Guest Column: How Much Environmental Due Diligence is Enough?

McCarter & English partner Jane Warren talks about how much environmental due diligence you need to perform in order to protect yourself against liabilities.
Jane Warren

Purchasers, investors and lenders involved with real property or businesses in the United States often ask how much time and money they need to spend to obtain “enough” information about potential environmental liabilities.

With the rapid growth of laws enacted to protect the environment over the past 30 years comes the potential for liability for cleanup costs being imposed on seemingly “innocent” parties in order to sustain the important public policy of safeguarding a clean, healthy environment. Accordingly, those involved with buying or selling real estate and businesses in the U.S. have learned that time and money must be spent early on in a transaction in order to avoid later becoming entangled in environmental disasters. But we come back to that question of how much investigation is enough.

Federal environmental law—and many corresponding state laws—requires that those trying to seek a defense to environmental liability as a “bona fide prospective purchaser” or “innocent landowner” must conduct “all appropriate inquiries” into prior uses of a property before proceeding with the purchase in order to receive liability protection. An “innocent landowner,” in general, is one who purchases a property without knowledge of any contamination (in addition to those who acquire by inheritance or escheat). Because knowledge of pre‑existing contamination negates the defense, the innocent landowner defense has proved to be of extremely limited benefit.

Accordingly, federal and state laws have been amended over the past decade to allow for purchasers of contaminated property to qualify as “bona fide prospective purchasers.” To qualify as a bona fide prospective purchaser, a person must have bought the property after Jan. 11, 2002, and must perform “all appropriate inquiries” prior to acquiring the property and demonstrate “no affiliation” with a liable party. A bona fide prospective purchaser must also comply with any environmental land use restrictions; take “reasonable steps” with respect to hazardous substances affecting a landowner’s property; provide cooperation, assistance and access to anyone trying to effectuate a cleanup; comply with information requests and administrative subpoenas; and provide any legally required notices.

In order to establish either of these defenses, a property owner must show that it conducted “all appropriate inquiry” into the prior uses of the property. Fortunately, the federal Environmental Protection Agency has promulgated standards regarding what constitutes “all appropriate inquiry,” better known as AAI, for environmental due diligence. The AAI Rule clarifies what is required in a Phase I Environmental Site Assessment in order to qualify for a defense to environmental liability, but compliance with the AAI Rule may also create a longer and costlier due diligence process that may not always be necessary.

Typically, a Phase I environmental site assessment is performed by an environmental professional for lenders, buyers or sellers of a property or a business for the express purpose of determining environmental risk. A Phase I is the first step in the due diligence process – it involves no intrusive soil or groundwater testing, but is, instead, a review of historic and current site conditions that can help a consultant determine whether additional investigation is warranted. Prior to the adoption of the AAI Rule, most Phase I’s were performed in accordance with ASTM (American Society for Testing and Materials) standards, which also provide guidance on the types of records that should be reviewed and the kinds of observations that should be made during an inspection of a property. Today, both standards remain in effect and either can be utilized when conducting a Phase I Environmental Assessment.

Some of the key differences between the due diligence required under the newer AAI Rule and the ASTM Phase I standards are as follows: (i) the term “environmental professional” is defined to clarify who is qualified to conduct Phase I’s (the AAI Rule sets forth strict standards that must be met in order to qualify as an “environmental professional” deemed capable of issuing an AAI-compliant Phase I); (ii) the required scope of historical research has been increased (AAI requires a search as far back in history as there is documentation that the property contained structures or was placed into use, versus ASTM’s “bright‑line” 1940 cut‑off date); and (iii) an analysis of the relationship of the purchase price to the site’s fair market value, if uncontaminated, is necessary so that it can be determined whether contamination played a role in the price paid for the property. These differences will add time and cost to complete a Phase I that conforms to the AAI Rule. While not all deals will require an AAI Phase I, lenders have generally adopted the AAI standards as the baseline for due diligence necessary in the loan decision process, so the rule has become a de facto due diligence requirement in financed transactions.

There are 10 criteria that must be investigated in order to achieve compliance with the AI Rule, as follows:

*        results of an inquiry by an environmental professional;

*        interviews with past and present site owners and occupants;

*        reviews of historical sources;

*        searches for recorded cleanup liens;

*        reviews of government records;

*        visual inspections of the facility and adjoining properties;

*        specialized knowledge of the individual seeking the defense;

*        relationship of the purchase price to the value of the property if not contaminated;

*        commonly known or reasonably ascertainable information about the property; and

*        degree of obviousness of the presence of contamination and the ability to detect contamination by appropriate inquiry.

A key provision of the AAI Rule is that some components of the environmental site assessment must be less than 180 days old in order for the user to be able to rely on its contents for liability protection. Further, the report itself must be dated within one year of property acquisition or financing. Finally, the Phase I Report must include an opinion as to whether conditions indicative of a release or threat of release have occurred, as well as an identification of any data gaps that might have impacted the environmental professional’s ability to recognize these conditions.

If a release has occurred, or the environmental professional identified any other known environmental conditions warranting additional information, a Phase II, which involves testing of the soil and groundwater, would likely be recommended. A Phase II typically takes several weeks to complete, and the costs can range anywhere in the five figures, so advance planning is critical.

Prospective business or property purchasers must also comply with state law requirements, such as those mandated by the New Jersey Spill Act or the Connecticut Transfer Act, in order to obtain liability protection under state laws. Perhaps the most critical component of environmental due diligence is to ensure that once an environmental report is received, it is reviewed by knowledgeable in‑house or outside experts, as oftentimes what is missing or not covered in a report is the most crucial information, which could significantly impact a property’s or business’s value.

Jane Kimball Warren, Esq., is a partner in the Environment and Energy Redevelopment practice of McCarter & English L.L.P.