Real Estate Trends: Environmental Representations and Warranties in Acquisition Agreements


During the past 30 years, there has been a profusion of environmental legislation and regulations regarding the generation, use and disposal of hazardous substances and waste, as well as regulating the emission, discharge and release of a wide range of substances into air, water, and soil. Violations of these statutes and regulations can result in the imposition of substantial penalties. Therefore, a potential purchaser of a business, particularly one involving real property, should intensely scrutinize the business' environmental compliance record, and a conscious decision should be made by both seller and buyer regarding the allocation of any environmental liabilities. Consequently, a crucial provision in any acquisition agreement is the seller's environmental representations and warranties.

Representations and Warranties

This article will examine common environmental representations and warranties and analyze a number of issues of concern to both buyers and sellers regarding those representations and warranties. This article will also address areas of dispute between buyers and sellers in negotiating environmental representations and warranties.

Common Representations and Warranties

The following are common environmental representations and warranties:

  • The usage of hazardous materials and/or substances is in compliance with all applicable laws;
  • The facilities involved have all necessary environmental permits and authorizations;
  • There has been no release of hazardous substances;
  • There are no pending enforcement, administrative actions or environmental claims against the company;
  • There is current and historical compliance with all environmental laws.

While these environmental representations and warranties may appear straightforward, disputes often arise regarding alleged breaches of these provisions. These disputes usually do not arise from misrepresentations, but rather from the representations failing to fully reflect the results of the due diligence, from vague draftsmanship of the language itself, and from incomplete and/or inadequate disclosure schedules.

While disputes cannot be totally eliminated, both buyer and seller can minimize them by adhering to the approach outlined below.

Avoid Boiler Plate Language

There is a natural inclination to save time and money by lifting a "standard representation and warranty" from a previous transaction rather than drafting a new representation and warranty. However, every transaction is different and the only way to achieve accuracy, and, therefore minimize future disputes, is to tailor the representations and warranties to the due diligence that has been performed and the particular business and property that is being conveyed.

The conducting of environmental due diligence, (i.e., a phase I assessment and where necessary a phase II assessment), has become standard for virtually all transactions. However, frequently there are boiler plate environmental representations and warranties that bear little or no relationship to the actual due diligence performed. It is essential that the persons responsible for the due diligence communicate with those responsible for the drafting of the agreement so the due diligence results are accurately reflected in the agreement. While boiler plate language is a helpful starting point, it must be tailored to the particular business and transaction.

Avoid Representations that are Overly Broad, Overreaching, Vague, or are Without Appropriate Qualifiers

Relating to the use of boiler plate language in representations is the use of overly broad language. For example, a representation that no hazardous substances have ever been used at a particular manufacturing facility raises a red flag. On its face, such a representation is usually false. Federal and state laws define hazardous substances so broadly that virtually daily we use some hazardous substances at home or at our offices. A more meaningful and accurate representation is that all hazardous substances are used in compliance with applicable law or consistent with ordinary industry practice and usage.

Define Key Terms

Often environmental representations will include broad and vague terms such as "environmental laws", "environmental requirements" or "environmental claims". It is critical that if these terms are used, they be defined. Although environmental issues are generally thought to refer to superfund liability and liability regarding waste handling and air and water pollution, sometimes the term "environmental" is used to more broadly refer to OSHA requirements, "sick building syndrome", common law nuisance and trespasses and numerous other public health issues.

Therefore, if a party is asserting a representation regarding compliance with environmental laws and requirements, these terms should be defined with sufficient specificity so that it is clear as to what is being represented. Without such definition and clarity, the parties are increasing their chances, despite their good faith efforts, of disputes in the future.

For example, the seller could make a representation that there are no pending environmental enforcement or administrative actions or claims against the company. If the seller intended this representation to only cover environmental laws regarding water pollution, superfund and solid and hazardous waste, the seller would assume this representation would be accurate even if there were a pending OSHA enforcement action. However, the buyer might assume that the term "environmental" includes OSHA. Therefore, if after the sale the buyer discovers there were pending OSHA violations requiring a change in certain activities at the facilities, the buyer would understandably be upset and allege a breach of the representations. Such a dispute could be avoided if there were clear definitions as to what environmental claims meant when making a representation.

Include Detailed Disclosure Schedules

Representations and warranties will often include exceptions. For example, a representation may be made that the facility involved has all necessary environmental permits and authorizations except as listed on a disclosure schedule. Therefore, it is essential that these disclosure schedules be detailed and comprehensive and written to incorporate the results of thorough due diligence.

Parties are often concerned that even with the conducting of thorough due diligence, it is difficult to list every possible exception to the general representations and warranties in these disclosure schedules. This concern should be addressed by referencing all the environmental reports that are part of the due diligence effort in the disclosure schedules themselves. In many agreements, the seller assumes liability for pre-closing environmental liabilities, while the buyer assumes liability for post-closing liabilities. Therefore, it is critical that a baseline environmental condition be established as of the closing. Detailed disclosure schedules, particularly the referencing of environmental reports, can provide this baseline. Ultimately, the best way for both parties to avoid disputes is to maximize their knowledge prior to the execution of the acquisition agreement, and have that knowledge reflected in the agreement with detailed, precise, and accurate representations and disclosure schedules.

Caveats

Even if both parties adhere to the above principles, there may be disagreements over the precise language of the representations and warranties during the negotiation of the transaction. These disagreements usually focus on certain caveats and qualifiers the seller often wishes to include in the representations that the buyer does not.

Materiality Standard

For example, the issue of materiality frequently arises in negotiations over the standard representation that a particular facility is in full compliance with all applicable environmental laws and regulations. The seller may argue that state and federal environmental regulations often are so arcane and deal with such minutiae that it is difficult for an entity to assert full compliance. Therefore, seller may argue that it is more accurate to state that a particular facility is in "material compliance".

The buyer on the other hand may argue that even minor violations of environmental law may result in onerous sanctions and therefore the buyer is not adequately protected with the inclusion of the "material" qualifier. Ultimately, the parties in each particular situation must resolve this issue. However, factors the parties may want to consider in negotiating this issue are the nature of the business being acquired and the level of due diligence. For example, while it may be reasonable to represent that an internet service company is in full compliance with environmental laws, it may be unreasonable to represent that an oil refinery with a long documented history of regulatory issues is in full compliance rather than in "material" compliance.

Knowledge Qualified

Another source of disagreement is whether a "knowledge" qualifier should be inserted in the representation. A seller may want to qualify each environmental representation with the phrase "to the best of its knowledge". The buyer may resist this approach, assuming that the seller's knowledge may be faulty or incomplete. As with the above example, the resolution of this issue is the subject of negotiation between the parties, but there are some representations where such a qualifier is quite reasonable, while for other representations it may not be. For example, representations are sometimes made that a particular facility is not under investigation by any local, state or federal agencies. Regulatory agencies often engage in investigations without informing the target of such investigations.

Therefore, it is logical that the statement "to the best of its knowledge" should qualify such a representation. However, a party would have a stronger argument that a representation regarding the issuance of all necessary permits should not include such a qualifier because whether or not a particular facility has necessary environmental permits should be a matter fully disclosed through due diligence.

Conclusion

There are, of course, numerous other issues regarding environmental representations and warranties that are the subject of negotiation and potential disagreement among the parties. These issues include the amount of time for the survival of such representations and warranties, the nature of indemnification provisions regarding environmental representations and warranties, the payment for the consulting firm performing due diligence, the amount of escrow, if any, put aside to handle environmental liabilities, and numerous other potential issues.

There can be, and have been volumes written about all these issues. However, this article discussed some common issues relating to the language of the environmental representations and warranties themselves and an approach in the drafting process to minimize disputes and to try to avoid future disagreements.