A Risk of Environmental Overkill: Must buyers and sellers obey a new EPA diligence rule?

As a dealmaker, you probably don’t want the Environmental Protection Agency (EPA) deciding what constitutes appropriate environmental due diligence for your transaction. But if you react to a new EPA rule without grasping its limitations, you may, in essence, allow that to happen. The rule, which will become fully effective on November 1, sets federal standards for the conduct of “all appropriate inquiries” (AAI) used in a type of environmental due diligence commonly focused on Superfund-type liabilities. “All appropriate inquiries” is the process of assessing a property’s environmental conditions and gauging potential liability for any contamination. But many diligence providers and dealmakers don’t recognize the very narrow intent of the AAI rule and apply it to situations for which it was not intended. Some even have adopted the rule as the “gold standard” for environmental due diligence, often with unintended deal consequences. Specifically, AAI sets out the due diligence requirements for prospective owners of property who seek to qualify for one of the so-called landowner defenses under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), which also is known as the Superfund law. Liability to landowners under Superfund is strict, joint, several, and retroactive. However, certain landowner liability defenses are available for buyers of property, after the contamination has occurred, who, among other things, conduct “all appropriate inquiries” into the previous ownership and uses of the site. The new rule clarifies the performance factors necessary to establish innocent landowner defenses and creates specific standards of practice for conducting all appropriate inquiries into the previous ownership, uses, and environmental conditions of a property. While the rule was established largely for deals involving commercial real estate and idle brownfields, its impact is spilling over into other transactions, such as acquisitions and divestitures. Overly zealous use of AAI has several serious risks, such as: * Desired protections may not be available if all of the complex requirements are not satisfied, both before and after a transaction; * Other, perhaps more important, environmental risks may be overlooked because they’re not relevant to the situations AAI was designed to address; and * The performance of due diligence to an AAI standard could create conflicts with other business objectives of a deal To achieve the desired outcome of a deal, environmental due diligence should look not only at the benefits and risks of AAI but go beyond it to examine the broad range of environmental, health, and safety risks presented by the transaction. In many deals, I see AAI adopted as if it were the holy grail of environmental diligence. Sometimes it’s used reflexively, as if the involved parties believe they are obligated to pursue a CERCLA defense without the necessary critical thinking about the relevance of AAI to the deal at hand or their more tangible needs for environmental due diligence. AAI demands more careful consideration. It views environmental risk through a very narrow lens, contains some very prescriptive elements that could limit a dealmaker’s ability to tailor due diligence to the specific business requirements of the transaction, and can constrain the environmental professional by requiring certain approaches to the inquiry. If participants in a deal act as if the innocent landowner protections under the Superfund program are paramount, they could miss the real environmental risks presented by the deal. What Deals Are Affected? Real estate AAI is most relevant and appropriate for buyers of commercial real estate who are seeking to establish one of the limited landowner protections. Congress clearly intended that these protections be available to buyers of commercial property that perform AAI. The AAI rule and its EPA-approved counterpart, the new ASTM E1527-05 standard practice for environmental site assessments, address the many environmentally related risks likely posed by a property transfer, and it’s likely – and appropriately – to become the most widely applied environmental due diligence practice for commercial real estate transactions. But what’s appropriate for real estate may not be appropriate for deals involving active facilities. And even for real property, the standard does not provide protection against state actions or requirements or non-CERCLA liability, including toxic torts. Acquisitions of businesses Buyers and sellers should be careful not to confuse AAI with a broad assessment of environmental, health, and safety risks. Today, Superfund liability often represents only a small aspect of the environmental risks posed by deals involving operating businesses, particularly those in the manufacturing or industrial sectors. Capital and operating costs associated with environmental compliance or remediation needs and limits to growth imposed by environmental permits more commonly and drastically affect the desired economic outcomes of a transaction. All parties to an M&A deal need to balance whether the benefit they get from possible innocent landowner protections is worth the additional efforts, costs, delays, and possible conflicts with business objectives during the deal process. A number of factors in the AAI rule can conflict with some critical needs of the buyer or seller, including: Confidentiality – Company transactions often are cloaked in confidentiality, but AAI’s interview requirements can breach the boundaries of those who are in the know on a given deal. In some cases, the required AAI interviews radically expand the inquiry within a target, and even may include third parties, such as former owners, neighbors, and facility managers, who are outside of the protected circle of contractual confidentiality. Materiality – AAI does not permit consultants to apply any threshold of materiality to their due diligence inquiry. Buyers or sellers who set a materiality threshold for what’s important in the deal may have trouble reconciling their need for big-picture strategic information against the detailed descriptions required in AAI reporting of site conditions and data gaps, not to mention that their environmental professionals will be unable to provide an AAI-compliant report. Auctions – In many auction settings, the limited access afforded for environmental due diligence can make AAI impossible to achieve. Yet, there may be unrealistic pressure or expectations from deal stakeholders that AAI will be used. Data gaps – AAI requires environmental professionals to identify data gaps encountered during the inquiry, comment on the significance of these gaps, and provide an opinion regarding additional appropriate investigation that may be necessary. Resolving data gaps could lead to delays, increased costs, sampling and analysis, and other consequences. The magnitude of those consequences will depend on the nature of the data gaps themselves and the appetite of the buyer or stakeholders to resolve the gaps in light of the available protections. Many in the industry foresee an increase in sampling efforts in order to close data gaps, perhaps at the request of non-principal stakeholders, such as lenders. The strength of the AAI as a liability defense could hinge on the presence or significance of the data gaps. Impact for lenders – Confusing the issue for many in the private equity arena is the likelihood that their lenders will demand AAI reports, even though the private equity firms themselves might prefer to avoid them. Private equity and lending markets no doubt will need some time to adjust to the implications of the AAI rule and the new ASTM standard. Even though lenders have longstanding CERCLA protections stemming from the Lender Liability Act of 1996, it’s likely that many will apply the new ASTM and AAI standards for due diligence reports. A conflict likely will arise, of course, when the buyer conducts due diligence according to its needs, and the lenders downstream of the deal look for AAI-compliant reports. Multinational deals – Simply put, there’s no such thing as an AAI-compliant due diligence effort for facilities in international locations. Stakeholders will need to be educated that the Superfund protections are not relevant for international facilities and that many of AAI task elements, such as data base or historical reviews and specific agency interviews, are impossible to complete in many countries. Stock deals – When you buy the stock of an enterprise, you buy the entire basket of assets and liabilities. The liability defenses provided under innocent purchaser protections simply are not available. Before starting down the AAI road, buyers, sellers, and advisers should carefully consider whether AAI would be practical and serve the interests of the deal. Divestitures The use of AAI in corporate divestitures or sales of private equity portfolio companies should be approached cautiously to be sure that deal requirements do not undermine the strength of the AAI report, or vice versa. In many vendor due diligence efforts, the seller’s emphasis is on providing factual disclosures, often to a specified level of materiality. Sellers often are quite specific and circumspect in how they define what is or isn’t material. This creates a number of areas in which the desires of the seller can be in conflict with performance factors that are the measures of an AAI assessment effort. For example, contamination of a property that normally would be identified as an issue under AAI could account for potential costs well below the materiality threshold established for a transaction. Additionally, AAI requires consultants to present an opinion regarding the conditions indicative of a release of potentially polluting materials, even if a release has not been observed or confirmed. Many sellers might balk at speculating about potential conditions that are not yet confirmed or documented. AAI, however, requires discussion of these data gaps and their significance in the assessment. In essence, the environmental professional will be called on to discuss what is known and not known about a site. Clearly, sellers will want to carefully weigh the benefits and consequences of completing AAI reports before considering that as part of their divestiture process. Strategic transactions There is often little interest on the part of our clients involved in strategic deals to seek the limited protections available under Superfund. In part, this is because most strategic acquisitions are stock deals that obviate the protections. More importantly, the interest of clients in these settings are the deal-killing issues at a high level of materiality, the reputation risks that can be attendant to company acquisitions, and the integration challenges required to bring the acquired company up to corporate standards. The Path Forward Because the ink is barely dry on the AAI rule, it remains to be seen how it will be received and managed by the marketplace. Until the rule becomes fully effective in November, the EPA notes that parties conducting environmental due diligence may use either the AAI rule and the new ASTM E1527-05 or the current interim standards – ASTM E1527-00 or ASTM E1527-05 – to satisfy the statutory requirements for the conduct of all appropriate inquiries. Due diligence for corporate and private equity deals should consider AAI with due care but also look beyond it to those environmental, health, and safety risks that could materially affect the desired business outcomes of their transactions. Alan Feldbaum is a Principal at Environmental Resources Management, an environmental consulting firm based in Exton, Pa. (c) 2006 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com