Lenders: Environmental Liability Risk in Real Estate Lending – Debunking Common Myths

Buyers, sellers, borrowers, and lenders frequently misperceive environmental liability risk in commercial real estate acquisitions and financings. These misperceptions make it difficult to identify, quantify and apportion environmental risk appropriately between parties to a transaction. The purpose of this Technical Brief is to define — and, more importantly, debunk — five common myths about environmental liability that frequently arise in today’s business transactions.

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MYTH 1: The buyer of a contaminated site is always liable.

A borrower looking to purchase contaminated property can avoid liability under the federal Superfund statute, provided they satisfy the bona fide prospective purchaser defense. This defense requires asset purchasers to conduct “all appropriate inquiry” into the property’s environmental condition prior to acquiring property and exercise “appropriate care” with respect to the property’s environmental condition. To qualify for the defense, the purchaser also must not be affiliated with any other party that is potentially liable for cleanup costs.

Under the U.S. Environmental Protection Agency’s “all appropriate inquiry” rule, the borrower must work with a qualified environmental professional to investigate the property (and its immediate vicinity) and prepare a report assessing the environmental conditions. The report —commonly referred to as a Phase I environmental site assessment — must include the environmental professional’s opinion as to whether the investigation indicates the possibility of a release or threatened release of hazardous substances.

To satisfy the “appropriate care” component of the defense, the purchaser must “take reasonable steps” to stop any continuing releases; prevent any threatened future release; and prevent or limit human, environmental, or natural resource exposure to any previously released hazardous substance. (Note that the U.S. EPA’s view of “reasonable steps” does not include the same types of contaminated soil or groundwater cleanup that a liable party would have to perform.)

Many states have comparable defenses under their state Superfund statutes, but the requirements can vary. For example, Michigan requires that purchasers collect, analyze and report the results of the analysis of subsurface samples in order to take advantage of the defense. Georgia has a program that does not exonerate purchasers from liability but instead limits their liability to implementing an agreed-upon cleanup plan. Once the purchaser completes the cleanup plan, it is shielded from further cleanup obligations with some qualifications.

MYTH 2: Leasing on a contaminated property always leads to lender liability.

In the early 1990s, the concern that lenders would become liable for contaminated property in which they held security interests crippled commercial lending in some business sectors. Congress has since created a safe harbor from federal cleanup liability for secured lenders. The secured creditor exemption has two parts.

Lenders administering security interests avoid environmental liability by not “participating in the management” of the facility. Undertaking responsibility for, and exercising decision-making control over, the facility’s environmental compliance, assuming day-to-day management of the facility’s environmental function, or taking control over substantially all of the non-environmental facility operations all constitute “participating in the management” and defeat the liability exemption.

But lenders can take a number of financial oversight measures and remain within the safe harbor from liability. Among other things, lenders can provide financial advice in an effort to mitigate, prevent, or cure a default or a diminution in the value of the collateral; restructure or renegotiate terms and conditions of the credit agreement or security interest; and monitor or enforce the terms and conditions of the credit agreement or security interest.

To maintain the liability exemption after foreclosing, a lender must not have “participated in the management” of the facility before foreclosing, and must seek to divest itself of the facility “at the earliest practicable, commercially reasonable time.” This does not mean that the foreclosing lender must sell or divest itself of the property at the earliest possible time. Market conditions and legal and regulatory requirements affect whether the lender’s conduct was commercially reasonable.

MYTH 3: A No Further Action letter rules out any future risk.

A state environmental agency determination that “no further remedial action” is required at a property may not rule out all potential risk. First, such determinations are typically qualified to allow the issuing agency to “re-open” the matter. Standard reasons for re-opening a past determination include the discovery of new information or changed circumstances that suggest the completed remedial activities do not sufficiently protect human health or the environment.

Second, state agency determinations that a cleanup is complete are often conditioned on site use; commercial or industrial site purposes can have a higher level of residual contamination than residential sites. State agencies often impose institutional controls to prevent human exposure to the residue: either proprietary controls such as restrictive covenants, easements, or other forms of deed restrictions, or governmental controls such as zoning, variances, and well-drilling prohibitions. Such controls obviously impede future use or development of a target site.

A common situation that is affecting acquisitions or financing on transactions today is the risk of vapor intrusion into buildings on the target site. The potential for vapors from subsurface contamination to intrude into buildings atop the site is a newly identified health risk. This health risk was frequently not evaluated when environmental regulators issued older, no-further-cleanup determinations. Now that they are aware of it, regulators may “reopen” their determinations with respect to properties previously deemed “clean.”

MYTH 4: Hazardous substance releases are the greatest liability.

Substantial environmental liability can arise from facility compliance issues, such as obtaining air emission and wastewater discharge permits, operating within the permit limits, and installing needed pollution control equipment. Depending on the nature of the business, the scope of facility compliance obligations can be substantial.

A facility that burns fossil fuels to generate power may confront substantial future capital expenditures to control air emissions. Even non-industrial, non-chemical intensive operations confront compliance obligations. For example, office buildings may have backup generators with fuel storage and air emission control obligations. Future development of a shopping center may be affected by storm water management and wetlands protection rules

MYTH 5: Asbestos always adds up to high removal costs.

There is no absolute obligation to remove building materials that contain asbestos. It is frequently possible to maintain asbestos-containing material that is in good shape so as to avoid its fibers becoming airborne and causing health hazards.

Asbestos was used abundantly in buildings until the 1970s, when certain asbestos-containing building materials were banned by the EPA. In non-friable form, asbestos does not pose much threat to humans. When asbestos is friable, the fibers are easily inhaled and can cause serious human health risk. Renovation and demolition activities may cause asbestos to become friable. Worker protection rules require employers and building owners to notify those who might be exposed to asbestos of the risk. If renovations and demolition are undertaken, specific rules apply to the removal and disposal of the material.

There are a number of important steps that lenders can take upfront to minimize their exposure to environmental liability starting with environmental due diligence. Making risk managers at your financial institution—and your borrowers—aware of these five common myths will help facilitate an efficient environmental due diligence process built around not only assessing a property’s potential environmental risk, but also managing any identified risks (e.g., vapor intrusion, asbestos, storm water management, etc.) to prevent liability or devaluation of collateral down the road.

NOTE TO SUBSCRIBERS:

EDR Insight is grateful to attorney Tom Mounteer for contributing this Technical Brief, which is the result of his 25 years of experience helping clients with their transactions and financings. Mr. Mounteer, an Environmental partner at Paul Hastings, is based in the firm’s Washington, D.C., office. He advises clients in all areas of environmental law. Chambers has ranked Mr. Mounteer among the leading environmental practitioners in Washington. His practice has particular emphases in the energy sector, financial disclosure of environmental liabilities, and the treatment of environmental liabilities in bankruptcy.
Mr. Mounteer routinely helps buyers and sellers, lenders and borrowers, and landlords and tenants identify, quantify, and apportion environmental liabilities that arise in business and real estate transactions. He oversees the investigation of site conditions, helps clients avail themselves of statutory defenses to liability, assists in quantifying potential liabilities, and negotiates and drafts contract terms relating to the sales and purchases, leases, and financings.