The complex environmental regulatory regime in the United States can raise a variety of legal and financial risks in real estate or corporate acquisitions. Accordingly, lawyers should understand the nature of potential environmental liabilities for different transactions, the relevant facts, and how to structure environmental due diligence tools to provide clients meaningful advice.
Tailoring Environmental Due Diligence to the Transaction
Environmental due diligence is not a “one-size-fits-all” activity. The type of transaction, and the client’s objectives, often dictate the appropriate scope of due diligence.
Transactions take a variety of forms, such as the purchase or lease of real property, acquisition of the assets of operating businesses or facilities, stock acquisitions, corporate mergers and divestitures. In real estate acquisitions, primary environmental due diligence concerns include identifying potential contamination, and either protecting against cleanup liability or evaluating remediation methods. These transactions usually rely on Phase 1 and 2 environmental site assessments to identify contamination, help establish landowner liability protections, and assess cleanup strategies. Analyzing other environmental regulatory constraints on site development may also be prudent.
Conversely, acquisitions of operating businesses or facilities, or corporate transactions such as stock deals and mergers, raise additional environmental due diligence concerns. These include evaluating the target company or facility’s regulatory compliance status, the availability of permits to conduct and grow the business, and capital and operating costs needed to achieve compliance, implement permit conditions, and satisfy other environmental requirements. For these deals, evaluating regulatory compliance and permitting issues may be equally, if not more, important than contamination concerns.
Superfund Liability and Defenses
In the U.S., fear of liability for contaminated property is largely driven by the federal Comprehensive Environmental Response, Compensation and Liability Act of 1980 (“CERCLA” or “Superfund”). CERCLA establishes four categories of parties liable for the release or threat of release of hazardous substances into the environment, including current facility owners or operators, former owners or operators at the time of disposal, those who arrange for hazardous substance disposal at a facility, and those who transport hazardous substances to a facility for disposal. Superfund liability can be severe, as it is retroactive, strict (i.e., regardless of fault), and joint and several.
Moreover, CERCLA offers only very limited defenses for landowners. The most useful of these is the bona fide prospective purchaser (“BFPP”) defense. This provision allows prospective purchasers to acquire facilities that the purchaser knows to be contaminated while avoiding Superfund liability. To establish the defense, the purchaser must satisfy several conditions. Pre-acquisition conditions include taking title to the facility after January 11, 2002 and after all disposal occurred; making “all appropriate inquiry” into the former uses and ownership of the facility consistent with good commercial and customary standards; and not being a potentially liable party or affiliated with such a party through certain relationships. The purchaser must also comply with several post-acquisition requirements, including making legally required notices; taking reasonable steps to stop continuing releases, prevent future releases, and limit exposure; cooperating with persons performing remediation; complying with any land use restrictions or institutional controls; and responding to governmental information requests. (Tenants may also utilize the BFPP defense in certain situations.)
Although the BFPP defense provides a valuable tool to protect against Superfund liability when obtaining contaminated property, the defense does not protect against potential liability under other federal or state environmental statutes. It is also not a defense to claims under other liability schemes such as tort, occupational safety and health laws, or breach of contract.
All Appropriate Inquiry (“AAI”) – Phase 1 Environmental Site Assessments
While all of the statutory requirements must be satisfied to support the BFPP defense, the primary objective of environmental due diligence in the U.S. involves performing AAI. In 2005, the U.S. Environmental Protection Agency (“EPA”) published a rule, 40 C.F.R. Part 312, establishing the regulatory requirements for AAI. In coordination with EPA, the standard-setting organization ASTM International revised its existing standard for Phase 1 environmental site assessments (“ESAs”) to comport with the Rule. In practice, purchasers seeking to perform AAI do so by following the ASTM Phase 1 standard (currently E1527-13).
Phase 1 ESAs are non-invasive property investigations that seek to identify and document recognized environmental conditions (“RECs”) indicating a release or threat of release of a CERCLA hazardous substance (or petroleum, which is not regulated by CERCLA). Unlike Phase 2 investigations, Phase 1 ESAs do not include sampling and analysis of environmental media. In addition to establishing one of the CERCLA BFPP defense conditions, a Phase 1 ESA (perhaps combined with Phase 2 testing) may also provide insight into possible common law and toxic tort risks posed by acquiring property, should the investigations identify contamination that could impact residential neighborhoods, potable water sources, or other sensitive receptors.
Most AAI tasks must be undertaken by an “environmental professional” meeting certain qualifications, or someone under his or her direct supervision. Basic Phase 2 elements include interviews with the current site owner, any occupiers likely to handle hazardous substances, state or local government officials, and potentially others; review of historical information sources (e.g., aerial photographs, fire insurance maps, land title records, and building permits) dating back to the earlier of 1940 or the property’s earliest developed use; review of federal, state and local regulatory agency records involving the property and other sites within defined search radii; and visual inspection of the property and of adjoining properties. In addition, the standard calls for certain information from the user of the Phase 1 (typically the prospective purchaser), such as a review of title and judicial records for environmental cleanup liens and activity and use limitations; any specialized knowledge the user may have of the property and surrounding area; and whether the purchase price reflects any discount for contamination. The environmental professional must document the evaluation in a written report containing, among other things, the professional’s opinion as to whether conditions indicative of a release or threatened release exist, and a list of any data gaps and their significance.
Although Phase 1 ESAs have become extremely commonplace in environmental due diligence, a few important points are worth noting. First, to satisfy the AAI rule a Phase 1 must be completed no sooner than one year prior to property acquisition, and certain elements must be completed or updated within six months before acquisition. Also, remember that Phase 1 ESAs are designed to identify potential contamination, and do not evaluate other environmental issues (e.g., the presence of asbestos or lead-based paint in buildings, mold damage, or wetlands and other natural constraints on site development) unless expressly added as “non-scope” items. In addition, given increasing scientific knowledge and regulatory concern regarding the potential for certain contaminants (such as those associated with petroleum and chlorinated solvent releases) to volatilize and enter occupied structures in vapor form, a 2013 update to the ASTM Phase 1 standard now requires evaluating the vapor intrusion pathway as part of identifying RECs. Finally, as mentioned above, the BFPP defense requires more than satisfying AAI; the purchaser must meet several post-acquisition conditions as well.
Phase 2 ESAs – Evaluating Contamination and other Due Diligence Concerns
When a Phase 1 ESA identifies one or more RECs at a property, the next step often involves performing invasive “Phase 2” testing to confirm the presence and extent of any contamination. Information from Phase 2 ESAs can serve several due diligence purposes, including deciding whether to proceed with or terminate the transaction; identifying post-acquisition tasks to satisfy the BFPP “reasonable steps” condition; allocating environmental responsibility through contract provisions such as purchase price adjustments, indemnities, cleanup obligations, and environmental insurance; developing remediation strategies and cost estimates to obtain liability protection through federal or state voluntary “brownfield” cleanup programs; and identifying natural or other constraints to site development.
Given their varying objectives, Phase 2 ESAs, unlike Phase 1 investigations, typically do not follow a single protocol. A Phase 2 investigation may involve one or more of several elements, such as collecting samples of soil, groundwater, soil gas, indoor air, or other environmental media for laboratory analysis; searching for underground tanks, vaults, and other subsurface structures using geophysical techniques; evaluating the presence and extent of environmental conditions inside structures such as asbestos-containing materials, lead-based paint, mold, and radon; and identifying potential site development constraints such as wetlands, endangered species, and cultural or historic resources.
Phase 1 and 2 ESA Practical Considerations
To protect their interests, both parties in a real estate or corporate transaction should negotiate access provisions governing the performance of Phase 1 and 2 ESAs during due diligence. These provisions should cover issues including, at a minimum, submission of a work plan for owner approval; permissible entry times, pre-entry notice requirements, and non-interference with ongoing site operations; restoration of any property damage; compliance with applicable law and proper disposal of any investigation-derived waste; provision of split samples, test results, and reports to the site owner; and insurance and indemnification related to liability arising from the investigations.
Access provisions should also address confidentiality of environmental due diligence results. Generally, owners require buyers to keep due diligence data and reports confidential, but buyers should seek certain exceptions including the ability to share results with lenders, counsel, and other due diligence team members (who may also be required to keep the results confidential), and to make disclosures if required by law (in which case the owner will want to control the reporting process).
Aside from access and confidentiality issues, parties planning to perform Phase 1 and 2 ESAs should keep a few other points in mind. First, although Phase 1 and 2 ESAs can be performed concurrently, it is better to use Phase 1 results to develop the Phase 2 scope. Also, take care when identifying and retaining an environmental consultant for the due diligence team. Phase 1 and 2 investigations can vary significantly in scope and extent, and therefore potential consultants and firms should be evaluated for the necessary experience and skills appropriate to the type of site and anticipated tasks. In addition, carefully review and negotiate consultant proposals regarding cost structure, markup of subcontractor and other expenses, anticipated timing for deliverables, and “boilerplate” terms and conditions such as insurance coverages, indemnity provisions, limits on liability, and confidentiality.
Evaluating Regulatory Compliance in Acquiring Ongoing Operations
In addition to assessing potential site contamination and development constraints, acquisition of an active facility or business requires evaluating the target’s compliance status with environmental regulatory requirements. These evaluations typically include issues such as whether the business or facility holds all permits and other approvals necessary to continue operations; whether these authorizations can or will need to be transferred as part of the transaction; and whether the business or facility currently has any significant noncompliance, or a history of noncompliance, with regulatory requirements or permit conditions (as evidenced by notices of violation, penalty assessments, administrative or judicial orders, consent decrees, etc.).
Depending on the type of operation, regulatory programs to evaluate for compliance issues may include, among others, air pollution control, wastewater and stormwater discharges, solid and hazardous waste management, emergency planning and community right-to-know reporting, management of storage tanks, use of pesticides, and maintenance and removal of asbestos-containing building materials. Information on a business or facility’s compliance status may be found by reviewing facility and agency files, interviewing the target’s environmental health and safety personnel, and searching agency on-line databases. In addition to identifying regulatory noncompliance issues, the due diligence effort should also attempt to estimate the potential costs of bringing the business or facility back into compliance.
Environmental due diligence in real estate and corporate transactions can be a complex and time-consuming task. To make this process as efficient and productive as possible, tailor the scope of the diligence effort to the type of transaction, the client’s objectives, and the time and resources available to complete the process before closing. Assembling a qualified and experienced team of technical and legal professionals to lead the diligence effort can help ensure that the client goes into a transaction with eyes wide open to potential environmental pitfalls.