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Monday, March 27, 2006

AVOIDING COMMON MISTAKES IN ENVIRONMENTAL DUE DILIGENCE

Note: This article is written from the perspective of Polish transactions. (1)

With environmental liabilities becoming an increasing concern in Polish company and land acquisitions, it is time to ask if environmental due diligence is doing its job. Given some publicized cases in Central Europe of embarrassing environmental liabilities coming due after acquisitions that used the classic environmental due diligence approach, it is fair to suggest that current practices are less than adequate. What mistakes and misconceptions exist and how should a company making what could be an environmentally risky investment look at this issue?

First, there is no guarantee from the due diligence firm. The only comfort level that can be achieved is by the design and implementation of an aggressive environmental due diligence effort itself. If something is missed, there is no recourse to the service providers and no insurance against mistakes being made, especially in Poland where no policies are offered.(2) Just saying that a firm uses environmental due diligence does absolutely nothing to protect the buyer, unless the effort being made is effective.

Second, in Poland, we are seeing firms being hired to find environmental problems that have very little experience actually handling environmental problems. Lawyers and technical consultants who have not dealt with complex environmental issues (most likely because the Polish experience has not provided for many opportunities) are being asked to “find” the potential problems. Everyone has checklists and thorough sounding objectives, but with little experience in how operations can environmentally go awry, their “books” may seldom be enough. See “Environmental Due Diligence Procedure.” FMC Technologies (2005):
http://www.fmctechnologies.com/HealthSafetyandEnvironment/_HSEWeb/HSEManual/Section3/31EnvDueDiligenceProced.aspxv.

Third, trying to dodge the bullet by some sort of representations and warranties in the legal documents is a very poor substitute for a detailed and expert due diligence investigation. There is no language that automatically can be used to fit the needs of the buyers and sellers. The seller cannot warrant that no hazardous material was disposed of on the site: small quantities of potentially hazardous material are released from the most harmless operations. The buyer cannot rely on assurances that all operations performed on the site were done under approved permits and legal authorities: because contamination clean-up does not depend on the lawfulness of the initial operations, only on the presence of the compounds above the Ministry’s action level. A seller’s certification that no contamination exists above Ministry levels may create a claim back under the contract, but will not alleviate the liability of the new registered owner of the land. Given that the Ministry’s standards go down to 15 meters and cover multiple substances commonly found in industrial and urbanized areas, it will be difficult for a seller to make this representation with any veracity. So lawyers have to look for more than a “silver bullet” clause.

Fourth, the “analytical fallacy” is the commonly viewed notion that site sampling will assure that nothing serious is present on the site. Random sampling or even sampling of production areas may be completely ineffective at finding serious contamination. Operations as they exist today may be materially different from what occurred twenty years ago, when on-site disposal was a more widespread or even typical practice. Tenants using the owner’s land in past years may have conducted activities that left problems. Some wastes migrate, notably volatile organic compounds, and will not likely be discovered at or even near their original source of release, especially after twenty years or more. The Polish standards go down to 15 meters and cover the whole piece of real estate. No sampling program devised from a visual inspection will be adequate to provide any reasonable degree of assurance than serious contamination, if present, is found.

Fifth, all information requests to a Polish organization should be “front-loaded.” Anything that you want from the buyer should be specified in advance from a top-down detailed memorandum. Polish employees will not normally exercise the normal initiative in supplying information or “filling in the holes.” Unless they have been directed by their boss to provide information, they will be unlikely to volunteer anything or feel compelled to even answer direct requests. This means careful prior planning on what you ask for as well as the need for “back channel” information, described below.

Sixth, potential buyers most often use consultants better designated to quantify and characterize contamination when it is discovered than to find likely contamination spots. Most technical disciplines are a poor fit for qualification as “environmental detective.” On the other hand, some experts can be valuable. Process engineers can provide information of what wastes were generated by the operations. Geologists and hydrologists may be able to make important contributions of what this material might have moved. But the basic question of where contamination is located is a “fact issue” for which witnesses and sometimes documents will hold far more intrinsic value. If the seller has the normal reluctance to volunteer information or his employees feel unsure of their role in cooperating, this can essentially be an adversary proceeding in character. Most technically-trained consultants are a poor fit for the task of “cracking this nut.”

Seventh, the opportunity of the transaction to be used to resolve the environmental issue to everyone’s satisfaction is normally lost on the parties. The seller normally perceives an environmental contamination issue to be a potential “deal stopper.” The buyer may either “bolt and run” if the issue emerges or insist on prohibitively expensive “set aside” funds or indemnification provisions. Both sides may assume the worst case scenario and see the transaction shaped by those assumptions. As discussed below, the transaction may afford the parties the best opportunity to obtain a regulatory approval of a result acceptable to all sides.

Eighth, the parties should have a written agreement on the disclosure and use of any report or samples taken from the property by the buyer’s team. Whatever confidentiality that is possible should be created by the seller restricting the use and distribution of information he provides. Attorney-client privilege over the report itself may be applicable depending on how the deal is done. The question also arises whether the seller will even want copies of reports or tests done. However, to drill a well in Poland, requires approval by a local official and undoubtedly will also be combined with a request for the results of any sampling. So the issues on disclosure and use of data will be complex and will vary in every case. The issue cannot be ignored, however, and should be the subject of an early strategy on both sides that is subject to reassessment as events develop.

So in the light of the above pessimistic picture, what should buyers be planning to do?

The initial step to create a team with the experience to offer the best shot at identifying problems and issues. The actual personnel who will be involved in the environmental due diligence should be looked at by the prospective buyer. Who are they and what have they done before? Lawyers or other experts that have experience with “adversary” type proceedings and hostile or reluctant witnesses may be essential to get the real facts involving past facility operations. It is unlikely that there will be a precise “document trail” to any contaminated location [although one has to ask for documents]: so the work will involve asking good questions based on an understanding of the processes conducted at the site.

Photographs are vital if they are available. Any pictures of the plant from past years can provide an enormous amount of information. Not only may disposal areas show up, but process operations can be identified and located. One old photograph can be one of the most valuable pieces of the puzzle available.

Perhaps the greatest change that can be adopted is for the buyer to accept that finding an environmental problem is not the end of the deal. The buyers’ acquisition team is normally geared, as they should be, to close the deal. They have worked hard on it and they do not want to see the effort go for naught. My experience is that the environmental expert in “deal team” is normally greeted with bare tolerance or even hidden hostility. This distrust has been earned by most of the people involved in the role, because all that they can do is stop the deal or hopelessly complicate it. The environmental due diligence team is seldom conceived of or operated as a “problem solving” group.

Situations ranging from a faulty integrated permit application or final permit to on-site contamination from past operations can obviously be dealt with constructively by the parties. The event of buying and selling the facility or property is not only important to the private parties involved, but also to the community and the government. To the latter it is not only an opportunity to continue economic activities that help the community, but should be viewed as an opportunity to get more resources devoted to addressing any environmental concern. The seller has some leverage to help get a consensus of what steps should be taken to address potential problems. Proposals to address the issues will probably never receive a better audience than at this stage.

While a complete agreement on a final solution may be impossible at this stage, in most cases, it should be sought where possible. If more information is necessary for a final decision, then the information needs can be quantified. A decision-matrix might be agreed upon, if no contamination is above this level or has reached this point, then certain actions can be taken. All of these efforts can dramatically reduce the uncertainty that normally kills the deal. Set-asides or indemnity provisions based on real facts and an agreed course of action can be down-sized to fit the facts. Even agreement on the next steps to be taken by the buyer, if they proceed with the transaction, can be valuable to all parties.

Poland does not provide for an innocent purchaser defense for existing contamination. The mere conduct of environmental due diligence is, on its face, no protection for the buyer. The buyer’s only protection is effective environmental due diligence. A seller with some environmental problems will likely face brutal assumptions on the scope of the problem by the buyer without real expert involvement. Both sides should benefit if the environmental due diligence can tell them not only what is there, but what does it mean.

New laws in Poland make environmental due diligence a more essential prerequisite for investment and real estate projects. Sending in a team poorly equipped to deal with its complexity or relying on some legal contract provisions alone may end up being a serious mistake.


1 All rights reserved. The author is an Environmental Consultant with CEC Government Relations, Warsaw, Poland, and Environmental Advisor to Kalwas and Partners, Warsaw. He has been involved in environmental due diligence and audits since work on the Love Canal in 1978.

2 Lenders can now obtain environmental liability insurance for their risks in a transaction, but this evolved as their industry made a judgment that environmental audits were not adequate protection: “The traditional due diligence process does not provide today’s commercial lenders with the ability to protect their interest adequately or allow for a reliable transfer of environmental risk to third parties.” Alan Bressler, Marsh Inc., “Environmental Insurance Changes the Game for Commercial Lenders,” Intenrational Risk Management Institute, Dec. 2002: http://www.irmi.com/Expert/Articles/2002/Bressler12.aspx

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