by Thomas H. Davis, Jr.

Exxon Corporation operated a gasoline station on the relevant property from November 1972 through September 1985, when Globe Oil Company purchased it. Globe Oil subsequently merged with Emro Marketing Company ("Emro"). Underground storage tanks ("USTs") that still contained petroleum remained on the property during the period of ownership by Globe Oil and Emro.

In June 1990, certain "Buyers" contracted to purchase the property from Emro to construct commercial lease space. The contract between Buyers and Emro included a representation by Emro that all of the USTs on the property had been removed.

That same month, Buyers verbally hired an environmental consultant (the "EC") to conduct a Phase I Environmental Site Assessment ("Phase I") of the property. The EC understood the terms of that verbal agreement to be that he would conduct a Phase I in accordance with the guidelines provided by the Federal National Mortgage Association ("Fannie Mae"), since Fannie Mae was financing the Buyers' purchase. Under these guidelines, the EC would conduct an on-site visual inspection of the property, a title search of public records and interviews with past owners to investigate the types of business conducted on the property in the past. Buyers, however, believed that the EC would conduct a more comprehensive Phase I using the then current American Society for Testing and Materials ("ASTM") Phase I standards.

Upon completing his Phase I, the EC issued a report to Buyers stating that the property was not a hazardous waste site and did not warrant Phase II environmental testing of soil and groundwater. The property sale closed in November 1990.

During site preparation by Buyers for the construction of commercial lease space, four USTs were discovered along with petroleum contaminated soil. During the Phase I, the EC was told by Emro, consistent with the contractual representation, that all USTs had been removed. Further, there were no pipes, islands or other visible signs to the contrary. Buyers promptly sued defendants Exxon Corporation, Emro and the EC. Buyers alleged that the EC was negligent for not using the more comprehensive ASTM standards and that, had he done so, he would have located the USTs.

All parties participated in a comprehensive mediated settlement conference. The mediation was successful, and as a part of the settlement, the EC agreed to pay Buyers $22,000, 18% of the settlement total of $124,000.

Lesson 1: A written agreement is imperative to clearly identify the scope of services an EC agrees to perform. The written contract should include a clear expression of:

1. the work to be performed under the agreement;

2. the work that will not be performed (to the extent possible);

3. the information to be provided in the Phase I report;

4. the identity of the beneficiaries of the Phase I report;

5. a method for resolving contract disputes (e.g. mediation, arbitration, etc.); and

6. a limited liability provision.

Lesson 2: ECs should carry Errors and Omissions Insurance. Given the significant amount of money that is often spent in reliance on Phase I reports and the cost of defending an EC suit arising from an incorrect report, Errors and Omissions Insurance is essential. The cost of this EC suit exceeded many years of premium payments, not including the settlement payment. A case that goes to trial would cost substantially more.

by Keith H. Johnson

North Carolina's appellate courts have never had to address the scope of an environmental consultant's liability for alleged negligence in preparing Phase I reports. It is likely, however, that the case law controlling accountant liability to parties relying on incorrect audit reports would be found analogous and control such a case. Currently, the standard used for an accountant's negligent misrepresentation is also applied to engineers, architects, real estate appraisers, and attorneys. Thus, we will first examine Raritan River Steel Co. v. Cherry, Bekaert & Holland, a leading case involving accountant liability for an incorrect audit report.

Plaintiffs Raritan River Steel Company ("Raritan") and Sidbec-Dosco, Inc. ("Sidbec") extended credit to Intercontinental Metals Corporation ("IMC") based on IMC's net worth. Raritan alleged that it obtained IMC's net worth from a Dunn & Bradstreet, Inc. report that showed the figure as reported by Cherry, Bekaert & Holland, Certified Public Accountants (the "CPA Defendants") for the years ending September 1980 and 1981. Sidebec did not specify from what source it obtained IMC's net worth. Both Raritan and Sidbec subsequently lost money on their extension of credit to IMC when IMC entered bankruptcy. Raritan and Sidbec sued CPA Defendants for negligent misrepresentation and breach of contract, alleging they were third party beneficiaries of the 1980-81 audits of IMC.

In Raritan River Steel Co. v. Cherry, Bekaert & Holland, 322 N.C. 200 (1988), the North Carolina Supreme Court considered only the negligent misrepresentation claims. The Court held that CPA Defendants were liable to Sidbec for negligent misrepresentation since Sidbec relied on the CPA Defendant's incorrect audit reports. CPA Defendants were not liable to Raritan because Raritan relied on a Dunn & Bradstreet, Inc. report that cited the audit report, not the report itself.

The North Carolina Supreme Court ruled that a claim of negligent misrepresentation arises when a party to whom an accountant owes a duty of care, such as Sidbec, justifiably relies to the party's detriment on an accountant's incorrect report. Accountants owe a duty of care not only to their clients, but also to those persons that the accountant knows will rely on the report and who the accountant intends to have rely on the report. Accountants also owe a duty of care to those parties the accountant knows the client intends to have rely on the report. Liability is limited, however, to those transactions that the information was intended to influence. The accountant's perception of the client's intent is measured at the time the accountant's report is written.

In the Court's opinion, the CPA Defendants knew that the audit reports would be used by IMC to represent its financial condition to creditors who would extend credit on the basis of them, and that Sidbec and other creditors would rely on them.

In a second appeal to the North Carolina Supreme Court, the Court reviewed Raritan's third-party beneficiary claim. Raritan River Steel Co. v. Cherry, Bekaert & Holland, 329 N.C. 646 (1991). The Law in North Carolina is that only third parties "intended" to benefit from a contract, not parties that benefit "incidentally," have a right to recover for breach of a contract. The Court cited the fact that the audit contract never refers to Raritan as a beneficiary, representatives from both IMC and CPA Defendants testified that Raritan was not an intended beneficiary, and that Raritan was neither aware that the report was being conducted nor received a copy of it. Based on these facts, the Court held that Raritan was not an "intended" third-party beneficiary of the IMC/CPA Defendants' contract.

Lesson 1: Given that the Raritan cases would likely control a court's application of negligent misrepresentation to ECs, ECs should draft Phase I reports keeping in mind the broad scope of parties that may rely on the report. This audience includes shareholders, investors, potential purchasers of the client and/or the client's property, and any other parties the EC knows the client intends to share the information with.

Lesson 2: While this audience appears very broad, the Raritan Court believed that it was narrow enough so that accountants could, "through the purchase of liability insurance, setting fees, and adopting other protective measures appropriate to the risk, prepare accordingly." The second lesson, therefore, is that ECs should purchase Errors and Omissions Insurance and conduct their Phase I in a manner that is appropriate to the amount the client is putting at risk.

Lesson 3: Liability for breach of contract may be limited through the use of clear contractual language. The second Raritan appeal highlights the importance of clearly identifying the parties for whom a Phase I report is being generated and who the report is intended to benefit.

In December 1993, Teer, a prospective investor, hired an environmental consultant (the "EC") to conduct a limited Phase I on three sites owned by Becker Builders Supply Company ("Becker"), a furniture manufacturer, in Wilmington, Castle Hayne and Morehead City, North Carolina. Teer asked the EC to conduct the Phase I quickly, to keep it confidential, and to restrict its investigation to a visual inspection of the sites. The EC alleged that Teer never disclosed the purpose for the Phase I. Teer, however, alleged disclosing that the Phase I report was needed for him to obtain financing to purchase a one-half interest in Becker's common stock. The EC completed the Phase I and issued a report to Teer in February 1994, concluding that no further assessment work was recommended for the Castle Hayne site.

Unbeknownst to the EC, Teer shared the EC's report with Freeman, another prospective investor in Becker. In reliance on the EC's Phase I, Teer and Freeman purchased all of Becker's common stock.

Teer and Freeman decided to sell the Castle Hayne site in early 1996. A prospective buyer hired Land Management Group, Inc. ("Land"), another environmental consulting firm, to conduct a second Phase I. While conducting this Phase I, one of Becker's neighbors coincidentally told Land about contaminated soil underneath Becker's building. Soil samples taken from under the building revealed high levels of soil and groundwater contamination consistent with furniture finishing operations. Land subsequently learned that this was the location of Becker's old wood preservative dip vat. Consequently, Teer and Freeman were required to spend a significant amount of money remediating the Castle Hayne site.

Teer and Freeman sued the EC for failing to discover this environmental hazard, asserting claims of breach of contract, negligence, fraud, negligent misrepresentation, and unfair and deceptive trade practices. The EC answered that Teer purchased only a limited Phase I and failed to disclose all readily available material information regarding the site's environmental conditions.

During the discovery phase of the litigation, the EC learned that Becker leased the Castle Hayne site from a third party between 1973 and 1978, when Becker purchased the property. Becker operated the old wood preservative dip vat responsible for the contamination until 1984. At that time, Becker abandoned this dip vat, buried it and covered the site with the concrete that became Becker's floor. The EC also learned that from 1973 until the time Teer and Freeman purchased their controlling shares of Becker in 1994, Freeman's father was an officer, director, and the principal shareholder of Becker. Freeman also worked at the Castle Hayne site when the old dip vat was in operation. Finally, the EC discovered that Freeman already owned 20% of the available common stock when he and Teer acquired control of Becker in 1994. Thus, both Freeman and his father knew of the old dip vat and did not disclose it to the EC.

Upon learning all of this information, the EC counter-sued Freeman and also sued his parents and Becker alleging, amongst other things, that they all were involved in a fraudulent scheme to shift the cleanup costs of an environmental problem they created and concealed onto the EC. See Teer v. Law Engineering and Environmental Services, Inc., 1997 U.S. Dist. LEXIS 9484 (E.D.N.C. May 30, 1997) (Order granting Law leave to amend its Answer).

The parties entered into a mediated settlement conference before the case reached trial. While the EC did offer to settle the case for $15,001, the actual settlement is confidential. The EC's cost of defending this lawsuit was estimated to be approximately $100,000.

While Teer v. Law Engineering and Environmental Services, Inc. represents a very unique set of factual circumstances, the case does present two general lessons.

Lesson 1: When a client places restrictions that prevent an EC from drawing substantiated conclusions as to whether property is a hazardous waste site, do not draw a conclusion. Instead, state the information that is known and identify what further steps must be taken to make the conclusions necessary. An EC should also memorialize the client's restrictions in the client's contract and, to the extent possible, identify how the restrictions will affect the Phase I report. It is prudent to alert clients prior to issuing a Phase I report that their restrictions may prevent the EC from being able to draw a conclusion on a site's status.

Lesson 2: Ask the client why they want a Phase I and to whom the report will be disseminated to and for what purpose.

If you have any questions regarding this article or other environmental law issues, please contact Tom Davis at 919.783.2816 pr thdavis@poynerspruill.com or Keith Johnson at 919.783.1013 or kjohnson@poynerspruill.com.