Click here for printer friendly page
Expanding environmental due diligence in the M&A context21/06/2006. Source: Nixon Peabody.
 In the past few years, notes Nixon Peabody, changes in the environmental regulatory framework have changed the way M&A professionals should look at environmental due diligence in connection with acquisitions and divestitures.
The ASTM Phase I environmental site assessment standard that many regarded as the foundation for due diligence will no longer be sufficient to constitute "all appropriate inquiry" if the EPA proposed rule is adopted in its current form, and in many cases that standard falls far short of the due diligence needed to protect prospective buyers in a merger or acquisition context.
CERCLA imposes liability for all costs relating to investigating and responding to actual or threatened releases of hazardous substances at a site on, among others, the current owner or operator unless that party shows that it had no reason to know the site was contaminated after having performed "all appropriate inquiry" into the prior uses and ownership of the property. This is the "innocent landowner defense" that triggered an entire industry devoted to conducting due diligence for lenders and buyers of property or manufacturing operations, and that led to the development (primarily by banking interests) of the ASTM Phase I standard to define what constitutes a good and customary practice for conducting "all appropriate inquiry."
The ASTM Phase I standard due diligence involves an evaluation based on non-intrusive means such as a site inspection, interviews with former employees and a review of various governmental databases. Even when supplemented by a Phase II (involving a limited testing program), the ASTM Phase I standard's principal focus is on the potential presence of "recognized environmental conditions" in which contamination is present and likely to lead to a regulatory demand for remediation. Since environmental cleanup liability is not limited to the amount of investment in the property, the innocent landowner defense and the ASTM Phase I due diligence are important due diligence tools. But, the innocent landowner defense has no applicability in two important contexts: (a) if the buyer discovered an environmental condition during due diligence, it could no longer acquire the property and still claim it had "no reason to know" the site was contaminated; or (b) if the site being acquired was in a state with a CERCLA counterpart law that lacked the innocent landowner defense (still about fifteen states do not recognize such a defense).
In addition, the innocent landowner defense offered no protection for potentially significant environmental liabilities that were not related to actual or threatened releases of hazardous substances. For example, environmental regulatory compliance issues could be a source of substantial penalties ($35,000 per violation, compounding daily) from the first day of operations under a new owner not to mention costs of implementing corrective actions to bring the operations into compliance. Health and safety issues also can be a source of exposure which, as a practical matter, can eclipse the environmental ones. Although parties often deal with these issues through transactional representations and warranties or escrows and baskets in an M&A context (whether in an asset or stock acquisition context), such protections are only as strong as the financial health of the company offering the indemnity.
A far greater measure of protection is assured by conducting a very thorough environmental health and safety due diligence process that identifies and quantifies all potential material issues and enables the parties to bargain from a position of strength.
In 2002, Congress adopted two new liability defenses and expanded the criteria needed to qualify for the innocent landowner defense. The "bona fide prospective purchaser" (BFPP) defense addressed the inability of purchasers to proceed with the acquisition if due diligence uncovered an environmental condition since they could no longer demonstrate they had no reason to know the property was contaminated. Under the BFPP, a new owner taking the property subject to a known condition can still qualify for CERCLA liability protection if the proper due diligence is conducted and the other qualifying conditions (relating to the new owner's obligations once they take title) are met. The new second defense protects a "contiguous property owner" who becomes the owner of property that is impacted by adjacent off-site sources which the new owner neither caused nor contributed to. Again, there are detailed conditions to be met to qualify for either defense, and very few states have counterpart defenses in their state laws.
Another key development is affecting the M&A environmental playing field. In August 2004, EPA proposed draft 40 CFR Part 312 which is the proposed "all appropriate inquiry" (AAI) rule. This was developed in a negotiated rule-making process and defines the due diligence process that must be undertaken (once the rule is finalized) to qualify for all three liability defenses. The rule will replace the ASTM Phase I standard (which will eventually be revised to conform to the new AAI rule) and it imposes significant new obligations on buyers and their consultants. Among the key differences are that the work must be conducted by an "Environmental Professional" with the qualifications described in the rule; broader visual site inspection, interview and documentation requirements will apply; specific opinions must be stated in the report; more focus on adjacent properties; new information on fair market value in relationship to purchase price must be provided; and other title/lien information is required. One important new element likely to impact the cost and timing of transactions is that consultants must identify any data gaps and opine as to their potential significance. For liability reasons, consultants will likely be cautious in offering "clean" Phase I opinions thus leading to more costly Phase II's and longer transactional lead times.
Other ominous trends are also emerging to affect transactional due diligence. These include:
(1) emergence of stricter vapor intrusion standards (risks to occupants of structures over remediated sites where residual contamination in soils or groundwater can cause contaminant vapors to intrude into indoor air) including reopening sites that have achieved regulatory closure (e.g., New York and California);
(2) revisiting of institutional controls (deed and use restrictions) and their effectiveness at controlling exposures to residual contamination, including the development of an EPA database and the inclusion of institutional controls in the conditions to qualify for the liability defenses discussed above;
(3) expansion of brownfields and voluntary cleanup programs with liability exemptions for lenders and new owners linked to performance of negotiated site cleanup work (e.g., Michigan and Pennsylvania);
(4) emergence of claims for damages to natural resources, including some states (e.g., New Jersey) passing statutes creating longer limitations periods or reviving long lapsed potential claims;
(5) regulation of chemicals under "homeland security" regulations at the federal level, including regulation of chemicals in certain industrial sectors (and even in college and university and health care settings) requiring "vulnerability assessments" considering chemical storage practices and the possibility of on-site releases and thefts of hazardous substances, and at the state level (e.g., Maryland) adopting state-wide chemical security regulations and granting agency authority over compliance and assessment of the potential for releases; and
(6) emergence of "compliance history" programs (e.g., Texas) in which the state develops a five-year "score" based on violations, permit performance, reported releases and other factors, which is then used to establish the rate of regulatory inspections, the toughness of permit conditions or access to incentive programs, and which score runs with the facility in the event of a transaction.
In short, there is more reason today than ever before to make the investment in a comprehensive due diligence program that goes well beyond the minimum criteria defined in the ASTM Phase I standard. The adage about an ounce of prevention being better than a pound of cure applies in this context. As in any transaction it is better to know the magnitude of the issues being faced and to address them up front in pricing the transaction than to face extensive transactional costs to enforce an indemnity or to rely upon the uncertain financial wherewithal of the indemnitor.
Jean McCreary is a partner and chairs the energy and environmental practice group of Nixon Peabody LLP, and she concentrates her practice on transactional due diligence, regulatory compliance, and environmental management system. She is a Certified Professional Environmental Auditor (BEAC) and has conducted or overseen transactional due diligence in about 40 states and more than 15 countries.
If you are not currently on our mailing list and would like to receive future publications of our M&A Advisor, please send your contact information, including your e-mail address, to lblaney@nixonpeabody.com.
Nixon Peabody LLP is one of the largest multipractice law firms in the United States, with offices in fourteen cities and more than six hundred attorneys collaborating across fifteen major practice areas. The firm's size, diversity, and state-of-the-art information systems enable it to offer a comprehensive, integrated range of legal services to individuals and organizations of all sizes in local, state, national, and international matters.
The foregoing summary of recent developments in the law and practice of mergers and acquisitions is provided by Nixon Peabody for education and informational purposes only. It is not a full analysis of the matters summarized and is not intended and should not be construed as legal advice. This publication may be considered advertising under applicable laws.
|
