Skinning the Cat24 October 2017 / by Andy Bajorat (author) / Chicago
Owners, buyers and sellers of industrial properties are all subject to potentially catastrophic environmental liabilities that can be highly challenging to address. This environmental challenge can impede or implode potential M&A and real estate transactions. One solution is to offload the majority of the risk through environmental insurance, including Pollution Legal Liability (PLL) policies that can box the risk and allow transactions to proceed.
Historical contamination of soils, groundwater and surface water is so ubiquitous that it can be considered an inherent risk of past industrial and manufacturing practices. If not actively investigated, it will remain undetected – and possibly migrate beneath the ground – until it is discovered, whether by the owner, a utility contractor, a neighboring property owner, EPA or another environmental agency. The current owner can be held liable for contamination created decades in the past.
This creates the risk of two basic types of liability for the owner: Response costs, including the direct costs of fully investigating and cleaning up the contamination wherever it may have spread; and tort claims including bodily injury (“toxic tort”) claims brought by employees or neighbors exposed to the contamination.
Skinning the Environmental Liability Cat
Knowledge is generally considered a good thing, and good transactional due diligence is always a must, but historical contamination sometimes puts that common wisdom to the test. In the counterintuitive world of environmental due diligence, sometimes a problem only comes to exist after you observe it. You might call this “Schrödinger’s Due Diligence Cat.” PLL insurance can help skin that cat.
For many sources of historical contamination, there is no affirmative legal duty to actively investigate or remediate the conditions while they remain undiscovered. However, once they are discovered, many sources of contamination must be reported to an environmental regulatory agency. In some jurisdictions this duty to report is very broad. The duty to report can be triggered by voluntary Phase II environmental site assessments (sampling and testing of soils and groundwater).
As a result, sellers often would prefer that potential buyers not generate Phase II data as part of their due diligence. Depending on their intended future use and own risk tolerance, many buyers would walk away from closing if Phase II results looked particularly bad. Sellers are left with evidence of contamination they might have to report and often don’t have the reserves and resources to remediate. Those same risks and liabilities would shift to buyer if they proceeded with the transaction.
Skinning the Cat with Insurance
PLL insurance can box the costs of historical contamination - both cleanup liability and torts – and also help keep Schrödinger’s Due Diligence Cat in its box, as just a hypothetical contingency.
First, the policy deductible quantifies and limits environmental risk during the policy period (as much as ten years). Without insurance, the seller may not be able or willing to contractually indemnify the buyer for environmental risks. PLL can often be the solution that lets the transaction close.
Second, PLL can help skin Schrödinger’s Cat by allowing the buyer to forego Phase II testing and avoid accelerated disclosures resulting from voluntary due diligence. Specifically, insurance companies frequently will underwrite environmental risk based on non-invasive Phase I environmental assessments (which do not include sampling and testing like a Phase II).
Although it is not a panacea – insurers sometimes insist on Phase II, they may exclude coverage for unknowns that present a higher than average risk of future discovery, and the policy may include other restrictions that limit its value – PLL can often be the best, most practical way to get buyers and sellers to closing in the face of costly unknowns.
The Nuts and Bolts of Environmental Insurance
Environmental insurance is best obtained by working with a specialized broker who can approach multiple markets and negotiate the best coverage terms. You can expect the underwriting process to take several weeks to complete, meaning it is important to identify the need for insurance as early in the due diligence process as you are able.
The insurance application can be relatively complex and may require assistance from your environmental staff or consultant to prepare. Depending on the limits of coverage, deductible and term of the policy, premiums can range from approximately $75,000 to $150,000 or more (the premium is a one-time payment made at the inception of the policy).
Case Example: Tool Manufacturer M&A
Environmental due diligence investigations determined the target companies were responsible for known and suspected environmental conditions at 35 properties in over ten jurisdictions, many of which had been unused or subject to remediation for many years at the time of the merger. The project involved extensive environmental risk analysis; negotiation of protective terms of purchase and sale; and scoping and acquisition of appropriate and cost-effective environmental insurance.
To get this transaction to closing, environmental consultants aided legal counsel in negotiating terms for a highly protective environmental indemnity that included post-closing covenants by seller to investigate and remediate known and suspected conditions at all properties. To function as planned, this indemnity had to be backed by environmental insurance paid for by the seller, as well as an escrow funded by the seller.
Without the use of environmental insurance to fill gaps, lower the escrow amount and reduce risk exposure for both parties, the seller would not have agreed to the broad indemnity and post-closure cleanup obligations. As a result, without insurance as a key part of the risk allocation by the parties, the transaction would not have closed.
Deals Close with Environmental Liabilities Managed
Industrial properties are often challenged with environmental liabilities. An existing liability does not have to result in parties walking away from a transaction, or one party assuming unreasonable amounts of risk. Pollution Legal Liability (PLL) policies can box the risk and allow transactions to proceed.
 For more background on the interesting topic of Schrödinger’s Cat: https://en.wikipedia.org/wiki/Schr%C3%B6dinger%27s_cat. Close readers will see our analogy is imperfect but may admit it is nevertheless useful.
 This article cannot provide legal advice. Please ask your lawyer for advice on applicable legal and regulatory requirements for historical contamination.
 Many industrial property owners have, of course, done their own “due diligence,” quantified their risks, and established adequate reserves. Unfortunately, many have not, or are not prepared to tap reserves in the context of a divestment.