Statement by Oliver Ireland, Associate General Counsel, Legal Division, Board of Governors of the Federal Reserve System.

Statement by Oliver Ireland, Associate General Counsel, Legal Division, Board of Governors of the Federal Reserve System, before the Subcommittee on Policy Research and Insurance of the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, July 10, 1991

I would like to thank you for the opportunity to discuss the issues of lender liability under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA). The issues presented in this legislation are complex, and I commend the committee for undertaking to explore them fully at this time.

As an initial matter, we strongly support the purposes of CERCLA. We all wish to live in a clean and healthy environment; however, the costs of achieving this goal are substantial. The Environmental Protection Agency has estimated that the cleanup of the 1,200 priority sites alone may exceed $30 billion. The General Accounting Office has estimated that as many as 425,000 sites may need investigation and possibly cleanup.

In light of these potential costs, we have become concerned over the effect of recent court interpretations of CERCLA that have held lenders liable for the cost of the cleanup of hazardous substances found on a borrower's property. Despite an exemption in CERCLA designed to shield lenders from CERCLA liability, these decisions, in effect, place lenders in the role of policing the hazardous substance disposal activities of their borrowers. Lenders are often ill equipped to perform this function, and imposition of unlimited liability can be expected to reduce their willingness to provide credit to prospective borrowers in any business or area in which there is a risk of CERCLA liability. A reduction in the availability of credit threatens the viability of these businesses and their ability to contribute to the cleanup of the environment. Consequently, we believe that the imposition of cleanup liability on lenders is counterproductive to long-term environmental goals and is contributing to an unnecessary and unwarranted constriction of credit availability to a wide range of otherwise creditworthy borrowers.

Under CERCLA, the owner or operator of a property may be held liable for the entire cost of cleaning up hazardous substances found on a site, regardless of whether the owner or operator is responsible for the release of the hazardous substance. By its terms, CERCLA generally excludes secured lenders from this liability; however, recent court decisions have largely eroded the protection furnished by this exclusion. Courts have imposed lender liability under CERCLA when a lender secured by property forecloses on property or has "participated in the management" of its borrower by virtue of the rights reserved by the lender under its lending and security agreements with the borrower. With the average projected cost of remedying contamination at sites on the National Priority List climbing to more than $25 million, liability in CERCLA cases may far exceed the amount of the lender's original loan.

Because of the erosion of the secured lender exemption, lenders to borrowers in businesses that use or produce hazardous substances are faced with a dilemma. Lenders can actively attempt to police hazardous substance disposal by their borrowers, risking being found to have "participated in the management" of the borrower and therefore liable for potential cleanup costs, or they can ignore the borrower's activities and risk nonpayment of the loan. Further, these court decisions may discourage even normal loan collection practices out of concern that they will be found to constitute management.

Lenders already have adequate incentives to encourage their borrowers to engage in environmentally safe practices so that these borrowers will avoid CERCLA liability. However, lenders do not generally have the technical expertise to police the environmental aspects of a borrower's operations. Covenants in borrowing agreements that give lenders a voice in their borrower's activities are designed to ensure that the borrower acts prudently in financial matters and places a high priority on the repayment of the debt not to permit the lender to substitute its judgment for the borrower's in technical aspects of the borrower's business.

Imposing affirmative liability for environmental cleanup costs on lenders because of the exercise of such covenants is likely to do little to prevent the pollution of the environment but is likely to interfere with the availability of credit to even prudent businesses that use hazardous substances, such as farmers, dry cleaners, service stations, and chemical and fertilizer producers. Credit is a necessity for the operation of commercial enterprises. Lenders, already reluctant to extend credit to borrowers that are subject to a high risk of CERCLA liability, will only be deterred further by the prospect of affirmative lender liability under CERCLA. Increased lender reluctance to provide funds to industries or areas that present a risk of CERCLA liability is likely to have a significant adverse effect on these industries or areas.

Lack of credit in these cases may also frustrate environmental interests. Companies that are unable to continue operating because they cannot obtain credit will not be able to make any contribution to the environmental cleanup costs. Consequently, the current thrust of court decisions imposing lender liability under CERCLA may actually frustrate the environmental goals of CERCLA and increase the cleanup costs that must be borne by the government.

While the Board does not have comprehensive data on lender losses because of CERCLA liability to date, clearly significant losses have already occurred. More important to the future is that data from the Federal Reserve Banks suggest that CERCLA liability is, in fact, affecting the availability of credit. Commercial banks are developing environmental guidelines that often indicate that the lender should decline to make loans collateralized by real property when past uses may have resulted in contamination of the property or to make loans to businesses that may use or produce hazardous substances in their operations. In some cases it appears that banks are declining to make loans regardless of the safety of a borrower's handling of hazardous substances.

In addition, banks are examining property carefully before they foreclose on it and are sometimes walking away from their collateral to avoid environmental liability. This problem appears to be widespread and is not confined to industrial areas of the country or to particular types of businesses. Virtually every Federal Reserve Bank reported instances in which lenders had walked away from collateral, even when the collateral was the only source of repayment for the loan. The experience of walking away from collateral to avoid CERCLA liability is likely to cause lenders to become increasingly cautious about loans to many businesses or areas, even if no actual liability has been incurred under CERCLA.

In carrying out its examination and supervisory activities, the Federal Reserve expects banking organizations to have policies and procedures in place to monitor and control the risks to which they are exposed. However, banks have experienced difficulty in determining the appropriate protective practices to minimize the potential for CERCLA liability. Lending institutions are at risk for hazardous waste liability whether they have ignored hazardous waste issues altogether or have actively attempted to monitor the safety of their borrowers' operations. The Board currently is developing guidelines for bank examiners to follow in determining whether a lending institution has adopted appropriate procedures and safeguards to recognize potential hazardous substance problems. Unfortunately, given the current state of the law, there is no clear guidance that we can provide as to how an institution can extend credit and still avoid liability.

Besides private-sector liability, CERCLA raises significant issues concerning the funding of government operations. Many lending institutions that are potentially subject to CERCLA liability are federally insured through the bank and thrift insurance funds. Unlimited liability under CERCLA poses a potential threat to the capital and solvency of these institutions, and in some cases could result in the costs of hazardous substance removal being borne by the bank and thrift insurance funds. We understand that the Federal Deposit Insurance Corporation (FDIC) has already incurred losses as a result of CERCLA.

Further, many agencies and instrumentalities of the federal government, such as Federal Reserve Banks, Federal Home Loan Banks, the Farm Credit System, and the Small Business Administration, are also lenders. Lender liability presents a threat to the ability of these organizations to carry out the missions assigned to them by the Congress. The Federal Reserve Banks fulfill important functions in providing adjustment credit and acting as a lender of las resort for depository institutions. In acting a lender of last resort, a Federal Reserve Ban may advance funds to a depository institution collateralized by the institution's loans, which may, in turn, be secured by real property Should the institution fail, the FDIC, as receiver, would likely acquire the loans from th Reserve Bank and would be left holding th loans. In these cases, the FDIC would b exposed to lender liability to the same extent a the original lender. If the FDIC chose not t acquire the loans, however, the Reserve Ban would be subject to this exposure.

It is not appropriate to shift the risks an expenses of environmental cleanup costs from the funds allocated by the Congress for this purpose to the bank and thrift insurance funds or to governmental instrumentalities such as the Federal Reserve Banks. Federal agencies and instrumentalities have been charged by the Congress with particular responsibilities. Their funds are intended to be used to fulfill these responsibilities, not to cover the costs of hazardous substance removal.

The Environmental Protection Agency has proposed rules that are intended to clarify the provisions of CERCLA relating to both private and public lenders. The proposed rules interpret the secured lender exception to permit a range of activities, including taking title to the property following foreclosure, that a lender may undertake without being considered an owner under CERCLA. The interpretation of the secured lender exemption would apply to both public and private lenders. EPA's proposal also attempts to address the concerns of governmental lenders by interpreting the provisions of the "innocent landowner" defense to apply to government entities that acquired property through their activities as lenders, conservators, or receivers. To use this defense, the governmental lender would also have to demonstrate that the contamination was caused by a third party with which it had no contractual relationship and that it had exercised due care and taken precautions against the acts of third parties.

We commend the Environmental Protection Agency for its efforts to provide regulations to clarify the secured lender exemption. Its efforts, however, are necessarily limited by the current statutory provisions, which may not provide sufficient protection, particularly for governmental lenders. For example, the EPA regulations do not expressly address the warranties that governmental entities are required to make under CERCLA, and the ability of the EPA to provide a broad exclusion from the warranty provisions for governmental entities such as the FDIC or the Resolution Trust Corporation is unclear. EPA regulations also cannot provide governmental lenders with any protection from liability under state environmental statutes. Additionally, there may be significant delays before the final rule can be promulgated and any judicial determinations as to its application made. We believe that greater certainty and protection for both public and private-sector lenders will be provided by statutory amendments.

In closing, it is in the interests of the financial and environmental communities to find a balanced solution to the lender liability issue. If this issue is not resolved, we risk a reduction in the availability of credit to any industry, area, or borrower that appears to present a risk of liability for hazardous substance removal. We also risk imposing additional costs on the bank and thrift insurance funds to pay for environmental cleanup costs that would otherwise be met from the funds allocated by the Congress for that purpose. In light of these considerations, we believe that the environmental goals of CERCLA will be furthered rather than hampered by federal legislation.