Environmental compliance audits are detailed audits of an operation or manufacturer to determine if the operator is in compliance with local, state, and federal regulations. Compliance audits differ from Phase I and II environmental site assessments (ESAs) in a fundamental way: Phase I and II ESAs focus on releases of hazardous substances to real estate, whereas compliance audits focus on whether or not operations comply with environmental laws with the objective of reducing regulatory risk, avoiding violations, enforcement, and fines. Environmental Site Assessments are a standard component of the transactional due diligence process, but conducting a compliance audit during due diligence is the exception, not the rule.
This is because non-compliance may not obviously de-value an asset, and the cost therefore may not seem justified. This is unfortunate because environmental compliance audits offer much more than simply an opportunity to avoid fines and violations. Compliance audits directly benefit each party involved in a large or small real estate or corporate transaction, whether it’s the buyer, seller, operator, lender, or investor.
The routine environmental compliance audit is, of course, used by an operator to identify regulatory deficiencies, correct them, and avoid fines. For large manufacturers, compliance audits can also be part of an environmental management system or corporate policy. The benefits for operators are obvious: they minimize the risk of non-compliance and the resulting fines. Correcting non-compliance also improves corporate image.
Real Estate Buyers and Sellers
As mentioned, the use of compliance audits in the context of real estate due diligence is uncommon. But, since compliance audits involve a detailed examination of operations past and present, environmental practices that could have contaminated real estate are often identified during a compliance audit. These may include historical waste handling, waste storage, and disposal practices.
While the ASTM standard for Phase I ESAs is of course designed to do just that, compliance audits usually include an even more detailed examination of actual processes and industrial operations….which is often the source of most hazardous waste releases. So, in a manufacturing setting, both Phase I and II ESAs and compliance audits can be used together to most effectively identify environmental problems.
For sellers, there is less motivation to conduct a compliance audit: the audit may identify a problem that reduces the sale price. But, for a seller that has worked hard to ensure that a manufacturing tenant is operating to the highest standards, an audit can help get in front of potential issues and consummate a transaction. Check out Partner’s Frank Romeo’s discussion on how due diligence can increase the certainty that your deal will close.
Lenders and Investors
Lenders and investors also benefit from an audit because the underlying asset (a business) can incur unexpected costs or losses to correct a problem. Since the ability to pay a loan or realize a return can be affected by cash flow and profits, identification of an environmental problem before closing is especially important to lenders and investors.
Mergers and Acquisitions
In the realm of corporate mergers and acquisitions, compliance audits really pay off. Most purchase and sales agreements contain representations by the seller regarding compliance with a wide range of regulations. In many instances, representations are based on a presumption of fact, especially regarding environmental compliance. The seller’s logic is often that if they know of no regulatory deficiencies, and can represent that they are in compliance with all environmental regulations to the best of their knowledge. For a seller, completing a compliance audit not only backs those representations, but also enables buyers to quickly move past environmental issues. Put yourself if the buyer’s shoes: wouldn’t you be more comfortable with a representation backed by an audit?
For a buyer, the motivation is obvious: make sure what you’re buying complies with environmental regulations. Obviously, for large acquisitions and major corporations, compliance audits are an integral part of due diligence. But for smaller operators and deals, compliance audits are often overlooked. Considering that the consequences of missing something can be really expensive, audits for smaller deals are used far too infrequently. A large unexpected cost on a small deal will have much more impact than on a large deal. So, environmental compliance audits are all that much important on smaller deals.
Scaling an Audit and Controlling Cost
Compliance audits can easily be scaled to match the level of effort needed to identify problems and match risk and cost tolerances. ASTM has published a standard for environmental compliance audits (ASTM E2107-06 (2014)). The standard is basically a shell that provides a format for the audit and establishes a minimum standard for the auditor or audit team. The ASTM standard does not specify which regulations must be included because regulations vary by location and specific operations. Unlike the ASTM standard for Phase I ESAs (E1527-13), which specifies specific review and inspection requirements, the ASTM standard for environmental compliance audits contains no such specificity. As a result, there is a lot of flexibility to tailor the audit to scope and cost requirements, while still remaining within the framework of the ASTM standard.
As with everything else, you get what you pay for, so basic audits will include less detail and increase the chances that a compliance issue is not identified.
Hidden Opportunities: Process Improvements
During the audit process, another opportunity arises. Since any audit evaluates a process in detail, compliance audits offer the opportunity for a third party to examine a process and identify inefficiency. Inefficiencies may not be obvious to an operator for many reasons. The operator may lack regulatory background, may not have an unbiased perspective, or may simply be accustomed to a certain process. In almost all instances, inefficiency equates to cost. A good auditor can often identify inefficiencies and suggest improvements.
So when you conduct due diligence, prepare for a sale, write a loan, or invest in real estate or a business, consider whether an environmental compliance audit benefits your deal in addition to a Phase I and Phase II environmental site assessments.