Conducting Cost-Effective Environmental Due Diligence in Corporate Mergers and Acquisitions

By Larry Schnapf

		Environmental due diligence is playing an increasingly important role in corporate transactions. Unfortunately, contracting parties often fail to do sufficient environmental due diligence or do not complete it early enough to effectively use the information in the transaction. As a result, parties may find themselves saddled with unexpected liabilities. This article discusses how to tailor a due diligence program to a particular transaction and how to use the information in a way that will bring maximum value to the transaction. 

1. Why Is Environmental Due Diligence Important?

	Federal and state environmental laws can impose significant liabilities on a wide range of corporate entities including successor and parent corporations. For example, under the federal Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”), corporations may be responsible for the cleanup of contamination at facilities they currently or formerly owned or operated as well as at disposal facilities where their waste was sent. 
    
	One common reason for performing environmental due diligence is to preserve the CERCLA innocent purchaser’s defense. This defense provides that a purchaser may be able to avoid liability if it can establish that it had no reason to know about the contamination. To establish that it had no reason to know, the purchaser would have to show that it undertook a reasonably “appropriate inquiry into the past uses and practices of the property that was consistent with good commercial and customary practices”. 

 However, there are other reasons why a purchaser should perform environmental due diligence. When done properly and early in a transaction, environmental due diligence can be used to achieve a wide range of business objectives and bring value to the process in terms of liabilities avoided and costs saved. For example:  

•	A purchaser can use the information to show what contamination existed prior to the closing and was not attributable to its operations.

•	The parties can use the information to allocate liabilities identified during the investigation obtain environmental insurance or re-price the deal. 

•	Nearly 70% of corporate acquisitions fail to achieve their business objectives. One principal reason is poor post-acquisition intergration. If a purchaser will be streamlining or closing obsolete plants, pre-acquisition environmental due diligence can help identify environmental costs associated with facility closings and help avoid or minimize unnecessary environmental costs

•	EPA and many states have implemented self-reporting auditing policies where companies that voluntarily disclose violations discovered during due diligence or an audit can obtain significant reductions in penalties. 

•	There has been an increase in bodily injury and property damage claims for persons and property exposed to hazardous substances. The parties to a transaction should be aware of the possibility of groundwater contamination migrating off-site or air emissions that could lead to such liability.

2. Environmental Due Diligence Standards 

CERCLA does not describe what constitutes an “appropriate” inquiry. While some of the 40 states that have enacted their own versions of CERCLA have established criteria that must be followed for environmental due diligence, parties generally develop due diligence based on the needs of a particular transaction. 

It is customary to perform environmental due diligence in discrete phases known as Phase I and Phase II. Each investigative phase is based on the information gathered in the preceding phase. However, there has been considerable uncertainty as to what tasks or issues should be addressed in each phase. 

In an attempt to provide some standardization to the process, the American Society for Testing and Materials (“ASTM”) has published two environmental site assessments standards. They are intended to establish what constitutes "good commercial and customary practice" to satisfy the CERCLA innocent purchaser defense but do not address requirements of other federal or state environmental laws. 

The first standard is known as a Transaction Screen (E 1528). It is a limited review that is based on the results of a questionnaire completed by a facility operator, a cursory site visit, and a limited review of government records. The Transaction Screen may be a useful device for deciding which sites to investigate in a multi-parcel transaction and as an issue-identifying device. The second standard, the Phase I Environmental Site Assessment (E 1527), is a more extensive investigation. 

The ASTM standards fall short providing a measure for what constitutes an “appropriate inquiry” because they give parties too much discretion in developing the scope of due diligence. Accordingly, purchasers should not blindly rely on environmental audits that were based on the ASTM standards but should independently review the SOW to determine if the investigation was adequately designed to assess conditions at a particular site. 

In addition, the person answering the Transaction Screen is only required to provide information in its actual possession and is not required to search for records not in their possession. Likewise, the investigator is not required to conduct an exhaustive search of company records but simply those that are “reasonably ascertainable” or “practically reviewable.” Reasonably ascertainable information is data that may be obtained “within reasonable time and cost constraints”while information that is practically reviewable refers to information that does not require extraordinary analysis. Records that are sorted or filed according to limited geographic areas may be considered “practically reviewable”while large data bases that are not organized by zip code or other geographic designation may not be considered practically reviewable.

Investigatora are only required to describe past uses or conditions that are visually or physically observable or that are identified from reasonably ascertainable records. However, prior uses or associated contamination may no longer be evident at a site.

3. Mechanics of Performing Environmental Due Diligence

The first step for an M & A professional is to determine the scope of the environmental due diligence. The extent of environmental due diligence will vary from deal to deal and will be influenced by the following factors:

•	The number and type of facilities to be investigated;
•	The value of the transaction;
•	The time allotted for performing the investigation;
•	The funds available for performing the investigation; and
•	The level of risk that the parties are willing to accept in developing remediation or liability estimates.

Enviromental due diligence should not be limited to industrial properties but also include commercial sites such as gasoline service stations, automotive repair shops, dry-cleaning establishments, photographic developers, paint operations, hospitals, jewelers, shopping malls, restaurants and even farms or undeveloped property that could have been used for illegal hazardous waste disposal or where toxic substances such as pesticides, herbicides and fertilizers may have been applied

Although it is preferable to conduct environmental due diligence on each parcel that will be part of the transaction, parties in multi-parcel transactions may have to restrict the investigations to a limited number of properties because of cost or time constraints. The sites that are selected will usually be those that are likely to have the worst problems or that represent the most valuable properties. The size of the transaction is a key factor since larger deals can absorb greater environmental liability. 

One screening technique for multi-parcel transactions is to have the seller complete a environmental due diligence questionnaire The information gathered from the questionnaire can be used to more narrowly focus the environmental due diligence. However, because of time constraints and disclosure concerns, this approach is rarely used now. 

Another critical issue is gaining access to the site and obtaining information from the facility personnel. Sellers may be reluctant to share information out of fear that the purchaser may disclose the information to the government. One way to address this concern is for the parties enter into a confidentiality agreement.

4. Retaining the Environmental Consultant

Environmental due diligence may be performed internally or by an outside environmental consultant. If an outside environmental consultant will be used, a request for proposal (RFP) will usually be prepared. If the transaction involves a limited number of facilities or the purchaser has had significant experience performing environmental due diligence, a Scope of Work (SOW) may be prepared and forwarded to the bidders in lieu of an RFP.

The RFP will describe the objectives of the work to be performed and request that bids be submitted by a specific date. If there is inadequate time to solicit bids, consultants may be selected based on prior experience. If a national environmental consulting firm is being considered, it is important to remember that the level of competence may vary between offices and individuals within offices. Thus, if a consulting firm is being retained because of a previous work association, it is advisable to request the same individuals who worked on a prior transaction. The consultant should retained by an attorney so that the opinions or conclusions contained in the consultant's report might be able to be cloaked under a legal privilege. 

The environmental consultant will prepare a SOW unless it was enclosed in the bid package. The SOW describes the specific tasks to be performed, the schedule for each task, and a cost estimate for the project. Specifically, this document will indicate the number of facilities to be visited, the priority of the site inspections, the kind of sampling to be performed, the substances that will be analyzed, and the regulatory information that will be collected.

5. Reviewing Environmental Consulting Agreements

Many consulting firms use standard contracts that should be carefully reviewed by an attorney prior to hiring the consultant. One of the more important issues involves ownership of all materials that are generated by the consultant. The consulting agreement should provide that all materials, including drafts, drawings, photographs, and field notes, are the property of the client and that the consultant will not release any information obtained in the investigation to any third party without the express written consent of the client. 

Consulting agreements frequently request that the client indemnify the consultant for any injuries or losses resulting from site conditions. Since the client will usually not be the party that is in control of the site, the client should not agree to such a provision.

Another important issue is insurance. It is recommended that the consultant should be required to maintain GCL, professional liability, automobile, workers' compensation, and employer's liability insurance and to add the client as an additional insured under the GCL polity.

The client should also seek the right to terminate the contract for any reason and have the consultant agree not to incur any further charges upon receipt of the termination notice. 

6. Phase I Environmental Site Assessments

	 The Phase I Environmental Site Assessment (“ESA”) is designed to identify areas of potential soil or groundwater contamination. The Phase I ESA consists of a site inspection and a review of public and private records to ascertain the present and past regulatory and operational history of the site including the following:

•	Title Search- The chain of title should be reviewed as far back as possible to determine how the property was used in the past. However, if the owner did not operate of the site, the title search may not reveal much information on historical property uses.

•	Historical Facility Records- Manufacturing or chemical facilities that have been in existence for a long time have probably significantly changed their environmental practices. Areas of a facility that may not appear to pose any current environmental risk may have been used in the past as lagoons, landfills or disposal areas and may have to be remediated. Thus, the consultant should review site plans, plats, engineering surveys, blueprints and aerial or historical photographs which may locate structures, underground storage tanks, floor drains, sewer lines, lagoons, settling ponds, trenches, railroad tracks, and areas of hazardous waste storage. Former employees who may have knowledge about past practices should also be interviewed if they can be located. Tax records, subdivision maps, building or land use permits and interviews with local officials may also be helpful.

•	Regulatory Compliance Records- Businesses subject to environmental regulation are required to maintain and file a variety of records with state and federal environmental agencies. These documents along with financial reports indicating expenditures for pollution control equipment or reserves for environmental liability, insurance policies, records and procedures for compliance with right-to-know, training and other health and safety requirements of OSHA. When reviewing permits, the examiner should confirm that the transferee is the permit holder and that the permit has not expired. Contacts with regulatory agencies must be handled with extreme care to avoid triggering reporting obligations.

•	Neighboring Properties-Because nearby properties can be a source of contamination and may also be impacted by contamination migrating from a facility, the consultant should observe properties within a one-mile radius and review state and federal databases filings within the geographic range.

•	Off-site Disposal Facilities- When purchasing a business, it is important to identify the disposal facilities where company sends and has sent its hazardous wastes to ascertain if it faces any potential CERCLA generator liability.  

	Each site inspection usually requires two person-days and an additional two person-days will probably be needed for collection of regulatory information. Another couple of days will be required to prepare a draft report, and oversight by management will add another person-day to the project. As a result, a Phase I ESA site inspection will typically cost between $5,000 to $7,000 per industrial facility without soil or groundwater sampling. If sampling is required, this could add $10,000 to $20,000 to the cost of each site depending on the number and depth of the wells that have to be installed, the number of soil samples, the kinds of parameters to be analyzed, and time that the laboratory has to analyze the samples.

The consultant should orally review the results with the client and the attorney at set intervals or after the investigation at certain key facilities have been completed. Following the oral report, the consultant should prepare a draft report. The report should ne limited to factual observations and not include any legal conclusions or opinions regarding status of regulatory compliance or speculations on the sources of potential contamination. The reason for this is that many clients will not be prepared to address all of the noncompliance issues that may be raised in a report and the existence of such findings in a report could be used by a government agency in any subsequent civil or criminal enforcement action as evidence of willful or deliberate noncompliance with environmental laws. After making requested changes, the consultant will issue a final Phase I report. It is advisable that the report be issued to the attorney to preserve confidentiality.

7.  Phase II Investigation

If the Phase I ESA reveals areas of concern (“AOCs”), the M & A professional should request a Phase II ESA to further investigate the AOCs. Many times when heavy industrial properties are involved, the parties to a transaction automatically perform a Phase II site investigation.

A second SOW will be prepared for the Phase II ESA specifying the subsurface investigations that are to be performed such as soil or groundwater sampling. Delineating the extent of soil and groundwater contamination can be expensive and may may make some deals economically unviable. Consultants are often asked to provided cost estimates which will often be expressed in a dollar range. The narrower the range that is desired, the more costly the investigation.

 Because many sources of contamination cannot be visually observed, the Phase II subsurface investigation may begin by using noninvasive screening methods such as metal detectors to identify buried metal structures, like storage tanks, as well as a volatile organic analyzer that can "sniff" gases evaporating through the soil from buried storage facilities or plumes of contamination.

If groundwater contamination is confirmed, additional wells may have to be installed to define the extent of the contamination and also determine the direction of groundwater flow. The groundwater flow can be particularly important because it may turn out that the contamination is flowing onto the site from an adjacent property so that the site may not be the source of the contamination. 

The environmental consultant should first communicate the results of the investigation orally and then prepare a draft report for review by the attorney.

	 	The recent trend towards selling corporate assets through a bidding process has heightened the importance of environmental due diligence. Sellers usually provide bidders with a form contract with little or no contractual protection for environmental liabilities and bidders generally do not have much leverage to negotiate acceptable environmental representations and warranties or indemnities. Thus, purchasers need to fully investigate the environmental liabilities associated with the assets so they can take those liabilities into account when preparing their bid offer.  

Sophisticated purchasers may be able to use the due diligence process to their advantage in the bidding process. Many states have adopted risk-based approaches to cleanups where the cleanup standard is based on the actual use of the property. Under this approach, states may allow higher levels of contamination to remain at a site or not require treatment of groundwater if it is not used for drinking water purposes which could result in less expensive cleanups. If purchasers develop sufficient information during their due diligence, they may be able to use environmental cost accounting techniques to develop a range of costs estimates with probability analysis and adopt a discounted cash flow approach instead of a estimating reserves. By using a sophisticated environmental cost accounting approach, a bidder may be able to determine that the environmental liabilities may not be as high as anticipated and use the cost savings towards increasing the bid offer. 

(c) Copyright 1999 Lawrence Schnapf

* Larry Schnapf is an New York City-based environmental lawyer whose practice concentrates on environmental issues associated with business and real estate transactions. He is also an adjunct professor at New York Law School where he teaches “Environmental Problems in Business Transactions.” He is also the author of “Environmental Liability: Managing Environmental Risk in Corporate/Real Estate Transactions and Brownfield Redevelopment” published by Lexis Law Publishing. He has an environmental law website at www.environmental-law.net.