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Liability issues for buyers and sellers.

Thorough environmental due diligence and a strong contact can mitigate many of the potential risk and costs arising in corporate transactions.

Increasing public scrutiny on environmental matters, current and evolving environmental regulations, and increasing environmental litigation have created significant risks in evaluating and consumating corporate transactions such as mergers and acquisitions, divestitures, restructurings, and public offerings.

Environmental issues are well-known risk factors in transactions involving chemical, petroleum, and refining companies but must be evaluated for any transaction involving real property. Liabilities may arise soley on the basis of ownership, particularly for an owner with "deep pockets"; the purchaser's lack of involvement in the activities that created the liability or lack of knowledge of the problem is not generally an adequate defense.

Consequently, a purchaser must perform thorough and comprehensive environmental due diligence to identify and quantify the risks involved in transactions with real property components in order to determine whether the risks are acceptable and/or can be appropriately shared through contract and other structural mechanisms.

A purchaser or lessee can be subject to substantial liabilities for such items as soil or groundwater contamination and hazardous waste disposal even if the purchaser did not cause or contribute to the release of hazardous substances. Key federal legislation that govern these liabilities include: * The Comprehensive Environmental Response, Compensation and Liability Act (CERCLA or Superfund), which provides funding and enforcement for cleanup of hazardous waste sites; * The Resource Conservation and Recovery Act (RCRA), which regulates solid and hazardous waste and underground storage tanks; * The Toxic Substances Control Act (TSCA); * The Clean Air Act; and * The Clean Water Act.

In certain instances, the largest expenditures may not be to remedy past problems but to comply with new regulations, such as those that will be issued pursuant to the amended Clean Air Act.

In addition, liabilities can arise under state law because a number of states have enacted laws similar to Superfund that impose liability for cleanup expenditures on real property owners. States such as New Jersey, Connecticut, Illinois, and Indiana also have enacted environmental legislation that imposes preconditions on real property transactions. The New Jersey Environmental Cleanup Responsibility Act, for example, requires a clean environmental "bill of health" or a plan to achieve it prior to transfer of control of industrial property.

Finally, if a business that is being purchased has operations in Europe, Asia, or even the Third World, careful attention must be paid to environmental laws in these regions, including emerging legislation such as European Community directives.

As an example of the impact of existing legislation on a potential purchaser, we will focus on the highly visible Superfund legislation. Superfund will be re-authorized and may be modified in the 1993 to 1994 time period. The federal government enacted Superfund to provide funding and enforcement for cleanup of hazardous waste sites and for responding to hazardous waste spills. If the U.S. Environmental Protection Agency (EPA) places a site on the National Priorities List, the EPA may clean up the site and then sue the potentially responsible parties (PRPs) for cleanup costs associated with the site, or the EPA may compel the PRPs to perform and pay for the cleanup. PRPs may include the present and past owners or operators of the site, parties who transported waste to the site, or generators who arranged for waste to be disposed or treated, either directly or indirectly with a transporter.

Liability under Superfund is retroactive, joint and several, and without regard to fault. The EPA generally will not pursue all PRPs in a Superfund action but may choose one or a few parties that have the "deepest pockets" and/or disposed of most of the waste at the site. Superfund provides, however, that a party that performs a cleanup may sue other PRPs for their share of the cleanup costs.

Defenses to Liability

Defenses to Liability under Superfund include acts of God, acts of war, or an innocent third party. The innocent third-party defense exists only if a person "did not know" and "had no reason to know" of the disposal of hazardous substances at the property prior to his ownership.. To establish the "no reason to know" defense, the purchaser must have made "all appropriate inquiry into the previous ownership and uses of the property consistent with good commercial or customary practice." Thus, comprehensive and thorough environmental due diligence is critical to an innocent third-party defense and this requires judgment, since no definitive due diligence standards have yet been established.

The objectives of environmental due diligence are to identify and quantify environmental liabilities and the potential risks associated with the transaction. Environmental due diligence allows the purchaser to: * Determine existing problems (baseline conditions). * Estimate the cost of remediation of these baseline conditions. * Allocate financial responsibility between the purchaser and seller through purchase price and contract adjustments. * Provide the purchaser with a full understanding of the environmental responsibilities that are being shouldered, if no allocation is possible, as in a stock acquisition. * Establish reserves and develop compliance programs in order to avoid triggering statutory or regulatory requirements.

Key Steps

In many transactions, environmental due diligence is the most time-consuming of all activities and may be the limiting factor in the timing of negotiating and closing a transaction. Key first steps that can be done confidentially involve a review of publicly available information, including public filings, public records, and aerial photographs. Consulting firms with established data bases covering federal and state environmental filings may serve as a helpful shortcut.

Although the Securities and Exchange Commission (SEC) is requiring increasingly detailed disclosure and quantification of environmental liabilities and environmental expenditures, disclosure is still inconsistent, and frequently very limited, and is unlikely to allow a purchaser to accurately quantify potential liabilities.

Depending on what is discovered in an initial screening, subsequent steps may involve discussions with senior management, site visits, and review of records. A standard of materiality will need to be applied in a large transaction, with most attention focused on the largest and/or most troublesome sites. Site visits should be made to these sites as well as to a random sample of representative smaller sites. Field investigation may be a final step, and includes soil and groundwater testing to determine the extent of contamination and the amount of cleanup costs. Formerly owned properties for which liability has been retained or assumed may need to be identified and examined. Lenders may be even more demanding than the purchaser as to the scope of environmental due diligence.

The extent of the environmental information that is exchanged between the seller and the purchaser is likely to become increasingly broad as the likelihood of a transaction increases. Initially, the seller will likely wish to prevent the potential purchaser from having contact with regulatory authorities due to concern about disruption of ongoing negotiations. The purchaser might at a late stage in negotiations, however, wish to contact regulatory authorities to confirm compliance with permits, consent orders, and decrees; to confirm the status of pending permit renewals or applications; and to establish that no new enforcement actions are under consideration.

Environmental due diligence is difficult to accomplish even with the cooperation of a company that is under investigation. In a hostile takeover, it is much more difficult to conduct adequate due diligence because of the need to maintain confidentiality. In addition, the potential environmental exposure is greater because the transaction will be a stock, rather than an asset, transaction.

In a hostile takeover, public information such as SEC documents and public filings must be relied on exclusively. Such information will usually result in only a broad picture of the potential liabilities involved but may nonetheless allow for identification of problems that could impact price considerations and the desirability of pursuing a particular transaction. Calls to regulatory authorities should not be made, as intentions could be revealed. A careful check should be performed of outstanding and potential environmental litigation, especially for companies with involvement in such activities as chemicals, asbestos, and refining.

Contract Negotiations

Once the baseline environmental risks are identified and quantified, they can be handled through contract negotiations involving represetations and warranties, indemnifications, and covenants/conditions to closing. A typical approach that is often taken in contract negotiation is for the seller to be responsible for pre-existing environmental conditions and the purchaser to be responsible for environmental problems that arise post-closing. In addition, the purchase price can be adjusted to reflect potential environmental liabilities. In uncertainties or disagreements are too large, particular sites can be excluded from the transaction.

Representations and warranties allow a purchaser to establish baseline conditions and known liabilities for which the seller will remain responsible. These liabilities are generally outlined in a schedule that provides exceptions to "clean" representation and warranties. From a purchaser's perspective, representations and warranties should survive the closing, with the length of such survival being a point of negotiation.

The seller will generally indemnify the purchaser for liabilities identified or arising out of circumstances outlined in the above-referenced schedule. The purchaser will seek to have the seller remain responsible for past disposal practices (particularly off-site disposal) not continued by the purchaser. In circumstances in which the purchaser continues the seller's operations that may give rise to a future liability, often a sharing provision will be agreed upon. The seller will want to limit his responsibilities to items identified in due diligence, but this may not always be possible.

Clearly, the value of the indemnification depends on the financial condition of the seller. If the purchaser is not satisfied with the credit quality of the indemnifying party, the purchaser may demand that a portion of the purchase price be placed in escrow.

Who Does the Cleanup?

Some sellers may wish to undertake more of the cleanup so as to suffer less of an adjustment to purchase price and have more control of the amount of money that is spent to accomplish the cleanup. Conversely, a purchaser may want to perform the cleanup with reimbursement by the seller to make certain that the cleanup is accomplished adequately and the regulators are satisfied with the extent and type of cleanup performed. Consequently, a cost sharing approach is often undertaken to provide mutually consistent incentives to both the buyer and the seller.

Covenants and conditions to closing would also be agreed on to provide for the accomplishment of certain objectives such as transfer of environmental permits or requiring the purchaser to refrain from action that increases or creates liabilities for the seller.

In addition to the form of contract, other structural mechanisms can be established to help shield the purchaser from environmental liabilities. If the purchaser buys assets rather than stock, the purchaser will avoid liability on assets that are excluded from the transaction. A seller of a private company may be particularly concerned about protecting his family from potential environmental liabilities and may, therefore, require a stock sale.

A purchaser may also be shielded from liability if a subsidiary corporation is the owner of the acquired assets. The EPA, however, has often tried to pierce to corporate veil to impose liability on "deep pocket" parent corporations. Some courts have demonstrated a willingness to disregard the corporate form under certain circumstances in hazardous waste cases, although something more than simply an ownership relationship is generally required for Superfund liabilities to be passed on to the parent.

Despite careful due diligence and contract negotiation, disputes often arise post-closing over what and who contributed to an environmental liability. The contract can provide for disputes to be resolved through arbitration, mediation, or other creative dispute resolution mechanisms as well as in a traditional judicial forum.

In conclusion, existing and potential liabilities have become major issues in any corporate transaction involving real property. Nevertheless, thorough environmental due diligence and a strong contract can mitigate many of the potential risks and costs arising from these liabilities.

Margery B. Fischbein is a Senior Vice President of Lehman Brothers, an international investment banking firm. She specializes in providing corporate finance and mergers and acquisitions advisory services to chemical and environmental services companies.
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Title Annotation:Meeting the Environmental Challenge
Author:Fischbein, Margery B.
Publication:Directors & Boards
Date:Jun 22, 1992
Previous Article:Liability and the financial statement.
Next Article:Positioning yourself for EC regulations.

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