Last week Governor Perry signed into law a bill that expands the Texas Environmental, Health, and Safety Audit Privilege Act (the “EHS Audit Act” or “Act”), making its protections available to purchasers of equity or assets for the first time. This amendment finally closes a gap that had hindered broader use of an otherwise very effective tool for management of environmental liabilities at commercial and industrial facilities.

Ground Rules of the EHS Audit Act

The EHS Audit Act was first adopted in 1997, and until now has remained unchanged since that time. The Act is designed to encourage companies to perform environmental self-audits of their facilities to voluntarily identify and correct violations of environmental laws and permits. It does this through two major provisions. Section 5 of the Act provides an evidentiary privilege for reports prepared in connection with an environmental audit, protecting the audit report from disclosure in civil litigation and administrative enforcement proceedings. The privilege applies even if the audit report or information contained in it is disclosed to the government, or to a contactor or consultant for the purpose of correcting any issues identified in the report. The most significant benefit of the Act, however, is the immunity from civil and administrative enforcement provided by Section 10 of the Act for companies that self-disclose violations discovered in an environmental self-audit to the Texas Commission on Environmental Quality (“TCEQ”).

To be eligible for Section 10 immunity, the Act currently requires that the person performing the audit notify the TCEQ prior to commencing the audit, and that violations for which immunity is sought to be discovered as a result of the audit. These requirements were designed to ensure that regulated entities do not invoke immunity any time a violation is found without having conducted the voluntary audit that the statute is designed to encourage. In addition, the Act makes immunity available only for violations that are disclosed promptly and voluntarily during or following the audit, and not when the regulated entity was under a legal obligation to report or disclose the violations in question (such as through a permit reporting or spill notification requirement).

While well-intentioned, the requirement that a violation be discovered through a noticed audit to be eligible for immunity has had the unfortunate side-effect of precluding companies acquiring new facilities through asset or stock acquisitions from taking full advantage of the Act. Responsible companies that perform thorough, pre-acquisition due diligence and discover violations during that process have not had the opportunity to obtain immunity for those violations through self-disclosure, since those violations were not discovered as a result of a noticed audit. Not only has this limitation deprived responsible companies from the benefit of the Act, it has also frustrated the Act’s purposes by removing the incentive for acquiring companies to perform audits and voluntarily identify and correct violations after closing, since many of the most significant issues will have been discovered during due diligence.

Changing the Game

In the recently concluded legislative session, the Texas legislature finally took steps to fix this issue. Senate Bill 1300 amends the EHS Audit Act specifically to address the issue of acquisitions. The Bill expands the definition of an audit to include evaluations conducted by persons “considering the acquisition of a regulated facility or operation.” Moreover, it states that the requirement to submit advance notice of an audit in order to be eligible for Section 10 immunity does not apply to audits conducted before the acquisition closing date. Thus, companies can perform their normal due diligence to identify environmental violations prior to closing, and following closing they will now have the ability to disclose those violations voluntarily and invoke immunity from enforcement under Section 10 of the Act.

The Bill does put some constraints around the opportunity for self-disclosure and immunity in the transactional context. The acquiror must make any voluntary disclosure within 45 days after the acquisition closing date to be eligible for immunity. The Bill seeks to prevent misuse of its protections through either related party or sham transactions by making them available only in the case of transactions involving independent companies. Thus, the voluntary disclosure must include a certification that the acquiror was not a majority owner of, majority owned by, or under common ownership with the selling entity, and was not responsible for the facility’s compliance with environmental laws prior to the acquisition.

Due diligence often provides only enough opportunity to identify the most significant issues, without opportunity for a finer-grained evaluation of all aspects of a company’s or facility’s compliance. The bill acknowledges this by allowing an acquiring company to continue an audit that began in the due diligence phase for up to six months following the closing. As with a self-disclosure invoking immunity for violations identified during due diligence, continuation of an audit post-closing requires submission of notice to the TCEQ within 45 days after the closing, along with the same certification of independence from the selling entity and facility.

Although the ability to obtain immunity for violations discovered through due diligence is the most significant aspect of the bill, it also extends the evidentiary privilege of Section 4 of the Act to persons considering acquisition of a facility subject to an audit. This allows companies that are conducting or recently conducted an audit to share the audit report with potential buyers without waiving the privilege.

Advanced Scouting Important

While the immunity from enforcement provided by Section 10 is a strong incentive for auditing and voluntarily disclosing identified violations, the immunity does not actually attach unless the violation is promptly corrected. Thus, companies utilizing the Audit Act must be prepared to follow through on resolution of the issues for which immunity is sought or they may wind up in the same or even worse position than if they had not reported the violations. Accordingly, it is essential to have strategic legal counsel to evaluate the findings of the due diligence and any post-closing audit, to determine which issues qualify and are ripe for disclosure, and to develop a strategy and timeline for resolving the issues that will pass muster with the TCEQ.

Governor Perry signed S.B. 1300 into law on May 24, 2013. The expanded flexibility it provides does not take effect until September 1, 2013, but come that date, entities acquiring companies or commercial or industrial assets in Texas will have a powerful new tool at their disposal that offers the opportunity to move forward with a clean slate.