Like any acquisition, the purchase of a biofuels company should involve substantial due diligence so the buyer can best determine the value of the target’s assets and liabilities, assess the risks associated with its business operations, and identify areas that may require further investigation.
In the context of biofuels companies, some of the principal assets driving the transaction value are the environmental attributes generated in connection with the target’s products and production process. The ability of a biofuels company to generate and monetize environmental attributes has been, and continues to be, critical to its ability to compete in the marketplace effectively and profitably. However, this area is often neglected during the due diligence process (with buyers opting instead to rely predominately on sellers’ representations and warranties relating to environmental attributes). These representations and warranties are a critical component of the definitive purchase agreement, but buyers should not rely on them to the exclusion of appropriate diligence of the environmental attributes which sellers represent are part of the target’s business assets and/or which support its cash flows.
The specific environmental attributes associated with biofuels companies and the applicable regulatory framework vary depending on the respective target’s products, production processes, and markets, but most are governed by complex regulations issued by the U.S. Environmental Protection Agency (“EPA”), as well as additional state and/or local regulations. The complexity of the regulatory environment continues to increase as federal, state, and local regulators expand the nature and scope of the requirements applicable to these environmental attributes – their generation, validation, verification, and continuing reporting and compliance obligations. For instance, one of the most notable expansions at the state level relates to regulations applicable to the California Low Carbon Fuels Standard (“LCFS”) issued by the California Air Resources Board (“CARB”), including amendments that became effective on January 1, 2020, requiring the submission of third-party validations of fuel pathway applications, as well as third-party verification of ongoing reporting of carbon intensity calculations and documentation.
As part of the due diligence process, a buyer should specifically request sufficient information to validate compliance with all EPA and LCFS regulations governing the environmental attributes represented as assets of the target, if applicable. Depending on the nature of, and current and forecasted markets for, the target’s products, the buyer’s diligence request should cover the following:
- Copies of annual attestations required for the target’s products under applicable EPA regulations;
- Documentation relating to the target’s EPA registrations, including registration of the target and its products and facility;
- Copies of all pathway applications submitted to CARB under the LCFS, together with copies of the required third-party validations;
- Copies of reports and documentation submitted to CARB relating to carbon intensity calculations, together with the required third-party verifications;
- Documentation evidencing the generation of renewable identification numbers (“RINs”) under the EPA’s Renewal Fuel Standard and samples of RIN generation calculations, product designations, and product transfer documents; and
- Copies of any third-party audits under the RFS Quality Assurance Plan program verifying the proper generation of RINs and validating RIN compliance under the RFS and applicable EPA regulations.
Buyers should also consider whether the circumstances support engaging a third-party consultant to aid in the diligence investigation of the environmental attributes. Depending on the target’s stage of development, the number of products and product pathways and the current and forecasted markets for the target’s products, use of a consultant can often be the most efficient and effective method to confirm compliance with the multitude of applicable federal, state, and local regulations and avoid post-closing compliance issues. And, if the diligence process identifies material validity and/or compliance issues, the parties can determine whether the financial impact of such issues warrants a reevaluation of the negotiated purchase price.
Whether diligence of the target’s environmental attributes is conducted by the buyer’s internal team, outside legal advisors, and/or specialty consultants, it is important to ensure that this aspect of diligence is included in the broader due diligence investigation to ensure that the buyer is obtaining such assets with the value represented. For instance, if the transaction involves a biofuels company asserting compliance with the LCFS and therefore, the ability to capitalize on the premium prices associated with the LCFS market, it is crucial to ensure that due diligence addresses LCFS compliance.
A comprehensive diligence investigation should then be combined with customary provisions within the definitive purchase agreement to provide further protection for buyers, which may include the following:
- Specific representations and warranties from the seller regarding the validity of the environmental attributes, as well as compliance with all applicable federal, state, and local regulations;
- Application of a longer survival period for the representations and warranties relating to the environmental attributes to ensure coverage through the applicable statute of limitations;
- Carveout of the environmental attribute representations and warranties from any indemnification caps or baskets;
- Creation of a special indemnity category relating to environmental attributes to cover any validity and/or compliance issues identified during the diligence process; and
- Creation of a special escrow to cover any damages resulting from breaches of the environmental attributes representations and warranties.
Proper diligence and thoughtful negotiation of the definitive purchase agreement with respect to the environmental attributes associated with a biofuels company are essential to ensuring that buyers are not faced with compliance issues following closing and are able to produce and sell products within the intended markets and at the expected values.