A Break for Buyers On Inheriting Pollution Problems: A Supreme Court decision limits imposition of environmental liabilities on acquirers that buy companies whose subsidiaries face cleanup problems.

In recent years one of the most troubling aspects of corporate acquisitions and mergers has been the potential to unwittingly inherit liability for pre-existing environmental conditions. On June 8, 1998, an unanimous decision of the U.S. Supreme Court, in United States vs. Bestfoods, et al., clarified one aspect of that potential liability. The ruling eased the imposition of liability on parent corporations for environmental contamination at facilities owned by subsidiaries. No longer will corporate parents become liable for environmental conditions at a subsidiary’s facility simply for taking an interest in their investment and keeping a watchful eye on a subsidiary’s activities. The Supreme Court stated that traditional notions of limited liability, unless specifically displaced by statutory language, remain intact. Under this decision, activities consistent with the parent investor status do not, per se, give rise to environmental liability. Although the Court’s precise ruling directly impacts only the exposure of parent corporations for the environmental liability of their subsidiaries, it also foretells the justices’ reluctance to expand environmental liability beyond the traditional notion of limited liability for corporations. In particular, the decision offers some solace to successors through acquisition or merger of former, potentially liable, parent corporations. Perhaps, the most significant part of the Court’s decision is the impact it will have on curtailing the expansion of liability by the lower courts into other aspects of corporate involvement, such as successors and individual shareholders. Since the enactment of many of the federal environmental statutes beginning in the mid-1970s, the courts have increasingly expanded the scope of liability for corporations under those statutes. As a result, acquirers became saddled with liabilities related to past operations of a target’s former subsidiaries, even if those assets were no longer part of the target’s inventory. The principal source of such liability has been the federal Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA” or “Superfund”) enacted by Congress in 1980. Superfund created a liability scheme based on status that is, who you are, not what you’ve done. Under Superfund, liability attaches to the owner and operator of property where there has been a release or “threat of release” of “hazardous substances” regardless of that owner’s involvement in the contamination of the property. Superfund’s definition of hazardous substances includes a broad number and variety of materials, including many materials whose use and disposal at the time was not only legal but very common in industry. Liability under CERCLA has been held by the courts to be strict, joint and several, and retroactive. Thus, it has become crucial to buyers and their lenders in any transaction to determine the amount of environmental risk a buyer may assume if they become parties to the deal. Superfund creates four classes of “responsible parties” liable for identified releases or threats of releases of hazardous substances into the environment at or from a facility: * The current “owner or operator” of the facility; * The owner or operator at the “time of the disposal” of a hazardous substance; * The “arranger” for the disposal or treatment of the hazardous substance; and * Transporters who select the place of disposal. Defenses to liability under CERCLA are limited to three very narrow circumstances: that the contamination was caused solely by an act of God, an act of war, or an act of a third party with whom there was no contractual relationship. To benefit from the so-called third-party defense, a responsible party must show, in addition to the absence of a contractual relationship, that it exercised due care with respect to the hazardous substance concerned and that it took precautions against foreseeable acts or omissions of any such third party. In an acquisition, these precautions require the taking of all appropriate inquiry regarding environmental conditions at the property to be acquired. Under CERCLA, responsible parties are liable for the costs of responding to releases or threatened releases of hazardous substances, including the costs of investigating the nature and extent of the release and the costs of any corrective or remedial measures required in response to the release. At times, the costs of the investigations alone have run into the millions of dollars. Liability attaches regardless of when the disposal of the substances occurred or whether such use and disposal was completely legal at the time. In the explosion of litigation that followed the enactment of Superfund, the courts began to rewrite the traditional notions of limited corporate liability. Courts expanded liability to include parent corporations and their successors, ignoring traditional limitations on such liability and expanding CERCLA to achieve its purported goals of prompt cleanup of hazardous waste sites and making “responsible” parties pay. Of course, the result of such expansion by the courts was to impose liability on parties that were not, in any realistic manner, “responsible” for the pollution. Courts had begun to find parental liability when the parent had been “actively involved” in the affairs of the subsidiary or even, as one court put it, if the parent corporation had the “authority to control” affairs at the subsidiary, even if it did not exercise “actual control.” Thus, parent corporations, as well as individual officers and directors, were subjected to liability merely for financially monitoring or exercising managerial control over the polluting company, even when they had no involvement in the polluting activity. As the courts were expanding the scope of owner and operator liability under Superfund to corporate parents, they also were expanding Superfund’s scope to include the successors to those corporate parents. As noted earlier, one of the few defenses to CERCLA liability enacted by Congress in 1980 was the so-called “third-party defense.” However, courts literally construed the provision, and the existence of any contractual relationship defeated the defense. Thus, subsequent owners without regard to when the property became contaminated and despite the lack of any involvement in the contamination of the property or in continuing the practices or operations that led to the contamination were held liable under CERCLA. Read in conjunction with the interpretations of several courts that parent corporations were the “operators” of the subsidiary’s contaminated facilities simply because they managed financial or personnel matters, successors to those parents also became liable for the past contamination unrelated to their own operations. Under traditional notions of corporate law, the extent to which ownership liability can attach to a successor corporation turns largely on the nature of the acquisition. Corporate transfers or transactions may be structured as acquisitions by merger, consolidation, or asset purchases. In a merger or consolidation, the widely accepted general rule is that the surviving entity assumes the debt and liabilities of the entity merged into it. However, under traditional notions of corporate law, this assumption of liability did not include liability for defunct or sold-off subsidiaries of the acquired company. Similarly, under traditional notions of corporate law, a corporation that purchases the assets of another does not, simply by virtue of the asset purchase, become liable for the obligations of the seller. Successor liability would only attach in four circumstances: * The acquiring corporation expressly or implicitly agreed to assume the selling corporation’s liabilities; * The transaction amounts to a consolidation or merger of the two corporations; * The purchasing corporation is a mere continuation of the selling corporation; and * The transaction is entered into fraudulently, in order to escape liability for the obligations of the selling corporation. Traditionally, a successor corporation was only considered a “mere continuation” of its predecessor thereby acquiring its liabilities when there was common ownership between the old and the new company. In other words, such liability only attached when the new company had the same shares of stock, the same stockholders, and the same directors. However, since CERCLA’s enactment, the courts began to expand the scope of successor liability. Citing the need for national uniformity in the enforcement of Superfund and Superfund’s interest in getting “responsible” parties to pay for cleanups, some courts began to expand Superfund liability to successors even when the traditional criteria for successorship liability were not present. Thus, prior to Bestfoods, a company could, by merger, unwittingly inherit environmental liabilities of the related subsidiaries of its merger partner even if the subsidiary was defunct or had been previously sold. In asset purchases, the courts expanded successor liability to include what became known as the “substantial continuity” or “continuity of enterprise” exception to limited liability. The substantial continuity exception eliminated the common ownership requirement and adopted a broader test where courts considered a number of factors. Under this test no single factor controlled nor was the absence of any one factor fatal to a finding of successor liability. Coupled with the expansion of parental liability, the trend toward expanding the scope of successor liability created a new layer of concern for the corporate acquirer. As parent companies changed ownership, corporate acquirers suffered the risk that they could inherit huge exposure to liability for environmental cleanups at properties that were long gone from the acquired company’s inventory. Even with careful due diligence, the risk remained that contamination later could be discovered at property owned by a former subsidiary of the acquired business and the federal government or third parties could seek the costs of cleanup and investigation from the unrelated successor to the former parent. In the Bestfoods case, which originated in the U.S. District Court for the Western District of Michigan, the Supreme Court narrowed the scope of liability faced by parent corporations. The high court ruled that there are two ways in which a parent corporation can incur Superfund liability for acts occurring at a facility owned by a subsidiary corporation: Parent corporations could be directly liable only for its own acts at the facility, or derivatively liable if the parent corporation was the “alter ego” of the subsidiary. According to the Court, derivative liability would be found only if, by applying traditional notions of corporate law, it could be shown that circumstances, such as fraud or other misuse of the corporate form, existed to justify piercing the corporate veil. The Court rejected any notion that a corporate parent can incur indirect or derivative liability as the “owner” or “operator” of the subsidiary’s facility merely because it exercised control of the subsidiary corporation consistent with its corporate parent/investor status. For direct liability, the Court endorsed what appears to be a very restrictive test for determining when parents can be held directly liable as operators of hazardous waste facilities owned by subsidiaries. Although the Court ruled that a corporate parent can incur Superfund liability for its own acts, or those of its agents, as the “operator” of a subsidiary-owned facility, Superfund “operator” liability cannot be incurred merely for acts taken by the parent as the owner of the subsidiary corporation. The “operation” must be of the subsidiary’s facility not simply the subsidiary corporation and must include operation of the aspects of the facility dealing with environmental compliance and the generation and disposal of hazardous substances. The only relevant evidence is the parent’s involvement in the operation of the waste facility, not other aspects of business control or activity that a parent may exert on its subsidiary or affiliate. Prior to Bestfoods, several courts adopted a middle ground between the two concepts and found direct “operator” liability where corporate parents had taken an active interest in the financial affairs of their subsidiaries even while legitimately maintaining the corporate form of each. The result was an expansion of Superfund liability where parent corporations unwittingly could be considered operators of their subsidiaries and liable for contamination they did not cause. In Bestfoods, the Supreme Court rejected this notion. According to the Court, for liability to attach, a claimant whether the federal government or private parties would have the burden of proving that the acquired parent, or its predecessor, actually ran the pollution-generating aspect of the target’s subsidiary facility. No longer can liability attach simply because the acquired parent had interests in former subsidiary businesses. The Bestfoods case itself involved the operation of a chemical plant in Michigan that had been owned and operated by a series of companies spanning a 20-year period. During this time, significant contamination occurred. In response to environmental conditions at the property, the Department of Justice, on behalf of the Environmental Protection Agency (EPA), sued several parties, including CPC International Inc. (now known as Bestfoods Inc.), the corporate parent of a defunct subsidiary that operated a facility at the property. At trial, the district court found the parent liable as the “operator” of the contaminated facility under CERCLA because the parent exercised control over the subsidiary. The Sixth Circuit Court of Appeals rejected this broad interpretation and determined that a parent corporation could only be held liable for the acts of its subsidiaries if the plaintiff could prove that the corporate veil should be pierced by applying traditional notions of corporate law. The Supreme Court agreed that indirect or derivative liability for the acts of a subsidiary would exist only when circumstances justify piercing the corporate veil. But it disagreed with the appeal court’s position that, absent piercing the corporate veil, a corporate parent never could be held liable under CERCLA for contamination at a subsidiary’s facility. The Supreme Court determined that it is a long-standing principle that a corporate parent, like anyone, may be held directly liable for its own acts in operating a subsidiary’s facility. However, the Court’s interpretation of when a corporate parent acts as the operator of a subsidiary facility is limited. For such liability to attach under CERCLA, the Court stated that the parent corporation must actually “manage, direct, or conduct operations specifically related to pollution, that is, operations having to do with the leakage or disposal of hazardous waste, or decisions about compliance with environmental regulations.” Involvement by the parent in other aspects of a subsidiary’s business is insufficient to create liability. The Court made clear that a parent corporation does not become an operator of a subsidiary’s facility through the routine practice of supervising the subsidiary’s business. The Court stated that: “Activities that involve [a subsidiary] facility but which are consistent with the parent investor status, such as monitoring of the subsidiary’s performance, supervision of the subsidiary’s financing capital budget decisions, and articulation of general policies and procedures…should not give rise to direct liability.” Further, the Court noted that the overlap of some or all the directors or executive officers is not, in and of itself, tantamount to operation of a subsidiary facility. In the Supreme Court’s view, the district court in Michigan failed to recognize that “it is entirely appropriate for directors of a parent corporation to serve as directors of its subsidiary, and that fact alone may not serve to expose the parent corporation to liability for its subsidiary’s acts.” Noting that corporate officers often serve both the parent and subsidiary corporations and are required to “change hats” to serve each, the Court stated that “it cannot be enough to establish liability…that dual officers and directors made policy decisions and supervised activities of the facility.” The Supreme Court rejected the concept that CERCLA replaces traditional corporate law with regard to indirect, or derivative, liability of a parent corporation. The Court held that the district court had “erroneously treated CERCLA as though it displaced or fundamentally altered common law standards of limited liability,” noting that nothing in CERCLA purports to reject the “bedrock principle” of limited liability under traditional corporate law. Perhaps the greatest potential impact of Bestfoods is what lower courts are likely to discern from the premise of the Supreme Court holding: that traditional corporate law principles should govern, and that CERCLA does not override those principles absent a clear and unequivocal expression of intent. As noted above, the decision, read narrowly, only directly affects the test for establishing “operator” liability of parent corporations under CERCLA. The underlying basis for the decision, however, strongly suggests a much broader reading: that in finding federal liability for releases of hazardous substances, traditional common-law principles of corporate liability should be strictly applied. The fact that the decision was rendered by a unanimous Supreme Court reinforces the potential significance of the decision. Since Superfund’s enactment, many courts have been persuaded to apply, or perhaps even distort, the rules of corporate law in a way that expands the net cast by Superfund liability. In fact, many courts have been persuaded to adopt an expansive “federal common law” rule to circumvent traditional notions of limited corporate liability and expand Superfund’s scope. The Supreme Court’s decision makes clear that there is no overriding “federal common law” under CERCLA regarding parent corporation liability. Hereafter, courts seeking to expand the scope of Superfund will do so at the risk of ignoring direction from the Supreme Court. In particular, the Bestfoods decision could significantly alter lower-court attitudes and interpretations on the liability of successor corporations under CERCLA. Although the Supreme Court did not directly address the successor liability issue, the opinion leaves a strong impression of the justice’s attitude on this issue. The Supreme Court was unambiguous in its holding that “traditional notions” of corporate law should be applied and that nothing in the language of CERCLA indicates that it is intended to replace the “entire corpus of state corporation law.” Although the Court declined to rule on whether state corporate law or a federal common law should be consulted in applying traditional notions of corporate law, in recent unrelated cases it has expressed a clear view that a judicially created federal common law should not supplant existing state law absent a statement of a clear congressional intent to do so. In fact, recognizing this trend, the Ninth Circuit Court of Appeals reversed its previous position on Superfund successorship liability and declined to adopt a “substantial continuity” exception to the traditional limits on corporate successorship liability. In light of its Bestfoods ruling, it appears that the Supreme Court would, if given the opportunity, agree with the Ninth Circuit and hold that the scope of successorship liability under Superfund should not be expanded to include the broader “substantial continuity” exception and should be limited to the traditional exceptions recognized under applicable state law. The Bestfoods decision clarifies the test to determine whether a parent corporation can be held liable under CERCLA. It presents a curtailment of further expansion of CERCLA beyond traditional avenues for the assumption of liability. Against this framework, companies can better forecast potential liabilities when considering acquisitions and appropriately structure the transaction to minimize the risk of inheriting Superfund liability. Furthermore, companies can become more active in monitoring the financial affairs and overall performance of their subsidiaries without fear of stepping into the Superfund trap. Traditional View Acquirers apparently have obtained some relief from a Supreme Court decision that limits imposition of liability for pollution problems caused by subsidiaries of their targets. According to the unanimous decision in June 1998, companies may be let off the hook if they are largely investors and overseers of the subsidiaries and not actual “operators.” The ruling affirmed that traditional corporate law principles of parent-subsidiary relationships are not replaced by federal environmental law which increasingly had been expansively interpreted by the courts. Among the situations impacted by the decision are cases in which the target’s subsidiaries that caused pollution are defunct or have had different owners since the contamination took place.