Costing and Disclosing Environmental Liabilities and

the Impact on Loan Contingencies

© The TBLS Group, LLC

Agenda • Two Lender Scenarios & What Due Diligence / ASTM Standards Applicable

• Environmental Liability & Valuation In Corporate Transactions

• Three New/Revised Environmental ASTM Standards that Help the Loan/No-loan Decisions in Corporate Transactions

• ASTM E-3123: Financial Impacts of All Environmental Liabilities including Asset Retirement Obligations, Guarantees, Contingencies, Commitments and other Environmental Obligations on Lenders

• Environmental Liability Recognition & Valuation – Part of Creditor/Bankruptcy, M&A Due Diligence & Support for Corporate Reporting Teams

• An M&A Case Study using Corporate/Business Recognition & Valuation of Environmental Liabilities as a Negotiation Tool

• Conclusions

Scenario 1: Real Estate Transaction & Property Repurposing – Phase Is and IIs Work in Most DealsTypical Property/Deal Characteristics• Vacant Land• Commercial Property• Industrial Property• New Construction on Repurposed Land• Underwritten with land/new development as collateral

Environmental Due Diligence• Phase I (ASTM E-1527-13) and sometimes Phase IIs – provide

“innocent purchaser” defense• Develops Cleanup Costs, Asset Retirement Obligation Costs at start

of repurposing (i.e. demolition, decommissioning, decontamination, reclamation and abandonment)

• New construction costs estimated and included in Buyer’s cash flow projections for Bank’s underwriting process

• Cleanup often done or started as part of repurposing activities depending on Bank’s preferences, sometimes with intermediate lenders holding creditor position

Lender Considerations• Bank’s underwriting process usually tied to cash flow and LTV

analyses of property with repurposed improvements• Phase I (and sometimes Phase IIs) with REC estimates usually

sufficient to determine book value or appraised value• Bank evaluates potential loan(s) according to its underwriting

with contingencies

Buyer / Borrower

Seller

BankBuyer’s Due Diligence /

Redevelopment Team

Scenario 2: Industrial Merger or AcquisitionM&A less common – but about $3-7 trillion annual business in U.S.

Deal Characteristics• Business usually not re-purposed but stays the same with new ownership,

fresh investment in capital improvements (CAPEX)• Seller’s Business Valuation

• Property and improvements valued by appraiser, with business valuation often done by accountants/financial analysts

• Typically includes several years of Seller’s audited financial statements• Seller’s records File Room (Physical and/or electronic) usually constructed by Seller and its

Advisory Team• Usually includes Environmental budget/spending records • Environmental liabilities and reserves are part of current business valuation

• Buyer granted greater access, to cover many facets of environmental record not typically evaluated in Property Repurposing deal

Environmental Due Diligence Access to Information• Phase I (ASTM E-1527-13) and sometimes Phase IIs, to provide “innocent

purchaser” defense, and Seller often does one too• Develops RECs, but more complex costs to maintain/cure are usually part of the

business valuation• Identified RECs are often settled in price negotiations; contractual obligations

& guarantees between Buyer & Seller w/Lender input• Lender requirements greatly influence Borrower’s costs

• Cleanup and its timing is just one of many environmental aspects that is part of reserves and cash-flow scenarios

Lender Considerations• Asset Retirement Obligations, Obligations, Commitments, Contingencies, & Guarantees, may

be transferred from Seller to Buyer, including financial reserves to be used at a later time

• Bank’s underwriting process usually tied to improved Business Valuation included in Buyer’s Business Plan/Pro Formas (including future Cash Flow projections) AND to LTV analysis of property with new improvements – ongoing and future Environmental Liabilities are developed as part of the projected Pro Forma and Cash Flow scenarios

Buyer / Borrower

Seller

Bank(s)Buyer’s

Advisory Team

Seller’s Advisory

Team

Why Phase Is and IIs May UnderestimateCorporate Financial Environmental Liabilities• Most are business risks, and Phase I non-scope issues• Phase I and II ESA Consultants may not have financial training, or access to all information• Environmental Compliance, often an annual multi-million-dollar business cost into the

future, may dwarf a facility’s cleanup requirements• Asset Retirement Obligations (AROs) usually are limited to asbestos or lead-based paint

evaluations in Phase I ESAs, and most Phase I ESAs do not cover extensive costs related to power-plant decommissioning, landfill closures, pipeline abandonment, oil well abandonment, mining reclamation, etc.

• Environmental Commitments such as PRP agreements, allocation agreements, contractual obligations between past owners, etc. may not be within the purview of a Phase I/II ESA Consultant

• Environmental Contingencies such as Natural Resource Damages (NRD) claims or environmental lawsuits may cost as much as environmental cleanups and cost analyses usually outside scope

• CAPEX: No in scope due-diligence requirements exist in Phase I/II ESA standards to evaluate conditions of existing pollution control facilities/equipment – only whether a permit exists, and if there have been historical violations

• Where there are pollution control facilities – such as landfills, RCRA Waste Storage or Handling Units, Wastewater Treatment Plants, Water Purification Plants and Air Pollution Control Measures – costs to upgrade/bring into compliance may run into tens of millions of dollars

• No requirements under the Phase I/II rules specifically target identification and determination of sufficiency of reserves & financial guarantees for environmental matters

What ASTM Guidances Should I Be Aware Of?Three ASTM Standards deal with Recognition, Estimation & Disclosure of Corporate Business Environmental Risks – These may or may not impact Real Estate Transactions

under Scenario 1 but will likely have major impact on corporate Financial Statements in Scenario 2). The Standards:• ASTM E-2137-17: Estimating Monetary Costs & Liabilities for Environmental Matters• ASTM E-2173-16: Standard Guide for Disclosure of Environmental Liabilities• ASTM E-3123-18: Recognition and Derecognition of Environmental Liabilities

These Standards provide guidance to Environmental Consultants who support corporations & their lenders, bankers, etc. on environmental matters, including for:• Mergers & Acquisitions • Business Valuations • Cash-Flow Projections embodied in audited

financials of existing companies &/or Pro Formas of Borrowers

Five Key Issues that inspired ASTM Updates ofE-2137-Estimating and E-2173-Disclosure

The results of a study of corporate 10-Ks conducted by the ASTM E-50-05 Committee found:

• Different terminology between Accounting Standards (IASB, GASB, FASB) and environmental practice

Financial Underwriters such as Banks and Insurance Carriers rely on corporate Financial Statements to make commercial business loans and to estimate risks

• Differences in Presentations and Disclosures in Financial Statements

• Environmental Reserves (ERL) and Asset Retirement Obligation (ARO) Balances were at an all-time high

• Annual EHS spending disclosed was not reducing the overall liability on subsequent Financial Statements

• Huge Gap between Book Value of Environmental Liabilities (what a company books) vs. Market Values of those Liabilities (what it really costs)

E-2173-16: How New Disclosure Standard Plays Out in 10Ks

From publicly available 2017 10-K – “PSE&G has determined that the estimated cost to remediate all MGP sites to completion could range between $358 million and $403 million on an undiscounted basis through 2021, including its $46 million share for the Passaic River as discussed above.…”

Schnitzer Steel

PSEG

E-2137-17: Estimating Monetary Costs and Liabilities for Environmental Matters

Most Common Uses:• Preparing Corporate Financial Statements• M&A• Environmental lawsuits • Insurance premium calculations and claim

settlements• Brownfield redevelopment • Construction and project control• Analysis of remedial alternatives • Budgeting, including environmental CapEx• Audit defense • Shareholder finance & investment analyses

ASTM E-2137-17 Metrics• Material Costs: Reasonable & Necessary,

Estimable Liabilities, More Likely Than Not Percentage of Risk

• Fair Market Value Estimates: Eliminate use of “Known Minimum” & “No Estimate”

• “Range of Risk”: Optimistic, Most Likely, Pessimistic scenarios

• “Timing Risk”: Analysis

E-3123-18: Recognition & Derecognitionof Environmental Liabilities

• Provides instructions to companies and their financial/environmental advisors to determine if a liability exists• Requires an “Obligating Event” to be material• Requires Fair Market Value, which may include probabilities and contingencies

• Environmental Liabilities are defined as:• Asset Retirement Obligations (future demolition, reclamation, restoration of assets such as power plants, pipelines, buildings, mines, etc.)• Obligations (e.g. regulatory permit requirements, regulatory ordered cleanup, RCRA requirements, Administrative Order of Consent)• Commitments (e.g. contracts creating environmental risks such as purchase & sale agreements, vendor/product contracts, access

agreements, litigation settlement agreements, allocation & PRP agreements, etc.)• Contingencies (e.g. de minimis cash-outs, unsettled litigation outcomes, Natural Resource Damages)• Guarantees (i.e. contractual, letters of credit, bonds, RCRA closure/post-closure, insurance policies, etc.)

And are noted and/or quantified in conformance with Accounting Standards for Financial Statements• Purpose is to provide standards for Environmental Estimator’s estimates and opinions when company financials are certified

by corporate officers and auditors • Past/Future spending to extinguish liability

• Is it probable?• Is it estimable?• Is it reasonable and necessary?

• Recognizing/Derecognizing environmental liabilities necessary for current book value of an entity• Scenario 2 (M&A) often results in a corporate “Obligating Event” for buyers and sellers when they determine who is

responsible for what costs as part of a purchase and sale transaction• Determining/Negotiating current company or facility “book value” is a critical component in M&A activities

• “Underwater Transactions” are a special subset of M&A embodied in “Turnaround Management” where a company’s book value is less than its liabilities, and a Seller (or sometimes a Creditor) pays the Buyer to take a non-performing asset

• An E3123-18 analysis is above and beyond the standard Phase I/II ESA protocols, but may bring to the surface unexpected additional environmental financial liabilities!

E-3123-18 Analyses: Environmental Liabilities to be Identified, Evaluated, and Sometimes Quantified

From ASTM E3123-18: “Standard Guide for Recognition & Derecognition of Environmental Liabilities”

Relevant Accounting Standards

Relevant Environmental Issues

ASTM E-3123-18 (new): Recognition & Derecognition of Environmental Liabilities• To Be Added

Asset Retirement ObligationsE-3123-18 Definition: “Legal or constructive obligation associated with the retirement of a long-lived asset that results from the acquisition, construction, development or normal operation of a tangible long-lived asset.” Includes but is not limited to:

• Demolition• Decontamination• Reclamation• Restoration • Abandonment

• Scenario 1 – Typical Real Estate Loans:May be part of price negotiations (in case of asbestos or PB-based paint) but usually out of scope of Phase I ESA

• Scenario 2 – M&A and Corporate Transactions: May be settled under deal obligations and/or reserve transfer for the eventual need to retire an asset

E-3123-18/E-2137-17 Why Environmental Valuation?• Estimation of Environmental Liability Necessary for Accurate Book Value of

Company• Enviro/financial matters are the most common dispute in M&A Transactions,

Liability Transfer Transactions, Bankruptcies, etc.• Fair Value Measurement needed for all Liabilities (Asset Retirement Obligations,

Environmental Obligations, Commitments, Guarantees)• “Probable” (Contingencies, Environmental Obligations)• “Reasonable & Necessary” (Reasonable Optimistic, Most Likely, Reasonable

Pessimistic)• Often involves modeling

• Establishes Schedule of Liabilities including Asset Retirement Obligations, Other Obligations, Commitments, Contingencies, & Guarantees

• Reserve Accrual Analysis allows spreading impact of closure costs/cleanup, matching revenue to accretions, taking advantage of amortizations, and booking depreciation costs

• Recognizing Lifecycle of Environmental Liabilities (Recognize Liability, Book Reserves, Expend Reserves, Retire Liability)

• Reviewed and added to, subtracted from for each reporting period• Review of Past Corporate Reporting, Annual Environmental

Budgets (compliance only? reserve funding? risk reduction?)

Case Study: M&A Acquisition of Paper Mill• TBLS was Part of Buyer’s Due Diligence Team

assisting in Negotiation of Price• Team Scope included review of:

• Due Diligence of Environmental, Seller File Room• Preparation of Cost Estimates and Timing Risk for

various business scenarios• Review of Seller environmental cost

estimates• Review of schedule to meet AROs,

Environmental Commitments, Environmental Obligations, Contingencies, Guarantees, if any, or to help establish one for negotiation with team members

• Review of annual environmental budgets (compliance only? reserve funding? risk reduction?)

• Review of Reserve Assets (insurance policy, Letter of Credit, RFS, Closure/Post Closure Bond, Seller Guarantee, etc.) including discount rates

• Part of multi-disciplinary team needed, including accounting, legal, environmental and business, to evaluate all aspects of proposed M&A deal

Case Study: Paper Mill M&A (cont.)• Environmental Liabilities from Phase I ESA (ASTM E-1527), Phase II ESA (ASTM E-1903) by Seller provided in due

diligence• One AOC Identified: Groundwater cleanup (Obligation)• For cleanup of the one AOC = $500,000 cost estimated by Seller’s divestiture team in Phase I & II from five years earlier• Environmental Insurance Policy listed as only asset

• Interrogatory Process for Questions Asked and Identified and/or Quantified by Buyer and its Lenders following ASTM standards:

1. If I must close the plant because the business fails, what will it cost me?

2. Did the Seller just maintain the status quo, i.e. are there additional Capital Expenditures (CapEx) for Environmental Upgrades or permit renewals, or are final permitting expenditures needed to operate?

3. Have all the Environmental AROs, Closure/Post Closure Care Plans and their Schedules been Identified?

4. Have all the Environmental Obligations been Identified? Are there Regulatory Obligation Events (OE)?

5. Are there Contingency Liabilities Identified? What is the regulatory and environmental litigation history? How about Natural Resource Damages claims potential?

6. What is the status of Environmental Commitments, and do they cover, or can they be amended to cover, the Buyer?

7. Does the corporate financial reporting list environmental liabilities, and have ERLs been established? Are they “fair value” estimates meeting the “reasonable & necessary” standard?

8. Are there assets listed to cover the Environmental Exposures (insurance policies, C/PC bonds, ERLs)? Are they scheduled and adequately funded? If so, are they transferable to Buyer, and are their terms adequate to cover the entire exposure?

9. How has the annual environmental budget been used to date – status quo/compliance only? Risk improvement management? Is spending reducing the long-term risks?

10. Are there any “Legacy” environmental issues, or current or pending environmental litigation issues?

E3123-17 Analysis of Paper Mill Environmental Elements• Permit Schedule and Enviro Budget Analysis• Audit Current Waste Handling Adequacy &

Environmental CAPEX requirements• AROs: Multiple USTs/ASTs, Landfill, WWTP, Sludge

Ponds, Landfarms, Waste-Handling areas, Buildings with Asbestos but not mitigated (ARO Cost/Schedule, Reserves established?, Enviro CAPEX?)

• Analysis of Five AOCs (Obligation-Regulatory or contingency?)

• Offsite Releases/NPDES to River with sediment impact (Obligation-Regulatory)

• Offsite litigation potential due to dioxin (Contingency)

• Natural Resource Damages (Contingency)• Sediment impact/NPDES (Recognized Obligation)

• Landfarms: AROs with Offsite sales of amended soils to farmers (Contractual Commitment, Offsite Cleanup contingency reserve?)

• Known Costs from Seller + Predicting other Material and Reasonable/Necessary Fair Value Costs

• Determining adequacy of Reserves & Guarantees (financial reserves/bonds/letters of credit, insurance policies, closure/post closure bonds) with Due Diligence Team Members (Broker, Accountants, Lawyers)

AROs, Obligations,

Commitments

No. of Units OE

Timing Risk

(Years)

ERL Cost ($M) from

RACER®

Landfill 1 Yes 5-30 $6M

WWTP 1 Yes 5-30 $2MSludge Ponds 3 Yes 5-30 $3M

Landfarm 6 Yes 5-30 $3M

Cleanup AOCs 5 Yes 0-5 $8M

Buildings/ USTs 16 Yes 5-30 $1M

Environmental Liabilities Valuation at Fair Market Book Value Negotiation

• Seller purchased site 5 years before and bought an insurance policy; no other investment or reserve accrual other than “status quo” compliance

• Buyer’s goal for 5-year business plan and improvements was to make business profitable (without future subtraction of environmental liabilities)

• Used RACER® Models (because of detailed back-up, ease) to establish Range of Values, and Monte Carlo to establish “Most Likely Value” at $8M cleanup for dioxin impact to soils onsite-and-offsite, 2 additional groundwater cleanups, in 2-5 Years timing risk

• Used RACER® and @Risk to estimate $14M closure costs for Landfill, WWTP, Ponds, Landfarm and Buildings for various (up to 30-year) timing risk; currently, no adequate reserve

• Established ARO schedule, Schedule of obligations & obligation events, contingencies, over time for setting reserves/accruals over time, to match new business cash-flow models

• Permit Analyses and Environmental Budget/Waste-Handling Needs Analysis revealed approximately $1M cost over 5 years likely to be required; set up schedules to match probable business cash-flow scenarios

• Legal part of Buyer’s team determined Environmental Insurance Policy forbadeinvestigations that could lead to discovery; was a Claims-Made Policy with no coverage for known contamination, only limited term remaining – thus no value for Buyer (or Seller)

• Buyer/Seller Negotiation Around Adequacy of Environmental Reserves/Liability Valuation versus Purchase Price

• Seller was unprepared for negotiation of Corporate Book Value• Enviro-Liability Timing Risk vs. Business Risk Already Present

Ultimately became a Go/No-Go Decision

Case Study: Paper Mill – Learnings

Rather than using “dueling Phase I” approach, Buyer/Borrower used the TBLS environmental valuation (E-3123-18/E-2137-17 Analysis) AND lack of adequate Seller reserves to:• Start negotiations at $22 million discount from the asking price,

ultimately settling with the Seller on $10 million as the “Fair Value”• Loan contingency for cleanup alone $500,000 + 150% loan

underwriting would not have accurately estimated the total book value liabilities of $10 M for business

• Buyer / Borrower Used the $10 M Fair Market Value to Establish a Reserve for potential future divestiture/closure in 5-30 years

Summary• In 90% of Real Estate Transactions, the Phase I/II approach works

• For the 10% of loans with ongoing industrial companies that have complex liabilities, the new and revised ASTM Standards on Estimating, Disclosure and Recognition of Environmental Liabilities help Lenders to make Loan/No-Loan Decisions:

• Provide Definition and Structure for Valuations• Enable quantification of costs, risks, and timing to enable Lenders to make smarter

decisions and better protect loan positions

• In cases with complex long-tail liabilities like the Paper Mill, where AROs, Obligations, Contingencies, Guarantees and Commitments were not identified and quantified by the Seller, environmental valuations based on these ASTM Standards protect Buyers and Lenders from environmental risks and exposuresIn the Paper Mill case, the Buyer’s risk exposure was close to $20 million

• Lenders can significantly protect their investments when complex Environmental Liabilities impact Loans related to:

• M&A Transactions• Bankruptcies • Portfolio companies

Questions?

Thank You!For more information or a consultation, please contact:

Frances Schlosstein, President Jeff Andrilenas, Environmental Lead

973-750-1500fschlosstein@theTBLSgroup.com

Jeffa@theTBLSGroup.comThe TBLS Group, LLC

New York and New Jerseywww.theTBLSGroup.com

A Transaction-Focused Environmental Advisory