Strategies to Protect Your Fund from Portfolio Company Environmental Liability
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Private equity funds with investments in U.S. industrial or manufacturing businesses, or businesses with substantial U.S. real estate holdings, may in some cases be liable for a portfolio company’s environmental liabilities, particularly when the portfolio company is in distress and cannot fund its environmental obligations. This note summarizes the potential issue and what private equity firms should be mindful of to minimize this risk.

Of particular concern is a fund’s potential liability under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA or Superfund) for contamination at a site owned or operated by a fund’s portfolio company. Under CERCLA, and numerous analogous state statutes, the “owner” or “operator” (and former owners or operators) of a contaminated property may be held strictly liable for the cost to investigate and remediate the contamination regardless of whether they caused the contamination. While these environmental laws do not specifically mention shareholders or analogous investors, parties seeking contribution for the cost of the cleanup have attempted to hold shareholders, including parent entities, liable for contamination. In response to these claims, courts, including the United States Supreme Court, generally have decided that ownership of the entity that causes the contamination or owns the contaminated site by itself is not enough to impose liability on that investor. However, investors can be found liable in two principal situations.

  • First, parent entities, and by analogy shareholders, can be liable if evidence supports “piercing the corporate veil” under common law. This is a fact-specific evaluation that looks at traditional grounds for piercing the corporate veil, including evidence of fraud, undercapitalization, disregard for the corporate form, absence of corporate records and/or intermingling of properties or funds.
  • Second, a parent entity or shareholder may be liable under CERCLA as an “operator” if it manages or controls activities or decision-making related to pollution or environmental compliance, particularly with respect to the contamination at issue. The determination of “operator” liability is a fact-based analysis, which means that there is no black line test for avoiding liability. Such a finding is rare as courts generally uphold traditional corporate law principles that shareholders are not liable for the obligations of the companies in which they invest. Normal corporate oversight by an investor, including such commonplace practices as a parent appointing its own officers and directors to similar positions in a subsidiary and supervising a subsidiary’s finances should not be grounds to hold the investor liable for the entity in which it invests liabilities.[1] That said, the United States Supreme Court identified four situations in which a parent company may be liable under CERCLA as an “operator:”
    • where the parent company actually directed operations at a contaminated site owned by one of its subsidiaries, such as when a parent has leased property from its subsidiary to conduct its own operations;
    • where a parent corporation participated in a joint venture with its subsidiary and the joint venture contaminated the site;
    • where an officer or director, who holds positions in both the parent and the subsidiary, abuses his or her position in the subsidiary by making decisions concerning hazardous waste or environmental compliance which, under the norms of corporate behavior, are not in the interest of the subsidiary and are more to the advantage of the parent; and
    • where an employee of the parent, who holds no position in the subsidiary, directly controls those operations at the site which involve hazardous substances or environmental compliance.

While case law in this area continues to evolve, and legal action against investors to pay for contamination liabilities that a portfolio company can no longer fund is rare, past decisions have resulted in several types of activities that private equity funds should attempt to avoid. These include:

  • Exercising actual control over, or the fund’s explicit assumption of responsibility for, the portfolio company’s operations, rather than financial or administrative matters.
  • Exercising actual control over the portfolio company’s management of hazardous materials or environmental compliance activities. For example, a fund should avoid asserting direct control over its portfolio companies’ environmental permits and should ensure (as is normally the case) that permits are held in the portfolio company’s name. Communication with regulators with respect to such permits should primarily be conducted by the portfolio company or its agents, although there is no reason that the fund cannot be copied or consulted as that likely would be considered normal oversight.
  • Ensuring that an officer or director of the fund who also holds a position in the portfolio company does not make decisions about environmental matters that are not in the interest of the portfolio company. For example, the First Circuit has found a parent corporation liable for contamination at a subsidiary’s facilities based on the acts of a parent corporation employee.[2] The First Circuit decision centered on the fact that the parent’s employee directly made the decisions on environmental matters at the subsidiary’s facility. He was the “lead man” in directing that cost studies be conducted to evaluate solutions to an environmental problem and in making the decision, based on cost and space factors, to use a cleaning system that resulted in the contamination that was the subject of the CERCLA action.
  • Ensuring that contaminated property is not held by a joint venture of the fund and portfolio company.

Generally speaking, actions against private equity funds seeking damages for contamination are likely only to arise when a responsible party cannot address the issue and the cost of completing an investigation and cleanup is substantial. This is because there is a general presumption in favor of corporate law liability protections, and as it is not a bright line test, plaintiffs need to develop a convincing factual record to show that corporate protections should be ignored, typically a costly and time consuming process.

In summary, while private equity funds, like other shareholders, including parent entities, typically rely on traditional principles of corporate law and structure to insulate themselves from direct responsibility for the acts and omissions of the companies in which they invest, establishing these structures is only the first step in adequately protecting a fund from exposure. As a general rule, a private equity fund will not be held liable for contamination attributable to its portfolio companies if the fund’s activities are consistent with their investor status and normal parent-subsidiary interactions generally will not put a fund at risk of incurring CERCLA liability. Funds generally will be protected from incurring liability under CERCLA for its portfolio company’s environmental liabilities unless (a) the facts are such to allow for piercing of the corporate veil or (b) the fund actively participated and exercised direct control over the operations that gave rise to the contamination.

 

[1] United States v. Bestfoods, 524 U.S. 51, 118 S. Ct. 1876 (1998). While Bestfoods dealt specifically with the liability of a parent corporation, its holding applies equally to situations involving individual shareholders, and in the case of private equity sponsors, the fund.

[2] United States v. Kayser-Roth Corp., 724 F. Supp. 15, 22 (D. R.I. 1989).