November 01, 2014

Regulation and Market Access Across Borders: Transactions in the Age of Global Chemicals Regulation

Catherine K. Lin and Philip A. Moffat

After decades of economic globalization, regulation of chemicals in the manufacturing and distribution of finished goods has become commonplace. Failure to understand and manage the environmental or human health risks posed by chemicals that are the building blocks of products marketed by a company can have a significant and deleterious impact on that company—a risk that is particularly acute for those with complex, global supply chains and international distribution. This is also true for mergers and acquisitions transactions (M&A transactions) involving such companies. The proposition that global chemicals regulation—including regulations focusing on chemicals within specific products such as cosmetics, biocides, clothing, food additives, and electronic equipment—should have a role in environmental, health, and safety (EH&S) due diligence may seem unusual. However, failure to perform due diligence on the target company’s chemicals use and management in manufacturing and supply chain operations could result in a flawed valuation of the transaction, reduced return on investment, loss of market access, reputational harm, and legal liabilities. Conversely, a thorough review of the target’s compliance with chemicals regulations can aid the identification of potential liability risks, while promoting their timely and effective management.

Today’s M&A transactions often include cross-border components, as more companies operate businesses located outside of the United States or complex supply chains that cross national borders. According to Mergermarket, an industry observer, the aggregated value of global M&A was US$ 2,215.1 billion in 2013, and has risen by 30 percent during the first half of 2014, with cross-border M&A accounting for 46 percent of total activity. If complex, global supply chains are ubiquitous in twenty-first century commerce, then reliance on them has become increasingly fraught. Of the industries with extensive global supply chains: food, pharmaceuticals, medical devices, consumer products, and automobiles, all have had high profile product recalls in recent years (e.g., melamine in pet foods, contamination of blood thinning drugs, catheters with a propensity to fracture, automobiles with faulty ignitions, electronic equipment with faulty batteries, and toys with high-lead content). While product recall is not new, the role of the global supply chain in creating or exacerbating this problem is garnering growing attention.

Product recall is not the only adverse outcome of supply chain noncompliance. The 2013 temporary shutdown of LG Chem’s Michigan plant is a case in point. Established to supply batteries to Chevrolet Volt and Cadillac hybrids, the company’s management had to halt operations mere days after commencing production, because a chemical used in the manufacturing process apparently was not notified to the US EPA under the Toxic Substances Control Act, triggering an agency inquiry and the ensuing regulatory exigency. Now, consider this hypothetical scenario: Six months prior to the shutdown, GM divested its Chevrolet Volt product line and the acquirer did not review the Volt’s supply chain’s compliance with applicable chemicals regulations, the prospect of production interruption at the Michigan plant would have been missed as would the attendant legal and commercial liability risks. Consider another hypothetical scenario: LG Chem’s battery subsidiary was acquired just prior to the plant shutdown, due diligence was performed on all production facilities to ascertain on- and off-site release of pollution and waste plus EH&S permits compliance, but review of chemicals regulations compliance was not made. Again, the potential risks associated with the plant shutdown would have been missed. Multiply these two scenarios across many jurisdictions and enterprises and we see the magnitude of challenge that chemicals use and regulation present to cross-border M&A transactions.

Before concluding that more due diligence is the answer to supply chain woes, we must ask: How can we conduct effective due diligence in a global economy driven by complex, geographically diffused supply and distribution networks? What is the appropriate breadth and granularity of this exercise? What are the most efficacious tools to use? How can we prioritize this due diligence within the constraints of time and limited resources? Clearly, we cannot read all agreements relevant to the supply chain nor conduct “All Appropriate Inquiry” of every production facility of each supplier. Yet, the consequences of supply chain failure can be severe and difficult to manage. This article proposes to meet this challenge by utilizing compliance reviews of a certain class of chemicals regulations, when applicable, as a due diligence tool for M&A transactions involving global supply chains. The regulations that we would propose using as due diligence tools must have a global reach by acting on the supply chain; force companies to identify, manage, and communicate the inherent hazardous characteristics of the chemicals they produce or use; and require their consistent allocation of resources, know-how, and management support to achieve compliance, effectively creating a self-selection process for companies committed to compliance. We begin with an outline of a representative regulation known as “REACH” and explore how a review of compliance with it can help capture the potential risks posed by the supply chain (as seen in the first scenario above) and at the enterprise level (as seen in the second scenario) when an M&A transaction is involved. As REACH is a double-edged sword, we also identify a few of the emerging EH&S due diligence challenges precipitated by “REACH-like” regulations in the M&A context. For each section below, we provide only a snapshot of the “forest,” leaving consideration of the “trees” for later.

Model Global Chemicals Regulation

A new approach to chemicals regulation is emerging from Europe and Asia, including China, Japan (new amendments), South Korea, Taiwan, Malaysia (voluntary), Vietnam, Turkey, Canada, Iceland, Norway, Switzerland, and Serbia. Each of these regulations share some features with the Regulation on Registration, Evaluation, Authorization, and Restriction of Chemicals (REACH (EC No. 1907/2006)), enacted by the European Union (EU) in 2006. This development is significant in many respects. From the economic perspective, the Asian countries involved are major manufacturing outsourcing centers that also form the fastest growth region for the chemical industries. From the policy perspective, these regulations share the same objectives as media-based environmental laws—to protect human health and the environment, by focusing on products in commerce. From the regulatory compliance perspective, while the details differ, most of these countries are establishing chemicals inventories or registries; predicating market access on registration or notification of chemicals not on those inventories (i.e., new chemicals) and, to a varying extent, existing chemicals; holding manufacturers/importers responsible for providing information on their chemicals; requiring hazard communication along the supply chain; and prioritizing chemicals placed on their markets for risk assessment and further regulation. We explore these features for their saliency to M&A transactions, using REACH as the representative regulation.

REACH addresses EH&S risks posed by chemicals in the stream of commerce. It is based on “No Data, No Market” and safe use of chemicals throughout the supply chain; and it places the responsibility for implementing these principles primarily on manufacturers and importers. This burden shifting from government to businesses requires the latter to compile, assess, and communicate information relating to the properties and uses of their chemicals germane to human health and the environment. The scope and extent of required data are proportional to the types of use, volume, and the hazard posed by each chemical—whether on its own, in mixtures or in products. The required information must be submitted to the European Chemicals Agency (ECHA) before a manufacturer or importer places one metric ton or more per year of a chemical on the EU market (Registration). Foreign producers and exporters must engage EU domiciled only representatives (ORs) to Register their chemicals before placing any on the EU market. In short, no data, no market.

Only one Registration is permitted per chemical. Manufacturers, importers and ORs (collectively, Suppliers) of the same chemical must share data and collaborate to prepare the Registration dossier. Because not all Suppliers place the same amount of a chemical on the EU market or for the same use, those with higher volume, more data, or greater stake in the market often collaborate to lead the Registration. Consequently, a layer of contractual rights and obligations arising from data sharing, but is wholly outside of the scope of REACH and jurisdiction of ECHA, is juxtaposed on the Registrants’ existing regulatory compliance obligations. The terms of these secondary agreements—and those between the foreign exporters and their ORs—could complicate a party’s ability to complete an M&A transaction in a timely manner, so should be subject to due diligence review.

Transfer of the primary responsibility for chemical safety from government agencies to private entities extends to hazard communication between Suppliers and their customers, the downstream users (DUs). The latter must inform the former of their intended uses for the chemicals, changes in use, and newly discovered hazards. Suppliers must provide DUs with extensive information on the safe use of these chemicals throughout their life cycles. The vehicle for communication is the Extended Safety Data Sheet, including annexes.

REACH is a bifurcated regime. While private entities are tasked with ensuring chemical safety along the supply chain, governmental institutions such as ECHA and the EU Member States are charged with upholding chemical safety at the EU-wide level, including limiting or banning chemicals with unmanageable risks or requiring substitution of safer alternatives. This is accomplished, primarily, by the Authorization or Restriction of select chemicals. Chemicals with certain high-priority hazards (i.e., a substance of very high concern (SVHC)) may be candidates for possible Authorization to secure proper control of risk, if not progressive replacement by safer alternatives. Interested parties (e.g., Suppliers or DUs) may apply for Authorization to avert an outright ban by seeking a sunset date to phase out the chemical or express limits on the chemical’s use. Absent other effective means to address the risk posed by a chemical at the EU level, Restriction can be deployed as a “safety net.”

Restriction and Authorization both enable public authorities to influence an existing product’s longevity on the market as well as the introduction of new products, as the threat of Authorization or Restriction may induce producers and distributors to remove or phase-out a product voluntarily. Thus, the public prong of REACH is more product-oriented, while its private prong is more chemical-oriented.

Authorization and Restrictions have few analogues under other REACH-like regulations. Although all such regulations have provisions to limit or ban high-hazard chemicals from the market, few have included predictable and transparent administrative procedures that afford affected parties and civil society with significant opportunities for participation. Therefore, in an M&A transaction, a due diligence review could reach different conclusions regarding the commercial and legal liability risks of a target’s product (and the underlying chemicals used), depending on the locations of the target, its market(s), or its strategic supply chain partners.

Application to a Target Company’s Supply Chain Due Diligence

When the focus of the EH&S due diligence is on liability risks associated with site contamination and pollution discharge, EH&S risks associated with the target company’s global supply chain are often regarded as an operational rather than legal risk, if not overlooked entirely. However, a target’s failure to manage the potential impacts of regulatory requirements on its suppliers can result in a loss of market access, civil or criminal liabilities, reputational risk, recall costs, and liability to the target’s own downstream users or consumers. Further, the dynamic quality of supply chain EH&S risks can elude traditional due diligence inquiries concerned with liabilities existing inside and outside of the property “fence line.” When we consider a global supply chain, each link often represents a step in the manufacturing process and is marked by a commercial contract. Together, these contractual relationships form a set of interlocking multiparty business networks. Thus, EH&S due diligence of a global supply chain is more akin to a review of ever-shifting commercial relationships in real time than that of a manufacturing installation or disposal site.

This dynamic network presents one of the most vexing due diligence challenges—namely, the inability to scrutinize the operations of all suppliers. Many suppliers to a company have their own network of suppliers whose operations are largely invisible to that company, the ultimate customer. Indirect suppliers are often unknown to, not audited or qualified by, and have no contractual privity with the ultimate customer. When a portion of the target company’s supply chain operates in the shadows, noncompliance by even a few suppliers (direct or indirect) can compromise that company’s values and lead to liability risks. Critical analysis of the target’s supply chain’s compliance with applicable REACH-like regulations can function as an “Occam’s Razor” that cuts through the complexity of the supply chain dynamics to root out the weakest EH&S links.

We hasten to note that compliance with REACH and REACH-like regulations is complex, difficult, time-consuming, knowledge-intensive, and costly. Required data may take years to generate, and hazard communication can involve hundreds of chemicals each with dozens of uses. For industries (e.g., aerospace, automobile, chemicals, clothing and toys, electronics, pharmaceuticals) with supply chains that pass through several countries with these regulations, compliance will often involve registration, dossier preparation, chemical safety assessment, and hazard communication performed multiple times as required by the particulars of each jurisdiction. Inevitably, suppliers will need to support their customers in such undertakings or comply directly with these regulations. Either way, to ensure compliance, the customers and their suppliers must implement effective chemicals management systems (CMS) in order to identify and track applicable legal requirements; rosters of qualified (direct and indirect) suppliers; hazard communication made and received; and records of relevant contracts, test data, and Extended Safety Data Sheets. Information for hundreds, if not thousands, of chemicals will populate such a CMS.

A business with the technical wherewithal, managerial infrastructure, and financial commitment to develop and maintain a CMS for regulatory compliance is more likely to engage in sound EH&S practices—thus, be a reliable supply chain partner. Hence, assessment of target’s and (possibly) key supplier’s CMSs is essential to the due diligence review of the target company’s supply chain EH&S performance. Scrutiny should be given to the hazard communication portion of the CMS to better evaluate the capability of the first and second-tier suppliers through their interactions with the target’s business, giving extra effort to how/whether the communicated information is made operational via implementation of specific risk management measures. When hazardous chemicals are involved, the interface of CMS with environmental management systems deserves close attention to ensure consistency of information communicated under both systems as well as that between the target’s chemical risk management and its pollution control measures, pursuant to environmental operating permits. In our experience, suppliers who struggle with chemical safety often struggle with pollution control too.

We can benchmark review of the material agreements against the results of the CMS review to gauge the collaboration between the target and its key suppliers regarding compliance with chemicals regulations. What representations did the supplier make with respect to regulatory compliance? What covenants were given to secure the supplier’s support of the customer’s chemicals regulation compliance obligations—especially, compliance with regulations in jurisdictions outside of the supplier’s home country that are critical to the customer’s continuing access to key markets for its products? If the target is a supplier, then the agreements should be read against the results of the CMS review to discern potential liability exposure arising from the legal obligations it assumed under the supply agreements with its major customers. When the target is both a supplier and a customer, a holistic review of its agreements is needed to understand how compliance-related liability risks are allocated both up and down the supply chain.

Application to a Target Company’s Enterprise-Wide EH&S Due Diligence

In addition to supply chain due diligence, review of a target’s own compliance with REACH-like regulations at the enterprise level can contribute to a sound valuation of the deal. Poor compliance can delay timely closing, disrupt post-closing business operations, or give rise to future legal liability and/or financial loss. We provide a few examples of risks that can either materially reduce the value of the target company or be triggered in the course of deal consummation, and therefore should be included in the EH&S due diligence review. However, an exhaustive discussion of all key issues is beyond the scope of this article.

From a commercial perspective, “No Data, No Market” means that registrations are tantamount to manufacture or import “licenses.” Generally, without a registration, it is impossible to place a covered chemical (and, possibly, products containing that chemical) on a market. Several countries with REACH-like regulations stipulate that a registration is specific not only to the chemical, but also to its manufacturer/importer/OR and related uses. Therefore, a foreign manufacturer that relegates registration to its importer may find itself locked out of the market if that importer switches to another producer. Under this scenario, the importer, not the manufacturer, is the registrant entitled to place the chemical on the market. Thus, the probative due diligence query is “how/by whom was the registration made” and not “was the chemical registered,” as only the former can elicit information on whether the target could lose market access, not by its noncompliance, but by the commercial decision of a third party. The only remedy to such an ill-conceived registration is to obtain a new registration (or join one) at significant cost and delay.

Another area of inquiry is whether Authorization or Restriction will affect the marketability of the target’s products in the EU. While these REACH requirements receive less attention than Registration, they can limit the continued economic viability of the target’s product, should the EU authorities determine that a chemical used for that product is SVHC subject to Authorization or Restrictions. To ascertain whether the target’s product could be in future regulatory jeopardy, a review of the relevant databases maintained by ECHA is needed. Conversely, if the target’s products contain chemicals that are safer substitutes for SVHC or Authorized chemicals, then this due diligence inquiry may have identified new commercial opportunities. Unfortunately, similar databases are not readily available in many Asian countries with “REACH-like” regulations, precluding reliable estimation of the future value and longevity of the target’s products in those markets.

Compliance with REACH and comparable regulations has precipitated new liability risks triggered in the course of an M&A transactions, such as the “permit transfer” problem well familiar to environmental lawyers. A registration is specific to the registrants as well as the annual volume and the identified uses of the covered chemicals. In a share transaction, the acquirer may need a new registration simply due to a name change. In an asset sale or sale of a product line, a new registration also may be necessary. For example, the acquirer may wish to combine the target’s operations with its own in-country operations, or consolidate the manufacturing of several product lines as they use the same chemical. A new registration could be needed if, post-closing, an increase in annual volume of the chemical used exceeds the applicable pre-closing regulatory threshold, or if the consolidation leads to changes in chemical use, resulting in a different exposure scenario that needs new risk management measures. If so, the acquirer might need to generate or procure additional data to support a new registration, or might need to conduct new chemical safety assessment and implement associated safety measures. The acquirer could face a Hobson’s choice: Face delay in production while obtaining a new registration or face the risk of enforcement action for failure to obtain a new registration. Either way, it could be “no data, no market.”

The process for obtaining a new REACH Registration due to M&A transaction is reasonably straightforward. However, the same cannot be said of countries like China, where the regulatory language is as ambiguous as the administrative process is opaque. The plain language of Measures for the Environmental Management of New Chemical Substances (Decree No. 7) does not specify whether the issuance of a new registration triggered by a M&A transaction is merely ministerial or if the regulatory authority can impose new requirements or additional reviews before issuing a new registration.

Obtaining additional data from private parties to support a new registration can be another challenge. Under REACH, many consortia have been formed to facilitate data sharing, so the acquirer can negotiate with them for access to additional data. In China, South Korea, and Taiwan, data sharing is mandated by regulatory language, but the processes for doing so are still inchoate. Further, the Chinese authority has cancelled registrations due to data fraud, so data obtained from third parties must be treated with the greatest vigilance.

Most important, review of chemicals regulation should be coordinated with “traditional” EH&S review to provide an integrated assessment that can harmonize potentially problematic inconsistencies or conflict in regulatory requirements. For example, under REACH, Suppliers must communicate information on the safe use of hazardous chemicals, including practical risk management measures to be implemented by DUs. This information is derived from the Supplier’s own safety assessment and generalized knowledge of that chemical’s uses, including downstream uses, but it is not based on the specific operations of each DU. The Supplier cannot know whether its recommendations comport with the requirements laid down by a DU’s environmental permits. Should the two be in conflict, the target/DU could appear to be “out of compliance” with either applicable EH&S laws (e.g., the Industrial Emissions Directive) or REACH. Environmental transactional attorneys can help address this concern during due diligence to resolve apparent conflicts and avoid potential post-closing liability risks or capital expenditure.

REACH is “the best of regulations, the worst of regulations.” It and its analogues can potentially strengthen EH&S performance of the supply chain and may encourage safer products to be marketed. Like many complex, game-changing regulations that came before (e.g., CERCLA, NEPA), REACH can be disruptive, costly, difficult to comply, and full of unintended consequences—for example, its impact on M&A transactions—before potentially becoming “best practice.” We can ease this process by incorporating review of chemicals regulations compliance into our established EH&S due diligence repertoire. Early identification of issues and risks will permit the deal team to construct a better value proposition for the transaction, structure a more protective deal, and develop effective strategies to reach completion with minimal disruption or delay.

Catherine K. Lin and Philip A. Moffat

Ms. Lin is of counsel at Verdant Law, PLLC, and Mr. Moffat is a principal at Verdant Law, PLLC, Washington, D.C.