Hazards of the Deal

Last year, the deal consolidating six metals-finishing companies into Lombard Technologies faced a potential roadblock. The private equity firm funding the amalgamation, Miami-based HIG Capital Management, wanted assurance that any as-yet-undiscovered pollution problems wouldn't crop up one day and jeopardize Lombard's financial condition. "With pollution, you never know when it might rear its ugly head," explains Roy Chapman, CFO of Bethesda, Maryland-based Lombard.

To ease similar concerns in the past, transacting parties required sellers to put money in escrow, indemnifying buyers against future environmental liabilities. That strategy, however, didn't fit the Lombard consolidation, given the relatively small size of the six target companies and their respective desires to retain usable capital. Instead, the company tried a new tactic: It purchased environmental impairment liability (EIL) insurance. "If not for insurance," says Chapman, "this deal would not have gone through."

Owing to a combination of prolonged softness in the insurance market, a red-hot mergers-and-acquisitions market, and eye-popping legal settlements, EIL insurance has emerged into the front ranks of viable risk management products. Terms and prices are more favorable now than ever, say experts. But with demand for environmental coverage rising and insurance markets generally tightening, EIL may not remain favorable for long.

The issue is not so much known environmental liability costs as the unknown liabilities. When these jump out, the costs can be crippling.

The stakes are high, as one recent example illustrates. In the early 1900s, DuPont never imagined that the thousands of pounds of toxic chemicals it produced at its Pompton Works chemical plant in New Jersey would someday migrate into groundwater tables. In the spring of 1997, however, the Wilmington, Delaware-based chemical giant settled a lawsuit brought by 427 Pompton Lakes residents for $38.5 million, one of the largest civil settlements in an environmental case.

Often these unanticipated liabilities emerge when a company is acquired. Spirax Sarco Inc., a 90-year-old Columbia, South Carolina-based manufacturer of pumps, valves, and other steam-related products, wanted to sell off a 30-year-old property that had been the site of its manufacturing processes in Allentown, Pennsylvania. The buyer was R.D. Management Corp., a New York­ based real estate development company.

"Our sales deal with R.D. Management assumed a clean site subject to an environmental study," says Don Harrison, Spirax Sarco vice president and CFO. The study pinpointed the presence of TCE, a toxic chemical that Spirax Sarco would need to clean up before the transaction could go through. After a second study confirmed the extent of the problem and the regulations with which Spirax Sarco would have to comply, the company contacted the Pennsylvania Department of Environmental Protection to develop a mutually acceptable cleanup plan.

Since the site would not be developed into residential real estate and would be capped by a parking lot and Home Depot structure, the company was limited to hauling away only contaminated ground above five parts per billion TCE. That effectively took care of the compliance issue. But, there was still a potential deal breaker. "Our buyer wanted peace of mind in case an environmental problem developed down the road and caused it undue reputational and brand risks," says Harrison. "We did, too, since we'd have to pay for it." Harrison notes that Spirax Sarco was not confident that huge, uncertain environmental problems wouldn't arise someday. "However, you can't always be sure, and when you're talking about something that could represent a major hit to earnings, you don't want to rely on instinct alone," he says.

But Spirax Sarco's board didn't like the notion of putting money in escrow to cover such a possibility. "We wanted to have a clean balance sheet," Harrison explains. "Nobody likes to tuck away a lot of money for years." So it turned to Exton, Pennsylvania-based ECS Inc., part of the large Bermuda-based insurer XL Capital Co., to develop an insurance alternative, forking over a $200,000 annual premium to cover its known and unknown pollution liabilities spanning the next 10 years, giving it a $4 million aggregate cap limited liability over 10 years.

"We've protected both companies' shareholders from environmental uncertainty and avoided a messy balance sheet," the CFO adds. "Had we said to the buyer, 'Take the property as it is,' there would have been no deal. The insurance secured the transaction for us."

EIL insurance also helps sellers fence in environmental liabilities to make their companies more appealing to potential buyers. Clark USA Inc., a privately held St. Louis­based oil refiner, was purchased in 1997 by Blackstone Capital Partners, a New York­based investment group. Blackstone didn't want to inherit Clark's unknown pollution liabilities or spin it off to the public with those potential exposures intact.

While the 60-year-old company already had environmental coverage through its existing property and excess-liability insurance protecting its four U.S.-based refineries against sudden and accidental environmental exposures, the insurance did not cover pollution that could emanate from these sites and, over the gradual course of time, migrate offsite to cause damage or injury to third parties.

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