Environmental Diligence: Tapping Local Knowledge in International Deals

Environmental due diligence helps to frame the potential risk of future liability from a M&A transaction. Future liability can arise from specific laws regarding contamination of the environment or may derive from more general legal theories of personal injury and property damage or a constitutional right. Political factors strongly influence environmental law, and legal liability varies significantly from country to country. As a result, local knowledge is key to understanding the potential risks and exposure in a particular deal.

Trend That is Changing the Enforcement Landscape. Despite ambitious environmental laws on the books, enforcement in many countries has often lagged. One emerging trend is the passage of new mechanisms to enforce environmental laws, regulations or constitutional guarantees. Many countries are establishing specialized courts and tribunals to hear environmental claims. For example, in 2010, Brazil, England and India all established new court systems devoted to environmental claims. China has also set up some 100 regional environmental tribunals throughout the country. Several countries recently passed legislation creating new kinds of environmental causes of action or increasing penalties for violations of environmental laws.

Legal System Structure Can Result in Local Variations. The structure of the legal system can affect the tenor of environmental law. In some countries, environmental law is based on overarching regional principles. Some countries have a strong centralized system, and others are driven by states, provinces or other political subdivisions. In still other countries environmental requirements may not be formalized and therefore rest on variable interpretations. Environmental laws and resulting liabilities vary from country to country. Below are some examples of legal structures.

• European Union. The European Union (EU) issues directives that member states are required to implement. The laws of an individual country may vary as long as the principles set forth in the directive are met. The EU Environmental Liability Directive (ELD) was issued in 2004 and supports the regulatory principle that “the polluter pays.” The focus of the ELD is on biodiversity and ecological damage (somewhat like the concept of Natural Resource Damages in the U.S.) as opposed to civil liability for property damage and personal injury, so that other directives and laws must be examined to establish the full range of potential liability. Some but not all countries in the EU have instituted requirements for businesses to demonstrate financial capacity, and some require insurance coverage to address potential environmental damages.
• Latin America. Individual countries within Latin America have distinct environmental programs. Mexico has a comprehensive site remediation program that includes property transfer requirements which prohibit the transfer of property contaminated with hazardous wastes without the express authorization of the federal environmental agency. Argentina has a more targeted program with sector-based standards for certain industries such as mining and petroleum operations, but does not have broad-based national laws regarding environmental contamination. Argentina has a federal system where the provinces retain significant authority, by contrast Mexico has a federal system where the federal government has enumerated powers. Brazil has a strict liability scheme where ownership of the land can result in liability for existing contamination.
• China. China’s Ministry of Environmental Protection has proposed Provisional Rules on Environmental Management of the Soil of Contaminated Sites, but these rules have yet to be adopted. Several national ministries have responsibility for defined aspects of environmental remediation; however, there is no national level law to address liability for contamination. Instead, remediation of contaminated sites is governed by a patchwork of regulation at the provincial and city level, with attendant risks and uncertainties for businesses. Existing contamination is often addressed by the local environmental protection bureaus. In some cases, developers are required to restore the property as part of the development costs. To complicate matters, procedures described in regulatory requirements are not always followed in practice.

Environmental Principles in International Project Finance. Financial institutions have developed overarching principles which may add an additional layer to the diligence review for large international projects. The Equator Principles (EP) is one such performance standard. It serves as a risk management framework to assess environmental and social risk in decision-making about projects and specifies a framework for due diligence that must be adhered to by member financial institutions. The third update of the EP was released in June 2013. Currently 79 financial institutions are signatories. Signing binds the signatory to require all ten principles to be addressed, including evaluation of the project for potential impacts, development of an environmental management system, stakeholder engagement and independent monitoring. The EP now cover some 70 percent of all emerging market project finance transactions and effectively determine whether or not a project is feasible and qualifies for financing.

Value of Local Knowledge. The potential risk of environmental liability varies by country. For example, groundwater contamination may not raise a significant concern if areas of industrial development are specified and individual companies do not bear the cost of cleanup. If legal theories such as successor liability do not exist under local law, then historically owned property or companies pose less risk. In some countries finding fault is a prerequisite to liability, whereas in others strict liability applies. Many countries have purposely chosen not to adopt aspects of the liability scheme developed under the U.S. Superfund statute. In some cases, the language of the laws may be similar to language in U.S. laws but interpretations differ in practice. It is important to tap into local knowledge to guide the diligence and quantify environmental exposure.