Detecting environmental risk: lenders should look out for contamination they may be held responsible for.
Lenders should look out for contamination they may be held responsible for.
In an all-out effort to pinpoint those responsible for the formation of hazardous waste sites, new government regulations are forcing mortgage lenders to manage environmental risks as never before. Arising from government attempts to control and clean up these sites, there are two primary dangers for modern lenders on industrial sites and similar properties. First, upon taking title at foreclosure, lenders may be held responsible for cleanup costs for contamination caused by the defaulting borrower or former lessees and owners. Second, upon bankruptcy of the borrower, lenders may lose the priority of their lien to that of the government for cleanup costs.
This article explains the foundations of these two risks and provides information that may be used to implement valuable risk management policies for lending institutions. It also discusses the valuable, albeit limited role that available insurance policies can play to further reduce risks.
Congress did not intend for the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA) nor its later amendment--the Superfund Amendments and Reauthorization Act of 1986 (SARA)--to be equitable legislation. Under strict liability provisions, seemingly innocent parties are often compelled to pay for cleanup of environmental contamination that they did not cause. Although faced with these inequalities, Congress also recognized that the Hazardous Substance Response Trust Fund ("Superfund") was insufficient to pay for treating or removing hazardous waste from all abandoned dump sites or from property with bankrupt owners. In some cases, the contaminated land has even escheated to state governments or has been willed to heirs. Neither can be held responsible for needed cleanup.
The primary purpose of CERCLA and SARA is to find "responsible parties" and have them pay for cleanup. The acts also enable individuals who have been harmed by the release of stored hazardous waste, such as pollution of groundwater, to recover damages.
In United States vs. Monsanto Co. (1988), the judge ruled, "Traditional elements of that culpability on which the site-owners rely simply are absent from the statute." In other words, the owners or other responsible parties can be liable without a clear personal breach of a statutory or common law duty. It is enough that they fall under the broad definition of responsible parties as defined by CERCLA and interpreted by the courts.
The following individuals or corporations are deemed responsible parties and as such are liable for cleanup and environmental damage from hazardous waste:
* The generators of the waste; * The transporters of it; * The owners or operators (lessees)
of the site where the waste is
treated or stored; * Previous owners or operators of the
site at the time disposal occurred.
CERCLA and SARA also contain civil and criminal penalties, separate from cleanup liability, for persons who discover the contamination, or release of waste from the site, and do not report it to federal or state authorities.
These penalties would extend beyond the defined responsible parties and apply real estate brokers, originating loan officers, or site engineers who may discover contaminated sites or hazardous conditions as part of a real estate transaction and do not alert public authorities.
If responsible parties can show that the environmental damage was caused entirely by someone else, such as a previous owner, they may escape liability. However, the courts have conditioned this "innocent purchaser or lessee" defense upon a thorough environmental audit prior to buying or leasing. If the title search or trial inspection yields any evidence of possible contamination, such as past ownership by a chromium plating company, the purchase or lease should be contingent upon a thorough inspection and report by an environmental engineering firm. The purchaser carries the burden of proof in establishing innocence.
Moreover, for lessors and lenders the various case decisions (e.g., United States v. Monsanto Co., 4th Cir. 1988) indicate that they must make occasional inspections of the property that have leased or acquired a security interest in. Only by establishing proof of diligent monitoring can these parties remain innocent.
The other recognized defenses under CERCLA include an act of God, such as the release of contaminated material caused by an earthquake or a hurricane and an act of war.
SARA also provides an exception for lenders who "may acquire title, without participating in the management of the site, and hold indicia of ownership primarily to protect their security interest." Courts have said that Congress intended the exemption only when the mortgagee becomes the holder by operation of law and not where the lender has willingly acquired full title. In other words, if title by law transfers to the lender between default and a foreclosure sale, the lender is not a responsible party.
Three leading federal court cases have defined four conditions that can trigger lender liability for cleanup costs for sites on which they hold a mortgage or similar security interest.
In United States vs. Mirable (1985), the secondary lien holder, American Bank and Trust Company, foreclosed upon default by the borrower. Four months after acquiring the property at the sheriff's sale American Bank assigned its bid to the Mirables. Mirables, found liable for cleanup of the site, had sought to bring the bank into the suit as a co-defendant based on American's status as a lienholder. The court ruled that although the bank personnel boarded up windows and changed locks at the plant, made inquiries into disposal costs of drums located on the property, and visited the property to show it to prospective purchasers prior to the assignment, these activities were only to protect American's security interest. Thus, the judge dismissed the bank from the suit.
However, the primary lien holder in this case was not so fortunate. The Mellon Bank (East) National Association, was held liable, like Mirables, for an undisclosed sum. Unlike American Bank, the Mellon Bank had participated in the daily operations of the borrower's business. A loan officer had come to the site frequently and insisted on certain manufacturing changes and reassignment of personnel. These actions were enough for the court to define the bank as a responsible party.
One year later in 1986, the district court in Maryland again ruled against a lender. In United States vs. Maryland Bank and Trust Company, evidence showed that, upon a forclosure, the bank had held title for three years before the government cleaned up the site and sought to recover its costs. Because it did not promptly seek to assign its interest acquired at the sheriff's sale, Maryland Bank was not allowed the same defense as American Bank. In early 1989, a Georgia federal court extended the Mirable ruling to include lender actions even when there is no foreclosure. In United States vs. Fleet Factors Corporation, the lender attained a bankruptcy court's permission to sell a defaulting borrower's inventory and equipment. While Fleet Factors did not take title to the site or assume any ownership interest, it did hire an auctioneer to sell the inventory and equipment. During the process of removing more than 400 leaking drums of hazardous waste to another site, the auctioneer caused environmental damage.
Fleet Factors was held liable along with the auctioneer for disposal of the removed drums and subsequent contamination. The court did not hold the corporation liable for cleanup costs on the plant site itself because it did not meet the responsible-party test.
Conditions creating liability
Review of these significant cases establishes four conditions that can create liability.
* The lender, by bidding the amount
of the loan, takes title to the
property without prompt reassignment. * The lender's personnel become
involved in day-to-day management of
the borrower's business, perhaps as
the result of a failed workout
program before the foreclosure. * The loan on the contaminated site
allows the lender to participate in
the earnings or equity of the
defaulting owner. * The lender creates further
contamination by actions designed to make
the property attractive and saleable.
Loss of lien status
The federal government may place a lien upon property to recover its cleanup costs. However, the lien ranks behind previously recorded real estate mortgages or deeds of trust. The danger to lenders is that, upon discovery of contamination and a probable default by the owner-borrower or lessor-borrower (ground lease), the lender may be backed into a position where it must abdicate its lienholder rights at the public sale.
More than likely, there will be few bidders other than the lienholder for contaminated property. The government may then take the site and attempt some later assignment.
Moreover, cleanup expenses take first priority over other existing debts for borrowers forced into bankruptcy. In 1986, the Supreme Court ruled in Midlantic National Bank vs. New Jersey Department of Environmental Protection that a Chapter 7 bankruptcy court does not have the power to authorize a trustee to abandon contaminated property "without formulating conditions to protect the public's health and safety." The court cleared the way for federal and state governments to compel the bankruptcy courts to spend estate money for cleanup and treat it as an administrative expense. This requirement would leave little of the estate to satisfy real estate liens; the administrative expense has priority.
Connecticut, Massachusetts, Maine and New Jersey have enacted "superlien statutes" that give priority to the states' cleanup outlays over previously recorded liens. Although the laws do not apply to residential development or would apply to undeveloped land purchased for residential development or nonresidential sites purchased for residential redevelopment.
Proponents justify superliens on the theory that the contaminated property is virtually worthless until it is cleaned up. A lender with a security interest in the land should not benefit when states spend public funds to finance the cleanup. However, no clear trend may yet be established toward additional superlien legislation among other states. Kansas, New York and Pennsylvania defeated superlien bills in 1988.
Once an environmental risk is identified, there are several practical ways to manage the situation. The easiest way is to avoid it. However, refusing to make loans on property that was once industrialized or farmed with heavy pesticides is not economically feasible. The innovative lender must seek alternative management methods.
Transferral of the risk may work in some cases. Mortgage provisions may require the borrowers to notify the lender of any change of use of the property, especially to a use that involves handling or storage of hazardous waste. Such a change of use should accelerate the loan. Additional hold-harmless provisions would also provide some protection. Yet, these precautions would not help when the innocent purchaser-borrower simply discovers the waste. The security for the loan may become worthless or the borrower may become bankrupt.
The lender can insist on insurance for environmental liability. Modern title insurance policies are carefully drafted to exclude any possibility of loss coverage, even in the case when a superlien takes priority; however, a lender's title policy does protect the lender if the title examiner overlooked an environmental lien recorded before the loan is made.
Environmental impairment liability (EIL) is the only property/casualty coverage today that allows lenders and borrowers to transfer some of the risk inherent in purchasing contaminated land. Yet, EIL covers only damages to third parties from releases of the hazardous waste, and does not cover injuries to the borrower's employees or independent contractors. Even more importantly, EIL insurance does not cover cleanup costs.
At the moment, only one company, National Union Fire Insurance Company of Pittsburgh is willing to write EIL insurance. The company is very careful in its underwriting practices and will not write a policy in excess of $15 million.
Moreover, it insists upon an environmental audit of the site, to be paid by the insured, before issuing the policy.
For all parties involved in the lending process, an environmental inspection or audit is the first step toward effective risk management. The audit is necessary for the borrower to qualify as an innocent purchaser, and provides the lender with vital information for an intelligent underwriting decision. The resulting report is a crucial component for the loan package if the loan is to be sold.
The inspection consists of two phases. Phase one uncovers information about actual or suspected past uses of the property. It entails assimilating information through documents, interviews, reports and site inspections. The title search should include a chain of title that contains not only names of the former owners but also descriptions of the normal operations associated with the owners.
A Phase one investigation should include the following:
* Prior ownership and use of the
property; * Materials used or stored at the site; * Waste treatment processes; * Wastes generated (past and
present) and their disposition; * Permits and other regulatory
requirements applicable to the
property and conditions affecting
transferability. * Compliance with permit
requirements, enforcement history, past
and/or outstanding violations and
their status or disposition and
regulatory investigations; * Compliance with recordkeeping,
monitoring, reporting requirements; * Upcoming changes to permits or
other regulatory conditions
applicable to the facility. * Complaints, oil spills, chemical
releases and similar incidents; * Presence and condition of
underground storage tanks and the
contents of such tanks; * Information about building
components (e.g., presence and condition
of materials containing asbestos,
contents of transformers and
capacitor that may contain polychlorinated
biphenyls ("PCBs"); * Past or current practices or
operations that may warrant close
scrutiny as possible sources of
contamination (e.g., fueling areas,
machine shops, vehicle
maintenance facilities, chemical storage,
abandoned buildings, waste
disposal areas and uncontrolled access
routes that may have resulted in
unauthorized dumping); * Evidence that may indicate
contamination or factors affecting the future
development of the property.
Examples include areas of disturbed
or discolored soil, evidence of
debris, construction rubble or other
waste materials on the surface,
blighted vegetation, filled-in or
highly eroded areas, streams,
marshes, ponds or other bodies of
water; * Status of the site with regard to
programs for protection of historic
resources, endangered species, and
other natural resources.
A Phase two investigation may not be necessary if the results of the previous one are favorable. To be prudent, however, lenders may require the further steps as a precaution. Phase two involves sampling and analysis of soil, groundwater, waste water, stored waste materials and building components. Because intricate lab analysis is necessary, the second-layer investigation may take a month or longer. Costs will vary with the turnaround time, the number of necessary analyses and sampling difficulty.
Phase two inspections should be done by experienced environmental engineers. Although a relatively young and growing profession, environmental engineering firms are available in nearly every metropolitan area.
Discovery of contamination creates a further legal obligation. The inspector must report the hazardous conditions to state or federal agencies if the owners or prospective purchasers do not file such a report. If no report is filed, all three face criminal and civil penalties.
Even if the loan is on single-family, residential property, originating mortgage bankers may face litigation from environmental damage. As discussed earlier, the land on which a housing subdivision is constructed can be polluted. In a current suit, Tanglewood East Homeowners vs. Charles-Thomas, Inc., owners for a subdivision are suing the developer, builders, a lending institution and the real estate agents that participated in the development. In this case, the owners incurred relocation and investigatory costs, and spent money to build dikes and trenches to contain hazardous substances resulting from former use of the land as a woodtreatment facility. The defendants maintain the subdivision is not a "facility," as defined by CERCLA. Recently, the Texas federal district court refused to dismiss any defendents from the case and is proceeding to hear arguments of merit. The decision in this federal circuit court case and in probable subsequent appeals should be followed with interest by lenders.
To effectively manage risk, originating lenders should have a copy of a developer's environmental inspection report or inquire about a developer's efforts to investigate for possible contamination. Any new development dependent upon groundwater should at least have available reports about priority of the water source.
Importantly, the loan originator should not recommend or require a particular environmental engineering firm because the lender does not want to share responsibility for a faulty report.
The cliche that says doomsday literature is never true does not apply to situations discussed in this article. Environmental risks are real. The case law about CERCLA or SARA and lender liability or loss is still developing. New cases can broaden or narrow lenders' risks and responsibilities. By maintaining professional awareness, lenders can respond to new obligations and dangers under environmental laws.
Jerry Ferguson is professor of real estate studies at Virginia Commonwealth University, Richmond, Virginia. He has written several books on real estate.
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|Author:||Ferguson, Jerry T.|
|Date:||May 1, 1990|
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