Environmental risks present both practical and legal challenges, quite unlike other factors you have to consider in a merger or acquisition, say David Hockin, Tanya Lloyd Jones & William Butterworth.

Environmental risks present both practical and legal challenges, quite unlike other factors you have to consider in a merger or acquisition, say David Hockin, Tanya Lloyd Jones and William Butterworth.

Evaluating the environmental liabilities and risks associated with a merger or acquisition used to be quite rare. But a combination of factors has encouraged companies to adopt a more systematic approach, and environmental due diligence is now widely practised The motivating factors include:

  • more stringent environmental legislation
  • more rigorous regulatory enforcement
  • intense public interest and awareness
  • more transparent financial reportingdisclosure of provisions and contingencies for environmental works.

    Environmental problems can be expensive to correct. The investigation and remediation of a contaminated site may cost millions of pounds. Furthermore, the remediation can take years, and involve long-term monitoring, while a programme of remedial works will inevitably expose the company owning the site to the strict scrutiny of environmental regulators, local people and neighbouring landowners, and possibly also to that of environmental pressure groups.

    Identifying the source of the contamination may not be difficult. Identifying those responsible for causing it can be. Contamination may take decades to show up. The responsible parties may no longer exist, so that the liability no longer rests with the original polluter, but with the organisation that has unwittingly acquired the contamination along with the site.

    The broad and strict liability regimes established in many jurisdictions mean that buyers must protect themselves against acquiring unwanted environmental risks in commercial transactions. The environmental due diligence goal is simple. It is to identify all the material environmental risks and liabilities of the company or the facilities that are being acquired. This allows the buyer to develop the best strategy for protection against such risks.

    What are environmental risks?
    Far too frequently, the only environmental risk examined is that of the contingent liability of contaminated land caused by past or present practices at the site. Where the commercial transaction is priced by its asset or property value, the presence of contamination may seriously affect that value.

    It will have less of an impact where the valuation relates to earnings from manufacturing output. The material environmental risks here are operational liabilities, where the company has failed to comply with operating permits against prevailing environmental standards.

    Examples are the discharge of effluent into surface watercourses or sewers, atmospheric emissions from chimneys, localised emissions into the factory workplace, or even noise. In such circumstances, it is important not only to evaluate the environmental risk but also the risk to the employees, by carrying out health and safety checks.

    Initial approach
    Once buyers agree the terms of the purchase contract, the due diligence period provides an opportunity to appraise the environmental aspects. Thorough research into the target company's operations at this stage minimises the risk of uncovering unexpected liabilities later. In extreme cases, these can result in significant costs to the purchaser.

    Before investigating individual sites, the environmental due diligence team can get a great deal of useful information about the corporate environmental record from the company's internal management system. Environmental management systems, such as those based on the International Standards Organisation (ISO) 14001 or the EU's eco-management and audit scheme (EMAS) protocol do not absolve a company from its environmental liabilities. However, they do demonstrate that the company is aware of the main risks its operations pose to the environment and possesses control measures to manage them. Where it has disclosed the environmental impact and controls (a fundamental part of EMAS), there is a publicly available record that demonstrates more than just an awareness of good environmental management.

    Often, acquirers do not consider environmental reviews until they have drawn up a contract and due diligence is well underway. This may be too late to pick up some of the environmental issues that a discreet, pre-contract evaluation would have revealed, particularly if the acquirer has not qualified indicative bids by environmental considerations.

    Understanding the potential environmental liabilities which a simple initial investigation can reveal gives buyers better knowledge of areas where it is safe to make concessions. It also alerts them to areas that they should not omit from warranties or indemnities. Even with only limited factual information about the business, initial enquiries can help protect against unexpected costs.

    Risk assessment
    Usually, buyers commission an environmental site assessment or environmental audit to assess risk. Not all sites owned or occupied by a company warrant audits. Audits should focus specifically on sites where there are, or have been, manufacturing or other environmentally sensitive operations. Consideration should also be given to including sites where the vendor has disclosed only limited information on environmental conditions.

    The environmental due diligence team inspects the selected sites. It interviews site management and reviews the records relating to permits, authorisations and consents. It also researches publicly accessible regulatory registers, databases, histories, maps or aerial photographs, to identify whether environmental problems exist.

    An identified environmental problem may require further work in order to arrive at a satisfactorily costed, technical solution. This could involve an intrusive ground investigation to confirm, delineate or examine the magnitude of soil and groundwater contamination. It could be an internal atmosphere air quality survey, or even an asbestos inventory.

    Additional work may be costly. It can also considerably delay the transaction timetable. Therefore, buyers often arrange legal solutions to the environmental issues, either in isolation, or in tandem with practical remedies.

    Environmental audits will not necessarily identify all the problems at a site. The buyer's legal advisers should ask the vendor for target environmental documents that could identify past or current environmental problems. These include:

  • past site environmental assessment audits
  • notices of environmental claims, violations or prosecutions
  • correspondence with environmental regulators or third parties, including neighbours
  • insurance claims
  • employee complaints or claims.

    The target company frequently makes and warrants representations that it:

  • has complied with all applicable environmental laws
  • possesses all the necessary environmental permits
  • is not a party to any current or pending environmental litigation
  • has not caused any releases into the environment of any toxic or hazardous material
  • has no obligations to decontaminate the soil at any site.

    Negotiation may lead to a practical solution to identified problems whereby the target company remedies the issues before acquisition. For example, buyers can require the target to remove hazardous waste or strip asbestos prior to closing. Clean-up of contaminated land, however, is typically done after completion, because of the long-term nature of problems.

    Contractual protection
    Establishing the most appropriate contractual protection depends on the type of environmental risk and the kind of transaction being contemplated. Risks could involve: f; localised or general contamination of the ground « migration of the contamination off-site onto adjoining land or into watercourses

  • off-site disposal of waste
  • prosecution by regulatory agencies
  • administrative fines or penalties
  • criminal litigation
  • occupational illness. The type of transaction is also important.

    Mechanisms appropriate for an acquisition may not be suitable for a merger. In many jurisdictions, structuring an acquisition as an asset purchase rather than a share purchase can reduce the buyer's environmental risk. In a share purchase, the buyer acquires all the environmental liabilities associated with the target company. In an asset purchase, the buyer generally only acquires the specific environment liabilities associated with the assets being acquired. In most circumstances, the latter will allow a buyer to avoid inheriting the environmental liability for previously owned, leased or operated businesses or properties. This can be a significant benefit.

    Indemnity agreements
    An environmental indemnity agreement or covenant is the most common method of minimising the buyer's environmental risk, apart from price adjustments. This says that the seller will meet the costs incurred by the purchaser for improving the environmental conditions as they existed at closing, in the event of a claim.

    The indemnity is unlikely to be specific as to issues identified at particular sites. It will be subject to time limits, de minimis provisions, caps and often carve-outs. It should specify in whose control the claim will be, and will have very specific trigger conditions.

    A purchaser may fear that a seller will not honour his obligation. In this case, the buyer should require the seller to escrow part of the purchase price to fund future claims. Escrow agreements are typically linked to specific, identified environmental issues. They may also include appointing third party arbitrators for any disputes.

    Another option is environmental insurance. Buyers are now becoming more comfortable with transferring their environmental risk by purchasing cover. While environmental insurance may be expensive, it can be an important mechanism for managing the risk. The buyer can obtain insurance for known and unknown environmental problems and use it to cover regulatory or private actions. Where particular environmental issues are identified, the buyer may ask the seller to share the costs of the policy.

    The right mechanism
    In essence, the environmental due diligence team should:

  • identify any previously undisclosed liabilities
  • shift those liabilities back to the seller and/or
  • provide the buyer with the leverage to negotiate a reduced purchase price.

    An important point is that, while the seller may accurately represent what the costs are as they relate to its current structure, the buyer will be more concerned with what the true costs will be on a go-forward basis.

    While there are many mechanisms by which buyers can minimise their environmental risks, no one method is right for every acquisition. Ultimately, the most effective mechanism will be the one which focuses on the specific environmental issues identified during the due diligence investigation.
    Dr David Hockin, director, Tanya Lloyd Jones, principal consultant and William Butterworth, principal consultant, are with RPS Group pic.

    Biological techniques for contaminated land
    The UK-based Construction Industry Research and Information Association (CIRIA) has announced a new research project to review a number of successful applications of biological techniques on risk assessment and remediation of contaminated land. CIRIA says that traditional techniques have technical and financial limitations. For example, analytical testing is most commonly used for measuring the level of contamination on land; but the results give no indication of the toxicity of the contaminants present. Similarly, excavation and disposal, currently the most commonly applied remedial options, are becoming more expensive with the introduction of landfill tax and are unacceptable to both local communities and government.
    The project is funded by the Department of Trade and Industry through its BIO-WISE programme, AstraZeneca, BP Amoco Group, Shell Global Solutions, the BOC Foundation, Shanks and AEA Technology.

    Environmental liability proposals
    ALARM, the UK forum for risk management in the public sector, has raised five key concerns in its response to the European Commission's White Paper on Environmental Liability.

  • While not specifically contesting the "polluter pays" principle, ALARM questions the "how, when and how much" issues raised by the proposed new European regulations, and is particularly concerned about the proposal to add a new liability for "damage to nature". It says that the White Paper's wording appears to open the way for claims for retrospective liability payments which have not been budgeted for or insured. The key sticking point is linking the trigger for liability to the "date of knowledge" which could include historical environmental damage.
  • ALARM asks for clarification of unclear wording in some parts of the legislation: for example, there is no definition of "significant harm" within the biodiversity regulations. ® With the EC aiming to establish an environmental liability regime for Europe, ALARM points out that the insurance market has yet to "respond adequately and cost effectively to such liabilities," possibly waiting for capping of levels for specific liabilities. Until it does, ALARM says suggestions of obligatory insurance should be shelved.
  • Local authorities should resist bringing damage caused by pollution within the scope of an environmental operating permit, says Liz Taylor, ALARM chief executive. "It would mean the encouragement of essential enterprise and economic growth is restricted due to draconian standards imposed by regulatory bodies." ALARM suggests this section be considered further, with possible enactment delayed until the insurance market introduces appropriate products.
  • ALARM believes that allowable defences for environmental damage - act of God, intervention of a third party and contribution to the damage or consent by the plaintiff - are too limited. It suggests widening these to include a defence based on "state of knowledge'.