Why Are Environmental REP(resentation)S Different?

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The purpose of asking for a representation in a purchase contract, lease or other agreement is two-fold. The representation serves as a risk-shifting device and it serves as an element of the due diligence process. This is never clearer than when it comes to the ever contentious “environmental rep.”

The transferor (seller, landlord or borrower) and the transferee (buyer, tenant or lender) are not on even footing when it comes to representations. The property owner holds all of the environmental knowledge and all of the environmental risk before any transaction with the transferee takes place. So, the questions are: (a) how much risk should the buyer, tenant or lender take over; and (b) what should the seller, landlord or borrower be required to reveal before the “closing” takes place? We all know that, in practice, the answer differs depending on the type of transaction. Lenders rarely will lend their money without broad, all-encompassing representations from their borrowers, coupled with the fullest of indemnities. And, their borrowers honor that demand.

At the other end of the spectrum, sellers often take the position that selling their property in “as-is” condition means that: (a) the buyer takes all the risk of acquiring a contaminated property; (b) it, the seller, can refuse to commit itself to saying anything when it comes to hazardous substances or prior practices; and even (c) its buyer should indemnify it, the seller, for stuff that was there before closing.

Tenants usually fall someplace in the middle, with their landlords accepting that the risk of existing hazardous substances at the premises will remain with them, but still being unwilling to commit themselves to reveal what they know about the property’s existing environmental condition.

Why is there such a range of practice when it comes to the same basic situation, i.e., in each case, the transferor holds all of the environmental knowledge and all of the environmental risk before any transaction with the transferee takes place? If the transaction doesn’t happen, it still holds all of the risk. Ruminations suggests that the answer lies in its commonly identified culprit – the “market place.”

Lenders, who we posit have the least exposure to risk, plain and simply won’t put up with taking any possibly known risk. The “market’s” pricing (i.e., the market interest rate) doesn’t cover the risk at all. There might be a price (interest rate) that would “take” the risk, but borrowers find it “cheaper” to acknowledge that they will be responsible for the consequences of contamination. Perhaps that’s because they “need the money” and, unlike in the buyer-seller or landlord-tenant-market place, very, very few, if any, lenders, will take any environmental risk. If the property were known to be contaminated, its value as collateral would be impaired and, if a loan were to be available, the size of the loan would be lower and if such a loan could be obtained, the interest rate would be (much) higher. So, if the borrower doesn’t know that its property actually is contaminated, it will “answer” the questions (i.e., give the representations) and agree to keep the entire risk. If it won’t, the marketplace will say: “no loan.”

We’ve gotten this far without saying anything about what an environmental representation might say or what the environmental risk might be. So, let’s do it now.

There isn’t a single form of environmental representation, but these representations come in three general flavors. The first, and most unlikely to be seen (other than in loan situations) is where the property owner says that its property is free of contamination (except, in the unusually case where specific contamination is listed). Whether that is true or not and whether that can even be known or not, the property owner is essentially saying that its buyer, tenant or lender can come back against the owner if contamination if found (but only if the buyer, tenant or lender didn’t know of the contamination before closing or taking possession). The property owner is saying that its transferee can act as if the property is “clean” unless the transferee actually knew otherwise. The representation isn’t saying that the owner actually knows the property to be contamination-free; it is saying that the buyer, tenant or lender can act as if it were.

Moving down the list, property owners, if not willing to “guaranty” the absence of contamination, are often willing to represent that they have received no notice from anyone who said there were hazardous materials on the property. That might be limited to written notice or only those from “governmental” sources. The representation might limit itself to hazardous substances on the property in violation of environmental laws. Why save this thought until the end? To Ruminations, getting a representation to the effect that the property owner has received no governmental notices of hazardous substances on the property in violation of environmental laws is the equivalent of getting ice in the winter. Such a representation shifts no risk; the recipient will be dragged into the environmental scuffle if bad stuff is later discovered at the property, and the recipient really hasn’t learned anything it couldn’t have found out on its own. The identity of all possible notice-sending governmental agencies is knowable and their records are public and searchable anyway.

Here is a critical point – one already raised above – the market place “prices” the risk of contamination into the price, be it the purchase price, the rental amount or the interest rate (though, as posited above, the interest rate for loans secured by contaminated property would be “out of the market”). Everyone recognizes that if there were two pieces of property, one of which could be mistaken for the other except that one was contaminated and the other was not, the contaminated property would command a lower price. Though never discussed, even if neither were known to be contaminated, a property “guaranteed” by the owner to be contamination-free would command a higher price than one being sold without environmental representations.

What a buyer, tenant or lender really wants to know is: what does the property owner know? – does it know, or is it aware, of any hazardous substances at the property. In our view, owners who respond: “we won’t represent what we actually know, it’s your problem, go figure it out yourself” are way, way off-base. That’s not in the price. A buyer or tenant is entitled to an honest answer. Either the owner knows or doesn’t know. This is a due diligence question, the answer to which can only come from the owner. To assert that the buyer or tenant should “do it’s own due diligence, i.e., hire an environmental consultant,” is not responsive. The environmental consultant is going to ask the question: “do you know of any contamination?” This isn’t a game of “how many things can you find wrong in this picture.” The property owner has some of the answers. Who else would know what the owner knows? If the fear is that it will be responsible for hazardous substances that it didn’t know about, the owner should read the question again. If the fear is that it “forgot” about something it should read the question again. To “know” doesn’t mean “used to know, but forgot.” It means what you know, “right now, when you are making the representation.” If you disagree with our understanding,” just qualify the representation to “having cognitive awareness” or something like that.

One last point for today – how much of a price reduction should correspond to an owner’s insistence that its buyer (or, sometimes its tenant) should “take over” the owner’s liability for pre-existing contamination by way of releasing the owner from such liability and indemnifying the owner for third party (including governmental) claims? If there were a “discount,” it should probably equal the cost of an environmental liability and clean-up insurance policy from issuers of such policies. Faced with such a demand, buyers and tenants should get premium quotes, and use the “price reduction” to buy such a policy (or keep the “premium” and self-insure). Given the way such policies are structured, the owner should still have some “skin in the game” in the form of retained liability exposure equal to the amount the deductible and a reasonable estimate of the required “co-insurance” commonly found in such policies. Lenders have less exposure because they wouldn’t normally be exposed to claims, only to impairment of their collateral, and that is priced into the interest rate. Of course, it would be more direct if the seller or landlord kept the risk and bought its own insurance policy or “self-insured” and kept the premium for itself.

There is a lot more to be said about this topic, but we’ll leave that to our readers, all of whom are invited to post a comment directly to Ruminations by clicking here: www.retailrealestatelaw.com.

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  1. Ira, if the Tenant, or Buyer or lender (at borrower’s expense) has the right to perform soils and hazardous materials inspections, why not take whatever the landlord is willing or seller to warrant? A sample clause for a lease follows:
    “Environmental and Soils Investigation” means an environmental and soils audit of the property of which the Premises is a part which may include at Tenant’s option a physical inspection of the Premises and investigation of property surrounding or in the vicinity of the property, and such other investigations of records deemed necessary or desirable by Tenant in connection therewith, including, without limitation, tests of soil and ground water and boring, percolation, and other soil and water tests for purposes of determining the physical characteristics of the sub-strata of the Premises and property, and/or such other investigations or tests commonly performed as part of a Phase I and Phase II environmental study. Landlord shall be responsible, at Landlord’s cost and using Landlord’s EPA ID number, for the disposal of any soil cuttings, development water and other waste materials associated with Tenant’s Environmental and Soils Investigation.

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