Expert Commentary

Industrial Bankruptcies and Environmental Cleanups

In the increasingly common context of industrial bankruptcies—where the full cost of environmental cleanup obligations to regulators must be met before the remainder of estate assets can be divided up among other creditors—bankruptcy courts and others (e.g., creditors, debtors) need an efficient and reliable means to quantify the amount of dollars likely required to remediate sites owned by the debtor and ensure that those dollars will remain sufficient over the long run.


Environmental
May 2016

An artificially low number would leave sites behind that are not only contaminated but also likely unused and otherwise unproductive. An artificially high number would undermine a debtor's chance of exiting bankruptcy and resuming its business; it would be unfair to creditors; and, in extreme cases, it could prevent any sort of orderly resolution and also result in, among other things, a legacy of contaminated and unproductive properties.

As bankruptcy courts have come to recognize in other contexts, the most reliable means of determining the right number is through market mechanisms of some sort. See Tronox Inc. v. Kerr McGee Corp. (In re Tronox Inc.), 503 B.R. 239, 292 & n.61, 296 (Bankr. S.D.N.Y. 2013). As set forth below, the best—perhaps the only—means of using market mechanisms to quantify the amount of dollars likely needed to meet regulatory cleanup standards is through insurance-backed fixed-price contracts (FPCs). The market incentives for FPCs not only work to develop cleanup estimates that are efficiently determined, they also help ensure that estimates are not later exceeded.

Fixed-Price Contracts

This article builds on the February 2016 article Fixed-Price Contracts Using Cost-Cap Alternatives for Environmental Cleanup, which explained FPCs and showed that by using cost-cap alternatives (CCAs) to provide the needed insurance, FPCs can still be accomplished despite conventional insurers' 2011 exit from the cost-cap insurance market. The earlier article discussed FPCs done on behalf of the Air Force at the former McClellan Air Force Base. With five separate FPCs having been applied at the Base since 2005, over 15,000 people already live and work at the former base, and the government estimates that when cleanup and redevelopment is complete, over $7.7 million in annual property and sales tax revenue will be generated.1

Since the late 1990s, FPCs have been used to clean up hundreds of contaminated properties. Importantly, because the McClellan FPCs came in the context of a transfer of military-owned contaminated property, they required the most rigorous form of regulatory review.

Many thought the availability of FPCs would end after conventional insurers stopped offering "cost-cap" (also known as "stop-loss") insurance that had come to be integral to FPCs of any significant size. The post-2011 FPCs discussed in the February article show that, where even the greatest regulatory assurances are required, government approval can still be expected for properly structured FPCs. In fact, regulators have applauded the post-2011 cost-cap alternatives because regulators had increasingly come to appreciate FPCs as a means to accomplish cleanups without litigation and other factors causing delay.

Notable Bankruptcies

To illustrate how FPCs should be applied in the bankruptcy setting, consider the lessons from the recent Kerr-McGee-related Tronox bankruptcy, cited supra. Although the bankruptcy began in 2009, resolution was not reached until late 2014, and cleanup funds were not released until 2015. Using the traditional model of litigation, the dispute required a 34-day trial with 14 expert witnesses, with the firm of just one expert spending over 40,000 hours on the matter.

These resources were not a good fit for the bankruptcy court to reach a reliable number. After 8 years of traditional litigation, the court was unable to quantify the expected cleanup costs anywhere beyond a range of $5 billion–$14.5 billion. Estimates from creditors' experts were three times those of debtors' experts (503 B.R. at 310). After nearly a year of post-trial settlement discussions and with pressing need for resolution, the parties finally settled on a number of $5.15 billion. The court accepted that number in November 2014, and the cleanup funds were released in January 2015. Post-settlement litigation regarding the adequacy of the funds is already underway (e.g., In re Tronox, No. 16–0343 (2d Cir. Feb. 8, 2016)).

Processes leading up to FPCs reach cost estimates that are not only more efficiently determined, but are far more likely to hold true over the long run.

FPC prices are typically derived within months of bidding contractors receiving a request for proposal and access to site data. Provided there is competition among bidding contractors, each contractor has a strong market incentive not to overestimate, if only because an overestimating contractor is unlikely to win the competition and get the work. Contractors face an even stronger market incentive not to underestimate because a contractor that wins an FPC award through an underestimate would have "shot itself in the foot," for it would receive inadequate funds to accomplish the statutory cleanup requirements it is contractually obligated to achieve.2

Reliable bid prices can be obtained even at debtor properties that are not fully characterized. At a property about which I wrote in more detail in 2003, Insured Fixed-Price Contracts as a Means To Quantify Costs and Obtain Funds To Clean Up Contaminated Sites: The Kenosha Model, an FPC was accomplished despite the significant absence of environmental data and with no "remediation action plan" of any kind. Two conventional (non-FPC) estimates previously obtained by the owner ranged from $15 million to $20 million, with no cost guarantee and not including the cost of preparing the land for redevelopment.

In the face of those uncertainties, the owner (and hosting city) considered an FPC. For $10.1 million, the FPC guaranteed full cleanup, full redevelopment preparation, and insurance and corporate guarantees up to $25 million. In the event that the cleanup is not completed (or needs to be "re-opened"), the contractor must continue (or resume) the work. With those structures in place, contractors are incentivized to approach sites in the manner they deem most efficient in terms of cost and time and to ensure that the cleanup obtains regulatory approvals that will hold true over time.

A broad (41-site) study of FPCs by the Army found that, with FPCs, cleanup schedules were consistently met; work quality was "from good to going beyond requirements;" and perhaps counter-intuitively, cleanup costs were, on average, over 21 percent below independent estimates made prior to the cleanup.3

The same steps can and should be employed in the bankruptcy context. Hard-fought litigation is not required in every industrial bankruptcy to arrive at a reliable cost estimate for cleanup obligations. For example, in In re Lyondell Chemical Co., 09–10023, 2010 WL 1544411 (Bankr. S.D.N.Y. April 19, 2010), the parties and court relied principally on outside consultants' estimates to settle on a figure of $108 million to remediate 23 properties. But that number was not market-derived, the cleanups were not insured, and the remediation contractors were typically not required to share the risk of cost overruns. Thus, if costs increase substantially under this system, the bankruptcy trusts are far more likely to become insolvent, and the properties remain contaminated and unused.

FPCs, by contrast, are typically insured up to twice the original cost estimates (see Fixed-Price Contracts), and FPC contractors are typically contractually bound to cover a third of any cost overages, giving them significant and ongoing market incentives to avoid cost overruns. While contractors cannot "cut corners" to avoid overruns—because environmental regulators (e.g., the United States Environmental Protection Agency (EPA) and its state counterparts) maintain full control over the site to ensure that the contractor completes the remediation—over 15 years of FPC data show that, at the end of the day, when contractors are given a direct and ongoing market incentive to keep costs low, on average, they complete cleanups at over 20 percent below original cost estimates.4

Conclusion

While FPCs are not a panacea, they should certainly be considered in the context of industrial bankruptcies as a means to quantify the amount of needed environmental costs, and then ensure that the determined amount is, in fact, sufficient over the long run.


1 US Air Force Civil Engineer Center, Public Affairs Office, Governor signs 528-acre land transfer for McClellan (January 15, 2013), http://www.afcec.af.mil/news/story.asp?id=123332596.

2 The February article describes the structures best designed to achieve these objectives. These procedures include that the contractor must (a) perform the cleanup to the full extent needed to obtain "No Further Action" certification from the EPA or its state counterpart; and (b) assume itself the risks for a significant portion (typically a third) of cost overruns up until the cleanup costs exceed twice the amount of the original estimate. In a well-structured FPC, contractors are willing to assume the risks of these financial downsides ("sticks") because the FPC also provides significant chance of reward ("carrots"). If the contractor completes the cleanup below its estimate, it receives not only the profit on the work it has done but also the entirety of the delta between the actual cost and the estimate.

3 US Army Environmental Center (USAEC), Tracking Performance on the Army's Performance-Based Contracts, at 4, 24, 31 (2006).

4 US Army Environmental Center (USAEC) study cited supra, at 31. 


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