B y Stephanie Karen Payne
In commercial real estate transactions, a lawyer's systematic review of Phase I environmental site assessment reports can produce many benefits for his or her clients. Those benefits include protecting the client's CERCLA innocent purchaser defense, preventing potentially misleading information from reaching other parties or public bodies and accumulating information to negotiate risk allocation. This article describes the objectives in reviewing Phase I reports and recommends an approach for practitioners to take. It includes an illustrative Phase I review format that counsel can adapt to a word processing macro.
All Appropriate Inquiry
The Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) imposes strict, retroactive, joint and several liability on various parties, including owners and operators of property and their lenders, for discharges of hazardous substances. 42 U.S.C. 9607(a).
CERCLA provides three statutory defenses to liability: acts of God, acts of war and acts of certain third parties. Id. at 9607(b). The third-party defense excuses a potentially responsible party (PRP) from CERCLA liability if the offending acts were those of a third party who is not an employee or agent of the PRP and not a party with whom the PRP has a contractual relationship, provided that the PRP exercised due care with respect to the hazardous substances and took precautions against foreseeable acts of third parties and their foreseeable consequences. Id. at 9607(b)(3).
Land contracts, deeds and other instruments transferring title or possession are excluded from the statutory definition of "contractual relationship" if the PRP acquired the property after the hazardous substance disposal and, for a private PRP whose acquisition was not by inheritance or bequest, the PRP did not know or have reason to know of hazardous substance disposal at the property. Id. at 9601(35). To establish that it had no reason to know, the PRP must have undertaken at the time of acquisition "all appropriate inquiry" into the previous ownership and uses of the property consistent with good commercial or customary practice. Id. This test is known as the "innocent purchaser" defense. Most parties involved in commercial real estate transactions are aware of the extensive reach of CERCLA and other environmental statutes and the elusiveness of defenses to them. As a result, clients often expect their real estate lawyers to identify environmental risks in a proposed transaction, estimate the probability that those risks will be encountered, anticipate the consequences of encountering those risks, devise strategies to allocate those risks and preserve client defenses. Toward that end, clients or their lawyers often engage consultants to prepare what have become known as "Phase I" environmental reports.
The ASTM Standard CERCLA does not define what constitutes "all appropriate inquiry." In response to this uncertainty, several real estate trade groups formed a subcommittee (Subcommittee) of over 400 members under the jurisdiction of the American Society for Testing and Materials (ASTM). The Subcommittee developed ASTM Standard E 1527-94: Standard Practice for Environmental Site Assessments: Phase I Environmental Site Assessment Process (Standard). Joseph Philip Forte, All Appropriate Inquiry: The ASTM Standards, 8 Prob. & Prop. 19 (Sept./Oct. 1994) (Forte). The Standard sets out in detail the required elements of a Phase I environmental site assessment. Generally, a Phase I consists of the following components: (1) records review; (2) site reconnaissance; (3) interviews with current owners and operators; and (4) report preparation and evaluation. For a more detailed discussion of the Phase I components, see Forte at 20-22.
A Phase I is neither a consult- ant's guarantee that the property is "clean" nor a compliance audit report. Clients or lawyers who want to know whether a facility is operating in compliance with environmental regulations should so advise the consulting firm before it begins the assessment project. A compliance audit usually requires the consulting firm to assign different personnel to the project team than it would assign for a Phase I project. Neither the Subcommittee nor ASTM can speak for Congress. The Standard is voluntary and should not be regarded as a CERCLA panacea. The Subcommittee did not suggest that following the Standard is the only ap-proach, or even a minimum approach, to qualify for the innocent purchaser defense. "Although courts may view it as a required level of inquiry, the Subcommittee intended that the Standard clarify an industry standard to serve as guidance for the legal interpretation of 'appropriate inquiry' under CERCLA." Forte at 22.
CERCLA does set forth factors to guide a court in determining what constitutes "all appropriate inquiry," including any specialized knowledge or experience of the PRP, the relationship of the purchase price to the value of the property if uncontaminated, commonly known or reasonably ascertainable information about the property, the obviousness of the presence or likely presence of contamination and the ability to detect contamination by appropriate inspection. 42 U.S.C. 9601(35)(B). The legislative history of CERCLA provides that the duty to inquire is judged as of the time of acquisition; that those engaged in commercial transactions should be held to a higher standard than those engaged in private residential transactions; and that the standard of knowledge will increase as public awareness grows. See H.R. Rep. No. 99-962 (1986).
The prospect of facing a higher standard has prompted some commercial parties and lawyers to de-velop their own "beyond ASTM" Phase I guidance. For example, they may ask the consultant to search electronic databases that are not required by the Standard and to use different search radii for the databases. Or they may ask the consultant to conduct an asbestos, radon or lead paint survey or to determine whether wetlands are present.
Phase I Review Objectives
Phase I review objectives vary with the reviewer. Counsel for a prospective purchaser of commercial real estate may review the Phase I in draft form, approve it and then authorize its issuance in final form and payment of the consultant. This procedure helps protect the client's innocent purchaser defense, assures that the client receives value for dollars spent on consultants and gathers information to use in negotiating environmental representations, warranties and indemnifications from the seller. Counsel for a commercial real estate lender may review the Phase I to evaluate the lender's potential en-vironmental risk and to estimate the value of the property collateral. Counsel for a commercial seller may review the Phase I, especially if the purchaser commissioned it, to preview information about the client or its property that might enter the public domain and to prepare for negotiations with the purchaser. Finally and most ominously, if the buyer must ever claim the innocent purchaser defense, counsel for the government will review the Phase I to build an argument that the buyer is not entitled to the defense.
Efforts by a lawyer to ascertain that a Phase I conforms to the Standard and to finalize the Phase I in an optimal format help safeguard the client's innocent purchaser defense and secure an accurate and reliable report. Despite a consultant's assertion that its Phase I was conducted in compliance with the Standard, counsel may want to determine independently whether the Phase I includes the ASTM elements.
Reviewing the Draft Report
Counsel may wish to review a Phase I report before it is placed in final form, suggest appropriate revisions and confirm that the consultant's conclusions are founded on diligent inquiry and are not too tentative.
- Word choice. Typically, the environmental professional who actually assesses the property drafts the Phase I report; a senior environmental professional or licensed professional engineer or geologist reviews it. Because the consultants seldom have legal training, they may not realize the significance their words may acquire after the Phase I report is in the hands of parties with differing interests or becomes a part of the public domain. Counsel therefore may want to review the client's Phase I before it is finalized, detect inaccurate or imprecise information and discuss appropriate revisions with the consultant. For example, a Phase I drafter might not realize the significance of saying that a party is "the" instead of "a" previous owner of property. In some cases, the Phase I drafter may use words that seem to be an opinion on legal matters. If the scope of the consultant's engagement includes a compliance review, then the consultant clearly must comment on whether conditions or practices may violate regulations. Otherwise, legal opinions may be inappropriate in a Phase I.
- Equivocal conclusions. Further environmental investigation by way of drilling borings, collecting soil or groundwater samples and having them analyzed is commonly called a "Phase II." Consultants are sometimes reluctant to recommend a Phase II, perhaps for fear that the client will blame the messenger for the bad news or decide that the consultant is trying to create more work for itself and never again engage the consultant.
A conclusion such as "if desired, the client could consider a Phase II" might seem equivocal if considered without supporting facts. If, however, the property has already been extensively studied and another subsurface investigation would probably add no new information for the additional costs involved, that kind of remark might be inappropriate. If the lawyer notices equivocal language, he or she may wish to confer with the consultant before the Phase I is finalized to determine and then work to clarify the consultant's true intent.
- Unqualified conclusions. In contrast, a consultant may reach an unnecessarily definitive conclusion, such as "a Phase II must be performed." Once a Phase II is recommended in a final report, the client has few choices. The client could authorize the Phase II, assuming it has the authority to enter the property to conduct the investigation and the current owner has released the client from the consequences of disclosing any Phase II results if required by law. Alternatively, the client can ignore the consult-ant's conclusion and devise a strategy to convince a future court that the innocent purchaser defense nonetheless survives.
A client may not want an unqualified Phase II conclusion if it would rather risk environmental liability than pay for a Phase II and potentially incur disclosure obligations. In that case, discussion with the consultant to clarify its true concerns is in order. Conversely, a client may welcome an unqualified Phase II conclusion if, for instance, it is a risk averse buyer and its sale contract includes a condition that the property be environmentally satisfactory. Counsel may want to discuss any unqualified conclusions with the client and the consultant before the consultant finalizes the Phase I report.
- Premature conclusions.
A consultant who finds evidence of the presence or migration of contaminants may forego additional research and prematurely recommend that the client proceed to a Phase II. The consultant may be facing a deadline or budget limit. The consultant may have performed only on-line or electronic searching, which is easy, quick and relatively inexpensive, without following up with a more time consuming and tedious visit to the relevant agency files or an interview with the agency case coordinator. In fact, sometimes a consultant will base its Phase I price quote only on electronic research. As a prerequisite to file review, some agencies require a Freedom of Information Act request or a prearranged appointment, and agency visits might require overnight travel. Thus, the information sought by the consultant may not be obtainable from its source within 20 days and at nominal cost_the ASTM defined "reasonable time and cost" constraints. Forte at 20.
Among other things, a premature Phase II recommendation could lead to unjustified expenditures. Phase II recommendations should be supported by diligent investigation that does not reasonably rule out the potential presence of contaminants. Extra research by the consultant is usually worthwhile. It will either uncover information clarifying the condition of the property (perhaps eliminating the Phase II recommendation) or will confirm that additional clarifying information is not available (justifying the Phase II recommendation). For instance, the consultant may learn that a groundwater monitoring well has been installed on the property boundary between the target site and an adjacent leaking underground tank site, that the well contains free petroleum product, that the relevant agency has ordered the PRP to delineate the contaminant plume and that the PRP has accepted responsibility to do so. In that case, a Phase II may only reveal information that is already known. Counsel may therefore want to discuss all Phase II recommendations with the consultant before the Phase I report is finalized.
Regardless of the party's role, the principal object of a Phase I in a commercial real estate transaction is to assess risk. To do so, counsel may be asked to estimate the prob-ability that environmental issues will expose the client to liability for investigation, monitoring and cleanup costs, fines, penalties, personal injury or property damages or will impair the current or future use, financeability or marketability of the property. A Phase I report can be the starting point for this broad inquiry.
For example, assume a proposed sale of a property adjacent to a former hazardous waste disposal site. The Phase I reports that the primary agency for the site has issued a letter stating that it will require no further action (called a "closure" letter), but that the closure was based on industrial risk-based corrective action (RBCA) standards. On checking further, counsel for the purchaser and lender learn that, according to industrial RBCA closure standards, the adjacent property has been deed-restricted against excavation below a certain depth and against non-industrial uses. As a consequence, there may be limits on exactly how the property can be developed, as well as a potential environmental stigma associated with the property.
The information contained in the Phase I can be valuable in drafting and negotiating environmental representations, warranties, indemnities and other environmental agreements and may also be a key to other non-environmental issues. For example, while reviewing a Phase I, a lawyer may recognize permitting issues, encroachments, trespass or nuisance claims or a violation of various ordinances or use restrictions related to the addresses, activities, objects, equipment, stains or other physical evidence of contaminants that the Phase I notes.
Review of Phase I Reports
There is no one correct approach to reviewing a Phase I. A lawyer should develop a Phase I review format that his or her office capabilities can best support and that addresses the issues of importance to the lawyer and his or her clients. Most Phase I reports begin with an executive summary and end with a list of references and various appendices. Beyond that the format and reader friendliness vary by consultant. Using a standardized and systematic review format helps assure that each Phase I receives the same scrutiny and that all review objectives are met.
A sample standardized review format accompanies this article. It consists of a series of questions for the reviewer to answer and prompts for information to supply as the reviewer reads the Phase I. In its simplest form, this approach could be accomplished with a pre-printed questionnaire that the reviewer completes by hand and then files. Or, using word processing software, a secretary could enter the handwritten document and store it electronically.
An even better approach is available to practitioners, especially those who regularly review Phase I reports or who are structuring a multi-site sale or loan. With basic word pro- cessing software and some word processing experience or an MIS staff member or handy teenager_a lawyer can develop a computer- generated "macro" that prompts with questions. When the reviewer completes the sequence, the answers are in memorandum form, ready to be printed and filed. The "comment" section of the review memorandum can be copied and pasted electronically into correspondence to the client and the consultant notifying them either that the Phase I is approved or that revisions may be appropriate and, if so, listing issues that require attention.
The review memorandum can be kept in a special folder in the transaction file for future reference. The reviewer can then quickly refresh his or her recollection of the Phase I without having to reread the Phase I or decipher marginal notes. Others who need information from the Phase I can locate it relatively quickly. Whether it is handwritten, typed or generated by a computer program or macro, a Phase I review similar to the sample form could prove efficient.
A systematic, standardized approach to reviewing a Phase I report can safeguard a client's future innocent purchaser defense and provide information necessary for a lawyer to identify environmental risks presented by a transaction, estimate the probability that those risks will be encountered, anticipate the consequences of encountering those risks and devise strategies to allocate the risks.
Stephanie Karen Payne is a lawyer with McGlinchey Stafford, PLLC in New Orleans, Louisiana. She is a member of the Real Property Division's Environmental Aspects of Real Estate Transactions (EG-3) Committee.
Sample Standardized Review Format
Basics. Identify the client; the matter; the client contact; the property name and address; the consultant's name, address, phone and fax number; the review date; the reviewer's name; and the report date (Phase I reports are usually presumed valid for 180 days after completion). Transaction. Describe details of the contemplated transaction, including whether it is a purchase, sale-leaseback, in-line lease or ground lease and whether the client is the lender, seller, buyer, landlord or tenant. (Because the trigger for liability might differ depending on a party's status, this information may help to evaluate potential environmental risk in the transaction and to prepare for negotiations.)
Reliance. Who ordered the Phase I and to whom is it issued? Can the client rely on the Phase I? (Most consultants will not, without authorization, release information to parties other than those to whom the Phase I is issued.)
ASTM compliance. Indicate whether the Phase I includes the required elements of the Standard, with details. For example, what are the past uses of the property? Did the Phase I identify any suspect conditions? Supply details about the remedial status of leaking underground storage tanks sites within critical distances of the property. Orphans. Were unmappable or orphan sites identified in the electronic search report? If so, did the consultant address those sites? Field ID. Did the consultant confirm, by field identification, the location of any potential sources of offsite contamination identified in the electronic regulatory database search report?
Beyond ASTM. Does the report fulfill all elements of the client's "beyond ASTM" standards? Prior studies. Did the consultant review prior environmental reports? If so, enter the name of the consultant and dates and titles of those reports. (This information may be useful in drafting and negotiating contractual representations and warranties.) Buildings. For existing buildings, are there asbestos surveys, lead-based paint and other issues that might give rise to regulatory or disclosure obligations?
Risk pathways. Enter information relevant to risk evaluation, such as the reasonably probable depth and gradient of perched groundwater, relative soil permeability, leachability or solubility factors, sources of drinking water, water wells in the vicinity, nearest surface water, neighboring property uses and other risk pathway data. Business interruption. What potential effect of any future business interruption could arise from preexisting environmental conditions? For example, what media are affected and what remedies will be employed at any potential sources of migratory contamination within critical distances of the property?
Consultant conclusion. What conclusion does the Phase I reach? Is it equivocal, unqualified or premature? Reviewer comments. Provide additional comments. (As the review is completed, the reviewer can make entries in this field each time the reviewer concludes that a necessary element is absent or that an issue needs further attention. The comments section can then be transplanted into other documents as needed.)
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