Environmental risks: paying for someone else's mistakes.

Is your company financially liable for environmental hazards it didn't create? Property buyers and sellers beware, warns one legal expert.

Kathryn E.B. Robb, Esq., Partner

Hunton & Williams

We have all heard the stories of the unfortunate investor who purchases an office building only to discover 10 days after closing that the cost of removing asbestos found in the building is 20 times the worth of the structure. Or the company that buys a piece of property and subsequently finds leaking underground storage tanks from a gas station once located there. Or the bank that learns the property it took as collateral on a now-foreclosed loan contains groundwater contamination requiring a $30 million cleanup.

Despite the recent publicity surrounding such situations, many investors still make unwise investments because they neglect to conduct an early and thorough investigation of a property that may have environmental liabilities.

What the law says

Recent developments in environmental law have modified the adage, caveat emptor: Now, buyer and seller must beware. Both businesses and individuals face significant new risks in property transfers and other business operations.

Federal statutes govern most environmental laws and regulations, although in recent years many states also have taken an active role. In 1980, Congress passed the Comprehensive Environmental Response, Compensation, and Liability Act, referred to as "the Superfund Act," empowering the Environmental Protection Agency (EPA) to enforce cleanup efforts. Since the EPA's fund for this effort now totals over $10 billion and current EPA regulations designate approximately 700 different elements and compounds as "hazardous substances," the possibilities for lawsuits brought by EPA to clean up property is rapidly increasing.

The reimbursement provisions of Superfund create huge potential civil liabilities for businesses because they allow the EPA (and others) to recover response costs (costs incurred in cleaning up a site) and payment for natural resource damages (costs incurred in remedying damage to flora, fauna, and wildlife at a site). This potential liability, which can far exceed the value of the property, in most cases belongs to the current property owner. And a purchaser's or seller's lack of knowledge about the presence of hazardous substances on the property rarely serves as a defense. Response costs at major sites average $25 to $35 million per site, and costs incurred as a result of natural resource damages may prove to be even more expensive. Furthermore, civil penalties for noncompliance with Federal law can run to $25,000 or more per day.

How do these issues affect real estate deals? Under Superfund, liability is far-reaching and affects both buyers and sellers. Consequently, a purchasing company must be able to identify the risks that real estate acquisitions present, and the firm must exercise business judgment in deciding whether those risks are worth taking and whether a deal can be structured to allocate the risks in a manner acceptable to both buyer and seller. For sellers, Superfund changed the rules: Superfund liability now prevents a former owner from ending potential liability simply by selling the property.

The scope of Superfund liability is startling. Persons not obviously connected to the risk, such as real estate brokers, lenders, parent corporations, purchasers in asset deals, passive lessors and lessees, insurance companies, and officers or other responsible corporate personnel, may be liable as "owners" or "operators" under the statute. These people may even be held personally liable under Superfund. Liability is assessed largely without regard to who caused the waste or whether the conduct in question was legal when undertaken, and the liable owner is virtually without effective defenses.

In addition to Federal Superfund issues, state law in recent years has addressed contaminated properties in other, novel ways. At least 40 states have statutes paralleling the Federal Superfund Act. Under some of these statutes-the "superlien statutes"-the state has a first-priority lien on the property of the party identified as responsible for cleanup costs incurred by the state. The statutes vary from state to state. Some state superliens attach to all of a liable party's real and personal property, not just the contaminated property, and may also apply to property acquired by the liable party after the claim is made. in some states, liability is limited to the costs of containing or cleaning up the contamination, but other states impose liability for damages to natural resources, income and tax revenue losses, and even for increases in property value resulting from the cleanup.

Many state statutes require that these superliens be recorded, but many of the recording requirements are inadequate. As a result, subsequent mortgagees or purchasers may enter real estate transactions without notice of the lien.

Several states also have either enacted or are considering legislation that regulates transferring or abandoning contaminated property and imposes a liability for cleanup costs. The prototype statute is New Jersey's Environmental Cleanup Responsibility Act (ECRA), a sweeping hazardous-waste law that regulates the transfer or sale of the control of certain industrial property. Other states, such as Connecticut, Illinois, and Indiana, have similar laws in effect or pending approval.

The owner of property on which hazardous substances are deposited or stored, or from which such materials are released, could also be held liable under state law for damages caused by such materials, even if the materials were placed on the property by a previous owner. jury verdicts in "toxic tort" cases have totaled $12.7 million of liability in one case and $9 million in another.

Some local jurisdictions also have laws governing hazardous substances and contaminated property. That's why companies purchasing property need to investigate the existence of such laws in particular locales.

The summary above is not exhaustive, but it should give executives some insight into the kinds of laws regarding contaminated property that have been passed in recent years.

The risk in business transactions

In business transactions, companies must assess two basic types of risk: First, a facility being purchased, sold, leased, or used as collateral may carry with it significant hazardous-substance or other environmental liabilities or may have the potential to develop such liabilities in the future. Second, the purchasing company may require various regulatory permits and approvals, both before and after the transaction. These risks normally cannot be eliminated, but they should be identified, analyzed, managed, and allocated within the context of the particular deal.

For real estate transactions, assessing these risks should include measuring the potential liability of each party to the transaction as an owner of a facility, an operator of a facility, or a person engaged in conducting a certain type of operation (for example, discharging pollutants into navigable waters).

The Federal Superfund Act imposes "joint and several" strict liability on hazardous-waste generators and transporters and on a broad range of persons who can be characterized under Superfund as past or present owners or operators of hazardous-waste sites. That is, any one responsible party can he held liable for the entire cleanup, without regard to fault or negligence, and that party is left to its own devices to collect a fair share from other responsible parties.

For example, one owner who leased property to a business generating hazardous waste was held liable even though the owner had no other connection to the lessee's operation. That's why site control is an important consideration. On the other hand, one lessee who maintained control and responsibility for use of a property was held liable as an owner. According to law, a lender also may become an owner or operator under the Superfund Act by assuming too much control over the debtor, by foreclosing on contaminated land, or by causing the release of hazardous substances. Residential developers, construction companies, and real estate agents and agencies may be liable in developing a subdivision on contaminated property. Successor corporations may be held liable when one corporation merges with another or purchases the assets of a present or past owner. A parent corporation intimately involved with a subsidiary's operation may be liable for cleaning up sites operated by the subsidiary. And corporate officers and shareholders who actively participate in managing a disposal facility may be held personally liable as owners or operators.

Finally, participants in a deal also must contend with:

Federal and state liens (some of which are "superliens") for hazardous-substance cleanup costs.

* Disclosure of environmental liability requirements under Federal securities laws.

* Various state restrictions on or regulation of the transfer of contaminated property.

* Federal efforts to hold parent corporations liable for the acts of their subsidiaries.

* Federal and state efforts to hold individual corporate officers, directors, and sometimes shareholders liable for regulatory and liability risks.

* Federal and state efforts to give priority status to environmental compliance and liability in any ensuing bankruptcy proceeding.

Environmental due diligence requirements in the secondary mortgage markets.

The lack of insurance capacity to deal with environmental risks and the unsettled state of the law on insurance coverage of past risks.

Two tips

What should you do to assess your potential risks in a transaction?

Look for environmental "red flags"-Environmental legal problems in business transactions are almost always driven by environmental risks either created by the business to be acquired or created in the past on the property to be acquired. These risks often can be identified simply by knowing the property. Executives should be alert from the outset to three conditions: whether the type of business in question creates, or may in the past have created, environmental problems; whether any real or personal property to be acquired is likely to be contaminated by hazardous substances; and whether there are certain other "red flags," like the presence of such well-known potential contaminants as asbestos or polychlorinated biphenyls (PCBs) or the location of the facilities in such economically sensitive areas as wetlands, on flood plains, in of near national or state forests or parks, in special groundwater or management areas, over sole-source aquifers, or over groundwater recharge areas.

Many types of heavy industry-manufacturing and chemical companies, electric utilities, electroplating operations, printing plants, and other similar commercial or industrial ventures-typically create operational environmental risks through discharging air and water pollution or generating and handling solid and hazardous wastes. In addition to raising compliance and permit-transfer problems under applicable Federal, state, and local law, these operational risks may have contributed to on-or off-site property contamination.

Thus, beyond examining the operational risks of the business to be acquired, the investor also must examine the physical condition of any property being transferred. The key is to inquire into present and past uses of the property and to examine it visually for evidence of spills, discolored soil or vegetation, and evidence of past or present waste lagoons or other waste disposal. Also, such facilities as dry cleaners, gasoline stations, and convenience stores may have used chemicals in the past or may have underground storage tanks from which gasoline or other petroleum products or hazardous substances may leak. And real estate developments such as shopping malls may have leaseholders that operate such facilities. All of these cases suggest contamination.

Where there is any chance that corporate liabilities will be transferred along with assets, a buyer must also consider property and businesses that have been owned by the seller in the past. Past operational practices (including both on-site and off-site disposal of wastes) and past ownership, leasing, or operation of a property may mean statutory or tort liability.

The net must be cast broadly, early in the transaction, to identify current operations causing environmental harm and the possible contamination of property currently or formerly owned, leased, or operated by the seller. The magnitude of contamination cleanup costs may bear no relation to the value of the business or property involved, and former owners or those who have in the past controlled the business or property may bear no liability. Thus, the prudent seller will know his property; the prudent investor will investigate it.

Deal with environmental issues early-When a project may involve significant environmental risks, executives should deal with the issues at the outset, before price and other central terms and conditions are resolved. Environmental and hazardous-substance risks can be deal-stoppers, or at least deal-benders. Left unaddressed until late in the project, they may force a company to undertake the necessary environmental due-diligence investigation under pressure and without adequate time to consider the risks it uncovers. The deal may then founder if the firm finds that such risks require fundamental change in the price terms or in the basic structure of the deal. The buyer and seller well might have successfully struck a different deal had these issues been addressed earlier. What to do after the transaction Executives should periodically monitor the properties brought into or already within the boundaries of the business to ensure they have adequately assessed the potential environmental liability. This process need not, however, become an invitation to high fees from outside counsel and technical consultants. just as companies can make a checklist to screen potential investments, so too can companies develop a checklist to monitor existing properties,

Businesspeople typically have an acute sense of costs and benefits that they apply when determining the level of detail needed in an environmental investigation. However, since the environmental liability may be large and bear no relationship to the size and assets of the business or to the value or size of the property, these periodic monitorings are an insurance policy available to all companies.

Environmental risks can indeed be assessed and managed. The amount of environmental investigation required will vary given the physical environmental risks created by the business acquired; the legal structure of the transaction; the specific value of the business or property; and the general credit-worthiness of the seller, to the extent that credit is involved or indemnities are being relied upon to cover environmental risks. Analysis of creditworthiness and business value is routine. With planning and effective management, the novel issues of identifying environmental risks and structuring a deal based on those risks can become routine.

Ms. Robb beads the environmental practice in Hunton & Williams' New York office.