Is There a Chinese Import Nightmare Looming from Nonroad Equipment?

Small, spark-ignited nonroad engines from China are the latest imports that run afoul of U.S. standards, as many do not meet the requirements of the Clean Air Act (“the Act”). Examples of such products include landscaping and lawn-mowing equipment; gas or diesel-powered tools such as chainsaws, power-washers and snow blowers; warehousing equipment, such as forklifts and conveyor systems; generators; and other construction equipment, such as pumps, earthmovers, and tractors. Diesel-powered golf carts and other recreation vehicles may also contain imported engines. Thus, the scope of the problem with imported engines may vastly exceed the issues previously raised by other imported Chinese goods.

The Problem

Why these engines, and why now? The Environmental Protection Agency (“EPA”) has been criticized for the lack of enforcement of the small, nonroad air emissions requirements of the Act, and has promised more vigilant enforcement going forward. The emissions from these engines include particulate matter, volatile organic compounds, air toxics, and nitrates of oxygen. In fact, on-road and nonroad engines contribute to nearly half of the air pollution in the United States. The EPA established emission standards to reduce the impact from these emissions, and recent testing suggests that an imported engine properly certified under the Act emits two to three times fewer emissions than a noncertified engine.

In furtherance of its stepped-up enforcement, the EPA is working with other federal agencies. First, the EPA and the U.S. Customs and Border Protection (“CBP”) have partnered to intercept illegal imports of such engines. Also, working with the Department of Justice (“DOJ”), the agency has filed a complaint against PowerTrain, Inc., Wood Sales Co., Inc., and Tool Mart, Inc. in the U.S. District Court for the District of Columbia, for violating the Act. The defendants are importers of small, nonroad engines that allegedly did not meet the requirements of the Act for imported nonroad engines by specifically failing to obtain proper certification from the EPA, by not properly warranting the engines, by posting deficient labels on the engines, and for violating regulatory recordkeeping requirements. The complaint seeks substantial penalties, to have the importers remedy the violations, and to mitigate the impact on the environment.

The Requirements of the Act

The basic requirements under the Act for importers and manufacturers of small nonroad equipment state that: 1) nonroad engines must be certified by the EPA to be in compliance with emissions standards; 2) an EPA-approved air emission label must be permanently affixed to each engine and be readily visible; 3) EPA Declaration Form 3520-21 must be completed for all imported engines; 4) importers must ensure that the engine manufacturers will honor an emissions warranty; and 5) records must be kept and maintained.

The Penalties

The penalties that the EPA may impose are harsh: 1) the EPA may seize the engines and export them out of the United States; and 2) the EPA may impose civil penalties of $37,500 per engine per day of violation. In addition, in concert with CBP, liquidated damages may be assessed for failure to redeliver non-conforming, imported products upon request, and civil penalties of 20% to 40% of the appraised value of the engines may be imposed for any material false statements related to EPA compliance and admissibility of the engines. Moreover, criminal action my be initiated against an importer that knowingly makes false or fraudulent statements or that omits material information required in a CBP entry document, with the criminal penalty including fines up to $250,000 and imprisonment for up to two years.

It is important to note that an importer is liable if it imports engines that are not certified or if the imported engines are otherwise in violation of the statutory and regulatory requirements. Thus, while an importer is not the manufacturer, an importer must exercise due diligence to ensure compliance, and must communicate with the foreign manufacturers of the nonroad engines regarding the requirements of the Act. If an importer learns of a violation after importation, the importer should notify the EPA of the violation and institute a recall if necessary. First-time violators who voluntarily disclose and remedy the violations may have the penalty substantially reduced, provided the disclosure occurs within 21 days of discovery.

The Risk and the Response

Typically equipment containing imported nonroad engines is acquired through an equipment lease or is purchased through a financing arrangement. Seizure of the equipment by the federal government, and/or the imposition of substantial penalties, will necessarily result in a default under the financing arrangement. Federal action would also greatly impair the securitization of the lease, as the equipment would be rendered valueless. The lessor or lender can ' and should ' do several things to ensure compliance with EPA regulations, protect its security, and preserve the lessee's ability to honor its payment obligations.

Compliance with regulations and protection of the security interest begin with the application process. The application should require the applicant to obtain a disclosure from the manufacturer/importer/distributor as to whether the specifications for the equipment contain imported engines. If the equipment does in fact contain a foreign-made nonroad engine, then the following must be produced by the applicant before the financing is approved.

1. EPA Certificate of Compliance;
2. EPA-approved air emissions label;
3. EPA Form 3520-1; and
4. Manufacturer's Emissions Warranty

Moreover, these documents should be scheduled and attached to the lease or financing document.

Second, financial institutions should conduct a thorough review of their equipment lease forms and financing document. The financing document should address both the manufacturer's and importer's warranties, including emissions warranties. There should be specific references requiring emissions warranties to be in place, and the document should require an assignment of the warranty to the financer where appropriate. There should be some comfort with the manufacturer's and/or importer's ability to honor the warranties, and this may require some extra-contractual due diligence by the applicant or financer.

The financing documents customarily contain liquidated damages provisions. To be effective, liquidated damages clauses should bear some rational relationship to the damages suffered by the financer in the event of a federal enforcement action. For example, a liquidated damages provision could provide that in the event of seizure or federally imposed penalty for violating the Act, the payments remaining be accelerated, due, and payable. In addition, if there is an anticipation of residual value of the equipment that would inure to the benefit of the financer, then the liquidated damages provisions should include the reasonable residual value.

Financing documents also typically require insurance to protect the security in the event of damage or loss of the equipment. Insurance is commercially available and covers the risk of recall, seizure, or other federal enforcement action. The insurance requirement in the financing documents should be expanded to include federal regulatory action due to violations of the Act from nonroad engines.

The financing documents almost always contain some sort of indemnity provision. The clauses should be reviewed and revised to include indemnity/hold harmless language sufficient to protect the lessor and financer in the event of federal enforcement action.

Finally, financial institutions usually require a corporate or personal guaranty of the lease or loan. Use of a corporate or a personal guaranty, coupled with indemnification language, would also serve to protect the financial risk. The guaranty agreement should be revised to provide the guaranty is effective, inter alia, in the event of federal enforcement action.

Companies and their financial institutions using nonconforming-imported engines in the company's operations do so at peril. We can expect regulators to seek authority to impose sanctions on commercial and industrial end-users who employ nonconforming engines, and that regulators will force end-users to cease and desist from using polluting engines. In the worst case, we could see the outright seizure of equipment containing nonconforming engines. Inventories should be inspected to determine whether currently financed equipment contains nonconforming engines. If so, pre-emptive remedial action will be necessary.