Environmental Due Diligence Gone Wrong

Practitioners engaged in transactions that involve the transfer of real property understand the utility, and in fact the necessity, of obtaining a Phase I Environmental Site Assessment (“ESA”) prior to closing. Having a properly performed ESA in the closing binder can bring with it substantial benefits should the new owner of the property someday need to avail him or herself of a landowner liability defense to environmental liability.[1]

The purpose of this article is not to describe how an ESA is performed, or who should perform one. Rather, the purpose here is to warn of the importance of fully understanding a key definitional requirement of every ESA, and to highlight the fatal consequences of the failure to understand and correctly apply key definitional terms. Those who wish may stop reading now and instead turn to a federal case from the Southern District of New York that makes the risks clear: 105 Mt. Kisco Associates LLC v. Carozza, slip op., 15-CV-5346 (USDC, SDNY, March 30, 2017).

Before delving into the details of that case, some background is helpful. As most are aware, the Comprehensive Emergency Response Compensation and Liability Act (“CERCLA”)[2], better known as Superfund, imposes strict liability on the owner of property. With the subsequent Superfund Amendments and Reauthorization Act (“SARA”)[3], a defense to Superfund liability began to develop if a land owner could demonstrate the contaminated property was acquired, after adequate inquiry, without knowledge of the contamination. To make that showing, the owner is required to establish that at the time of acquisition of the property “all appropriate inquiries” (“AAI”) into the previous ownership and uses of the property was undertaken, such that the new owner took title to the property with no knowledge of, nor reason to know of, contamination conditions that preexisted acquisition.

The question became how a prospective property purchaser could demonstrate that AAI was undertaken. In response, ASTM International developed standard practices for the conduct of ESAs[4] specifically intended to satisfy AAI requirements[5]. The Standard, known today as Standard Practice for Environmental Site Assessments: Phase I Environmental Site Assessment Process, ASTM E 1527-13, has been updated and revised at intervals over the course of the past 20 years or more. Today ESAs are routinely performed according to the ASTM Standard as a component of transactions involving real property.

Counsel representing a prospective purchaser must have a working understanding of ASTM E 1527-13 however in order to preserve the benefit of landowner liability defenses based on a properly conducted ESA. Application of the Standard depends on numerous defined terms, often reduced to acronyms, that it is critical are understood by the purchaser and counsel. Section 3.3 of the Standard defines over 25 acronyms – RECs, CRECs, HRECs, PRPs, NPL etc. Counsel and buyers must understand the significance and implications of each.

A threshold issue, sometimes overlooked in the rush to closing, is who the ESA identifies as the authorized “user” of the report. Section 3.2.98 of E 1527-13 defines “user” as “a potential purchaser of property, a potential tenant of property, an owner of property, a lender, or a property manager.”[6]  To be eligible for a landowner liability defense, it is mandatory that the party subsequently asserting the defense have been identified in the ESA as a “user” of the document.

A potential problem arises when a buyer/borrower relies on its lender to commission the ESA. Although paid for by the buyer as a cost of closing, it may be that only the lender is identified in the ESA as the “user.” This deficiency means of course that the purchaser is not in privity with the consultant for contract purposes. In addition, the owner will also be ineligible to assert an innocent landowner defense and so is, at least potentially, strictly liable for all the costs of assessments and remediation as the current owner of contaminated property. In other words, the defenses will be entirely unavailable.

This is the situation the borrower/property owner faced in the Mt. Kisco case. Here, the transaction was a refinancing not a conveyance, however the refinancing can be considered a “title transfer” for the purposes of Superfund liability. The borrower did not retain the environmental consultant that performed the ESA; instead its lender entered into the contract with the consultant and the lender was the only identified “user.” As is typical however, the expense of the ESA was taken out of closing costs.

After closing, it became evident that an environmental condition that the borrower claimed should have been documented in the ESA was missed. As reported, the result could amount to $30 million in liability. The buyer brought suit against the consultant, but had the claim dismissed for lack of privity of contract.

Failure to be properly identified as an authorized “user” of the ESA also results in a borrower/owner losing the ability to successfully assert a landowner defense to liability under Superfund, consequently facing potential strict, joint and several liability in a government enforcement action. So, the Mt. Kisco borrower could be responsible for all study and remediation costs resulting from distant historical[7] activities with which it had no involvement.

The correct way to have handled the transaction would have been for the borrower to have obtained a reliance letter from the consultant explicitly identifying the borrower as a “user” of the ESA. Reliance letters are typically given in this situation, but they need to be requested.  That was apparently not done in the Mt. Kisco case.

The lesson is never to treat ESA as a commodity and just another box to be checked off the closing list. It is not only a technical endeavor entrusted to environmental consultants, but a legal document of potentially very significant importance that may not become evident until years in the future. Legal counsel should be directly involved with the work of the environmental consultant and must have a sound working understanding of ASTM E 1527-13, or consult with someone who does.