Financial institutions that foreclose on commercial properties may find themselves liable should a site require an environmental cleanup, a problem made worse by the financial crisis. Experts say smaller financial institutions; including mid-market firms, often lack the deep pockets of their larger counterparts should such a liability arise. Under the U.S. Comprehensive Environmental Response, Compensation and Liability Act, better known as the Superfund law, owners or operators of properties containing hazardous materials are required to dispose of them or provide for their treatment. The 1996 Asset, Conservation, Lender Liability and Deposit Insurance Protection Act amended CERCLA, providing a secured creditor exemption eliminating owner/operator liability for lenders provided they do not “participate in the management of the facility.” “As long as banks avoid participating in the management of the foreclosed property, they are pretty well protected from liability.” While the 1996 amendment grants some protection for lenders, “there is still confusion on how to navigate this exemption and what is considered participating in the management of the on-site operations as well as other liabilities or costs a lender may face.”
Delinquency rates continued to decline for commercial and multifamily mortgage loans in the fourth quarter of 2012, according to the Mortgage Bankers Association’s Commercial/Multifamily Delinquency Report. “The concern for lenders is, should they take ownership of a property and then be involved in the use of that property or its operations, they could very well be liable for any environmental problems associated with that site.” Lenders also could face “third-party liabilities for bodily injury and/or property damage from either on-site tenants, or an adjacent property owner” for contamination that may have migrated to their property. Additionally, the lender could incur defense costs associated with the third-party claims. The issue requires superior due diligence not just of the potential for a site’s past or future contamination, but also of the lending document contractual language. Although real estate lenders are generally shielded from liability for environmental contamination on properties in their portfolios, lenders could inadvertently lose those protections and assume unnecessary environmental risk if they are not careful.
Lenders can minimize their risks associated with contaminated properties by exercising caution in conducting their due diligence, drafting loan documents, and managing properties serving as loan collateral. The federal Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”) imposes broad liability on owners and operators of a facility at which hazardous substances were disposed of, persons who transported hazardous waste to the facility, or persons who generated the hazardous waste. CERCLA is a strict liability statute, which means that parties can be held responsible for the cleanup regardless of fault. A lender who holds a security interest in property generally is exempt from liability for environmental contamination on the property as long as it does not participate in the management of the facility and does not add to or make the contamination worse. A “security interest” includes having a right under a mortgage, deed of trust, assignment, judgment lien, security agreement, factoring agreement, lease, or any other right to secure the repayment of money.
What constitutes “participating in the management” of the facility is a bit harder to define and has been the subject of litigation. A lender is deemed to participate in the management of a facility if it undertakes decision-making control or responsibility for the hazardous substances handling or disposal practices at the site. A lender could also be deemed to participate in the management of the facility if it exercises managerial control over the “day-to-day decision making” with respect to the operational functions of facility, such as acting as plant manager or operations manager. Management of the facility typically becomes an issue after a lender forecloses on the property and then has some control over the property before it can be sold.
Minimizing Financial Risks for Environmental Contamination
Lenders face several types of risks involving loans secured by contaminated property. First, the costs of remediating contaminated property and complying with environmental laws may impact a borrower’s ability to repay its loan, as well as the value of the collateral for the loan. Second, environmental contamination may impact a lender’s decision to foreclose on property if it will be difficult to resell because of actual or perceived contamination. Third, lenders who do foreclose on contaminated property to protect their security interest must be careful not to accidentally become an “operator” of the property and assume liability for the contamination. Lenders can take several steps to avoid inadvertently assuming risks associated with environmental contamination:
• Conduct Appropriate Environmental Due Diligence: An environmental due diligence review in the form of a Phase I and/or Phase II environmental site assessment can identify environmental risks associated with the property and help the lender evaluate the degree of any risk. The type and scope of the environmental site assessment will depend on the past, present, and future uses of the property and nature of the surrounding area. The inquiry is not necessarily whether the property has any recognized environmental conditions, but whether any such conditions could affect the intended use of the property, the borrower’s ability to repay the loan, or the lender’s ability to transfer the property if the lender acquires the property through foreclosure. A lender can rely on an environmental site assessment conducted by the borrower, but should be satisfied that it is sufficient for the lender’s purposes and should perform its own assessment if necessary.
• Address Risks in Loan Documents: After environmental risks are identified in the due diligence process, lenders or their attorneys should address those risks through appropriate contractual language in the loan documents. For example, a lender could require an indemnification from the borrower or a guarantor, or could require a certain amount to be held in escrow or in reserve to cover potential environmental claims. A lender could also protect itself by requiring environmental insurance such as pollution legal liability to cover cleanup costs and/or potential third party claims.
• If Foreclosure is Necessary, Avoid Active Participation in Management: In the event that it becomes necessary to foreclose on environmentally-challenged property, a lender should carefully limit its involvement in the day-to-day operations of the property and environmental decisions for the property. Although a lender can take actions to protect the property and prepare it for sale, it should avoid any gray areas that could be perceived as assuming managerial control over environmental matters.
CERCLA Environmental Lender Liability
Lenders can maintain CERCLA exemption by following ownership / liability tests. The EPA Lender Liability Rule does not encourage controlling borrowers but rather it supports proper loan management. It may appear the EPA holds financial institutions responsible for the failings of others because lenders have attempted to be responsible in their dealings with developers on environmental issues. However, we must keep in mind that the EPA is responsible for defining and identifying responsible owners and operators in order to assign responsibility for environmental failures, which can have long-lasting and far-ranging effects. Indeed, the EPA has, on occasion, ruled that lenders have been too involved in the daily operation of a company and, therefore, have been given the responsibility for clean up. Ongoing daily involvement, even if initiated more recently than the violations, confers responsibility because it also suggests some knowledge or awareness of the failures. Lenders that have failed to conduct due diligence or which were not thorough in protecting their security interests have inherited huge environmental liabilities under CERCLA. There are, however, important and appropriate lender activities as an owner or operators which are shielded from CERCLA (1980) liability under the secured creditor exemption. The Lender’s Exemption provides that the term “owner” or “operator” specifically does not include a person, who “without participating in the management of a facility, holds indicia of ownership primarily to protect his security interest in the facility.” The stated purpose of the EPA Lender Liability Exemption is to define and specify the range of permissible activities a lender may conduct without exceeding the bounds of exemption. The EPA has defined three key and identifiable elements of activities which lenders may conduct without being deemed to have exceeded the bounds of CERCLA exemption. Those elements are: “indicia of ownership”; the requirement that ownership be held “primarily to protect security interest”; and, the prohibition of secured creditors from participating in the management of a facility. The key elements, all of which must be in place for the lender to avoid liability, are expanded for clarification: “Indicia of ownership” is defined by the EPA rule as “evidence of interests in real or personal property.” Qualifying indicia of ownership include a mortgage, deed of trust, legal or equitable title obtained through foreclosure, a guarantee of an obligation, an assignment, lien, pledge, or other right or form of encumbrance against the property. To avail itself of the exemption, a lender must prove it holds the indicia of ownership principally for the purpose of securing payment, or performance of a loan or other obligation.
There is a two-pronged test for identifying when a lender has crossed the lines and can be deemed to be “participating in management.” Activities of management the secured creditor is prohibited from include:
• exercised decision-making control over the borrower’s environmental compliance; or,
• assumed overall management responsibility encompassing the day-to-day decision-making of the borrower’s enterprise.
The EPA Lender Liability Rule does not encourage controlling borrowers but rather it supports proper loan management. The United States Environmental Protection Agency has defined four areas where lenders can be involved in environmental inquiries and loan management without being labeled as having “participated in management” of a borrower’s company.
Acceptable loan management activities from an environmental standpoint may occur:
• Before the loan transaction takes place, or at the inception of the loan
• During the tenure of the loan
• While undertaking a financial workout with a defaulting borrower
• At foreclosure and when preparing the facility for sale or liquidation
Lender Loan Management Programs
There are several tools and a number of procedures for the various phases of loan management which comprise an effective Lender Loan Management Program. At the inception of the loan transaction, a Transaction Screen Questionnaire (defined by the ASTM in protocol E1528-93) is used to determine if a Phase I Environmental Site Assessment will be necessary. It is rare that some form of in-depth evaluation is not required on commercial property. Furthermore, it is inaccurate and can be risky to view the Transaction Screen as a shortcut or substitute for a Phase 1 environmental site assessment because, performed according to ASTM protocol, there are many points where the screen leads directly to a full Phase 1 environmental site assessment.
The technical term for that time when a facility undergoes a detailed audit in which all phases of environmental compliance are investigated is “multimedia environmental compliance audit.” Put simply, it means the auditor’s investigation will include all areas for which the potential of contamination exists: soil, air, and occasionally, employee safety and health. The Tenant Environmental Compliance Audit examines not only the paper trail, but chronicles the actual daily practices to minute detail. It is a comprehensive audit process which is important in that it detects noncompliance with numerous and varied regulations, many of which impose heavy fines and cleanup requirements.
Is the property in compliance with all applicable environmental laws?
This is a basic point, but a critical issue. A defaulting borrower often tries to cut costs wherever it can, including costs related to environmental compliance. While the loan documents probably contain representations, warranties, covenants, and indemnities addressing environmental compliance, the value of such provisions is questionable with a defaulting borrower. For this reason, particularly with industrial properties, it is advisable for the lender to engage an environmental consultant pre-foreclosure and obtain a comprehensive environmental picture of the property. It is also a good idea to involve environmental counsel in these initial discussions.
Are there ongoing enforcement matters concerning the property?
If such matters exist, the lender should evaluate whether it will be responsible for resolving such matters post-foreclosure. The lender may want to consider meeting with governmental regulators pre-foreclosure to discuss the property and the lender’s plans for it. The regulatory agency may view foreclosure as a positive step if the lender is stepping forward to replace an insolvent borrower.
Is there a current Phase I Environmental Site Assessment (“Phase I”) of the property?
One of the reasons most purchasers require a current Phase I is that they want to qualify for the statutory defenses to CERCLA liability that require a Phase I. While lenders ordinarily are protected from liability by the secured creditor exemption, which does not require a Phase I, it is still a good idea to evaluate the current environmental situation at the property.
If there are buildings present on the property, do they contain asbestos-containing materials (ACMs)?
If ACMs are present and people are using the building, the lender may need to ensure that any ACMs (often found in, by way of example, insulation and floor tiles) are maintained in good condition. Ordinarily, this is done through an operations and maintenance (O&M) plan. If the lender has no information whatsoever regarding ACMs in the building, but the structure was built before 1980, the lender should consider undertaking a limited ACM survey to determine whether ACMs are present. Lead-based paint (LBP) may raise similar issues.
Is there unfinished construction on the property?
Storm water runoff that violates the CWA can give rise to significant civil and, in certain cases, criminal liability. If the answer to this question is “yes”, the lender will need to assess the situation very carefully. To the extent possible, the lender should refrain from foreclosing on a property where storm water “best management practices” (BMPs) are not in place. Depending upon the circumstances, it may even be appropriate to contact government regulators pre-foreclosure to discuss the situation.
Are there wetlands on the property?
Wetlands are protected under the CWA. Where the property owner has defaulted on it’s financing, there is a heightened risk that the owner may not be taking the necessary steps to protect wetlands on the property. If there are wetlands and unfinished construction on the property, this issue is particularly important. This same issue exists if there are endangered or threatened species or critical habitat on the property.
Are there underground storage tanks (USTs) on the property?
If there are active USTs on the property, the lender may assume ongoing compliance obligations after foreclosure. In certain situations, a lender might also have exposure related to releases from old, abandoned UST’s on the property. Certain states have lender liability safe-harbors for UST liability and the lender should coordinate with counsel to make sure it qualifies, where possible, for those safe-harbors. Although this article is primarily aimed at commercial/industrial foreclosures, it is worth nothing that foreclosures on residential properties, particularly in the northeast, can present unique environmental issues related to leaking home heating oil USTs.
Have environmental permits been issued for operations on the property?
If so, there may be notice/compliance obligations imposed upon the lender by virtue of the foreclosure. Additionally, if a permit is nearing expiration, the lender may be forced to take the lead in filing for a renewal of that permit.
Is there pending or threatened environmental litigation related to the property?
Depending upon the nature of such litigation, foreclosure could result in the lender being added as a defendant. In a worst case scenario, foreclosure could even make the lender the primary defendant.
Is there ongoing environmental monitoring/remediation at the site?
If so, a foreclosing lender may be obligated to continue such monitoring/remediation post-foreclosure. Needless to say, the cost of such activities can be significant.
Is hazardous waste generated or stored at the facility?
If so, the lender may be responsible for dealing with the disposal of such waste post-foreclosure. Improper disposal of hazardous waste can result in environmental liability. However, even proper disposal of hazardous waste can be costly and should be taken into account by the lender.
Is the lender aware of any reportable environmental issues?
Depending upon the circumstances, a property owner may be required to report certain issues (such as releases) to governmental authorities. Ordinarily, a lender does not have those obligations. However, a lender should be aware that foreclosure on the property arguably could trigger those obligations.
Utah Environmental Law Lawyer
When you need legal help with environmental law and foreclosure law in Utah, please call Ascent Law LLC for your free consultation (801) 676-5506. We want to help you.
8833 S. Redwood Road, Suite C
West Jordan, Utah
84088 United States
Telephone: (801) 676-5506
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