Very few directors, risk managers, insurance brokers, accountants, auditors or solicitors can claim to be up to speed with environmental law and the current financial reporting disclosure requirements for environmental issues. Hitherto, many directors have muddled by, relying on their past knowledge, picking up through hearsay what others believe to be their requirements and benchmarking themselves against the non-activity of others.
But they are now running a very real danger of exposing their companies, as well as their own financial well being, to legal action.
What has changed? There are a number of disclosure requirements that have been introduced, and are continuing to be introduced, by statute (many enacting EU directives into national law), by financial reporting standards, and through good governance practice.
The director's role
Directors are responsible for the governance of the company. They owe their duties to the company itself and not to the shareholders, although they must have regard to the interests of present and future shareholders.
Directors have extensive fiduciary duties, such as a duty to use their powers for the benefit of their company. In addition to this general duty, directors, including non-executive directors, have the following specific duties:
- to act in the best interests of the company at all times: a duty of utmost good faith
- not to make a secret profit (for example, not to profit from an abuse of their powers)
- not to place themselves in a situation where their duty to the company conflicts with (or may conflict with) their own personal interests.
The revised Turnbull Guidance on Internal Control was recently released for consultation, the deadline for submissions being 16 September. However, the number of people who participated in the joint submission by the Institute of Risk Management and the Association of Insurance and Risk Managers to the previous round of consultation earlier this year, suggests that not many directors or risk managers outside the FTSE250 will have picked up its existence. Or, if they have, they mistakenly believe it is just a concern for accountants and auditors.
Another influence on governance reporting stems from the Sarbanes-Oxley Act 2002. Primarily this is a concern for the CEO and CFO of companies with a US listing (including foreign companies listed on a US stock exchange), insofar as their certifications of the effectiveness of disclosure procedures and controls are concerned (Section 302 of the Act).
In addition, there is an implication for such directors when accounts are also produced for UK shareholders, for example when a subsidiary of a US parent company is also listed in the UK. It is noteworthy that the mandatory nature of SOX, as opposed to the voluntary disclosure approach of Turnbull, is favoured by some EU member states, and, should voluntary disclosures not achieve the required level of safeguard for shareholders and other stakeholders, a SOX-style approach may be introduced throughout the EU. (The Draft Revised Turnbull Guidance includes a separate section on complying with SOX.)
Governance disclosure requirements in the UK are not limited to Turnbull.
The Companies Act 1985 (Operating and Financial Review and Directors' Report etc.) Regulations 2005 came into effect from 1 April 2005, and introduced a requirement for quoted companies to prepare an Operating and Financial Review. This review must include information about environmental matters, information about the company's employees and information about social and community issues. In particular, it must include information about the policies of the company in each of these areas. For other companies there is a requirement for the business review within the Directors' Report to contain a description of the principal risks and uncertainties facing the company.
How many directors even consider the environmental risks that face their companies? Even if they do, they may well limit their thoughts to such headline topics as reducing potentially harmful emissions, more efficient use of energy resources, climate change and carbon trading, and so feel they have discharged their responsibilities through the approval of a corporate social responsibility report. But what about the real financial exposure to legacy environmental risks that practically all owners, and even merely users, of property in the UK, and indeed across much of Europe, have?
Sources of environmental risks
Clearly, companies using or transporting potentially hazardous products or waste run an exposure for spillages and the resultant damage. Their prime protection against this is a good environmental management system (EMS). However even with the best EMS, accidents can and will happen.
In some countries some environmental risk protection is afforded by public liability and general liability policies, or policies placed through a local 'pool' arrangement. But before undue reliance is placed upon such cover, it is essential that adequate research is undertaken to avoid misconceptions.
For example, what is meant by 'sudden and accidental?' If a spillage occurs because an underground pipe bursts, is it sudden and accidental? What if the pipe has rusted?
Put aside the notion that only so-called dirty industries run an environmental financial exposure. Most business premises, even those used by service industries, have been built on former industrial sites. The primary source of a potential liability is likely to be that acquired through the ownership, or potentially just tenancy, of these properties.
The next source is that which is often bought in when a new property is acquired, or when a subsidiary that owns or uses a property is acquired.
In the latter case, a subsidiary can bring with it a tail of responsibility for properties it and its own former subsidiaries may have owned or occupied.
Finally, there is the liability that can be unknowingly retained when a property, or a subsidiary owning a property, is disposed of.
Environmental liabilities and the valuation of property assets
When an independent valuation is commissioned for a property that is being acquired, it is common practice for the consultant surveyor to add caveats to their report by stating the valuation does not take into account the costs of the environmental condition or contamination status of the land.
Where a property has known contamination, the vendor may attempt to pass on any potential financial exposure to the new owner. This was often the case when former public utilities were privatised. The Contaminated Land Regime introduced by the Environmental Protection Act 1990 Part IIA, allows for liability to be passed when such a property is sold in exchange for a discount from the consideration. However, in practice this is often not simple to achieve.
In such a case the vendor may engage an environmental consultant to undertake an appropriate environmental site assessment (ESA). Alternatively, in order to quantify the extent of their future potential liability, the acquirer may engage the services of such a consultant. Commonly, however, the terms of engagement for the environmental consultant are not properly formulated. For instance, they may refer to a Phase I or Phase II ESA produced to ASTM (American Society for Testing Materials) Standard. This states that a properly performed ASTM Phase I ESA consists of three parts:
- a review of government records and interviews with appropriate officials regarding the property and adjacent properties
- a site reconnaissance of the property and all structures
- an evaluation of acquired information and the presentation of findings and recommendations in a written report.
The trouble is that the government registers referred to have no equivalents in the UK, or in many countries outside the US. For example, there is no equivalent to the LUST (Leaking Underground Storage Tank) Register.
Thus, outside the US, a Phase I cannot be undertaken to ASTM standards.
It is therefore key that the specific requirements for the ESA for any Phase I and Phase II (intrusive) surveys are specified. Only then will the purchaser of the report have a degree of certainty that some recourse to the environmental consultant exists.
Even allowing for a properly specified report, there are often further misunderstandings. The first of these is that the estimated cost of remediation is exact. If the environmental consultant's estimate is later found to be incorrect, there is a misconception that the consultant can be called upon to make good the amount of any underestimation. But this is simply not the case. The report will indicate the figure is only an estimate and will generally contain sufficient caveats to protect the firm of consultants, providing they have undertaken the work professionally.
The next pitfall is that acquirers and their legal advisers often believe the remediation estimate will represent the full extent of any potential environmental liability. Consequently they seek supportive warranties and indemnities for this amount within the relevant sale and purchase agreement. Again, this is not the case; the report does not extend to the potential remediation for adjacent properties to which the contamination may have travelled, or for third party liabilities for bodily injury or illness caused by the contamination, either on or off site.
In order to make proper disclosure, directors need to check that the value reflected on the balance sheet as the 'lower of cost and net realisable value', or the 'revalued amount', of the property takes proper account of any liability for environmental remediation.
In addition, the potential environmental liability for users and owners in regard to third party issues needs to be considered in terms of FRS 12/IAS 37 as well as for governance disclosure purposes. Often, these disclosures are ignored because an exact estimate cannot be obtained, or no attempt has been made to evaluate the potential exposure.
Besides being a failure to fulfil a duty of utmost good faith through not valuing the assets stated on the balance sheet correctly, or in failing to disclose potential environmental liabilities, the failure to take account of these issues may well result in inflated profits being reported. As a consequence there could well be a secret profit earned by the director in the form of an annual bonus. Thus the failure to account for environmental liabilities could be seen to lead to a failure in the third duty of the director, through causing him to place himself in a situation where his duty to the company conflicts (or may conflict with) his own personal interest (the gain of increased remuneration through failure to disclose).
Some directors may believe their directors' and officers' (D&O) insurance will afford them protection against such failures. However, D&O policies often contain pollution exclusions. Even where they do not, the emergence of effective and meaningful environmental insurance products, may mean that the claim under the D&O policy would prove unenforceable if the directors had not taken reasonable steps to protect the D&O insurer by placing adequate environmental insurance.
Environmental insurance has of late become a viable purchase, and directors are encouraged to seek advice on the placement of such insurance in order to be able better to protect their companies (and themselves) against unforeseen liabilities incurred as a result of inadequate disclosure.
- Robert Martin, Tel: 020 7216 3901, E-mail: robert.j.martin@aon.co.uk, and Marcel Steward, Tel: 020 7216 3902, E-mail: marcel.n.steward@aon.co.uk, are directors of the environmental consulting and solutions division of Aon Limited.
