Designing an “EHS Due Diligence Program” in M&A Transactions: Four Areas of Focus and Managing the Risks

Introduction

To help organize our thoughts during environment, health, safety, and sustainability (“EHS&S”) transac­tional due diligence in the context of M&A transac­tions, the realm of potential downside risks can be grouped into four (possibly five) areas of focus: 

1. Subsurface
2. Infrastructure
3. Operations
4. Business

In addition to the four focus areas listed above, a fifth area that can be considered is “post-acquisition integra­tion and investment thesis requirements”. This requires a different thought process, moving away from an im­mediate downside risk mentality and looking at how the implementation of the investment thesis post-ac­quisition may be affected by environment, health, and safety (“EHS”), sustainability, or environmental, social, and governance (“ESG”) factors. Ultimately, downside risks identified throughout due diligence work can be dwarfed and/or become moot if there are significant EHS&S or ESG hurdles that will derail or significantly inhibit the investment plans post-acquisition.

The following sections provide more in-depth discus­sions on each of these focus points.

Subsurface Risks

Subsurface risks almost universally focus on the po­tential for the presence of petroleum products or haz­ardous substances (as defined by the United States Environmental Protection Agency). It would be nearly impossible to list every source and type of contamina­tion that we might encounter in transactions, but some of the more typical examples are as follows:

• releases from underground storage tanks containing petroleum products, process chemicals, or pro­cess waste streams;
• discharges from septic systems that have received non-sanitary waste streams (e.g., wastewater from an industrial process containing metals, solvents, or other process wastes);
• contamination from surface spills (e.g., spilled drums, mishaps from truck unloading, or automo­bile accidents);
• fugitive air emissions that are deposited on roof or ground surfaces (e.g., untreated air emissions from a plating operation);
• leaking utility lines containing regulated substanc­es (e.g., leaking joints in a sanitary sewer line trans­mitting industrial wastewater);
• releases from historical degreasing operations (e.g., solvent-based parts washers);
• releases from industrial process sumps and pits;
• drywells receiving stormwater from roofs or park­ing areas;
• releases of per- and polyfluoroalkyl substances (“PFAS”) sources during firefighting activities, such as foam in fire sprinkler systems;
• buried wastes (e.g., waste deliberately buried by fa­cility operators); and
• the potential for vapor intrusion, specifically vapors entering indoor workspaces from underground sources (e.g., solvent vapors migrating into indoor air spaces, emanating from subsurface solvent contamination).

Defining and characterizing subsurface issues can be challenging, even for the most seasoned environmen­tal professional. Uncertainty is more common than not and is usually the basis for discussion when monetiz­ing issues at the deal table. The most problematic sub­surface issues typically involve one of two situations — those involving affected third parties and those with an immediate potential to affect workers’ health. This is not to downplay the substantial costs associ­ated with other risks, such as involvement with Super-fund cleanup liability, which can have a tremendous amount of uncertainty in terms of duration, cost, and closure requirements. However, when third parties or human health effects are involved, the issues can be­come unmanageable.

Infrastructure Risks

Contaminated infrastructure is typically more routine and easier to manage than subsurface risks, although it can in many cases still involve uncertainty that requires characterization and management. Infrastructure is­sues typically encountered include the following:

• asbestos-containing materials in roofing, flooring, ceilings, mastic, and various types of insulation (pre-1980s);
• lead paint;
• contaminated dust (e.g., metals in dust from indus­trial processes);
• contaminated sumps and pits (e.g., oils, solvents, or metals);
• contaminated sprinkler systems containing PFAS from aqueous film-forming foam;
• contaminated process equipment (e.g., tanks or piping); and
• contaminated heating, ventilation, and air condi­tioning systems (e.g., systems that transmitted air discharges with hazardous substances, such as hoods from metal plating operations).

Often, contaminated infrastructure does not pose a risk for ongoing operations, assuming proper manage­ment, employee notification, labelling, and procedur­al instructions for engaging with such infrastructure. However, when considering operational changes, par­ticularly associated with post-acquisition investment thesis plans such as expanding, selling or shutting down an operation, contaminated infrastructure can involve large capital expenditures that need to be ac­counted for during the due diligence.

Operations Risks

By operational risks, we typically mean risks associated with any EHS-related issue pertaining to the contin­ued operation of a facility in accordance with appli­cable rules and regulations. EHS-related operational risks can be equally concerning as subsurface, infra­structure, and business risks. They can be thought of in two categories: (1) environmental; and (2) health and safety. Example topics include:

Environmental:

• stormwater control and pollution prevention plans;
• sanitary sewer discharge compliance;
• hazardous waste management;
• universal waste management;
• toxic chemical reporting (Toxic Release Inventory);
• tank registrations and testing;
• Toxic Substances Control Act (TSCA);
• radon;
• wetlands; and
• ecological impacts.

Health and Safety:

• safe workplace rules and regulations;
• noise monitoring and protection;
• personal protective equipment (PPE);
• machine guarding;
• hazard communications and planning;
• industrial hygiene (e.g., worker safety associated with hazardous materials and workplace exposures);
• explosives atmospheres;
• plans, programs, and recordkeeping;
• training programs;
• emergency planning;
• lockout/tagout electrical system controls;
• confined spaces;
• ingress/egress (fire safety);
• risk-based hazard planning; and
• safety culture and safety awareness.

Other than a strict analysis of regulatory compliance, a thorough due diligence program should also give thought to planned operational changes and associ­ated capital expenditures (e.g., expanding an operation post-acquisition, thereby affecting volumes and types of emissions; changes to a process due to banned sub­stances, thereby affecting the makeup of wastewater discharges; or modifications to and transfers of per­mits and any associated nuances).

Obviously, costs to maintain compliance with EHS-re-lated operations can be substantial and material if cor­rective actions are required. However, beyond the im­mediate costs for corrective actions, costs associated with the perhaps unlikely event of operational inter­ruption can dwarf any costs associated with corrective actions. In other words, identifying operational risks that could inhibit facility operations is paramount. Ex­amples may include a worker fatality or a gross viola­tion of a discharge permit that causes a regulator to impose a cease and desist order.

Business Risks

The term business risk can be difficult to define, be­ing perceived by different stakeholders to mean some­thing quite different depending on their vantage point. In general, business risks are risks that can be tagged to a business but are not necessarily associated with a current asset. In other words, traditional site-specific asset-based due diligence would not necessarily reveal a broader business risk.

Arguably, EHS due diligence traditionally focuses on the presence of contamination, contaminated materi­als, and operational regulatory compliance. According­ly, an assessment of business risks tends to follow suit, although it really should not be so narrowly focused.

use of chlorinated solvents for more than 30 years at a formerly owned property that was sold by the business and for which there are no records of site characteriza­tion, with legal indemnities provided by the business (to the buyer) in a purchase and sale agreement (risk: potential liability to the business for any contamination that may be discovered in the future at the formerly owned property);

• historical handling of asbestos gaskets by unpro­tected workers associated with a small engine manufacturer that was reported to have taken place in the past (risk: potential for worker health claims that have not yet manifested themselves); and
• involvement in a third-party Superfund site (Unit­ed States) as a potential responsible party (“PRP”), where the business’ hazardous wastes were ulti­mately disposed by a licensed waste hauler (risk: as a PRP, the business may be responsible, in part, for cleanup costs at the third-party site).

Examples of other less tangible business risks identi­fied in some of our work include the following:

• identification of labor force practices that conflict with investor requirements for responsible invest­ing criteria;
• water source vulnerability study that shows sig­nificant risks for future water supply (e.g., ground­water extraction rights or competing with regional competition for limited aquifer yields); and
• critical EHS staffing lost in connection with an ac­quisition or the spinoff of a manufacturing division, resulting in a gap in institutional knowledge and operational leadership.

More broadly, the topics of ESG risks and sustainability programs under the business risk category are becom­ing increasingly mandated during EHS due diligence work, particularly in connection with European opera­tions. ESG screening tools are commonly deployed in due diligence work to help profile a target specific to the ambitions of the buyer. ESG concerns are typically driven by third-party stakeholders, but not always. The understanding of a client’s ESG ambitions and driv­ers ultimately determines the focus for ESG screening work during due diligence.