CHAPTER 3 ASSESSING AND ADDRESSING ENVIRONMENTAL LIABILITIES

• Jurisdiction: United States

Due Diligence in Oil and Gas Transactions
(May 2011)
CHAPTER 3
ASSESSING AND ADDRESSING ENVIRONMENTAL LIABILITIES
Charlotte Neitzel
Holme Roberts & Owen LLP
Denver, Colorado
Colin Harris
Holme Roberts & Owen LLP
Boulder, Colorado

COLIN HARRIS is Chair of the Holme Roberts & Owen Environmental Practice Group. He provides counsel and handles regulatory and enforcement proceedings at the forefront of environmental law, with emphasis on resolving increasingly complicated and controversial Clean Air Act initiatives. He has served the oil and gas industry for over 20 years, with clients engaged in upstream E&P and related services, midstream field gathering, processing, and compression, downstream transportation and refining, and oil and products storage. He brings a thorough knowledge of oil and gas-related environmental regulations, risks and trends to the table which results in cost-effective and innovative environmental representation. Mr. Harris advises oil and gas industry clients on day-to-day regulatory issues, on project development and transactional matters, rule-makings, permitting, public lands issues, water quality, and the latest developments in climate change regulation. Mr. Harris also represents oil and gas clients in oil and gas commission, Office of Pipeline Safety and OSHA matters. His multi-faceted, sophisticated environmental experience in the industry and contacts with regulators makes him uniquely situated to help keep oil and gas operators in compliance so they can focus on their businesses while managing risk in a practical and cost-effective way. Perfect compliance by oil and gas operators is difficult, especially with heightened agency scrutiny and rapidly evolving regulations. When compliance falls short, Mr. Harris' oil and gas clients rely on his strategic and tactical crisis management, negotiation, and litigation skills to communicate problems and solutions, minimize liability, and protect the client's reputation. Mr. Harris is a persuasive advocate, whether in the negotiation room, discovery process or in court. He can reduce arcane regulatory matters to clear and understandable concepts and themes. In recent cases, as lead environmental counsel, his team convinced a Utah federal district court to deny the Unite States' motion for summary judgment as to the method for calculating emissions from natural gas compressor stations on Indian land in Utah, and obtained preliminary injunctive relief against efforts to stop construction of a gas processing plant.

ENVIRONMENTAL DUE DILIGENCE

ASSESSING AND ADDRESSING ENVIRONMENTAL LIABILITIES

By

Charlotte L. Neitzel

Holme Roberts & Owen LLP

Denver, Colorado

I. Introduction

EPA's recent pronouncements regarding the oil and gas and mining industries highlight the importance of organized and effective due diligence. EPA's six National Enforcement Initiatives for Fiscal Years 2011-2013 include two that specifically relate to oil and gas and mining: (1) reducing pollution from mineral processing operations; and (2) assuring energy extraction sector compliance.¹ EPA cites inspections of "65 mining and mineral processing sites that pose significant risk to communities and found many to be in serious non-compliance with hazardous waste and other environmental laws."² It also states that "toxic spills into waterways from mining and mineral processing caused massive fish kills and impacted the livelihood of low income communities."³ With respect to energy extraction, EPA states that new techniques for oil and gas extraction pose a risk of pollution of air, surface waters, and groundwater if not properly controlled.⁴ In addition, EPA claims that "an unprecedented acceleration of oil and gas leasing and development has led to a significant rise in the level of air pollution throughout the

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intermountain West," and that "[d]rilling activities have led to concerns about ground water pollution and the safety of drinking water supplies in various parts of the country."⁵

As a result of these regulatory concerns, a facility may be subject to regulatory scrutiny not seen in years past. In addition, regulatory changes are occurring which may increase the costs of compliance and the magnitude of environmental liabilities.

II. Due Diligence Process

A. Identifying the Purpose

When a client calls about a potential acquisition, a lawyer must first determine the purpose and the deadlines for due diligence - that is, what decisions depend on the due diligence. For large transactions, the "decision" might be whether to move forward in submitting a letter of intent or entering into a definitive agreement. If a target company is subject to a bidding process, the decision may involve whether to submit a bid and the amount of the bid. In identifying the purposes, any requirements of a lender's due diligence need to be taken into account. In addition, the persons doing due diligence need to understand the purchaser's plans for the acquired facilities. For example, if the economics of the transaction depend on whether the facilities can increase production, due diligence needs to focus on whether permits can be amended and waste storage or disposal facilities can be expanded. Similarly, if the economics depend on the future sale of some facilities in a multi-facility transaction, due diligence will focus on whether any contamination or other environmental problems may hinder the opportunity to sell the facilities. All of these factors will affect the scope of due diligence.

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B. Understanding Materiality

Whatever decision is being made, the materiality of current and future environmental compliance and liabilities, whether expressed in a qualitative or quantitative way, is always paramount. Materiality must be understood in the context of a transaction. A $100,000 problem in a $1 million transaction may be material, but may not be in a $50 million transaction.

Both federal and state statutes generally have risk-based cleanup statutes which sometimes involve restrictions on the use of property, such as institutional controls. A challenge in any transaction is to evaluate liabilities when a regulatory agency has not signed off on cleanup levels. Environmental cost accounting techniques can be used to provide a range of cost estimates. These techniques use a discounted cash flow approach and probability analyses. ASTM E2137-06 provides a standard guide for estimating monetary costs and liabilities for environmental matters.

C. Understanding Confidentiality

A key consideration in planning a due diligence process is also confidentiality. If a sale has not been announced, only a few higher level management individuals employed by the seller may have available information. Confidentiality concerns may even preclude contact with regulatory agencies, which are key sources of information about the status of environmental issues. A sure way to sour a deal is to disclose prematurely to a third party that negotiations are underway.

D. Identifying the Assets or Companies Being Acquired

Identifying the specific properties and companies that are subject to due diligence is one of the most important initial tasks of due diligence. If a company, as opposed to a facility, is being acquired, a purchaser needs to identify whether potential liabilities may be associated with

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previously owned or operated facilities or with offsite landfills or other offsite treatment or disposal sites. Because CERCLA imposes liability on certain prior owners and operators who owned or operated a facility at the time of a release of hazardous substances and on generators who send hazardous substances offsite for treatment and disposal, companies can retain the potential for CERCLA liabilities for facilities that it does not currently own or operate.⁶ Therefore, prior transaction documents of the seller should be reviewed to determine whether liabilities have been retained and whether previously sold properties are now owned by financially viable entities that can absorb liabilities. Similarly, parent companies can sell subsidiaries and retain environmental liabilities of those subsidiaries. Due diligence must determine what liabilities have been retained through such prior transactions.

Another tricky area is successor liability in stock acquisitions and mergers. If the target company acquired all or substantially all of the assets of another company in the past, but excluded some properties with environmental problems in that prior transaction, a future plaintiff might allege that the target company inherited the liabilities associated with the problem properties. This is of particular concern if the subsequent owner of the problem properties has dissolved or is otherwise no longer viable.⁷ Research into applicable law must be conducted regarding whether federal law or state law is likely to govern successor liability, and the particular factors in determining successor liability, which vary in different jurisdictions.

E. Organizing the Team

The next step is to create the team to conduct due diligence. For larger transactions, the due diligence team generally is comprised of four sets of individuals. The first set is the

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purchasing company's environmental managers who have been designated to work on the due diligence. Depending on the size and importance of the transaction, these individuals may want to play a major or relatively insignificant role. The second set is the acquiring company's environmental legal staff. The third set is an environmental consultant with expertise in the business of the seller and with appropriate insurance options. In many transactions, outside or in-house counsel retain the consultant to create confidentiality over the work product. Clear directives should be set forth in the scope of work for the consultant. The fourth set is the client's outside law firm.

At the outset of...