When parties to an M&A deal consider most environmental risks, they essentially seek the same goals that they seek with respect to other liabilities in the deal. M&A sellers, particularly private equity sellers, seek to avoid continuing environmental liability for companies or assets being divested. Buyers seek to avoid known and unknown environmental liabilities not factored into the purchase price. For private equity buyers, the investment horizon and need for an exit strategy are also paramount concerns. Given these goals, it is important to understand how the nature of the environmental risks have changed over time, as well as how the tools used to manage and allocate the environmental liabilities have evolved.
Due Diligence – “Knowledge is Power”
Since the allocation of environmental liabilities between sellers and buyers involves negotiation and, often, compromise, the first step is understanding what is at stake. The breadth and depth of environmental due diligence depends not just on the nature of the operations and assets of the target business but the constraints on timing and cost imposed by the deal. Of course, where the deal involves third-party financing, the minimum due diligence is what the lender is willing to accept.
Typically, buyers start their review with the following sources of environmental due diligence information:
- seller-provided documents;
- seller’s responses to due diligence questions; and
- publicly available information including target website information, publicly available environmental database searches and, where applicable, public company filings.
Where the target operates in an environmentally-regulated business sector and the transaction involves real property, the most common due diligence tool remains the Phase I Environmental Site Assessment (the “ESA”). Although the report format certainly can vary, the majority of ESAs in M&A transactions continue to rely on the protocol established by the ASTM standard which focuses on identifying conditions indicative of releases of hazardous substances (commonly known as “recognized environmental conditions”). Buyer-commissioned Phase II ESA’s that include sampling or other invasive environmental investigations are uncommon, especially in bid situations or pre-signing. For operating businesses, buyers also typically want the ESA report to include the results of a limited compliance review designed to identify potentially material environmental non-compliance.
The last several years have seen an increase in sellers supplying prospective buyers with current ESAs and, where appropriate, limited compliance reviews to better manage and streamline the diligence process—particularly in bid situations. By providing ESAs, sellers can avoid the operational chaos of multiple due diligence inspections by the bidders. Seller-commissioned due diligence reports also provide the seller with some input into how environmental issues are described, eliminating unreasonable hyperbole and speculation while maintaining accuracy and completeness. Moreover, a well-organized environmental due diligence data room containing seller-commissioned ESAs and limited compliance reviews reflects positively on the seller’s management of environmental matters, in general. The key with seller-commissioned due diligence reports is to ensure that the preparing consulting firm has a reputation nationally or internationally for knowledge, professionalism and independence sufficient to engender reasonable buyer reliance on the resulting reports.
Since the requirements of environmental law and the potential for material environmental liability evolve based on regulatory amendments, changes to enforcement priorities, and judicial interpretation, due diligence should evaluate the risk of uncertainties and future requirements. The buyer’s due diligence strategy should consider delayed, proposed and potential regulatory changes and how the timing of those changes might relate to exit strategy. For example, where a target business generates significant quantities of greenhouse gases or has a global footprint, a prudent buyer should consider whether there exists a potentially material or disproportionate impact to the target’s business from potential future efforts to regulate climate change.
Buyers will also want to consider planned changes to the business after closing. For example, if the buyer intends to close a facility subject to a permit pursuant to the European Union’s Industrial Emissions Directive (or its predecessor, the Integrated Pollution Prevention and Control Directive), it will be required to assess the state of soil and groundwater contamination. Knowing this, a buyer might insist on more pre-closing due diligence. Similarly, when evaluating businesses that use material quantities of chlorinated solvents or that manufacture or distribute consumer electronics and other products, buyers will want to consider whether the relatively recent and likely future focus on the risk of vapor intrusion in structures from chlorinated solvents in soil or groundwater, or product stewardship laws requiring changes in the chemical composition of electronic products, should be included in the environmental risk calculus.
Deal Structure – “There’s More Than One Way to Skin a Cat”
Deal structure continues to play a fundamental role in allocating environmental liabilities. Buyers often use newly-formed subsidiaries, limited liability companies or limited partnerships to acquire businesses to insulate themselves from the target’s environmental liabilities (assuming no basis for veil piercing exists and the buyer does not intend to manage, direct, or conduct hazardous waste related operations or make decisions about environmental compliance). Buyers sometimes structure a transaction as an asset acquisition to minimize the risk of acquiring environmental liabilities. Under most environmental cases in the United States addressing successor liability, the buyer of assets should not be responsible for the seller’s environmental liabilities unless the buyer expressly or impliedly assumes the liability, the transaction is a de facto merger, the buyer is a mere continuation of the seller, or the transaction was entered into fraudulently. However, unless the buyer qualifies for certain exceptions to liability, if the buyer acquires real property, liability as the current owner/operator of contaminated property remains possible under the federal and some state Superfund laws (the laws that impose strict, joint and several liability on owners and operators of real property, among others, for releases of hazardous substances).
Buyers can employ other strategies to manage contamination risk associated with real property, including leasing, rather than buying, real property subject to known or potential environmental liabilities. Although a buyer could still have current operator liability as a tenant, a short term lease may enable the buyer to continue operations while arranging for a new operating location. As a result, the buyer could be exposed to a lower environmental liability risk than it would by purchasing the property—particularly when coupled with a seller/landlord indemnity.
Contract Provisions – "You Can't Always Get What You Want"
Typically, transaction agreements allocate environmental liabilities by including environmental representations backed by an indemnity. Environmental representations often address compliance with environmental laws and permits, release of or exposure to hazardous substances, off-site disposal issues, and third-party claims and litigation. It is less common to see separate, general environmental indemnifications in share deals unless the buyer has a low risk threshold coupled with leverage or there are specific, known, material, environmental liabilities.
In asset transactions, the parties may draw a “line in the sand,” with the seller remaining responsible for and indemnifying the buyer for pre-closing environmental liabilities and the buyer providing a reciprocal indemnity for post-closing environmental liabilities. Where the buyer continues the seller’s operations without material change, parties sometimes couple this division with contractual presumptions regarding responsibility. For example, the agreement might provide that contamination discovered within a certain period of time post-closing is presumed to have resulted from pre-closing operations. Alternatively, the parties might phase out the indemnity, with buyer’s percentage share of responsibility increasing with time. Where the parties seek more certainty as to the division of pre- and post-closing liabilities, they can consider commissioning a baseline study that documents the environmental condition of the relevant property at or close to closing.
Indemnity limits and procedures form an important part of the allocation of environmental liabilities. Seller proposed so-called “no-hunt” provisions, which eliminate buyer’s indemnity recovery for voluntarily discovered contamination, are a recent trend. The following is an example of such a provision:
Seller shall have no liability for any Losses to the extent arising out of any sampling or other investigation of air, soil, soil gas, surface water, sediments, groundwater, building materials or other environmental media that is not required by applicable Environmental Law or pursuant to an express order or directive of any Governmental Authority with jurisdiction.
Such provisions derive from the theory that the buyer should not be permitted to look for latent conditions for the primary purpose of triggering an indemnity claim. Buyers sometimes seek exceptions for sampling necessary for construction, response to third-party claims or response to an imminent and substantial threat of harm. Another typical provision limits corrective action subject to an indemnity to the minimal action required by applicable environmental law consistent with the site use, and may require the buyer to consent to the use of engineering controls (e.g., capping, fences, etc.) and institutional controls (e.g., deed notices) that would not unreasonably interfere with continued operations. Sellers may also seek to exclude from the indemnity any environmental costs arising from the sale, transfer or redevelopment of the property. Buyers and sellers frequently negotiate over which entity has the right to defend claims, undertake any required corrective action, and control communications with the regulators and third-parties.
Insurance – "Hope for the Best, but Prepare for the Worst"
Representation and warranty (“R&W”) insurance is becoming increasingly popular as a tool to manage liabilities in deals. Buyer-side R&W policies pay the buyer directly for losses arising from seller’s breach of its representations and warranties. Seller-side R&W policies reimburse the seller for indemnity payments made to the buyer for breach. However, some R&W policies exclude all environmental representations from coverage and others only provide coverage for certain environmental compliance representations. Therefore, in finalizing a deal with an R&W policy the parties may need to cover the environmental risk with another insurance tool, a Pollution Legal Liability (“PLL”) policy. PLL policies can cover remediation, personal injury losses, property damage losses and defense costs for both pre-existing and new conditions. Coverage terms can extend to 10 years, but shorter terms (three to five years) are more common. The principal challenge in acquiring PLL coverage in connection with an M&A deal is often ensuring adequate time for the underwriter’s evaluation of the due diligence information.
It has been years since the mere hint of an environmental issue in an M&A deal was enough to bring sophisticated parties to a standstill. Nevertheless, the environmental issues affecting transactions have continued to grow and change. As described above, the tools that can be used to manage environmental liabilities in M&A transactions have evolved. Working with experienced environmental counsel, particularly those focused on transactions, parties can utilize these and other tools to identify and allocate environmental liabilities, thereby, successfully closing deals.