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“The Risk and Necessity of Environmental Testing”

Inside Counsel By Arthur A. Vogel, Jr.

In acquisition mode, most buyers will evaluate the likelihood of some adverse environmental impact on the property or business to be acquired. During due diligence, a buyer will generally commission a Phase I Environmental Site Assessment (ESA) to determine whether there are "recognized environmental conditions" (RECs) that warrant physical testing and analysis, like soil borings and groundwater wells. To increase the likelihood of its characterization as an “innocent successor,” a buyer needs to demonstrate that “all applicable inquiries” were undertaken before acquiring assets. That may include work to evaluate RECs that become apparent during a Phase I ESA. Physical testing typically takes phase during Phase II of the overall site assessment.

It gets tricky when the buyer wants to perform physical testing, and the seller sees no need for it in the first place. The seller may be thinking as follows:

I have no current obligation to assess the condition of my property. I have no knowledge of conditions requiring investigation, much less cleanup, from a regulatory perspective. I can operate my business indefinitely without incurring costs to address environmental conditions. Why should I consent to testing, when the business can operate “as is” without incurring these costs?

The buyer’s point of view, by contrast, is as follows:

Right now, I have no obligation whatsoever to investigate/remediate the target parcel. If I take title, however, and if contamination is later discovered on site, I may be liable for corresponding costs (remediation, etc.) even though I didn't cause the contamination in the first place and even though the cost of remediation was not accounted for in the purchase price of the underlying assets. At a minimum, I need to demonstrate “all appropriate inquiry” in order (1) to assert my status as an “innocent successor” with respect to historic contamination that comes to light after closing, and (2) to make sure that I am not buying a pig in a poke (i.e., that I am not paying for an asset only to discover later that there is a six- or seven-figure cleanup obligation associated with the site). If there are environmental liabilities, I need to factor that in to my thought process before closing—either to walk away from the deal altogether or lower the purchase price to account for the likely cost of investigation and cleanup.

The seller, in turn, thinks further:

If I allow sampling, and if the deal dies because the seller backs out (or reduces the purchase price), then I am left holding the bag. I will have environmental issues and costs to address, but these are expenses that I don’t have right now running the business in the status quo. Why should I accept that risk?

The answer to the last question is pretty straightforward. Chances are—assuming a reasonably sophisticated buyer (or a sophisticated lender taking the property as collateral)—that the buyer will insist upon Phase II sampling to understand potential risks and liabilities associated with property ownership. Put another way, if you want to hold onto the business and operate it under the status quo, that’s fine. On the other hand, if you want to sell the business, this is likely to be an issue one way or another.

In the best possible case, of course, samples would be collected, no dramatic conditions would be apparent, and the sale would proceed consistent with its terms. It is certainly possible, however, especially for parcels with a long industrial history, that conditions will be discovered that require remediation in one form or another. Hopefully, costs can be reasonably projected after collecting Phase II data, and adjustments can be made in the purchase price or the parties can negotiate terms to make clear who is responsible for what as the cleanup proceeds. Again, this may just be a necessary evil—a quid pro quo, so to speak—to selling the business, because the condition of the property is likely to be examined by any reasonably sophisticated buyer. Similarly, if the buyer walks away from the deal, leaving the seller with cleanup obligations, then the seller can address the circumstances in its own time in its own way to manage costs as effectively as possible and to minimize the risk that this will be an issue with a different buyer in the future.

Now, just because Phase II sampling may be required, the scope of the Phase II work can still be debated and/or negotiated. Technical arguments might be made regarding the number of samples, the location of samples, and the parameters to be addressed in the sampling protocol, to name a few of the relevant issues. To engage a discussion at the technical level, the parties might want to enlist the aid of a qualified consultant to negotiate the scope of Phase II work.

The parties should also negotiate the standard for cleanup. The seller of industrial property will generally not want cleanup to “background” or “residential” standards, while the buyer will want to make the parcel as "clean" as possible for unrestricted use. That said, for industrial parcels that will remain industrial parcels, conditions should generally be evaluated against industrial standards for soil and groundwater cleanup, not background or residential conditions.

In the next installment, we'll discuss how insurance might be used to distribute risk in general, and maybe even to avoid some Phase II testing altogether.

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