EPA Policy Creates Incentives for Acquiring Company to Report Violations Found in Audit

When one company buys another, it can inherit the seller’s environmental problems and become subject to fines and penalties for conditions its predecessor created. In August, to encourage prompt disclosure and abatement of environmental violations, EPA published new guidelines that offer acquiring companies a measure of protection from penalties and fines stemming from the actions and inactions of their predecessors. Called an “Interim Approach to Applying the Audit Policy to New Owners” (Interim Approach),[1] the new policy updates EPA’s 2000 “Audit Policy” by creating “tailored incentives” to self-report that are additional to those extended to companies who discover and report violations in the normal course of operating their business.

Background to the Interim Approach: EPA’s Audit Policy

EPA first published its Audit Policy in 1995[2] and made substantial revisions in 2000.[3] The Audit Policy encourages entities to disclose environmental violations by reducing and potentially eliminating civil penalties associated with the violations, and by recommending that the United States Department of Justice not pursue criminal prosecution.

Entities that meet all nine of the Audit Policy’s “conditions” are eligible for elimination of 100% of any “gravity-based” civil penalties that otherwise could be assessed in settlement of the disclosed violations.[4] Regulated entities that meet all of the conditions except for the “Systematic Discovery of Violations Condition” are eligible for mitigation of 75% of gravity-based penalties.[5] A “gravity-based” penalty is the dollar amount established by statute, but does not include the “economic benefit” portion of a penalty. The economic benefit component of a penalty represents the economic gain that an entity may have enjoyed as a result of noncompliance with environmental requirements, which EPA estimates based on the potential value of investing money that the violator would otherwise have spent on environmental compliance.

In a 2007 guidance document, EPA “recognize[d] owners of newly acquired facilities as uniquely situated to examine and improve performance at newly acquired facilities.” Subsequently, EPA published a May 14, 2007 notice seeking public comment on “whether and to what extent the Agency should consider offering tailored incentives to encourage new owners of regulated entities to discover, disclose, correct, and prevent the recurrence of environmental violations pursuant to the Audit Policy.”[6]

Based in part on the comments received in response to the May 14, 2007 request for public comment, EPA identified at least two reasons why new owners may be reticent to make disclosures under the Audit Policy. First, even if EPA eliminates the gravity-based portion of a penalty, new owners may still face substantial penalties associated with the economic benefit portion. At a time when new owners are unclear about the gamut of compliance issues at the newly acquired facilities, they may be reluctant to invite EPA’s regulatory attention. Second, the lack of certainty and consistency regarding how EPA will treat an entity’s disclosure may cut against the potential benefits of disclosing violations under the Audit Policy. EPA’s Interim Approach seeks to ameliorate these perceived deficiencies to the Audit Policy and to create additional benefits tailored to new owners.[7]

Overview of the Interim Approach

The Interim Approach creates incentives for disclosure by “New Owners” (a defined term) by carving out exceptions from the nine “conditions” that a company otherwise would have to meet to qualify for protection under EPA’s Audit Policy.

“New Owner” Criteria and Timetables

A “New Owner” is a company that can certify that:

1. Prior to the transaction, it was not responsible for environmental compliance at the subject facility, did not cause the violations being disclosed and could not have prevented their occurrence;
2. The relevant violation originated with the prior owner; and
3. Prior to the transaction, the buyer and seller did not share a corporate parent or have the largest ownership share of the other entity.[8]

These certification criteria seek to exclude circumstances where the New Owner actually or effectively controlled operations at the facility prior to the acquisition or initiated the violations.[9]

Entities that meet these criteria are considered “New Owners” for nine months after the date the transaction closes. Within this nine month period, a New Owner has the opportunity to enter into an “audit agreement” with EPA, and “specify the facility or facilities to be audited, the scope of regulatory programs covered, dates for completion of audits and disclosure of violations.”[10] In the alternative, a New Owner can elect within the nine month period to make individual disclosures within 21 days of discovering the violation, or within 45 days of the closing, whichever is longer.

Greater Opportunity for Penalty Mitigation for New Owners

Although the Audit Policy currently allows mitigation of all or most of the gravity portion of a penalty, regulated entities remain liable for the economic benefit portion. This aspect of the Audit Policy has presented a quandary for New Owners: disclose violations under the Audit Policy and potentially incur liability for economic benefit or correct the violations without disclosure and risk later enforcement if the violations come to light. EPA’s Interim Approach acknowledges that New Owners who are willing to address violations and ensure future compliance should not be penalized for the potential economic benefit that a prior owner enjoyed as a result of a violation. Accordingly, the Interim Approach re-calculates the penalties applicable to New Owners by eliminating the gravity and economic benefit penalties assessed for the pre-acquisition period, and by eliminating post-acquisition penalties for economic benefit associated with capital expenditures or with unfair competitive advantage, so long as the New Owner corrects the violations within 60 days from the date of discovery or within another agreed-upon timeframe.[11]

Reformulation of Five of the Audit Policy Conditions for New Owners

The Interim Approach also modifies five of the nine conditions in the Audit Policy for entities that meet the “New Owner” criteria. The relevant modifications are as follows:

• Condition 1: The “Systematic Discovery Condition” under the 2000 Audit Policy normally requires a “going concern” to discover violations through an environmental audit or a compliance management system. The Interim Approach recognizes that an entity’s pre-acquisition due diligence may not meet the “periodic” criterion of the Audit Policy’s definition of “environmental audit.” Accordingly, under the Interim Approach, a New Owner is eligible for 100% mitigation of gravity-based penalties if a violation is discovered through pre-acquisition due diligence, even if that procedure does not qualify as “periodic.”[12]
• Condition 2: The “Voluntary Discovery Condition” requires an entity to disclose a violation voluntarily, as opposed to through a “legally mandated monitoring, sampling, or auditing procedure that is required by statute, regulation, permit, judicial or administrative order, or consent agreement.”[13] Previous EPA guidance provided only one exception to this condition, for new owners that discover Clean Air Act violations at newly acquired facilities during the new owner’s examination of facility compliance under Title V of the Clean Air Act. The Interim Approach significantly expands this exception, by including New Owners that disclose a violation or enter into an auditing and disclosure agreement “before the first instance when the monitoring, sampling or auditing is required.”[14]
• Condition 3: The “Prompt Disclosure Condition” requires a regulated entity to fully disclose a violation to EPA within 21 days after discovering that the violation may have occurred. Under the current Audit Policy, EPA will “stop the clock” on this 21-day requirement whenever an entity enters into an audit agreement for any subsequently discovered violations.[15] The Interim Approach increases the flexibility under this condition by allowing 45 days after the closing date for violations that were discovered pre-closing. Additionally, entities have 21 days to disclose any post-acquisition violations, but no fewer than 45 days after closing.
• Condition 8: The “Other Violations Excluded Condition” excludes from treatment under the Audit Policy any violations that resulted in serious actual harm to the environment or may have presented an imminent and substantial endangerment to human health or environment. The Interim Approach states, however, that EPA will not exclude pre-acquisition violations from treatment under the Audit Policy on the basis of this condition, unless there is a fatality, community evacuation, or “other seriously injurious or catastrophic event” brought about by the violation.[16]

Comment Period Ends October 30, 2008

The Interim Approach policy became effective upon publication in the Federal Register on August 1, 2008. EPA is accepting comments through October 30, 2008.[17]

For more information on EPA’s Audit Policy, please contact Meli MacCurdy or any other member of Marten Law Group’s Property Development and Acquisition practice group.