Colgate Selden

January 24, 2001

Today, tools exist to help reduce the costs associated with environmental issues in a transaction.  These tools, supplementing environmental due diligence, come in the form of environmental insurance and incentives to perform self-audits.  In the past, the possibility of environmental liability frightened even speculative investors and snuffed out enticing deals.  Now, wary buyers, sellers, investors, owners, and operators can walk back into transactions with more confidence.

Background

Due diligence has become an extremely important part of our legal landscape.  Disagreements over terms, desire for information, liability, and regulation all have converged to necessitate the due diligence inquiry.  Environmental due diligence has become particularly important to reduce risk after statutes such as the Comprehensive Environmental Response, Compensation, and Liability Act[1] CERCLA) were authorized and regulatory bodies such as the Securities and Exchange Commission (SEC) considered environmental information to be material to an investor's decision making.[2]  Some examples of events where environmental due diligence comes into play include: "real estate transactions, mergers and acquisitions, regulatory requirements, internal auditing, loan transactions, insurance underwriting, [and] securities disclosures."[3]

Under CERCLA for example, cleanup liability for hazardous substances can become the responsibility of current and former owners or operators of facilities.[4]  Other parties such as parent corporations can become responsible if they exercise "control" over the facility.[5]  Liability is joint and several.[6]

Likewise, ongoing pollution could result in the imposition of fines by environmental authorities.  The potential impact on an income statement and a corporate image can be difficult to overcome.  Thus, environmental due diligence becomes a major tool in reducing risk before and during ownership.

If environmental due diligence is performed, there is no guarantee that it will reveal every environmental issue.  Since the extent and thoroughness of the inquiry is variable depending on use, a possibility exists that the wrong type of inquiry might be conducted.[7]  And, those who are performing the due diligence may not be skilled or are subject to mistakes.  Hence, no one can be completely assured of minimal environmental liability attached to a property or entity.

Even if risks are known, a simple purchase of assets transaction expressly excluding certain liabilities will not necessarily relieve the purchasing party of them.[8]  For example, courts can use successor liability to broaden CERCLA's net to capture more potentially responsible parties.[9]  Buyers can become liable even if the assumption of liability was not contemplated by agreement.

Also, in purchase of asset transactions, the parties may not be able to agree on the liabilities to be excluded.[10]  This could lead to increased pressures that result in deadlocked negotiations.[11]  Or, one or both parties may suffer enormous expense.[12]

Many times, buyers choose to make a purchase with the specter of liability hanging overhead.  These buyers conduct environmental due diligence and find existing environmental liabilities.  But for them, the benefits of the transaction outweigh potential liability costs from known and unknown risks.  However, the potential costs associated with liability are difficult to discern precisely.

Environmental Risk Today

Now, the means exist (beside traditional methods like warranties and indemnity clauses) to achieve a second chance after the transaction is complete and the unfortunate situation arises where a lack of environmental due diligence leads to a surprise.

First, the Environmental Protection Agency (EPA) in 1995 created incentives that may reduce a party's potential gravity-based or non-economic benefit civil liability by as much as 75%.[13]  These incentives require a facility operator or owner to perform environmental due diligence, disclose any violations, and make corrections (if a party fails to disclose known violations, then criminal liability could follow) in order to potentially escape maximum penalties.[14]  This approach speeds up efforts to clean the environment, establishes an atmosphere conducive to cooperation, and lends some certainty to potential liability.[15]  After self-reporting, the party may be foreclosed from any future liability for that particular issue.[16]

Second, insurers are returning to the environmental insurance market with cheaper, more meaningful products.[17]  In the past, most insurers backed away from issuing environmental policies as a result of large civil and criminal penalties and uncertain liability against the insured.  Policies are now written to cover the policyholder's potential liability and costs associated with unknown and known environmental issues.[18]  Previously, insurance companies, after suffering significant losses, were quick to add pollution exclusions to their products to limit coverage.[19]

Effects of environmental insurance include lowered costs and increased certainty.  Transactional costs may be reduced because environmental due diligence does not have to be as extensive since policies can cover unknown liabilities.[20]  Loan costs can be reduced because the need to offset potential liability is not as significant.[21]  Costs due to structuring the transaction may also be reduced because buyers and sellers need not dedicate as much of their resources to specific transfers or exclusions of liability.[22]  Hence, the transfer of risk to insurers leads to increased confidence in transactions.

For example, bond rating companies recently approved the use of environmental insurance instead of "Phase One" Environmental Site Assessments for commercial mortgage backed securities.[23] This favorable treatment is due to the transfer of risk.[24]  At least one insurance company's environmental products were used in the place of phase I environmental due diligence on 90% of the secured properties it covers.[25]

Conclusion

The potential liability arising from environmental degradation is still very real and significant.  A minimal amount of environmental due diligence must generally be performed.  However, a large part of this liability can now be reduced or transferred to another party.  Voluntary disclosure incentives and environmental insurance are two alternatives that can add certainty and reduce the costs of transactions.  As a result, mergers, acquisitions and land transfers involving environmental liability issues can increasingly be completed with confidence.

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[1] Comprehensive Environmental Response, Compensation, and Liability Act, 42 U.S.C. §§ 9601-9675 (1994).

[2]Disclosure: SEC Commissioner Warns Corporations to Disclose Environmental Liabilities, BNA SEC. L. DAILY, d3 (Apr. 8, 1994).

[3] Sean Monaghan, Environmental Due Diligence, 1176 PLI/Corp 109, 114 (2000).

[4] 42 U.S.C. § 9607.

[5]United States v. Bestfoods, 118 S. Ct. 1876 (1998).

[6]See generally, 42 U.S.C. § 9607(a)(4).

[7]See Monaghan, supra note 3, at 117.

[8]See, e.g., In re Acushnet River & New Bedford Harbor Proceedings re Alleged PCB Pollution, 712 F. Supp. 1010 (D. Mass. 1989).

[9]See id.

[10] Andrew N. Davis et al., Let's Make a Deal Transferring Environmental Risks for a Reasonable Price, 25 CONN. L. TRIB. 45 (Nov. 15, 1999).

[11]Id.

[12]Id.

[13] Incentives for Self-Policing: Discovery, Disclosure, Correction and Prevention of Violations, 60 Fed. Reg. 66,706 (Dec. 22, 1995).

[14]Id.

[15]See id.

[16]See id.

[17] Davis et al., supra note 10.

[18] Rick Mandell & Michael B. Gerrard, Clean Sweep, 16 FIN. EXECUTIVE 2 (Mar. 1, 2000), available at 2000 WL 13301007.

[19] Davis et al., supra note 10.

[20]See Mandell & Gerrard, supra note 18.

[21] Davis et al., supra note 10.

[22]Id.

[23]Environmental Insurance Gains Favor, 4 MORTGAGE SERVICING NEWS 6 (May 19, 2000), available at 2000 WL 18803313.

[24]Id.

[25] Adam Tempkin, Miller & Associates: Insurance Brokers: Broker Continues to Penetrate CMBS Environmental Insurance Market, MORTGAGE BACKED SEC. LETTER, (Oct. 2, 2000), available at 2000 WL 4547068.