Regulatory Re-Interpretation Triggers Contractual Indemnity

Historical environmental compliance is critically important in corporate transactions especially when a business or facility may be subject to a regulatory programs that is evolving or subject to re-interpretation such as the New Source Review program. In such cases, the parties will try to contractually allocate the risks. Despite the fact that these agreements are heavily negotiated, regulatory issues may subsequently arise that the parties may have no contemplated or that the parties simply disagree on how the agreement addressed the issue.

An interesting example is the unreported decision in Lucite International, Inc. v E. I. Du Pont De Nemours and Co., No. 2:09-cv-02279 (W.D. Tenn. 5/17/11) involved a 1993 sale of aMemphis acrylics plant by DuPont to ICI Acrylics, Inc. (now known as Lucite International, Inc). Unreported decision tend to be overlooked by the legal trade press because they have no precedential value. However, the vast bulk of law is made in unreported cases and these opinions can provide insights on how judges may view similar situations or provide roadmaps on what arguments  may present the best chance of success. These informal decisions can also often provide practical insights and lessons learned about contract drafting and interpretation.

In this case, theMemphisplant manufactured methyl methacrylate.  The manufacturing process used a sulfuric acid recovery unit (“SAR Unit”) to convert spent acid sludge into sulfuric acid. In 1973, the Tennessee Division of Air Pollution Control (the “TDAPC”) classified the SAR Unit as a “process” instead of a “sulfuric acid plant. If the SAR unit had been classified as a sulfuric acid plant, it would have been potentially subject to the New Source Performance Standards (NSPS) of the Clean Air Act (CAA). The TDAPC subsequently delegated permitting authority to theMemphisand Shelby County Health Department (“MSCHD”). This agency initially informed Dupont that the SAR was considered to be a ‘pollution prevention device’ and not a NSPS-regulated unit because it recycled the spent acid to the process eliminating the discharge of spent acid to the process server.

In 1975, Dupont applied for a permit from the MSCHD to construct a second furnace train. In 1982, the MSCHD issued a permit that allowed the plant to emit 11.9 tons per day of sulfur dioxide (SO2) which exceeded of the amount permissible under the NSPS. EPA subsequently approved the facility’s Title V operating permit with the SO2 emission rate.

In November 1985, the MSCHD advised Dupont that it had re-classified the SAR Unit as a sulfuric acid plant. However, the MSCHD informed Dupont that it would not enforce the NSPS or retroactively penalize Dupont for modifications made between 1975 and 1978 since the facility had relied in good faith on the prior determination that the SAR unit was not subject to NSPS. However, the agency cautioned that any future modification would trigger the NSPS. The MSCHD indicated in its letter that while it believed the SAR classification was correct, DuPont could request a determination by the EPA.

In December 2002, the EPA conducted a multimedia compliance investigation and subsequently concluded that the plant was operating in violation of the NSPS emission limits for SAR units since at least 1978, when the second furnace train came online. Following two years of negotiations, EPA and Lucite entered into a consent decree in February 2006 where Lucite agreed to install dual absorption technology to bring the SAR unit air emissions within NSPS and paid almost $25 million in civil penalties. The consent decree was terminated in 2008 after the court determined that Lucite had complied with its terms.

In May 2009, Lucite filed a breach of contract action against Dupont for failing to honor it’s indemnification obligations under the 1993 the Asset Purchase Agreement (APA). Specifically, Lucite alleged that Dupont had breached APA Clause 12.2.1 that provided that the seller indemnify the buyer for “Environmental Liabilities” attributable to conditions existing at the Closing Date.

Dupont argued that it was not required to indemnify Lucite because the environmental liabilities resulted from Lucite’s failure to install dual absorption technology. Dupont claimed that Lucite had failed to mitigate or avoid exacerbating environmental liabilities. Dupont specifically pointed to APA clause 12.2.2 providing that its indemnity obligation did not extend to environmental liabilities that “have arisen, been increased, exacerbated, enhanced, or caused as a result of an act or omission (whether direct or indirect) of the buyer . . .”.  Dupont also argued that it was not required to indemnify Lucite the NSPS determination by EPA was a change in legislation after the closing of the APA agreement.

On Dupont’s claim that Lucite caused its damages by failing to install the dual absorption technology, the court said that for an act or omission to constitute a complete bar to indemnity, the court said that Dupont would have to show that Lucite was the sole cause of the environmental liabilities but had failed to do so since the EPA Investigation Report had concluded that the SAR had been exceeding the NSPS emission limits years before Lucite purchased the site.

On the related issue that Lucite failure to mitigate its damages relieved Dupont of its indemnity obligation, the court said the duty to mitigate only attaches once a material breach of contract occurs and then all that is required of the non-breaching party is to act reasonably so as to not unduly enhance the damages. The court said the APA did not alter the traditional mitigation duty. The court pointed to APA Clause 12.4.1 which suggested a narrow range of activities that Lucite had to perform to mitigate against environmental liabilities, such as “carrying out (where reasonably practicable) soil tests” (APA Clause 12.4.1.1) and “settling a claim of any party . ..with respect to loss, harm or other damage” (APA Clause 12.4.1.3).

Under these clauses, the court continued, Lucite only had to take reasonable and practical steps to mitigate damages. Requiring Plaintiff to install a multi-million dual absorption technology prior to an allegation or determination by a government regulator that the NSPS apply to the SAR Unit would not be reasonable or practicable. Thus, the court found that the earliest point at which a “potential environmental liability” may have arisen to trigger APA Clause 12.4.1 was when the EPA first informed Lucite that it intended to assert claims for violations of the NSPS. Prior to this event, the court reasoned, Lucite was not aware of any “potential environmental liabilities” and thus could not be found to have failed to mitigate such liabilities under APA Clause 12.4.1. The court also rejected Dupont’s interpretation that Lucite had a duty to “monitor the status of the law” and to “proactively request” an NSPS applicability determination from the EPA.

In response to the Lucite’s claim that Dupont had breached its environmental compliance warranty, Dupont asserted that its disclosures in the Schedules of the APA relieved it of any duty to indemnify. Dupont specifically pointed to APA Clause 9.7 providing that “[t]he Buyer shall not be entitled to make any claim with respect to any breach or alleged breach of the Warranties to the extent that: the facts, matters or circumstances giving rise thereto (with respect to which any such claim or alleged claim arises) have been disclosed in this Agreement or the Schedules hereto.” Dupont also relied on APA Clause 1.2.2 that stated that the schedules forms part of the APA and Clause 9.2.1 that provided that the warranties are given subject to the information disclosed in the Schedules. Dupont pointed out that ICI had requested information identifying all environmental capital expenditures during the last ten years that were greater than $100,000 and that the schedules referred to a Site Assessment Report and Environmental Baseline Study that included an entry of “SO2 Stack Dual Absorption” at a cost of “8 million dollars. Dupont also cited a document disclosed in the schedules titled “Environmental Topics and Path Forward,” that summarized a meeting between ICI and MSCHD representatives concerning emissions permits in October 1992

However, the court ruled that the disclosures in the APA Schedules did not viscitate its indemnity obligation. The court said the disclosure about the SO2 Stack Dual Absorption reflected a potential but unauthorized capital project that did not come to fruition. The mere fact that Lucite subsequently had such a project on its capital forecast, the court said,  did not obligate Lucite to install the equipment. The court also found that pre-closing communications did not relieve Dupont of its potential indemnification obligation since the APA constituted the final, integrated agreement among the parties.

The court said that Dupont agreed to indemnify Lucite for environmental liabilities attributable to pre-closing conditions and failed to cited any cases supporting its arguments that pre-closing disclosures can nullify express representations in a contract. The court pointed out that Delaware law provided that a party to a contract can rely on express warranties and representations in that contract regardless what they learned or should have learned during due diligence. The court said contracting parties do not have to prove that they were justified in relying on the representations and warranties set forth in the contract. Accordingly, the court held that Lucite’s failure to install dual absorption technology prior to being informed by the EPA that the agency intended to assert claims against Plaintiff for violations of the NSPS did not constitute an omission or a failure to mitigate under APA Clause 12.4.1. However, the court did find there was an issue of material fact as to when the EPA informed Plaintiff of its intent to bring these claims.

Dupont also argued that EPA’s determination that the NSPS applied to the SAR Unit fell within the change of law exclusion to its indemnity obligation since the EPA interpretation ran counter to prior rulings of the state and MSCDH. The court rejected this claim, holding no change in legislation occurred when the EPA issued its 2003 Investigation Report. The court said neither the governing law enforced by the EPA or the NSPS regulations had changed since the 1993 closing date. The court said that the MSCDH had informed Dupont in 1985 that the SAR Unit was incorrectly classified as a sulfuric acid process but had decided to exercise its discretion not to enforce the NSPS. The fact that EPA decided to enforce the long-existing NSPS regulations did not constitute legislation not in effect at closing.

Moreover, the court rejected the assertion that the MSCDH had “grandfathered” and exempted the SAR from the NSPS regulation. The court said EPA’s delegation to the state expressly reserved EPA’s right to enforce any applicable standard and EPA was not bound by any decision of the state or local authority. In addition, the court said, neither Congress nor the EPA delegated to local authorities the power to make local plants “exempt” from federal laws and regulations. Indeed, the court noted that MSCHD acknowledge in its letter to Dupont that the EPA could make a subsequent enforcement determination and informed Dupont that it could request a determination by the EPA if they so desired. Regardless of what the parties believed, the court ruled, EPA retained the authority to decide that the parties’ understanding of the compliance status of the SAR Unit was in error, regardless of whether it was operating under emissions permits issued by the MSCHD.

The court docket had lots of sealed documents presumably to prevent disclosure of confidential information or trade secrets. Recently, the parties reacged a confidential settlement of this case.