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By CHRIS SMY, a managing director with Marsh USA and Global Environmental Practice leader, JIM VETTER, a managing director with Marsh USA responsible for the Northeastern United States, and JEFF GRACER, a partner at the law firm of Sivet Paget & Riesel PC in New York

During the 12-month period ending Sept. 30, 2008, the rate of businesses filing for Chapter 11 bankruptcy protection increased by 49 percent, according to the Administrative Office of the U.S. Courts.

The trajectory from financially healthy to financially challenged companies shifts the risk profile across many areas, and environmental risk is no exception. Environmental risk will be an important factor to manage for businesses on a trajectory toward bankruptcy; businesses entering bankruptcy or contemplating emergence from bankruptcy; businesses seeking to avoid bankruptcy through a workout and businesses that may have contractual counterparty risk from mergers and acquisitions, lending or joint ventures with companies in bankruptcy.

Companies entering bankruptcy can successfully address environmental issues during the bankruptcy and be optimally positioned for emergence. At the same time, creditors and other counterparties with an interest in the bankrupt company can take prudent steps to protect their environmental risk profile.

There are three elements that must be considered as part of any successful process involving environmental issues in bankruptcy. They are, understanding one's risks and exposures, assessing alternatives for addressing, resolving and discharging environmental liability and knowing solutions for managing environmental liabilities.

Environmental risks and exposures can develop from diverse sources, such as operational risk, for example.

Environmental losses from operations can have material financial impacts even during normal economic and operating times. In downturns, cash-flow pressure can influence compliance and risk investment decisions, such as capital improvements and headcount.

This can negatively influence overall environmental performance and possibly lead to increased probability of an operational event and release resulting in cleanup costs and the possibility of substantial third-party claims and business interruption.

In addition, decisions to close facilities or halt construction can increase environmental risk through the release of stored chemicals, migration of contamination, or storm water runoff from closed construction sites. A number of states are highlighting the risk posed by closed or abandoned facilities and are making this a focus of regulatory enforcement in 2009.

An entirely different set of exposures can come from legacy risks. Existing environmental contamination and associated regulatory and contractual obligations represent the most common environmental exposures to be considered during bankruptcy.

Known issues can result in substantial financial cleanup obligations and uncertainty around cost projections, and "unknowns" can create significant financial variability and uncertainty.

Quantification, disposition and management of legacy risks tend to comprise the most significant environmental challenges in a bankruptcy or workout, particularly with respect to the direct cost of cleanup and indirect costs such as third-party claims and legal defense costs.

For business partners, reliance on contractual mechanisms, such as indemnification or prior insurance programs may not be adequate in the current environment. A best practice in this area is "risk mapping" to identify actual and potential exposures, and to quantify them.

ALTERNATIVES FOR LIABILITY DISPOSITION

Companies entering bankruptcy with environmental liabilities have four disposition strategies at their disposal. Each has advantages and disadvantages.

Discharge of Environmental Claims. Companies entering bankruptcy may seek to have outstanding claims discharged or essentially erased. This provides the greatest relief upon emergence.

However, in practice it is often difficult for companies to obtain full discharge without protracted legal proceedings, and it is more common for claims to be settled with the government and parties that are also responsible for the pollution in exchange for release from future claims against the reorganized company.

This settlement can put other potentially responsible parties at risk as they may be saddled with an increased share of the liability. In addition, companies relying upon indemnities for unknown pre-existing risks could be wholly unprotected.

Section 363 Asset Sales. Companies in bankruptcy reorganization may seek to raise cash through sales of assets--either individual property or entire business units. Environmental liability runs with the land and a potential purchaser because a 363 court order stating that the purchase is made "free and clear of all liens and claims" may not eliminate the purchaser's liability as a new owner/operator under applicable environmental law.

Environmental Trust. Section 554 of the bankruptcy code provides bankrupt companies the potential to abandon assets of limited value. In reality, this ability is very limited for contaminated property based on case law from the United States Supreme Court.

The typical outcome for contaminated property, in lieu of outright abandonment, is for the bankrupt company to create an "environmental trust." The trust owns the property, has the responsibility to remediate contamination and subsequently sells the property. Remediation obligations are typically funded through the bankruptcy proceedings and the proceeds from the sale may be returned to the bankrupt party's estate.

Rejection of Indemnity Obligations. The bankruptcy code permits companies to seek rejection of contracts that have been fully performed on one side, so-called executor contracts, including certain environmental indemnity obligations of a bankrupt company. Where such rejection is possible, it may create a significant financial risk to the other party that was relying upon future performance of that indemnity. Even if rejection is not possible, an environmental indemnity obligation also could be discharged through the bankruptcy proceedings.

Each of these scenarios provides opportunities for companies entering into bankruptcy to mitigate liabilities if financial uncertainties around known and unknown risks can be quantified and risks managed as part of the process. These outcomes can also create increased risk for third-party business entities with contractual rights that a bankruptcy may eliminate.

It is possible to mitigate these increased risks to third parties through environmental risk management solutions. In each of the scenarios described above, environmental risk and exposures have two basic types of financial uncertainties: cost escalation around known risks arising from more governmental interest as a result of a bankruptcy filing and new costs surfacing from previously unknown risks.

Managing these financial risks and uncertainties is critical when trying to maximize asset value from sales under Section 363 and environmental trusts for companies in bankruptcy and knowing when to minimize or eliminate liability to third parties from environmental liability discharges and rejection of contractual indemnities.

Environmental insurance can play a key role in managing these uncertainties. As demonstrated by the challenges faced by a few insurance carriers in 2008, insurance companies are by no means immune from financial stress.

ENVIRONMENTAL MANAGEMENT TOOLS

However, as highly regulated entities with stringent controls on how they are capitalized, monitored and to some extent backstopped by state funds, they likely represent a more robust and transparent form of counterparty credit risk than some private or publicly traded companies. Parties can use any of the three following environmental insurance risk management tools to control the financial uncertainties discussed above.

Pollution Legal Liability. This insurance policy can cover risk from unknown risks, including legacy or operational risks. Core coverage can include cleanup, third-party bodily injury and property damage, legal defense and business interruption. These policies can be manuscripted and coverages enhanced to meet client and situation specific needs.

In addition, excess of indemnity coverage can also be provided to protect third parties from failure of bankrupt companies to meet indemnity obligations. Pollution legal liability is the policy most frequently used to control risk and a range of carriers can provide this coverage.

Remediation Cost Cap. This insurance policy is used to cover cost overruns around known environmental risks. Cost Cap requires sufficient known information about a pollution condition so that a remediation plan, schedule and cost can be forecasted. The insurance carrier underwrites the risk and agrees on an "attachment point" for the remediation above which it will play claims should the attachment point be exceeded or overrun.

Environmental Liability Buyouts. An embedded assumption in many transactions and outcomes is that an existing party must retain liability or that the liability is apportioned between buyer and seller. However, an environmental liability buyout may provide an alternative.

A number of consulting and brownfields companies have evolved from doing remediation to contractually assuming liability. These companies will assess and value the liability and contractually assume remediation and regulatory obligations in exchange for being paid to take on the forecasted liability.

Environmental insurance is typically used to wrap around the contractual obligation using a combination of pollution legal liability and/or remediation cost cap. Environmental liability buyouts have been used successfully on Section 363 sales so that emergent companies can emerge relatively free of these exposures.

Bankruptcy is an event that creates significant uncertainty and financial risk for companies and business partners, particularly involving environmental risk. There are established outcomes for disposition of liabilities that can help raise cash for entities in bankruptcy yet also increases risk to business partners. A thoughtful analysis of risk and use of environmental risk management vehicles can help enable positive outcomes around cash generation and minimize risk to third parties.

March 3, 2009

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