JurisdictionUnited States
Due Diligence in Oil & Gas and Mining Transactions
(Sept 2018)


James C. Morriss III
Leslie Reynolds
Thompson & Knight LLP
Austin, TX

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JAMES C. MORRISS III is a Partner in Thompson & Knight's Government and Regulatory Practice Group and serves as the Firm's Austin Office Leader. Jim represents clients in a variety of industries, but a significant portion of his practice is devoted to assisting oil and gas clients in both the upstream and midstream sectors engaged in offshore development and onshore activities across the United States. Jim focuses his practice on environmental permitting; compliance counseling; facility siting, including wetlands and endangered species work; and administrative and judicial litigation before local, state, and federal environmental agencies and state and federal courts. He has extensive experience in counseling clients in environmental risk management, including the design and implementation of environmental auditing programs and environmental management systems, and in the investigation and disclosure of environmental liabilities and contingencies. Jim also has significant experience in litigation involving the investigation and remedy of complex sites, including the development and presentation of risk based solutions to contamination. His work with clients in establishing programs for the use, reuse, and recovery of solid and hazardous waste and energy conservation has evolved into broader issues of sustainable development. Jim received his J.D., with honors, from The University of Texas School of Law and his B.S. in Mechanical Engineering, with high honors, from Southern Methodist University. He has served as an Adjunct Professor for The University of Texas School of Law and Lewis & Clark Law School on the subject of "Fracking and More: Environmental Issues in Unconventional Oil and Gas Development." Jim is a Fellow of The American College of Environmental Lawyers and has been honored by numerous prestigious legal directories, including The Best Lawyers in America®, Chambers USA, and Texas Super Lawyers®.

A. Scope of Environmental Review

1. Environmental Due Diligence Generally

Due diligence is a tool for the management of risk and risk avoidance--the look you take before you step. A buyer that has acquired an understanding of the risk through diligence may be able to avoid problem assets or facilities by simply carving them out of the transaction. In the alternative, a buyer may be able to negotiate transaction terms whereby the seller (i) adjusts the price to reflect the cost of compliance or required remediation, (ii) brings the facility into compliance or cleans up spills or releases before closing, or (iii) retains liability for the costs and risks of addressing such environmental conditions following the closing. Further, the buyer may be able to utilize regulatory programs or legal rights afforded by statutes and enforcement policies to avoid or minimize liability for conditions which must be remedied after closing. These programs are discussed in more detail below. First, how is the scope of due diligence defined?

2. Scope of Due Diligence

One of the lessons learned from experience is that one size does not fit all. Often the nature of the transaction will define the nature and scope of the diligence. The time available for due diligence may constrain the scope. The familiarity of a buyer with the industry or the facility or operation being acquired will also affect the scope of diligence. For example, if the buyer has been operating the very facility it now plans to buy, the buyer will have little interest in or patience for detailed due diligence because the buyer knows the operations, is likely liable for current compliance issues, and appreciates the risks. If the buyer is in the same industry, the buyer may be familiar with and very accepting of the kind of risk that a new but similar operation poses. This is often the case in oil and gas operations in which a buyer can assess the risk of owning more of the same type of assets (e.g., pump jacks, engines, tankage, and pipelines) as it already owns and operates on a daily basis.

3. Does "Phase I" Really Mean What You Think it Means?

One of the most misused terms in environmental due diligence is "Phase I." Clients and deal lawyers alike often use this term to describe what they think is a comprehensive environmental assessment. "We will just get a Phase I" is a common refrain amongst corporate colleagues. Purchase and sale agreements will propose to limit a buyer's diligence to a Phase I. In fact, a Phase I site assessment has a very specific and limited scope that is actually ill-suited to defining risks associated with a regulated activity, including due diligence in the oil patch. This is not surprising given that the Phase I scope of "all appropriate inquiry" has its origin in commercial real estate transactions. The scope of a Phase I is defined by an American Society for Testing and Materials ("ASTM") International standard and by U.S. Environmental Protection Agency ("EPA") regulation.1 The defined scope includes a review of records, a visit to the property,

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limited interviews, and an assessment of whether there is a recognized environmental condition ("REC") on the property. A typical REC revealed by a Phase I might be a history of intensive industrial use or visual contamination on the property that resulted from a spill or release. Thus, an REC is basically a condition noted from a site visit or records review that might give rise to liability. Obviously such conditions do exist on oil and gas properties. In fact, they are often commonplace on older properties, where tanks may have leaked due to age, where little attention may have been paid to spills and clean up, and where years of frequent transfer to and from trucks may have resulted in historical contamination from oil and produced water. In addition, the long term use of production and storage pits may have contributed to accumulations of contaminants in soil and/or groundwater.

While a Phase I may note the obvious, it does not encompass many of the important elements that should factor into environmental due diligence. For example, a Phase I does not include any testing or an assessment of the aerial extent and depth of the contamination or whether groundwater has been affected. You should, however, insist that a consultant conducting the Phase I include specific recommendations for any additional work such as sampling of soil or groundwater deemed necessary to assess the risks. Such further work is typically characterized as a Phase II. Further, many potentially significant conditions are not included within the scope of a Phase I site assessment. For example, a determination of the presence of polychlorinated biphenyls ("PCBs"), naturally occurring radioactive material ("NORM"), or asbestos is not within the scope of a Phase I. The location of the properties relative to endangered species habitat, wetlands, or available water resources is likewise not within the prescribed scope of a Phase I site assessment. These should be added to the scope of the environmental due diligence. Further, a Phase I does not address whether a facility is in compliance with environmental laws. For example, while the presence of oil around a well or tank may be noted, the failure to comply with spill prevention and countermeasure control ("SPCC") requirements will not. With the increasing number and complexity of environmental regulations applicable to oil and gas operations, compliance is a critical component of diligence. If the buyer wishes to consider whether a facility is in compliance or whether critical siting issues may present a problem for continued or future operations, a broader review must be commissioned. The scope can be characterized as an "Environmental Assessment" which can include but not be limited to a Phase I. The definition of "Environmental Assessment" should then go on to include the other critical components of environmental diligence discussed above.

4. Access and Sampling

As noted above, the term "Phase II" typically refers to testing to evaluate an REC identified in the Phase I. Such testing might involve samples of soils and groundwater. Generally, this assessment is still focused on a limited set of physical site conditions, such as suspected soil or groundwater contamination. Again, unless specifically commissioned, a Phase II does not include assessment of compliance with laws or of significant siting considerations such as wetlands, endangered species, or water resources.

Access to both property and records for due diligence should be addressed in the underlying agreement for the transaction (e.g., the purchase and sale agreement or stock purchase agreement). What access will the buyer and buyer's agents and contractors have to the property? What information will be shared between the parties and to what extent may government agencies be

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consulted during diligence? What protocols will be followed? The right to sample soil and groundwater in a Phase II should also be addressed. Will samples be split? Sellers will often seek to restrict access to the invasive steps of a Phase II without prior approval of the scope of work. If so, the agreement should establish the procedure for proposing invasive testing and obtaining approval. The consequence for refusal to provide access should also be established. Typically, in an asset deal, a buyer will demand the right to drop the property from the transaction. In addition, sellers may not have control over access to certain sites. The agreement must address how access to sites with third party operators will be sought and the consequences of failing to get such access. Buyers should resist blanket exclusion of privileged materials from...

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