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TABLE OF CONTENTS (Concluded).
Page
Bibliography ' 139
Glossary 145
Appendix A Evaluating the Effectiveness of Alternative
Financial Tests
Appendix B Cost Analysis for a Financial Test
ii
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I. INTRODUCTION
Section 3004 of Subtitle C of the Resource Conservation and
Recovery Act (RCRA) of 1976, Pub.L. 94-580 (October 21, 1976), requires
tnat tne Environmental Protection Agency promulgate regulations
establishing such performance standards applicable to owners and
operators of facilities for the treatment, storage, or disposal of
hazardous waste as may be necessary to protect human health and the
environment. Section 3004(6) states that these standards shall include
requirements respecting "...the maintenance of operation of such
facilities and requiring such additional qualifications as to ownership,
continuity of operation,... and financial responsibility as may be
necessary or desirable...."
The need for regulations establishing financial responsibility
requirements for closure of hazardous waste treatment, storage and
disposal facilities and for post-closure care of disposal facilities was
addressed in the Preamble and Background Document accompanying the
financial responsibility regulations promulgated on January 12, 1981,
and the reader is referred to those documents.
The need for a financial test and corporate guarantee as optional
methods of demonstrating financial assurance for closure and post-
closure care was stressed by many commenters on the financial
responsibility regulations proposed on December 18, 1978, and May 19,
1980. Those commenters argued that such provisions would achieve
significant savings in costs to the regulated community and would at the
same time satisfy the goals of RCRA. As a result of the study described
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in Chapter IV of this Background Document, tne Agency believes that
these mechanisms are effective means of assuring financial
responsibility and that they will result in cost savings.
The fundamental objective of the financial responsibility standards
is to ensure that funds will be available for proper closure of
facilities that treat, store, or dispose of hazardous waste and for
post-closure care of hazardous waste disposal facilities. (In the
balance of this Background Document references to "closure and post-
closure care" should be understood, unless otherwise iadicated, to
include closure alone, post-closure care alone, and closure and post-
closure care.)
A. Organization of the Regulations
Financial responsibility requirements established pursuant to the
Resource Conservation and Recovery Act (RCRA) of 1976, Pub.L. 94-580
(October 21, 1976) for owners and operators of hazardous waste treat-
ment, storage, and disposal facilities constitute Subpart H of Parts 2b4
and 265 of Chapter 40, Code of Federal Regulations. Part 264 contains
facility standards that will be used in the permitting process. Part
265 contains standards that apply to owners and operators with "interim
status", i.e., their facilities were in existence as of November 19,
1980, they have notified EPA as required by Section 3010 of RCRA,
properly applied for a permit, and are awaiting final administrative
action on their permit applications.
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Under tne Subpart H regulations of both Parts 264 and 265, the
owner or operator of each treatment, storage, or disposal facility must
establish financial assurance for its closure. The owner or operator of
a disposal facility must also provide financial assurance for post-
clcsure care.
The regulations that this Background Document accompanies are
included in Subpart H of Parts 264 and 265. They provide that a
financial test and corporate guarantee may be used by owners or
i
operators to establish financial assurance for closure and post-closure
care.
The regulations do not include a revenue test for municipalities
that was part of regulations proposed on May 19, 1980. This Background
Document includes ,.an analysis .of the decision not to allow a municipal
revenue test as a means of satisfying the financial assurance
requirements.
6. History of the Regulations
The development of these regulations has been greatly influenced by
public comments received on two sets of proposals. The first proposed
regulation, issued December 18, 1978, allowed only trust funds as the
means of assuring availability of funds for closure and post-closure
care (43 FR 58995, 59006-7).
The EPA reanalyzed the issues raised by the commenters on this
original proposal and other issues, and developed a second proposal
which was published May 19, 1980. Alternatives to the trust fund for
closure and post-closure care were proposed: surety bonds, letters of
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credit, a financial test, guarantees of the closure and post-closure
obligations of one entity by another entity .which met the financial
test, a revenue test for municipalities, State guarantees of performance
or funding, and State-required mechanisms if they were substantially
equivalent to mechanisms specified in the regulations of Parts 264 and
265 (45 FR 33260-78).
In its proposal of May 19, 1980, the Agency invited comments on the
proposed financial test, guarantee, and revenue test provisions (45 FR
33264-5). Extensive comments were received. Because of the complexity
of the issues raised, the Agency could not complete its analysis in time
to announce a decision regarding the financial test, guarantee, and
revenue test on January 12, 1981, when it promulgated regulations
establishing financial responsibility standards (46 FR 2821-29; 2851-
2866). The Agency has .now completed that analysis, including review of
those comments received after January 12, 1981. The following chapters
discuss the rationale for the regulation and the analysis of comments
pertaining to the financial test, corporate guarantee, and revenue test
for municipalities.
C. Description of the Regulations
1. Financial Test and Corporate Guarantee
A financial test has been developed to determine financial sound-
ness of a company owning or operating a hazardous waste management
facility for the purpose of assuring funds for closure, post-closure
care, or both closure and post-closure care. Meeting this test is an
alternative means of assuring funding of closure and post-closure
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care. In addition, a parent company passing this test would be allowed
to guarantee funding for its subsidiary. The test requires that a
company have net working capital and tangible net worth each at least
six times the sum of current closure and post-closure cost estimates and
tangible r.st worth of at least $10 million. Meeting two of the
following three ratios is also required: total liabilities to net worth
less than 2.0, sum of net income, depreciation, depletion, and
amortization to total liabilities greater than 0.1, and current assets
to current liabilities greater than 1.5. Specific reporting
requirements must also be satisfied. An alternate test requires an
investment grade bond rating issued by Standard and Poor's or Moody's,
and tangible net worth greater than six times the sun of current closure
and post-closure costs and tangible net worth of at least $10 million.
Any firm passing either test must have at least six times current
closure and post-closure costs in assets in the United States, or at
least 90 percent of its assets in the United States.
The "current closure and post-closure cost estimates" referred to
in the test criteria must include, first, all such estimates for
i
facilities of which the firm using the test is the owner or operator and
for which it is demonstrating financial assurance through the financial
test of parts 264 of 265. Second, if the firm is providing one or more
guarantees as specified 'in these regulations (see later discussion of
corporate guarantee)> the cost estimates of the facilities for which
closure or post-closure care is being guaranteed must be included.
Third, if the firm has facilities in States where EPA is not
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administering the financial requirements but the firm is demonstrating
financial assurance to the State through a financial test equivalent or
substantially equivalent to the test in Parts 264 and 265, the cost
estimates covered by such tests must be included. Finally, if the firm
is the owner or operator of facilities for which financial assurance for
closure or required post-closure care is not being demonstrated, to a
State or EPA, through the financial test or any of the other mechanisms
specified in these regulations or equivalent or substantially equivalent
State mechanisms, the closure and post-closure cost estimates for such
facilities must be included. There are likely to be seme facilities in
this last category because, in the first pnase of authorization of
States to administer the RCRA regulations, States are not required to
adopt requirements for establishment of financial assurance, although
they are encouraged to do so. In later phases of authorization, States
must have financial requirements equivalent or 'substantially equivalent
to those in Parts 264 and 265.
The Agency's objective in these latter provisions is to assure that
the sum of closure and post-closure costs against which the firm's
financial condition is being tested through the financial test is
complete. The sum should include all estimated closure ana post-closure
costs which the firm is obligated to cover, minus those covered by
acceptable financial assurance mechanisms other than the financial test.
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2. Reporting Requirements
In order to qualify for .use of the., financial test, a letter must be
sent to the EPA signed by the chief financial officer of the firm con-
taining the required data derived from the firm's independently audited,
year-end financial statements for the company's most recently completed
fiscal year. The letter must Vist all facilities and associated cost
estimates as described above.' The letter must be accompanied by a copy
of the independent certified public accountant's report on examination
of the firm's financial statements for the latest completed fiscal year,
together with a special report from the CPA stating that he has compared
the data set forth in the chief financial officer's letter with the
amounts set forth in the financial statements, and no matters have come to
his attention which cause him to believe that the specified data should be
adjusted. If the accountant's opinion contained in his report on examina-
tion of the firm's financial statements is an adverse opinion or contains
a disclaimer of opinion, the firm will not be allowed to use the financial
test to comply with the financial responsibility requirements. The
Regional Administrator may disallow use of the financial test based on
other qualifications expressed in the auditor's opinion.
3. Corporate Guarantee
An owner or operator which is a subsidiary of another firm will be
allowed to satisfy the financial responsibility requirements for closure
and post-closure care by obtaining a parent company's written guarantee.
In order to qualify as a parent corporation for this purpose, a firm must
own at least 50 percent of the voting stock of the subsidiary firm which
is the facility owner or operator.
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The guarantor must meet the same requirements as the owner or operator
using the financial test and has an independent contractual obligation to
EPA. In effect, he "stands in the shoes" of the owner or operator, as far
as assurance for closure or post-closure is concerned, through this
guarantee. If the owner or operator fails to perform closure or post-closure
care as required, the guarantor must do so or fund a trust in the full amount
of the cost estimate in the name of the owner or operator. If the guarantor
falls below the test criteria or is disallowed from continuing as a guarantor
because of qualifications in the auditor's opinion of the guarantor's financial
statements, the guarantor must provide alternate financial assurance in the
name of the owner or operator if the owner or operator himself does not do so.
The cancellation provisions are comparable to those of the surety bonds
and letters of credit. The guarantor must give a 120-day notice of cancel-
lation to the owner or operator and the Regional Administrator by certified
mail. If the owner or operator does not establish alternate financial
assurance and obtain written approval of the assurance provided from the
Regional Administrator within 90 days after the notice is received, the
guarantor must provide such alternate assurance in the name of the owner or
operator.
4. Revenue Test
After intensive study, the Agency has decided to withdraw the revenue
test mechanism for municipalities because it does not appear to be an ade-
quate means of demonstrating financial assurance of closure and post-closure
care costs. Financially sound municipalities should be able to acquire the
alternate mechanisms. The Agency believes State guarantess may be especially
appropriate for closure and post-closure care at municipally owned or operated
hazardous waste management facilities.
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D. Key Definitions
When used in these regulations and the Background Document, the
following definitions apply. All financial and accounting terms used
for tne purpose of complying with this regulation are intended to repre-
sent the common meaning of the terms as they are generally used in the
business community.
-(a) "Assets" means .all existing and all. probable future
economic benefits obtained or controlled by a particular
entity.
(b) "Current assets" means cash or other assets or resources
commonly identified as those which are reasonably
expected to be realized in cash or sold or consumed
during the normal operating cycle of the business.
(c) "Current liabilities" means obligations whose liquidation
is reasonably expected to require the use of existing
resources properly classifiable as current assets or the
creation of other current liabilities.
(d) "Independently audited" refers to an audit performed by
an Independent Certified Public Accountant in accordance
with generally accepted auditing standards.
(e) "Liabilities" means probable future sacrifices of
economic benefits arising from present obligations to
transfer assets or provide services to other entities in
the future as a result of past transactions or events.
(f) "Net income" means revenues minus expenses for an
accounting period, which is the net increase (net
decrease) in owners' equity (assets minus liabilities) of
an enterprise for an accounting period from profit-
directed activities that is recognized and measured in
conformity with generally accepted accounting principles.
(g) "Net working capital" means current assets minus current
liabilities.
(h) "Net worth" means total assets minus total liabilities
and is equivalent to owner's equity.
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(i) "Parent corporation" means a corporation which directly
owns at least 50 percent of the voting stock of the
corporation which is the facility owner or operator; the
latter corporation is deemed a "subsidiary" of the'parent
corporation.
(j) "Quick assets" means the working capital items that can
be quickly converted to cash at close co their book
value; generally, cash plus accounts receivable.
(k) "Tangible net worth" means the tangible assets of an
entity that remain after deducting its liabilities; such
assets would not include intangibles such as goodwill and
rights to patents or royalties.
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II. BASIS FOR CONSIDERING A FINANCIAL TEST AS A MEANS OF ASSURING
FINANCIAL RESPONSIBILITY
A. Legislative Authorization
The Resource Conservation and Recovery Act of 1976 (RCRA) (P.L. 94-
V
580) provides in Section 3004(6) that the EPA shall promulgate
regulations, applicable to owners, and operators of facilities for the
treatment, storage or disposal of hazardous waste, "requiring such ...
qualifications as to ... financial responsibility as day be necessary or
desirable."
The Agency believes that the use of a financial test as a financial
assurance mechanism is consistent with Congress1 intent regarding
acceptable means of assuring financial responsibility unoer KCRA.
Congress defined "financial responsibility" at least twice before
the passage of RCRA. In 1966 it provided that:
financial responsibility may be established by any one
of, or a combination of, the following methods . . .:
(1) policies of insurance, (2) surety bonds, (3) qualifi-
cation as a self-insurer, or (4) other evidence of finan-
cial responsibility.1
f\
Congress used the same definition again in legislation passed in 1972.
Congress placed no definition of financial responsibility in RCRA when
it passed that law in 1976, or when it amended RCKA in 1980. However,
Congress used the above definition of financial responsibility once
again in the Comprehensive Environmental Response, Compensation, and
Liability Act of 1980, which deals with many problems similar to those
addressed in RCRA.
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The Agency believes for several reasons that a financial test and
corporate guarantee is an appropriate mechanism for the assurance of
financial responsibility for closure and post-closure care requirementSt
The plain meaning of the term "financial responsibility" does not
preclude the use of a financial test or corporate guarantee. A common
definition of responsibility is the ability to pay debts or meet
business obligations. Thus an assurance of financial responsibility
might include any mechanism, including a financial test and corporate
guarantse, that inspires confidence in the ability to pay debts or
obligations.
In addition, the definition of financial responsibility previously
approved by the Congress in 1966 and 1972 and inferred by the Agency to
be applicable to RCRA includes, in the list of mechanisms autnorized by
Congress, "other evidence of financial responsibility." In its promul-
gation on January 12, 1981, of financial responsibility regulations for
closure and post-closure care, the Agency adopted two mechanisms — the
trust fund and the letter of credit — not specifically listed by
Congress in this definition but clearly appropriate as "other evidence
of financial responsibility." The Agency believes that a financial test
and corporate guarantee is similarly appropriate.
In adopting these mechanisms, the Agency was aware that an impor-
tant characteristic of financial responsibility for closure and post-
closure care is that it is not contingent upon the occurrence of an
unexpected harm. Closure and post-closure care are instead required
activities which are certain to occur.
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The Agency also recognized, however, that although its principal
consideration in selecting the mechanisms was the effectiveness of each
mechanism in assuring availability of sufficient funds when needed for
closure and post-closure care, it might be necessary or desirable to
balance other considerations against ready access to funds. Among those
considerations are the avoidance of a capacity shortage in hazardous
waste management, avoidance of unnecessary costs to the regulated coca-
muni ty, the desirability of allowing flexibility in meeting the require-
ments, the administrative burden on the Agency, and the availability of
the mechanisms. (See 46 F.R. 2822).
The Agency believes that the study descrioed in this Background
Document demonstrates that a financial test and corporate guarantee for
closure and post-closure care can achieve the primary purpose of the
financial responsibility requirement in RC'RA and, at the same time,
further some of the objectives listed above.
The Agency has therefore concluded, on the basis of both the
language and the purpose of RCRA, that it possesses legislative
authority to adopt a financial test and corporate guarantee as a means
of demonstrating financial responsibility for closure and post-closure
care.
B. Federal, State, and Local Precedents
In gathering information to use in developing financial require-
ments, EPA examined Federal, State and local requirements that have
purposes similar to the closure and post-closure financial
requirements. Review of these requirements provided not only precedents
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for the RCK& regulations but also alternative regulatory scenarios. It
helped ensure that the experiences of other Agencies with financial
instruments which might be appropriate were considered. In a few cases,
information about experience in implementing these programs was valuable
in pointing out the strengths and weaknesses of the various alterna-
tives. The following is a summary of regulations which the Agency
examined. Additional discussion of them can be found in Section IV.C.
of this Background Document.
1. Federal Maritime Commission Regulations
The Federal Maritime. Commission (FMC) has issued financial
responsibility regulations under several different programs. Section
311(p) of the Federal Water Pollution Control Act (33 U.S.C. §466 et.
seq.) requires vessel operators to demonstrate that they are
"financially able to meet their liability,to the United States resulting
from the discharge of oil or hazardous substances" into waters over
which the United States has jurisdiction (46 CFR §542.l(b)).5 FMC
regulations require vessel operators to select a financial mechanism
approved by the FMC to prove that they will be able to meet potential
obligations arising from spills. Such proof may be made by "any one of,
or by an acceptable combination of, the following methods: Insurance;
surety bond; qualification as a self-insurer; guarantee; and other
methods" (§311(p) and 46 CFR §542.8(b)). Qualification as a self-
insurer is accomplished by submitting balance sheets and other financial
statements which show acceptable levels of working capital and net worth
(46 CFR §542.8(a)(3)).
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The FMC also has implemented regulations . involving financial
responsibility for losses suffered by passengers of vessels due to non-
performance^ and for death or injury to passengers on voyages. These
regulations allow a carrier to self-insure by providing proof that
certain financial measures, such as working capital, net worth, credit
rating, income and surplus are at a level acceptable to the FHC.
Finally, the FMC has promulgated regulations on financial
responsibility for oil pollution of operators of vessels carrying oil
o
which has been transported through the trans-Alaska pipeline and of
vessels operating in certain waters and engaged in transportation of oil
Q
produced from offshore facilities on the Outer Continental Shelf. The
former regulations may be satisfied through insurance, a surety bond, or
maintenance in the United States of working capital and net worth in
specified amounts. The latter regulations allow financial
responsibility to be established through insurance, surety bonds, self-
insurance, or a guaranty.
The FMC has advised the Agency that the most frequently used mech-
anism under both the oil spill and the passenger vessel regulations is
insurance, followed by self-insurance, guarantees, and surety bonds.
According to the FMC, their financial responsibility program has
had no major problems. About 50 percent of the payments are from insur-
ance companies and 50 percent from sureties, self-insurers, and guaran-
tors. These percentages are roughly proportional to the numbers of
vessels using these types of mechanisms. The amount of time it takes
for a payment to be made varies widely. Some payments are immediate,
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while others require lengthy litigation. The latter situation, however,
has been very rare. It has generally been more" difficult to collect
from self-insurers because they are giving up their own working
capital. The FMC has found that the mechanisms easiest to administer
are those for which it has standard forms—insurance and surety bonds.
Self-insurers and guarantors become eligible by demonstrating net worth
and working capital requirements on yearly balance sheets and auditors'
statements. The financial statements are reviewed carefully by FMC
staff who are expert financial analysts. There has been only one
bankruptcy of a self-insured firm. In its submissions to the FMC prior
to bankruptcy the company had solidly qualified as a self-insurer under
the passenger vessel regulation. Although no passengers lost money, had
there been injuries the firm may not have had enough assets to pay
claims. *
2. Federal Surface Mining Regulations
The U.S. Department of the Interior issued regulations (30 CFR 800-
809) in March 1979 under authority of the Surface Mining Control and
Reclamation Act of 1977, (30 U.S.C. §§1201 et seq.) requiring that
surface coal mining companies obtain a performance bond as certification
that the mining activities will be conducted in accordance with certain
performance standards. Performance bonds as defined in these
regulations include: surety bonds; collateral bonds; escrow accounts;
self-bonds; or a combination of the above. The regulations pertaining
to self-bonds are currently being revised. A requirement that those
electing self-bonding show net worth of $10 million and assets of $
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million is under consideration. Proposed regulations*, as well as a
1 7
study of self-bonding, are scheduled to be ready in 1981.
3. U.S. Coast Guard Regulations
t
Under the Outer Continental Shelf Lands Act Amendments of 1978,
(P.L. 95-372) the Coast Guard has issued regulations requiring coverage
of liabilities that may result from oil spills (33 CFR Part 135).
Among other forms of financial responsibility, these regulations
authorize the use of self-insurance. A party may qualify as a self-
insurer by submitting a current balance sheet, incoae statement, and
statement of changes in financial position, all certified by an inde-
pendent Certified Public Accountant. In addition, a statement must be
provided certifying that current U.S. assets exceed current U.S. liabil-
ities and that net worth exceeds the amount of the requested self-insur-
ance, or a statement showing that sufficient assets or cash flow will be
available to retire a claim (33 CFR §135.213).
No detailed information is currently available concerning the
effectiveness of these regulations.
4. Nuclear Regulatory Commrm'ssion Regulations
Persons licensed to operate nuclear reactors or to possess ana use
plutonium in a processing or fuel fabrication plant are required by the
Nuclear Regulatory Commission (NRC) to provide "financial protection"
for liability for injury or damage resulting from the hazardous
properties of nuclear material. "Financial protection" is defined as
"the ability to respond in damages for public liability and to meet the
cost of investigating and defending claims and settling suits for such
damages" (10 CFR §140.3(d)).
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In addition to liability insurance, another means approved' by the
Nuclear Regulatory Commission is proof of "adequate resources to provide
the financial protection required ..." (10 CFK. §140.14(a)(2)).
Such proof can be provided through the submission of annual financial
statements for the three years preceeding the date of .filing, together
with an opinion on these statements of a Certified Public Accountant.
The NRC may require additional proof if it desires. Apparently this
provision has not been utilized by nuclear facility licensees. There is
consequently no record of its effectiveness available.
The NRC is also developing regulations on financial assurance
mechanisms for uranium mill reclamation, both for decommissioning and
for long-term care after decommissioning, and for land disposal of low-
level nuclear waste. The mechanisms currently under consideration
include surety bonds, cash deposits, trust funds, deposits of government
securities, escrows, letters or lines of credit, and combinations of
those mechanisms, or such other types of mechanisms as may be
approved. Self-insurance has not been found an acceptable mechanism,
apparently because of the long term — 100 years — over which financial
responsibility may have to be maintained.
5. State Precedents
A majority of the States allow firms to use self-insurance for the
purpose of assuring financial responsibility for liabilities to the
employees of those firms under State workers' compensation laws.
Although the Agency has not undertaken a comprehensive study of the
individual State provisions, it has learned tnat frequent or common
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features of such provisions are minimum financial, size, and
administrative standards, including minimum net worth requirements.
States sometimes require self-insurers to obtain bonds for the
performance of their obligations or to pay into solvency funds or to
1 A
make security deposits.
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References for Chapter II
l.The Act of November 6, 1966 on Maritime Carriers, 46 U.S.C.
§§817(d)(a) and 817 (e)(a).
2. Federal Water Pollution Control Act Amendments of 1972, 33 U.S.C.
§1321(p.)
3. Pub. Law 96-510 §108(a)(l) (December 11, 1980). Congress has also,
on at least two occasions following the passage of RCRA, defined
"financial responsibility" to include a guarantee. Both the Outer
Continental Shelf Lands Act Amendments of 1978 (43 U.S.C. §1811 _et_
seq.) and the Motor Carrier Act. of .1980 (P.L. 96-296 $30) provide
that "Financial responsibility may be established by any one, or any
combination, of the following methods: evidence of insurance,
guarantee, surety bond, or qualification as a self-insurer." 43
U.S.C. §1815.
4. Black's Law Dictionary
5. See generally Staff of House Comm. on Public Wonts, 92d Cong. , 1st
Sess., OIL POLLUTION AND FLANCIAL RESPONSIBILITY; A REPORT TO THE
PRESIDENT AND THE CONGRESS FROM TH£ SECRETARY OF TRANSPORTATION
(Comin. Print 1971)
6.46 CFR §540 Subpart A, issued pursuant to 46 USC §§817d(a) and
8l7e(a).
7. 46 CFR §540 Subpart B.
8. 46 CFR Part 543.
9. 46 CFR Part 544.
10. Memoranda on meetings between Federal Maritime Commission staff and
EPA staff on financial responsibility requirements, November 16,
1979, March 7, 1980, and August 14, 1980.
11. Id.
12. Memorandum on meeting between EPA and Office of Surface Mining staff
on February 28, 1980; 11 Environmental Reporter: Current Develop-
ments 2201.
13. Memorandum on contact between staff of EPA and staff of NRC Uranium
Recovery Licensing Branch, July 30, 1980; Regulations issued by NRC
Uranium Recovery Licensing Branch, 45 FR 65521 et seq. (October 3,
1980); Proposed Regulations issued by NRC Low-Level Waste Licensing
Branch, 46 FR 38081-38105 (July 24, 1981).
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14. Appleman, Insurance Law and Practice (Berdal ed.), §4601; National
Commission on State Workmen's Compensation Laws, Compendium on
Workmen's Compensation, 243-65 (1973).
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III. SYNOPSIS OF PREVIOUSLY PROPOSED REGULATIONS
Requirements for financial responsibility for closure and post-
closure care of hazardous waste management facilities were proposed on
December 18, 1978 (43 FK. 58995, 59006-7), reproposed on ;-lay 19, 1980,
(45 FR 33260-78), and promulgated on January 12, 1981, (46 FR 2851-66,
1377-88). The reader is referred to the Preamble and Background
Document for the reproposal for explanations of the differences between
the reproposal and the original proposal, and to the Preamble and
Background Document for the regulations promulgated on January 12, 1981,
for explanations of the differences between those regulations and the
reproposal.
In addition to those means of assurance of financial responsibility
for closure and post-closure care, that were promulgated on January 12,
1981, the May 19, 1980, reproposal also allowed the following means of
assurance, which were not promulgated on January 12, 1981, because the
Agency had not concluded its analysis of them:
Financial test and guarantee. By demonstrating financial strength,
an entity would not be required to provide other assurances. The test
criteria were: $10 million in net worth in the U.S.; a ratio of total
liabilities to net worth of not more than 3; and net working capital in
the U.S. twice the amount of the closure and post-closure cost esti-
mates. An entity with these characteristics could guarantee closure and
post-closure funds for another entity. These characteristics had to be
V
demonstrated in quarterly audited financial statements containing uncon-
solidated balance sheets. If the company no longer met the criteria, it
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had to notify EPA wi'thin 5 days and establish other financial assurance
within 30 days (45 FR 33268, 33272).
Revenue test for municipalities. If the owner or operator was a
municipality, it could meet the requirements by having undedicated tax
revenues amounting to 10 times the cost estimates. The municipality had
to send a letter to EPA stating that it met this requirement. If reve-
nues fell below the required level, the municipality had to notify EPA
and establish other financial assurance within 30 days (45 FR 33268,
33273).
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IV. ANALYSIS OF COMMENTS AND RATIONALE FOR STANDARDS
Comments on the proposed financial test and guarantee for financial
assurance of closure and post-closure care, and comments on the revenue
test for municipalities, the Agency's responses, and the rationale for
the chosen actions are discussed in this chapter.
This chapter is organized as follows:
A. General Analytic Approach
1. Possible Elements of Financial Tests
2. Methods of Identifying Firms Which Will Later Go Bankrupt
a. Effect of Firm Size on Failure Rates
b. Ratio Tests
c. Bond Ratings
d. Alternative Methodological Approaches
3. Methods of Identifying Firms Which Will Later Have Suffi-
cient Ability to Pay
4. Analysis of the Costs of Financial Tests
a. Types of Costs Analyzed
b. Overview of tne Cost Model
c. Costing Conventions
5. Rationale for Standards
a. Financial Test
\
b. Limits to the Analysis
c. Corporate Guarantee
d. Revenue Test for Municipalities
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B. Criticisms of Test Components Proposed on. May 19, 1980,
Financial Test
1. Net Worth Requirement
2. Working Capital Requirement
3. Total Liabilities to Net Worth Ratio Requirement
C. Suggested Alternative Components for Financial Test
1. Other Ratios
2. Other Multiples
3. Bond Ratings
4. Other Suggested Alternatives
D. Applicability of Financial Test
1. Request for Industry-Specific Criteria
2. Industries Requesting Special Provisions
3. Distinction Between On-Site and Off-bite Disposers
E. Level of Financial Assurance Provided
1. Comparability to Alternative Financial Assurance Mechanisms
2. Collateral Effects on Alternative Financial Assurance
Mechanisms
F. Reporting Requirements for Financial Test
1. Type of Financial Statements Required
2. Time Schedule for Reporting
3. Distinction Between Domestic and Total Resources
G. Corporate Guarantee
1. Enforcement of Corporate Guarantee
2. Terms of Corporate Guarantee
25
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. 3. Accuracy of Underlying Financial Data .. _,,
4. Need for Guarantee
H. Revenue Test
1. Likelihood of Municipal Default
2. Municipal Ability to Shift Expenditures
3. Suggested Alternative Municipal Tests
4. Definition of Municipality
5. Other Issues
I. Other Issues
Unless otherwise specified, the discussions below refer to both
Part 264 and Part 265. Also, the discussions of the financial test
refer to its use for assuring botti closure and post-closure care unless
otherwise specified.
A. General Analytic Approach
The Agency received a variety of comments questioning the specific
financial test proposed on May 19, 1980, or suggesting different test
components or alternative tests. The Agency agreed with comments
suggesting that a careful reanalysis and validation of the financial
test and guarantee proposal should be performed. It therefore has
conducted such a study. In its reanalysis of the financial test and
guarantee, the Agency took into account the comments it had received.
This section of this Background Document first provides the general
analytic approach used by the Agency, and then provides responses to the
comments received by the Agency and the rationale for the actions chosen
by the Agency.
26
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The Agency's analysis proceeded in two steps.. It first examined a
large number of possible financial tests to determine how well they
performed with respect to two related but dissimilar functions: passing
firms that were capable of meeting their closure and post-closure
obligations; and failing firms that would enter bankruptcy without
meeting those obligations. The Agency then determined the relative
costs associated with different tests and compared those costs with the
costs associated with other mechanisms for assuring financial
responsibility. A detailed description of the first step of the
Agency's analysis is provided in Appendix A. Appendix B of this Back-
ground Document describes the Agency's determination of costs. These
Appendices provide full analytic support for the numerical results
reported in the following discussion.
In developing the financial test the Agency was particularly
concerned with ttiree general goals: (1) Funds should be availaole for
closure and post-closure care for protection of human health and the
environment. (2) As a matter of equity, the parties responsible for
closure and post-closure obligations, i.e., owners and operators, should
pay those costs. (3) Costs to the regulated community of providing
financial assurance should be as low as possible. Thus, the Agency was
concerned that tne test chosen be effective, and in assessing the
various possible test criteria it considered costs in selecting the
elements of the test.
One particularly important feature of the development of the anal-
ysis should be noted. One element of the financial test originally
27
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proposed on May 19, 19b(J, was tne requirement that a firm have over $1U
million in net wortn, and the analysis was originally limited only to
those firms able to meet that requirement. In the course of the anal-
ysis, however, the Agency concluded chat a requirement; should be added
that only independently audited firms could qualify to use the financial
test. The analysis therefore proceeded on a somewhat revised basis,
being conducted for those firms of over $10 million in net worth which
are independently audited. The results in this Background Document are
reported for independently auditea firms. The Agency also conducted a
special, examination of the results for those firms of less than $10
million in net worth which are independently audited. The Introductions
to Appendix A and Appendix B describe the analytic steps in greater
detail ana explain further the data in those Appendices.
1. Possible Elements of Financial Tests
A financial test should combine two types of elements to achieve
two different purposes. Some elements should serve as indicators that
the firm will not become bankrupt without meeting its closure and post-
closure obligations. Other elements should demonstrate that if a firm
ceases to pass a financial test, it will continue at that time to
possess assets sufficient so that it will be able to pay the costs
associated with financial responsibility. Both elements are essential
to an effective financial test.
Many different types of indicators to perform these functions were
suggested to the Agency. Financial data from balance sheets and income
statements, multiples of tnose data, ratios which can be computed from
28
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those data, bond ratings, and expert opinions by trained financial-
analysts were the indicators most frequently suggested. The Agency
analyzed tne use of all of these suggested indicators. The results of
the Agency's study are described in detail in the sections which follow.
2. Metnods of Identifying Firms Which Will Later Go Bankrupt
The Agency began its analysis by determining the historical failure
rates of all sizes and types of firms. Dun and Bradstreet statistical
series (Dun and Bradstreet Corporation, The Business Failure Record, New
York., 1979) indicate that the arithmetic mean of annual business fail-
ures over the post-1945 period is approximately 44 per 10,000 firms, of
all those firms of whatever size, whether incorporated or not, reported
upon by Dun and Bradstreet. The Agency used that figure as the baseline
failure rate with which to compare the performance of the following
selected indicators.
a. Effect of Firm Size on Failure Rates
The financial test originally proposed on nay 19, 19bU, required
that a firm have over $10 million in net worth. Commenters suggested
both higher and lower minimum net worth requirements, as well as recom-
mending that the requirement be discarded. The Agency therefore exam-
ined the relationship between the size of firms, as measured by their
net worth, and their failure rates. Because there is no large-scale
data base on business failures by size of firm, precise quantification
of the effect of the requirement was difficult and uncertain. However,
a review by the Agency of the available data suggested that failure
rates are in general lower the larger the firm. The specific choice of
29
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$10 million in tangible net worth as a suitable cut-off point was most
strongly suggested by a study by Dun & Bradstreet (cited in Hacker and
Gosman,1978) which provided data for failure rate by traae credit rating
and tangible net wortn. For tnose trade credit ratings with significanc
f ailure - rates, trie failure rate was sharply lower for those firms with
over $10 million in tangible net worth than for firms with tangible net
worth in the range of $1 to $1U million or in classes representing lower
tangible net worth. A review of all data suggested that firms with over
§10 million in tangible net vortti had, at most, one-naif the baseline
failure rate, or approximately a failure rate of 22 per 10,000 firas.
(For a discussion of the evidence on relation of firm size to failure
rate, see Appendix A,'Section II. -., In contrast, in tnose additional
analyses conducted for firms of less than $10 million in'net worth, the
Agency assumed that because of the special problems associated with
owning TSDFs wnich coula themselves cause bankruptcy (.e.g., nigh costs
of cleanup and repair, liability judgments in excess of insurance
coverage), and because of the historically demonstrated greater
instability of small firms, firms of less than $10 million in net worth
would have a higher than average failure rate. The Agency was also
concerned that unless a $10 million in net worth requirement were
established high administrative expenses would be incurred for examining
the records of smaller companies to ensure their financial stability.
(See Appendix B, Section IV.C.).
30
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b. Ratio Tests
The financial test proposed on May 19, 1980, included a requirement
that a firm have a ratio of total liabilities to net worth of not more
than tnree.. Several alternative or additional financial ratios were
suggested by commenters. The Agency examined whether tests based on
specific financial ratios were more effective in forecasting eventual
bankruptcy than a single test of net worth, and sought to identify
• - •—• ~* ••••"• • •• ^
particularly useful financial ratios.
In order to evaluate the ratio tasts, separate unmatched samples of
bankrupt and non-bankrupt firms . were developed. (Definitions of
statistical terms and a detailed description of the industry sample and
other statistical procedures are provided in Appendix A to this
Background Document.) The Agency identified 66 bankrupt firms from
previous bankruptcy forecasting literature and .from independent
research; all had total assets of greater than.?l million and had filed
for protection under the Bankruptcy Act between 1966 and 1979. For non-
bankrupt firms, 178 companies, identified by the industry index of
Moody's Industrial Manual as members of industrial categories that
generate and dispose of. large quantities of hazardous waste on-site,
were selected. Financial data on. these companies was obtained for the
three-year period 1973-1975. The recession year 1975 was deliberately
included to evaluate the effects of business cycle fluctuations on
financial ratio performance. This sample was designed to represent the
average asset size range and mix of industries likely to seek to use a
financial test. Both the bankrupt and non-bankrupt samples were tnen
31
-------
randomly divided into primary and "holdout" groups in order to control
against sample bias.
Many commenters on the May 19, 1980 regulation suggested that
electric utilities and hazardous waste management firms possessed unique
financial characteristics ^nd shoula be governed by a separate financial
test. To test this suggestion, financial data for twenty-six utilities
and two representative large hazardous waste management firms were also
examined.
The Agency reviewed the existing literature on bankruptcy fore-
casting to identify those financial ratios that had been previously
evaluated. In addition, it used tne comments on the May 19, 19bU pro-
posed regulation and the suggestions of bond rating experts and credit
analysts to identify other candidate ratios. The list of ratios
assembled was extensive and varied widely in content and estimated
effectiveness. From this list, the Agency selected seven financial
ratios for detailed evaluation:
o cash flow/total liabilities
o net income/total assets
o total liabilities/net worth
o current assets/current liabilities
o quick assets/current liabilities
term cash flow refers to the sum of net income, depreciation,
depletion, and amortization.
No distinction between tangible and intangible net worth was made with
respect to this ratio.
32
-------
o net working capital/total asaets
o net sales/total assets
These ratios were chosen because they satisfied three basic condi-
tions: (1) they produced significant predictive results in the prior
literature, (2) they were frequently identified by bond rating services
and credit analysts as key parameters, and (3) their values were readily
available from corporate balance sheet data.
Financial ratios can correctly identify a very high percentage of
future business failures, but only at the expense of incorrectly identi-
fying some percentage of future non-bankrupt firms as bankrupt. There-
fore, several measures of a test's predictive value were computeo. to
provide a means for comparing test alternatives. They were designed to
assess the public and private impacts of the various test options.
The most important of these measures of a test's overall predictive
value was found to be the effectiveness measure (.E), which represents
the Agency's estimate of the number of firms (per 10,000 that pass a
given financial test) that will go bankrupt without providing alterna-
tive financial assurance. The second major measure of the test's
performance was the measure of the percentage of non-bankrupt firms that
pass a given financial test (A^g).
The effectiveness measure (E) was calculated according to the two-
step procedure used by all previous bankruptcy studies that have derived
effectiveness data. Such data are necessary to determine the best test
for a particular purpose, such as, for example, to determine the costs
of given tests. Figure 1 describes how E is calculated.
33
-------
Set of
Firms
Number of Bankrupt Firma
According to Baseline
Failure Rate
Percentage of Bankrupt
Sample that Pass Test T
(Minelassifled Bankrupt
Fi rnis)
.Bankrupt Sample
Number ot Firms tbat Pass Test and Go Bankrupt
Number of Non-Bankrupt•
Firms According to
Baseline Failure Rate
.Percentage of Non-Bankrupt
Sample that Pass Test T
(Accurately Classified
Non-Bankrupt Firms)
(ANB>
..Non-Bankrupt
Sample
FICURI! 1
PUOCEDURK FUK CALCULATING TIIK KVFKCT1 VliNF.SS (K) MLCASURK
-------
Each test was applied to both the bankrupt- and the non-bankrupt
firm samples. The results were then used to calculate the percentage of
the bankrupt sample that passed the particular test (i.e., the percent-
age of bankrupt firms that were misclassified by that test as non-bank-
rupt) , and also to calculate the percentage of the non-bankrupt sample
that passed the particular test (i.e., the percentage of non-bankrupt
firms that were accurately classified by that test as non-bankrupt).
At the same time, the Agency calculated how many, of a set of
firms, could be expected to go bankrupt according to various baseline
failure rates. This procedure yielded a number for firms that would go
bankrupt according to the baseline failure rate, ana a number for non-
bankrupt firms according to the same baseline failure rate.
In the second step of tnis process, tne Agency multiplied the
number for bankrupt firms at. a particular baseline failure rate by the
percentage of bankrupt firms misclassified as non-bankrupt by a partic-
ular test. This operation yielded a number for firms that pass a
particular test and go bankrupt.
Similarly, the Agency multiplied the number for non-bankrupt firms
at a particular baseline failure rate by the percentage of non-bankrupt
firms that are accurately classified as non-bankrupt firms by a partic-
ular test. This operation yielded a number for firms that do not go
bankrupt and pass a particular test.
Finally, the Agency used these results to calculate wnat percentage
of all firms passing a particular test are firms which will go bankrupt.
(In Figure 1, this operation is represented by T^ divided by I^u plus
35
-------
Tjg.) That percentage was tnen multiplied by 10,000 to yield the number
of firms per 10,000 that pass a given financial test that will go bank-
rupt. This number, E, is the measure of effectiveness of a particular
test. It can be reconverted to a percentage by dividing by 10,000.
The Agency's evaluation of various tests was also based on assump-
tions about the length of time that will be necessary to guarantee that
a firm that no longer passes a financial test will still be able to
establish an alternative financial assurance mechanism. Based on the
Agency's analysis of the race of deterioration in the liquid assets of
failing firms, and its assessment of the potential for delays in litiga-
tion and enforcement, the following assumptions wete made: (i) ao.1
firms which first fail a financial test at least three years prior to
bankruptcy will provide alternative financial assurance, (2) one-half of
those firms eliminated between three and two years prior to bankruptcy
will set up alternative financial assurance mechanisms, and O) no firms
which first fail a financial test less than two years prior to
bankruptcy will provide financial assurance. A more detailed discussion
of these assumptions is included in Appendix B.
The seven financial ratios selected for evaluation were first
tested individually against the primary bankrupt and non-bankrupt firm
samples, using a variety of pass-fail cutoff points derived from the
bankruptcy forecasting literature for each variable. The most promising
ratios were then combined together to form 120 alternate multi-ratio
tests, which were then retested against the primary sample. The ratios
were combined in three ways: two-ratio tests (firms must pass both
36
-------
elements of the test .to pass), three-ratio tests- (firms must pass all
three elements of the test to pass), and three-ratio contingent tests
(firms must pass two of three elements to pass). Twenty-nine of the
multi-ratio tests produced E results (2.2 firms per 10,000 that will
fail without providing alternative assurance) that were approximately 90
percent lower than the baseline failure rate (22 per 10,000 firms) for
firms independently audited. However, these increases in efficiency in
classifying bankrupt firms were largely obtained by excluding increas-
ingly nigh percentages of viable firms (defined as finus that will not
go bankrupt within three years). Alternatively, 17 of the ciulti-ratio
tests evaluated permitted more than 80 percent of the non-banKrupt firm
population to pass the financial test; these tests were able to reauce
tne undetected failure rate to between 6.3 and 11.4 firms per 10,000 for
large firms.
Consequently, a second phase of the testing exercise was undertaken
to determine whether other financial ratios could be added to these
tests to improve their ability to discriminate between viable and non-
viable firms, while retaining the same high levels of bankrupt firm
detection. Ten ratios were tested for their ability to correctly clas-
sify 32 non-bankrupt and 12 bankrupt firms that had been consistently
misclassified by the original tests. One ratio, the ratio of net fixed
assets/total assets, greatly enhanced predictive accuracy. To test the
validity of this ratio against the entire primary sample, the Agency
evaluated 31 new tests including this ratio.
37
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Using the E and A^g results ootained from evaluating tests against
the primary sample, the Agency generated performance curves for all of
the tests analyzed. Any test falling on one or uore of the performance
curves was considered to be a "best test," and was then evaluated
against the holdout sample, to control for sample bias. The holdout
results generally confirmed the results obtained from the primary sam-
ple. Comparison of the average financial characteristics of the primary
sample with the characteristics of samples developed for other studies.
supported tne conclusion that the primary sample results represented a
conservative, lower-bound estimate of likely test effectiveness.
In examining tne performance of possible tests, the Agency examined
each test based upon one-year and three-year eligibility requirements.
A one-year eligibility requirement allows a firm to use a financial test
in a given year if it met the requirements of the financial test for its
financial statement of tne previous year. A three-year eligibility
requirement requires a firm to have passed the financial test for three
consecutive years prior to being allowed to use a financial test instead
of another financial mechanism. Figure 2 provides a summary of the best
test results.
The Agency also examined the question of industry differences in
test performance, particularly in regard to those industries (primarily
electric utilities and hazardous waste management firms) that had
previously objected to the use of certain financial test formats, on the
grounds that a given financial test may serve quite well for most indus-
tries, but unique characteristics of a specific industry may cause a
38
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90-
bO-
75-
V
(I'ei ccnt.ij'K-
of non-
nkrui't (.;••
r.c'mj j a:
si)
/THi" in i '-• i (i'
Xi::'M '.)
139(1)
l!o lib I'.'l) 2'.b 1.'(> 'li^ 'i!(l A.S S.'o i!s tild 6.S ?!() 7.'i S.'d B.'i 9.'ll '} .'i Id'.O Id'.'.
!•: (Ni.rilxT i'l t • i in; tit.i* j-.i:-.: .-j .nveii f i n;inr i <'i 1 lost tti.it will >i't h.liikr ll|rt williont. pi i>vi (ll lift
..icoin.i'i •• I i n.in. i .1 I -i: : MI .in..-i: ).<•! lU.IIIKI | i i in: )
Source: Appendix A, Figure V-4.
1'lGURi; 2
I'KKl-'ORMANCIi CUKVl1: OK HEST FINANCIAL TESTS WITH EITHER
ONE-YEAR OK TilKEE-YEAK El.KJI.UIF.ITY KRQU1KEMENTS
-------
high percentage of cue viable firms in that industry to fail a given
test. Although some industry differences in ratio performances were
encountered they were generally not significant, and a number of the
best tests (especially those at the less stringent end of the spectrum)
were found to be acceptable measures of performance for all industries,
particularly when the ratio tests were supplemented by a bond rating
test. The Agency concluded that problems both of design and of
administration rendered unfeasible the development of tests tailored to
different industries. A fuller discussion of the performance of tests
for all manufacturing industries, 'including percentages of firms in
particular industries which pass '""or fall various test criteria, is
included in Section VI.A. of Appendix A.
A comparison of the results obtained by the Agency with other
bankruptcy forecasting studies published in the literature indicated
that the results of the "best" Agency tests are comparable to tne best
results obtained by previous forecasting efforts. The Agency tests
would also be less difficult to administer. (See Section V.D. of Appen-
dix A of this document.)
c. Bond Ratings
Several commenters on the May 19, 1980 proposed regulation sug-
gested that bond ratings should be used as an alternative or substitute
for the proposed financial test. The Agency therefore analyzed the
possibility of using bond ratings as a financial test. A fuller discus-
sion of bond ratings is included in Section VII of Appendix A.
40
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Bond ratings provide an.,appraisal .of .the ability .of—f inns ..to .repay.
specific long-term debts. They therefore are more useful than credit
ratings, which are primarily evaluations of ability to repay short-term
credit and trade credit. The Agency considered whether bond ratings
could be used in a financial test in either of two ways: as the sole
criterion, or as a supplement to a financial test. Because ratings tend
to be limited to firms that issue large quantities of publicly held
debt, their use as the sole basis of a financial test would eliminate
many substantial firms which do not have bona ratings but do nave assets
and net worth adequate to cover the costs of closure and post-closure.
The Agency aecerminea, however, that as a supplement to a financial
test, bond ratings could provide a useful method that firms could use to
demonstrate their financial responsibility. Although firms with rated
bonds are a small subclass of all firms, the Agency's study showed that
few firms with rated bonds fail. The Agency noted, for example, that
none of the 66 firms in its sample of bankrupt firms had an investment
grade rated bond and few had ever issued a major bond offering. A
variety of industry-specific problems also could be overcome, since bond
ratings involve the application of judgment and expertise to a specific
firm.
The Agency's conclusion was based on a study of the available data
concerning bond ratings. Although the nationally recognized rating
services assert that ratings provide a useful indicator that a firm will
not become bankrupt, numerical data on the effectiveness of these
ratings are difficult to find. The Agency conducted a literature search
41
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which found only one quantitative- sCudy of the performance of agency
ratings of the bonds of private entities. This study is somewhat dated,
covering the period 1900-1943, but it does examine a period of economic
volatility which provides a good test of the results of ratings
services.
Table 1 shows the performance of ratings for the period 1900 to
1943 according to this study. The ratings used are those assigned at
the time of issue; thus, if the bond was downgraded prior to default but
after issue, this would not be reflected ia thsse performance indica-
tors. Given the volatility of the economy for tne period in question,
and the face that changes in rating were not accounted for, this Table
presents a strict judgment of bond ratings. The Agency translated the
accuracy of the bond . ratings under alternative assumptions about the
failure rate into the measure of effectiveness (K) used by the Agency to
represent the number of firms (per 10,000 that pass a given financial
test) that will go bankrupt without providing alternative financial
assurance. (See the portion of Table 1 labeled "Effectiveness in
Predicting Defaults.") The first assumption is the failure rate of 22
per 10,000 that the Agency estimated is the rate for firms of over $10
million in net wortn. The second reflects the possibility that the
failure rate for the kinds of firms which would have rated bonds might
be as low as 11 per 1U,000. The Agency based this lower estimate on the
fact that public bond ratings are generally given to bond issuances from
substantial firms. The numerous large public bond issues whicn are not
rated at all have a much higher failure rate than the failure rate of
42
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PEKKGKMANCE OF ACKHCY KAT1NUS ( I 'JOG- I 943)
-t-
U)
Agency Rating
A. All Corporate
llotuls Rated
(Industrials,
public utilities,
railroads)
1
11 or above
11 J or above
3/
IV or above —
U. Industrials Only
I
11. or above
ill or above
IV or above-
Percentage of
Default! DC
Firms
With Rating
6.6
17.1
44. 3
72.5
0
5
28
73
Percentage of
Nonclef aulti ng
Firms
With' Rating
l.'J
46
74
94
13
33
66
93
Effectiveness in P red in ting Defaults
I'or 10,000 Firms AasumlngL/
Haselliiii Fulluro.
Kate = 22/10,000-'
7.6
8.5
13.0
16.8
0
3.3
9.5
17.3
Ikiseline Failure
Kate = J. 1/10,000
3.8
4.3
6.5
8.3
0
1.7
4.7
8.6
— Calculated as for Effectiveness Calculation In Appendix A. • •
2/
— The baseline failure rate of 22 pur 10,000 .is the fajJun.; rate, for firms with greater
than $10 million in net worth. I'lrms with loss than at least $10 million in net worth
are assumed not to receive bond ratings.
— Agtnicy ratings of IV or above represent investment grade bonds.
SOURCE: Appendix A, Table VII-2.
-------
those which are rated. The unrated issues are ..excluded from...the., entire
rating system, and from the percentages shown in this Table.
There is no equivalent study for the post-war period on the perfor-
mance of bond ratings. The basic reason for the absence of further and
more recent research on this question is the very low default rate on
large bond issues in the post-war period. One study found that the
default rate for all large corporate bond issues, including privately
placed issues, for the period 1944 to 1965 was approximately one-
twentieth of that for the period 1900 to 1943. Halt of the defaults in
the 1944-1965 period were in the transportation industry, particularly
tne railroad sector. Defaults have therefore been sucti rare events that
statistical assessment is meaningless. In gathering data on bankrupt
firms for this study, the Agency found very few failures by firms with
rated bonds, and only two failures by firias with a bond rating of
investment grade or better within three years of default (W.T. Grant and
Penn Central, which were not included in the bankrupt firm sample
because they were in industries considered unlikely to dispose of
hazardous waste). The percentage of firms assigned ratings below
investment grade is 5 to 10 percentage points lower throughout the post-
war period than in the 1900-1943 period, but this is viewed by most
observers of the bond market as an indication of the improved quality ot:
public offerings and of the tendency of firias that would receive ratings
of less than investment grade to place bonds privately. The Agency has
concluded, on the basis of the work of most financial analysts who have
written about this subject, that bond ratings continue to be at least as
44
-------
accurate as they were over the 1900-1943 period. A fuller discussion of
the performance of bond ratings is included in Section VII of Appendix A.
d. Alternative Methodology Approaches
The Agency was aware that alternative methodological" approaches
could have been used for the above study. EPA is satisfied, however,
that those alternatives would not have yielded superior results. More-
over, some of the alternatives were not feasible. (A discussion of these
alternatives is included in Section V.D. of Appendix A.)
The Agency's study examined financial tests that required specific
financial ratios to be certain levels. An alternative approach would
have been to use financial test that consisted of linear or nonlinear
functions of a set of financial ratios. Three methods have been pro-
posed in the literature for developing financial tests that consist of
functions of financial ratios. One approach is simply to rely on expert
judgment to decide what ratios should be included and what values should
be associated with them. However, there is no statistical method of
determining whether the values or the financial ratios chosen have been
appropriately determined. A second approach is to develop a functional
model of the factors that lead to business failure and to use this model
to estimate the probability of business failure for any specific firm.
This approach has been attempted once in the literature reviewed for
this study, and that attempt did not include any statistical validation
of the model. Considering the relatively short time available in which
to analyze the financial test, the Agency decided not to attempt to
45
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develop an untested technique that might, in the end, not be effective
or satisfactory. The third approach, and that most commonly used in the
bankruptcy forecasting literature, is that of multi-discriminant
analysis. This is a statistical search technique for arriving at the
best linear or nonlinear function for a set of chosen financial ratios
for discriminating between bankrupt and non-bankrupt firms. This is the
most statistically sophisticated approach to tne problem. The use of
this approach was rejected in this study for two reasons: (1) a func-
tion of financial ratios would be more difficult to compute, moire diffi-
cult to administer, and more difficult to check quickly than a simple
set of ratio requirements; ana (2) it has been pointed out several times
in the literature on bankruptcy forecasting that although multi-
discriminant analysis is statistically more sophisticated than other
approaches, it has not in fact yielded more accurate forecasts of bank-
ruptcy than the simpler approach adopted here. As a check of the
validity of the procedures adopted, the Agency compared the results of
the financial tests it developed to financial tests developed in bank-
ruptcy forecasting studies employing multi-discriminant analysis. AS
noted above, the results obtained by the "best" Agency tests are
comparable.
In developing its statistical sample, the Agency also chose not to
attempt to gather a large population of firms, determine which ones had
later entered bankruptcy and which ones had not, and tnen examine tests
against this entire sample for their ability to forecast bankruptcy.
The problem with this procedure is that bankruptcy is a relatively rare
-------
event. The average business failure rate in the post-war period has
been approximately 44 per 10,000 firms per year, of all firms of
whatever size, whether or not incorporated. In order to obtain a
sample of bankrupt firms as large as that used in this study, it would
have been necessary to obtain data on a total of 15,000 firms. Such an
effort would not have been feasible, and had not been attempted in any
previous study of bankruptcy forecasting.
Finally, a number of commenters felt that it would be advantageous
to have specific tests for different industries. This approach could
not be tested, however, because of the difficulty of gathering a large
sample of bankrupt firms. An extensive search for firms which had gone
bankrupt and which had publicly available financial statements yielded a
total of 95 firms. Several of these were retail firms and therefore not
appropriate for this study. None of these firms were electric utilities.
To further subdivide this sample, for example, into two-digit SIC codes
would result in samples of bankrupt firms too samll to be statistically
usable. Thus, industry-specifc tests cannot be developed from the data
currently available. A review of the bankruptcy forecasting literature
found only one study which had developed industry-specific tests. This
study, which was of the railroad industry, had to use bankruptcies over
a period of 50 years in order to develop adequate sample size.
3. Methods of Identifying Firms Which Will Later Have Sufficient Ability
to Pay
In addition to identifying firms that may go bankrupt, an adequate
financial test should also provide assurance that at the time a firm
ceases to pass the financial test, it will continue possess assets
47
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sufficient so that it is able to ..pay for. closure and post-closure
costs. Otherwise, it is possible that the attempt to pay these costs
will be sufficient to force the firm into bankruptcy before these
closure and post-closure costs nave been fully paid. In sucn a case,
the balance of the costs would have to be claimed by the. EPA in the
bankruptcy proceeding, which could be a time-consuming and sometimes
ineffective process that the agency wishes to avoid if possible.
To evaluate this ability to pay question, the Agency reviewed
financial data for twelve bankrupt firms wnich were especially difficult
to classify because their financial condition had deteriorated very
rapidly in tne two to three years prior to their declaration of bani<-
ruptcy (see Section II of Appendix A). The Agency analyzed the ability
of these firms to pay three, two, and one years prior to their bankr
ruptcy. The Agency's review of their financial statements revealed that
eleven of tne twelve firms retained significant amounts of cash and
liquid assets, positive net working capital, and positive net worth two
years prior to bankruptcy, and two-thirds of these firms continued to
aeet these conditions one year prior to bankruptcy. Additional data
about bankrupt firms generally confirmed the accuracy of these results.
Although this demonstrated the general availability of cash and capital
resources to fund the establishment of an alternative form of financial
assurance, other factors were noted (negative cash flow, rapid deterio-
ration of working capital) which could threaten the Agency's ability to
secure these resources. In order to avoid the occurrence of sucft
problems under a financial test provision, the Agency determined that
48
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the best approach would be to specify certain minimum-levels of net
working capital and tangible net worth (defined as multiples of the
firm's closure and post-closure-estimate)" that-would-have-to -be--met-as
part of any test selected.
The multiples of these financial variables required to ensure the
ability to pay were calculated for the twelve sampled firms. The
results indicated that a multiplier of six would be appropriate to
ensure the presence of the necessary funds.
The factor of six was determined ay combining two judgments. Trie
Agency concluded first that net working capital and tangible net worth
of at least twice the estimated closure and post-closure costs would
have to be present at the time the funds were paid, to ensure that such
payment did not put the-firm-into.-a negative-.net. .working capital .and.
negative net worth situation. Secondly, the Agency concluded that it
was necessary to provide against rapid deterioration in tangible net
worth and net working capital during the period between the
determination that a firm no longer passea the financial test and the
time that the necessary funds could be collected from the firm. Such
delays could occur, for example, because of legal proceedings. Analysis
of firms subject to rapid deterioration in their financial condition
showed that their net working capital had fallen by an average of bb
percent in two years, or an average of 33 percent per year. A factor of
three was therefore considered adequate to guard against such rapid
decreases in tangible net worth and net working capital. The factor of
2 (to ensure current ability to pay) was then multiplied by the factor
49
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of 3 (to.ensure against a high rate of deterioration before payment can
be brought about) to obtain the factor of six chosen by the Agency. In
order to ensure more fully that firms will be able to secure needed
funds, the Agency further determined that net worth should be required
to be tangible net worth. A fuller discussion of the rationale for the
multiples requirement is presented in Section II of Appendix A.
4. Analysis of the Costs of Financial Tests
In the course of its study of the performance of financial tests
the Agency examined over 300 possible financial tests. From aaong then
it identified a smaller group of tests whose performance dominated the
other alternative tests or which were otherwise of particular interest
to the Agency. Next, the Agency undertook an evaluation of the costs of
these possible financial tests, and a comparison of their costs with the
costs of other forms of financial assurance.
The tests chosen for analysis included the May 19, 1980 proposed
financial test; a test labeled "Ability to Pay" wnicn required only $10
million in net worth and both net worth and net working capital greater
than six times closure ana post-closure costs; a "Wo Financial Test"
option whose costs were based on the assumption that all firms will use
a letter of credit; and all of the ratio tests deceruined to be "best
tests." Some of these tests had an eligibility period of one year;
others required firms to meet tue requirements of a test for three
consecutive years before they would be eligible to use the test as an
assurance of financial responsibility. The costs of various tests for
closure and post-closure were .measured for those firms which would be
50
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eligible to use a test with, .a $.10 .million .in, net_ worth and-an_ indepen-
dent audit requirement. The Agency assumed, for this purpose, that 50
percent of- all owners or.-operators..of....haz:ar.dous,;_waste._:mana§ementt.f.aei-l-.,
ities would have over $10 million in ..net. worth...and..,that .3.4.. .percent of
those firms would be independently audited. In addition, supplementary
studies were conducted relaxing certain of those assumptions.
Because of certain assumptions adopted for the cost analysis which
do not affect the choice of a financial test but which would become
critical if the methodology for trie cost analysis were to be applied for
other purposes, the analysis presented in Appendix B cannot be used as a
basis for a cost analysis of tne financial responsibility requirements
as a whole.
a. Types of Costs Analyzed •
Two types of costs were examined by the Agency: direct public
costs and private costs.
(1) Direct public costs were defined as those costs of closure and
post-closure that must be borne by someone other than the owner or
operator of a hazardous waste TSDF. Direct public costs thus represent
a quantification of the threat to human health and the environment posed
by unfunded financial needs. The costs measured represent the sum of
costs which ultimately must be borne by the public for conducting
closure and post-closure. Thus, if the funds available from a financial
mechanism at the time of need were inadequate, but other funds could be
recovered from an owner or operator through legal proceedings, tne
Agency did not count such recovered funds as part of the direct public
51
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costs. Any coses of litigation associated with the recovery of funds
from bankrupt firms were not included in direct public costs. Costs
that aid not differ with respect to the choice of'"financial "mechanisms,"
such as the costs to the Agency of administering the regulation and
processing reports were also not included, because they are costs that
all financial mechanisms have in common.
Within the broad category of direct public costs associated with
closure and post-closure financial responsibility, the Agency distin-
guished two subtypes:
(i) Direct public costs due to bankruptcy of firms using a letter
of credit. (For an explanation of why the letter of credit was used,
see the following text.) These are all the costs of closure and post-
closure-that cannot be adequately funded from the letter of credit or
from any other funds recovered from the firm.
(ii) Direct public costs due to the bankruptcy of firms using a
financial test. These are all the costs of closure and post-closure
that cannot be recovered through legal action from firms that go
bankrupt after passing the financial test but without providing another
mechanism of financial assurance prior to going bankrupt.
(2) Private costs were defined by the Agency as the costs to the
regulated community of obtaining financial mechanisms to serve as assur-
ances of financial responsibility, e.g., fees for letters of credit,
fees for surety bonds, and costs of financial reports. Because the
function of the cost analysis was to compare the costs of the financial
mechanisms used to satisfy the closure and post-closure, requirements,
52
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only the differencial costs .'of mechanisms were-measured. ...Costs-that-all
financial mechanisms have in common, such as the costs to the owner or
operator of preparing and revising costrestimatesf-time-spent' on ehoos-—
ing a financial mechanism,- and- routine. management~eoscs^-associ-ated-.wi'th=.-f.
maintaining any financial mechanism were not included in private costs.
For the analysis of financial tests providing financial assurance
for closure and post-closure care, two types of private costs were
considered:
(i) The private costs of letters of credit. These costs induce
the fees for the letters of credit. They do not include the fees for
the accompanying standby trust funds; these fees, however, will in most
cases be minimal. The effect of a letter of credit on future borrowing
costs is not included as a..cost of a letter of credit-,"because it would
be extremely difficult to distinguish, this effect from the more general
effect of having a certain future obligation (i.e., an obligation to
perform closure or post-closure care) for which the letter of credit
only provides a type of third-party guarantee. Borrowing costs for all
owners or operators may be affected by closure and post-closure finan-
cial assurance obligations whichever financial assurance mechanism is
provided, albeit to different extents.
The letter of credit was chosen as the instrument whose costs in
the absence of a financial test would be analyzed in comparison to the
costs of a financial test because it would be the instrument most likely
to be used by independently audited firms of greater than. $10 million in
net worth, and because . it will probably be the least expensive
53
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instrument. Both the letter of credit and the surety bond will oe less
expensive than the trust fund. However, the letter of credit will be
more readily available, particularly .to firms that-can..supply, .collateral.
or which have established credit, and will probably be slightly. Less
expensive than tne surety bond. The costs of the closure insurance
mechanism will probably fall between those of the letter of credit and
tnose of the trust fund.
(ii) The private costs of a financial test. These costs include
tha annual preparation of auditors' special reports. The Agency
requires that tnese firms be independently audited and that the special
reports be based on annual independently audited financial reports.
b. Overview of the Cost Model
The structure of the model used by the Agency to examine the direct
public costs and private costs of financial tests for closure and post-
closure financial assurance is shown in Figure 3. A fuller description
of the model and the assumptions are included in Appendix i> to this
document. The cost analysis was carried out first for independently
audited firms of more than $10 million in net worth and then for all
independently audited firms, including those with less than §1U million
in net worth. (No costs are included for firms which would not be
eligible for the test because they are not independently audited.) The
Agency estimated that about 34 percent of those firms over $10 million
in net worth are independently audited and approximately 2.7 percent of
those firms under $10 million are independently audited. The results
reported in tne background Document are for all independently audited
54
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FIRMS POTENTIALLY ABLE
TO USE SOME FINANCIAL TEST
. PASS TEST
(PAY PRIVATE COSTS
' OF FINANCIAL TEST)
X
FAIL TEST
(USE LETTER OF CREDIT)
(PAY FEES FOR LETTER
OF CREDIT)
DOES NOT
FAIL
BUSINESS FAILURE
(DIRECT PUBLIC
COSTS: 60% OF
FUNDS RECOVERED,
PLACED.IN TRUST
FUND)
DOES NOT
•FAIL
BUSINESS FAILURE
(DIRECT PUBLIC
COSTS: 60% OF
FUNDS NOT IN
LETTER OF CREDIT
RECOVERED, ALL
FUNDS PLACED IN
TRUST FUND)
FIGURE 3
STRUCTURE OF THE COST MODEL
SOURCE: Appendix B, Figure 1-1.
55
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firms or more than $10 million in net worth. Costs for all
independently audited firms, including firms with less than $10 million
in net worth, are included in Section IV.C-. of Appendix B to the
Background Document.
The Agency assumed in tnis model the following set of potential
events. All firms will either pass or fail any given financial test.
All firms that pass the test will incur the private cost of a financial
test, i.e., the cost of obtaining an independent auditor's special
report. If a firm passing the test does not enter bankruptcy during the
period it passes the financial test, there are no direct public costs.
If a firm passing tne test enters bankruptcy witnout establishing an
alternative financial mechanism, direct public costs are incurred due to
a financial test. In determining tne amount of these direct public
costs, the Agency assumed on the basis of a review of bankruptcy
procedure and cases that for firms of more than $10 million in net wortti
60 percent of the funds needed for closure and post-closure care could
be recovered in a bankruptcy proceeding, ana for firms with less tnan
$10 million in net worth only 25 percent would be recovered. It further
assumed that the recovered funds would be placed in a trust fund. (.See
Appendix B, Section III E.)
The Agency assumed that all firms which fail the financial test
initially or which establish an alternative financial mechanism prior to
bankruptcy would secure a letter of credit to provide financial
assurance. The private costs are the fees for the letter of credit.
For a firm using a letter of credit, two alternative events may occur.
56
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First, the firm .may continue.. ._t.a_be_a_non-.bankrupt.-firm. Ln.-..that case,..
no public costs would be incurred. Alternatively, the firm may enter
bankruptcy. In that case,., .direct p,ub.M;c cos.ts .will ..be ..incurred, .for .any..
costs not. covered .by. .the. letter...of-.cr.edi.t....whi.ch._.canno.t...bfi.,-r.eco.v.er.ed..f.r.oci-
the bankrupt firm. Again, the Agency assumed that 60 percent of the
closure and post-closure care costs not covered by the letter of credit
could ultimately be recovered from bankruptcy, and funds for post-
closure would be placed in a standby trust fund.
The Agency computed the total private costs for eacn financial test
by adding the private costs of the financial test for those firms able
to pass that test and the fees associated with tne letter of credit for
those firms unable to pass the test. The direct public costs of each
test were then computed as the sum of the direct public costs due to use
of a financial test for those firms able to pass the test that later
enter bankruptcy and the direct public costs due to use of a letter of
credit for those firms that fail a financial test and latar enter bank-
ruptcy.
/
c. Costing Conventions
All costs developed ia the study are presented as annual costs in
1980 dollars. The annual cost presented should not be confused with
expenditures required in any given year, however, because both public
and private costs incurred during the post-closure period were computed
at their present value and annualized over the life of the facility.
Since costs are measured in 1980 dollars, no account was taken of the
effect of inflation on the actual required current dollar expenditures
57
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in any given year. The post-closure private costs and direct public
costs of disposal facilities were annualized.over the life of the facil-
ity. This means that expenditures that would be required over the
entire 30 year post-closure period are presented as annual costs in the
year the facility fails, and failures occurring in the post-closure
period are annualized back over the life of the facility.
5. Rationale for Standards
a. Financial Test
In reviewing tiie results of the cost analyses of tne various poten-
tial financial tests for closure and post-closure, the Agency compared
alternative financial test formats to each other and considered finan-
cial tests in relation to other mechanisms for financial assurance. The
Agency, in this review, paid particular attention to three goals.
(1) Funds should be available for closure and post-closure
care to ensure protection of human health and the
environment.
(2) As a matter of equity, the parties responsible for
closure and post-closure obligations should pay those
costs.
(3) Costs to the regulated community should be as low as
possible.
The two cost measures developed by the Agency — direct public
costs and private costs — capture major aspects of the goals set for a
financial test. Direct public costs provide a measure of the costs that
must be paid by the public to prevent threats to human health and the
environment that could be caused by facility deterioration if closure or
post-closure care were not performed, because direct public costs also
represent the costs of closure and post-closure care not paid for by the
58
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party, responsible for the facility, they are . an indirect measure of
equity. Private costs represent 'the costs to owners and operators of
ensuring that funds will be available.
In examining . possible financial, tes.ts,. th.e..Ageacy_.fi.r.st...ident.ifie.d
the test which minimizes the sum of direct public and private costs.
Such a test provides the lowest sum of all costs to the public because,
over the long run, private costs to owners and operators will be passed
on to the public through increased costs of goods and services. The
Agency concluded that the proper method of determining which test to
choose should be to determine whether a test can provide the sum of
lowest costs and still meet tne Agency's goals. These costs include
both costs of unfunded closure and post-closure paid directly by the
public and costs to the regulated community ultimately passed on to the
public.
Applying the criterion of minimizing the sum of direct public and
private costs to those financial tests which it had previously analyzed,
the Agency identified a test which was significantly superior to the
test proposed in the May 19, 1980 regulations, and to the option of no
financial test. The results of the analysis of the costs of alternative
financial tests requiring over $10 million in tangible net worth are
shown in Table 2. This test, labeled! "Test 100" in Table 2, has a one-
year eligibility period and consists of the following requirements:
(1) Tangible net worth of at least $10 million; and
(2) Two of the following three ratios: a ratio of total
liabilities to net worth less than 2.0; a ratio of the
sum of net income, depreciation, depletion, and amortiza-
tion to total liabilities greater than 0.1; and a ratio
of current assets to current liabilities greater than
1.5.
59
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TABLE 2
PERFORMANCE AND DIRECT PUBLIC AND PRIVATE COSTS OF
ALTERNATIVE FINANCIAL TESTS FOR CLOSURE AND POST-CLOSURE*
(in thousands of 1980 dollars per year)
Test
Description
No Financial
lest
139
125
13E
127
13E
151
13-
Eligibility
Requirement
(one year or
three year) ]
HA
EP
NA
1 , 0
3 i l.i
3
3
5.4
1.9
1 ; 2.8
1 3.7
1
13t' 3
133 • 1
' 14' i 1
136
137
98
146
100
Ability to
Pay Test
Ability to
1
1
1
4.6
,,
0
49
56
82
67
76
77
79
82
1
5.6 , 83
6.0 87
7.9
9.1
9.3
I
1
1
3
1
Pay Test
Hay 19. 1980
ll'
9.9
. 10. 1
',8.4
20.2
15.7
Test
89
92 .
93
95
96
99
100
90
Direct Public
Costs but to
Failure of
Firms Using
a Financial
Test
0
0
19
Direct Public
Costs Due co
Failure of
Firms Using 1
a Lecter
of Credit
142
Total Direct
Public Costs
142 .
142 ; 142
137 , 156
31 ; 134 165
24 136
160
51 : 129 180
68 124 ; 192
87 ! 119
106 : 114
112 112
125 1 109
169 97
' 201
206
220
224
234
266
68 i 289
207 86 i 293
225 j 82 j 307
234 : 80
439 i 24
1 48*
| 366
1
12
44
314
463
496
401
Private Costs
of a Finan-
cial Test
0
123
14!
16E
161
191
193
199
206
20E
219
224
231
23-.
Private Costs
of a Letter
of Credit
3,334
Total
Private Costs
3,334
1.701 1,824
1,467 j l,60f j
1,100
1,201
l,26b
1,362
I
800 ] 991
76?
700
600
960
899
806
567 i 775
434
367
267
653
591
498
233 467
239 167
241
~249~~
251
244
133
33
0
100
406
374
282
251
344
Sua of Direct
Public and
Private Cost*
3,476
.
1,966
1.764
1.433
1.522
1.171
1.152
1.105
1.026
999
, 887
i 857
! 787
760
713
688
745
747
745
— The May 19, 1980 proposed test had a one-year eligibility requirement.
SOURCE: Appendix A. Table V-3; Appendix B, Table IV-1.
*The assumptions used In this analysis differ somewhat from those used
In the preliminary Regulatory Impact Analysis. Probably the most
Important differences are that the cost estimates for closure and post-
closure costs are somewhat higher In this analysis than those used In
the preliminary Regulatory Impact Analysis. However.- these difference*
In assumption do not affect Che choice of the test which minimizes the
sum of public and private coses. See Section IV. B of Appendix B.
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The Agency estimated that. .adoption - of.. Tes.t -100 11. year) could
result in direct public costs of $314,000 a year due to the bankruptcy,
with associated unrecovered .costs._£or...unfundea....clos,ur-.e..and,.,post-clos.ur;e».
..care, of. f irms .using ..this _.f.inancial...t.es.t». ~_.Ihe_iacremenLsl. ,.p.uhlicM.c.osJt,,.
over not adopting any financial test would be $2,788,000. However, this
test had the lowest combined public and private cost ($688,000) of any
test studied. The combined public and private cost would be $7288 lower
than the cost if the test were not adopted. Only about 10.1 firms out
of every 10,000 firms tnat pass this test could be expected to go
bankrupt without providing alternative financial assurance. Such
bankruptcies would affect about 2.5 sites per year. About 96 percent of
all non-bankrupt firms would pass this test.
Such results are conservative estimates, because the final
formulation of the test adopted by the Agency also includes the
following additional three requirements, whose effects were not part of
the analysis, but which clearly make the test more stringent:
(1) Net working capital and tangible net worth each at least six
times the sum of the current closure and post-closure cost
estimates;
(2) Assets in the United States amounting to at least 90 percent of
total assets or at least six times the sum of the current
closure and post-closure cost estimates; and
(3) Submission of an independent auditor's opinion of the firm's
financial statements and footnotes, which must be unqualified
in order for use of the financial test to be allowed without
further review. Adverse opinions, disclaimers of opinion, and
opinions which raise "going concern" questions will disqualify
a firm from using the financial' test. Firms which receive
other types of qualified opinions will be evaluated on a case
by case basis.
61
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Tests without the $10 million in ...tangible nat worth requirement
lead to even lower sums of public and private costs. The test with the
lowest possible sum of public and private costs is Test 100 without the
requirement of $10 million in tangible net., worth. This test would lead
to savings of 3878,000 per year over Test 100 with a S10 million in net'
worth requirement. Those savings would, however, be entirely in private
costs, which would decline by $950,000 per year, while direct public
costs would rise by at least $72,000 per year. The rise in public costs
could be much larger, since the estimate fails to take account of cer-
tain special problems of admitting smaller firms to use the financial
test. (.See Appendix ¥?, Section IV.C. for a full discussion of Che
consequences and results of deleting the $10 uiillion in net worth
requirement).
Having found the two variants of Test 100 (botti with and without a
$10 million in net worth requirement) to be of special interest with
respect to the minimization of public and private costs, the Agency
reviewed those tests and other possible tests in light of the criteria
of protecting human health and the environment, equity, and minimizing
costs to the regulated community. Table 3 provides further data on Test
100 used in this review.
In respect to protecting human health and the environment, the
Agency estimated that if Test 100 were to be adopted, an average of 2.5
facilities per year would enter bankruptcy without providing an alterna-
tive financial responsibility mechanism. This is a small number of
facilities and means probably could be found of providing funds for the
62
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TABLE 3
CHARACTERISTICS OF FIRMS THAT PASS SUCCESSIVELY LESS STRINGENT TESTS
Firms That Paua
Test 100 (One-Year)
With a $10 Million
Met Worth Requirement
Firms That
Pass Test 100
(One-Yc-nr) Without a
$10 Million Net Worth
Kequlromont. That Would
Not Pass Test 100
With a $10 Million
Net Worth Requirement
Firms That
Pass an Ability to
Pay Test (One-Year)
Without: a $10 Million
Net Worth Require-
ment That Would Not .
Puss Teat 100 With-
out a $10 Million
Not Worth Requirement
..-iiuber of facilities affected
Number of firms per 10,000 per year
that pass the test and will go
bankrupt without providing alter-
native financial assurance
I/
llumbcr of facilities falling per year-
Number of bankruptcy proceedings per
yearl'
Percentage of closure and post-closure
costs not recovered in bankruptcy
proceedings
2,448
10.1
2.5
.6
40*
28.5
.6
.6
75Z
11(1
285
3. 1
1.2
46%
— The number of facilities falling per your is derived by applying tin: failure ratu listed above for the glvcMi tost to the
number of facilities affected.
— The number of bankruptcy proceedings Is bused on the assumption that firms of greater than $10 million in not worth own an
average of four facilities and firms of less than $10 million in not worth own an average of one.
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closure and post-closure of such facilities. For the near future,
Superfund will also be available as a supplementary source f o funds to
pay some of the costs not paid by owners or operators. To ensure, by
not allowing a financial test, that no facilities would'fail without~ ~
providing alternative financial mechanisms would lead to an additional
$3.3 million in private costs per year. That is, private costs of $1.1
million per facility failure would be required to ensure than an
alternative financial mechanism would be available in all cases. The
Agency considers this an excessive cost for the small additional
assurance provided.
The analysis of numbers of failures shown in Table 3 is based
upon the assumption that firms of under $10 million in net worth which
would use the test are relatively typical of all independently audited
firms of under $10 million in net worth. However, the hazardous waste
regulatory program will introduce requirements that may add to the
expense of treating, storing, or disposing of hazardous waste. The
Agency is concerned that the future business failure rate for firms with
less than $10 million in tangible net worth which treat, store, or
dispose of hazardous waste and the number of such facilities which close
because of noncompliance with the regulations could be higher than the
historical rate for small firms in general.
The Agency also was concerned that if an owner or operator
purposely sought to circumvent these and other regulations (i.e.,
64
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bubpart G, Closure and Post-Closure care.)., by abandon! ng.-his -facili.ty-
without having provided for its closure or post-closure care, he might
do so by setting up a-.firm which was.-just-...-a±>le....to meet .the^multip-le^and.
ratio requirements,.of,.a, financial,,tes,t...,....,Tiie....$.10..JHjLLlion.in..,t^ngi.ble™aet..
worth requirement should make it less likely that an owner or operator
would find it possible or even profitable to plan to avoid
responsibilities by satisfying the financial, test. There will be fewer
cases where the facility itself represents the only significant asset of
the owner or operator. Monitoring the use of the financial test would
be made more difficult if its use were not limited to the larger more
stable firms. Small firms that obtain an independent audit solely for
the purpose of satisfying the financial test would be difficult to
monitor because these audits would not be subject to SEC review.
Furthermore, the number of situations in which failure to close a
facility might cause unusual threats to tiunan health and the environment
should be reduced.
Because an estimated 99.9 percent of the firms tnat pass Test 100
in any given year will not enter bankruptcy without providing alterna-
tive financial assurance, the Agency's equity goal would also be satis-
fied. The Agency estimates that on the average 60 percent of funds will
be recovered from those firms that do not enter bankruptcy without an
alternative financial mechanism. (For firms with under $10 million in
net worth, the Agency estimates that this recovery percentage would fall
to 25 percent.) For a facility with a facility-life of 20 years and a
post-closure care period of 30 years, 98 percent of facilities passing
65
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Che financial test will be able to meet closure costs or provide alter-
native financial assurance without entering bankruptcy, and 95 percent
will provide all closure and. post-closure- care- .expenditures—or—alternaT,.
tive financial .assurance without. .ent.ering_.bankrup.tcy.-. ......As. .noted., above,
if 100% of the firms eligible for this financial test had to use the
alternate financial mechanisms allowed by the regulation, this would
cost them $3 million a year. Thus, the equity goal of the regulation
has been substantially achieved, and to achieve it more perfectly would
entail very substantial costs.
Given the very high percentage of firms that are ultimately able to
pay all costs associated with closure and post-closure, the Agency con-
sidered whether it would be reasonable to choose a somewhat less strin-
gent test, such as the tests labeled "Ability to Pay Test" in Table 2.
Such tests could require either a one year or a three year eligibility
period. They both require net working capital and tangible net worth
six times the sume of closure and post-closure cost estimates, but do
not include any ratio requirements. Use of a one year Ability to Pay
test would allow approximately 110 additional firms to use the financial
test to provide assurance of financial responsibility. However, use of
the Ability to Pay Test would also double the number of situations in
which a firm passing the financial test would go bankrupt without
providing alternative financial assurance, and would at least double the
number of bankruptcy proceedings the Agency would participate in each
year. The 110 firms that pass the Ability to Pay Test but fail to pass
Test 100 have an annual failure rate of 2.85 percent per year.
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The Agency's analysis indicated that only 56 percent of such finis
passing the test would be able to either meet closure costs or provide
alternative financial assurance-without entering, bankruptcy, .over, the-,20-..
year period of facility life during which closure could be required.
Finally, the Agency estimated that only 26 percent could last the entire
50-year period of facility-life (20 years) plus post-closure care (30
years) and the Agency found this possibility to be unacceptable from an
equity viewpoint.
In respect to minimization of private costs, the Agency found that
Test 100 with a $10 million in net worth requirement has the lowest sum
of public ana private costs of any test with a $10 million in net worth
requirement. An Ability to Pay Test with a $10 million in net worth
requirement and several tests, without a $10 million .in. net worth
requirement have lower private costs. Test 100 without a $10 million in
net worth requirement has the lowest sum of public and private costs,
although, as will be discussed in the limits to the analysis section
immediately below, under possible but relatively unlikely alternative
assumptions the Ability to Pay Test could emerge as the test that
minimizes tne sum of public and private costs.
Taking into consideration all of its goals, including protection of
"human health ana the environment and equity, however, the Agency con-
siders Test 100 with a $10 million in net worth requirement to be the
best of the available tests and has adopted it for purposes of the
financial assurance regulations. In so doing, the Agency noted that the
lower private costs associated with firms of under $10 million in net
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worth using a financial test would be negated by the need for tne Agency
to spend public funds for review of audits not otherwise reviewed by the
SEC. The possibility that the Agency- wo.uld. find i.t .necessary...to- review.
audits is relatively unlikely for firms of greater than $10 million in
net worth because the cost of an audit for such firms would normally
exceed the cost of alternative financial instruments and these firms
therefore would have little inducement to obtain questionable audits in
order to avoid other costs.
As an alternative for utilities and other firms tnat are finan-
cially strong but cannot pass Test 100 due to special financial
circumstances (although almost 70 percent of all utilities coula pass
Test 100), the Agency has decided to adopt the suggestions of a number
of commenters and use bond ratings, coupled with a tangible net worth
requirement, as a substitute criterion in the financial test. Analysis
of available data on the performance of the two major bond rating
services showed that firms receiving any of their four highest ratings
(investment grade bonds) have compiled a record of financial assurance
at least equal to that of Test 100. The Agency noted that no firm with
an investment grade bond rating was among the sample of bankrupt firms
it had collected. In order to ensure that adequate assets are available
to cover possible closure and post-closure expenditures, a firm using
the bond ratings test is also required to have a tangible net worth of
at least $10 million and six times tne closure and post-closure cost
estimates to be covered. To ensure accessibility of funds, the firm is
required to have 90 percent of its assets in the United States, or to
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have assets in the United . States six times. . tne_..amount. _of_.the _cos.t.
estimates. Bond ratings must be for the most recent bond issue of the
owner or operator. The Agency initially will accept only bond ratings-
issued by MoodyVs or Standard ana-Poor's.
b. Limits to the Analysis
An analysis of the type used to develop the results in Table 2 must
incorporate uncertainties and approximations. Many assumptions had to
be made about financial mechanisms which have never been used before in
exactly the same form, and aoout the technical and financial character-
istics of the hazardous waste management facilities wnich will be
affected by this regulation.
The degree of accuracy of those assumptions could affect the con-
clusion about which test-best satisfies the Agency'-s '-criteria-.- - --The
Agency therefore conducted a sensitivity analysis . to determine wnicn
changes in assumptions were most likely to affect results significantly.
This sensitivity analysis, described in Appendix B, indicates that even
with a wide variety of changes in assumptions, Test 100 (one-year) mini-
mizes the sum of direct public and private costs for firms with over $10
million in net worth. The most important limitations on this conclusion
are described below.
If a significant percentage of firms failing Test 100 (one-year)
had to use a trust fund as the alternative financial mechanism, the test
termed "Ability to Pay Test" in Table 2 would have a lower sum of direct
public and private costs. Given the uncertainties about the number of
firms that would be forced to use a trust fund if unable to pass a
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financial test, however, tne Agency did not incorporate these costs in
the comparison of Test 100 (one-year) with other less stringent tests.
The Agency calculated the effects of shifting._from,_Tes.t. 100,_to. t.ne. less
stringent Ability to Pay Test (see Table 3) to see if this assumption
could have a significant effect on the choice of test. Use of the
Ability to Pay Test would allow approximately 110 additional firms to
use the financial test to provide assurance of financial responsibility.
However, use of the Ability to Pay Test would also double the number of
situations in which a firm passing the financial test would go bankrupt
without providing alternative financial assurance, and would at a aini-
mum double the number of bankruptcy proceedings the Agency would nave to
participate in per year. The additional failures would considerably
increase the risks to human health and the environment, .the alleviation
of which would add $182,000 to public costs, in return for a savings of
only $123,000 for the additional 110 firms enabled to pass the less
stringent Ability to Pay Test. Even if some of these firms were forced
to use the more expensive trust fund if Test 100 (one-year) were the
chosen test, the Agency concluded that the potential threats, inherent
in the use of the Ability to Pay Test, to human health and the
environment make Test 100 (one-year) preferable.
The determination of the test which minimizes the sum of direct
public and private costs is highly sensitive to the percentage of viable
firms passing the test. This percentage cannot be calculated with a
high degree of accuracy without better data than are now available on
the financial characteristics of owners and operators. The percentage
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of viable firms shown as passing a test in Table.-2 are based upon a
sample made up of firms of various sizes in those industries believed to
be likely to own or operate TSDFs. Unfortunately, data- concerning who
would,apply for permits were not available at the time this analysis was
developed. As a result, the actual owners or operators of hazardous
waste TSDFs could have a different distribution of financial character-
istics than firms that the sample employed.
Without detailed data on the distribution of net worth and net
working capital of owners or operators and the closure and post-closure
cost estimates for each owner or operator, it is impossible to determine
the eftect of the multiple requirements upon either E or A^fi. The
results in Table 2 were derived by assuming that firms that could meet a
set of ratio-reqirrrements-—and ~had positive--net- -worth—and- net -working
capital would be able to use a financial test. As a result of this
assumption, tae values of E and A^ are overestimated. The levels of
the multiple requirements for tangible net worth and net working capital
were based upon an analysis snowing that these levels would provide
reasonable financial assurance rather than upon an analysis of their
effects upon E and ANfi.
Other limitations to the analysis were considered unlikely to
affect the results with respect to which test minimizes the sum of
direct public and private costs. They could, however, significantly
alter the values of the costs shown in Table 2. The number of firms
independently audited and thus potentially eligible to use the financial
test is highly uncertain. The sensitivity analysis presented in
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Appendix B showed that this uncertainty, .did not .affect- the. .result that
Test 100 (one-year) is the test which minimizes the sum of direct public
and private costs. The accuracy of this assumption could significantly
alter the costs associated with the financial responsibility regulations
as a whole and the cost saving associated witn allowing a financial
test.
Because the number of independently audited firms is highly uncer-
tain, the Agency was also unable to predict the number of subsidiaries
of independently audited firms chat woula oe eligible for cne corporace
guarantee provision.
A variety of other assumptions, particularly witu respect co the
costs of closure and post-closure care, the baseline failure rate, and
the fees for various financial instruments, are highly uncertain, but
the range of uncertainty is not such as to alter the result as to which
financial test minimizes the sum of direct public and private costs.
The estimate of direct public costs due to failure of firms using a
financial test assumes that there is no growth in costs due to the
absence of funds to provide adequate preventive care. It is possible
tnat if no funds were available to take preventive measures, damages
caused by delayed or insufficient closure of a facility could result in
higher closure and post-closure costs than would have been incurred if
funds had been available. This increase in costs could be prevented
only if there existed a national fund from which money could be approp-
riated to prevent such occurrences. Avoiding such cost growth due co
the absence of funds is a major benefit of financial mechanisms (.other
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.than a financial test) which is not accounted for, in this analysis.
However, the sensitivity analysis in Appendix B shows that this factor
could be quite substantial and still not alter the result that allowing
a financial test has a lower sum of direct public and private costs than
not allowing a financial test.
The analysis does not consider, certain potential economic benefits
associated with financial responsibility requirements. To the extent
that financial responsibility requirements result in owners.or operators
of TbDFs internalizing cost externalities, the price of hazardous waste
management will more accurately reflect its true costs. This higher
price will lead to less use of hazardous waste TSDFs. Further, if
owners or operators are assured that they will ultimately pay for the
costs of closure and post-closure care, they will take special care to
avoid events that could lead to high closure ana post-closure care
costs. As a result, the regulation may produce economic benefits
resulting from more efficient resource allocation.
One effect of the above limitations is that the analysis presented
in Appendix B cannot be usea as a basis for a cost analysis of tne
financial responsibility requirements as*a whole. Certain assumptions,
which do not affect the choice of a financial test, would become criti-
cal if the methodology for cost analysis employed in Appendix B were to
be employed to analyze the financial responsibility requirements as a
whole.
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c. Corporate Guarantee
The Agency did not carry out a cost analysis of the corporate
guarantee provision. It is convinced, however, that the corporate
'guarantee will enable large, financially secure parent firms to assume
responsibility for the hazardous waste management facilities owned or
operated by their subsidiaries when tne parent firms.might otnerwise be
unwilling or unable to do so, and will therefore add to the assurance of
financial responsibility provided by the regulations. After a careful
review of the terms of the guarantee proposed on May iy, 1980, the
Agency added several provisions designed to make the instrument more
flexible and to help ensure that it can be enforced easily. It included
a waiver of notice of acceptance, an express agreement on the part of
the guarantor to remain bound notwithstanding modifications in the
closure or post-closure plan or certain other modifications or
alterations, and an agreement that.the guarantor will perform closure or
post-closure care or tuna a crust fund in the amount of tne current
closure or post-closure estimates.
The Agency decided to limit use of the guarantee to parent
corporations, defined as firms owning at least 50 percent of tne voting
stock of the subsidiary which is the owner or operator of the hazardous
waste facility. At least 50 percent ownership was adopted as a require-
ment in order to ensure that the connection between the two firms is
close and direct. The capacity of the guarantor to enter into the
guarantee is more certain if it is directly promoting its own business
purposes by means of a guarantee for a corporate subsidiary. Further-
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more, the parent company is lively to have a strong interest in the
satisfactory performance of its.subsidiary, both in financial terms and
in respect to tne subsidiary's performance of its legal obligations,
and, in the Agency's view, this incentive strengthens .the corporate
guarantee.
The Agency also decided to refer to tne guarantee as a corporate
guarantee to clearly differentiate it in the regulations from the
financial guarantee by sureties and from guarantees by States.
d. Revenue Test for Municipalities
In determining the applicability of the financial responsibility
standards established under Section 3004(6) of RCRA, the Agency con-
cluded that the regulations should apply to local government owners or
operators of hazardous waste facilities. Because States and the federal
government have proven longevity and the capacity to raise significant
financial resources, the Agency decided that those government entities
will always have adequate resources to conduct closure and post-closure
care activities properly. Consequently, in a financial responsibility
final regulation issued on May 19, I960, the Agency provided that the
fact that a facility was owned or operated by a State or the federal
government was sufficient to establish assurance of financial
responsibility (45 FR 33262, 33198-99).
The Agency was aware that local governments share with States and
the federal government characteristics which distinguish them from
private owners or operators. They have access to unique sources of
1
revenue not available to private entities. They are institutions of
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indefinite longevity, which do not fail or go out of existence in the
same ways that private businesses do. Finally, local governments are
organized to secure the well-being of their citizens, and may be
expected to seek conscientiously to carry out their obligations which
affect public health and the environment.
The Agency was also aware, however that unless "municipality" —
the category of local government used in RCRA to encompass all
government entities except States or the federal government — is
defined properly, entities that do not share the characteristics of
longevity, financial strength, and responsibility toward human health
and the environment could be included in it. Furthermore, tne record of
municipalities in avoiding bankruptcies and defaults is not as good as
the record of the States. Some municipalities might be too small to
have sufficient financial resources to fulfill their closure and post-
closure obligations. Finally, the options of readjusting expenditures
or raising revenues might be legally, practically or politically
impossible for some local governments. The May 19, 1980 reproposed
regulations (45 FR 33268, 33273) therefore provided that if the owner or
operator of a hazardous waste facility were a municipality it would have
the option of providing an assurance of its financial responsibility for
closure and for post-closure care by giving evidence of having annual
revenues from property, sales and/or income taxes equal to 10 times the
adjusted closure and/or post-closure cost estimates. Such tax revenues
had to be legally available. That is, they could not be dedicated to
other purposes or otherwise precluded from use. Tne Agency reasoned
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chat a municipality with such tax revenues could if necessary shift or
curtail its expenditures so that money for closure and post-closure care
would be available. If the annual tax revenues at any time failed to
meet the minimum multiple or. . became ... .legally unavailable, .the
municipality would be required immediately to secure another fora of
financial assurance, such as a trust fund, letter of credit, or surety
bond. Alternatively, if a State were to assume legal responsibility for
compliance with closure or post-closure requirements, the local govern-
ment would not be required to provide another form of financial
assurance (45 FR 33273).
In response to comments received on tne reproposed regulations of
May 19, 1980, the Agency reanalyzed the subject of municipal financial
responsibility for closure and post-closure care.
First, the Agency considered the argument that facilities owned or
operated by municipalities should be given the same treatment as that
accorded to State or federally owned or operated facilities. A few
commenters suggested that municipal!cies may include large cities or
public authorities, with sizable populations and financial resources,
which are operated according to sound financial principles. The record
for such entities of avoiding defaults is quite good, and they
eventually have repaid . their obligations even on those occasions when
they technically defaulted. Like other government entities, they are
the subject of strong public pressures to conform to laws protecting
human health and the environment. On balance, however, the Agency
concluded that there is a reasonable basis for according different
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treatment to State and federally owned or operated facilities frou that
accorded to those owned or operated by municipalities. Such local
entities are not legally autonomous bodies, but are instead-creations of
the States. Thus they. ..are...subj.ec.t._to___rest.ricti£>ns on_..tne ty_pe._...and.
extent of the financing they may employ, and they may be required
unexpectedly and involuntarily to make additional expenditures. Among
them there will be many smaller entities, with fewer resources at their
ultimate disposal. As noted above, municipalities as a whole have a
history of a greater number of defaults than States or the federal
government. It generally takes them some time to pay their obligations
after default, and ensuring that facilities are closed in a timely
manner is an important purpose of the financial responsibility
requirements. Finally, because they are smaller, they may be more
likely to be influenced by the needs of a single large industry or plant
to keep the level of taxation low, even at the cost of unmet needs, or
to be the focus of so-called tax revolts.
Second, the Agency examined the budgeting and accounting practices
of municipalities to determine' whether there are particular methods by
which they could dedicate portions of their funds to closure and post-
closure care. It also reconsidered its assumption that a municipality
can shift funds already received and budgeted to specified purposes away
from those purposes to the task of providing closure and post-closure
care. Finally it considered whether a mechanism similar to a financial
test could be developed by which the Agency could determine the ability
to pay closure and post-closure costs of a municipality. The Agency
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determined that there are limits on municipalities ability both to
dedicate funds and to shift, reallocate, rebudget, or cut back funds,
and that a test for municipalities' based on detailed financial
information was not currently feasible due to variations in accounting
procedures.
The Agency has determined that in practice municipal budgeting,
expenditures, and accounting procedures vary greatly and respond to many
different factors. (See, e.g. , Break, Financing Government in a Federal
System, 187 ff. , (1980); Levine, ed., Managing Fiscal Stress; The
Crisis in the Public Sector (1980)) The budgetary categories and limits
of local governments are ordinarily set through the political process
and through a process of planning and priority setting. Ideally this
procedure is accompanied .by -long-term revenue .and expenditure forecasts.,.
and by an accounting system which allocates the revenues of the govern-
ment to funds set up to preserve the resources necessary to accomplish
the planned objectives. Because of shifting political and policy
priorities and chronic immediate needs for funds, however, it appears
that in practice, in the absence of legal provisions requiring money to
be set aside, the funds for closure and post-closure care probably would
not be placed in a specially isolated fund, but would be reallocated
from the general funds of most jurisdictions at the time they are
required. The Agency has concluded that,it is not feasible at this time
for it to specify and enforce accounting practices for municipalities
that will require them to set up special accounts for closure and post-
closure funds.
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On the question.,.of budget reallocations and cutbacks, the Agency
has concluded that although in emergencies municipalities might be able
to reduce budgeted expenditures in some areas to shift the funds to
closure and post-closure care, there is no strong evidence that such
shifts could occur. Net reductions in total city spending have been
documented for a few cities faced by financial crises. A study
conducted by the Advisory Commission on Intergovernmental Relations of
city .financial emergencies notes that in the early 1970's two cities
were able to make reductions in their expenditures of 10 and 14 percent
of the previous year's expenditures. The study concluded, however, that
the cases examined "did not answer the question of now far services can
be reduced or taxes increased without serious consequences to cities in
financial trouble." (ACIR, City Financial Emergencies: The
Intergovernmental Dimension, 48 (1973)) More recently, New York City
was able to carry out a 20.8 percent attrition of its work force
(Glassberg, "Organizational Responses to Municipal Budget Decreases,"
Public Admin. Rev. 327 (1978)) This reduction, however, was conducted
in extremely unique circumstances. Kent, Ohio recently closed a budget
gap of almost 20 percent using innovative computer techniques to revise
allocations. (U.S. Dept. of H.U.D., Local Financial Management in the
1980's: Techniques for Responding to the New Fiscal Realities, at 61-67
(1980)) A study of 30 major cities for the period from 1975 to 1977
apparently concluded that "most governments were capable of readjusting
their expenditures to balance with reduced revenue growth ...." Of the
15 cities with deficits, however, only six had imoalances greater than
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five percent of expenditures. (Dearborn,. "Elements of Municipal
Financial Analysis: Part II: Budget Performance," Special Report, First
Boston Corp., 1977, cited in Petersen, "Simplification and
.Standardization .of _State .-and._io.caL....Gpxer.niaeat-_.Eiscal__Injdi.cator.s,-'l~XXX.
Nat. Tax. J. 304 (1979)
Aside from these isolated case studies interpreting data from the
early and middle 1970's, the Agency has not been able to find or to
generate strong empirical support for the possibility of a 5 to 10
percent reallocation of municipal expenditures in one year, especially
under current economic and fiscal conditions. Most analyses do not
provide broad data on past cutbacks, but instead concentrate on the
politics and management of cut back situations. (See White, "Government
Response to Spending Limitations," XXX National Tax Journal, Supplement,
201 (June 1979); Hale and Douglass, "The. Politics of Budget Execution:
Financial Manipulation in State and Local Government," 9 Administration
and Society, 367 (Nov. 1977); Levine, "Organizational Decline and Cut-
back Management," Public Admin. Rev. 316-25, (197b); "More on Cutback
Management: Hard Questions for Hard Times," Public Admin. Rev. 179-183
(1979), and Glassberg, "Organizational Responses to Municipal Budget
Decreases," Public Admin. Rev. 327 (1978)). The Agency does not believe
that the public finance literature provides adequate support for the
proposed revenue test.
Most commenters on the proposed revenue test have suggested to the
EPA that they do not believe that shifts in expenditures are possible,
up to the level of 10 percent suggested in the May 19 proposed
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regulation, without severely affecting .other essential public
services. Several challenged the assumption in the May 19 proposal that
expenditure shifts up to 10 percent of tax revenues could be made
speedily and without disrup.tion-..i.y_l.o.cal_.go_v.e.rnments.. S.ome._did_sugges.t.
that shifts on the order of 5 percent of tax revenues were more likely
to be possible without serious local hardship. Several comraenters
argued that even if expenditure shifts were possible, the Agency could
not feel certain that they always would be acceptable. On balance,
therefore, the Agency concluded that tiie public comments did not support
the proposed revenue test.
The Agency also considered the use of a test for municipalities
based on detailed financial information indicative of current financial
solvency. Because accounting and reporting procedures of minicipalities
in general vary greatly, however, the Agency concluded that a
requirement which would be based upon the quantification of assets and
tangible net worth would not be uniformly applicable or would impose a
heavy administrative buraen on the Agency to verify. The Agency does
not believe that municipal bond ratings, a criterion suggested by
several commenters, would be adequate as a sole indicator of ability to
pay the amounts of the estimated closure or post-closure costs. The
.Agency was thus unable to develop a set of financial indicators, similar
to the financial test criteria, that would be suitable for
municipalities in general. A number of special-purpose, fee-based
municipalities are essentially identical to private entities; because of
their financial characteristics and accounting and reporting practices
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they may be able to use the financial test to satisfy the financial
assurance requirements.
In its analysis the Agency investigated the possibility that a
municipality might, obtain ,additional._,inconie.-.wi.th__which.-..ta-_car.r.y- ..out
closure or post-closure care. It concluded, however, that the
traditional sources of income could not always be expanded as needed to
provide closure or post-closure care, or that such expansion could not
be accomplished quickly enough to provide the necessary degree of
financial assurance. Budgetary and legislative processes, bond issues,
or voter approval of new taxes could all be sources of delay.
Finally, enforcement proceedings against a municipality to bring
about the availability of funds for closure or post-closure care by a
municipality may engender-difficult issues in .federal-state-municipal.
relations.
For these various reasons the Agency has concluded that it will not
include the revenue test as a means of assuring financial responsibility
by municipalities.
The Agency believes that municipalities that are financially sound
will be able to use one of the other financial assurance mechanisms
allowed. These include the State guarantee, which may be an especially
appropriate mechanism for municipalities. Municipalities are creatures
of State law, and the States are in a far better position to gauge the
financial condition of their municipalities than is EPA. Consequently,
in the event a State wishes to reduce the cost of the program to its
municipalities, it may choose to guarantee the obligations of certain or
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all of its municipalities. In the event a State lacks sufficient
confidence in the fiscal strength of its municipality to extend such a
guarantee, it would clearly not be in the interest of the public as a
whole for EPA to allow, such .a -municipal:.--enti-ty_:t-o_--av.oid-.:.these^:.:.
requirements.
B. Criticisms of Test Components Proposed on May 19, 19ttO
1. Net Worth Requirement
The financial test proposed on May 19, 1980 required tnat an owner
or operator seeking to seet the standards of Part 264 or Part 265 hav^
at least $10 million in net worth.
Comments and Responses
o The $10 million in net worth requirement is unnecessary.
o The $10 million in net worth requirement is too hign.
The analysis described in Section IV above and in Appendices A and
B has convinced the Agency that the proposed $10 million in net worth
requirement is necessary in order to achieve the goals described in
Section IV.A.5 above. The precise size of the net worth requirement was
determined after analysis of data showed that firms in the $10 million
in net worth and larger category have sharply lower failure rates tnan
smaller firms. CSee Appendix A, Section II)
o A test component involving absolute size, such as a
minimum level of net worth, will help to satisfy the
financial responsibility requirement.
o A test component involving absolute size discriminates
against small firms.
o A net worth requirement should specify tangible net worth
to ensure that assets can be quickly converted into casn.
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o The value of a hazardous waste management facility should
not be included in net worth for purposes of satisfying
the $1U million in net wortn requirement.
An absolute net worth or an absolute size, criterion- ..do.es_ enhance
the effectiveness of a financial test in predicting bankruptcy .. and
therefore in reducing the level of direct public costs. :Such a crite-
rion, however, also substantially increases the private costs of a
financial test, since it requires firms falling below the criterion to
use other mechanisms. In its analysis the Agency considered the costs
of financial tescs both with and without a $10 million in uec worth
requirement. It concluded that it couia best achieve its goals by
adopting a financial test that contained a $10 million in net worth
requirement.
It- is correct -that—a tes.t- comp-anent req.uiring~a particular -Lev.eL..of.
assets, net worth, or net working capital may make it more difficult for
small firms to pass tnat test. Such a criterion, however, bears a
reasonable relationship to the purposes of a financial test. The
financial responsibility regulations are designed to assure ttiat funds
will be available for closure and post-closure care. Firms with small
amounts of resources may face certain inherent limits on their ability
to manage treatment, storage and disposal facilities and to provide
financial responsibility for hazardous waste management facilities.
Although every firm may not be able to use the financial test, the
Agency has also provided several other options for assuring financial
responsibility.
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The Agency agrees that the $10 million in net worth requirement
should require tangible net worth. Assets of firms often include sig-
nificant amounts of intangible assets such as goodwill or patents and
trademarks, which uiay be difficult to convert into casti. Requiring
tangible net wortn will avoid situations where firas that have passed
the test but later enter bankruptcy will be unable to convert intang-
ibles into cash to meet closure and/or post-closure costs.
The Agency has not required the value of the hazardous waste
management facility to t>e subtracted rrom net worth for purposes of
satisfying the $10 million requirement because to do so would raise the
private costs of tne test significantly. Such values are not orcinarily
reported, and therefore a special auditor's evaluation would be
required, at considerable cost.
Final Regulation
The Agency has decided to retain the $10 million in net worth
requirement proposed on May 19, 1980 as a part of the financial test.
It has added the requirement that only tangible net worth may be usea
for this purpose.
2. Working Capital Requirement
The financial test proposed on day 19, I960 required tnat an owner
or operator seeking to meet the standards of Part 264 or 265 have net
working capital of at least twice tne adjusted closure cost estimate,
post-closure cost estimate, or sum of closure and post-closure cost
estimates.
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Comments and Responses
o The requirement that net working capital be a multiple of
closure and/or post-closure costs is unfairly restric-
tive. The Agency should require only that a firm have
positive net working capital after closure and/or post-
closure costs are subtracted from working capital.
The Agency's analysts, •"described' in-Appendix"'Ay of "financial -data
for bankrupt firms indicated that a very large majority of them experi-
enced rapid deterioration of working capital in the years immediately
prior to bankruptcy. In addition, the Agency wanted to avoid a situa-
tion in which closure and post-closure costs created a negative nee
working capital position. Particularly for manufacturing firms, nega-
tive net working capital may place the firm in a difficult financial
situation. The Agency therefore believes that a multiple of net working
capital is necessary. A discussion .of the rationale for the multiples
selected is presented in Section II of Appendix A.
o The net working capital requirement unfairly discrim-
inates against particular industries that are financially
secure but do not customarily maintain high levels of
working capital.
The Agency sought insofar as possible without significant loss of
performance to adopt a financial test which does not unfairly discrim-
inate against any particular industry. It is convinced that a worfcing
capital multiple requirement is a necessary part of a financial test
provision.
In its analysis, descrioed in Appendix A, tne Agency reviewed the
working capital practices of several industries. In particular, because
it assumed that many hazardous waste facilities would be owned or
operated by manufacturing firms, it looked at the working capital of
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such f irms,,.,. and determined tnat they normally maintain positive net
working capital.
The analysis did show tnat many financially strong utilities QO not
maintain positive net working capital. However, as a general solution
to this problem, the Agency also ceveiopea a bona-rating test alterna-
tive which will be available to utilities and to firms in other indus-
tries that do not maintain high levels of wonting capital but are finan-
cially sound.
o The availaoie lines of credit of a firm snouia be
included in its net working capital.
o The liquidation value of the fixed assets of a firm
should be included in its net working capital.
o The cash flow of a firm should be included in its net
working capital.
The Agency sought to adopt the conventional definitions of terms
used in generally accepted accounting practices. Because cash flow
generally is not included in net working capital, the Agency does not
accept the suggestion that it be included for the purpose of these
regulations.
Whenever possible, tne Agency also sought to use financial
categories that can be independently certified. Because it would be
difficult to obtain certification for available lines of credit, and
because Certified Public Accountants do not certify the liquidation
value of fixed assets, as well as because those terms are not generally
included in working capital, the Agency does not accept the suggestion
that they be included for purposes of a financial test.
o Firms should be required to have a net worth at least as
great as the net working capital requirement.
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Although it would be unusual for a firm to have less net worth than
net working capital, the situation is .possible. Such a firm would be
very weak financially..- The Agency therefore . determined to add a
requirement that.-.a firm have., tangible ..net,-.wor.th-..at...leas.t_-six... times .the.
current closure and post-closure'"cosx**estimates. • _....._
Final Regulation
The final regulation requires net working capital and tangiole net
worth each at least six times the sum of the current closure ana post-
closure cost estimates.
3. Total Liabilities to Net Wortn Ratio Requirement
The financial test proposed on islay 19, 1980 required that an owner
or operator seeking to meet the standards of Part 264 or 265 have a
ratio of total liabilities to net worth of not. more than three..
and Responses
o A ratio of total liabilities to net worth of not more
than three is too permissive.
As a result of its analysis of ratios as components of a financial
test, the Agency has changed the required ratio of total liabilities to
net worth from not more than three to one, to a more stringent require-
ment of not more than two to one. This ratio need not be met, however,
by an owner or operator who can satisfy the two other ratio requirements
in the financial test adopted by the Agency.
o Accrued closure and post-closure costs should not be
included in current or total liabilities.
The Agency has concluded that a number of firms will probably show
part or all of the estimated costs of closure and post-closure care of
their hazardous waste facilities as a liability on their financial
statements. The Agency therefore has accepted this suggestion.
i
o
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Final Regulation
The final.regulation requires an owner or operator to satisfy at
least two out of tnree financial ratios. One of the three ratios is a
total liabilities to net worth ratio of less .than 2.0. Closure and
post-closure costs included in liabilities in financial statements may
be subtracted from total liabilities in the report from the chief finan-
cial officer used to support use of the financial test by a firm.
C. Suggested Alternative Components
In addition to recommending changes in the financial test as ic was
proposed on May 19, 1980, several commenters, who generally supported
the use of a financial test, suggested alternative components for such a
test.
1. Other Ratios
Several commenters proposed otner financial ratios as better indi-
cators of firm viability than tne proposed ratio of total liability to
net worth.
Comments and Responses
o The total liabilities to net worth ratio should oe
replaced by a debt to equity ratio.
o The total liabilities to net worth ratio should be
replaced by a total liabilities to cash flow ratio.
o The total liabilities to net worth ratio should be
replaced by a total liabilities to net income ratio.
o The total liabilities to net wortn ratio should be
replaced by debt to total capital ratio.
o Either the so-called "current ratio" of current assets to
current liabilities or the so-called "quick ratio" of
current assets less inventory to current liabilities
should be adopted to evaluate short-term liquidity.
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o The ratio of income to return on investment should be
used as an indicator of earning power.
o The so-called "debt ratio"., of total debt to .total assets _.- .
should be used to evaluate the risk of loss in the event
of bankruptcy.
o The so-called -"times-interest-earned- ratio"- of earnings
before interest and taxes to interest charges could be
modified and used to evaluate the extent to which earn-
ings can decline before a firm is unable to meet its
closure or post-closure obligations.
The analysis performed by the Agency and described in. Section IV.A.
above and in Appendix A included a careful study of tue performance of
numerous financial ratios. These ratios included those found in the
bankruptcy forecasting literature, tnose suggested in comments, and
those proposed, by financial experts. The Agency gave particular atten-
tion to the ratios that had previously produced significant predictive
results, were identified as key parameters, and were readily available
from corporate balance sheet data. Tne Agency did not analyze all
possible ratios, including some of those proposed in comments, since tne
range of possible ratios is very large and its own or previous work had
already determined that some ratios were not useful. Previous studies
(W.H. Beaver, "Financial Ratios as Predictors of Failure," 5 Journal of
Accounting Research, Supplement: Empirical Research in Accounting:
Selected Studies, pp. 71-102, 1966; and E. B. Deakin, "'Business Failure
Prediction: An Empirical Analysis," Financial Crises: Institutions and
Markets in a Fragile Environment, E. I. Altman and A. W. Sametz, eas.,
1977) have concluded that the financial data included in many relatively
complicated ratios can also be found in less complicated ones. The
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Agency sought, when possible, to use the simplest availaoie ratios. It-
concluded that analysis of minor, variant ratios would not be likely to
add significantly to the results of the study.
Final Regulation
The final regulation requires an owner or operator to satisfy
at least two of the following three financial ratios:
Total liabilities to net worth less than 2.U
Sum of net income, depreciation, depletion, and amortization
to total liabilities greater than 0.1
Current assets to current liabilities greater than 1.5.
2. Other Multiples
Several coomienters proposed other financial multiples as better
indicators of firm viability and ability to pay than the proposed tang-
ible net wortn and net working capital multiples.
Gomaents and Responses
o Add to the existing test components a. requirement that a
firm have positive net income for at least four consecu-
tive years.
A requirement that test criteria be uet for a number of successive
years was analyzed by the Agency. Such a requirement, in effect,
creates an additional set of financial tests. These tests did not
provide significantly greater effectiveness than tests which require
criteria to be met for one year. In addition, multi-year tests are
likely to add unnecessary private costs, mainly because they preclude
financially sound firms which have suffered a short period of earnings
decline from providing financial assurance through the use of the finan-
cial test. In addition, reporting costs would be slightly higher
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because data from several years-would-have to. be-provided..- The-Agency.
therefore decided not to adopt .this requirement.
.o As an alternative to tne net working- capital' provision,-~
require a statement, based on an analysis of the owner's
or operator's ..f inancLal:_pos.i.tion,-,.that;-s,uf.ficient_a£s.et3.^_
or cash flow are available for liquidation to provide
funds at least equal to two tiaes adjusted closure costs.
The Agency rejected the approach to a financial test advocated by
this comment because it would have required reliance on a personal
judgment by an analyst. The Agency believes, on the basis of a review
of this subject with accountants, that Certified Public accountants
would not be willing make the certified predictions called for by the
comment. Even if accountants would make such predictions, they might
vary markedly" depending on the subjective approach of individual
accountants.
Final Regulation
The final regulation requires net working capital and tangible net
worth each to be at least six times the current closure and/or post-
closure costs.
3. Bond Ratings
Commenters proposed that bond ratings be approved as either a
supplement to, or an additional component of, a financial test.
Comments and Responses
o Allow investment grade bond ratings issued by Moody's,
Standard and Poor's, or Fitch's to be used as an alterna-
tive to the proposed financial test.
The Agency agrees, on the basis of an analysis of the effectiveness
of bond ratings, that investment grade bond ratings should be allowed as
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an alternative criterion of the financial test. It has been aole to
review the effectiveness of such bond ratings . issued . by Moody's and
Standard and.Poor's, and at this time will only allow ratings issued by-
one or the other of these agencies to _be. used. . However ,_._in order._to..
determine whether there are other bond rating services that could also
be used, the Agency is requesting information establishing the
performance of their ratings with respect to the performance of the
ratings of these two services.
o Allow the use of bond ratings by particular inaustries as
an alternative to the proposed financial test.
The bona rating alternative test developed by the Agency allows tue
use of bona ratings by all industries.
o Require tnat the bond rating adnere to a recently issued
bond (for instance, within the past three years;.
The Agency nas required that the bond rating be the current rating
for the most recently issued bond. It has not required that tne bond be
issued within a certain period, such as two to three years, however,
because such a limitation would reduce the availability of a bond rating
test to smaller firms tnat only occasionally enter tne bond market.
Even a bond rating for a bond due in two or three years would represent
the financial health of the firm for the next two to three years. It is
not the purpose of the financial test to make long-term predictions of
financial health. This is why the test must be renewed on an annual
basis.
o The rated bond should oe an unsecured or general obliga-
tion bond.
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The data tne Agency used^ to arrive at the conclusion that an
investment grade bond provides satisfactory protection included both
secured and unsecured bonds. .A .requirement-..that only, .unsecured .or
general obligation, bonds-.be. .used would-...eliminate.-..a^h-i-gh; -percentage.-..:of.-,,-
utilities from using 'the bond rating variant of - the financial test.--
Since the bond rating alternative is primarily designed for the use of
utilities, such a requirement would largely negate its purpose. As a
result, the Agency believes that it is necessary to allow the use of any
bond issue if the oond rating portion of the tesc is to serve its
primary purpose and that such an approach provides adequate protection.
Final Regulation
The regulation provides that a firm may satisfy tne closure and
post-closure financial-.requirements-by-having a current rating for its
most recent bond issuance of AaA, AA, A or ritsb as issued oy Standard and
Poor's or Aaa, Aa, A, or Baa as issued by Moody's; and tangible net
worth of at least $10 million and six times the current closure and
post-closure costs, and have assets in the United States at least six
times tne current cost estimates or at least 90 percent of ics assets in
the United States.
4. Other Suggested Alternatives
Commenters proposed several alternative financial responsibility
criteria adopted by other agencies of the Federal government. As noted
in Section II.C. above, the Agency reviewed these programs as part of
its development of its financial responsibility requirements.
-------
o Adopt tne Coast Guard financial responsibility regulation
(33 CFR 135.213(a)(2)) as an alternative to the proposed
financial test.
The Agency reviewed the proposed alternative ..^financial. responsi-
bility program but decided not to follow the suggestion that it be
adopted for use for several reasons. First, it is primarily adapted to
self-insurance for marine oil pollution liabilities wnich are likely to
involve fewer firms than the hazardous waste financial responsibility
requirements. Secondly, EPA has sought to develop a program which
insofar as possible uses already existing financial aaca and reports.
The Coast Guard program requires several additional statements to tse
prepared and certified by a Certified Public Accountant. Third, hi PA iias
sought to avoid a requirement that would involve financial experts in
the making of judgments about the sufficiency of available assets to
cover costs.
o Adopt tne Nuclear Regulatory Commission financial respon-
sibility regulation (10 CFR 140.21) as an alternative to
the proposed test.
The NK.C program requires "adequate resources to provide the finan-
cial protection required," but does not specify in greater detail wnat
will constitute adequate proof of such protection. Because the NkC
program deals with relatively few facilities, the Commission can devote
special financial expertise to eacn applicant. Because, in contrast,
the program of financial responsibility for hazardous waste management
facilities will apply to several thousand owners or operators of TSDFs,
the Agency has developed a test that does not rely on such individual-
ized judgments.
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The Agency also., reviewed. final.._and_. proposed- NRC-^regulations.-.per-_..
taining to financial responsibility for uranium mill decommissioning and
for land disposal of -low-level-nuciear wast-e. • Many-of these mechanisms
are similar to mechanisms, proposed, by the..Agency...- ._ . ..
o Adopt the Federal Maritime Commission financial responsi-
bility regulation (46 CFR 5542) as an alternative to the
proposed test.
The FMC self-insurance program requires both working capital and
net worth to be shown up to a specified dollar limit. The Agency, in
contrast, has decided to adopt a test which requires a multiple of
closure and post-closure costs to be on hand as tangible net worth and
net working capital. The FMC also utilizes expert financial analysts to
review the financial records of applicant firms. The Agency has
concluded that the number of owners or operators who .are covered by the
financial responsibility requirements renders such review
unfeasible.
o Allow a pledge of business assets similar to that pre-
viously used by the Office of Surface Mining (30 Ct'R
§806) as an alternative form of financial assurance.
The Agency studied the possibility of accepting pledges as an
alternative form of financial assurance. However, it determined that
because of the problems of defining proper assets to be pledged, valua-
tion of those assets, custody of the assets, and sale of the assets, it
would not adopt this suggestion. The Office of Surface Mining has also
withdrawn this option from its regulatory program.
The Agency further investigated the possibility of adopting a
security interest as a financial assurance mechanism. Some of the
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proolems associated with the ^..pledge, .and the administrative .problems of
filing the proper forms to create and maintain a secured interest,
caused tne Agency to reject this possibility. • - '
•. - • o-•- Adopt the' SEC .-40-60 variable "early-warning" system ror
•identifying firms in financial difficulty.
The Agency concluded that the proposed .test would create an
unreasonable reporting burden on owners and operators since data would
have to be provided on many more financial variables. The Agency has
sought the least complicated test possible to secure its goals. It is
convinced on the basis of its analysis that the test it has chosen
provides adequate warnings of financial difficulty.
Final Regulation
Because the Agency did not find any of the proposed alternative
tests satisfactory for its purposes, it has developed the financial test
in these regulations.
D. Applicability
The financial test proposed on flay 19, 1980 establisued a single
set of requirements for all firms seeding to use the test. Several
commenters questioned the use of one test for ail industries.
1. Request for Industry-Specific Criteria
One commenter proposed tnat a broad set of specific tests be
developed.
Comments and Responses
o Fifteen to twenty tests should be designed for specific
industries, defined by specific SIC codes, to take into
account tne particular characteristics of their financial
practices and requirements.
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As described in -Section- IV--above and--in-Appendix A, the ^Agency- was-
unable to develop tests for specific industries because of the impossi-
bility of creating a sufficiently large-^sample- of—bankrupts-firms-- in
several industries to obtain statistically- - sufficient—results. --The
financial test adopted is generally applicable to almost all industries.
2. Industries Requesting Special Provisions
Several commenters from specific industries proposed that tests be
t ----- • --• - ... . ... ......
developed for their particular industry.
Comments and Responses
o Utilities should be exempted from the financial responsi-
bility requirements, because their service is required by
the public and they will not disappear.
o Rural electric cooperatives are stable and are federally
supported.
The Agency does not agree tnat utilities should be given a generic
exemption. Electric utilities or other public utilities do not neces-
sarily exhibit proven longevity, access to sizable resources, and avoid-
ance of bankruptcy. Their assets are not always large. Indeed, an
electric utility may consist of a single power generating facility or a
facility distributing power to a very small area. Such a facility may
not be able to afford an unplanned expenditure for closure or post-
closure care of a treatment, storage, or disposal facility.
In the past, electric utilities and otner highly regulated indus-
tries have experienced bond defaults and other severe financial diffi-
culties. Although a utility may continue to exist and provide customer
service following liquidation, there could be delays in obtaining
adequate funds for closure and post-closure care and they mignt not be
performed in a timely manner.
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Even thougti rural electric, cooperatives have successfully avoided
default and receive special Federal government support, it is not clear
that every rural electric cooperative could-afford the-closure and..postr_
closure expenditures- .that- would—be—r.eq.uir.ed._of_ them... .Eur.tne.rmo.re., Che.
qualification of a rural electric cooperative for Federal financial
support is under the discretion of the Administrator of the Rural
Electrification Administration (R£A). The Federal loans and loan
guarantees mandated by the Rural Electrification Act of 1936 to be made
to the rural electric cooperatives are contingent upon the cooperatives'
loan application passing legal, engineering, economic, and financial
tests developed by the R.EA.
o Utilities typically do not hold high net working capital,
and therefore, special financial test provisions that do
not require net working capital snould be developed for
their use.
The Agency agrees with tnis comment in the sense that it has devel-
oped a bond rating test for use £>y all categories of industries,
including utilities.
o The wood preservation industry is composed of many small
firms. Special provisions should be created for small
firms.
The Agency has found that the $10 million in net worth requirement
is a necessary component of a financial test. Use of the financial test
will probably therefore be unavailable to members of this industry.
However, this is not a special problem of this industry, but of small
firms generally. The Agency has concluded that there is a rational
basis for limiting the use of financial tests to firms with at least 310
million in net worth. The reasons for this conclusion have been
discussed above.
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o Airlines frequencly do not have positive net working
capital even when they are in good financial condition.
Special provisions should be created for airlines.
The Agency has provided a bond rating test as an alternative to the
financial test. The Agency has also promulgated other mechanisms that
owners or operators may use to satisfy the financial responsibility
requirement.
3. Proposed Distinction Between On-Site and Off-Site Disposers
Comments and Responses
o Hazardous waste management facilities that handle on-site
generated wastes will be likely to maintain the facility
responsibly. The test provisions should therefore be
less stringent for such firms.
The Agency believes tnat business failure can strike either on-site
or off-site disposers, ana that both should be required to provide the
same assurances of financial responsibility.
Final Regulation
The final regulation does not distinguish between on-site and off-
site disposers.
E. Level of Financial Assurance Provided
Several commenters on the May 19, I960 financial test ana guarantee
proposal discussed the effectiveness of the financial test.
1. Comparability to Alternative Financial Assurance Mechanisms
Some commenters argued that a financial test would provide better
results than those obtained with other approved mechanisms of financial
responsibility, and other commenters said that it would be less
effective.
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Comments and Responses
o Firms using the financial test may be as secure as the
banks, sureties, or insurance companies supplying alter-
native financial assurance mechanisms.
EPA did not attempt to.analyze in~detail-the likelihood_of_failure .
of banks, surety companies, or insurance companies, or to compare those
failure rates to the measure of effectiveness it developed for financial
tests. It is of course true that where a firm uses a secured financial
assurance mechanism, such as a surety bond, no loss will occur unless
both the firm and the surety fail, whereas if a firm uses the financial
test, a loss could occur if it alone fails. However, the Agency believes
that the test it has adopted provides adequate protection, while mini-
mizing the costs of financial assurance.
o A financial test will not provide adequate financial
assurance.
The study performed by the Agency and described in this Background
Document was designed to test whether a financial test could provide
adequate financial assurance. The study demonstrated that a financial
test can do so, and the Agency therefore does not agree with this
comment.
o The EPA may be unable to recover funds from a firm in
bankruptcy proceedings.
The Agency has studied the prospects for its recovery of funds in
bankruptcy proceedings. In general, the Agency's study suggests a strong
likelihood that recovery can be had in bankruptcy proceedings; such recovery,
however, may be limited. Assumptions derived from this study about the
likely rates of recovery were used in the analysis of the costs of various
financial test. (See Appendix B, Section III-E.) The Agency determined,
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through sensitivity analysis, that these assumptions were not critical
variables in the costing procedure.
Final Regulation
The Agency studied the comparability .of...financial, tests-.w.it-h.-.other;
mechanisms of financial assurance promulgated on January 1-2, 1981. It
is convinced that a financial test can appropriately be' offered as an
alternative to the trust fund, letter of credit, and surety bond options
promulgated earlier.
2. Collateral Effects on Alternative Financial Assurance Mechanisms
Commenters argued that the existence of a financial test would
create adverse effects on other mechansims of financial assurance.
Comments and Responses
o The rates charged for other financial mechanisms will be
raised by a financial test, because only small firms,
with greater risks of insolvency, will be required to
obtain them.
The Agency recognizes the possibility that allowing a financial
test could reduce the market for other mechanisms of financial responsi-
bility, particularly the bonds and letters of credit. However, the
requirements that firms using the financial test have at least $10 million
in net worth and be independently audited will mean that a large number
of viable firms will not qualify for the use of the test, and will there-
fore create a demand for the other financial mechanisms. The rates for
the bonds and letters of credit, moreover, are based on the credit
worthiness and other considerations presented by the individual owner or
operator and would not be significantly affected by the size or strength
of other owners and operators using the same mechanism.
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In addition, the trust fund mechanism is likely to be available
irrespective of the extent to which the financial test is employed,
and the Agency expects that the insurance mechanism will be used by
smaller firms which would not qualify for._the financial test... __Hence..the...
Agency does not agree with this commentt
o Banks, sureties, and insurance companies will be reluctant
to provide financial assurance instruments to companies
that cannot pass the financial test.
Banks, surety companies, and insurance companies each perform their
own financial analysis of applicants for their services. This analysis
is designed to identify weak firms according to specific criteria set by
each financial institution. Although the fact that a firm cannot qualify
to use the financial test may in some instances be considered as one
criterion by a bank, surety company or insurance company in an analysis
to determine whether to provide another financial assurance mechanism,
the Agency does not believe that the financial test results will be
adopted as the sole determining factor by banks, surety companies or
insurance companies. Each of these financial institutions has, for
example, developed and maintained its own independent criteria and
analytic techniques specifically adopted to its own business purposes.
They have not adopted a uniform approach among themselves. Other
financial responsibility provisions adopted by other agencies have not
been substituted for these specially adapted techniques.
Even if, in some cases, weak firms which cannot pass the financial
test also cannot obtain letters of credit, surety bonds, or closure
insurance policies, trust funds will continue to be available to them.
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o If a financial test is not allowed, smaller firms will be
unable to obtain trust funds, surety bonds, etc., because
they will be outbid for such services by firms that would
otherwise use a financial test.
The Agency does not agree with this comment. It expects trust
funds to be available under all circumstances. However, because a
financial test is being allowed, the question is moot.
F. Reporting Requirements
The financial test proposed on May 19, 1980 required an owner or
operator seeking to use the test to demonstrate the necessary financial
characteristcs by submitting a financial statement. A large number of
comments were received on the details of this reporting requirement.
1. Type of Financial Statements Required
The May 19, 1980 proposed regulation required that a financial
statement audited by an independent certified public accountant, and
containing unconsolidated balance sheets, be submitted by the owner or
operator to qualify for the financial test.
Comments and Responses
o A requirement should be added that the financial state-
ment submitted must be certified by an officer of the
firm to establish a greater degree of responsiblity for
both the owners or operators and the accountant.
The Agency agrees with this comment. The regulation now requires a
letter from the Chief Financial Officer of a firm seeking to pass the
financial test certifying that the firm meets the required standards.
In addition, the firm must submit a copy of the independent Certified
Public Accountant's report on examination of the firm's financial
statements for the latest completed fiscal year, together with a special
report from the CPA stating that he has compared the data set forth
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in the chief financial officer's letter with the amounts set forth in
the financial statements, and no matters have come to his attention
which cause him to believe that the specified data should be adjusted.
o Unconsolidated balance sheets should not be required,
since unconsolidated data are ordinarily not reported.
o The phrase "unconsolidated balance sheet" is not clearly
defined. It can either refer to a parent company sepa-
rate from its subsidiaries or a U.S. entity separate from
its foreign subsidiaries, or both.
The Agency agrees that unconsolidated balance sheets are not neces-
sary. The statement that such data ordinarily are not reported is
correct. The Agency therefore is not requiring unconsolidated balance
sheets.
o Instead of unconsolidated data, the Agency should require
financial information about the lowest corporate entity
(i.e., a subsidiary) that has ownership of a treatment,
storage or disposal facility.
The corporate guarantee provision in the regulation allows an
entity with consolidated data to guarantee the financial responsibility
of a subsidiary. Furthermore, the Agency is no longer requiring uncon-
solidated data. A firm could, of course, arrange to provide an
independent audit for a subsidiary owning a facility if it desired to
do so.
o Instead of the proposed reporting requirements, the
Agency should use the requirements for reporting to the
SEC and to stockholders for publicily held firms and
an annual audit plus an opinion letter from a CPA for
privately held firms.
o The reporting requirements established by this proposed
regulation do not correspond to SEC reporting requirements.
o New disclosures should not be added to those financial
disclosures already required by the SEC.
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o Instead of the required financial statements, the Agency
should substitute quarterly published statements that
include balance-sheets, such as .the SEC Form.,
o Use of already available financial reports supplemented
by a letter from company management should be permitted.
The Agency has sought to avoid requiring any data that are not
currently prepared in the course of an independent audit, and are not
required by other governmental agencies, such as the SEC. Beacuse of
the large number of hazardous waste facilities, however, the Agency has
required that the necessary data be placed in the format of a letter
from the chief financial officer which can be used for the purposes of
the financial test without adding significant administrative burdens or
requiring high levels of financial expertise on the part of Agency
personnel.
The Agency has determined that the letter from the chief financial
officer must be based upon an independent audit and accompanied by
two reports from an independent Certified Public Accountant: (1) a copy
of the CPA's report on examination of the owner's or operator's financial
statements for the latest completed fiscal year, and (2) a special report
from the CPA stating that he has compared the data set forth in the chief
financial officer's letter with the amounts set forth in the financial
statements, and no matters have come to his attention which cause him
to believe that the specified data should be adjusted.
Since the purpose of submitting a copy of the auditor's report on
examination of the financial statements is to provide the Agency with
assurance from an independent source that the financial statements were
prepared in accordance with generally accepted accounting principles
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and present the results fairly and consistently, the Agency cannot allow
use of the financial test where the auditor gives a qualified opinion,
an adverse opinion or a disclaimer of opinion regarding the owner's
or operator' s financial .statements... _.JThe .American-Institute-of. .Cer.ti.-^-..
fied Public Accountants has set standards as to what qualified opinions,
adverse opinions, and disclaimers of opinion should say and when they
should be issued.
1. Qualified Opinion
A qualified opinion states that "except for" or "subject
to" the effects of the matter to which the qualification
relates, the financial statements present fairly finan-
cial position, results of operations, and .changes in
financial position in conformity with generally accepted
accounting principles consistently applied. Such an
opinion is expressed when a lack of sufficient competent
evidential matter or restrictions on the scope of the
auitor's examination have led him to conclude that
cannot express an unqualified opinion, or when the
auditor believes, on the basis of his examination, that
a. the financial statements contain a departure from
generally accepted accounting principles, the effect
of which is material,
b. there has been a material change between periods in
accounting principles or in the method of their appli-
cation, or
c. there are significant uncertainties affecting the
financial statements, and he has decided not to
express an adverse opinion or to disclaim an opinion.
2. Adverse Opinion
An adverse opinion states that financial statements do
not present fairly the financial position, results of
operations, or changes in financial position in con-
formity with generally accepted accounting principles.
Such an opinion is expressed when, in the auditor's
judgment, the financial statements taken as a whole are
not presented fairly in conformity with generally
accepted accounting principles.
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3. Disclaimer of Opinion
A disclaimer of opinion states-that-the_auditor^-does-not---=-
express an opinion on the financial statements. When the
auditor disclalims an opinion, he should state in a sepa-
rate paragraph(s) of his report all of his substantive
reasons for doing-so>'"and'va-lsov-shou'ld'cdiscl6se*-any-''other
reservations he has regarding fair presentation in con-
formity with generally-•a:ecepted~-aceount7±ng;:priricirpie's-'orv" "
the consistency of their application. . The disclaimer of
opinion is appropriate when the auditor has not performed
an examination sufficient in scope to enable him to form
an opinion on the financial statements. A disclaimer of
opinion should not be expressed because the auditor
believes, on the basis of his examination, that there are
material departures from generally accepted accounting
principles.
(Statement on Auditing Standards No. 2, Reports on
Auditied Financial Statements, AICPA, 1974, para-
graph 29, 41, and 45.)
If the firm receives either an adverse opinion or a disclaimer of
opinion, in the Agency's view the scope of the audit is not sufficient
to confirm whether or not the fintr satisfies the" financial test.
The Securities and Exchange Commission will not accept adverse
opinions or disclaimers of opinion and discourages qualified opinions in
connection with filings involving the sale of securities to the public.
Firms receiving either adverse opinions or disclaimers of opinion
must provide assurance of financial responsiblity using mechanisms
other than the financial test. The Agency was aware that when auditors
express opinions with "going concern" implications, the probability that
the firm will fail within a short time is high; A study by Edward B.
Deakin showed that 20.6 percent of firms which auditors classified as
failing in 1971 later failed. Auditors were considered to have classi-
fied firms as failing if they had issued an opinion that refers to
109
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ability to continue profitable operations or to meet existing debts as
they come due or to a going concern exception, or had disclaimed an-
opinion for going-concern related reasons. (See "Business Failure
Prediction: An Empirical Analysis"- in • "Financial" "Crl's'e'sY ""In'slfit'utTd'ris' " '
and Markets in a Fragile EnviTonmenty^-'edit^d''by-EvT'. ftitinah arid~fivw;' ~"' "
Sametz, New York: John Wiley S Sons, 1977, p. 85.)
The Agency recognized that opinions with "going concern" implica-
tions might not be expressed as straightforwardly as adverse or
disclaimer of opionion. If the Agency judges, however, that the opinion
raises questions as to whether the firm will continue as a "going concern,"
the Regional Administrator will disallow use of the financial test. Other
qualified opinions will be evaluated on a case by case basis.
Requiring that firms be independently audited in order to qualify
for the financial test will mean that the Agency will not have to under-
take a detailed financial analysis of previously unreviewed data. The
fact that almost all firms which are publicly held must also submit
independently audited financial statements to the SEC by 90 days after
the end of their fiscal year will provide a second measure of assurance
that almost all of the data will be accurate. Finally, the Agency
developed the financial test provision from information available on
independently audited consolidated income acounts and balance sheets
because it could not determine the accuracy of non-audited data, or the
effects on the financial test results of errors in non-audited data.
The requirement for a special report from the auditor was adopted by
the Agency to ensure that there is a fair representation of the results
obtained through the independent audit in the chief financial officer's
110
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letter. Independent auditors are familiar with the preparation of special
reports. The use of such a report will relieve EPA personnel of search-
ing balance sheets and income, statements--to..verify the..accuracy...of._
statements made in the- letter- fronu.±he_ .chief—financial-officer i_.._-_^_^.. ,_
Final Regulation ._ . _
The regulation'-requires'-a-.f-irm' s-eek;i-ng--t-O"Use-the-.f±nanciai~.it-est--to - —
provide a letter from the chief financial officer certifying that the firm
meets the required standards, based upon the independently audited year-end
financial statements and footnotes for the most recently completed fiscal
year. The chief financial officer must certify the levels of the required
financial measures, and that they meet or exceed the levels required by the
regulation.
In addition, the regulation requires a copy of an independent Certi-
fied Public" Accountarrtr''S"~report-on—his- examination—of—the f±rm*-s—
financial statements for the latest completed fiscal year,.together with
a special report from the CPA stating that he has. compared the data set
forth in the chief financial officer's letter with the amounts set forth
in the financial statements, and no matters have come to his attention
which cause him to believe that the special data should be adjusted.
2. Time Schedule
The May 19, 1980 proposed regulation required that the financial
statement be dated no more than 140 days prior to the current date. The
proposal also required that if at any time during the operating life of
the facility the owner or operator failed to meet the requirements of
the test, he must notify the Agency by certified mail within 5 days of
learning the failure to meet the requirements.
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Comments and Responses
Commenters opposed both the requirement of quarterly financial
statements, and the timing requirement for notice of changed
circumstances.
o The 140-day requirement should be increased to at least
180 days.
o Financial statements are ordinarily prepared by an inde-
pendent certified public accountant once a year. Requiring
them more frequently will add considerably to the expense
of the regulation.
o If quarterly data are required, the Agency should ask for
12 months of data/ updated every three months.
o Quarterly data should not be required, since seasonal
fluctuations in firm performance will be given unnecessary
significance by such data.
The Agency has concluded that quarterly data are not required. The
financial test it has developed provides adequate warning of bankruptcy
using annual data. Use of quarterly data, or a moving average of annual
data adjusted quarterly, would provide somewhat more stringent tests, but
the results of such tests would not justify the additional paperwork and
costs they would require.
However, the regulation does provide that if the Regional Administrator
has reason to believe that the owner or operator may no longer meet the test
criteria, he may request additional financial reports or other relevant
information from the owner or operator. Upon a finding by the Regional
Administrator that the owner or operator no longer meets the criteria, the
owner or operator will be required to establish other financial assurance.
Failure to provide alternate assurance when required, after disallowance or
after no longer passing the test, will be considered a violation of RCRA
regulations and cause for issuance of a compliance order or initiation of
legal proceedings under Section 3008 of RCRA.
'' 112
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c Firms should be given 5 '.corking days ratner than calendar
days to notify the Agency of change in status.
•o Firms should.-be raquirea .to ..no.tif.y,._t.he_Ag.e.ncy..of....a .change.,. ..
in status only within a certain pericc after a quarterly
or annual ..financiaJ rep.o.rt....i.s.^.i.s.s..ue.a,. -.•
The Agency accepts the suggestion that the time period for notifi-
cation of a change in status proposed in tne May 19, 19ciU financial test
should be revised.
Final Regulation
The regulation p
chief financial officer's letter and the. auditor's reports so that they
are received ty tlie Regional Administrator by the effective date
of these regulations. Since the effective date of the regulations may
cone too soon after tne ena of an owner's or operator's fiscal year to
allow adequate tine to prepare the-required documents based on data for
the most recently completed fiscal year, tne financial test provisions
in Part 265 allow a one-time extension if an owner's or operator's
'fiscal year ends during tne 90 days before tne effective date and if tne
firm's financial statements are being independently audited. The
extension aay last up to the date 90 days after tne ena of the fiscal
v
year. To obtain the extension the chief financial officer of the firm
must send a letter to tne Regional Administer by the effective' date of
these regulations. In the letter he must request the extension; certify
that he nas grounds to believe tiiat his firm meets the financial test
criteria; identify the facilities to be covered and their cost
estimates; specify .tne da-ce when tne firm's fiscal year endeci; specify
113
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tne dace no more than 90 aays after the end of cne fiscal year vnen tie
will suDziit the docucer.cs required; and certify ir.at che firm's year-end
financial statements are being independently audited.
After the initial submission of the chief financial officer's
letter and the aucitor's reports, updated information consisting
of a new letter from the chief financial officer and new auditor's
reports must be received by the Regional Administrator annually
within 90 days after the close of each succeeding fiscal year. The
As^ior.£j. Administrator !jay r^cucit additional ;.:::rcr.'jaci::-r. at any ii—e ;.;
he has reason to believe that the owner or operator no longer meets tne
test criteria.
If the owner or operator no longer meets tne criteria of t:ie
financial test he must send notice to the Regional .Administrator, oy
certified aail witnin 90 cays arter the end of the fiscal year for wnich
tne year-end financial data show that he no longer aeets the criteria,
of intent to establish alternative financial assurance. The owner or
operator must provide alternative financial assurance vitnin 120 days
after the end of such fiscal year.
3. Distinction between Domestic and Foreign Assets
The May 19, 19SO proposed regulation required tnat tne financial
statement show net worth and net working capital in the United States as
well as total net worth and total working capital. Only net worth and
net working capital in the U.ii. could be used to qualify under the
financial test.
1 14
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Comments and Res.po.na.es.-....
o Many companies do not separate U.S. and foreign assets on
their reports. -
o Obtaining data about U.S. resources will impose a high
cost on firms. .that .do no.t.^no.w. generate ^
Tbe Agency has concluded that in order to ensure that it tias legal
access to the assets of firms that utilize the financial test, it is
necessary to retain this requirement. Non-U.S. assets may be either so
sheltered that they cannot be levied against easily, or so at risk that
the Agency cannot be certain tney will be available when needea.
Precedents for a requirement that U.S. assets be relied upon are
present in botn the Coast Guard iiarine Oil Pollution self-insurance
requirements (33 CFR §135.213(a)(l) ) , and the Federal Maritime Commis-
sion Water- -Pollution- Financi-al Responsibility- seif-insuranee--require-
ments (46 CFR §542. 8(a) (3) ).
The Agency has determined tnat AICPA Professional Standards provide
that information about the identifiable assets of foreign assets be
presented in financial statements of an enterprise if the assets of the
foreign operation are 10 percent or more of the consolidated total
assets as reported in the enterprise's balance sheet, or if revenue
generated by the enterprise's foreign operations from sales to unaffili-
ated customers is 10 percent or more of consolidated revenue as reported
in the enterprise's .income statement. The Securities and Exchange
Commission also requires that firms filing Form 10K reports identify
assets by location in or outside the U.S. if 10 percent or more of
assets are located outside tne U.S.. A firm with 10 percent or more of
115
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its assets outside_-the_U-.S.~Jwill.-.therefor.e_.no.t.. hav.e_..to_take-addi-tional_
steps. to identify the exact amount of assets "in the U.S. in order to
meet this requirement of the financial test.- ---
. _ o A substantial—per.centage-,:of_^the__f.innLs..acti.vi.tie5,_t;i-jDri_i ;
instance, 75 percent) should be required to be performed
in the U.S.
The Agency did not consider this a useful substitute for its
requirement that the firm show U.S. assets six times greater than
current closure and post-closure costs. A requirement of a substantial
percentage of U.S. activities would eliminate many of the sounaeat and
largest multi-national firms from using a financial test. Further, if a
fina met all other elements of the financial test, it would be unlikely
that U.S. assets could be overwhelmed by even more significant foreign
liabilities. The Agency did, however, add the option that a firm need
not meet the requirement of U.S. assets of six times current closure and
post-closure costs if it has more than 90 percent of its assets in the
U.S. This alternative method of meeting the U.S. assets requirements
was added for firms that might not be required by SEC to report their
U.S. assets separately.
Final Regulation
The test requires that a firm have assets located in the United
States amounting to at least 90 percent of total assets or at least six
times the sum of the current closure and post-closure cost estimates.
G. Corporate Guarantee
The proposed regulation of May 19, 19bO provided that an owner or
operator could meet the financial responsibility requirements by obtain-
116
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ing the written -guarantee— of—another ^TitTty~-for-the" amoont""of '"the" esti-
mated closure and/or post-closure costs. The entity providing the
guarantee was required to qualify according to the terms of the finan-
cial test- propos-ed-on-May-19-, 1980v~amP'tb exe'cure'-the'guarantee . i'nstru-""
ment on a form which estaLlished specific terms required by the Agency.
The Agency received several comments concerning whether a guarantee
should be allowed and pertaining to the terms of the guarantee.
1. Enforcement of Corporate Guarantee
Two comments questioned wtiether tne Agency would be aole to enforce
a guarantee.
Comments and Responses
o The guarantee provision will not ensure that the costs of
financial assurance will be paid.
o The EPA .may not ..txe able -to ..secure, payment .of-a guarantee
if needed.
The Agency has revised the corporate guarantee instrument tnat it
is requiring all guarantors to use. Clauses were added to the
instrument in which the guarantor waives notice of acceptance ana agrees
to remain bound notwithstanding amendment or modification of the closure
or post-closure plan or certain other modifications or alterations. The
corporate guarantee obligation, in the opinion of the Agency, will be
binding on the guarantor and will be enforceable in the same manner that
other contracts are enforced. The Agency believes that these changes
will help to preclude potential defenses to the obligation created by
the corporate guarantee. The Agency has also provided that the
corporate guarantee may oe cancelled after 120 days notice to the
117
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subsidiary and the Regional Administrator. If the subsidiary does not
establish approved alternative financial assurance within 90 days the
guarantor must provide such assurance. •--
2. Terms of the Corporate Guarantee- - - --. ...
Commenters recommended that the EPA not specify tne terms of the.
guarantee.
Comments and Responses
o The guarantee provision unduly restricts parent firms
that might provide a straightforward written guaranty
that tney are responsible for a subsidiary.
The Agency does not agree with this comment. It has concluded that
uniform language is required for trie financial assurance instruments,
including tne corporate guarantee. Such standard forms ensure that
excessive efforts will not be required by the Agency to monitor tne
content of the instruments. They also avoid the expenditure of effort,
time, and cost on the part of owners or operators to develop tneir own
forms, and preclude any inequities caused by differing forms. The
Agency is convinced that parent firms can provide straightforward
corporate guarantees for their subsidiaries with the corporate guarantee
instrument it has provided.
3. Accuracy of Underlying Financial Data
One commenter questioned whether the EPA could ootain accurate data
from guarantors.
Comments and Responses
o The EPA will not have the autnority over third party
guarantors that will ensure that it obtains accurate
reports of their financial condition.
118
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The guarantor is_ required.-b.y._tne_r.egula£ion-_tx> provide--the— same
assurances that.it passes the financial .test as a. firm..seeking to
qualify directly .under, the'.financial test...provis.ion.~-«_Ihus.,....trie.~guaran=.._^;
tor must, .als.o, .proxide.._a.^le.t.ter^ bas.ed_,.u.pon-_,the...,,indepenaently .^auditea.*.^
year-end financial statements and footnotes .for the immediately '
preceding fiscal year, from its chief financial officer, and a special
report from an independent certified public accountant to accompany the
letter. These data should be as accurate as that provided directly by
an owner or operator.
4. Need for Guarantee
Several commenters supported ttie need for a guarantee
provision.
Comments and Responses- - -- .
The Agency agrees that a guarantee provision is desirable.
It will allow parent corporations.which .are capable of passing the
financial test to provide assurance of financial responsibility
for their subsidiaries which may have fewer financial resources.
The Agency believes this arrangement will help to reduce both the
public and the private costs of the financial responsibility
requirements.
Final Regulation
The final regulation provides that an owner or operator may
meet the financial responsibility requirements by obtaining its
parent company's corporate guarantee. The guarantor must meet the
requirements of the financial test and - must furnish the same .
financial test documentation. The wording of the corporate
guarantee must be identical to wording specified by the Agency.
-------
H. Revenue Test for Municipalities _ .
The proposed regulation of Way 19, I960 provided that if an
owner or operator was. .a. municipality- (as_..defined.-.J3y;^.RCK:A)>,*r- it.
could me.e.t... the.-.. elosur-.e_-.;,aivd-AQ.r^ p.os:t-clos.ur.e_-^fina.a'ei;al_-.ueisur'ance-:
requirements by having annual revenues from property, sales,
and/or income taxes equal to 10 times the adjusted closure and/or
post-closure cost estimates. To be acceptable, those tax revenues
had to be legally available; that is, they could not be dedicated
to other purposes or otherwise precluded froa use in meeting cne
financial assurance responsibilities.
1. Likelihood of Municipal Default
Several commenters argued that municipalities do not fail,
while other commenters suggested that municipal viability was not
a complete assurance of financial responsibility.
Comments and Responses
o Local units of government should be exempced from
financial assurance requirements since they meet their
commitments.
o Municipalities should not be treated any differently from
other entities. There is no guarantee that they will
have funds when needed if they must go through the
budgetary or legislative process to get the funds.
Cities will be able to pay for closure but are not neces-
sarily willing to when the time comes.
o The test seems like a reasonable approach. These costs
will not pose a major problem. Local governments face so
much pressure for environmental responsibility tnat there
is no way hazardous waste facilities will not be closed.
o The revenue test is of little use because it doesn't tell
us anything about the financial strength of the commun-
ity. Few cities will flunk the test.
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The Agency ..agrees, that., _in_gener.al.,^l.ocal1__units_of^goy.ernment.t can.
be expected to meet closure and post-closure requirements in-a conscien-
tious manner. .Public healtn,-.is^_a^f,undamen-.tal.;i.ao.nceEQ_o£s;tiie:sejuni'£-s-aaS:
-it. is- for. other-levelse.' ofiMg;Ov.er.nmeniEv«xrllurf:her.nQ£e7asun'Li^eitaii2pJ^Vjate-.
party, municipalities generally cannot walk away from their facilities.
Where there have been defaults on debts, municipalities eventually pay
off or are assisted by the State to do so.
Table 4 shows municipal default experience under Chapter IX of the
Bankruptcy Act. As can be readily seen, the number of municipal bank-
ruptcies was low, and the recovery rate was high, particularly in recent
years. The Agency also examined the wider record of total defaults on
State and local debt, since not all defaults are dealt with througn
Chapter IX. Table 5~ shows the-total-default—record-for-the- period-l-y-2-t) .
to 1965.* For the period 1945 to 1965, there were a total of 329
defaults of all kinds. Of these, 266 defaults were recorded only in tne
records of banks, and many of these were considered by the compiler of
these data to be purely temporary or technical defaults resulting from
inexperience on the part of municipal finance officers rather than
representing any serious financial distress. Table 6 compares the
default record of various kinds of municipalities to the failure records
of businesses for the period 1960 to 1965.
*This record of defaults is the result of a careful study of the
municipal default record examining a variety of sources of default
data. In part because of the rarity of default events, there is no
single data base from which the total number of municipal defaults can
be gathered, and this record cannot therefore be brought up to date.
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TABLE 4
.MUNICIPAL DEFAULT EXPERIENCE UNDER CHAPTER IX
Period
1938-40
1941-50
1951-59
1960-72
1973-79
Number of
Municipal .
Cases Filed3
210
115
27
10
7
Recovery" Rate
For Cases Filed
and Concluded^
66%
65%
75%
95%
-
Total Business
Bankruptcy Cases
Filedc
„
56,766
89,880
211,340
195,785
aSource: Hempel, George H. The Postwar Quality of State and Local Debt.
Columbia University Press, New York, 1971.
Percentage of admitted debt in default ultimately paid for cases filed
and concluded.
/•»
Source: Tables of Bankruptcy Statistics. Administrative Offices of the
United States Courts, 1980.
122
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TABLE 5
DEFAULTS ON STATE AND LOCAL DEBT
1940-49
States 0
Counties and
Parishes 6
Incorporated
Municipalities 31
Unincorporated
Municipalities 7
Special Districts 5
Other 30
Source: Hempel, George H. The
1950-59 1960-65
0 0
12 17
31 70
4 20
23 41
42 44
Postwar Quality of State
Number of
Governmental
Units-1962
50
3,043
17,997
17,144
34,678
18,323
and Local Debt.
Columbia University Press, New York, 1971.
123
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TABLE 6
LOCAL GOVERNMENT ANNUAL DEFAULT RATE COMPARED
TO AVERAGE BUSINESS FAILURE RATE (1960-65)
(defaults or failures per 10,000 entities)
Counties
and
Parishes
Incorpo-
rated
Munici-
palities
Unincor-
porated
Munici-
palities
Special
Districts
Other
Business
Failure
57
Derivation: Local governments from Table I; business failures from
Dun & Bradstreet, The Failure Record Through 1978, Dun & Bradstreet,
1979.
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However, the Agency is ---concerned—that .«v--if--«. funds -have not—been set-
aside by a municipality- for the purpose of closure and post-closure
care, it may face difficulties--in-allocating- those—funds- %wh:en--t-hey -are
needed, -.and--.-.securingseitinierl.yi:_-.c;l;asur e:zcand^r pos^-c±osur:e:i-u-ca-r e::-is^^an
important goal of the financial responsibility requirements. If
budgetary and legislative processes, bond issues, or voter approval of
new taxes are necessary, it may be some time before funds become
available. Even with the best intentions, municipalities may feel
forced to put off closure and post-closure activities because of other,
unexpected, seemingly more urgent demands for funds. The relative
freedom of municipalities from default does not take care of this
problem.
2. Municipal Ability to- Shift-Expenditures-
The revenue test proposed on May 19, 1980 assumed that municipal-
ities would be able to adjust their expenditures to provide for closure
and post-closure care.
Comments and Responses
o The notion that a municipality can reallocate 10 percent
. of its budget in any year is unrealistic. A level of 5
percent might be more easily reallocated.
o The wording of the revenue test, "10 times adjusted
closure and post-closure cost," is ambiguous and should
instead make reference to a percentage of revenue.
As described in Section A.5. above, the Agency has found few
studies providing empirical data on the level of budget reallocation (or
cuts from other services) a municipality can reasonably accommodate
without diverting large sums of money away from other essential public
125
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services. A report by tne Advisory Commission on Intergovernmental
Relations has looked at eight cities that had experienced severe
financial problems in the recent past. Of the eight cities in the
study, only two. resor..t.ed_.£o. _r.e.d.uc.t.io.ns in., expeadit.ur.es. ..Although both
cities reduced their expenditures oy over 1U.percent in one year, cne
report concluded that the case studies did not provide an answer to the
question of how far services could be reduced or taxes increased without
serious consequences to cities in financial trouble. The studies do
indicate that sharp deviations from the norual level, of expenditures car.
be difficult for cities to manage.
A majority of comments received from local officials and otner
individuals knowledgeable in local finances, as well as the literature
on the subject, haye...s.tress.ec the.lact.-that.. there, is, no slack in local
budgets, and some cities are in severe financial straits. The majority
of comments received concurred with tue ACIR data ttiat suggests a 10
percent budget reallocation would be possible only in extreme
situations.
Data in the U.S. Census of Governments indicate on average chat
except for such major services as police protection and education, which
represent 11.5 and 13.6 prcent respectively, no municipal expediture
category exceeds 8.2 percent of annual municipal expenditures.
Municipal services such as fire protection, .sanitation, nealth, sewage,
and parks and recreation correspond to annual expenditure percentages
well below the 10 percent level. The Agency believes that it is
unreasonable to expect a municipality to afford an unplanned expenditure
126
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that amounts -to -1.0_--per-cent--_of.^.the~munici^ali;cyJ^-^aeomcii:t£-ecl--.-;revenues=.--
Although the ACIR study has shown that; cuts/as rlarge;as 10-percent have
been implemented -in- two ci-ties- exper-i-enc±ng--;seve-r-e'-'frinairc-iai~e-r-rses, --the-
-Agency .believes: -.t.ha;tv_the:itevenu£r;Lt:es£i^ho.uid,^
of expenditure reduction.
Several studies on the financial condition of local governments
have indicated that while many units of government are experiencing
financial problems, small communities have unique fiscal problems.
These factors may raise doubt as to a small community's ability to close
in a timely manner if closure and post-closure costs comprise too large
a portion of uncommitted revenue and the closure and post-closure costs
were not already provided for.
For these reasons,, the Agency finds merit in criticism of the
proposed multiple .of 10. .. .The Agency has also not been able to find
strong empirical support for the argument tnat a larger multiple, such
as the suggested multiple of 20, will provide satisfactory assurance.
The evidence is not clear that all municipalities will be able to shift
expenditures rapidly to closure or post-closure, irrespective of the
multiple adopted.
Final Regulation
The Agency has therefore decided not to adopt the proposed revenue
test for municipalities.
3. Suggested Alternative Municipal Tests
Commenters suggested several additions to, or substitutes for, the
proposed revenue test.
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Comments and Responses
o The revenues derived from taxes alone do not give the
whole picture of a municipality's financial situation.
The phrase ". . .from property, sales, and/or income
taxes. . ." should be deleted. All income should be
considered. .-.-—-. .. . . _ •
The Agency investigated the question of whether municipal 'income
could be increased quickly to satisfy financial assurance requirements.
It concluded that it is not reasonable to assume that any of the tradi-
tional sources of income (e.g., taxes, fees, borrowing, and intergovern-
mental transfers) could be expanded quickly.
Taxes:
The general property tax traditionally has formed the largest
component of local government revenues. It has been moderately elastic,
expanding with population increases and growth-of the economy, but also
contracting significantly during the Great Depression. It has recently,
in some parts of the country, become the subject of publicly-initiated
tax limitation or reduction movements. Over time, the property base of
the tax can be eroded by the growth of tax exempt property, or by the
decline in value of taxable property. Property tax revenues do not
respond as quickly as expenditures to inflation.
Local governments also rely, to a lesser but growing degree, on
sales and income taxes. Both types of tax are strongly elastic. Wltn
few exceptions, the use of the income tax as a source of local revenue
has been limited to urban areas in a relatively few states. In those
cases, however, income taxes are frequently at least as important as
property taxes in providing fiscal support to the local government.
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Local sales taxes= areI-=mo.r.e_.=.wicLes.pr.ead.,._^and.-^OLve.r.all they...-_..provi.de.^the
greatest amount of non-property tax revenue. Frequently, however, their
use is restricted by-.the S-tatea. ^-x^^.-. _.„,.,:
Because vJLoea-L pr.opjerty.-,. ._aal.es'i!,-.i.,.-ancL^income;. -t.ax_,.,r.eceipts^ate^all.,
closely, although not absolutely, dependent on-the economic situation of
the locality collecting the tax, they can vary markedly over time.
Particular indicators of a government's revenue-raising capacity, such
as data on personal incomes, the volume of retail trade, and property
values, can be measured. However, it would not be administratively
feasible for the Agency to monitor such measures for each local govern-
ment operating a hazardous waste TSUF, nor is it clear that the trend of
such measures would prove to be an adequate.predictor of the longr-term
fiscal situation of "the local government;-and- -hence- its- future ability
to provide closure and post-closure. ..care... .(See AC1R, Measuring tne
Fiscal Capacity and Effort of State and ..Local..areas, 1971.) .
Tax receipts are also dependent on political decisions. The ACIK.
has attempted, in cooperation with State revenue departments, to deter-
mine whether selected state tax collection increases in the past decade
were due to economic or political factors. Their findings suggest that,
at least for states, there has been a reluctance to take conscious
political action to raise taxes. Recent increases in tax collections
have been primarily attributable to inflation, and secondarily to growth
in the economy.
The Agency therefore decided that it would not attempt to develop a
financial assurance mechanism dependent on increases in taxation.
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Fees;
Numerous local governments operate public service enterprises wnich
take in fees paid—by-the customers—of--ehe~-en-te-r-pri*sev Such- -fees- -,---how-
ever, may oe insufficient to f-uliy.~co.v.er.,the.-costs of--the service,.--ana,
subsidies are sometimes paid from other sources of revenue to the enter-
prise. Even if the enterprise does operate with a surplus of fees over
costs, such fees are frequently pledged for the repayment of the bonds
that financed the facility. Localities are often forbidden to use fees
to raise general revenue. There is some evidence that scalier local
governments are more likely than the larger jurisdictions to diversify
and expand their revenues by adopting fees. (See ACIR, Local Revenue
Diversification: Income, Sales Taxes and User Charges, 1974.)
Public entities that are entirely'dependent for'their revenues" upon
fees are essentially identical to private entities, ana are subject to
the same fluctuations in revenue as private firms. Sucn public enter-
prises have occasionally been forced to aefault on tneir bonded indebt-
edness, and the incidence of their defaults has been higher than for
other units of local government.
Borrowing;
Public debt has traditionally been used to finance capital expendi-
tures for projects with long productive lives. Payments are spread out
over time and fall on those generations of citizens who can expect to
derive benefits from the investments.
A local jurisdiction adhering to these principles might choose to
treat its hazardous waste facility as a capital project, and include the
130
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amount estimated^-.£or. ^closure..in.--the^de.bt _concraeted^_f.o.rL-.the. .pr.oje.cc--.at-
the beginning of. its life.' Such debt could, .then be .repaid., .from the..
proceeds over the lite of- the -facili.ty.--..._ .;-•-_..-^ .... -/.•-„.
.- . If, however, the,. iacili.ty.^has_ib.een^in-L.exi-s.c.e.nce»ifor.£.soQe,.cime,is~.an(i.:
the local jurisdiction seeks to borrow to obtain the resources for
closure or post-closure care at the time such funds are needed, several
problems could result. Funds may not become availaole in a timely
fashion, since local debt must usually be approved directly by the
voters. The amount of such debt could be limited by debt ceilings
imposed by the State. In addition, trie use of short-term debt to
finance current expenses is frequently discouraged as a potential con-
tributing factor to municipal default. The Agency therefore decided it
would not-attempt to-develop -a—financial—assurance -mechanism- dependent
on local debt.
s
Intergovernmental Transfers:
Intergovernmental transfers currently provide a large portion of
the aggregate revenue of local governments. Such transfers include not
only Federal General Revenue Sharing, but also other forms of direct
federal aid, and state aid to localities. Significant differences
exist, however, in tne extent to which different local governments rely
on their own source revenues or on federal or state aid. In addition,
many intergovernmental transfers are in specific functional areas (e.g.,
highways, employment security, education, health, public welfare, and
counter-cyclical programs) rather than being undesignated funds avail-
able to be spent on projects chosen at the discretion of the local
131
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government. • There are indications that direct federal -transfers- to_
local governments may decline in the future, .and it is not yet clear
wnether State aid to local governments will -De- increased- by-..a-.-^pr.opor- ;
tionate or greater .amount. . (-S.ee. A.CIK., Re.cant T.r.ends in ^.Eedexal^aaa.-.
State Aid to Local Governments, 1980; The State of State-Local Revenue
Sharing, 1980; National Governor's Association, Allocation of State
Funds to Local Jurisdictions, 1980.) There is also some evidence that
larger cities place greater reliance on intergovernmental transfers than
do smaller jurisdictions.
Several commenters suggested that the most desirable form of
financial assurance for a municipality would be a guarantee for its
closure or post-closure costs from the State in which it was situated.
The January 12, 1981 regulations provide that:
If a State either assumes legal responsibility for an owner's
or operator's compliance with the closure, post-closure or
liability requirements of these regulations or assures that
funds will be available from State sources to cover those
requirements, the owner or operator will be in compliance with
the requirements of this subpart if the State's assurances are
equivalent to or exceed the assurances provided by the
requirements of this Subpart.
46 FR 2861
The Agency found several reasons why an assumption of legal
responsibility by a State to provide funds for closure and post-closure
care for a municipality is appropriate.
Benefits from a municipal TSDF would probably extend to surrounding
communities, and problems arising at such a TSDF would almost certainly
have impacts outside the immediate municipality. State involvement
would help spread the costs of the benefits or burdens cf the site over
more of the affected citizens.
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Such a State igua;ran£e.e:-,=wjQulja,ii.oiiaw_cvicr£.at_,t:nen(is- .cowAr,ai_gr-eat.er-_
State involvement in .local finance s.....—Tke.fiscal...position i-of.._the. States...
has improved- .since., the .-L-950';s and-,. 1.9fe0^s..; vis-a-^is^-both g .thegrf-^edera-^,;
government and local governments. This has .resulted in a modest
increase in State aid to local governments (see ACIR, The States and
Intergovernmental Aids; The Intergovernmental Grant System, at 1-13
(1977); ACIK, Recent Trends in Federal and State Aid to Local Govern-
ments, at 1-15 (1980); ACIR, The State of State-Local Revenue Sharing at
3 (1980); ACIR ana National Academy of Public Administration, The States
and Distressed Communities: The 19bQ Annual Report, (1980)). In addi-
tion, State-imposed limits on taxation' or State-required expenditures
frequently limit the control of local governments over significant parts
of their - own --budgets —(-see—ACTR^ - State- •-Limitations' ~onr Local "Taxes- -and—
Revenues (1977); ACIR, .State Mandating of. Local Expenditures (1978)).
o Since quasi-state ..organizations, do. .not have..taxing, autho.-. _
rity, a project undertaken by such an authority must be
self-sustaining and based on the revenues of such pro-
jects. These organizations should be required to meet
specific financial requirements parallel to those pro-
posed for private entities.
o The Agency should allow uncommitted revenues from user
charges and contracted revenues to be used to meet the
financial assurance requirements.
The Agency agrees that "authorities" and other public entities that
are primarily dependent upon fees for their revenues should be consid-
ered essentially identical to private entities and should be allowed to
meet the same financial assurance requirements. Thus, if sucn entities
can qualify under the financial test, they will be allowed to do so.
133
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o Several commenters...said-.that._bond._..s.eryice..ratings...should_
be considered as an element of the revenue test, but
other commenters on the use of bond ratings were gener-
ally of the opinion that bond ratings were not partic-
ularly accu.r.ate.....indi.c.a.torst-._.of._-a^.c.ommuni.t^s.™f .inanci,al~..
health.
Municipal bond ratings have been said to take into account the
subjective impressions of the rating service and the past history of the
municipality to the extent that changes in a municipality's rating often
follow a financial event, rather than predict it. In the major default
era of 1929 to 1937, 7b percent of all defaulted municipal oouct issues
and 94.4 percent of the dollar value of all defaulted municipal bond
issues were rated in. the top two categories by both major rating
services. Also, an analysis of the defaults of public corporation
revenue bonds since WW II has shown the ratings at the time of purchase
were not lower for. corporations that ultimately defaulted than for those
that did not. because of chese anomalies, and tne questions about
timely allocation of funds discussed earlier, the Agency has decided not
to allow a revenue test based on municipal bond ratings.
o The Agency should design a revenue test for municipal-
ities incorporating a minimum net worth test to eliminate
those municipalities that are on the verge of bankruptcy.
The Agency has considered the use of detailed financial information
to determine the current financial solvency of municipalities, but has
decided not to use this approach at the present time. Municipal
accounting and reporting procedures vary greatly (see Coopers & Lybrand
and the University of Michigan, Financial Disclosure Practices of the
American Cities; A Public Report, 1976; Coopers & Lybrand, financial
Disclosure Practices of the American Cities II; Closing the Communica-
134
-------
tions Gap, 197,8). In .addition,.__the._f inancial .statements, .and audits of
local governments are .frequently .not ...released. ,in. -a -timely. .way..... The.
Agency has ..theref o.re,..,eoncluded. tha£i.-i.t-:-£annat--_spe.ci-fy_.a--se.t—of^..f-inancial_
indicat-ors similar to the financial .test. -that - would be suitable for.
municipalities.
4. Definition of Municipality
Several commenters questioned whether a clear distinction could be
made between a State and a municipality.
Comments and Responses
o It is not clear whether some entities are municipalities
or are part of the State and therefore qualify for tne
State exemption.
RCKA itself provides a definition of both "State" and
"municipality":
"(31) The Term 'State' means any of tne several States, the
District of Columbia, the Commonwealth of Puerto Rico, tne Virgin
Islands, Guam, American Samoa, and the Commonwealth of the
N'orthern Mariana Islands.
"(13) The term 'municipality' (A) means a city, town,
borough, county, parish, district, or other public body created by
or pursuant to State law, witn responsibility for the planning or
administration of solid waste management, or an Indian tribe or
authorized tribal organization or Alaska Native village or organi-
zation, and (B) includes any rural community or unincorporated
town or village or any other public entity for which an applica-
tion for assistance is made by a State or political subdivision
thereof.
42 U.S.C. S6903
The financial responsibility regulations, in turn, provide that
"States ... are exempt from the requirements of this ... [financial
assurance] Subpart." 46 FR 2851.
135
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Several commenters have stated that .these -pr-oyisions-.-axe_inadequate—
to resolve all cases of ambiguity about whether an entity .should 'be
classified as a State- or a -niunicipa-lity.-s.;---In-tpart-icula-ri they"-beli-eve—-
cnat the law and regulation, read together, -do.not maKe it clear whether.
a "district or otner public boay" created by State law for the purpose
of handling hazardous waste should be treated as a "municipality" ana
required to provide assurances of financial responsibility. If so, they
argue, the exemption already granted to the States would be very narrow,
and the States coula be discouraged iron setting up hazaraous wasti
facilities.
The Agency generally believes that the treatment of each of those
facilities may have to be determined according to its individual
facts. A facility is exempt from the requirements of this regulation if
it is owned or operated by a State. "Districts or other public bodies"
created by State law for the purpose of handling hazaraous wastes would
be exempt only if they were instrumentalities of the State and the State
were fully liable for their obligations.
Commenters also questioned whether the distinction between munici-
palities and private entities was clear.
o Some private business could incorporate and pay taxes
sufficient to meet the municipal revenue test require-
ments. This "municipality" may not provide adequate
financial assurance and the regulations should preclude
this possibility.
The Agency recognized that determining the legitimacy of municipal-
ities for the purpose of a revenue test was a difficult problem.
Because the revenue test has been witndrawn, however, tne Agency
136
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believes that- the—problem .of—"sham"- or—!lcompany.".--towns need—not—be-
addressed. Both municipalities and private owners and operators, are
required, to .obtain. assur.ances^of-±"inancial~xies,p.oiis.i-bil-i£y..^^^ ._.:.:.-. ..^Sa^^jL
5; Other Issues
Several commenters suggested-minor- refinements or variations in the
proposed revenue test. Since the Agency has withdrawn that test, those
comments are not responded to here. In addition, the following issues
were raised:
o The Agency should allow municipalities to guarantee the
closure obligations of other public and private entities.
A municipality that currently disposes of its hazardous
waste outside of its borders or through a private owner
or operator might want, in order to ensure tne continued
availability of the service, to guarantee that it will
provide funds for closure care.
The Agency-has-reviewed-municipal- law on the- subject-of guarantees
and has determined that reliance on a municipal guarantee could leave
the Agency without .the-financial-, assurance. ..i.t -feels, .is .necessary.. In
particular, a municipal corporation can only act within tne bounds of
its charter, and it will be limited by the State constitution, by
statutes passed before the guarantee was undertaken, and even in some
cases by statutes enacted after the guarantee was undertaken. The
Agency would have to ascertain in each case whether the legislative
charter and other State law gave the municipality the express power to
act as a guarantor. Otherwise, it could later be faced with a
determination that the contract was void because it was outside the
power of the municipality. The Agency therefore determined that
municipal guarantees should not be allowed as an option at the present
137
-------
time, since financial assurance could. not_ be.,.adequately- guaranteed
without an extensive analysis of the legal powers of each municipality
offering a guarantee. . . .
o Federal ana State authorities are likely to oe more
reluctant to prosecute a governmental entity cnan a
.v private offender; therefore, a stringent test is
required.
o Funds may be obtainable but enforcement efforts may be
weak or ineffective.
The Agency does not expect tnat the closure obligations of a
publicly owned or operated hazardous waste facility will be enforced any
less vigorously than the closure obligations of a private entity. The
Agency does believe however, that 1'egal enforcement proceedings can be
more complicated when brought against a municipality. Difficult issues
of federal-state-municipal relations may have to be dealt with. This is
another factor that argues against a revenue test. Publicly owned or
operated facilities, however, also offer options that private entities
do not which may allow ttie Agency to secure timely closure by avoiding
litigation. In addition to the legal option available to the Agency,
there are public pressures from State agencies and from the local
citizenry, who can be expected to be sensitive to the need for proper
management of hazardous waste facilities.
o Municipalities should be allowed to use the financial
test if, because of their financial structure, they can
fulfill its requirements.
o If a State were to guarantee the closure and post-closure
obligations of a municipality, does the municipality
still have to provide other financial assurance?
138
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The regulations point out that a hazardous waste facility njust
demonstrate that it has established or meets the criteria of one of
the financial assurance mechanisms, or that the State has guaranteed
these obligations. Therefore, an entity that can demonstrate that its
closure obligations are backed by the State need not provide the Agency
with any other form of assurance. Also, an entity that meets the
requirements of the financial test may choose to demonstrate financial
assurance through this test or may utilize any one of the other financial
mechanisms. The Agency believes that trust funds, letters of credit,
and surety bonds will be available to municipalities.
I. Other Issues
Comments and Responses
o RCRA does not authorize the use of a financial test or
self-insurance to provide assurance of financial
responsibility.
The Agency has carefully reviewed its legislative.mandate to. autho- -
rize the use of a financial test and self-insurance to provide assur-
ances of financial responsibility. Its basic conclusion that such
mechanisms were authorized by Congress, and its reasons for reaching
that conclusion, are described in Section II of this Background Document.
o Review AICBA Professional Standards text for definitions
of financial terms.
The Agency sought to adopt the conventional definitions of terms. It
recognizes that the definitions may not provide the precise meanings of
terms in all particular cases, but do provide general guidance which can be
used to satisfy these requirements. As stated in the regulations, "the
definitions are not intended to limit the meaning in a way that conflicts
with general usage." The Agency will continue to consider specific
suggestions on how the definitions can be improved.
139
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GLOSSARY
Consolidated Income Statement and Balance Sheet Values
CA Current Assets
C7 Cash Flow (NI •*• depreciation, depletion, and amortization)
CL Current Liabilities
CURRAT Current Ratio (CA T CL)
E3IT Earnings Before Interest and Taxes - ..
NFA Net Fixed Assets
NI Net Income
MS . .Net Sales
NW Net worth
NWK Net Working Capital
PC Balance sheet value of preferred and coinnon stock
QA Quick Assets (CA - Inventory)
QRAT Quick Ratio (QA T CL)
RE Retained Earnings
TA Total Assets
TL Total Liabilities
VOPAD Value of Property After Depreciation
Variables Esoloved in Financial Tests
A, Percentage of a saaple of non-bankrupt fir=s that .pass a
given test.
3 A subscript for M and E indicating Che use of che best case
assumption. If a test fails a fira at least tvo years prior
to bankruptcy, there will still be sufficient time co ensure
the funding of alternative mechanisms.
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GLOSSARY (Continued)
C Percentage of a sample of bankrupt firms that fail a financial
test with sufficient time remaining prior to bankruptcy to
ensure that alternative financial mechanisms'are funded.
D The difference between the percentage of non-bankrupt firms
passing a test and the equivalent percentage of bankrupt
firms passing the same test. It is sometimes referred to as
the discriminating power of the test.
E . The number of firms per 10,000 which pass a given financial
test and will enter bankruptcy without funding alternative
financial mechanisms.
H Subscript used to indicate that a result refers to the
holdout sample.
M The percentage of a sample of bankrupt firms which would fail
a given financial test with insufficient time remaining prior
to bankruptcy to fund alternative financial mechanisms.
? Subscript for M and E indicating the use of the most probable
case assumption. For all firms that are first eliminated by
a test three years prior to bankruptcy, there will still be.
sufficient time to ensure the funding of alternative•financial
mechanisms. One-half of the firms eliminated by a financial
test two years prior to bankruptcy will fund alternative
financial mechanisms prior to bankruptcy.
U Subscript used to designate that a given value is based upon
results using the utility sample.
W Subscript for M and E indicating the use of the worst case
assumption. If a test fails a firm at least three years
prior to bankruptcy, there will be sufficient tine to er.sure
the funding of alternative financial mechanisms.
x Year of bankruptcy.
x-1 One year prior to bankruptcy.
x-2 Two years prior to bankruptcy.
:c-3 Thrae years prior to bankruptcy.
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GLOSSARY '(Continued)
Variables Used in Computing Costs of Financial Assurance Mechanisms
Percentage of viable firms that pass a given financial test
C Closure costs . •
C Private costs of auditor's special report/facility/year
£\
C_. Annualized private cost of auditor's special report/facility/
year of facility life
C, Annualized private cost of fees for letter of credit/
facility/year of facility life
C.., Fees for letter of credit during post-closure/facility/year
C.s Fees for letter of credit during facility life/facility/year
E Number of firms per 10,000 that pass a given financial test
that will go bankrupt without providing alternative financial
assurance
h ' Rate of inflation
i Subscript for facility type (storage, surface impoundment,
land disposal, incinerator)
L, Average.loss from a letter of credit due to failure to
~ adjust for inflation during facility life
N Number of facilities owned by firms with S10 million in net
worth and independently audited
P Post-closure costs
PTLp Direct public costs due to failure of firms using a financial
test/facility
PUT Direct public costs due to failure of firms using a latter
" of credit/facility
r Real interest rate
r Real rate of return on trust fund
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GLOSSARY (Concluded)
RC_ Share of closure ana pose-closure costs not recovered from
bankruptcy proceedings
t Time
T Length of the post-closure period
v Rate at which finns which will later go bankrupt voluntarily
shift froa a letter of credit to a trust fund
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