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Increased Loan Volume Leads Lenders to Revisit Environmental Best Practices

on Wednesday, 13 November 2013 in Banking Update

Although a lender’s risk of environmental liability is a consideration with any loan, the recent resurgence in commercial real estate and commercial and industrial lending after an extended lull over the last few years has caused some to place renewed emphasis on environmental compliance.

 

Environmental liabilities associated with the use or ownership of real property may arise from common law or state laws, although the primary source of cleanup liability for environmental contamination is the federal Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”). CERCLA imposes strict liability for cleanup and related response costs on “owners and operators” of properties and facilities giving rise to the contamination. Importantly to lenders, CERCLA excludes from the definition of “owner and operator” any lender that holds an interest in real property solely in connection with a security interest in the real property. Despite this secured creditor exclusion, there are two categories of risks lenders should consider associated with potential contamination of real property collateral.

 

The first type of risk is a lender’s potential failure to meet the secured creditor exclusion and being exposed to direct liability under CERCLA. The secured creditor exclusion does not apply if a lender is overly involved in the management of the property, especially with respect to environmental contamination, waste disposal or cleanup issues. These limitations do not preclude a lender from engaging in routine monitoring and inspecting or imposing loan covenants in regards to environmental matters, but a lender should avoid directly instructing a borrower (whether or not in default) with respect to environmental contamination.

 

The second type of environmental risk lenders should evaluate is the credit risk associated with its borrower’s exposure to potential removal or remediation action brought against a borrower under CERCLA. The costs of remediating real property can be quite substantial and may affect a borrower’s ability to meet its credit obligations. Lenders can mitigate this risk by requiring a borrower to take steps to establish an affirmative defense to liability under CERCLA.

 

As an “owner or operator,” a borrower can establish a defense against a CERCLA enforcement action if it can establish one of several “all appropriate inquiries” defenses. To establish each of the “all appropriate inquiries” defenses, a borrower must conduct a Phase I Environmental Site Assessment (ESA) in accordance with applicable standards. While conducting a Phase I ESA is not the only requirement for establishing such a defense, it is the most significant pre-acquisition requirement. If a borrower is refinancing already-owned real property—or in any event if a Phase I ESA is completed in connection with acquisition financing—a lender should review any pre-acquisition Phase I ESAs to ensure it complies with the applicable standards, and to evaluate whether potential contamination affects the value of real property collateral. If a lender requires a Phase I ESA to be directed to both the borrower and lender, the Phase I ESA may also establish the “all appropriate inquiries” defense for the lender, as a backstop to the secured creditor exclusion discussed above.

 

Taking ownership of real property through foreclosure also creates several issues a lender should evaluate. The secured creditor exclusion extends to a lender’s post-foreclosure ownership of contaminated property, but a secured creditor should exercise caution when foreclosing property that is expected to be contaminated. In order to avoid environmental liability, a lender foreclosing a mortgage or deed of trust must divest at the earliest practicable, commercially reasonable time, on commercially reasonable terms, taking into account market conditions and legal and regulatory requirements, in order to avoid becoming liable for cleanup as an “owner or operator” under CERCLA. Lenders should monitor real property collateral for potential environmental issues prior to default or foreclosure, and consider engaging in additional environmental due diligence prior to taking ownership of the property through foreclosure.

Ben M. Klocke

1700 Farnam Street | Suite 1500 | Omaha, NE 68102 | 402.344.0500

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