Environmental Law Bulletin: Corporate Liability

Today, a comprehensive web of environmental laws regulate the use, disposal and remediation of hazardous materials. This regulatory scheme includes federal laws (such as CERCLA, SARA, RCRA, the Clean Air Act, the Clean Water Act, and the National Environmental Policy Act) and a whole host of state statutes (including such California statutes as the Porter Cologne Water Quality Act, the Carpenter-Presley-Tanner Hazardous Substance Account Act (California Superfund), the Underground Storage Tank Act, the California Clean Air Act, the Air Toxics "Hot Spot" Act, Prop. 65, and the Hazardous Waste Control Law).

Although the terminology used in each of these statutes varies, the basic message they convey is:

• Any person who participates in, exercises control over, or has responsibility for controlling a hazardous material activity may become liable for the consequences of such activity; and
• The cost of remediating environmental contamination may be imposed upon all persons who:
  • actively or passively participate in the activity;
  • profited from an activity that caused the contamination; or
  • will benefit economically from the remediation of the contamination.

This Bulletin will briefly discuss the legal basis for subjecting corporations, shareholders, and directors to liability for the environmental issues affecting a corporation and will suggest numerous strategies that can be employed to limit such liability.

Corporate Liability

A corporation which uses hazardous materials can face a number of potential environmental issues. In addition to liability for contamination caused by a release of hazardous materials, a corporation which uses hazardous materials may face civil and criminal penalties if it fails to obtain required permits and approvals for its storage, use, transportation, discharge, and disposal of hazardous materials or if it transfers hazardous waste to an unreliable waste disposal company. A corporation which uses hazardous materials may also face toxic tort suits if it exposes its employees or customers to hazardous materials, fails to provide adequate employee training, or fails to provide required notice of hazardous materials dangers to employees, customers, neighbors, or the public.

Even a corporation which does not use hazardous materials can incur significant liability if it owns or leases a facility which contains hazardous materials (such as asbestos) or which has an on-site source of contamination (such as a leaking underground storage tank). Under certain circumstances, a corporation can also become liable for the cost of investigating or remediating hazardous materials which migrate onto property leased or owned by the corporation, even if the corporation did not cause the contamination.

Because investigative, remedial, and administrative costs incurred in responding to such environmental problems can be significant, it is advised to be vigilant regarding the potential for environmental liability in connection with all business transactions they undertake. A pro-active approach to prevention and remediation is generally advisable and, through the various phases of a corporation's existence.

Start-up Phase

A new corporation has no environmental liabilities. To increase the probability that the corporation will not become subject to such liabilities as it acquires a facility and puts its employees to work, at the earliest stages of its existence the corporation should consider taking the following steps:

Baseline Environmental Audit

Conduct a baseline environmental audit of all new facilities in order to identify potential environmental liabilities. Such liabilities can include responsibility for existing on-site contamination, underground storage tanks, asbestos, radon, or upgradient plumes of contamination which may impact the facility. Even if a building is new, the soil and groundwater beneath the facility may be contaminated or a prospective landlord may intend to fund required clean-up cost through additional tenant charges.

A minimum environmental audit is a so-called "Phase I" report, which includes 1) a review of governmental agency records of enforcement actions, 2) a review of environmental reports and other applicable data and records, 3) a site and vicinity history based on interviews with current owners and other tenants, and 4) a review of available public records, aerial photographs, chain of title reports, building permits, and other data. A complete audit also includes a "Phase II" soil and groundwater sampling survey of property.

A basic Phase I report costs $3,000 to $5,000. The cost of a Phase II survey depends on the sampling method used, the number of samples analyzed, and the turnaround time required. At a minimum, a Phase II survey usually costs an additional $5,000 to $15,000, but costs can be substantially greater depending on the circumstances.

Health Risk Assessment

Conduct a health risk assessment before occupying facilities near known environmental problems in order to minimize the risk of employee exposure claims. A health risk assessment scientifically estimates the likelihood that persons near contamination will be exposed to the contamination and the probability that any such exposure will result in health or reproductive effects. A cursory "health screen" review usually costs $5,000 to $10,000, but complex and exhaustive assessments can cost as much as $25,000 to $75,000.

Environmental Indemnity Release

Obtain an environmental indemnity/release from the landlord of each new facility. Although landlords often resist broad indemnities, most landlords will provide some type of protection from environmental problems existing at a facility when a lease is signed or which are created after the lease commences through no fault of the tenant. Such protection ranges from a simple release of landlord's claims for reimbursement to an agreement to fund clean-up required by law and/or indemnity from third party claims arising from such contamination.

Evaluate Creditworthiness of Indemnitor

Before embarking on an environmentally risky transaction based on an indemnity, evaluate the creditworthiness of the indemnitor and the remedy available for breach of the indemnity. Like insurance, an indemnity is only as valuable as the creditworthiness of the party providing the protection and the ease with which payment of a claim can be obtained. Obtain financial information from any environmental indemnitor and to pay close attention to the remedies available for breach of the indemnity. In some cases, consider whether security, parent guaranties, or other appropriate credit support for the indemnity is appropriate.

Negotiate Protections

Negotiate appropriate protections from any environmental remediation activities that may be conducted by others in the vicinity of new facilities. Obtain modifications to landlord lease forms to provide:

1. rent abatement for interference with use of the facility caused by contamination which the tenant did not cause;
2. tenant approval of the location and aesthetics of any remedial equipment on the facility;
3. the right to participate in meetings between the landlord and governmental agencies concerning contamination at the facility; and
4. the right to receive important documentation relating to any remediation project that may be conducted at the facility.

Hazardous Materials Plan

Do not engage in hazardous materials activities without a comprehensive, well thought-out hazardous materials management/response plan and all necessary governmental approvals and permits. An environmental inspection by one of the numerous local, regional, state, and federal governmental agencies is not the time to discover that an environmental regulation applies to a particular business practice. A corporation's environmental compliance experience is routinely investigated by prospective lenders, investors, purchasers, and underwriters, and a history of violations will adversely affect the value of the corporation.

Environmental attorneys can assist corporate clients in identifying and complying with the environmental regulations that affect their operations and in locating experienced, competent, and price competitive engineers and consultants who specialize in providing the engineering assistance required to prepare hazardous materials management/ response plans and to apply for permits required by those regulations.

Ordinary Course of Business Phase

After a corporation is settled into its first facility and has begun its operations, there are a number of ongoing procedures that can reduce the risk of environmental liability from day-to-day operations. These include:

Maintain Working Relationship with Government Agencies

Maintain an excellent working relationship with governmental regulatory agencies. A governmental enforcement official is much more likely to provide the corporation with an opportunity to correct a violation without imposition of a fine and extraordinary cost if the corporation has been generally responsive to regulatory requirements and environmental problems in the past.

In this regard, when responding to information requests by such agencies, the deadlines should be met or extended. However, it may not be prudent to respond until the intended use of the information is understood.

Correct Violations Immediately

If a notice of violation is received, correct the violation immediately. The correction should be documented fully. In appropriate cases, advising the regulator of the correction may avoid additional inspections and enforcement.

Seek Legal Advice Before There is a Problem

Seek legal advice prior to responding to regulatory inquiries concerning environmental accidents. Criminal enforcement of environmental regulations against the corporation and its employees has become commonplace, and negligent training or supervision alone can support a criminal case against both a corporation which is otherwise attentive to environmental compliance issues when an accidental spill or discharge occurs. In such cases, legal advice may be required to appropriately respond to questions posed by the fire department, department of health, OSHA, and other governmental officials investigating the incident.

Maintain Detailed Records

Maintain detailed records of purchases and disposals of hazardous materials used in the corporation's operations, so that:

1. a record of proper disposal is available as a defense to environmental enforcement actions; and
2. the quantities and types of chemicals used by the corporation can be easily established. In this regard, the corporation should be attentive to matching hazardous materials purchases with aggregate discharges, air emissions, and production losses in order to establish that no hazardous materials used by the corporation could have caused contamination.

Properly Dispose of Hazardous Waste

Dispose of hazardous waste only through reliable, creditworthy hazardous waste disposal companies. Where possible, a corporation should recycle or treat (rather than landfill) hazardous waste. Since the creditworthiness and safety practices of waste handlers varies greatly, a periodic audit of the financial responsibility and waste handling practices of each waste transporter, disposal facility, or recycler involved in the disposal of the corporation's waste is also advisable. There are many examples of corporations which have properly manifested materials to a licensed waste transporter, but which have been forced to contribute substantial sums to remediate contamination caused by the transporter or another waste handler to whom the waste was eventually delivered. In this regard, the contract with the waste handler should also be scrutinized by the corporation and legal counsel to ensure that waste handling processes and responsibility for the waste after it leaves the corporation's facility are clearly spelled out.

Implement Compliance Program

Implement a comprehensive hazardous material compliance and reduction program. Good business practice, as well as the California Hazardous Waste Source Reduction and Management Review Act, requires each corporation to devote substantial attention and funds to an evaluation of its current hazardous materials use and the creation and implementation of a comprehensive plan for the reduction or prevention of such usage. Additionally, compliance with the standards of international agencies, including those adopted by the Geneva, Switzerland-based International Standards Organization (ISO) should be seriously considered by all companies. Many businesses worldwide are certified to ISO 9000svoluntary standards governing quality controls which are rapidly becoming requirements for customers and distributors internationally before they will purchase goods.

Similarly, many businesses are keeping a watchful eye on the developments under ISO 14000, a wide-ranging set of international environmental management standards. These standards mandate how companies manage, measure, improve, and communicate the environmental aspects of their operations in a systematic manner. The standards influence the design, manufacture, and marketing of products, the selection of raw materials, the type of environmental data that are gathered, and how those data are communicated internally, to governments, and to the public. Failure to conform to ISO and other standards could severely restrict business opportunities for companies that manufacture or sell products or services abroad.

Obtain Insurance Coverage

To the extent available from reputable insurers at commercially reasonable premiums, obtain environmental impairment insurance coverage for the corporation's hazardous materials activities. Although environmental impairment insurance is not widely available and the current standard forms of property and liability insurance policies exclude environmental claims, a corporation which engages in hazardous materials activities can, in limited circumstances, obtain liability coverage for harm caused by its mishandling of hazardous materials. Since environmental impairment policies are relatively new, their scope of coverage and the deductibles are negotiable.

Note, however, that although such policies may cover suits brought by neighbors whose properties are affected by chemical spills migrating off-site, and some toxic torts claims, they do not routinely cover the costs of remediating the insured's property or harm caused to the insured's employees.

In addition, many insurers will not write policies in excess of $1,000,000 of total coverage. Also, a corporation generally must qualify for coverage by demonstrating insurability and safe handling practices and must agree to be subject to frequent inspections in order to maintain the coverage. Some insurers even require the corporation to pay for expensive inspection reports from insurer "approved" companies before the insurer determines whether the corporation is insurable.

Deductibles for such insurance customarily range from $50,000 to $250,000, depending upon the number of sites and circumstances involved, and premiums for such policies generally start at $50,000 per year for $1,000,000 of coverage under a claims made, single limit policy. For a large premium, a few small insurance companies also may write first party property damage coverage, insuring the corporation's property against accidental contamination, but only if the corporation demonstrates that the facility was not contaminated at the time the policy was issued and that the corporation employs safe hazardous materials handling practices.

Acquisition and Disposition Phase

As a corporation grows, it will engage in various transactions to acquire or dispose of assets or various lines of business. To avoid acquiring environmental liabilities in connection with acquisition transactions and to avoid unnecessarily retaining environmental risk in connection with disposition transactions, a corporation must exercise care.

Corporation As Buyer

When a corporation acquires assets or a particular line of business, it may acquire toxic liabilities along with the targeted assets or company, unless care is taken to identify and avoid such liabilities. In this regard, it is generally suggested that the corporation:

Conduct an Audit

Conduct an environmental audit (similar to the one described above for new facilities) with respect to any real estate:

1. that the corporation will directly acquire in the transaction;
2. that is owned or leased by an acquired company at the time of the transaction; or
3. that has been owned or occupied in the past by an acquired company. As a prerequisite to closing certain types of transactions, (e.g., leases, transfers, plant shutdowns, etc.), some local agencies require the sellers or former operators to obtain a "closure" permit based upon agency approval of a completed environmental audit (with sampling).

In these jurisdictions, the acquiring corporation may be able to piggy-back its environmental due diligence off the seller's "closure" process and, more importantly, should obtain protections from the seller for an incomplete or defective "closure" process.

Conduct a "Compliance Audit"

Conduct a "compliance audit" of the hazardous materials storage, use, sale, discharge, and disposal practices of any acquired company. In some cases, it also may be advisable to conduct a "health screening" of the target company's employees who have been working with hazardous materials as part of the audit.

Obtain Indemnity from Seller

Obtain a comprehensive environmental indemnity from the seller. The seller's indemnity:

1. should anticipate further assignment to future buyers, lenders, subtenants, and other concerns doing business with the corporation;
2. should include appropriate survival provisions; and
3. should include a methodology for making indemnity claims which is compatible with the particular problems which arise in the context of environmental liabilities (e.g., right to participate in determination of appropriate remedies, protection from claims as well as reimbursement for sums actually paid, and right to control remediation activities on acquired facilities).

Corporation As Seller

A sale of a line of business or the subleasing or sale of real property offers the corporation an opportunity to reduce its ongoing environmental risk. In order to take advantage of this opportunity, consider the following:

Preparation for Environmental Audit

Take control over the preparation of the environmental audit. The buyer will usually request an environmental audit which can vary in scope, depending on the circumstances of the transaction. In general, buyers seek to expand the scope of the investigation and sellers wish to restrict it. Although a baseline study evidencing full environmental compliance can provide a seller with significant protection from future environmental claims, soil, and groundwater sampling may disclose contamination which may result in termination of the transaction and other adverse consequences to the seller. To minimize the likelihood of error and to ensure the best result possible, request control (or to at least share in the control) of the environmental audit. In many cases, a three party arrangement between the buyer, seller, and the environmental consultant who actually performs the audit can be successfully negotiated and implemented.

Limit Indemnities Given to Buyer

Limit environmental indemnities given to the buyer. Although it is becoming customary for a seller to provide some environmental protection to a buyer, such indemnities can be limited in amount, time, and scope. If a seller can avoid environmental liability through proper structuring of the sale, look closely at the economic aspects of the transaction before agreeing to retain environmental liabilities or agreeing to indemnify the buyer from environmental liabilities that the seller does not otherwise face. Demanding that a buyer bear a portion of the costs covered by an indemnity also may help ensure that the claims made by the buyer under the indemnity are reasonable.

Obtain Releases and Waivers

Obtain blanket releases and waivers of all environmental liabilities, other than the liabilities expressly retained. In addition to remedies created by contract, buyers can recover environmental remediation costs from sellers under several environmental statutes and common law causes of action. Request that the buyer waive all theories of recovery for environmental matters, other than the negotiated contractual rights specifically set forth in the transaction documents.

Obtain Indemnity

Obtain an indemnity for the environmental liabilities which are assumed by the buyer or which may arise from the buyer's post-closing activities. Confusion as to liability under contractual indemnities can arise from, among other things, exposure of a continuing business' employee to a hazardous material or continuing migration of contamination through groundwater both before and after the consummation of a transaction. Obtain protection from the buyer for any harm that may be attributable to the post-closing aspects of such exposures and migration. It is also advisable to request an indemnity from environmental liabilities arising from the buyer's other post-closing activities.

Shareholders' Liability

The "corporate veil" that customarily protects a shareholder from corporate liability may not, in the context of environmental liability, provide the protection that shareholders expect in other circumstances. The veil may be "pierced" if the requisite elements of that legal theory can be proven. In addition, upon a showing of some ability of the shareholder to "control" or "direct" the hazardous materials activities of the corporation (based on the shareholder's percentage interest in the corporation or other relevant facts), the veil will be entirely ignored and environmental liability will be imposed upon the shareholder.

In fact, most environmental lawyers believe that where no other responsible party is economically capable of responding to an environmental problem, the courts may go so far as to hold a major shareholder responsible for environmental remediation and response costs even in the absence of control or participation in the corporation's management. This belief is consistent with several federal court opinions which discuss at length the propriety of requiring persons who have benefitted (economically or otherwise) from the past hazardous materials practices of the corporation or who stand to benefit from remediation of contaminated property or correction of illegal conditions, to bear the attendant environmental costs before the burden of such costs are passed on to the average taxpayer.

In light of the foregoing, a shareholder is well advised to develop strategies:

1. to reduce the environmental liabilities of its corporation (see above discussion);
2. to ensure that other responsible parties are contractually bound to reimburse the shareholder, as well as the corporation, for any costs or penalties attendant to such liabilities; and
3. to avoid investments in a corporation which has or may potentially acquire significant environmental liabilities and which is not fiscally capable of responding to them.

To this end, A shareholder of a large block of stock in an environmentally sensitive corporation should consider the following strategies to reduce the risk that the shareholder will become liable for the corporation's environmental liabilities:

Do Not Participate in Day-to-Day Operations

Do not participate in the day-to-day business of the corporation and rely on the corporation's board of directors to consider environmental matters, in order to reduce the claim that the shareholder "controlled" the corporation's environmental affairs.

Creation of Sister Corporations

Consider separate operation of environmentally sensitive lines of business by creation of "sister" corporations, contracting with third parties for performance of such activities, or conducting such activities in jurisdictions with less onerous environmental regulations. (Note, however, that environmental regulation is becoming more comprehensive in most jurisdictions and such strategy may not create lasting benefits.)

Stict Adherence to Corporate Formalities

Strictly observe corporate formalities to reduce the risk that the corporate veil will be pierced.

Audit Prior to Additional Investments

Update environmental audits of the corporation prior to making additional capital investments in the corporation. Environmental risk associated with a corporation can change quickly. A shareholder is well advised to consider environmental issues each time the shareholder makes a new investment in the corporation.

Director’s Liability

A corporation's environmental liabilities is typically not directed personally upon a director, unless the director is also a shareholder or officer. However, a director should not feel that he or she is protected from environmental liability by the absence of such cases or because of the traditional "business judgment rule." Since a director has the "ability" and "duty" to control the environmental activities of the corporation, it is quite possible that a court will find a relatively passive director responsible for the corporation's environmental liabilities (using the "taxpayer balancing" analysis discussed above in the context of shareholders), especially if all other sources of recovery have been exhausted.

In assessing whether a director has sufficient "control" of the corporation's environmental activities to be held accountable for its environmental liabilities, courts generally examine the following factors:

• The director's participation in the creation and approval of the corporation's business plan;
• Whether the corporate activity giving rise to the liability was active or passive;
• Active participation by the director in day-to-day management of the corporation (especially with respect to the corporation's hazardous materials activities);
• Repeated presence of the director at the corporation's facilities;
• The director's ability to control, prevent, or abate the corporation's environmental activities; and
• The nature of any action taken (or not taken) by the director to prevent the corporation's release of hazardous materials or the violation of environmental laws.

In light of the foregoing, the best way for a director to avoid personal responsibility for environmental liabilities is to actively attempt to eliminate such liabilities by establishing corporate policies and procedures that ensure environmental caution and compliance. Thus, it is advised that board member clients to vote to adopt resolutions:

Formal Corporate Policy

Establishing a formal corporate policy which requires management to undertake such actions as are necessary to comply with all environmental laws and sound hazardous materials business practices.

Require Reporting

Requiring periodic reporting by management to the board of the environmental status of the corporation, in order to verify implementation of the above policy.

Appoint Environmental Officer

Appointing a qualified individual as the corporation's responsible environmental officer and promptly replacing such officer if a prior appointee leaves, retires, or is discharged.

Require Independent Consultant

Requiring management to retain an independent consultant to conduct periodic environmental audits of the corporation's activities and facilities to ensure compliance with environmental laws and to make recommendations concerning steps that the corporation can take to reduce environmental risk.

Prevent Acquisition of Equipment that uses Hazardous Materials

Preventing acquisition and installation of capital equipment which will use hazardous materials until an appropriate evaluation of required governmental permits and the overall effect of attendant activities on the corporation's environmental compliance program is completed. A corporation's failure to comply with environmental regulations which mandate "no net increase" in pre-cursor air emissions, hazardous material source reduction and plant retrofitting whenever hazardous material equipment is added or modified can have serious consequences which can only be avoided by proper planning.

Require Environmental Software

Requiring the corporation to acquire environmental software to assist management in complying with applicable laws. For example, several software packages are available to assist companies in managing the use of chemicals and in preparing hazardous materials management plans and facility information required by applicable governmental agencies. The cost of these packages begins at approximately $2,000.

Require Reporting on Environmental Liabilities

Requiring immediate reporting by management to the board of all significant environmental liabilities. Management's report should be accompanied by a description of the response and mitigation measures that have been and must be undertaken to correct the problem and prevent its recurrence.

Require Programs to Reduce Error

Requiring management to implement programs to reduce employee error and exposure of employees to workplace contaminants, including compulsory and comprehensive employee training programs, purchase of special protective equipment and, in appropriate cases, institution of a periodic employee health screening program.

Require Adequate Reserves for Liabilities

Requiring establishment of adequate reserves for environmental liabilities. FASB Rule 5 requires that a reserve be established for all asserted environmental claims and for any unasserted claims which are reasonably likely to result in a loss to the corporation. Although FASB Rule 5 also permits the corporation to take the "lowest reasonable estimate" of the liability as a contingency reserve, the establishment of such loss reserve (or a large adjustment to an under-funded reserve) in a single fiscal quarter can have a significant adverse effect on corporate profitability and stock price. Moreover, if a significant liability arises and the corporation does not have the fiscal ability to respond, the board of directors of the corporation may face personal liability for the loss.

Accordingly, the board of directors of corporate clients who participate in significant environmental activities are well advised to anticipate the potential for environmental losses by establishing appropriate reserves.

Obtain Indemnity from Corporation

Obtaining adequate indemnities from the corporation. Before an individual agrees to serve as a director of an environmentally sensitive corporation, the scope of the indemnities (and the credit support for such indemnities) should be examined. Many standard director indemnity agreements, while broad, do not specifically cover environmental liabilities.

Obtain Insurance for Officers and Directors

Obtaining a suitable environmental endorsement to the directors and officers liability policy, if such coverage is available at commercially reasonable premiums from adequately funded insurance companies.

Conclusion

In the environmental arena, as with all other business matters, there is no substitute for sound business practice and attentiveness to legal compliance. The strategies suggested above may provide insight into the steps that can be taken to reduce the likelihood of corporate, shareholder, and director environmental liability. However, there is no substitute for expert advice from an environmental attorney.