Chadbourne conducts regular training sessions for young lawyers on issues that come up in project finance transactions.  The following is the transcript from a training session lastfall on environmental issues that need to be covered during the due diligence phase of a project.  The speakers are Andrew Giaccia, an environmental partner in the Chadbourne Washington office, and Roy Belden in the New York office.  Belden moved recently to GE Energy Financial Services as a senior vice president for environmental support.

MR. GIACCIA: We will cover four topics today. The first one will give you a sense of what we mean by environmental laws.  Then we will proceed to a discussion of what a due diligence process could or possibly should include. We will then talk about provisions that you see across project finance agreements and then, finally, we will conclude with a few words about structuring around environmental risks in a transaction.

Key Environmental Statutes

MR. GIACCIA: Starting with the key environmental statutes, the top four are the Clean Air Act, the Clean Water Act, the Resource Conservation and Recovery Act, or “RCRA” — which is the hazardous waste law — and Superfund or “CERCLA.”

Between RCRA and Superfund, you get most of your remedial obligations to address contamination under federal law — not all of them, but most of them. The Clean Water Act regulates discharges into “waters in the United States.” The Clean Air Act provides for the comprehensive regulation of air emissions.  It is also the statute that has received the most attention in the last 15 years in terms of new regulatory developments.  It was renewed in 1990 with more than 800 pages of Congressional mandates, and it has taken quite a number of years for implementing regulations to be written.

Another significant statute is the National Environmental Policy Act or “NEPA.” It provides a comprehensive procedural process that we will get into in a little more detail.  NEPA may require that a detailed environmental impact review be done for a project.  Developers try hard to avoid having to do such reviews because they are expensive and time consuming.

There are also numerous state and local environmental laws that may provide comparable protections as the federal statutes, but on a level closer to home.  We spend so much time talking about federal environmental laws, but the framework for regulating air emissions, water emissions, hazardous waste management and hazardous substance cleanup is that the rules are implemented not so much by the federal government but by the state and local governments with some federal oversight.  As a result, you will see repeatedly that the state and local environmental agencies are implementing these federal programs pursuant to approvals by, or delegation agreements with, the US Environmental Protection Agency.

Permitting Due Diligence

MR. BELDEN: I’m going to pick up here and talk first about the nature of permitting risk.  Next, I will discuss the scope of the environmental compliance review that we typically go through in different project finance transactions.

Anything that could have an impact on the environment or human health is potentially covered by an environmental statute. You do not always need an environmental permit, but most often there is an environmental statute or regulation that covers an activity, such as air emissions or wastewater discharges.

What is a permit?

A permit is a document that gives permission from a federal, state or local government to undertake some action affecting the environment — either to emit air pollutants or discharge wastewater or dispose of ash at a landfill.  It is generally not a property right.  Permits usually have a condition in them that says that they do not convey any property rights.  Without the requisite permits, a particular project cannot be built.

Permits are generally divided into two categories. There are construction permits and operation permits.  In project finance transactions, the focus is often on obtaining the preconstruction approvals.  Permits will also have numerous conditions and limitations.  Look at those to make sure there are no specific conditions that will limit a plant’s operations and affect the economics of the deal.  For example, an air permit may have hours of operation limits that could restrict the plant’s operation at different times.

There may be other permit conditions that, on their face, do not look like they will restrict plant operations, but look behind those conditions and review the permit application to get a sense of whether the conditions potentially restrict the plant’s output.  An example may be a gallon limitation on burning fuel oil as a backup fuel. That oil restriction could limit a plant’s ability to operate when high natural gas prices make it uneconomic to run unless the plant can burn oil.

Very stiff penalties could be imposed for violating the permit conditions.  Federal statutes typically authorize penalties of upwards of $32,500 a day per violation.  An air permit with numerous emission limits in it could trigger multiple violations due to one excess air emission.  In other words, you can have numerous violations for a relatively few number of exceedances that could add up to substantial fines.

Another area of permitting risk is the potential for changes in law that increase the costs of the project.  Recent examples include the “clean air mercury rule” and the “clean air interstate rule” that EPA promulgated in 2005. These rules will come into effect in the 2009 and 2010 time frame, and they could impose very significant costs on individual power companies.

Air Emissions

MR. BELDEN: Turning to air permit issues, the preconstruction air permit is probably the most important permit for a thermal power plant.  Both major and minor emission sources will need to go through new source air permitting.  Issuance of a preconstruction air permit is required before a developer can commence construction, and it often involves a complicated permitting process.  Typically, major emission sources have to go through a control technology review, and the permitting agency will then decide what type of pollution controls may be necessary. The developer’s consultant will prepare the initial control technology review document that will be submitted as part of the air permit application.  In a control technology review, you are required to review the requested emission limits for the plant against the limits in permits that have been issued for other new plants.  A new plant’s air emission limits will be based on the limits that have been achieved by similar sources using state-of-the-art equipment.

Air permits typically have an appeal period, and there may be an automatic suspension of a permit when an appeal is filed.  Some regulatory schemes allow permits to remain in effect when an appeal is filed.  A lender will not want to close the financing if there is an appeal pending on a permit.

You may also need emission reduction credits in order to build a plant. The country is divided into two areas for purposes of the Clean Air Act.  There are areas meeting the six national air quality standards, and there are other areas that fail to meet at least one of the six ambient air quality standards. There are separate ambient air quality standards for sulfur dioxide (or SO2), nitrogen dioxide, particulate matter, carbon monoxide, ozone and lead.  If a plant with significant air emissions is going to be built in a nonattainment area, then the applicant will need to purchase emission reduction credits to offset the new plant’s emissions.  This adds to the cost of the project.

There are emission allowance programs that are different from the preconstruction emission reduction credit programs.  Depending on the type of plant and where it is located, a developer may need one allowance for each ton of a particular pollutant emitted by a plant. The most well-known allowance program is the acid rain program or the SO2 allowance program.  There is also a summertime “ozone season” NOx allowance program that applies to 20 states east of the Mississippi that are subject to the federal limits on nitrogen oxide emissions called the “NOx SIP call rule.”

NOx allowance prices have fluctuated, but they are currently around $3,000 per ton.  SO2 allowance prices have gone up steadily in the last year and hit $800 a ton earlier this year, which is an all-time high.

MR.  GIACCIA: The peak in the SO2 allowance market really started when people took seriously the prospect that EPA was going to cut back on the number of available allowances under the “clean air interstate rule,” and people started to realize that SO2 allowances that could be stockpiled this year and then sold or used in future years were going to have increasing value. The NOx and SO2 emission allowance markets exhibit volatility and, without advance planning, that volatility can lead literally to millions of dollars of extra costs.  This is an increasingly important area of due diligence.

MR. BELDEN: To clarify the difference between an emission reduction credit and an allowance, emission reduction credits are also known as “offsets,” and they are generally a right to emit a pollutant in perpetuity.  Some states recognize a “discrete” emission reduction credit that allows a one-time emission of one ton of a pollutant.  Emission reduction credits can be generated when an existing plant shuts down or ratchets back its emissions and accepts an enforceable limit to prevent emitting a pollutant above a certain level.  Either of these actions will generate a tradable emission reduction credit that typically must be approved and certified by a state agency.  A plant that is going to put on a new unit will basically take off line older, less efficient units and generate emission reduction credits that can be transferred to the new unit.

MR. GIACCIA: When the emission reduction credits are generated, they have to be registered and approved by the state.  They do not exist legally until an application is filed and the state reviews, quantifies and approves the application.  Then, once that happens, they are “banked.” They are in a state emissions bank and are now tradable.

MR. BELDEN: The emission reduction credits are used for nonattainment areas.  Those are essentially areas where the air is dirtier than in other areas.  Under the Clean Air Act, the goal is to maintain or improve the air in an attainment area and to improve the air in a nonattainment area over time.  In contrast, allowances are a going-forward operational requirement that you need every year.  For example, under the acid rain program, a project must have one allowance for every ton emission of SO2 that it emits in a particular year, and sometimes those allowances can be banked or carried forward so that the project can sell the surplus or use it in a future year.

Once a project buys or creates an emission reduction credit, it is a right to emit in perpetuity.  An allowance, on the other hand, is not.  An allowance is a discrete permission to emit one ton of that particular pollutant in a particular year or, if it can be carried forward, to emit one ton in a future year.

MR. GIACCIA: This is a very complex area. We can speak for an hour on this subject because there are so many nuances, but in terms of the geographic scope of the program, an emission reduction is only usable in the state where it was created unless there is an actual agreement between the two states to allow cross-border use.  In the handful of states where those provisions exist, the states usually place a lot of restrictions on their use and ratchet them down, so it is typically not a one-to-one offset.

MR. BELDEN: You can trade SO2 allowances under the acid rain program throughout the United States. The NOx allowances are only good in the states that are affected by the NOx SIP call rule. There are 20 eastern states in the NOx SIP call program where you can trade NOx allowances.

Other Key Permits and Approvals

MR. BELDEN: In addition to preconstruction air permits, there are a number of preconstruction approvals that may be required depending on the type of project.  There are state and local land use approvals, which would include a zoning or subdivision approval and most local building permits. The next category to consider is power plant siting laws. There are a few states that have power plant siting laws that are meant to be a one-stop shop where you would get one permit or certificate that covers a number of different approvals that are required from state and local agencies.  It does not mean that the applicable state and local agencies are not involved.  For example, Florida has a power plant siting law, and the Florida Department of Environmental Protection issues a comprehensive certificate that covers most of the major state and local environmental requirements.

Wastewater discharge permits implementing the requirements of the federal Clean Water Act are typically issued by the states.  In addition, some states also have their own wastewater discharge programs.  For example, Arkansas issues a single wastewater discharge permit for both the federal and state programs.  A wastewater discharge permit is an operational permit, but it is a major approval and a project finance transaction will not reach closing without having a wastewater discharge permit in place.  Some wastewater discharge permits also address storm water.  Other states provide coverage under general storm water permits.  An applicant meeting the requirements for coverage under a general permit would simply need to file a “notice of intent” requesting coverage.

There are also section 10 and section 404 permits issued by the US Army Corps of Engineers.  A section 10 permit is required for the installation of a structure in a navigable water such as a dock or water intake system.  Any sort of filling in of wetland areas will require an Army Corps of Engineers section 404 permit.  Some impacts on wetlands may be relatively minor, and the developer can get by under what they call a nationwide general permit.  However, if the impacts are more significant, he or she will need an individual section 404 permit.

Another important permit is a water withdrawal approval. This approval is particularly important in the western, midwestern and mountain states where water is scarce.  Sometimes these approvals can be difficult to obtain.  Some states treat water withdrawal approvals as a property right that you need to apply for or have transferred.  For withdrawals from a surface water body, a project will also need to construct a cooling water intake structure.  That approval process is wrapped into the wastewater discharge permit, and there are new federal regulations that apply to clean water intake structures.

Archeological reviews and endangered species reviews are typically required when you have a federal permit like an Army Corps of Engineers permit.  If there is a likelihood that you are going to kill an endangered species or destroy its habitat, you will need to get an “incidental take permit” from the US Fish and Wildlife Service.  Incidental take permits are very difficult and time consuming to get; they require advance planning.  Governmental rights-of-way and easements may also be needed for linear projects like pipelines and transmission lines. To the extent that you are going to run a pipeline under submerged lands, the states will issue a submerged lands easement for activities within state waters.  There is new language in the Energy Policy Act of 2005 that authorizes the US Department of Interior to issue easements for projects on submerged lands on the outer continental shelf, or the area just beyond the three-mile limit of a coastal state’s jurisdiction.  If you are working with a project that is on the coast, the state will also need to issue a Coastal Zone Management Act approval.

In addition to the numerous preconstruction approvals, there are also separate operating permits that are typically obtained after the closing on the construction financing for a new plant.The most important is the air operating permit.  Major emission sources must file an application for a title V operating permit within 12 months after the plant commences operations.  Some states have different interpretations on when operations commence.  Some take the position that it occurs at first firing, and other states view it as occurring after the completion of the shake-down period when the plant achieves its planned operating mode.  The title V operating permit is intended to include all of a plant’s applicable air emission requirements, including the conditions from the preconstruction air permit.

There are a lot of permits and approvals to think about and, if that is not enough, the project may also require an environmental impact review, which often involves a very time-consuming procedural review process.

National Environmental Policy Act

MR. BELDEN: A National Environmental Policy Act or NEPA review is required for any major federal action that will significantly affect the environment.  It is not required for all projects, but only if you have a federal permit like a US Army Corps of Engineers permit or federal funding is involved.

Several states also have similar state environmental policy act requirements.  California and New York, for example, have state environmental policy act processes that are fairly detailed.  A NEPA review or similar state review is a precondition to most project permits.  If a review is triggered, you will need to go through the environmental review process before the permits can be issued, and it is a very convenient forum for public opposition. The outcome of that process is either a short “environmental assessment” and a finding of no significant impact, or a finding of a significant impact, which will require preparation of a full-blown “environmental impact statement.” The environmental assessment or environmental impact statement documents are intended to address all the environmental aspects of the project, and the public is invited to comment and attend a public hearing if an environmental impact statement is being prepared.  Some of the key elements of that process involve the identification of the scope of the project, a cumulative impact analysis and a review of the alternatives.  If the project involves a federally-permitted dock or transmission line, then the developer may be able to limit the scope of the project just to the dock structure or the transmission line instead of the entire project.  For example, a power plant project may need an Army Corps of Engineers’ permit for a dock structure to unload coal. The goal would be to limit the NEPA review just to the dock structure.  In the alternative analysis, one alternative that is always considered is the effect of not constructing the project at all. The NEPA or state equivalent review is a comprehensive look at the project involving not only the air quality and water quality, but also the habitat, aesthetics, local environmental impacts, transportation impacts, the traffic congestion and other impacts.

MR. GIACCIA: The environmental impact review is such a time-consuming and costly process that in those states where it is not required by state law, projects will go out of their way to avoid it if they can, and they often can. The typical power project in a state that does not have a state environmental policy act review can avoid this whole process if it avoids wetlands areas and structural work in a surface water. Therefore, if you can build your plant to avoid wetlands, and if you can keep from having a wastewater discharge by building an evaporation pond rather than discharging into a river, then you can avoid NEPA.  We have seen many projects go out of their way from a design standpoint just to stay away from it.  It is not triggered by air permitting, and it is not triggered by some of the other basic permitting that you see for power plants.

MR. BELDEN: I want to touch on other types of permitting risks.  The most important is the permit appeal risk. You are not going to close a project if there is a pending appeal of a major preconstruction permit. There may be situations where a statutory appeal period is still open, but it really depends on the type of permit in order to determine whether you can close the transaction with an appeal period still open.  I have not seen a project closed where a Clean Air Act permit has an open appeal period.  The one exception was a situation where a lender was willing to close notwithstanding a pending certiorari petition before the US Supreme Court, and the lender was comfortable that it was highly unlikely that the petition would be granted to consider the permit appeal.  Nevertheless, that deal ultimately closed after the court denied certiorari.  Some projects have very long appeal periods.  For example, the US Army Corps of Engineers permits typically have a statute of limitations under the federal Administrative Procedures Act of a six-year period.  Other permits have a very short appeal period of 30 or 60 days.  Another point is that some permits may have postponed decision making or a condition that requires resubmittal after a particular milestone. This may present an opportunity for public opposition when an agency makes a final decision on a post-closing submittal.  And then there are often third-party approvals that are typically outside the control of the developer, but are nevertheless very important to the project.  For example, if a local wastewater treatment authority is constructing a wastewater treatment plant that will be receiving wastewater from a power plant, then you need to know that the wastewater plant has its permits in place, and can actually be built.

Environmental Compliance Review

MR. BELDEN: The environmental compliance review involves a review of a project’s inspection reports, prior environmental audits and monitoring reports.  Reviewing the air emission monitoring reports and wastewater discharge monitoring reports will give you a sense of how the unit has been operated. These reports may also give you an indication of whether the unit had to ratchet back its operations because the project is bumping up against a permit limit.  We will also look at notices of violation, notices of noncompliance and correspondence with state and federal agencies to see if there may be compliance issues.  We will also go through the conditions in each of the permits and, where available, review the history of past capital improvements at a facility to get a sense of whether those improvements should have gone through a permit modification or triggered a new permit.

Federal and state agencies may have different enforcement priorities, and one well-known initiative was the federal government’s actions in 1999 to target coal-fired plants to review whether some such older plants made capital improvements that should have gone through new source review permitting for air emissions.  In 1999 and 2000, the federal government filed several lawsuits against utilities with older coal-fired power plants.  Many of those lawsuits are still in the courts and are in the process of being resolved.  A number of the cases have also settled, and the penalties have been very significant. There have been fines of millions of dollars, and several utilities are spending hundreds of millions of dollars on pollution control equipment at the plants.

Federal and state agency enforcement practices may differ depending on the underlying statute and the agency’s settlement guidance. The settlement guidance typically allows the agency to settle a pending lawsuit or an enforcement action for basically a fraction of the possible civil penalties.  An agency’s settlement posture may depend on which party is in power and the goals it is trying to achieve.

A number of the environmental statutes authorize citizen suits, and some state statutes do as well.  If a citizen lives near an industrial source, many environmental statutes gives him or her the right to file an action for alleged violations.  The person must satisfy “standing” requirements, including showing that he or she was harmed.  Visual and other nonphysical impacts may be sufficient.

Turning to environmental noncompliance, liability for noncompliance typically remains with the seller of a project unless there is a contractual shifting of that liability.  Responsibility to pay the costs of site contamination liabilities and past noncompliance liabilities can be allocated contractually between a seller and buyer. What we have seen in some plant divestitures is that the seller will try to shift past noncompliance liabilities to the buyer.  This was more common in the past three or four years when the market favored sellers.  In more recent divestitures, sellers have retained most pre-closing environmental liabilities.  In project finance transactions, the lender will require that the borrower absolutely comply with environmental laws, and the lenders will not take any noncompliance risk.  A lender will have its independent engineer monitor that risk.

Environmental compliance liability differs from site contamination liability in that, particularly under Superfund, site contamination liability is often triggered based on a party’s status as owner or operator.  It does not matter if it had any role in causing a release of contamination.  Under Superfund, just the fact that you are an owner or operator of a property that has had a prior release on it could lead to liability.

Site Contamination

MR. GIACCIA: Site contamination issues require a thorough review.  As Roy Belden said a moment ago, this notion of status liability boils down to the fact that there does not have to be culpability.  Cleanup can be very expensive. That said, cleanup costs have been coming down a great deal in recent years, probably the last decade.  Ten years ago, virtually everything in an environmental remediation was handled in pretty much the same way.  You dug up soil, and you pumped out contaminated groundwater and treated it.  The technologies have been advancing rapidly so that there are various remediation options depending on the nature of the contamination.  A lot of contamination can now be treated in place using anti-bacterials.  States have also tried to simplify the remedial process.  One of the things that has always led to significant increases in cost has been the bureaucratic oversight requirements.  A majority of the states have issued “brownfield” laws that attempt to streamline the remediation process. “Attempt” is the operative word there.  In reality, the practice has been that you still have the same bureaucrats administering those supposedly streamlined requirements and, therefore, similarly difficult bureaucratic bottlenecks are still present.

From a cost standpoint, you also have to consider the possibility of delay.  If you are dealing with a new plant construction, it becomes an important issue even if the overall cost is not significant. The process of putting a slab-constructed plant on top of the contamination cannot begin until the government gets around to approving the capping remedy that has been selected for the site. This can lead to delays even though nothing is really being remediated and the cost is relatively minimal.

Toxic torts and property damage are always issues.  We see this in cases of groundwater contamination and also airborne contamination or exposure, such as asbestos. The problem with those claims is that they typically have a very long lead time.  Illnesses do not manifest themselves for years and, therefore, it is difficult to project the potential liabilities.

Property damage can occur to private property or to public resources, and this is a frightening area that continues to evolve from an environmental remedial standpoint.  Both at the federal government level and the state level, there is an increasing emphasis on the recovery of the costs of the injury and the actual damage to natural resources.  New Jersey has gone so far as to have a program where it charges for groundwater that was polluted, even if that groundwater is not being used by anyone.  These charges are assessed on top of the cleanup costs.  They are a penalty or natural resource recovery charge for the damage to the groundwater itself, based on the aerial extent of that groundwater contamination.

There is contamination and there is contamination — it cannot all be treated in exactly the same way.  It is important to evaluate it.  People think contaminated groundwater is unacceptable, but that is not true. There are federal drinking water standards that allow low levels of contaminants.  Even some of the worst contaminants have a threshold that is allowed in drinking water. The level is very low, but there is a threshold.  It really depends on the particular threat the contaminant presents.  For example, No. 6 fuel oil, because it is so thick, basically does not get into groundwater and does not spread very much.  A solvent, or something like a gasoline additive like MTBE, mixes with groundwater rapidly and spreads very rapidly.  Finally, the issue comes up when you are dealing with contamination or potential contamination, in how much investigation should you engage.

Phase I and II Audits

MR. GIACCIA: The format of a phase I environmental audit has now been standardized by the American Society for Testing Materials, which is a standard-setting organization for all sorts of engineering applications.  ASTM Standard 1527, which was written in 2000, is now the standard for phase I environmental site assessments.  If you see a contract provision that says that a phase I assessment will be done, that contract provision should specify compliance with ASTM Standard 1527.  That standard is tremendously detailed because it tries to address a large number of potential situations.  It also calls for a number of basic investigative activities.  Among them are a review of government regulatory files and databases. There are numerous databases that tell you all kinds of information both about the site and about what goes on in the surrounding area.  As part of the phase I audit, a database radius search will be done, probably within a one-mile radius from the site, to find every hazardous waste facility, leaky tank, spill site and everything else you can imagine from an environmental husbandry standpoint.

A phase I audit will also involve an inspection of the site, but they are not walking around with shovels, testing equipment or anything of that sort. They are just looking for things that could be a problem. They will also look at past land use records to see whether years ago, although there is no evidence of it now, the site was a landfill or a more environmentally-sensitive type of industrial facility, such as a chemical plant or something of that nature.  They will look into records, if they are available, of the existing facility or of operations that were formerly associated with the site, interview employees and neighbors, and then there will be a recommendation for further action.  They will identify something called recognized environmental conditions or RECs.  When RECs appear at the conclusion of one of these reports, you never just stop there.  You must go on to the next level, which is a phase II environmental site assessment.

There is also an ASTM standard for phase II audits. The size and scope of a phase II environmental site assessment can vary tremendously.  Phase I site investigations can run $5,000 to $15,000.  Phase II investigations are typically more expensive, picking up somewhere where a phase I left off.  Maybe $30,000 to $35,000 is an average phase II audit, but they can be, depending on how much sampling you have done, much more expensive than that.

The areas of investigation in a phase II environmental site assessment involve intrusive physical sampling of the site.  That includes samples of the soil, perhaps in areas where stains were observed or where sensitive activities were previously observed or known to have occurred.  For the phase II investigation, the groundwater investigation may also be associated with particular areas of concern at a site, or groundwater sampling might be used to get a more complete picture of the site, because groundwater contamination spreads.  If you can get the right number of wells in place, then you can get a broader picture of what might be going on at the site even though there is no indication on the surface that there is something to worry about.

An area of sampling that is increasingly important — it has really exploded in the last couple of years and will continue to take off — is soil gas sampling. There is a heightened sensitivity in environmental agencies to the cumulative exposure risks associated with volatile organic compounds that evaporate readily, which in the soil or groundwater may work their way up into the surface air, and, therefore, may be potentially inhaled by human beings, particularly if human beings are in an enclosed space sitting on top of the leaking contaminants. This is an area that states, particularly New York, are scrambling to address.  New York announced last year that it was going to rethink every remedial site where there are volatile organic compounds.  Soil gas sampling issues are a big deal.

Once the sampling is performed, the results are compared to regulatory standards.  Some contamination is permissible, and higher levels are permissible if the use will be commercial or industrial, as opposed to something more sensitive like residential.  A phase II site assessment report might recommend further action that could include additional sampling.  There could be a phase III, IV,V or remedial action.

Superfund

MR. GIACCIA: We briefly talked about this concept of Superfund status liability. The operative terms are owner or operator, and you do not have to be culpable, but if you are the current owner of the site or the operator, or if you were a former owner or operator when a release occurred at the site, you have liability under Superfund.

Most state Superfund laws also generally have liability sections that are written the same way as the federal Superfund law. The liability is joint and several, which means that if you have liability for a little, you have liability for everything if you cannot find somebody to share it with.  Case law has made that whole process of trying to allocate the liability a lot worse.  There are some defenses.  Those defenses are centered around due inquiry at the time of acquisition for the most part and, therefore, those phase I and phase II site assessments that we talked about earlier, particularly the phase I assessment, need to be done properly to have any chance of taking advantage of some of those innocent purchaser, bona fide prospective purchaser or contiguous properties defenses under the statute.  Lenders should ensure that their borrowers investigate the site.  There is a secured creditor exemption for creditors that went into the law years ago, but lenders still think potential risks exist.

The lender exemption is not tied to due diligence.  It is tied to behavior.  If the lenders simply conduct themselves as lenders, and do not get caught up in the day-to-day operations at the site and the decision making, then they are entitled to the exemption. They can even foreclose on the property and run it for a while and still be entitled to the exemption, at least to the extent that there is pre-existing contamination, as long as they sell the property the first time somebody makes a good faith offer for the property.  So it is not about the diligence the lenders engage in.  It is about behaving as lenders while the loan is outstanding. That last point is important by the way. The state brownfield laws and other remediation statutes can throw the whole thing out the window. The Superfund defenses are great, but they are not always reflected under state law and, therefore, they have to be looked into very carefully.

The law is very clear on the secured creditor exemption and so is the case law that, from a Superfund standpoint, the mere fact that the lender is in a position to control its borrower’s conduct and even exercise that control, just in the way that lenders normally exercise their control, is perfectly fine.  In every loan agreement, there is an obligation to do cleanups, and enforcing that obligation is not a problem.  What you are really looking for from a liability standpoint is getting too involved in the conduct that caused the contamination.  But the cautionary point is that the exemption is under the federal Superfund statute, and most, but not all, state Superfunds have adopted a similar lender liability exclusion. There are other state remedial statutes that are not Superfund models where a lender could get caught up, particularly in a post-foreclosure scenario.

A brief comment about parent-subsidiary liability: this comes up once in a while, and not often in a finance context.  There is a 1998 case where the US Supreme Court in Bestfoods listed specific standards of conduct that a parent corporation can engage in that would define whether the parent corporation was so involved in the operation of the subsidiary as to have treated it as an alter ego or so involved as to be directly liable as an operator under Superfund.  We will not get into too much analysis on that, but it is something to be aware of.

Project Agreements

MR. GIACCIA: Environmental provisions can pop up in most project agreements.  You would expect to find environmental provisions in land-related project agreements, such as purchase agreements, lease agreements and easement agreements.  It is not necessarily the case that a lessor, for example, will take responsibility for contamination on the site.  It is a question of leverage.  It is more often the case than not that the lessor will take responsibility for pre-existing contamination and for the migration of such contamination.  It is best to discuss potential environmental liability in a lease.  It is always much better to sue under a contract for cleanup costs than it is to try to pursue a common law or statutory remedy.

Another place to find environmental provisions is the engineering, procurement and construction or “EPC” contract.  In the standard EPC contract, and it is rare to find anything differing from this, the construction contractor will not take liability for pre-existing conditions.  It will not take liability for any conditions that it does not cause, and it typically will not take any responsibility even for dealing with something that it encounters during construction. The minute the contractor encounters it, the EPC contract usually says he is entitled to stop, let the owner-developer know about it, and the owner-developer must do something about it.  The other place in the EPC contracts to look is the performance guarantees. There inevitably will be in either the EPC contract or in separate vendor agreements, particularly for thermal power plants, contractual guarantees that address air pollution performance. To a lesser extent, you will see wastewater pollution performance, and then you will also typically see noise performance standards.  Air and noise are the two key ones.

In facility services and operation and maintenance agreements, environmental provisions will also pop up.  A steam supply agreement frequently will have provisions in it about the quality of the condensate water returning or other related services.  Water supply agreements are key agreements, particularly for thermal power plants with cooling water being in such a high demand. This is frequently an area that requires considerable analysis whether it is in the form of a water supply agreement or some sort of a tariff agreement with a public authority. There must be an analysis about the strength of those water supply arrangements and the quality of the water being supplied.

Finally, credit agreements, participation agreements and other types of transaction documents include environmental provisions. These agreements contain several basic types of environmental representations.  While there are many variations on this theme, the level of detail in the representations may, in part, turn on the level of detail of the informational materials provided and the need to confirm that certain questions are asked and answered through the representation.  Basic representations will include a compliance-with-environmental-laws representation. You want to look at both current compliance, and past compliance, because past compliance can point to chronic conditions or future penalties.

There will also typically be a representation regarding the completeness of the environ- mental permits, and that they are in full force and effect, and are not appealable. The full force and effect and nonappealable language is a standard representation in credit agreements.  It is found probably less than 50% of the time, maybe even 25% of the time, in an M&A deal.  Another representation will address the fact that the plant is not subject to any environmental enforcement action, prior claim, or notices of noncompliance.  One of the big sticking points in purchase and sale agreements is to what extent the seller is really willing to give essentially a guarantee that the site is not contaminated.  There are many variations on the representation about contamination liabilities, both at the site and also off-site where materials may have been sent for disposal.  In a credit agreement, the borrower generally has no option but to give a fairly complete representation that there are no on-site or off-site contamination liabilities.

There will also generally be a representation about the completeness and accuracy of the due diligence materials provided.  In addition, in a purchase and sale agreement, we typically request a representation that the plant retains all of its emission reduction credits and allowances.

MR. BELDEN: You will also see some qualifiers in representations.  For example, in M&A transactions, you will have disclosure statements from the sellers essentially carving out from the representations certain known conditions. There may also be knowledge qualifiers that are typically heavily negotiated, and there may be material adverse effect qualifiers.  These limitations on the representations are all heavily negotiated.

MR. GIACCIA: From an environmental standpoint, the toughest ones to negotiate are the knowledge qualifiers, because you need to push knowledge down to get to a point where you can get a fairly high degree of certainty for a lender or a buyer.  Lenders do not usually allow such qualifiers.  A buyer will want to confirm that the company has enough knowledge to make the representations.

Environmental covenants might include maintaining permits and compliance with laws. Those are not unique to the environmental regime.  Prompt notice is usually required of not only claims you get from the government or a third party like notices of violation or claims, but also of material releases or material violations of which the borrower becomes aware.  A covenant requiring notice of a material release or violation is often a heavily negotiated provision because borrowers do not want lenders to be hovering over them, and there is always some sort of spill going on. There may be a covenant imposing an obligation on the borrower to investigate and remediate contamination and rectify any violations.  In a sale transaction in particular, but sometimes in a loan transaction, there may also be a covenant requiring the plant to maintain its inventory of allowances or emission reduction credits and to prevent the sale of the allowances or credits so that value is not taken out of the project.

Project agreements will typically include environmental indemnities.  In acquisitions, the past liabilities go with the seller, and post-closing liabilities with the buyer, but that can be shifted around.  It is not against the law to shift. You can divide it up really any way you want, whether it be a compliance liability or a contamination liability.  It is typical to subject them to the same dollar thresholds as the other indemnities or to have individual dollar thresholds for environmental claims. The important thing is the aggregation of claims.  Roy Belden mentioned that, in environmental air emissions, you can have multiple violations in one day. Those might individually each garner a smaller penalty than your threshold, but this could go on for days or months. You could end up having a huge potential fine that if the provision is written incorrectly, and aggregation is not allowed, the fines could get swept out by the claim threshold provision.

Determination of which party controls the cleanup is oftentimes specified in the special environmental provisions in the indemnity.  Environmental claims are not always like other types of litigation.  An environmental claim can have an effect on how the plant is to be operated in the future.  Certainly for remediation claims, somebody needs to control the cleanup and you could put in provisions about cleanups having to be reasonable and justifiable, et cetera, but there is no better way to save yourself money by making sure it is done economically than to do it yourself, and so who manages a cleanup becomes an important point of negotiation for the indemnifying party.

The last point is that there is no really meaningful statute of limitations under most environmental statutes. They exist under environmental laws for compliance issues, but because of the way they are worded and interpreted, a lot of times they do not begin to run for a long time and, therefore, it is unacceptable unless, of course you are the party benefiting from it, to subject environmental liabilities to a statute of limitations because the indemnification obligation may never go away. Typically, we see environmental indemnification obligations contractually limited to a specific term of years.

Structuring Around Environmental Risk

MR. BELDEN: We will finish up on structuring around environmental risk.  We have separated the topic into two areas — one is new domestic projects and the other is existing domestic projects, which includes M&A transactions.

In financing a new project, you are definitely going to want to see a phase I environmental site assessment at a minimum and, depending on where the project is located, you may need a phase II environmental site assessment.  You may have a new project that is built on former farmlands, which is what is referred to as a “greenfield” project, or you can have a project built on what is called a “brownfield” site, which is an area where there is prior industrial use or near an industrial area where there may be contaminated groundwater near the site.  If it is a brownfield location, you are definitely going to want a phase II environmental site assessment of the site.

As part of the transaction process, you need to identify the government approvals that will be required.  In connection with a financing, there will be a governmental approvals opinion that is issued at closing by the borrower’s counsel, and there may be a separate opinion issued to cover federal permits and then another opinion that covers state and local permits. The legal opinion is important in that it confirms that the project has all the permits that it needs to construct the plant, and it identifies all the permits the plant needs to operate. The legal opinion will also confirm that the applicable appeal periods for each permit have expired or, if not, then the opinion will identify the issues involved with an open appeal period.

On financing new projects, there may be post-closing risk that you will need to work with, for example, implementing a backup water supply plan. You want to make sure that such a plan can be readily implemented, if needed.  Typically, a credit agreement would spell out the timing for the delivery of that backup water supply plan or backup wastewater discharge plan.  In credit agreements, the indemnities will run in favor of the lender, and the borrower is on the hook for all environmental liabilities. There will be an independent engineer’s report and you will want to make sure that the independent engineer has identified any issues that should be addressed.

For brownfield sites, there may be ongoing cleanup responsibilities or deed restrictions that apply to the site.  Be fully aware of what those are and if there is a cleanup obligation, how that may affect the construction of the plant and the plant’s operation.  If there is existing contamination of the site, an environmental insurance policy may be an option.  With environmental insurance policies, there are typically a lot of exceptions that apply.  The utility of an environmental insurance policy is sometimes in doubt, but it may be useful for a very specific situation.

MR. GIACCIA: If there is a known issue, by the way, the insurance product that is relevant is called cost cap insurance. If it is an unknown issue, then there is environmental remediation liability insurance. With cost cap insurance, the insurance company is not interested in actually paying for the cleanup, but the policy caps the overall costs, basically at a number that reflects both the projected remedial costs plus an additional 10% to 15% buffer, and then above that, the insurance company is responsible.

MR. BELDEN: Now we will shift to structuring risks for existing projects. There is definitely more pressure for a phase II site assessment at an existing plant.  As part of the power plant divestitures a few years ago, these were plants that had been in operation for 20, 30 or 40 years.  The phase I reports identified areas of potential contamination at the plant sites.

For the acquisition of an existing plant, typically you will have some sampling done to find out what your contamination risks might be. You will also want to take a look at the operating permits of the plant. In general, construction permitting is not an issue since these plants have been in existence for a while.  But you may need to anticipate what change-in-law risks exist.  For example, in a divestiture of coal-fired plants, factor in the impact of the clean air mercury rule, the clean air interstate rule and possibly climate change risks.  There may be mandatory carbon reduction requirements some day in the US, and, with an existing plant, you want to take a careful look at the compliance history and review any environmental liabilities the owners may have agreed contractually to cover.

In an asset sale, the mere fact that you are buying assets is not a shield against liability issues. With a divestiture, you want to try to have the seller provide a comprehensive indemnity.  An alternative is to set aside part of the purchase price for possible environmental liabilities.  Environmental insurance may also be an option.

MR. GIACCIA:I have to tell you that I can think of only two transactions in which I have been involved where an insurance product got us over an environmental problem.  However, some people who do environmental transaction work believe in them as a useful tool.  The variable may very well be your preparedness, the quality of the broker that you work with and your ability to negotiate a policy that is effective.  Because if all you are planning to do is call an insurance company, get the basics done, and get a policy signed up, then you are kidding yourself that you are going to get something that is useful.  It takes time to get an effective policy, and you can usually not get one at the 11th hour.  If there is enough time and enough information about the site, then you may be able to negotiate an insurance policy that is useful.