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Between legal and environmental due diligence

Before entering into a transaction, an investor will often hire consultants to conduct environmental due diligence. The environmental impact of business operations are also an element of legal due diligence. How are these two types of due diligence interrelated?

In the most general sense, the purpose of environmental and legal due diligence is the same: to assess the environmental compliance of the operations of the target. Under the extensive legal regime governing nearly all aspects of the environmental effects of operations, most environmental requirements derive directly or indirectly out of universally binding laws. Because of the close connection between the law and the environment, the two types of due diligence are sometimes treated as interchangeable.

In practice, however, environmental due diligence, conducted by environmental consultants, differs significantly from legal due diligence, primarily because they use a different set of diagnostic tools and different methods, under different conditions.

The purpose of an environmental audit, broadly speaking, is to verify the compliance of the operations with the requirements across all areas connected with environmental impacts. The audit includes verification of the correctness of the procedures followed with waste, management of water and wastewater, fulfilment of reporting requirements, the procedures followed when using chemicals, maintaining permissible levels of substances in wastewater, conducting required testing and monitoring, and so on.

Environmental consultants evaluate the risk arising out of violation of specific requirements, typically within the context of the expenditures that would be required to eliminate irregularities. This major difference from legal due diligence is often overlooked by investors. Risk assessment in legal due diligence is aimed primarily at identifying the legal consequences of non-compliance. These consequences may or may not be related to incurring certain costs to bring the operations into compliance with these requirements.

The environmental and legal risk will be described similarly if environmental damage is found, because the basic consequence will be the need to take remedial measures (e.g. to clean up the pollution by replacing the contaminated soil), which will require certain costs to be incurred. But the risk will be described differently if there are irregularities found that involve the formal legal aspects of operation of waste storage. In such a situation, the environmental audit will identify the need to incur certain costs to conduct all actions and tests, prepare documentation and carry out work necessary to correct the formal legal status of the facility. The legal audit will identify the risks of administrative liability, e.g. the need to pay increased fees for storing waste without holding the required administrative decision defining the waste storage methods.

This illustrates the complementary nature of environmental and legal due diligence. While they overlap to a certain degree, for the most part each type of examination supplements the findings of the other.

Environmental audits are often based on the environmental site assessment model developed in the United States, including two stages: a preliminary but comprehensive review known as a Phase I Environmental Site Assessment, and a more thorough analysis, known as a Phase II Environmental Site Assessment, in which samples of materials and substances are collected and tested in order to verify the suspicions raised in Phase I. The testing is largely based on the methodology in force in the US, primarily guided by the federal legal regime of CERCLA (the Comprehensive Environmental Response, Compensation, and Liability Act, also known as “Superfund”). The standards for environmental testing under CERCLA were developed and approved by ASTM International. Proper application of CERCLA also requires that parties follow the guidelines developed by the US Environmental Protection Agency.

Generally, under CERCLA, an acquirer of contaminated property may be liable for cleanup even though it did not cause the contamination (the release of hazardous substances) or was not even aware that it occurred. However, the acquirer may avoid liability by asserting the “innocent purchaser defence” or the “bona fide prospective purchaser defence.” These defences against liability may be available when contamination is discovered after the purchaser acquired the property but the purchaser can show that it did not know and had no reason to know that any hazardous substance which is the subject of the release or threatened release was disposed of on, in, or at the facility.

During international transactions in which environmental consultants perform audits of installations in dozens of different countries, a uniform scheme is developed for conducting the examination to assure that comparable results are obtained. Therefore the methodology developed in the US is often used in Poland, despite major differences between the legal regimes of the two countries.

It should be borne in mind that the environmental site assessment model is designed primarily from the perspective of specific rules for environmental liability. Therefore it does not provide a comprehensive evaluation of the compliance of the operations with environmental requirements. Such a comprehensive review is sometimes referred to as an environmental compliance audit.

Given these characteristics, in many instances only a review by both lawyers and environmental consultants will enable proper evaluation of the risks associated with acquisition of a specific plant, property or installation.

Dominik Wałkowski, Environmental Law Practice and Mergers & Aquisitions Practice, Wardyński & Partners

See also Dominik Wałkowski, “Legal and Environmental Due Diligence,” in Environmental Law in M&A and Real Estate Transactions, edited by Dominik Wałkowski & Izabela Zielińska-Barłożek (Lexis-Nexis, Warsaw 2014), pp. 71 and following (in Polish).