Environmental Insurance and Due Diligence Activities

Steve Ziesmann
Godfrey & Kahn, S.C.
Milwaukee, Wisconsin

Introduction

Real property transactions almost always involve some level of environmental due diligence activities. However, in recent years, concerns about the information obtained during due diligence has caused some parties to consider foregoing traditional due diligence activities and covering potential environmental liabilities through the use of environmental insurance. This article will review the concerns regarding due diligence and will discuss the applicability of environmental insurance in lieu of traditional due diligence.

Due Diligence

Due diligence activities are typically considered during real property transactions for a number of reasons including establishing the "innocent purchaser" defense under CERCLA, allocating liabilities between buyer and seller, renegotiating the purchase price, and establishing an environmental baseline.

However, in some real property transactions, a seller may be reluctant to allow the buyer to perform adequate due diligence for fear that the investigation will positively identify contamination. If the discovered contamination is significant or if the buyer walks away from the transaction after performing the due diligence, the seller may be left with a known environmental condition that may require notification to the regulatory agencies and thus creates potential cleanup liability for the seller.

In cases where a seller is reluctant to allow due diligence, the parties may agree to contractually limit the buyer’s potential environmental risk through specific representations and warranties from the seller concerning the environmental condition of the property coupled with appropriate indemnity provisions. However, as with most contractual obligations, the protections afforded the buyer in this scenario are only as good as the financial viability of the seller, and the buyer may ultimately be saddled with cleanup responsibility despite the contract.

Environmental Insurance

Recently, several insurance products have been developed that allow the transfer (or sharing) of the environmental risk associated with potentially contaminated properties. In a typical "as-is" real estate transaction, the buyer may assume the responsibility for costs and other liabilities arising from any pre-existing contamination on the property whether such contamination is known or unknown at the time of transaction. Conversely, in other transactions, the seller may agree to retain the liability associated with pre-existing contamination through an indemnity clause or some other provision in the purchase/sale agreement. In either case, the parties may desire some type of insurance product that essentially guarantees that the party assuming the risk will be able to financially manage the risk. Furthermore, parties are increasingly looking to insurance to protect them from the liability associated with unknown contamination that is not discovered through due diligence (either because the due diligence was inadequate or was not performed at all).

The most common insurance product currently available to cover this situation is generally known as a Pollution Legal Liability ("PLL") policy. The PLL policy typically provides coverage for third-party claims and cleanup costs arising from pre-existing and/or new contamination. These are multi-year policies, with policy periods ranging from five to as long as twenty years. These policies may include coverage for any (or all) of the following environmental risks:

• On-site and off-site cleanup costs related to known or unknown pre-existing contamination and/or new contamination;
• third-party bodily injury and property damage claims;
• legal defense costs;
• business interruption and costs of delayed construction; and
• diminution in property value.

Limitations of Environmental Insurance

It is important to note that the basic premise of any insurance product is the contractual sharing (or transfer) of some risk between two or more parties. For a specified premium, insurance companies are willing to share the risk of some event occurring to the insured if the insurer can effectively estimate the probability and magnitude of the loss averaged over some large pool of insureds. Where the probability or magnitude of a loss cannot be accurately estimated or spread out over a large number of insureds, insurers will necessarily set policy premiums artificially high in order to compensate for these unknowns.

Thus, in order to accurately judge the potential for future environmental risks, most if not all insurers will require an extensive environmental investigation (i.e., due diligence) of the property to be covered before they will write a policy. Without the knowledge generated by such an investigation, an insurer would be taking on an unknown amount of environmental risk and this uncertainty would be reflected in substantially higher premiums for the insurance (if indeed the insurer were willing to provide coverage at all). Similarly, most lenders will not provide financing for a real estate transaction unless they are comfortable with the amount of environmental risk associated with the property. At a minimum, most lenders require a Phase I Environmental Site Assessment for commercial or industrial properties.

Some parties have also argued that they may be better off not performing due diligence and covering all unknown pollution conditions through insurance. However, as indicated above, the less that is known about a particular site, the higher the premium is likely to be for the environmental insurance. In most cases, it is expected that the additional cost of the premium would make the insurance product prohibitively expensive. Moreover, it appears that this argument may be based in part on the thought that insurance may not be available for known conditions as implied by the old adage, "we cannot insure a burning building." However, most PLL policies specifically provide coverage for known conditions if all of the information regarding the known condition is disclosed to the insurer (and provided that no claim has been made against the insured based on those known conditions).

Possible Protections During the Due Diligence Phase

Recognizing that most insurers will not provide an insurance policy for a site until after an investigation is completed, how do parties protect themselves during the due diligence phase? For example, what is the seller’s recourse if contamination discovered during the investigation causes the buyer to walk away from the deal and the environmental insurance premium based on information obtained during the investigation is beyond the financial ability of the seller?

One common method of seemingly avoiding this issue is to have the buyer agree to conduct the due diligence on their own behalf and not share any information with the seller. In this way, the seller does not have actual knowledge of the environmental condition of the property and presumably has no obligation to report such conditions to a regulatory agency. However, in this situation it is not clear if the seller could be held to a "should have known" standard regarding environmental conditions based on the buyer’s investigation. This may be especially true if the only contingency left regarding the transaction is the environmental due diligence. In that situation, if the deal fails to close after conducting the due diligence, an agency or third party could easily argue that the buyer’s failure to complete the transaction was a clear indication of significant environmental problems. Moreover, if the buyer’s investigation reveals conditions that may represent an immediate endangerment to human health, does the buyer incur any obligation to inform the state or other potentially impacted parties? If the buyer does not provide any notification, does the buyer then assume the risk of third-party claims based on their knowledge and failure to notify?

Another potential method exists to satisfy the buyer’s desire to perform an investigation while providing some comfort to the seller that buyer is willing to go forward with the deal. The method is to include a provision in the purchase/sale agreement that allows the buyer to conduct due diligence but also requires the buyer to complete the deal regardless of the results of the investigation provided that the cost or liability associated with newly discovered environmental conditions does not exceed some specified maximum amount. In this way, the parties can satisfy their respective concerns, and the deal can close unless a (presumably) unlikely level of contamination is found. However, it is still possible that the seller may find itself in the situation where significant contamination is found, the buyer terminated the deal, and the seller now has a reporting/cleanup obligation that it would not have had but for the due diligence investigation.

Conclusion

The bottom line on conducting an adequate due diligence investigation is that it will most likely be a prerequisite for any but the most basic of transactions. Thus, due diligence will likely be required before financing for a property can be obtained and will almost certainly be required in order to obtain a reasonably priced environmental insurance policy. In other words, environmental due diligence is a requirement for, and cannot be replaced by, current environmental insurance products. Furthermore, there still may not be an adequate mechanism that will sufficiently insulate a seller from potential liability based on a buyer’s due diligence.