Periconi, LLC

Environmental Due Diligence in Real Estate Transactions Blog Series: Part II - Contract of Sale of Real Property

In our first post in this blog series, we explained exactly what is meant by the term "environmental due diligence" in real estate transactions and discussed some of the "tools" of environmental due diligence. In this post, we'll cover in detail one of those tools: the contract of sale for real property.

Why is the contract so important?

Some consider the environmental site assessment process alone to be adequate environmental "due diligence," but contract drafting is integral to the success of the overall environmental due diligence process. Drafting appropriate contact provisions and establishing the property's baseline environmental conditions are central to the desire by buyer and seller to get the benefit of their bargain and minimize unnecessary exposure to liability.

In our first post in this blog series, we explained exactly what is meant by the term "environmental due diligence" in real estate transactions and discussed some of the "tools" of environmental due diligence. In this post, we'll cover in detail one of those tools: the contract of sale for real property.

Why is the contract so important?

Some consider the environmental site assessment process alone to be adequate environmental "due diligence," but contract drafting is integral to the success of the overall environmental due diligence process. Drafting appropriate contact provisions and establishing the property's baseline environmental conditions are central to the desire by buyer and seller to get the benefit of their bargain and minimize unnecessary exposure to liability.

Parties can use their knowledge of environmental conditions on the property to better allocate liabilities in the contract of sale, and thus to some extent "fix" their expectations realistically, minimizing later problems. Proper contracting also helps establish certain statutory exemptions against statutorily-imposed liability, should a problem arise after the closing. To do this properly, each side in the transaction requires an environmental attorney who is knowledgeable about federal andNew YorkStateenvironmental statutes, as well as common law background principles.

Important contract provisions.

Before getting into the specific language, we will review the functions of the several types of contract provisions that can be found in a contract of sale and why these provisions are an important part of environmental due diligence.

A representation is a statement of fact made to induce another party to enter into a contract. A warranty is a promise that the statement is true; intended to relieve the buyer from having to determine if the facts are true. A covenant is a promise by a party to perform certain tasks, e.g., to correct environmental problems uncovered during the due diligence period, obtain No Further Action Letters or other government approvals, close inactive tanks, or do remediation. Lastly, an indemnity is a full and complete shifting of liability to another party.

Representations and warranties help the seller organize its disclosures and records, help the buyer focus its due diligence effort by identifying and quantifying the environmental liabilities, and help the parties allocate environmental risks and obligations. However, representations and warranties should not be relied on as a substitute for including an indemnity provision in the contract that will specifically allocate liability, nor should they be a substitute for undertaking the necessary due diligence through the environmental site assessment process.

The scope of an indemnification provision is often a troubling issue. From the buyer's perspective, it is better to have a stand-alone environmental indemnity that states those specific matters for which the seller must indemnify the buyer, usually presented as a schedule annexed to the contract that lists all the known environmental conditions. Business and real estate counsel need to work with environmental counsel (and vice versa) to ensure that the environmental indemnity provision harmonizes with the contract of sale's general indemnity provision

Furthermore, if you are the buyer, environmental counsel should help determine - and explain to you - whether there are pre-existing indemnity agreements affecting the assets you want to purchase, e.g., did the seller agree to assume certain liabilities when it acquired the business it is now selling, or did a previous seller retain environmental liabilities?

Examples of specific environmental language in purchase and sale contracts.

As part of the overall environmental due diligence process, it is important to ensure that certain provisions - such as those discussed above - and certain specific language - such as that listed below - are included in a purchase and sale contract for contaminated properties. Fortunately, on the Periconi, LLC blog, we've already highlighted most of the specific language that we recommend including in any purchase and sale contract. Therefore, the following discussion includes links to those previous posts.

A. Environmental Representations and Warranties

Before the parties can set forth representations and warranties, it is important to define the terms that will be found in those contract provisions.

1. Definitions:

a. Hazardous Materials

b. Environmental Requirements

c. Environmental Claims or Environmental Damages

d. Material Adverse Effect or Adverse Environmental Condition

2. Representations:

a. Inducement/Best Knowledge

b. Compliance with Laws/No Violations

c. Representations: All Required Permits

d. No Hazardous Substances/Hazardous Waste/Hazardous Operations on Property

e. No Notices or Knowledge of Basis

f. No Asbestos, PCBs, or Underground Storage Tanks (USTs)

g. "As Is" Clauses

B. Pre-Closing and Post-Closing Covenants

1. Maintenance of Representations and Environmental Site Assessments

2. Borrower's Covenants

C. Indemnities

The indemnity provision provides even greater security for a party than do representations and warranties alone. Great care should be taken in drafting, and reviewing, the environmental indemnity provision in your contract.

The environmental indemnity should cover the following occurrences:

  • The presence in, on or under, or the escape, seepage, leakage, spillage, discharge, emission, disposal or release from, the property of any Hazardous Materials.
  • Environmental Claims asserted or arising under any Environmental Requirements.
  • Any representation by seller (or borrower) being false or untrue in any material respect.

Additionally, the indemnity should address the following issues:

  • Should the indemnity be made by the party alone, or by that party and its successors, assigns and guarantors?
  • Should the indemnity extend to any successor or assign who acquires an interest in the property or otherwise succeeds to the rights of the buyer or lender under the agreement?
  • Should the indemnity cover the directors, officers, shareholders, employees, partners, agents, contractors, licenses, affiliates, lessees, mortgages and invitees of the indemnitee?
  • Should the indemnity create an exception for the negligence or willful misconduct of the indemnitee?
  • Should the indemnity be limited to a fixed amount of money?
  • Should the indemnity survive for a fixed amount of time?
  • Should the indemnified party have the right to approve counsel retained by the indemnitor?

D. "Walk-Away" and Post-Closing Cost-Sharing Provisions

1. Environmental Site Assessment ("ESA")

(For a summary of the processes and requirements, click here for Phase I ESAs and here for Phase II ESAs.)

Any pre-closingESAcontingency must provide a right for the buyer (or lender) to walk from the deal if the assessment reveals risks which the buyer is unwilling to take. The buyer will want such a determination to be solely within their discretion, while the seller or borrower will want to limit that discretion to risks of "Environmental Claims" that may be reasonably said to give rise to "Adverse Environmental Condition."

A basic format is to require that if the assessment reveals any violations of "Environmental Requirements" or other environmental exceptions, it is the obligation of the seller (or borrower) at its sole cost and at its sole discretion to remediate the exceptions. If the seller decides not to remediate, then the buyer may terminate the agreement by sending a written notice of termination to the other party. The time in which such a remediation must occur or such notice be delivered should be limited to assure finality of contract. And, even where the seller is willing to remediate, a time limit or re-opener may be needed to assure that the buyer is not locked into an unreasonable extension of the closing date.

Finally, confidentiality of the ESA report will be of importance to all parties, but particularly to sellers. The buyer must agree to maintain absolute confidentiality of the report, to the extent permitted by law, until buyer has accepted transfer of title from the seller.

2. Cost-Sharing

Where "Adverse Environmental Conditions" are anticipated, the parties may agree in advance to an apportionment of the cost of the Phase I and II ESAs, the cost to remediate, and the cost of consultants. However, this is generally difficult to do unless the site has been thoroughly assessed. Even a Phase II ESA (which includes soil and groundwater sampling) may not be adequate to provide the parties with knowledge of the full extent of environmental problems at the site.

Cost-sharing provisions limit the obligation of the seller. These limitations can be coupled with an obligation for the seller to remediate the environmental exceptions, with the knowledge he or she does not have an unlimited contingent liability. Therefore, if cost-sharing is utilized, a monetary cap is usually imposed on the seller's obligations. As with the pre-closing ESA contingency, the parties may agree to share the cost of consultants and the remediation according to a pre-established allocation formula.

***

Please contact us if you have any questions about environmental due diligence in real estate transactions, or if we can help you draft or understand the environmental provisions of your own real estate purchase and sale contract.

This blog series is based on an article written by James J. Periconi and published in the Winter 2008 Bloomberg Corporate News Journal. Mr. Periconi also discusses the details and the nuances of environmental due diligence of commercial real estate transactions in his bi-monthly continuing legal education course.

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