CHAPTER 8 ENVIRONMENTAL DUE DILIGENCE AND DEFECT PROCEDURE

• Jurisdiction: United States

Oil & Gas Agreements: Purchase & Sale Agreements
(May 2016)
CHAPTER 8
ENVIRONMENTAL DUE DILIGENCE AND DEFECT PROCEDURE
Larry W. Nettles
Partner
Ross Woessner
Vinson & Elkins LLP
Houston, TX

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LARRY W. NETTLES is a partner in the Houston office of Vinson & Elkins LLP. He has been practicing environmental law full-time since 1981 and has an exceptionally broad range of environmental law experience that makes him particularly well suited to advise clients with multi-faceted environmental problems, such as those frequently encountered in large business transactions. Larry currently serves as Co-Chair of the firm's Energy and Infrastructure Practice Group and Chair of the Shale and Hydraulic Fracturing Task Force, and is a member of the firm's Environmental and Climate Change Practice Groups. Larry has been recognized as the top environmental lawyer in the United States for the past eight years by United States Lawyer Rankings. He has also been recognized as one of the best environmental lawyers in the nation in the most recent edition of Best Lawyers in America®; one of the best environmental law attorneys in Texas on the "Texas Super Lawyers" list published in Texas Monthly, and by Chambers & Partners in its recent guidebook on America's Leading Lawyers for Business.

I. INTRODUCTION

Environmental laws have historically regulated oil and gas exploration, production, and development less heavily than other activities with comparable environmental effects. Many federal and state laws establish exclusions and exemptions specific to the oil and gas industry. Oil and gas operations face increasing environmental regulatory burdens, however, and operators must comply with their complex requirements. This regulatory burden has increased scrutiny on environmental issues in oil and gas transactions. As a result, the parties to a transaction will carefully evaluate the environmental compliance of assets for sale and negotiate the allocation of any risks or liabilities they may present. This paper discusses the primary federal environmental laws that affect the upstream oil and gas industry and how purchase and sale agreements may address them.

II. ENVIRONMENTAL ASSESSMENT PROCESS

Most buyers are unwilling to rely solely upon the representations and warranties the seller of oil and gas properties makes with respect to environmental compliance and environmental cleanup liabilities. As a result, buyers should, and typically do, elect to conduct their own environmental investigation of the properties being purchased. The primary purpose of the environmental assessment is to aid the parties in assessing environmental risk associated with the transaction. Therefore, the parties should balance the potential magnitude of the risk with the transaction costs associated with conducting environmental due diligence. The larger the transaction and associated environmental risk, the more substantial the environmental due diligence should be. Conversely, however, in a large transaction, the buyer might be prepared to assume a greater environmental risk and establish a higher threshold for investigation, because only greater risks will be material to the amount being paid for the assets. In upstream oil and gas transactions, the seller typically wants to avoid post-sale environmental risk, particularly if the seller is the operator, because the seller does not want to incur post-sale claims after it has lost the ability to bill non-operating working interest owners. Thus, the seller will want the parties to address all environmental liabilities at closing. This may drive the environmental defect process.

A. Scope of Assessment

Environmental due diligence focuses on liabilities associated with compliance with environmental laws and regulations. Liabilities associated with environmental conditions

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include not only regulatory requirements, but also potential common law liabilities, such as unasserted toxic tort and nuisance claims. Although these liabilities are traditionally considered significant because of the potential for high damage awards, the mere assertion of these claims can also interfere with ongoing operations. For example, if remediation of a particular parcel of real estate is required, that parcel may become less valuable as a producing property if the cleanup remedy interferes with the use of the parcel. Similarly, to achieve additional leverage in their claims, private litigants may seek to intervene in permit proceedings to contest the issuance of a permit needed for operations.

Compliance with environmental laws is frequently overlooked as a due diligence issue, but it is also important. Environmental laws carry significant civil and even criminal penalties. Further, governmental agencies can take injunctive action to force compliance, including the requirement to undertake corrective action. For example, failure to comply with Clean Air Act ("CAA") technology standards could require a costly retrofit of air pollution control devices. In extreme cases, this type of relief could require the temporary or permanent cessation of operations at noncompliant facilities. Finally, the assessment should include regulatory matters that could impede the future development of the assets, such as the presence of wetlands, endangered species, species that regulators have proposed to list as endangered, or archeological resources. Regulators may restrict the assets' development or operation in light of these local environmental conditions. Environmental assessments that include compliance reviews are known as environmental audits.

B. Background Information

The first step in the environmental assessment should be the collection and review of all available background information. The buyer should use this background information to design the remainder of the assessment and to focus on those areas that are more likely to present environmental concerns. Much of the background information will need to come from the seller. The information provided should reflect the seller's current operating practices and emphasize the seller's waste management and pollution control practices. The buyer should also request copies of any environmental assessments prepared by or on behalf of the seller or the seller's predecessors for the properties being purchased. In addition, the background information should reflect any changes in the seller's operating practices over the years, particularly changes in the waste disposal practices. Moreover, the buyer should request copies of all environmental permits the seller holds and review all of the environmental files the seller maintains, including any files related to agency inspections or enforcement actions. In addition to reviewing documents, the buyer should interview the seller's employees who have knowledge of the seller's current and past operating practices.

C. Environmental Site Assessments

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To assist in identifying potential environmental liabilities and environmental compliance issues, the buyer may engage an environmental consultant to conduct an assessment of the facilities. As counsel for the buyer, the attorney may assist in selecting a reputable firm and defining the scope of the assessment. If the buyer already has a good relationship with an environmental consulting firm, the client may elect to have the attorney engage the firm to seek to establish a claim of legal privilege over the consultant's work product.¹ What is most important, however, is that the attorney and the environmental consultant have a clear understanding of the scope of the assessment and that they work together to identify and quantify the environmental risk.

1. Phase I

The initial step in any environmental assessment, after compiling seller and agency information, is to conduct a "Phase I" environmental site assessment of all or representative facilities. The American Society for Testing and Materials, now called ASTM International ("ASTM"), has largely standardized the scope of work for a Phase I environmental site assessment. ASTM has published certain standards for assessing environmental compliance and potential environmental liabilities at industrial and commercial facilities, including standard E1527-13, regarding Phase I environmental site assessments.²

A Phase I environmental site assessment generally consists of a records review, site reconnaissance, interviews with current owners and operators, and an evaluation and report.³ Site reconnaissance consists of a walkthrough and visual inspection by the naked eye. The records review generally consists of searching public records regarding the subject property and properties with a certain distance of it, to the extent that the assessor can perform such a review within a reasonable time and at reasonable cost.

In large oil and gas transactions, hundreds of facilities may be involved, and a Phase I environmental site assessment for each of them may be cost prohibitive. Therefore, the buyer may use agency background information and the information the seller provided to identify which facilities merit an actual site inspection. In some instances, it may be appropriate to select a sampling of facilities for site visits. In addition, the ASTM Phase I process may generate a large volume of unhelpful data by requiring the assessor to search public records regarding properties within a certain distance of the assets. If the transaction involves a large number of properties, the user may choose to conduct environmental assessments that do not meet the E1527-13 standard in order to focus their results. The buyer may also select which facilities to

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visit based on prior Phase I environmental assessments or recent aerial photography. For widespread oil and gas assets, particularly in hard to reach areas, some buyers use drones to perform such inspections to save time and money. A Phase...