Volume 18, Number 3
April/May 2001

ENVIRONMENTAL DUE DILIGENCE: HOW MUCH IS ENOUGH

Carol R. Boman

The enforcement of environmental laws has led to a new growth industry in real estate, one composed of experts in the field of environmental due diligence. Environmental laws and regulations are a critical part of any real estate transaction, whether acquisition, sale, lease, or financing process. The parties need to know whether the underlying real estate is contaminated and, if so, what effect contamination will have on the economics of the deal.

Environmental due diligence has become important for a number of reasons. Buyers, for example, need to determine the costs associated with environmental contamination, such as leakage from an underground fuel tank. Developers need to know whether contamination will prevent development of the property or make it prohibitively expensive-asbestos abatement costs, for example, can significantly increase the cost of renovation work. In all these cases, the parties need to know whether or not there is contamination and the estimated remediation cost.

Due diligence is not a new concept. For years, cautious purchasers of real estate, governed by the principle "let the buyer beware," have undertaken prepurchase investigations. But the focus was different in earlier days. For example, before the enactment of modern environmental laws, buyers might have investigated a property for the presence of underground storage tanks, but they did so because they knew that buried tanks made soil removal more costly. State and federal environmental laws enacted in the 1980s changed the focus of this type of investigation. These laws impose potential cleanup liability upon owners and operators of property, regardless of whether the parties were involved in causing the contamination. In response to complaints about the unfairness of imposing liability on persons who unwittingly acquired contaminated real property and who had no involvement in the release of contaminants, federal law now allows for an "innocent purchaser defense." This defense exempts a purchaser from liability if the person can demonstrate that the property was acquired after the hazardous substance release occurred and that before the acquisition, the buyer had neither knowledge of nor reason to suspect the contamination after having conducted "all appropriate inquiry" into the property's environmental condition. (The inquiry, of course, must have been consistent with good commercial or customary practice.)

Neither the law itself nor the courts offers much guidance as to what constitutes good commercial or customary practice to establish an innocent purchaser defense from environmental liability. Early court decisions confirm that at least some level of inquiry is required, but not how much. Some buyers cynically assumed that if contamination was later found, the courts would decide that they had not conducted enough due diligence. Others made the decision to forgo any deal if the property was at risk for contamination rather than conduct due diligence and be able only to hope that, retrospectively, it would be deemed to have been sufficient.

In this uncertain climate, a standard for the conduct of due diligence slowly developed. The first motivator was the financial community. Because the laws as enacted were so far-reaching in their scope, lenders became concerned about their own potential liability for properties to which they held title. Even after relief was provided by Congress, lenders required substantial due diligence because they knew borrowers would be less likely to pay back a loan secured by contaminated property. As a result, any real estate transaction that involved third-party financing also required due diligence.

The second motivator to greater and more sophisticated due diligence was the shortage of good commercial and industrial development locations in many parts of this country during the economic boom of the 1990s. This resulted in pushes for infill or "brownfields" development sites. Former industrial sites often are good for commercial, office, and even residential development. However, because the sites are likely to be contaminated, research must be done before the redevelopment work can be undertaken. The developer must know the nature and scope of the contamination, the level of potential exposures and consequent health risks, and the least expensive but most effective methods for containing the contamination.

Against this background has emerged the concept of the preliminary site assessment (also commonly known as the "Phase I assessment"). In late 1989, real estate trade groups comprised of owners, lenders, lawyers, and environmental consultants initiated a project to standardize the due diligence process. They used as a starting point the goal of defining for the real estate community the level of due diligence necessary for a buyer of property to qualify for the innocent purchaser defense under the federal Superfund statute.

This informal working group was approached by ASTM, an organization of volunteers dedicated to the development of scientific standards that offered to sponsor their efforts. In March 1990, the Subcommittee on Environmental Assessments in Commercial Real Estate Transactions was formed. This subcommittee eventually grew to more than 400 members, including representatives of environmental engineering firms, real estate owners, trade group representatives, representatives of industrial concerns, real estate lawyers, and lenders. After several years of negotiation, the group released the ASTM standards in May 1993.

The ASTM standards have been modified and expanded on a regular basis since they were first issued, but they retain their primary purpose: to assist buyers, sellers, tenants, appraisers, lenders, insurers, legal counsel, and environmental professionals in the conduct of environmental due diligence. The guidelines are intended to reflect customary and prudent business practices to be followed, without prohibitive cost or delay. As a result, "appropriate inquiry" does not mean exhaustive assessment of a site that is likely to be clean. However, it does mean that the amount of due diligence will depend on the property involved, the uses of the property, and the risk tolerance of the owner. The ASTM standard practice recognizes that performing environmental due diligence will not completely eliminate uncertainty about the possibility of past contamination.

The two ASTM standards originally released are the Transaction Screen Process and the Phase I Environmental Site Assessment Process. The Transaction Screen Process is a questionnaire for the buyer, seller, or a representative; it provides an overview of the site, its present and past uses, and known information such as the current or prior presence of underground storage tanks or facts that might reveal the potential for contamination. Although this document is no longer in use, an interview/site walkthrough process based on this initial ASTM standard practice is commonly used by property owners or buyers as a first step to determine the level of actual due diligence to be conducted, or as the sole due diligence in areas where the potential for risk is deemed minor by the parties.

The Phase I Environmental Site Assessment Process is frequently suggested as the initial step by an environmental consultant who receives a request to perform environmental due diligence. It may be modified in specific instances by the parties but generally contains four components: records review, site reconnaissance, interviews with current owners and operators, and evaluation and report. A great deal of professional judgment is involved in developing the individual scope of work, but the standard leaves the actual degree of diligence to the discretion of the buyer or lender.

Records review involves a search of general records covering an approximate search distance, to the extent that such a review can be performed within a reasonable time and budget. These commonly accessible records exist in commercial databases of contaminated sites. Although such a review generally does not include visits to government agencies, letters to relevant agencies with follow-up telephone inquiries would be considered part of a reasonable records review.

Site reconnaissance involves a site visit to identify potential sources of contamination such as fill spouts for underground storage tanks. The consultant also interviews people who may have knowledge about the site and its present and former uses. If a site reconnaissance does not point to the presence of an underground storage tank but the records review indicates such a possibility, the reviewer must explore additional sources or interviews to arrive at a reasonable conclusion. At each stage in the process, the discretion and judgment of the assessor are essential. Although the goal of the ASTM standard is uniformity, it recognizes that each property is unique and that the needs of the parties requesting due diligence differ.

The report must conclude whether an environmental condition was discovered and, if so, describe it. The report does not, however, specify recommendations for further work, gauge the potential for liability, or make other risk evaluations. These items are beyond the scope of the ASTM standard but can be added to the scope of work by the parties in the contract.

Perhaps as important as selecting and modifying the standard of necessary diligence is the selection of the consultant who will perform the work. Although it may be tempting for a buyer to purchase an "off the shelf" due diligence package, the final product depends greatly on the involvement of the buyer in the due diligence process, so a good working relationship is important. Environmental due diligence is a team effort. Each party has specific responsibilities to be fulfilled in order to obtain a useful work product. The owner must conduct a separate title search or otherwise inform the consultant about prior owners and uses of the property. The buyer must advise the consultant about particular needs that might require a change to the customary scope of work. If the consultant is left to perform the work without being fully informed about the client's goals, the work product will suffer.

Consultants have significant concerns about their potential liability for an inadequate due diligence report. Unless the owner or buyer carefully defines the project and works with the consultant during the investigation, the consultant will be tempted to interpret the scope as narrowly as possible-it is not unusual for a final report to contain little more than a transaction screen and database search or other comparable records review. This is particularly common where the purchaser has asked the consultant to perform the work within an unreasonable time frame.

The value of an environmental site assessment hinges on the skill of the person in the field who performs the investigation. In recent years, the risk of liability, competition among firms, and low margins for basic due diligence activities have conspired to reduce the number of qualified engineering firms willing to perform basic Phase I Site Assessments for anyone except their best customers. In spite of this, and even as demands upon the consultant for information have increased, the price of an environmental site assessment has dropped drastically. This problem is aggravated by the tendency to hire the lowest bidder, because the importance of qualitative differences among assessments is not known or because the real value of the due diligence is underappreciated and interpreted as a "necessary evil" imposed by the lender. As a result, even consultants who would like to produce a quality work product are under pressure to complete their work as quickly and as cheaply as possible. For many, the price is not worth it.

Within engineering firms that remain actively involved, younger, less experienced personnel too frequently are assigned to perform the site investigation work because the firm, having bid low to get the contract, is now under pressure to cut costs for its profit. These inexperienced consultants may miss important but subtle details, spending little time to analyze or understand the information. Site history is often minimal, token letters to government agencies are not followed by telephone calls, let alone visits, and the report is hastily written and poorly developed. This type of assessment is of minimal value to the client, leaving unanswered more questions than it resolves.

This trend presents serious risks for those who rely on environmental site assessments to make critical decisions and for consultants as well. Aside from obvious liability for remediation costs in the event that contamination is overlooked, the property's value may be seriously undermined. Business operations at the site could be seriously affected by remediation activities, and delays occasioned by such activities could result in increased holding costs and lost opportunities.

The consultant is also exposed to increased risk by a superficial report, facing increased risk of lawsuits for negligence and breach of contract. Even if the consultant is able to limit its liability for damages, costs for defense, increased malpractice insurance premiums, and lost executive time add up. And, in the end, it is the consultant's reputation that suffers.

The changed real estate market necessitating development and reuse of former industrial sites, and the entry of more sophisticated players, has led to a greater need for facts about the sites in question. No longer is it sufficient to learn just the likelihood of environmental contamination. In many instances, that likelihood is an accepted fact, and the parties need more detailed information concerning the nature and extent of that contamination.

The due diligence report is an essential tool to identify the best candidates among potential locations for redevelopment and to assist the parties in determining remediation technologies, acceptable cleanup levels, cleanup costs, and health risks for the affected community. As a result, the consultant is under great pressure to perform a scientifically rigorous assessment that has practical value. This pressure can lead to an increased cost for the due diligence work product, but it will also result in a more valuable report.

Carol R. Boman is senior counsel with Chevron Energy Solutions, L.P., in the company's San Francisco office, where she provides advice concerning real estate, construction law, energy, and environmental matters.

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