Canada: Business Valuation and Financial Loss

Environmental liability is an issue that arises in many business valuations, in particular, where the subject company handles or is exposed to hazardous or potentially hazardous substances.  Depending on the circumstances, both known and contingent environmental liabilities may materially affect the fair market value of the shares or net assets of the company subject to the valuation.

Generally speaking, environmental liability is comprised of two separate aspects:  regulatory liability arising from the violation of government rules and regulations; and civil liability that results from a lawsuit initiated by person claiming to have been harmed as a result of one or more common law causes of action (e.g. negligence, nuisance and trespass) allegedly caused by some other party.  In general, regulatory standards are increasingly onerous and stringent as standards tighten imposing greater compliance-related costs on a regulated company.  Monitoring for compliance by provincial environmental agencies is on the rise and there is a trend towards aggressive enforcement in several jurisdictions.  At the same time, the consequences of regulatory non-compliance are more serious as government agencies explore new methods of punishing non-compliance.  Further, the possibility of a large award for damages as a result of civil lawsuits over environmental actions is increasing with the possibility of class actions and the willingness of certain courts to impose larger penalties.  As a result, larger industrial companies as well as those companies with potentially significant environmental issues are devoting greater resources to environmental matters, frequently having one or more full-time employees dedicated to monitoring environmental compliance and related matters and keeping up with the ever-changing scope of guidelines, rules and regulations.

In Canada, the most comprehensive piece of federal legislation related to the environment is the Canadian Environmental Protection Act, 1999 (“CEPA”).  Enacted in 1985 and significantly revised in 1999, this Act consolidated and repealed a number of earlier statutes, among them the Clean Air Act, the Environmental Contaminants Act, the Ocean Dumping Control Act, and parts of the Canada Water Act.  CEPA establishes controls over the release, use and elimination of certain regulated substances that can impact air, land, and water; controls the use of substances that are thought to deplete the ozone layer; imposes requirements on the registration and use of new chemicals, substances and genetically modified or designer organisms; and has introduced the concept of pollution prevention programs.  In addition to CEPA, the federal Fisheries Act prohibits the deposit of substances into aquatic habitats that could harm aquatic organisms and aquatic habitats.  An aquatic habitat has been broadly interpreted and in some cases, has included areas where surface water flows for only part of a year.  In addition to federal environmental regulation, all of the provinces and territories have complimentary environmental laws e.g. the British Columbia Waste Management Act, the Ontario Environmental Protection Act, the Quebec Environment Quality Act and the Newfoundland Environment Act.  Provincial and territorial environmental laws and regulations govern various activities that impact on human health and the environment within each jurisdiction, including prohibiting the release or discharge of certain substances in excess of specified standards, governing the transport, storage and disposal of hazardous and non-hazardous waste and imposing requirements or the ability to require remediation of contamination or contaminated properties under certain circumstances.  The third layer of environmental regulation lies at the municipal level.  In general, municipalities have powers to enact by-laws to regulate the release or discharge of process effluents and industrial waste into the sewer system, but it appears that this scope can be broadened.  A recent Supreme Court of Canada decision has potentially provided municipalities the ability to regulate other aspects of the environment as long as such matters have not been assumed or assigned to the provincial/territorial or federal government.

Environmental liabilities generally are difficult to quantify with any degree of certainty.  In open market transactions, environmental liabilities often are dealt with through provisions that assign, exclude or allocate liabilities between the parties.  These provisions can include negotiated representations, warranties, indemnification, holdbacks and escrow arrangements that are set out in a share or asset purchase agreement or are addressed in a stand alone agreement.  This allows for a sharing of ‘environmental risk’ between the vendor and the purchaser.  In notional market valuations, it typically is not the case that environmental liabilities can be dealt with in the same manner as in open market transactions.  In notional market valuations, two options exist when faced with an environmental liability issue:

• attempt to reasonably quantify the environmental liability based on available evidence.  This typically can be done reliably only in circumstances where adequate evidence is available to assist in quantifying an alleged environmental liability; or
• in the absence of adequate evidence to assist in quantifying the alleged environmental liability, any valuation conclusion should be qualified to account for this.

An environmental liability can fall into one of the following categories:

• a known environmental liability – that is a legal or regulatory compliance obligation of the subject company to incur a one-time or ongoing future expenditure(s) due to the past or ongoing manufacture, use, emission, release, or threatened release of a particular substance, or other activities, that may impair or adversely affect human health or the environment (referred to herein as ‘Environmental Activities’).  For example, the subject company may be ordered or otherwise required by regulatory authorities to clean-up or address an on-site landfill, waste pile, emission source or contaminated area so that compliance with current legal requirements is achieved;
• a planned environmental liability – in certain circumstances, a company may not  face a legal or regulatory obligation but may choose, for ‘public policy’ or other reasons, to incur a one-time or ongoing future expenditure(s) due to Environmental Activities.  For example, the subject company may decide to incur costs to alter its handling of a particular hazardous substance in circumstances where the current practice meets existing regulations but is perceived to be a health threat by the company’s employees or customers; or
• a contingent environmental liability – that is a potential legal obligation to incur a one-time or ongoing future expenditure(s) due to Environmental Activities.  For example, the subject company may be named as a defendant in a regulatory prosecution or civil lawsuit related to the subject company’s alleged breach of a regulation or for allegedly causing a nuisance.  One other example is the uncertainty over the impact of future regulatory changes, particularly when a government has released a policy statement or introduced draft regulations for consideration that tighten existing laws, but does not provide a definitive date when such changes will take effect.

Environmental liabilities vary with both the nature and timing of the cost.  Examples of one time costs might include:

• initial capital outlays and expenditures needed to clean up contamination which existed at the valuation date; and
• initial capital outlays and associated expenditures needed to comply with current environmental laws (e.g. air scrubbers, waste water treatment upgrades, control equipment, design changes, etc.).

Examples of ongoing costs might include:

• additional operating costs resulting from capital outlays (e.g. the hiring of personnel to operate new environmental equipment; maintenance, repair and monitoring costs);
• foregone revenues resulting from the forced curtailment of operations; and
• additional operating costs resulting from required changes to the subject company’s waste disposal practices.

When assessing the impact of additional costs, potential cost savings or other benefits that might arise from capital outlays or operational changes resulting from environmental compliance requirements should also be considered.

Environmental liabilities include:

• compliance obligations related to laws and regulations that apply to the manufacture, use, handling, disposal, and release of chemical or other hazardous or toxic substances and to other activities that may impair or adversely affect human health or the environment.  In this regard, whether the subject company was in compliance with existing laws and regulations at the valuation date should be considered along with the possibility that new laws and regulations will be enacted that the company may  be in a difficult position to comply with, at least initially.  In the event that it is discovered that the subject company is not in compliance, the expected costs of achieving compliance should be assessed.  These costs can range from modest outlays necessary to conform to administrative requirements (e.g. record keeping, reporting, training, etc.) to more substantial outlays, including monitoring costs and capital costs for new equipment or changes to the facility to alter existing processes.  A newer trend among certain regulators is to require financial security from a company to guarantee certain regulatory obligations (e.g. closure costs).  Further, when assessing compliance costs, exit costs (e.g. waste disposal and site closure costs) should not be overlooked;
• remediation obligations (existing and future) related to contaminated property (either leased or owned that resulted from the operations of the company, although with owned properties, this obligation is often broadened).   Remediation costs typically are incurred to bring the condition of the lands into compliance with existing laws, regulations, or in some cases, commercially accepted remediation guidelines that have been accepted by business as an appropriate standard.  These are sometimes included as part of compliance obligations;
• obligations to pay fines and penalties for non-compliance.  These are punitive and are intended to act as a deterrent to the subject company;
• obligations to compensate private parties for damages in respect of personal injury, property damage, and economic loss.  Damages could be awarded to individuals, their property, and/or businesses due to the release of toxic substances or other pollutants or as a result of contamination that has impacted their property;
• obligations to pay punitive damages for grossly negligent conduct; and
• other environmental related obligations.  For example, ethically motivated environmental expenditures.

Due Diligence

When valuing a business that has or may have environmental liabilities, some or all of the following activities should be undertaken, as considered necessary and appropriate:

• interviews and correspondence with the compliance officer and/or other employees of the subject company who are knowledgeable with respect to the subject company’s environmental affairs;
• review of the following documents, as applicable:
  • minutes of meetings of shareholders, the board of directors and any regulatory or environmental committees of the board;
  • recent business plans prepared by management of the subject company with a particular focus on any budgets/forecasts of any environmental related expenditures that might exist;
  • legal opinions received pertaining to potential environmental liabilities to the subject company and/or the recourse available to the subject company against third parties.  For example, the environmental issue facing the subject company may have been caused by the subject company when it was under different ownership.  In this circumstance, the subject company and/or its current shareholders, may have legal recourse against these prior owners;
  • environmental certificates, approvals, permits and licences;
  • filings with securities regulators such as the Ontario Securities Commission, U.S. Securities and Exchange Commission, etc.;
  • environmental insurance policies;
  • internal non-financial audits, environmental audits and health and safety audits;
  • correspondence between the subject company and governmental environment ministries and other agencies that may oversee environmental matters;
  • independent environmental site assessment reports or environmental consulting services reports  in the possession of the subject company;
  • due diligence documents prepared to obtain financing or for a recent sale of either the shares or net assets of the subject company;
  • real estate transaction records;
  • documentation regarding the firm’s corporate compliance program, environmental management system and incident reports;
  • statements of claim against the subject company for damages resulting from alleged activities or incidents that caused environmental-related harm;
  • court orders against the subject company for damages in respect of environmental matters; and
  • financial statements, including supporting notes and schedules pertaining to environmental matters.

Quantification Considerations

Once it has been established that either known or contingent environmental liabilities exist, it typically is necessary to attempt to reasonably quantify them.  There are two basic approaches to do so.  First, the discount rate applied to projected discretionary after-tax cash flows can be increased to reflect the increased risk that the identified environmental liability may negatively affect future cash flows.  The second method is to attempt to calculate the present value of the after-tax future environmental costs (net of any potential benefits) and to adjust the fair market value otherwise determined by this amount.  This could include one-time costs, an ongoing stream of costs, or both.  The latter method typically is preferred if appropriate evidence supporting said costs exists.

When quantifying environmental liabilities, consideration generally should be given to:

• the likely quantum and timing of anticipated prospective after-tax environmental related costs (net of related benefits).  Depending on the circumstances, it may be appropriate to engage an independent expert to assist in estimating the amount and timing of said costs;
• the probability of the environmental liability materializing and the cost thereof where said liability is contingent on a future event (e.g. the outcome of existing litigation).  Where appropriate, an assessment of the best-case, worst-case and most likely case scenarios should be undertaken;
• possible recourse by the subject company against third parties (e.g. prior owners) with respect to the environmental situation at hand.  Depending on the circumstances, the advice of independent legal counsel may be appropriate; and
• where a transaction involving the shares or net assets of the subject company was aborted prior to the valuation date as a result of an environmental issue, the different negotiating positions of the vendor and the buyer specifically related to the environmental issue.  Often, this can provide persuasive evidence as to how the vendor and buyer quantified the environmental liability in an open market scenario contemporaneous to reasons for a notional valuation being conducted.

Independent Environmental Assessments

Where there is a known or perceived risk that the subject company is exposed to an environmental liability, the subject company’s management may have obtained or may be in the process of obtaining, some form of environmental compliance audit or Environmental Site Assessment (“ESA”). 

An environmental compliance audit is typically conducted by an independent certified auditor for the purpose of assessing the level of compliance of an operation with applicable environmental laws and regulations.  The auditor will review business operations, practices, emissions and materials handling, storage and disposal practices before identifying any deficiencies.  A report can then be generated containing a list of deficiencies and, if requested, recommendations for correcting any identified deficiencies.

There are three types of ESAs:  Phase I, II and III ESAs.

The goal of a Phase I ESA is to identify environmental issues.  It is designed as a screening tool to research historical and current site uses, determine if potential impacts are possible, and recommend further work to confirm those suspicions.  Items included in a typical Phase I ESA can include a site description and the current use, past historical uses, current and past material and waste storage practices, properties surrounding the subject site and potential areas of concern.  A Phase I ESA typically involves an environmental consultant evaluating the subject property without collecting air, soil or groundwater samples.  The consultant indicates if there are any issues of environmental concern that have been identified and what further investigation is required to confirm the presence or absence of the concern. 

Phase II assessments are more thorough than Phase I assessments and therefore provide a better indication of the likely costs of clean-up or other matters to address the identified environmental concerns.  Phase II ESA’s can consist of air, soil, surface water, groundwater and waste sampling; analyses; interpretation; and report preparation.  Recommendations can consist of no further action, maintaining awareness of a concern, or further investigation of a concern that exists to delineate identified impacts.

Phase III ESA’s are the final stage of environmental assessments.  They consist of developing alternative proposals and cost estimates for cleanup and other remediation activities prior to actual implementation.  Phase III ESA’s typically are time consuming and costly.

Conclusion

As society’s attention continues to focus on the health of the environment, environmental liability issues likely will continue to surface with greater regularity.  As a result, environmental liabilities likely will continue to come under greater scrutiny in both notional market and open market transactions.