursue their mission as effectively as possible and comply with grant and contract terms. Legal services and pro bono programs must make very clear to nonprofit clients, in advance, the kinds of matters the programs will not accept. One possible approach may be to rule out representing nonprofit clients in litigation matters in general; this would avoid involvement in actual instances of issue conflicts but preserve some flexibility for exceptions.

III. Negotiating Contracts with Government Agencies and Government Counsel

As the chief executive of a nonprofit that provides access to subsidized child care observed, cutting costs and preserving the government's administrative options are key goals of government agencies in contracting with nonprofit entities. These goals and the peculiar role of government counsel color the contract terms and negotiations.

A. Government Agency Interests
Some believe that government contracts intentionally pay nonprofit contractors less than the true cost of providing services. The unstated assumption is that nonprofit organizations will bring donated funds and volunteer labor to make up the difference. For example, Los Angeles County has a public-private partnership program, which seeks to shift primary care services from county facilities to private nonprofit clinics. Payments to community health clinics under this program are typically well below the actual cost per patient visit.⁵

Beyond pricing of direct program services, virtually all government contracts set unrealistically low limits on reimbursement for the costs of direct administration of the social services and indirect costs.⁶ In many cases the contracts also deny payment altogether for indirect costs to organizations that have not gone through the arduous negotiation of an indirect cost rate from the source of federal funds.⁷ This inhibits the ability of nonprofit providers to hire and retain adequate staffing in program assistant, clerical, and administrative positions; this often means that skilled professionals such as licensed clinical social workers or physicians' assistants must spend more time doing administrative and clerical tasks, and less time serving clients, than would be optimal. The reimbursement limits also inhibit nonprofit providers' ability to improve systems, equipment, and facilities to support the level of case management, data collection, evaluation, and financial management (not to mention good customer service) that government and private funders demand and that clients deserve.⁸ Whether the purpose is to maximize service to clients, prevent waste and inefficiency, or both, there is good reason to doubt that this approach is effective.⁹ Whatever its purposes, this flawed approach to monitoring service contracts is relatively straightforward for government agencies to administer, and this may be the point.

Preserving the contracting agency's flexibility in changing program priorities and staffing levels may be another important government interest. Local legislatures and department chiefs may use subcontracting in the same way private corporations do, as a strategy that allows them to downsize more cheaply when necessary. Terminating a contract with a nonprofit subcontractor is much easier than laying off government employees protected by civil service rules or collective bargaining agreements. Indeed, the practice of making annual contracts and reserving the right to terminate contracts for convenience, discussed below, shifts the risks of employment liability and broken lease and finance obligations to nonprofit contractors.

The irony is that flexibility is a virtue if it functions to allow nonprofit contractors to experiment with innovative ways of delivering service and to introduce an additional point of contact in terms of accountability.

B. Government Counsel
Government counsel have a different attorney-client relationship from what private attorneys have. Where private bar attorneys view their role as providing legal advice and leaving business decisions to the client, government counsel may not be so deferential to the business judgments of agency officials. A common complaint of nonprofit entities regarding government counsel is that they become in effect a third party in the negotiations, opposing business terms of the deal or withholding approval of the agency's authority to enter into the agreement without specifying legal reasons. Government counsel at times view themselves not as serving government agency clients but rather as equally entitled to decide the government's interests in the matter. As a practical matter the views of government counsel about deal terms tend to decide the issue for the government, unless very senior agency officials get involved; midlevel agency managers are likely to be uncomfortable deciding whether the argument concerns a business issue, which should be their responsibility, or a legal issue.

Attorneys representing nonprofit entities should ask government counsel to specify the legal reasons for their objections. Government counsel often cite established practice or convenience to resist making changes in draft agreements; they claim that to make such changes would be unfair to other nonprofit entities with similar contracts or, more to the point, would require the agency to make similar changes in those contracts. One good approach to avoid this problem is to gather many nonprofit organizations with similar contracts and negotiate with the government as a group. In Los Angeles County, for example, the Community Clinic Association of Los Angeles County, a nonprofit organization comprising thirty- five nonprofit clinics, and the Los Angeles Alternative Payment Alliance, a coalition of fourteen nonprofit child care resource and referral organizations, have successfully increased their bargaining power by negotiating contracts together. In turn, the government agencies with which they contract appreciate the ability to negotiate common issues at once and depend upon the coalitions to help resolve disputes with coalition members.

Government counsel may raise procedural issues, such as the necessity of getting express approval from the city council or county board of supervisors for concessions or changes in standard documents; this introduces the prospect of significant delay in completing the agreement. Whether this objection is sincere or is simply a negotiating tactic is difficult to tell. Since the rules are unclear and government counsel themselves have primary responsibility for determining whether board action is required, nonprofit entities and their attorneys are unlikely to prevail in disputes over procedural issues.

IV. Legal Issues in Government Contracts

A distinguishing feature of contracts between government and nonprofit entities is that the intended beneficiary is the public or a designated population, not the private interests of the parties themselves. The parties' organizational interests are very much involved, and may even predominate, but they are in the background, at least in the writing of the agreement. The legal documents themselves aim to ensure delivery of goods or services to the third-party beneficiaries. Oddly, however, the rights of those beneficiaries are rarely addressed in the contract documents probably because the beneficiaries are not typically in the room. Public interest legal advocates can monitor and observe contract negotiation with the interests of the contract's ultimate beneficiaries in mind.¹⁰

A. Securing Service Delivery, Not Property Rights
In a typical private contract the focus is on protecting the property rights of the parties, both to ensure the benefit of the bargain and to protect against harm in the event of breach. In human and social service contracts, in contrast, the government agency is purchasing services to a chosen population of third parties, and there is no appropriate property for collateral. The government's primary security in such agreements is structuring payment in arrears, enforcing a strict regimen of reporting and auditing requirements, and threatening significant penalties on organizations that cannot justify their performance under the contract.

This approach places emphasis foremost on proving costs, rather than seeking improved services to clients. Further, it builds in inefficiency by placing significant burdens on nonprofit contractors. As described further below, nonprofit contractors typically must (1) cover substantial up-front costs to earn payment and carry interest costs, which they cannot recover under the contract, while awaiting payment, and (2) dedicate significant staff time and energy to keeping records and meeting reporting requirements, the costs of which usually exceed the level of administrative costs eligible for reimbursement under the contract.

We can reasonably expect a government agency to do its best to ensure that public funds are put to their intended use; we can also reasonably expect a nonprofit to guard against the threat of penalties that could damage the organization's reputation and even put it out of business. But we are not being naïve to expect government officials to develop better ways to exercise their oversight responsibility, although this may require placing more responsibility with, and expecting more work from, agency officials.¹¹ The primary emphasis should be on maximizing benefits for clients.¹²

B. Key Contract Provisions
The cardinal rule for transactional attorneys is to stick to legal issues and leave business issues to the client. Effective representation, however, requires that the attorney clearly understand the deal terms in order to ensure that the contract accurately reflects the client's intent. This aspect of the attorney's role may be even more important when representing nonprofit organizations entering into government contracts than it is in a private business transaction. Nonprofit managers in most cases are very smart, skilled, and sophisticated people who know their business field well. They tend to focus first on meeting the needs of their clients, however, and perhaps may not be as likely as for-profit businesses to consider how performing the contract will affect their interests as an organization. A poorly planned program or badly drafted contract can destroy a nonprofit contractor by imposing performance targets or onerous reporting requirements that it cannot hope to fulfill.¹³

The following is a brief outline of a few key contract provisions for nonprofit counsel to review with their clients.

Contractor's Obligations: Scope of Work: The objectives that a nonprofit contractor is expected to fulfill, and the means by which it may pursue them, are often set out in a lengthy appendix or attachment to the main body of the agreement, commonly entitled "Scope of Work." The description of the scope of work is critically important. The nonprofit contractor's performance will be measured against the objectives in the scope of work, and poorly drafted or neglected provisions in the scope of work can result in very costly surprises.

Payment: Cost Reimbursement: Most government contracts pay on a reimbursable basis for work that the contractor already performed. An important issue for nonprofit entities is whether they will be able to pay the up-front costs required by a new, significant government contract. To perform, they may need to hire additional staff, lease space and equipment, and take on other expenses before they are able even to request payment. Payment may come anywhere from thirty days following the invoice to several months later. (For example, a not unusual local government contract may require a nonprofit bidder to certify, with a letter from its bank or outside accountant, that it can carry the costs of implementing the contract services for at least ninety days at any point in time.) The carry costs typically cannot be recovered by charging them to the contract, so they consume charitable funds from private sources. On large contracts, this "float" can cost the equivalent of a part-time or even full-time staff person, and this means that fewer clients are clothed, housed, provided medical treatment, and so on. Nonprofit counsel may pursue an advance of contract costs (one or two months is not uncommon) or payment of interest on receivable amounts. (A government agency is unlikely to agree to pay the interest, but counsel should request it.)

Payment: Eligible Costs: Most government contracts specify a maximum amount that contractors can recover for both (1) direct administrative expenses (i.e., the salary and support costs of senior staff who supervise the nonprofit's work and compliance with contract requirements) and (2) indirect expenses, sometimes poorly described as "overhead" (i.e., costs which cannot be allocated directly to the contract work, such as necessary improvements in computer networks, case management systems, telephone systems, or improved facilities). These direct and indirect expenses are essential to effective operation, and they are sorely underfunded in the nonprofit sector in general. Very likely the nonprofit client's actual costs will exceed the contract limits; this means that unless the nonprofit can raise funds from other sources, it will lose money on the contract.¹⁴ There is often little room for negotiation here, but counsel should review cost-eligibility provisions with their clients, ensure that terms are clearly described and, if applicable, request parity with terms afforded any for-profit contractors with similar agreements.

Term: Many contracts specify an initial term of one year, and most allow the contract to be renewed upon mutual agreement. Many contracts give the government the unilateral right to renew. Nonprofit counsel should make sure that renewal requires the agreement of both parties. A one-year term for a program of any size exposes the nonprofit to significant risk of loss if the contract is not renewed; nonprofit contractors may be required to make significant up-front investments in staff, facilities, and equipment to accommodate the contract work, and they could suffer potential employment liability (and damaged morale) arising from layoffs and heavy losses on equipment and office leases. Wherever possible, nonprofit counsel should assist the nonprofit in pursuing either a multiyear term of agreement or reasonable advance warning that a contract will not be renewed.

Termination for Convenience or Lack of Funds: Local government contracts commonly give the government the right to terminate for convenience. This is essentially efficient breach, for which the government should pay. Counsel should require that on termination for convenience (as it is different from termination for cause) the government give significant advance notice or pay or both notify and pay the nonprofit for its work during a reasonable period of winding down the services (e.g., three to six months). Counsel should also ensure that the government make reasonable compensation for the cost of commitments, such as property or equipment leases, that the nonprofit incurs because of the contract. Even a few months' rent may enable the nonprofit to negotiate its way out of commitments with less harm. Some government agencies, such as community college districts, make the contract contingent upon appropriation of funds by the relevant legislative body, which can include the district's own board.¹⁵ In these cases, the contract should make allowance for payment to the contractor; the allowance for payment should be similar to provisions on termination for convenience.

Mediation and Alternative Dispute Resolution: As prevalent as alternative dispute resolution has become, many government contracts do not provide for or require arbitration or mediation. Alternative dispute resolution forums can help nonprofit entities avoid the disaster that may result from conflict by requiring the parties to get together quickly and involve the assistance of a neutral party. Nonprofit counsel should see whether the contract allows recourse to mediation or arbitration, and may want to consider requiring disputes to be submitted first to an affordable, relatively quick alternative forum, such as mediation by a party identified in advance.

Recourse: Real Property Security for Services: In real property transactions, such as government financing for construction of affordable housing or community service facilities (secured by a promise of services), the loan documents should specify that the loan is "nonrecourse" meaning that the government lender's only remedy is to foreclose on the property. This is fair to the government interest, which is that the property asset be used by some other contractor capable of providing public benefit, and will enable the nonprofit contractor to walk away from a potentially crippling financial burden in the event that it cannot raise the funds from other sources needed to meet its service obligations without endangering its other programs. Reducing liability risk also removes a significant barrier to the nonprofit recruiting and retaining the volunteer leadership it will need to be effective.

Recourse: Reimbursable Payments for Services: As described above, government agencies try to secure adequate performance by paying on a reimbursable basis and imposing strict requirements regarding eligible costs and reporting. The government reasonably expects to recover misused funds or payment for ineligible costs. Unfortunately some government contracts go further to require the contractor to acknowledge that, in the event the contractor becomes unable to deliver the contract services, the agency can charge to the nonprofit contractor the costs of hiring someone else to provide the services, not just the difference in cost.¹⁶ Attorneys representing nonprofit contractors should seek to limit the government's recovery to payments already made for ineligible costs, with appropriate penalties, which are usually dictated by regulations or statute.

Public Notice, Meeting, and Disclosure: Nonprofit organizations are private entities, and, although they are subject to extensive reporting and public disclosure requirements, they typically are not required to meet public notice requirements and allow the public to attend board meetings. Nonprofit counsel should review the contract to see whether it imposes public notice requirements or otherwise brings the nonprofit contractor under those requirements (e.g., by involving the government agency in selecting or approving members of the board of directors). Counsel should seek to limit application of those public notice and open meeting requirements to meetings at which the nonprofit contractor's board makes decisions about the contract services.

Evaluation: Government agencies have sought to evaluate programs based on their "outcomes" rather than simply counting activities, and this method of evaluation has become a dominant trend in the nonprofit sector. Counsel should review the means of evaluation that the contract requires and whether it permits the use of contract funds to pay for the cost of evaluation. Counsel should encourage their clients to review those requirements in light of the scope of work.

MORE GENERAL DRAFTING TIPS ARE BEYOND THE scope of this article, but I should make one key point here. Make the document fit what the parties actually do. Many contracts include requirements which are unreasonable, inappropriate, or impossible for nonprofit entities to fulfill (e.g., independently checking backgrounds of child care providers, as opposed to simply requiring providers to supply proof of license), or extremely onerous, such as requiring a nonprofit to pay the cost of hiring a successor service provider. Government agency officials commonly respond to concerns by saying that they are unlikely to try to enforce such clauses. If so, they should remove them from the document.

¹ This article is based primarily on my admittedly limited experience and is meant to be helpful to legal services and especially pro bono private attorneys who may not be familiar with government contracting for human services.

² From the perspective of empowering clients, transactional legal services work may be more client-driven than litigation. In transactional matters, clients presumably know far more about their business goals and the practical concerns involved than their attorney, they are much more in charge of decisions, and the attorney's role is simply to advise the client of potential risks and try to protect the enforceability of the benefit the client seeks.

³ See www.powerofattorney.org; www.abanet.org/buslaw/probono; www.probonoinst.org.

⁴ Counsel might also view this as an opportunity to try to influence the development of more fair, compassionate practices than might be established without their involvement.

⁵Telephone conversation with Lucien Wulsin Jr., project director, Insure the Uninsured Project (Jan. 2, 2002).

⁶ See, e.g., Office of AIDS Programs and Policy, L.A. County Dep't of Health Servs., Capacity-Building Initiative for HIV/AIDS Service Providers, Addendum to Request for Proposals, Capacity-Building Contract (Oct. 18, 2001), available at www.lapublichealth. org/aids/rfp.htm.

⁷ Id.

⁸ In some cases nonprofit entities turn down contracts or turn down increases in funding and caseload because they cannot recover the required investment in boosting capacity or, even where they have capacity, they would lose money by taking on more work.

⁹ For-profit contractors doing identical work may not face the same restrictions. E.g., a nonprofit organization serving immigrants and low-income people in east Los Angeles and a for-profit business both prepare meals for children and seniors under contract from the same government agency. The for-profit may charge its full costs and a percentage for profit, while the nonprofit may charge only the direct costs of producing the meals and a fraction of the associated indirect costs. (Ironically the nonprofit is considering purchasing the for-profit provider but will do so only if it may continue to operate that business as a for-profit, with the more favorable terms.) In other contexts, such as affordable housing or community development projects, apparently architects, attorneys, consultants, and construction companies are paid their industries' standard fees, while nonprofit entities may not fully recover their costs.

¹⁰ For an excellent article that makes this point strongly, see Jane Perkins & Kristi Olson, An Advocate's Primer on Medicaid Managed Care Contracting, 31 CLEARINGHOUSE REV.19 (May-June 1997).

¹¹ A similar point can be made about private foundation officers managing performance by grantees.

¹² Much of this "don't trust, verify" regime may have arisen as much from concerns about avoiding patronage and corruption in selection of contractors as from a need to hold contractors accountable. Also, part of the problem may be the negative incentive structure for government officials: pain is very likely to result if procedural requirements are not met, while success in meeting important social needs is both hard to measure and, only partly as a result, unlikely to lead to rewards and recognition.

¹³ In one case an organization that provided training and placement for low-income minority youth in well-paid production jobs in the entertainment industry, with significant success, was sued by the state attorney general to recover job-training funds for services the organization had not properly documented. With funding cut off, the organization had to stop its services while it spent nearly a year trying to prove that it had complied with the contract requirements. The organization succeeded in proving that of $300,000 the government claimed had not been documented, it had properly spent $290,000. The attorney general still would not drop the suit, and to settle the case the organization's founder had to guarantee repayment of the remaining $10,000 personally. Employment Training Panel v. Maga Link Inc., Case No. BC 100260 (Cal. Super. Ct. L.A. County Mar. 9, 1994).

¹⁴ Also, such arbitrary, one-size-fits-all limits disproportionately affect smaller community-based organizations that have not achieved sufficient economies of scale. They create strong incentives for cost shifting or misstatement of actual indirect costs; this, besides misleading funders and donors, distorts the information that nonprofit managers and board members use to make important decisions.

¹⁵ Conversation with Catherine Endo Chuck, counsel for Los Angeles Community College District (Nov. 21, 2001).

¹⁶ Assuming that the government has not lost contract funds or will recover them, charging the costs of paying another contractor to a nonprofit that may be providing other important services using charitable funds does not make sense.