Top Ten Mistakes Committed By Clients When Performing Environmental Due Diligence for Corporate Transactions
By Larry Schnapf

Since the innocent purchaser’s defenses was add to the Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”) in 1986, environmental due diligence has played a critical role in corporate and real estate transactions.  Yet despite a decade and half of experience, there continues to be considerable uncertainty about what constitutes an acceptable environmental site assessment (“ESA”). 
This article will discuss the ten most common mistakes that clients commit when requesting consultants to perform environmental due diligence program. 

Why Is Environmental Due Diligence Necessary?

	Federal and state environmental laws enacted during the past two decades can impose substantial liabilities on a wide range of entities. For example, under CERCLA, current and former owners or operators of facilities (“owners or operators”) may be held strictly liable for the cleanup of hazardous substances. Cleanup liability can be imposed on owners or operators even when they were not responsible for the contamination. In addition, companies who arranged for the disposal of hazardous substances (“generators”) as well as those entities that transported the wastes (“transporters”) might also be liable for the cleanup of contamination at disposal facilities where the waste was sent. (42 U.S.C. 9607(a)(1)-(4)). These four types of liable parties are known as potentially responsible parties (“PRPs”).   

	CERCLA imposes joint liability on PRPs, which means that a PRP may be held responsible for the entire cost of the cleanup even though there may be other PRPs for a site. Moreover, because CERCLA provides for strict liability an entity may be found responsible for the cleanup of the contamination even when its actions were lawful at the time. 

	Federal courts have broadly construed CERCLA and have expanded the liability of parent corporations and purchasers of corporate assets. Traditionally, state law has governed liability of corporations. A basic tenet of corporate law has been that a corporation is a separate entity from its shareholders who are protected from the liabilities of the corporation by a corporate veil. In order to hold a shareholder liable, plaintiffs have to pierce this corporate veil. To hold a parent liable for the liabilities of its subsidiary, a plaintiff usually had to show that the parent dominated the subsidiary to the point that it had no separate identity and that honoring the corporate form would result in injustice. In order to ensure uniform enforcement of this federal statute, courts have adopted a more liberal federal common law test. However, in United States V. Bestfoods, 118 S. Ct. 1876 (1998), the United States Supreme Court ruled that a parent corporation may be considered a CERCLA  “operator” of a subsidiary’s facility only if the parent exercises actual control over that facility. The focus for “operator” liability is not on the relationship of the parent to the subsidiary but on the relationship between the parent corporation and the individual facility. A parent may also be held liable as an “owner” of the facility under a “piercing the corporate veil” analysis.

	Likewise, the liability for purchasers of corporate assets has been expanded. The traditional rule has been that a purchaser of stock assumes all of the liabilities associated with a corporation but an asset purchaser does not incur liability unless the purchaser assumed those liabilities, the transaction constitutes a de facto merger, the new corporation is a continuation of the old corporation, or there is fraud. Because plaintiffs have had problems imposing liability on successor corporations under these four exceptions, federal courts have established a new test for imposing liability under CERCLA. Under this doctrine known as the Continuity of Enterprise theory, an asset purchaser may be liable for the liabilities of its predecessor if the purchaser merely continues the same business operations. Among the factors courts will examine to determine if a purchaser should be considered a successor corporation will be if the new business retains the same officers, uses the same facilities, makes the same products, and retains most of the workforce. (United States v. Mexico Feed and Seed Co., Inc, 980 F.2d 478 (8th Cir. 1992))  
    
	There are only three statutory defenses to CERCLA liability: Act of War, Act of God, and the Third Party Defense. (42 U.S.C. 9607(b)). The 2002 Amendments to CERCLA added two liability exemptions for Bona Fide Prospective Purchasers and Contiguous Property Owners. However, the most commonly asserted defense is the third party defense. Under this defense, a defendant must show that the release of hazardous substances must have been SOLELY caused by a third party who was not in a contractual relationship with the defendant. (42 U.S.C. 9607(b)(3). This defense is generally unavailable to purchasers when the seller caused the contamination since the sales agreement would qualify as a contractual relationship. Likewise, landlords have been unable to assert the defense when a tenant caused the contamination since the lease constitutes a “contractual relationship”. Even if a defendant can get past the “contractual relationship” barrier, there are two additional hurdles it must satisfy before it could assert a third party defense. The owner would also have to show that it took reasonable precautions against the acts or omissions of third parties and that it exercised due care regarding the hazardous substances at the property. In other words, the purchaser cannot allow previously deposited drums to deteriorate or allow groundwater contamination to continue to migrate if it wants to be able to assert this defense.

 	Because the third party defense was unavailable to new landowners who did not cause the contamination at a site, Congress enacted the innocent landowner’s defense. This defense provides that a purchaser will not be considered to be in a “contractual relationship” and thus be able to assert the defense if the purchaser could establish that it did not know or had no reason to know about the contamination. (42 U.S.C. 9601(35)(A)). 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. In reality, this defense has been largely unavailable because most courts have ruled that if the purchaser did not discover the contamination prior to the transaction, it probably did not conduct a sufficient inquiry. 
	Despite their importance, there are no uniform federal due diligence standards. CERCLA provides only that purchasers use "appropriate inquiry into the previous ownership and uses of the property consistent with good commercial or customary practice." In determining whether "all appropriate inquiry" was made, a court is required to examine "any specialized knowledge or experience on the part of the defendant, the relationship of the purchase price to the value of the property in an uncontaminated state, commonly known or reasonably ascertainable information about the property, the obviousness of the presence or likely presence of contamination at the property, and the ability to detect such contamination by appropriate inspection." (42 U.S.C. 9601(35)(B)).

While parties to a transaction usually perform environmental due diligence to preserve the innocent purchaser defense, there are other reasons why companies should perform environmental due diligence. Some of the reasons for performing environmental due diligence include:  

•	A purchaser who wants to assert the third party defense must show it exercised due care regarding hazardous substances at a facility. Unless a purchaser thoroughly examines a site, it may not become aware of contamination and thus may not take the steps necessary to assert the defense successfully. 

•	A purchaser can use the information to “draw a white line” around the facility to show what conditions existed prior to the closing. In this way, the purchaser could not only demonstrate in any future litigation what contamination it knew about but also what contamination was not attributable to its operations.

•	If environmental due diligence is performed early enough in a transaction, the parties can use information to allocate liabilities identified during the investigation, draft indemnities, or perhaps re-price the deal. The information may also be used to obtain environmental insurance that may be used to help allocate environmental liability. 

•	Some states have financial assistance programs that can help pay for contamination associated with underground storage tanks (“USTs”) or dry cleaners. Parties that are aware of these sources of contamination can determine the availability of funding sources and use this information in the contractual allocation of these liabilities.

•	Nearly 70% of corporate acquisitions fail to achieve the business objectives that were anticipated when the purchaser agreed to enter into the transaction. One of the principal reasons for the poor performance is post-acquisition integration. The environmental practices of a seller often differ from those of the purchaser. Pre-acquisition due diligence will help the purchaser identify the probable environmental costs of these changes and plan operational changes that may be necessary. If the business was operated in violation of environmental laws and those violations continue to take place after the purchaser takes over the business, the purchaser may become liable for those violations that take place after the closing. 

•	A purchaser must evaluate the various facilities to be acquired in an effort to understand how the new business will fit into its current structure. The purchaser may find itself with excess production capacity and obsolete plants and will have to develop a plan for streamlining or restructuring operations and closing obsolete plants. Comprehensive pre-acquisition environmental due diligence will help the purchaser understand the environmental implications of these choices and help it avoid or minimize unnecessary environmental costs.

•	EPA and nearly two-dozen states have implemented self-reporting auditing policies under which companies that voluntarily disclose violations discovered during due diligence or an audit can obtain significant reductions in penalties. (See “Incentives for Self-Policing; Discovery, Disclosure, Correction and Prevention of Violations,” 65 F.R. 19618, April 11, 2000)  If a purchaser uncovers violations during its due diligence, it may be able to take advantage of these policies. However, if the EPA or state agencies perform a site inspection after the purchaser takes control of the business and discover violations, the purchaser of the business will no longer be able to take advantage of the penalty reduction policies. One note of caution, however. If environmental site assessments do identify violations and the purchaser does nothing about them, the existence of the violations in the reports can be used by government regulators to allege that the purchaser knowingly violated the law and therefore could be criminally liable. 

•	Similarly, the federal Securities and Exchange Commission (“SEC”) has begun to insist on more comprehensive disclosures of environmental liabilities in the disclosure statements that publicly traded companies are periodically required to file. A purchaser who conducts comprehensive environmental due diligence can also use this information to assess its SEC disclosure obligations without having to conduct another expensive environmental compliance audit after the acquisition.

•	Partly because SEC rules may require sellers to reflect indemnities on their balance sheets, sellers are increasingly reluctant to provide purchasers with environmental indemnities. Accordingly, it is important that the purchaser understand the liabilities associated with the business so that those risks are adequately reflected in the purchase price or other consideration given in the transaction.  

•	There has been an increase in bodily injury and property damage claims for persons and property exposed to hazardous substances, particularly indoor air issues such as mold and vapor intrusion from groundwater contamination.  The parties to a transaction should be aware of the possibility of groundwater contamination migrating off-site or vapors from the contamination migrating into buildings that could lead to significant liability.

•	Environmental audits may also be used by lenders to evaluate the likelihood that a heavily leveraged borrower may be required to fund a cleanup that could render it insolvent. Finally, lenders or purchasers can use environmental audits to screen or exclude properties from the transaction or to identify properties that can be foreclosed.

The Top Ten Mistakes

	If done properly, environmental due diligence can be used to achieve a wide range of business objectives and bring value to the process.  Properly designed and implemented due diligence can more than pay for itself in terms of liabilities avoided and costs saved. However, clients often do not understand what constitutes an appropriate ESA nor have any strategy for using the information. As a result, clients frequently find themselves saddled with unexpected liabilities. 
Following are the most common mistakes committed by clients when they retain environmental consultants.

1.	Relying on “Commodity-Style Reports- Clients often focus on the price of the due diligence without understanding the scope of the assignment. Clients are usually unaware of the difference between an ASTM-quality ESA and a so-called “commodity-style” site assessment. These assessments generally consist of a desktop records review and a cursory inspection of the premises usually by an inexperienced employee who may not be familiar with industrial operations. The reports may appear to be comprehensive because of thick appendices containing database searches but do not be fooled. The reports are sketchy on substance and highly unreliable. A recent government study suggested that over 70% of these “commodity-style” Phase I reports failed to discover site contamination. Users should tailor the Phase I ESAs to their particular needs such as taking advantage of the new defenses added to CERCLA, opportunities to reduce cleanup costs under state brownfield programs, and understanding how site conditions will impact future development or business plans

2.	Over-Reliance on Representations and Warranties- Clients often link the scope of their due diligence to the extent of the representations and warranties received from the seller. Purchasers should not give into the temptation of relying on representations and warranties in lieu of due diligence to save the investigation costs. Representations or warranties should be viewed as a starting point for helping purchasers identify possible environmental issues and get a sense of management’s attitude towards environmental compliance. 

3.	Insufficient Time- Many clients view environmental due diligence as a necessary evil or a cost item that must be incurred to satisfy a bank or some legal defense. Clients also often think the work can be done a few days before the closing. As a result, clients usually fail to provide enough time to perform due diligence. Even where clients may allow for enough time to physically perform the ESA, they often have already negotiated the major deal points so that they cannot effectively use the information to re-price or re-structure the deal. If performed early enough in the transaction, the information generated by an ESA can be used by a client to bring value to the transaction by helping the parties re-structure a transaction, negotiate mechanisms to address cleanups, change site plans to minimize cleanup costs, and take advantage of new self-disclosure rules that reduce liability for past violations.
 
4.	Historical Information- Clients usually are not aware that “Commodity style” reports often have skimpy historical site information since reviewing local records and interviewing local government officials can be labor-intensive and costly exercises. However, clients often do not appreciate the importance of historical information especially for older facilities since they have changed considerably over time and evidence of past improper disposal may no longer be obvious. Key issues are often former fuel and heating oil USTs that were closed under more lenient standards, former septic systems or dry wells that could have been sources of groundwater contamination, former disposal areas on a property and former uses of the property that are now not apparent. 

5.	Former Facilities- Clients often ask consultants to simply focus on the facilities that a company currently owns or operates. However, courts are increasingly willing to impose liability on successor or parent corporations and on former property owners. Thus, it is important that clients determine what facilities a company may have operated or owned in the past and how possible environmental liabilities for those assets may have been contractually allocated. It is not uncommon for courts to rule that contracts executed prior to the enactment of CERCLA nevertheless allocated CERCLA liability. Environmental consultants and lawyers need to inform their clients about their potential liability for these prior owned or operated facilities.  

6.	 Disposal Facilities- Likewise, clients usually focus on the existing property owned or operated by the company and not the facilities that the company may presently to dispose its wastes or may have been used in the past, including those that may have been used by discontinued units or operations that were sold. Clients should be alerted that they need to identify these disposal facilities and that they should authorize a data base search on those facilities to determine if any CERCLA cleanups are likely to be required at those facilities. 

7.	Old Audits- To save costs, clients often like to rely on audits that may be several years old. It is important for clients to understand that facilities are not static entities and that conditions may have changed in less than a year. Moreover, the clients may not be as comprehensive as necessary to satisfy the client’s needs. As a result, clients should be advised to perform new ESAs or perhaps to consider ordering a rundown when an audit is less than a year old to determine if anything at the facility as changed. If so, another audit would be advisable. 

8.	Seller’s Audits- For the same reasons, clients who are purchasing a company or property should not rely on audits provided by a seller. Reliance on due diligence performed by another party is not considered an “appropriate inquiry”. If a client insists on relying on environmental due diligence provided by a seller, the consultant should ask to review the scope of work to make sure that the investigation covered all of the areas that the buyer wants to be examined. Without reviewing the SOW, it may be hard to determine if a particular environmental issue was not discussed in a report because it was not examined.

9.	Estimating Liabilities- One of the principal reasons clients request environmental due diligence is to understand the cleanup liabilities associated with a transaction. Yet, the client often asks the consultant to develop these estimates based on insufficient information or without taking into account actual cleanup standards that may be allowed by the state environmental agency. Without adequate information, the cleanup cost estimates may be over- or under-inflated. The client should be made aware that if it wants a precise cost estimate, more resources would have to be devoted to the project. Moreover, the client may want to consider having the consultant develop cost estimates based on a probability analysis using a low-, mid- and high-range estimate. When a cleanup escrow is established, the buyer has incentive to make sure that the escrow is used up so a seller should make sure that the most cost-effective cleanup allowable by the state is used. For example, if a state allows residual contamination to remain at a site provided a deed restriction is placed on the property, the cleanup estimate should not be based on the cost of excavating and disposing contaminated soil at an off-site facility.  

10.	Bid Data Rooms - Many sellers offering assets in bids want to limit a buyer’s due diligence to the documentation provided in the data room. Buyers should insist that there consultants be given the opportunity review all documents in the actual or constructive possession of the seller relating to environmental issues, request access to environmental managers and schedule inspections of the seller’s facilities.

(c) Copyright 2004 Lawrence Schnapf