Court Protects CEQA Categorical Exemptions by Limiting Unusual Circumstances Exception

Real estate developers who have opponents alleging that CEQA exemptions are unavailable to them because the environmental impacts of their projects alone are unusual won an important victory this week in the California Supreme Court.  Even if a project has negative environmental impacts, a categorically exempt project is spared from CEQA review so long as the project itself is consistent with the class of projects that typically qualify for the exemption, the Court held.

The Court’s holding is an important victory for developers and public agencies. Both will have an easier time relying on so-called “categorical exemptions,” which exempt a proposed project from California’s Environmental Quality Act (“CEQA”).  Categorical exemptions are classes of projects that are exempt from complying with the environmental study procedures of CEQA because, as a policy matter, the projects are unlikely to have a significant impact on the environment.  Developers and public agencies rely on categorical exemptions to streamline the processing of projects and more efficiently use public resources on other projects that are likely to have significant environmental effects.  Project opponents, on the other hand, often seek to disqualify a project from using a categorical exemption so that CEQA review is required.

Berkeley Hillside Preservation v. City of Berkeley concerns a property owner who sought approval to build an almost 6,500 square foot house with a separate 10-car garage on a steep, wooded slope in the hills of Berkeley, California.  The homeowner claimed that the project was exempt from environmental review because it qualified for two “categorical exemptions:” one for single family residences and another for in-fill development projects.  The City of Berkeley agreed with the owner and approved the project.

Opponents of the project sued, arguing that the homeowner’s claimed categorical exemptions could not be used because an “exception-to-the-exemption” in the state’s CEQA regulations says:  “A categorical exemption shall not be used for an activity where there is a reasonable possibility that the activity will have a significant effect on the environment due to unusual circumstances.”  This “unusual circumstances” exception-to-the-exemption attack is frequently used by project opponents in an attempt to “backdoor” a project into CEQA review.

In this case, the argument was over how to interpret the text of the unusual circumstances “exception-to-the-exemption.”  Opponents were able to persuade the lower courts to hold that the fact that a proposed project may have a significant impact on the environment is itself an unusual circumstance that renders a categorical exemption inapplicable.  Fortunately, the California Supreme Court did not accept that interpretation, reasoning that opponents and the lower courts did not give meaning to all of the words in the exception:  the significant effect must be due to unusual circumstances.

Going forward, if a project opponent sues arguing that the “unusual circumstances” exception applies, a reviewing court must apply a two-step inquiry. First, a court must determine whether a particular project presents circumstances that are unusual for projects in the class described in the categorical exemption.  In making this evaluation, the court applies a “substantial evidence” standard of review.  After resolving all evidentiary conflicts in the public agency’s favor and indulging in all legitimate and reasonable inferences to uphold  the finding, the court must affirm the agency’s decision if there is any substantial evidence, whether contradicted or uncontradicted, to support it.

In light of this first prong, developers and public agencies will do best to place in the record evidence and reasoning showing how the project under consideration is typical for its class.  Project opponents may introduce evidence in the record that the environmental effects of the proposed project tend to show that the project is unusual for its class; however, that evidence alone is not dispositive of the issue. Therefore, it is crucial for the public agency to make a specific finding of fact that the project does not present “unusual circumstances.” A specific finding made by a public agency in light of the evidence in the record will be entitled to great deference at this step in the analysis. This is important, because if a person relying on a categorical exemption prevails on the first prong of the test, the inquiry ends.

The second prong of the test is whether there is a reasonable possibility that the unusual circumstance will produce a significant effect on the environment.  In making this evaluation, the court reviews the record.   If substantial evidence supports a “fair argument” that there is a reasonable possibility of a significant effect on the environment due to the unusual circumstance, then the “exception to the exemption” would be triggered.  The claimed categorical exemption cannot be used to exempt the project from CEQA review.

The “fair argument” standard should be familiar to CEQA practitioners. It is the same standard under which an agency must prepare an EIR whenever substantial evidence in the record supports a fair argument that the project may have a significant effect on the environment.  The “fair argument” standard has killed many negative declarations prepared by public agencies that may not have relied on a carefully prepared record of decision.

The Court’s decision in the Berkeley Hillside Preservation case was eagerly awaited by CEQA practitioners.  Its impact will be felt not only in the single family residential and urban infill context, but also in every case in which a categorical exemption is relied upon by a project applicant and a local government body.

Environmental Due Diligence In Real Estate and Company Acquisition Transactions

Before a buyer purchases a company or a real estate asset, it should review and assess records and other information about the target for the purpose of providing input into potential environmental issues.  By performing environmental due diligence, a buyer can determine compliance risks, properly structure the deal, better value the target, and budget for integrating the asset into the buyer’s portfolio or operations.

Every buyer has an interest in identifying issues that will need to be resolved either prior to closing or after closing.  Up-front due diligence can quantify the costs to remedy a clean up or compliance problem or estimate a range of potential costs if further investigation is required.  If a property or product is contaminated beyond use thresholds, the presence of hazardous materials can rise to the level of preventing the business to operate.   A buyer can also be exposed to potential tort or civil liability for existing conditions at the property.  Finally, buyers are increasingly concerned about reputational risks, since many large corporations have corporate social responsibility (“CSR“) programs and reports.

Environmental due diligence can help value a target company or real estate asset.  Noncompliance with environmental regulations can be expensive to fix, as in the case of a company’s failure to install air pollution controls in its facilities.  The clean up of contaminated property can involve significant expense — in the millions of dollars — or interfere with the use or planned disposition of property.  For example, one company acquiring a target may desire to buy the target and then consolidate real estate assets and dispose of facilities that are no longer needed to efficiently operate the combined company.  If the assets of the target company that are to be disposed of are contaminated with hazardous substances, the property may have to be cleaned up prior to its sale as a separate asset, resulting in costs and delays in fully implementing a business plan.  Finally, the acquiring company may be unable to sell the target’s products legally if the target’s products do not comply with U.S. or foreign laws.

Fines and penalties imposed by the U.S. EPA can be as high as $37,500 per day per violation.  Because a myriad of federal, state and local regulatory authorities have jurisdiction over environmental compliance matters, noncompliance can trigger  conversations with regulators that impact the time, energy and financials of an acquiring company.

Early identification of environmental issues has several benefits.  First, the acquiring company can seek to avoid or resolve the issue prior to closing, through closing conditions and pre-closing covenants between the acquiring company and the target.  Second, due diligence can help business leaders appropriately value the target company or asset, if post-closing expenses will be incurred to bring the target into compliance.  Third, the parties can determine an appropriate deal structure.  For example, if a target company has numerous real estate assets and a few of them are contaminated, it may not make sense to structure a transaction as a stock purchase transaction, but rather as an asset purchase so that the contaminated assets can be excluded from the deal.  Fourth, the buyer and the seller can properly negotiate the amount of any escrow holdback from the purchase price for post-closing covenants or obligations, or determine the scope of any post-closing indemnity from the target (or a guarantor of the target).  Finally, an acquiring company can properly include post-closing environmental compliance costs into its integration planning and budgeting.  In this way, counsel and environmental health and safety professionals can engage business leaders in a conversation about the transition costs for bringing the target company or asset into compliance after closing, if necessary.

The environmental due diligence process is too complex to detail in a step-by-step way in this post, but a few essential elements should be mentioned.  It is very important to develop a due diligence strategy up front to assess compliance risks.  The more decision-makers have “buy in” on the strategy, goals and objectives of the model, the greater they will value the results of the investigations. A tiered approach to standard due diligence questions is a practical method, where general questions are followed by more specific questions once relevant issues are revealed.  This approach avoids unduly burdening the target with numerous potentially irrelevant questions.  Areas of concern can be explored either based upon publicly available information or upon the responses to due diligence questionnaires.  Representations and warranties should be included in the purchase and sale contract, customized in response to the results of due diligence.  Representations and warranties are frequently used to test assumptions and flush out accurate facts about a target.  Finally, among other things, the model should include guidance on how to deal with “red flags” and “deal breakers” that are identified during due diligence.

In today’s transactions, environmental due diligence often starts with access to a data room or electronic document depository.  As a condition to access, a buyer will likely have to sign a confidentiality agreement, which should be reviewed by counsel prior to execution.  Due diligence periods are often limited, so counsel should be consulted to determine a realistic amount of time to fairly collect, review and analyze information that will be useful for decision-makers.  To the extent that confidentiality concerns may limit the exchange of information, counsel for the buyer and the seller need to be focused  on the objective of consummating a deal that makes sense for both parties.  It may be necessary to think creatively to resolve confidentiality issues so that the deal can be properly structured and evaluated.  For example, the number of individuals with access to highly sensitive information can be strictly limited to those with a need to know.  Failing to reveal information that is material can result in future claims of fraud and concealment against a target — claims that cannot typically be avoided through the application of “as is” clauses or release provisions in a purchase and sale contract.

In addition to documents provided in an electronic data room, environmental due diligence may need to include a review of filings made with regulatory authorities.  Occasionally, the target company will have to consent to the release of this information, particularly regulations recognize that such filings may include trade secrets or other proprietary information, such as the chemicals used in a particular process.  The buyer’s coordination with the target company is crucial in order to maintain good relations with both the target and the regulator.

Finally, environmental due diligence typically involves the hiring of a third party consultant to enter and inspect the property.  Prior to the entry, a target will typically require an access agreement and proof of insurance.  It is important that counsel review the scope and limitations in the access agreement, so that the buyer and the seller understand the types of inspections that are permitted and a process is established for more extensive inspections should problems be revealed.  An inspection of the property can be merely visual or invasive.  A Phase I Environmental Site Assessment is an investigation designed to determine whether hazardous materials have been released on property and the potential for hidden liabilities for purchasers, owners, operators, insurance and financial institutions.  Proper compliance with the laws and regulations applicable to a Phase I Environmental Site Assessment is crucial to shielding the buyer from future liability under the federal Comprehensive Environmental Response, Compensation and Liability Act (CERCLA).  If the Phase I Environmental Site Assessment discloses matters of concern, a Phase II Environmental Site Assessment may be necessary which requires more invasive testing of the property. If the property is contaminated, consultants can characterize the extent of the release of hazardous materials and the potential remedial actions that may be required. Of course, any final corrective action would need to be approved by the applicable authorities who are becoming increasingly likely to impose “green and sustainable” remediation of sites. Hiring a consultant or counsel that has experience negotiating clean up solutions with regulators can help clients assess whether “green and sustainable” remediation will be required, which may be more costly than more traditional restoration methods.

Environmental due diligence is a complex process that requires coordination among buyer, seller, counsel and their consultants. Successful efforts rely on thoughtful preparation, open communication and strategic decision-making.