Avoiding the Quagmire

By Clarke, Thomas H., Jr. | Mortgage Banking, July 1995 | Go to article overview
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Avoiding the Quagmire

Clarke, Thomas H., Jr., Mortgage Banking

There are several steps lenders can take to avoid the black hole of liability for cleaning up contaminated property.

DURING THE LAST DECADE, FINANCIAL INSTITUTIONS have faced a growing problem from loans involving contaminated commercial real estate. Even when due care and abundant caution are taken, financial institutions may find themselves either holding contaminated property with little or no net worth, or without recourse for a loan default because the collateral is contaminated.

The presence of contamination raises issues of the lender's liability and questions about the lender's obligations and opportunities with regard to the property. The so-called lender liability rule until recently provided a measure of protection for a financial institution by insulating it from some liability when it foreclosed upon contaminated commercial property. But that rule was invalidated by the U.S. Court of Appeals for the D.C. Circuit in Kelly v. EPA. Even before the appeals court ruling, the rule only provided protection from a small portion of potential environmental liability.

Given these facts, lenders seeking to minimize their exposure to environmental problems must take a new tack. They must understand their exposure under the applicable state and federal statutes and common law, as well as plan and implement a program to minimize that exposure at each juncture of the process of loan application, issuance and repayment.

This article examines options for addressing these issues, in particular:

* Screening commercial property pledged as loan collateral.

* Offering practical steps for ensuring viability of collateral during the life of a loan.

* Revealing liability exposure as well as reporting and cleanup obligations of lenders obtaining title to contaminated property.

* Obtaining reimbursement for cleanup costs and shifting cleanup responsibilities to those entities that caused the contaminated condition.

* Structuring deals to allow for lease or resale of contaminated commercial property obtained in foreclosure.

No strategy can guarantee that a lender will avoid ownership of contaminated property. But while the words "hazardous waste" and "toxics" tend to evoke visceral fear and anxiety, in the real world environmental matters are rarely disasters of epic proportion. Taken together, these strategies can severely curtail a lender's exposure and maximize its opportunities when contaminated collateral is present.

Avoiding contamination from the outset

A lender's fondest hope is that it will not wind up with contaminated collateral in the first place. To achieve this outcome a lender needs an integrated strategy of preloan analysis aimed at ensuring that collateral is uncontaminated at the time the loan is made, coupled with ongoing monitoring of activities at the site after the loan is made to ensure that the property remains uncontaminated during the repayment period.

Preloan analysis is another term for due diligence directed at the property, not the borrower. Frequently, a so-called Phase-1 site assessment is made. A Phase-1 study is not a standardized review; its components will vary depending on the consulting firm conducting the study and the scope authorized by the client. As a rough rule of thumb, a Phase 1 involves a walk-through of the site; a review of records held by various federal, state and local agencies; and, sometimes, a review of aerial photographs.

The rationale for a Phase 1 is that it acts like a screening device, bringing to the forefront readily observable indicators of environmental problems. For example, local building permits may indicate that underground tanks were installed, aerial photos may show that a site was once a manufacturing plant, or a walk-through may find oily stains indicating possible releases or disposals of substances of environmental concern.

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