Legal issues

Environmental Risk: 10 Myths

Do you really know what your liability is?

Buyers, sellers, borrowers, and lenders frequently misperceive environmental liability risk in acquisitions and financings. These misperceptions make it difficult to identify, quantify, and apportion environmental risk appropriately between parties to a transaction. This article identifies — and debunks — 10 common myths about environmental liability that frequently arise in business transactions.

MYTH #1: A new purchaser is always liable for cleaning up contaminated property.

Purchasers buying contaminated property avoid liability under the federal Superfund statute if they satisfy the bona fide prospective purchaser defense. This defense requires asset purchasers to conduct “all appropriate inquiry” into the property’s environmental condition prior to acquiring property and exercise “appropriate care” with respect to the property’s environmental condition. To qualify for the defense, the purchaser must not be affiliated with any other party that is potentially liable for cleanup costs.

According to the Environmental Protection Agency, “all appropriate inquiry” means requiring an environmental professional to investigate the property (and its immediate vicinity) and prepare a report assessing the environmental conditions. The report — commonly referred to as a Phase I environmental site assessment — must include the environmental professional’s opinion as to whether the investigation indicates the possibility of a release or threatened release of hazardous substances.

To satisfy the “appropriate care” component of the defense, the purchaser must “take reasonable steps” to stop any continuing releases; prevent any threatened future release; and prevent or limit human, environmental, or natural resource exposure to any previously released hazardous substance. (The EPA’s view of “reasonable steps” does not include the same types of contaminated soil or groundwater cleanup that a liable party would have to perform.)

Many states have comparable defenses under their state Superfund statutes, but the requirements can vary. For example, Michigan requires that purchasers collect, analyze, and report the results of the analysis of subsurface samples in order to take advantage of the defense. Georgia has a program that does not exonerate purchasers from liability but instead limits their liability to implementing an agreed-upon cleanup plan. Once the purchaser completes the cleanup plan, it is shielded from further cleanup obligations with some qualifications.

MYTH #2: Leasing, rather than buying, contaminated property is a sure way to avoid liability.

Lessees can become statutorily liable for contamination that predates their tenancy in two ways. First, under the federal Superfund statute “current operators” of facilities are liable for contamination that predates their occupancy. Second, lessees with sufficient control over the leasehold can be deemed “current owners” of the facility, and “current owners” are also generally liable.

The Superfund statute is unforgiving with respect to the liability of current owner/operators. Courts have rejected arguments that there has to be a nexus between a party’s “operation” on a site and the conduct that caused the release of hazardous substances. Liability exists regardless of when the disposal occurred.

Lessees that exercise a degree of control over the property can be held liable as owners. Courts look at the duration of the lease term; whether the landlord has control over the use of the site; lease termination rights; the lessee’s right to sublet without consent of the landlord; and whether the lessee is responsible for taxes, repairs, and assessments.

MYTH #3: Lenders who take contaminated property as collateral for a loan inevitably risk being liable for the property’s cleanup.

In the early 1990s, the concern that lenders would become liable for contaminated property in which they held security interests crippled commercial lending in some business sectors. Congress has since created a safe harbor from federal cleanup liability for secured lenders. The secured creditor exemption has two parts.

Lenders administering security interests avoid environmental liability by not “participating in the management” of the facility. Undertaking responsibility for, and exercising decision-making control over, the facility’s environmental compliance, assuming day-to-day management of the facility’s environmental function, or taking control over substantially all of the non-environmental facility operations all constitute “participating in the management” and defeat the liability exemption.

But lenders can take a number of financial oversight measures and remain within the safe harbor from liability. Among other things, lenders can provide financial advice in an effort to mitigate, prevent, or cure a default or a diminution in the value of the collateral; restructure or renegotiate terms and conditions of the credit agreement or security interest; and monitor or enforce the terms and conditions of the credit agreement or security interest.

To maintain the liability exemption after foreclosing, a lender must not have “participated in the management” before foreclosing, and must seek to divest itself of the facility “at the earliest practicable, commercially reasonable time.” This does not mean that the foreclosing lender must sell or divest itself of the property at the earliest possible time. Market conditions and legal and regulatory requirements affect whether the lender’s conduct was commercially reasonable.

MYTH #4: If the target site has been cleaned up under the supervision of a state agency, then there is no need for further concern.

A state environmental agency determination that “no further remedial action” is required at a property may not rule out all potential risk. First, such determinations are typically qualified to allow the issuing agency to “re-open” the matter. Standard reasons for re-opening a past determination include the discovery of new information or changed circumstances that suggest the completed remedial activities do not sufficiently protect human health or the environment.

Second, state agency determinations that a cleanup is complete are often conditioned on site use; commercial or industrial site purposes can have a higher level of residual contamination than residential sites. State agencies often impose institutional controls to prevent human exposure to the residue: either proprietary controls such as restrictive covenants, easements, or other forms of deed restrictions, or governmental controls such as zoning, variances, and well-drilling prohibitions. Such controls obviously impede future use or development of a target site.

A common situation that affects acquisitions or financing is the risk of vapor intrusion into buildings on the target site. The potential for vapors from subsurface contamination to intrude into buildings atop the site is a newly identified health risk. This health risk was frequently not evaluated when environmental regulators issued older, no-further-cleanup determinations. Now that they are aware of it, regulators may “re-open” their determinations with respect to properties previously deemed “clean.”

MYTH #5: In every deal, the principal environmental liability risk arises from the release of hazardous substances to the ground.

Substantial environmental liability can arise from facility compliance issues, such as obtaining air emission and wastewater discharge permits, operating within the permit limits, and installing needed pollution control equipment. Depending on the nature of the business, the scope of facility compliance obligations can be substantial. A facility that burns fossil fuels to generate power may confront substantial future capital expenditures to control air emissions. Even non-industrial, non-chemical-intensive operations confront compliance obligations. For example, office buildings may have backup generators with fuel storage and air emission control obligations. Future development of a shopping center may be affected by storm water management and wetlands protection rules.

MYTH #6: Environmental liability disregards the limited liability protections afforded by the corporate, LLC, or LLP form.

Generally speaking, environmental law respects the limited liability of the corporate, LLC, or LLP form. Accordingly, shareholders, parent corporations (as 100 percent shareholders), LLC member interest holders, and partners in LLPs are protected from environmental liability, unless specific, unusual circumstances justify disregarding the treatment of the business as a separate entity.

As it does with other types of liability, limited liability protection for environmental conditions evaporates when it is appropriate to impose “direct” or “derivative” liability. In the environmental context, “direct” liability — affixed because a parent, share, or other interest holder is directly involved in the liability-creating conduct — is generally termed “operator” liability. For example, a parent company involved in the operation of a subsidiary’s facility would be liable for environmental conditions at the facility. Similarly, a shareholder involved in a business manner considered “eccentric” for typical shareholders — for example directing the company to change a production process — can be deemed a liable “operator” of the business.

Derivative liability is commonly referred to as “veil piercing” liability. State law principles that allow piercing the veil to impose liability on a parent, share, or other interest holder apply to environmental liability as well. The precautionary steps to prevent derivative or environmental liability are observing corporate formalities, maintaining a separate board and accounts, and ensuring a subsidiary is adequately capitalized.

MYTH #7: When it comes to federal environmental liability, the asset purchaser defense to successor liability does not hold up.

The traditional rule that the purchaser of assets (as opposed to equity) does not succeed to the predecessor’s liability applies in the environmental context as well. Of course, the exceptions to the asset purchaser defense to successor liability also exist for environmental liability, and are generally a matter of state corporate common law. They include explicit assumption in the asset purchase agreement; the “de facto merger” doctrine; and the “mere continuation” exception, which generally requires some degree of common equity ownership before and after the purchase.

Some courts construing liability under federal environmental statutes have adopted a federal rule of decision that morphed the state “mere continuation” exception into a “substantial continuity” exception. By eliminating the common equity ownership component of the state “mere continuation” exception, the “substantial continuity” exception allows the imposition of liability under federal environmental statutes more leniently.

While the law remains unsettled, the emerging trend seems to be that there is no need for the federal “substantial continuity” exception. That is, the “mere continuation” exception under state corporate common law is the proper test. Continuing to operate by the same name, to hold out the acquired business as the continuation of the prior business, and to retain the same personnel are factors that make a purchaser vulnerable under the “mere continuation” exception.

MYTH #8: Buying an older building with asbestos-containing materials will mean incurring substantial costs to remove those materials.

There is no absolute obligation to remove building materials that contain asbestos. It is frequently possible to maintain asbestos-containing material that is in good shape so as to avoid its fibers becoming airborne and causing health hazards.

Asbestos was used abundantly in buildings until the 1970s, when certain asbestos-containing building materials were banned by the EPA. In non-friable form, asbestos does not pose much threat to humans. When asbestos is friable, the fibers are easily inhaled and can cause serious human health risk. Renovation and demolition activities may cause asbestos to become friable.

Worker protection rules require employers and building owners to notify those who might be exposed to asbestos of the risk. If renovations and demolition are undertaken, specific rules apply to the removal and disposal of the material.

MYTH #9: If there is mold in a building, the best practice is to have the indoor air quality analyzed.

The presence of mold indicates a moisture problem. The best practice is to diagnose and eliminate the source of the moisture.

Mold typically grows in closed environments and will grow where moisture and oxygen are present. Excessive moisture is generally traceable to building defects: a leaking roof, a faulty heating, ventilation, and air conditioning system, or leaking or sweating pipes. IAQ sampling and analysis does nothing to help locate or correct these defects.

Treatment can range from sanitizing and/or decontaminating building components to complete removal of severely affected building materials. Nonporous building materials such as steel and glass can be cleaned and left in place. Porous material such as drywall or insulation should be removed. The extent of the contamination will determine the level of isolation required and the type of personal protective equipment required during abatement activities.

MYTH #10: Any business lawyer familiar with drafting robust indemnity provisions can write an effective environmental indemnity.

As with any specialty discipline, environmental law has its unique vocabulary, and an understanding of the nuances of various terms is needed for drafting indemnities. Adoption of a statutory definition of the term disposal, for example, may inadvertently omit less active forms of release. Borrowing one statute’s definition of hazardous substance will exclude petroleum from the agreement’s scope.

Other traps for the unwary go beyond vocabulary. Just ask the lawyers who let their client agree solely to bear environmental costs. They intended for the term sole to be construed only as between the buyer and seller. What they learned was that use of the term extinguished their clients’ statutory contribution rights against third parties.

Other traps for the unwary include:

• the ineffectiveness of “as is” clauses against statutory contribution claims;

• the interpretation of assumption and retention of liability clauses with respect to specific categories of environmental liability and on statutory contribution rights;

• setting an appropriate endpoint for a cleanup indemnity and allowing for the use of institutional controls to reach that endpoint; and

• the meaning of “survival” clauses that purport to endure for the length of the corresponding statute of limitations for the indemnified environmental liability.

Tom R. Mounteer is a partner in the real estate department in the Washington, D.C., office of Paul Hastings. Contact him at tommounteer@paulhastings.com.

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