In mergers and acquisitions, I have found that when one can show the target company has a week environmental financial disclosure process and week internal controls, a significant potential advantage may arise for the acquiring entity. On the other hand, failure to identify these weaknesses can prove problematic for the acquirer after closing the deal. As a result, for the appropriate M&A transaction, a review of the environmental disclosure policies, processes, and internal controls can yield valuable information for the acquiring entity and protect it from future risks and liabilities.
In the context of what I’ve been discussing in the Environmental Corporate Governance area, it is important for directors and management to ensure that the company considers environmental disclosure issues in each acquisition with potential material environmental risks and liabilities, both to manage risk and to consider the opportunity to identify the true value of the target company.
A. Review for Understanding and Negotiating Value or Other Concessions
The first issue is the extent to which the target has properly accounted for loss contingencies under Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies.” One should review lawsuits, demands, and other potential claims to attempt to assess whether the financial statements have adequately reserved for such claims. Moreover, the policies and processes, if any, the company has in place for identifying, valuing, adjusting, and reporting FAS 5 claims can be reviewed to better understand if the internal controls are adequate. After the SEC enforcement case against Ashland (discussed in another post on this blog), it is critical that the review and adjustment of the reserve estimates received from the environmental manager or staff be rigorous and documented.
As for asset retirement obligations (AROs) and conditional AROs under Statement of Financial Accounting Standards No. 143 “Accounting for Asset Retirement Obligations” and Financial Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations”, again a careful review of what has been accounted for and the policies and procedures that have been established and how they have been implemented can shine significant light on the value of the company and its potential liabilities, as well as its FAS 143/FIN 47 internal controls.
The other key is to try to do this early. Deals are somewhat like basketball games, the ability to obtain and process information has to conclude within a period of time, often a very short period of time. The other side may hold out in terms of providing information or making documents available or allowing access to sites that need to be assessed. The “four corners” or “stall game” can “run the clock out.” Pressure builds to close the deal as one approaches the closing date. For environmental lawyers armed with financial disclosure expertise, time is one of our many challenges.
Another point to keep in mind is that the due diligence process has to be tailored to the deal in terms of what is the nature of the buyer’s goal in making the acquisition, how will environmental issues play into this acquisition strategy, what type of company or asset is being acquired, what is the market in terms of how many other potential buyers are out there, and is it a buyer’s or seller’s market.
There are a variety of tools that can be used in the deal, and some or all of these may be helpful in certain transactions, but not in all of them. The point being one must chose the weapons for each deal to fulfill the goals of the buyer. One advantage to this approach is that the environmental due diligence plan and process will hopefully match the business strategy of the client in making the acquisition, pricing the acquisition, and then dealing with environmental compliance, management and disclosure issues after closing. What liabilities or costs will the acquiring entity have to address post closing? Will this arise two years after acquisition as the new assets or company is reviewed in the acquirers environmental audit process or through review of these issues in the context of the financial disclosure review? What if the financial auditor determines the new assets or company does not have adequate internal controls or accounting for environmental? Will a situation arise where the acquiring entity must restate its financials as a result of the acquisition?
It is important to begin with traditional environmental due diligence—identify risks, costs, liabilities, then use this information and more advanced environmental due diligence to identify potential AROS/ CAROs or loss contingencies. The traditional due diligence will lead to discussions with the other side and then to internal control/lack of knowledge of environmental disclosure requirements with the seller’s environmental manager and then the accounting staff.
In some deals, the target and its financial accounting people often do not have a good understanding of the environmental accounting issues, so knowledge can become power if the other side seems uneducated and unprepared to deal with a close review of their reserves for FAS 5 and accounting for FAS 143/FIN 47. Of course this will vary with the size of the seller. Smaller companies are often like shooting fish in a barrel—they have little expertise in accounting for environmental liabilities and few controls in place to address the issues. Bigger companies may be more sophisticated, but it is likely you may be able to poke holes in their accounting, reserves, internal controls, etc.
This is true with respect to both FAS 5 and FAS 143. Do not underestimate how the other side underestimates their loss contingencies just because FAS 5 has been around awhile. Accounting for FAS 143 and FIN 47 may be practically non-existent or poorly documented and justified.
Typical purchase and sale agreement contain representations regarding compliance with Generally Accepted Accounting Standards (GAAP). Some agreements call for price adjustments for liabilities not properly addressed in the financial statements under GAAP. These GAAP provisions may provide useful tools both for rooting out failure to account for costs, liabilities, and retirement obligations, and for arguments for adjusting values in the transaction.
Whether a price reduction or other advantage can be gained in a transaction, depends on the acquirer representatives and how bad they want the deal. Issues may have to be considered “material” either in the SEC sense or the deal sense. With a party wishing to take a strong stand on negotiating price, the value of the environmental financial review can often greatly support price negotiations. The overall sense of the deal drives environmental negotiations—that is, if the buyer is looking for a price reduction, then environmental issues can be a mechanism to attempt to achieve that end.
What is important is to go into the deal with an education of the corporate or transactional lawyers and client that this is potentially a useful tool. In my experience, it arises after the fact through the environmental lawyer educated about financial disclosure issues raising concerns and failure to account or account accurately for environmental issues.
B. Environmental Due Diligence to Protect the Acquiring Entity
The other side of the coin is the need to protect the acquiring entity. US Liquids (discussed in another post on this blog) and its directors found the company in a criminal enforcement case after acquiring waste management companies that were accused of criminal violations of environmental statutes. The drop in the stock price found the not only the company, but the directors as well in a shareholder lawsuit. To add further injury, the Fifth Circuit Court of Appeals ruled the directors were not covered by the director and officer insurance.
The Ashland case reveals issues the SEC identified that caused them concern in an enforcement action over environmental reserves and disclosure. Taking care to understand the target’s practices at the environmental estimation level and the review by management could avoid future problems and identify accounting changes that need to be implemented after closing.
Thus, the value of conducting due diligence into the environmental financial disclosure practices of target companies in M&A deals provides a potential two-fold advantage: (1) further vetting of the value and environmental practices of the target company, and (2) protecting the acquirer from potential problems if the target’s practices are far less robust then the acquirer and avoiding future restatements or identified weaknesses in future financial disclosure and auditing. Corporate boards and management should ensure that their acquisition teams are conducting environmental disclosure due diligence in the appropriate cases where environmental risks and liabilities may be significant.
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