What if one party is financially weak? Privately-held? Or a liquidating trust?
Following the example of financial assurance tests for closing landfills (tests described in RCRA and State laws), newer CERCLA consent decrees contain a form of financial testing for the PRP group, ensuring parties are – as a group – solvent.
What if your company has a 5% share, and the next three largest PRPs are threatening bankruptcy? A likely outcome is that your 5% share will grow with each bankruptcy. A kind of musical chairs.
The accounting term is “counterparty nonperformance risk”.

What tools and processes can offset counterparty risk?
Simple.
Regular credit checks. Letters of credit from failing parties. Internal cashouts among PRP members.

We see this tracking as a good business decision where a few conditions justify the expense of periodic tracking:
• Future group cash calls above $5 million
• Privately-held parties have a combined allocation above 10%
• Three years or more before most cash calls are collected
• Long-term O&M, with annual cash calls over $500,000/year

This notice reduces the circumstances where “no action/deferral” is the expected and near-term outcome, and by accelerating decommissioning timetables, leaseholders can undergo financial stress by restating their higher-NPV liabilities and then monetizing them through financial assurance instruments.

Financial assurance is supposed to offset the probability – often the inevitability – of bankruptcy resulting in stranded environmental costs…to the taxpayers or peer PRPs. Cleanup projects that are already in the  process will be subject to these requirements, once issued. If you’re managing a multiparty cleanup project, why is financial assurance a useful part of the relationship among the members of the PRP group?

Keep three scenarios in mind: “mind, bind and grind”.

Mind: documented financial assurance, even if it is just in the form of corporate guarantees and annual attestations, keeps PRPs contractually aware of the cost and pace to closure. For a site without current cash calls, employee turnover or a change in external counsel can unravel a PRP group.

Bind: for smaller PRPs without the financial strength to test out of financial assurance requirements, a binding instrument (like a letter of credit for the value of future cash calls) ensures a PRP group will not be an unsecured creditor if the PRP declares bankruptcy. Documenting financial assurance reinforces the corporate commitments.

Grind: when asked to provide a financial instrument, smaller PRPs with a significant allocation learn whether a multiparty site cleanup is a survivable exercise. If future cash calls are added to outside counsel and now financial instrument costs, a PRP will eventually quantify a better decision for all: cashing out promptly.

Remember that when USEPA knows a cleanup project has at least one deep-pocket PRP, their work is almost done. If a PRP group doesn’t implement an active financial assurance process, USEPA will enforce the work with a passive system until enforcement is needed. If you think of a cleanup project as the business risk that it is – a negative NPV investment that can get much worse – you would almost never select the peer PRPs as your partners. Financial assurance can clarify the decision of a shaky PRP to cash out of a site

Strategic defaults are on the rise. The LA Times reports that 2008 saw 588,000 homeowners strategically default on their mortgages, more than twice as many as in 2007. The Wall Street Journal has also reported on the phenomenon, reporting that as many as one in four defaults may be strategic, and that the trend is amplified in high-foreclosure areas where homeowners have been emboldened by their neighbors’ actions. What does this have to do with your environmental risk portfolio? Well, several recent bankruptcies demonstrate that this phenomenon may not be limited to the housing market.

In my previous blog entry, I wrote about the January 2009 bankruptcy filing of Kerr-McGee spinoff Tronox.  When Tronox spun off from Kerr McGee in 2005, it took hundreds of millions of environmental liabilities with it. One can see a similar story by looking at Solutia, which filed for bankruptcy protection 6 years after spinning off from Monsanto.  “We simply could not continue to sustain our operations burdened by Monsanto’s legacy liabilities”, said John C. Hunter, CEO of Solutia.  Looking at both of these bankruptcies with 20/20 hindsight it seems that these companies were doomed from the start, but were they strategic defaults?

It’s important to remember that strategic default may be used by companies you are financially tied to through multiparty remediation sites. When dealing with multiple PRPs, it is now mandatory under FSP FAS 157-f (now FASB ASC 820) to be able to quantify the risk of a fellow PRP defaulting on its liabilities. ERCI is launching a new product, CounterParty Defender, which allows you to test and quantify long-term non-performance risk of other PRPs.  By combining real-time credit ratings with PRP share data and cash call projections, this framework allows you to monitor third-party companies and end business relationships with the highest-risk companies.

Looking at a recent bankruptcy with significant environmental liabilities, I wondered if an investor could spot a problem using this ratio.

Tronox was a publicly-traded spin off of the Kerr-McGee Company, which had an IPO in November 2005. In January 2009, Tronox Chapter 11 filed for reorganization, listing$1.6 billion in assets and $1.2 billion in liabilities, leaving shareholder equity of about $0.4 billion. From their 2007 annual report, Tronox announced an environmental reserve balance of $188.8 million as of 12/31/2007 and fiscal year 2007 spending of $50.2 million. At the 2007 spending rate, the reserve would last another 3.76 years.

Tronox was clear about several matters in their 2007 10-K filing – cost overrun allocation with Kerr-McGee, the pending reimbursements from future spending, even the recent reserve increases – to demonstrate transparency to their shareholders. Two tough questions: was $189 million enough? Was four years enough?

Some years later, we might learn what a reasonable environmental reserve should have been, but the number in place in December 2007, $189 million, was already a big drain on Tronox’s $430 million in stated shareholder equity. On August 2009, the SEC 8-K filing showed the shareholders equity was already marked down to-$159 million, and that the environmental reserves were larger and not decreasing any time soon.

For forward-looking managers, spending today’s cash on yesterday’s liabilities seems like a tempting target: why not delay? Why not switch to a new strategy like “fence and monitor”? Why not litigate?

If you manage an environmental liability portfolio for your company, remember a  rule from baseball: this is a pitch in the dirt, and you don’t have to swing.

Participating in consent decrees and cleaning up sites usually goes beyond a financial obligation. Showing commitments and visible progress to regulators and their communities is not just good PR, it’s good business. Contractors are sensitive and reactive to their clients’ stop and start messages.

Let’s face a few facts: environmental cleanup projects deal with the unknown. What is the target soil volume? How long will the groundwater treatment system need to run? Is the plume off-site? What cleanup goals will the regulators accept if the technology doesn’t work?

Reserve updates are a communication channel to bring new information forward, at least once a year. Using that discussion to revisit old decisions is tempting, but rarely brings the desired outcomes of lower costs, faster closure, or a more valuable brownfield property.

When there is a major bankruptcy, your company may find out that it is…was…in business with a well-known company that is now going to discharge future environmental liabilities very quickly.

In 2006, the Financial Accounting Standards Board released Statement 157 on Fair Value Measurement. This standard applies not just to assets, but to environmental liabilities as well. One new obligation is that environmental remediation liabilities (covered under FASB 5) and asset retirement obligations(FASB 143) now need to contain a company’s definition of counterparty risk.

Counterparty risk is the expected value of default from a company on the other side of a transaction.

If your company if jointly funding an RI/FS with a ten-party group, and two of those parties go bankrupt, your company may not see any future cash calls paid for the RI/FS, and may be implementing the remedy without them. Filing a claim with the bankruptcy court, typically through common counsel, is often the only step available in this game of musical chairs.

The rule for PRP bankruptcies: next time the music stops, get ready to file aclaim.

In other words, a company needs to state its environmental liabilities and then discount that liability if there is doubt that it will actually pay them.

Dun & Bradstreet notes that the general default rate for US companies is about 1.4% a year. This isn’t a “bankruptcy rate”, but will be a proxy for our example. During good times, with a growing client base and ample credit, a company may determine its own chances of filing bankruptcy at <1%. During a recession, after losing key clients and credit facilities, it may determine that there is a 10% or 15% chance of filing bankruptcy.

Under FASB 157, an environmental liability of $10 million would still be about $10 million in good times, but when a company decides it is less creditworthy, it should revalue the liabilities to $9 million or less. By changing the self-assessment of bankruptcy from 1% to 10%, the income statement shows a liability write-down of $1 million; in other words, a paper profit. If you see this in an income statement, stay on your toes. It’s a deadbeat dividend.

Think about that moment, when a company decides it is time to confront its credit condition, it cuts environmental liabilities because the “ability to pay” is diminishing, and the reward is… a book profit.

Fast forward two years, the same company survives, and the ability to pay improves. The reward is… a book loss for marking the liability up to the full, original value.

Environmental liabilities are never going to be simple again.

Do environmental liabilities need multiple sets of books?

We have found the answer is simply “yes.”

One set of books is needed for reserve estimation, under FAS 5 or GASB 49. The duration of a company’s reserve horizon and the phase of a project usually mean reserve numbers can be robust and rigorous, or vague to non-existent for early-stage projects.

A second set of books is needed for cost recovery. When cashing out a small PRP or an insurer, the risk premiums and inflation of sunk costs, along with speculation about future costs, can trigger a widely different liability estimate from a reserve forecast.

A third set of books is important for an operating facility. Not every environmental  project is funded with reserve dollars. Often, there are capital expenditures or asset impairments which create different assets or liabilities on the balance sheet. Plus, there are normal environmental operating expenses.

Now that there are three sets of books, keep in mind that the backup may be different. The raw estimates, with price and quantity assumptions, are essential but volatile. The data displayed to management, in a portfolio summary, applies program-wide assumptions to each project. The disclosure to shareholders requires the application of rules regarding materiality and consistency across environmental projects and other contingent liabilities.

More than one set of books is just a part of our business.