Insurance Can Facilitate Environmental Transactions

Representations and Warranties” insurance has become a strategic option that can help clients mitigate risk and successfully buy and sell businesses. Over the past fifteen years, Reps and Warranties coverage has evolved to become a useful tool for getting deals done and use of the product has become increasingly popular.

In an excellent article titled, “Representations and Warranties Insurance as Deal Making Tool,” published in the New York Law Journal on September 24, 2012, Howard B. Epstein, a partner at Schulte Roth & Zabel, and Theodore A. Keyes, Special Counsel at the firm, provide useful and practical advice to the practitioner concerning the advantages and potential disadvantages of purchasing this coverage.

As Epstein and Keyes explain, Reps and Warranties policies come in two types – buyer-side and seller-side policies. When a buyer obtains a buyer-side policy, the insurance is often intended to replace the indemnification obligations of the seller. The benefit of a seller-side policy is that the seller can walk away from the transaction at closing without having to worry about trailing liabilities arising from an unanticipated inaccuracy in the representations and warranties made in the acquisition agreement.

As Epstein and Keyes observe, the seller-side policies provide advantages to private equity or venture capital funds that need to distribute all proceeds to their limited partners after closing without incurring the risk of having to request the return of funds to fund an indemnification obligation on a later date. Similarly, seller-side coverage provides security to sellers who plan to use the proceeds from the sale to fund their retirement. On the other side of the equation, buyer-side Reps and Warranties policies may be used as a replacement for a more complete seller indemnity.

As Epstein and Keyes point out, every deal is different, and it is always important to review the specific terms of the proposed insurance policy to make sure it meets the needs of the particular transaction. However, in the right circumstances, Reps and Warranties insurance can be used strategically to provide a practical way for parties to a transaction to allocate their risk and potentially resolve issues that might stand in the way of completing their deal.

In particular, Reps and Warranties insurance may be particularly helpful in an environmental context. As Reps and Warranties insurance has evolved, underwriters have developed processes that are more streamlined and less obtrusive. Increasingly, parties to deals recognize that it may be appropriate for an insurer to have a seat at the table during negotiations.

 

Can Phase I Reports Hurt Your Client?

In an article titled, “How Phase I Reports Can Hurt Your Clients,” (ALI-ABA Practical Real Estate Lawyer, Vol. 27, No. 6, November 2011), environmental guru Larry Schnapf cautions purchasers of property that an ill-conceived Phase I report may result in their losing CERCLA ability protection or expose them to misrepresentation claims.  The article’s primary concern is that a Phase I report may not necessarily assist a purchaser in establishing a CERCLA:  1) third-party defense; 2) innocent landowner defense; or 3) bona fide prospective purchaser defense, the requirements for each of which are set forth in the statute. 

To qualify for CERCLA liability protection, a property owner or operator must, among other things, demonstrate that it investigated the past use and ownership of the property consistent with the requirement of the EPA “All Appropriate Inquiries” (“AAI”) rule and exercised appropriate care with respect to contamination at the property.  In an earlier article, “The New ‘All Appropriate Inquiries’ Rule,” (ALI-ABA Practical Real Estate Lawyer, January 2007), Schnapf observes that ASTM’s standard practice for environmental site assessments (ASTM E1527-00) may be inconsistent with the statutory criteria set forth in Small Business Liability Relief and Brownfields Revitalization Act of 2002 (the “2002 Brownfields Amendments”) and spurred EPA to develop the AAI rule.  Thereafter, ASTM worked with EPA to revise E1527-00 to ensure that a revised standard would satisfy the requirements of the AAI rule. When EPA issued the final AAI rule, which became effective November 1, 2006, the agency announced that E1527-05 was now consistent with the final rule so that environmental site assessments consistent with the ASTM standard could be considered compliant with the rule.  Do pitfalls remain?

Schnapf cautions that the absence of a “recognized environmental condition” (“REC”) in a Phase I may not guarantee that there is no “business environmental risk” (“BER”).  For example, over the years, some Phase I reports have come to include environmental issues (e.g., asbestos, lead-based paints, radon mold) that do not fall within the definition of an REC because they do not involve releases of hazardous substances, although they could still be of concern to a property owner, tenant or lender.

  In Bank of New York Mellon Trust Company et al. v. Morgan Stanley Mortgage Capital Inc. (MSMCI), 2011 U.S. Dist. LEXIS 69168 (S.D.N.Y. June 27, 2011), a New York federal district court denied a motion to dismiss filed by a mortgage originator who was alleged to have failed to adequately disclose environmental conditions at a shopping center.  In that case, a mortgage loan purchase agreement was entered into in connection with a shopping center that had been constructed on a former landfill.  The landlord at the shopping center was required to monitor methane gas and had been subject to a number of violations.  Just before the loan closed, the largest tenant of the shopping center issued a Notice of Default accusing the owner of failing to properly manage the methane gas and alleging that methane gas levels had reached dangerous levels.  Although the landlord’s Phase I discussed the methane issue, the court declined to grant the defendant’s motion to dismiss finding that the purpose of the report was to identify RECs, that the report had not identified any RECs.  The court held that an “item of environmental concern” was not necessarily congruent with an REC.  Accordingly, the court found there was a legitimate dispute as to whether the Phase I had adequately disclosed the existence of a material environmental threat, which resulted in the loss of the primary tenant.

In addition to providing a caution to due diligence counsel concerning the scope of the Phase I, Larry also raises a concern about the practice of some environmental consultants in providing recommendations for further investigation or remediation in the Phase I report.  If such recommendations are made, and the purchaser fails for any reason to promptly implement them, the purchaser’s bona fide prospective purchaser defense arguably may be jeopardized.  Accordingly, the article recommends that any recommendations for further investigation or remediation be provided by the consultant in a separate letter to counsel and not be transmitted to the client directly.