Environmental Phase I and Phase II Assessments - When Testing Reveals Problems in M&A Transactions

The call came three weeks before closing. The buyer’s environmental consultant had found elevated levels of trichloroethylene in the groundwater beneath the manufacturing facility—a legacy from degreasing operations the current owner didn’t even know had occurred there decades ago. What had been a straightforward $8 million transaction for a precision machining company with 45,000 square feet of production space suddenly became a complex negotiation involving environmental attorneys, remediation specialists, and state regulators. The deal eventually closed, but only after four months of additional due diligence and a complete restructuring of how environmental liability would be allocated between the parties.

Executive Summary

Environmental site assessments have become standard practice in business acquisitions involving real property, and for good reason. These assessments—beginning with the document-driven Phase I review and potentially escalating to the sampling-intensive Phase II investigation—can reveal contamination, compliance violations, or remediation obligations that fundamentally alter transaction dynamics.

For business owners preparing for exit, understanding environmental due diligence isn’t optional. Industry practitioners and environmental consulting firms report that approximately one-third of commercial real estate transactions identify some level of environmental concern during the Phase I process, with the exact percentage varying significantly by property type, geographic region, and historical use patterns. A meaningful percentage of those require Phase II testing that confirms contamination requiring attention. When testing reveals problems, sellers face difficult choices: negotiate cleanup responsibilities, structure indemnification to allocate liability, accept reduced valuations, or watch deals collapse entirely.

This article examines how environmental assessments work, what they commonly reveal across different business types, and how experienced advisors structure transactions to address environmental exposure. We provide frameworks for proactive environmental management that can prevent surprises during due diligence, strategies for negotiating remediation responsibilities when problems emerge, and approaches to indemnification structuring that protect both parties while allowing transactions to proceed. Business owners who understand these dynamics can approach their exits with realistic expectations and strategic preparation.

Introduction

Environmental liability represents a significant deal risk that can, under certain circumstances, create substantial and long-term financial obligations. While liability exposure varies considerably based on contamination type, extent, and regulatory jurisdiction, cleanup costs for serious contamination can exceed the value of the underlying business and create obligations that persist for years or even decades. Buyers understand this asymmetry, which explains why environmental due diligence has become standard practice in most transactions involving real property.

The Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) and its state equivalents create strict, joint, and several liability for environmental contamination. This means that current property owners can potentially be held responsible for contamination they didn’t cause, that occurred before they owned the property, and that they had no knowledge of. But CERCLA also provides certain defenses—including the “innocent landowner” defense, the “bona fide prospective purchaser” defense, and the “contiguous property owner” defense—that buyers can establish through appropriate due diligence. For buyers, conducting thorough investigation is necessary both to understand risk and to preserve potential liability protections. For sellers, it creates an obligation to either demonstrate environmental cleanliness or negotiate appropriate protections.

Environmental assessments follow a tiered approach designed to balance thoroughness with cost-effectiveness. Phase I Environmental Site Assessments review historical records, conduct site inspections, and interview knowledgeable parties to identify Recognized Environmental Conditions (RECs)—circumstances that suggest contamination may exist. When Phase I identifies concerns, Phase II assessments employ actual sampling and testing to confirm or rule out contamination and characterize its extent.

For business owners in manufacturing, distribution, automotive services, dry cleaning, or any industry with significant chemical use, environmental assessment findings can become the pivotal issue in transaction negotiations. Understanding what assessors look for, what findings mean, and how deals accommodate environmental issues gives sellers the knowledge needed to navigate these challenges successfully.

What Phase I Assessments Reveal and Why They Matter

Phase I Environmental Site Assessments follow standards established by ASTM International (currently ASTM E1527-21) and serve as the foundation for all environmental due diligence. These assessments don’t involve sampling or testing—they’re investigative exercises designed to identify conditions that suggest contamination might exist.

The Four Components of Phase I Assessment

Every Phase I includes four investigative elements that together create a complete picture of environmental risk:

Historical Use Review examines how the subject property and surrounding properties have been used over time. Assessors review aerial photographs dating back decades, fire insurance maps (Sanborn maps), city directories, building permits, and other historical records. This research often reveals previous uses that current owners never knew about—the dry cleaner that operated on site in the 1960s, the gas station that once occupied the adjacent parcel, or the industrial operations that preceded the current business.

Regulatory Records Review searches federal, state, and local environmental databases to identify known contamination sites, permitted facilities, underground storage tanks, hazardous waste generators, and enforcement actions. This review extends to surrounding properties because contamination can migrate from neighboring sites onto the subject property.

Site Reconnaissance involves physical inspection of the property looking for evidence of current or historical environmental concerns. Assessors examine chemical storage areas, floor drains, staining patterns, ventilation systems, and any visible signs of releases. They also observe surrounding properties for conditions that could affect the site.

Interviews with current and past owners, operators, and occupants can reveal practices and incidents that don’t appear in written records. Long-term employees often provide key information about chemical handling, waste disposal, and environmental incidents that shaped current conditions.

Understanding Assessment Findings

Phase I assessments categorize findings using specific terminology that has legal significance:

Recognized Environmental Conditions (RECs) indicate the presence or likely presence of contamination in soil, groundwater, or building materials. RECs typically trigger recommendations for Phase II investigation because they suggest contamination that could create liability.

Controlled Recognized Environmental Conditions (CRECs) represent contamination that has been addressed to regulatory satisfaction but remains in place under ongoing controls or restrictions. CRECs don’t necessarily prevent transactions but require buyers to understand and accept continuing obligations.

Historical Recognized Environmental Conditions (HRECs) indicate past contamination that has been fully remediated with no further action required. These findings confirm that environmental issues existed but no longer create liability concerns.

De Minimis Conditions represent minor issues that don’t rise to the level of RECs but warrant documentation. Small quantities of properly stored materials, minor staining, or similar conditions might be noted as de minimis.

For sellers, Phase I findings determine whether the transaction proceeds smoothly or faces environmental complications. Properties with no RECs identified provide buyers the comfort needed to close without additional investigation. Properties with RECs face Phase II testing and the potential for significant findings that affect deal structure.

When Phase II Testing Confirms Contamination

Phase II Environmental Site Assessments involve actual sampling and laboratory analysis to confirm whether contamination exists, identify contaminants present, and characterize the extent of impacts. Based on industry experience and environmental consulting firm fee schedules, these investigations typically cost between $10,000 and $100,000 depending on scope, property size, number of sampling points, and contaminants of concern. Complex sites with multiple potential contamination sources or extensive groundwater impacts can exceed these ranges significantly. Environmental cost estimates carry inherent uncertainty due to unknown subsurface conditions, changing regulatory requirements, and the potential for additional contamination discovery during investigation.

Phase II investigations typically require four to eight weeks for sampling, analysis, and report preparation, though this timeline does not include regulatory review periods, additional investigation if contamination extent exceeds initial scope, or time required for agency approvals. In our experience, sellers should add two to four weeks for regulatory coordination on any investigation requiring agency notification.

Common Contamination Scenarios by Business Type

Different business types present distinct environmental risk profiles based on their operations and the materials they handle:

Manufacturing Facilities often face contamination from process chemicals, metalworking fluids, solvents, and waste handling practices. Degreasing operations using chlorinated solvents like trichloroethylene (TCE) or perchloroethylene (PCE) present particular concerns because these dense chemicals sink through soil and can contaminate groundwater over wide areas. Machine shops, metal finishers, and fabrication facilities frequently discover contamination around former degreasing stations, waste storage areas, and floor drains. For smaller manufacturing operations in the $2M-$10M revenue range, environmental exposure may be more contained than large industrial sites, but even limited contamination can represent a material transaction issue relative to deal size.

Dry Cleaning Operations represent one of the highest-risk categories for environmental contamination. PCE, the dominant dry cleaning solvent for decades, creates persistent groundwater contamination that can require hundreds of thousands to millions of dollars in remediation depending on extent and hydrogeological conditions. Properties with current or historical dry cleaning use almost always require Phase II investigation, and contamination findings are common.

Petroleum Distribution and Automotive Services face risks from underground storage tanks (USTs), aboveground storage, and product handling. Even properly managed UST systems can develop leaks over time, and older facilities often operated without leak detection or secondary containment. Gas stations, fleet maintenance facilities, and any property with fuel storage require careful investigation. Some states have UST cleanup funds that can offset remediation costs, though these programs vary significantly in availability—many state funds have been depleted, suspended, or have waiting lists that delay assistance for years. Eligibility requirements, coverage limits, and deductibles also differ substantially by jurisdiction.

Agricultural Operations can present contamination from pesticides, herbicides, fertilizers, and fuel storage. Properties with historical agricultural use may contain persistent organic pollutants that were legal when applied but now create liability concerns.

Printing and Graphics Operations use solvents, inks, and cleaning chemicals that can contaminate soil and groundwater if improperly handled or released. Older facilities often disposed of waste materials in ways that created lasting environmental impacts.

Characterizing Contamination Extent

When Phase II sampling confirms contamination, additional investigation typically follows to characterize the extent of impacts. This characterization serves multiple purposes: it satisfies regulatory requirements, enables accurate remediation cost estimation, and provides the information needed for informed transaction negotiation.

Characterization involves understanding both horizontal and vertical extent of contamination, identifying whether impacts have reached groundwater, determining whether contamination has migrated off-site, and assessing whether vapor intrusion threatens building occupants. Each of these factors significantly influences remediation costs and liability exposure.

When Environmental Issues Cannot Be Resolved

While we focus throughout this article on structuring transactions to accommodate environmental findings, some environmental situations genuinely cannot be resolved through deal structuring, regardless of how motivated the parties are. Certain contamination scenarios have derailed transactions entirely:

Extensive off-site migration where contamination has spread to neighboring properties creates multi-party liability situations that few buyers will accept regardless of indemnification. When contamination plumes extend beneath residential neighborhoods or commercial properties owned by third parties, the complexity and uncertainty of liability allocation often exceeds what any deal structure can accommodate.

Contamination affecting public water supplies triggers regulatory intervention and potential enforcement actions that make transaction timing unpredictable. Regulatory agencies may impose requirements that override any negotiated deal terms, and enforcement discretion creates uncertainty that cannot be contractually managed.

Unknown or emerging contaminants like PFAS (per- and polyfluoroalkyl substances) present particular challenges because regulatory standards are still developing and remediation technologies remain uncertain. Properties with potential PFAS exposure face indefinite liability that cannot be reliably quantified.

Sellers with inadequate financial resources to backstop meaningful indemnification may find buyers unwilling to proceed regardless of deal structure. When the seller’s ability to fund potential claims is questionable, indemnification provides limited practical protection.

Regulatory agencies that must approve transactions can impose conditions or deny approvals in ways that override negotiated terms. States with transfer-triggered assessment requirements (like New Jersey’s Industrial Site Recovery Act) give regulatory agencies significant control over transaction timing and conditions.

Understanding that some situations lack workable solutions helps sellers evaluate their positions realistically and consider whether environmental issues should be addressed before marketing—or whether the business sale should proceed as an asset sale excluding contaminated real property.

Transaction Structuring When Environmental Issues Emerge

Environmental assessment findings that reveal contamination don’t necessarily kill deals, but they do require creative structuring to allocate liability appropriately and protect both parties’ interests. Experienced advisors use several approaches to keep transactions moving forward despite environmental challenges.

Price Adjustment Approaches

The most straightforward response to environmental findings involves adjusting the purchase price to account for remediation costs. This approach works when contamination is well-characterized, remediation costs are reasonably estimable, and the seller accepts a reduced price in exchange for clean transfer of liability.

Price reductions for environmental issues typically reflect estimated remediation costs plus a risk premium to account for uncertainty. To show you how this works: a contamination issue with estimated cleanup costs of $200,000 might result in a price reduction calculated as follows: $200,000 base remediation estimate plus a risk premium of 25% to 75% (representing $50,000 to $150,000), yielding a total reduction of $250,000 to $350,000. In our transaction experience, risk premiums tend toward the higher end of this range when characterization is incomplete, regulatory requirements are uncertain, or remediation technology selection remains open.

This approach transfers environmental liability to the buyer along with the property. Sellers receive less but walk away clean. Buyers accept known contamination at a discount but assume all risk that actual costs exceed estimates.

Remediation Before Closing

Some transactions allow time for sellers to remediate contamination before closing. This approach works when contamination is limited in scope, remediation can be completed within a reasonable timeframe, and sellers prefer addressing issues themselves rather than accepting price reductions that include risk premiums.

Seller remediation typically involves achieving regulatory closure or at least substantially completing cleanup before the transaction closes. Buyers benefit from receiving clean property without assuming remediation management responsibility. Sellers retain control over the remediation process and avoid paying buyer-imposed risk premiums.

Remediation timelines frequently extend beyond initial estimates, depending on contamination type, regulatory requirements, and site complexity. Regulatory approvals can require months of back-and-forth with agencies. Additional contamination discovered during remediation expands scope. Weather, contractor availability, and disposal facility capacity create delays. Sellers should realistically expect remediation to take 1.5 to 2 times initial timeline estimates, and buyers typically require termination rights if remediation extends too long or encounters significant complications.

This approach requires careful structuring of timelines, performance standards, and consequences for remediation delays or failures. Sellers should expect buyers to require progress reporting, approval rights over remediation contractors, and the ability to terminate if remediation stalls.

Escrow and Holdback Structures

When remediation cannot be completed before closing but parties want to proceed, escrow and holdback structures provide a middle path. A portion of the purchase price is held in escrow to fund remediation, with release conditions tied to cleanup milestones or regulatory closure.

Escrow amounts must account for remediation cost uncertainty. Sophisticated buyers often require escrows of 150% to 200% of estimated remediation costs to protect against overruns—a significant capital tie-up for sellers. Sellers should negotiate release mechanisms that return unused funds at defined milestones rather than holding escrows until final regulatory closure, which can take years. Staged release provisions might return 50% of excess escrow upon completion of active remediation and the remainder upon receiving a no further action letter.

Holdback structures work similarly but involve the buyer retaining funds rather than depositing them with a third-party escrow agent. This approach gives buyers more control but provides less protection for sellers concerned about buyer creditworthiness or disputes over remediation performance.

Alternative Transaction Structures

Beyond standard price adjustments and escrows, certain environmental situations benefit from more creative deal structures:

Asset sales excluding real property allow buyers to acquire business operations while leaving contaminated real estate with the seller. The seller may lease the property to the buyer during remediation or sell it separately once environmental issues are resolved. This structure works when business value derives primarily from operations rather than real estate, and it may be preferable to accepting deep discounts for contaminated property.

“As-is” sales with full disclosure represent another option when remediation before closing isn’t feasible and parties cannot agree on appropriate price adjustments. In these transactions, sellers provide complete environmental documentation, buyers accept known conditions, and purchase prices reflect the contamination risk. This approach requires buyers with environmental sophistication, risk tolerance, and often their own remediation capabilities.

Special purpose vehicle structures can isolate environmental liability in a separate legal entity. While these structures don’t eliminate liability, they can provide operational businesses with some protection from environmental claims and simplify eventual resolution.

Phased acquisitions allow buyers to acquire operating assets immediately while deferring real property transfer until environmental conditions are satisfied. This approach keeps businesses operating during remediation but requires careful attention to lease terms and option exercise conditions.

Indemnification and Insurance Solutions

Environmental indemnification provisions allocate liability between parties regardless of how contamination affects transaction pricing. Even in price-adjusted deals, sellers typically provide some level of environmental indemnification to protect buyers against unknown contamination or cleanup cost overruns.

Effective environmental indemnification addresses several key elements:

Scope of coverage defines what contamination is covered—typically pre-closing contamination regardless of when discovered, excluding contamination caused by buyer operations.

Survival periods establish how long indemnification obligations continue. Environmental indemnification often survives for extended periods (seven to ten years or longer) given the delayed discovery nature of many contamination issues. Some agreements tie survival to statutes of limitation for environmental claims, which vary by state.

Caps and baskets limit seller exposure while providing meaningful protection. Environmental claims may have separate caps from general indemnification, often higher given the potentially substantial nature of environmental liability. Baskets (deductibles) help avoid disputes over minor issues while preserving coverage for significant claims.

Procedural requirements govern how claims are made, how disputes are resolved, and who controls remediation of indemnified contamination.

Environmental insurance products can supplement or replace seller indemnification. Pollution Legal Liability (PLL) policies cover cleanup costs and third-party claims arising from contamination. These policies can be structured to benefit buyers, sellers, or both, and they provide certainty that sellers may find valuable if their indemnification obligations would otherwise be open-ended. Premium costs vary widely based on site conditions, coverage terms, and underwriting factors, but in our experience typically fall in the range of 2% to 5% of coverage limits for relatively straightforward situations. Policies also carry deductibles (often $25,000 to $100,000 or more), coverage exclusions for known conditions or certain contaminant types, and claims processing requirements that affect their practical value. Sellers should work with experienced environmental insurance brokers to understand the total cost structure before relying on insurance solutions.

Geographic Variations in Environmental Liability

Environmental liability rules and remediation requirements vary significantly across states, creating important considerations for transactions in different jurisdictions:

State Superfund programs operate alongside federal CERCLA with varying liability standards. Some states impose liability standards stricter than federal law, while others have adopted liability limitations for certain property transfers.

Voluntary cleanup programs differ substantially in their availability, requirements, and protections offered. States like Pennsylvania, Ohio, and New Jersey have well-established programs that provide meaningful liability protection upon completion. Other states offer more limited programs or none at all.

Transfer-triggered assessment requirements exist in states like New Jersey (Industrial Site Recovery Act) and Connecticut, requiring environmental assessment and potentially remediation before certain property transfers can occur. These requirements give regulatory agencies approval authority over transactions, which can affect deal timing and structure regardless of what parties negotiate.

UST fund programs vary widely in coverage, deductibles, and eligibility requirements. While some state funds cover substantial remediation costs, others have been depleted, suspended enrollment, or maintain waiting lists that delay assistance for years. Sellers should not assume UST fund availability without confirming current program status with state regulators.

Sellers should work with environmental counsel familiar with applicable state requirements, as these variations significantly affect both transaction structuring options and ultimate liability exposure.

Proactive Environmental Management for Sellers

Business owners planning exits in the coming years should address environmental risk proactively rather than waiting for buyer due diligence to reveal problems. Several strategies can improve transaction outcomes:

Obtain Your Own Phase I Assessment

Commissioning a Phase I assessment before going to market identifies issues that will inevitably surface during buyer due diligence. Early knowledge allows sellers to investigate further if needed, address manageable issues before marketing, and prepare responses for issues that can’t be resolved quickly.

Seller-obtained Phase I assessments from reputable firms carry credibility with buyers and can streamline the due diligence process. While buyers will typically commission their own assessments, seller-provided reports demonstrate transparency and reduce surprise risk.

Sellers should consider operational implications of early assessment. If Phase I reveals significant concerns requiring Phase II investigation and potential remediation, the discovery creates management distraction during what may be years of cleanup activity. Employee awareness of environmental issues can affect morale and retention. Sellers should weigh the benefits of early discovery against these operational considerations.

Address Known Issues Before Marketing

Sellers aware of environmental concerns should evaluate whether addressing them before sale makes economic sense. Remediation costs often exceed price reductions because buyers apply risk premiums. Sellers who manage their own remediation avoid these premiums and maintain control over contractor selection and process management.

Even if full remediation isn’t feasible, documenting conditions thoroughly, implementing interim controls, and demonstrating proactive management can reduce buyer concerns and improve negotiating position.

Organize Environmental Records

Thorough documentation of environmental permits, compliance history, waste disposal practices, and any historical investigations should be organized and available for due diligence. Missing records raise concerns and invite assumptions that conditions may be worse than documented.

Records demonstrating consistent compliance, proper disposal through licensed contractors, and absence of releases or enforcement actions provide affirmative evidence that reduces perceived environmental risk.

Understand Regulatory Programs

Some contamination situations benefit from voluntary cleanup programs or brownfield initiatives that provide liability protection upon completion. Understanding available regulatory tools before marketing can reveal options for addressing environmental issues efficiently and with regulatory support.

State voluntary cleanup programs often provide covenants not to sue or no further action letters that give buyers comfort about regulatory closure. These programs may also offer technical assistance that improves remediation efficiency.

Actionable Takeaways

Business owners preparing for exit should take the following steps to manage environmental risk effectively:

Commission a Phase I assessment two to three years before your target exit date. This timeline allows for Phase II investigation if needed and provides opportunity to address findings before marketing. For typical commercial properties under 50,000 square feet with straightforward historical use, budget $3,000 to $6,000 for Phase I assessment. Larger properties, complex industrial histories, or multiple buildings will increase costs accordingly.

Review historical records for previous property uses that might create environmental liability. County records, old telephone directories, and long-term employee interviews can reveal historical uses that assessors might miss.

Document your own environmental practices thoroughly. Waste disposal manifests, compliance inspection records, and permit files should be organized and readily accessible.

Engage environmental counsel early if you know or suspect contamination exists. Legal strategy for managing environmental issues differs significantly from technical remediation strategy, and preserving available defenses requires careful attention to process.

Budget for environmental due diligence in your transaction timeline. Phase II investigations and negotiation of environmental provisions can add two to four months to transaction timelines, plus additional time for regulatory review and approval. Remediation before closing can extend timelines significantly further—often by 12 to 24 months for meaningful contamination issues.

Recognize that while most environmental issues can be accommodated through creative structuring, some situations genuinely cannot be resolved. Extensive off-site migration, emerging contaminants, or inadequate seller financial capacity can create obstacles that no deal structure overcomes. Evaluate your situation honestly and consider pre-sale remediation or alternative transaction structures when standard approaches won’t work.

Evaluate state-specific programs that might provide liability protection or financial assistance for environmental remediation. Confirm current program status directly with state agencies—don’t assume fund availability based on historical information.

Conclusion

Environmental site assessments represent an unavoidable element of business sales involving real property. When these assessments reveal contamination or compliance issues, transactions become more complicated, but not impossible. The difference between deals that close despite environmental challenges and those that collapse often comes down to preparation, realistic expectations, and creative structuring.

Sellers who understand environmental due diligence can manage their exit planning with clear eyes about potential issues. Those who proactively investigate, address manageable concerns, and prepare for buyer scrutiny position themselves for successful transactions even when environmental findings emerge. The time to think about environmental liability is years before your exit, not weeks before closing when a buyer’s consultant makes an unwelcome discovery.

At Exit Ready Advisors, we help business owners navigate the full range of due diligence challenges, including environmental issues that can derail unprepared sellers. Early planning and strategic preparation remain the most reliable approaches to achieving your exit objectives regardless of what assessments reveal.