[co-author: Scott Mayer, Womble Bond Dickinson]
What You Think Won’t Be an Issue Might Be – Don’t Wait to Assess Environmental Liabilities
Total commercial real estate transactions in 2022 were valued at approximately $1.14 billion. As events of environmental contamination and public concern over the health hazards caused by hazardous substances have increased—leading to greater federal and state regulation—buyers and sellers of commercial real estate should take steps to protect their respective interests from continuing liability to third parties, public agencies, and one another.
In our experience, we have found many purchasers wait until late into the transaction to assess environmental conditions at or near the site they are buying. The property’s environmental liabilities can result from various sources, such as the type of operation that was on the site, any chemical or waste disposal that may have taken place on or near the site, how the land was developed, or even natural disasters. As the new owner, you will be responsible for those liabilities going forward, unless steps are taken to mitigate your exposure. As the seller, you cannot generally eliminate your exposure to any responsibility for environmental damage merely by selling off your assets. There also is a potential gap between how the buyer or seller assesses the value of environmental liability. Therefore, for both parties, conducting an environmental due diligence investigation early in the transaction may save needless financial and operational headaches in the future. When a well-executed environmental liability transfer is completed properly, it is a “win-win” for the buyer and the seller and may benefit the surrounding community as well when an idle industrial property is put back into productive use.
While a seller of a commercial property has a duty to disclose facts affecting the value or desirability of the property, including whether the property is affected by hazardous substances, a buyer should perform an environmental evaluation of the property and negotiate contractual terms, including representations and warranties, and indemnity protections. For example, a buyer should require a seller to represent and warrant that there has been no release of hazardous materials on, under, or around the property, and that the seller and the property comply with all applicable environmental laws. A buyer might also require an indemnity from the seller against any liability to third parties for cleanup costs and other damages associated with hazardous conditions. A buyer may also consider the availability of an environmental impairment insurance policy or endorsement.
A buyer should conduct a review of current and past uses of the property, including an investigation of public records, the seller’s records, and of the property. Such a review is often satisfied by conducting a Phase I environmental site assessment (ESA). Typically, such a review is performed and analyzed by an environmental consultant. Depending upon the outcome of the initial review, further investigation, including soil, water, and air testing, may be warranted. The Phase 1 ESA helps the buyer make informed decisions regarding the environmental health of the property and can be instrumental in securing financial or insurance coverage and mitigating legal risk in the future, but often it does not go far enough. Utilizing data from site inspections, historical records, interviews with prior owners, and obvious regulatory obligations, an environmental professional can evaluate the likelihood of contamination and what potential impact there might be on the existing property and the surrounding area. No party should think of an ESA as merely a box-checking exercise. Often, conducting work beyond the scope of an ESA is beneficial to more clearly understanding the environmental liabilities of a property.
A seller will strive to sell the property in its existing condition with no representations or warranties along with a release from the buyer of any liability from hazardous substances, even unknown contamination.
Spirited negotiation will ultimately resolve the terms of the purchase agreement, including indemnities and releases, but the seller and buyer should also understand possible liability or defenses for third-party claims seeking damages for contamination under applicable federal and state regulations. Generally, current and past owners of a contaminated property may be responsible for cleaning up the property even if they did not cause or know about the contamination. For example, the Comprehensive Environmental Response, Compensation and Liability Act of 1980 provides that owners must clean up properties where hazardous substances have been released and gives authority to the federal government to take or require such remedial actions. In California, in addition to liability for common law fraud, a prior owner may be strictly liable in an action by a subsequent owner or public agency for damages associated with contamination. Defenses to such actions, including the innocent landowner defense, are available, but subject to certain conditions such as having conducted a reasonable investigation to determine the presence of hazardous substances.
Case Study Examples
Below are two case studies related to performing (or not performing) proper due diligence, and the resulting consequences.
In our first instance, performing a thorough due diligence site inspection led to the discovery of a leaking underground storage tank, saving the buyer hundreds of thousands of dollars in remediation costs.
This recent case involved a real property transaction. The buyer hired well-trained environmental professionals to conduct the due diligence assessment, with the intent to identify liabilities (and not just check boxes). The desktop review of the environmental history and site inspection suggested no environmental liabilities, although the inspector noticed a mysterious pipe in the basement unconnected to anything in the building. Rather than dismiss the observation as having no obvious environmental connection, the inspector called for a geophysical survey of the pipe and its underground connections that revealed the presence of an unknown underground storage tank. Upon excavation of the tank, it was clear that the tank had leaked. Follow-up investigations revealed contamination extending to nearby properties, resulting in significant remediation costs for the seller.
In our second instance, skipping environmental due diligence led to millions of dollars in liability for a New York City-based seller.
In this property transaction, limited, if any, due diligence was conducted. To account for potential liabilities, clawback provisions were added to the purchase and sale agreement such that if environmental issues were identified, the buyer would be reimbursed by the seller, up to a capped amount. As the revelry of this “successful” deal wore off, enforcement actions from environmental regulatory agencies came into focus, leading to the implementation of significant corrective actions. While the seller was responsible for many of the associated costs, the clawback cap was exceeded, and the buyer also incurred millions of dollars of costs.
Environmental due diligence needs serious consideration early in a contemplated transaction allowing enough time and resources to perform a thorough evaluation. While this may seem obvious to many, we continue to see examples where excluding environmental due diligence in a rush to get a deal done, or under pressure from mergers and acquisitions’ directives to not let environmental issues “tank the deal,” leads to unexpected and significant losses for both sellers and buyers.
