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EPA's final rule on lender liability.

In late April, the long wait was over for lenders seeking clarification of their exemption from toxic cleanup liability under Superfund.

The Environmental Protection Agency's (EPA's) long-awaited rule on lender liability under the Comprehensive Environmental Response Compensation and Liability Act, or CERCLA, was announced by President Bush and released by the White House on April 24, 1992. It was promulgated by publication in the Federal Register on April 29, 1992.

The final rule published in April differs significantly from the proposed rule that appeared in the Federal Register on June 24, 1991. It is accompanied by a lengthy preamble addressing the approximately 350 comments received by EPA on the proposed rule.

The final rule continues to offer substantial protections to lenders against liability for contamination they are innocent of causing. Many of the changes were made in response to comments from the lending industry suggesting improvements. While lenders will welcome it, the final rule is not a panacea. Lenders will need to be particularly conscious of avoiding preforeclosure activities that may trigger liability.

Although the final rule, like its predecessor, generally allows a lender to operate the business on a property following foreclosure (provided certain conditions are met), such operation is not allowed prior to foreclosure. A lender's pre-foreclosure servicing and workout activities should be carefully structured to avoid liability under the final rule. Lenders should revise their servicing and workout practices accordingly, and all those whose loans are serviced by others should revise their servicing agreements for conformity with the final rule.

Notwithstanding the lesser likelihood of a lender's being directly liable for cleanup costs if it forecloses, the decision whether or not to foreclose will remain important in the environmental context because lenders will still have the business risk that the property will be unmarketable due to contamination and because of risks of liability under state laws.

It is anticipated that the rule will be challenged in court very soon by those who would like it to be invalidated. (A provision of CERCLA essentially requires challenges to CERCLA regulations to be filed within 90 days of promulgation in the Circuit Court for the District of Columbia.) Because the rule offers substantial protections to lenders, they should be prepared to defend the rule in any such litigation (for example, by amicus briefs or intervention).

Both the final rule and the proposed rule interpret the secured creditor exemption to liability under CERCLA or Superfund. CERCLA imposes a harsh scheme of strict, as well as joint and several, liability on several classes of potentially responsible parties, including current owners and operators of properties, and owners and operators at the time of release of a hazardous substance, even if those owners and operators are innocent of causing contamination.

The secured creditor exemption provides an exemption to owner/operator liability for those "who, without participating in the management of a vessel or facility, hold indicia of ownership primarily to protect a security interest." This exemption has been eroded by the courts, notably by U.S. v. Fleet Factors (901 F.2d 1550 [11th Cir. 1990]).

The EPA final rule addresses the specific activities of the holder of a security interest that will and will not trigger liability as "participation in management," as well as who is entitled to take advantage of the exemption.

Participation in management

The final rule continues to clarify that participation in management does not mean "the mere capacity, or ability to influence, or the unexercised right to control facility operations." Thus the final rule overturns the onerous dictum in U.S. v. Fleet Factors to the effect that the mere, unexercised capacity to influence the disposal of hazardous substances could trigger CERCLA liability.

Test for pre-foreclosure participation

in management

Like the proposed rule, the final rule has a two-pronged test for what constitutes participation in management "while the borrower is still in possession of the vessel or facility." Both prongs of the test differ materially from the proposed rule.

First Prong: Under the final rule, the first prong of the test for participation in management is that the holder:

* exercises decision-making control over the borrower's environmental compliance, such that the holder has undertaken responsibility for the borrower's hazardous substance handling or disposal practices.

While the first prong of the test still relates to exercising control over the borrower's environmental compliance, the major change is that a lender can be liable even if its actions do not result in a release or threatened release. Thus, the threshold for a lender's triggering participation in management has been considerably lowered, and lenders can more easily lose the protection of the secured creditor exemption.

Second Prong: Under the final rule, the second prong of the test for participation in management is that the holder:

* exercises control at a level comparable to that of a manager of the borrower's enterprise, such that the holder has assumed or manifested responsibility for the overall management of the enterprise encompassing the day-to-day decision-making with respect to (A) environmental compliance or (B) all, or substantially all, of the operational (as opposed to financial or administrative) aspects of the enterprise other than environmental compliance.

Operational aspects of the enterprice include functions such as those of facility or plant manager, operations manager, chief operating officer or chief executive officer. Financial or administrative aspects include functions such as those of credit manager, accounts payable/receivable manager, personnel manager, controller, chief financial officer, or similar functions.

The second prong of the test had previously related only to control over environmental compliance responsibilities of the borrower, but it has now been expanded to refer to as test for participation in management similar to that in U.S. v. Mirabile (15 ELR 20994 [E.D.Pa. 1985]). The mirabile decision had allowed participation in the borrower's financial affairs but restricted some involvement in the borrower's operational affairs. Clearly, the second prong of EPA's test allows a lender free reign in financial and administrative matters. Operational aspects, while restricted, are still subject to the general language that the lender must take "responsibility for the overall management of the enterprise encompassing the day-to-day decision-making of the enterprise."

It is important to note the addition of the word "overall" to modify the word "management" in this test. This critically important change means that the security holder must have assumed primary (if not nearly all) management with regard to the specified areas. Thus, a lender is not likely to trigger liability by an isolated act and presumably may make occasional recommendations to the borrower about environmental matters and operational matters.

Changes to this second prong of the test were made, at least in part, to address the concern that a lender might assume nearly total control of the borrower's operations, artificially carving out only environmental compliance matters in order to avoid liability.

The bottom line of this two-pronged test is that a lender should be careful not to take control over either the borrower's environmental compliance or hazardous substance handling or disposal practices (even if the lender's actions do not result in a release of a hazardous substance); or substantially all of the operational management of the borrower's enterprise, other than environmental compliance, although involvement in financial and administrative aspects is allowed.

The final rule continues to state clearly that no act or omission prior to loan origination will trigger liability, including conducting or requiring an environmental inspection, requiring cleanup (at any time, before or after origination), and requiring compliance with any applicable law or regulation (not just environmental laws).

Policing and workout activities

The final rule, like the proposed rule, lists a number of servicing and workout activities that do not constitute participation in management. Nevertheless, the two-pronged test of what does constitute participation in management, is of critical importance because of troubling provisos in the sections governing policing of the loan and workouts. Introductory sentences apparently first sanction the specified activities, but then state that the activities remain within the exemption only provided that the general, two-pronged test for participation in management is met. Thus, there is a risk that all of the language regarding what is not participation in management will be interpreted as unprotective of lenders. Language in the preamble may help offset this risk, but the buttom line is that lenders must be careful not to violate the two-pronged test in either servicing or workout situations.

Subject to the foregoing proviso, the final rule allows policing (loan administration or servicing) acivities including: requiring the borrower to comply with any (not just environmental) laws, regulations and rules; securing and exercising authority to monitor and inspect the property or the borrower's business or financial condition; and taking other actions to adequately police the loan and enforce borrower obligations.

Subject again to the earlier mentioned proviso, allowed workout activities have been expanded to allow cure or mitigation (in addition to prevention) of default and to allow preserving (in addition to preventing diminution of) the value of the property. A lender may: restructure or renegotiate the terms of the loan; require payment of additional interest or rent (presumably for lease financing transactions); exercise forbearance: require or exercise rights pursuant to an assignment of rents (or other amounts); require or exercise rights pursuant to an escrow agreement pertaining to amounts (for example, rent) owing to the borrower; provide specific or general financial or other advice, suggestions, counseling or guidance, and exercise any right or remedy the holder is entitled to by law or under promises from the borrower.


While a lender's activities prior to foreclosure are restricted by the two-pronged test for participation in management, a lender is allowed far more latitude following foreclosure - including actually conducting operations on the property - provided that the lender did not participate in management prior to foreclosure and is diligently seeking to dispose of the property.

It is important to note that foreclosure is broadly defined to include when a lender obtains possession, as well as title to, the property securing the loan, which presumably will offer the post-foreclosure protections to lenders who are mortgagees in possession. (A new provision applying to policing and workouts clarifies that policing and workout activities cover and include all activities up to foreclosure and its equivalents.)

The term "foreclosure and its equivalents" is defined to include purchase at a foreclosure sale, acquisition or assignment of title in lieu of foreclosure, acquisition of a right to title, an agreement in satisfaction of the obligation, termination of a lease or other repossession (presumably to accommodate lease financing transactions), and "any other formal or informal manner... by which the (security) holder acquires title to or possession of the secured property."

The final rule provides that, after foreclosure, indicia of ownership continue to be maintained primarily as protection for a security interest - and thus continue to be eligible for the exemption - only if the holder seeks to dispose of the property "in a reasonably expeditious manner, using whatever commercially reasonable means are relevant or appropriate with respect to the vessel or facility, taking all facts and circumstances into consideration."

While the proposed rule had required prompt efforts to dispose of the foreclosed property, a lender was required to demonstrate those efforts in only one manner: within 12 months following foreclosure, the lender had to list the property with a broker, dealer or agent who deals with the type of property in question and begin advertising the property, on at least a monthly basis, in one of several broadly specified types of publications. Comments froim the lending industry had noted that there are often more appropriate means of disposing of properties than by listing and advertising them (for example, selling a package of properties may be the only practical means by which an undesirable property may be disposed of.)

The final rule is a significant improvement over the proposed rule in that the listing and advertising requirements are only one of the means by which the lender may establish that it is seeking to dispose of the property in a reasonably expeditious manner.

Moreover, the final rule has modified the 12-month period. It now begins to run not from the date of foreclosure, but "from the time that the holder acquires marketable title," and it imposes a new requirement that the holder act diligently to acquire marketable title.

Some had commented on the proposed rule that under certain circumstances a lender would have been unable to meet the requirement of showing it was seeking to dispose of the property because it would have had to advertise and list the property when it lacked clear title to convey (for example, because of legally imposed redemption periods or because the Durrett rule may overturn a foreclosure sale within one year of a bankruptcy filing as a fraudulent conveyance). In these circumstances, there are no actions a lender can take to diligently pursue iriarketable title. The final rule allows a lender to delay disposition until such periods have elapsed without losing the exemption.

Although the listing and advertising provision is no longer required, there may well be instances when lenders will want to avail themselves of this option. It provides a bright line test by which a lender can inarguably show that it is seeking to dispose of the property. Lenders who elect to use this option should note one important change: under the final rule, the reference to "begin" advertising within the 12-month period has been deleted; it is now ambiguous whether the advertising must begin within the 12-month period or must take place in all of those 12 months.

As in the proposed rule, the final rule allows the lender to sell, liquidate and wind up operations on the property. The final rule also allows a lender to "maintain business activities ... and take measures to preserve, protect or prepare the secured asset prior to sale or other disposition."

Fair consideration

The final rule provides that a lender may not outbid, reject or fail to act on an offer of fair consideration for the property securing the loan; doing so "establishes that the ownership indicia in the secured property are not held primarily to protect the security interest, unless the holder is required, in order to avoid liability under federal or state law, to make a higher bid, to obtain a higher offer, or to seek or obtain an offer in a different manner."

This provision replaces two similar provisions in the proposed rule: one governing outbidding or refusing bids of fair consideration at the foreclosure sale, and another governing rejecting or failing to act on offers of fair consideration following foreclosure. This provision in the final rule responds to comments that in some instances a lender is required to obtain or to seek to obtain an offer in excess of what the rule defines as fair consideration.

The term "fair consideration" has been defined more precisely in the final rule than it was in the proposed rule, although both rules define this term so as to allow a lender to recoup what would be its losses in a property, but no more than this amount. Neither the proposed rule or final rule defines fair consideration in terms of fair market value of the property, presumably because a major principle of the rule is that a lender is not holding the property for investment, but as security for a loan or obligation; if a lender tries to recoup more than its losses, it is demonstrating that it is holding the property for investment purposes.

The final rule defines fair consideration as "the value of the security interest." This term is an amount at least equal to the outstanding principal owed to the lender, plus unpaid interest and rent (presumably for lease financing transactions), plus all reasonable and necessary costs incurred by the lender (including costs incident to workout, foreclosure and post-foreclosure activities, such as preparing the property for sale), less any amounts received by the lender.

The final rule also explicitly addresses fair consideration in terms of holders of senior and junior security interests. Fair consideration for a holder of a junior security interest includes the value of all the outstanding senior security interests, plus the value of the security interest held by the junior holder.

Written bona ride offer

The final rule provides significant improvements in the types of offers that must be responded to or accepted. A holder may not outbid, reject or fail to act upon within 90 days of receipt of an offer of fair consideration that is "a written, bona fide, firm offer of fair consideration for the property received at any time after six months following foreclosure." The term written, bona fide, firm offer means "a legally enforceable, commercially reasonable, cash offer, solely for the foreclosed vessel or facility, including all material terms of the transaction, from a ready, willing and able purchaser who demonstrates to the holder's satisfaction the ability to perform."

The proposed rule did not specify that the offer must be for cash, thus opening up the possibility that a lender would have to finance the transaction. The proposed rule also did not require that the offer be "commercially reasonable," thus opening up the possibility that the lender would have to accept unreasonable terms or conditions (for example, unreasonable warranties or indemnifications). And the proposed rule did not specify that the offer be solely for the foreclosed vessel or facility, thus opening up the possibility that a lender would have to accept an offer for the subject property even though it may not be satisfactory with regard to other properties offered in a package by the lender.

The six-month period is measured from acquisition of marketable title after the expiration of a redemption or waiting period, (as in measuring the 12-month period for listing and advertising the property following foreclosure).

Protection for CERCLA Good


Several provisions in the final rule clearly sanction actions by the holder to address contamination whether before or after foreclosure. Without a provision sanctioning such activities, courts and lenders could easily have been confused about whether such actions might be considered sufficient participation in management to void the exemption, particularly under the pre-foreclosure two-pronged test.

The language sanctioning such activities specifically sanctions response actions taken under section 107 (d) (1) of CERCLA, which has been called the Good Samaritan provision of CERCLA because it relieves persons from CERCLA liability (although not for their own negligence) when they are acting to clean up a property pursuant to the National Contingency Plan or at the direction of an on-scene coordinator.

Who is protected by the rule

The statutory language of the secured creditor exemption allows those who "hold indicia of ownership primarily to protect a security interest" to take advantage of the secured creditor exemption. The final rule continues to emphasize that the interest must be held not for investment purposes but primarily to protect a security interest.

The final rule addresses separately the terms "indicia of ownership," "holders of indicia of ownership," and "primarily to protect a security interest." In addition, those not specifically covered are eligible if they meet generic definitions of the three terms. The term "holder" is used throughout the final rule to refer to the person who is eligible for the exemption.

Reading these sections together, those who are eligible for the exemption include those who hold mortgages, deeds of trust, liens, assignments, pledges and legal or equitable title in real and personal property obtained pursuant to foreclosure and its equivalents. They also include sureties, guarantors, successors in interest to holders of security interests and subsequent purchasers of security interests in the secondary market. The final rule has made a number of changes clarifying that lease-financing transactions are specifically covered.

The proposed rule's list of examples of eligible indicia of ownership included "title acquired incident to foreclosure and its equivalents." On the other hand, the final rule's list of examples ends with "or their equivalents," thus extending the concept of equivalence to all of the examples named, not just foreclosure.

A critical distinction has been made in citing the lists of examples of indicia of ownership and security interests eligible for the exemption. The proposed rule had provided that the terms may include the examples, whereas in the final rule the terms include the examples. Thus the cited examples are eligible for the exemption (assuming the tests for participation in management are met) rather than ineligible pursuant to some unspecified or vague criteria.

A new sentence was added to clarify that a person is not required to hold title or a security interest in order to maintain indicia of ownership. Presumably this change was made, at least in part, to clarify that the rule applies in states where lenders hold a lien or other encumbrance to property securing a loan during the term of the loan (lien theory states), as well as in states where lenders hold actual title to property securing a loan during the term of the loan (title theory states). The preamble also clearly states that the final rule is intended to apply equally in lien theory and title theory states.

A significant addition is that receivers or other persons who act on behalf of, or for the benefit of a security holder are now specifically eligible for the exemption. Lenders had been concerned that receivers might not qualify for the exemption when they are officers of the court rather than agents of the lender and might not be eligible as a successor to a lender. In workout and foreclosure situations, in some states, it is only through receivers that lenders may effectively exercise their remedies upon borrower default.

Sale and lease-backs, conditional sales, installment sales, trust receipt transactions, certain assignments, factoring agreements, accounts receivable financing arrangements and consignments continue to be named as those transactions that may create eligible security interests. However, the final rule substitutes a different test to make a determination in these and other unclear cases: these transactions are eligible if they are "an interest in a vessel or facility (created or established) for the purpose of securing a loan or other obligation," which is the general definition of an eligible security interest. Equity kickers and shared appreciation mortgages are not mentioned, but presumably they will be covered if they meet the generic definitions of terms.

Miscellaneous issues

Many private parties sue lenders under the two CERCLA provisions authorizing private party suits. EPA has made an effort to have the final rule bind private parties by making this rule an amendment to the National Contingency Plan. It would eliminate a serious threat to lenders to have third parties, in addition to the federal government, bound by the rule. Nevertheless, it is expected that the rule will be challenged in court shortly, and it remains to be determined whether this provision will be enforced.

The proposed rule clearly put the burden of proof on the party opposing a person claiming the secured creditor exemption. Courts would probably not have enforced this provision, and it has been dropped. Thus, courts will impose the burden of proving eligibility for the secured creditor exemption on those who claim it (e.g., lenders).

Some interested parties were concerned about a statement in the preamble to the proposed rule to the effect that EPA reserved the right to sue any lender who may have been unjustly enriched by a government-financed cleanup. They were afraid that this statement might allow a CERCLA lien for government cleanup costs to be interpreted as a superlien, a lien taking priority over existing liens. But the preamble to the final rule puts this concern to rest by a clear statement that a CERCLA lien is not a superlien.

Some people confuse the secured creditor exemption to CERCLA liability with the innocent landowner defense to CERCLA liability. The innocent landowner defense requires a party to conduct "all appropriate inquiry into the previous ownership and uses of the property consistent with good commercial or customary practice." Many lenders who wish to take advantage of the innocent landowner defense do require or conduct an environmental assessment of a commercial real estate property securing a loan in order to meet this appropriate inquiry standard. On the other hand, environmental assessments are irrelevant to the secured creditor exemption under existing law. Nothing on the face of the statute or in legislative history indicates that a lender needs to conduct or require an environmental assessment in order to obtain the secured creditor exemption, and EPA's rule does not require a lender to do so.

When lenders may not be protected

by the rule

In addition to alternative lending transactions and private party suits, (previously addressed) there are other situations when lenders are not or may not be protected by the final rule.

A variation on a provision that appeared only in the preamble to the proposed rule is now in the text of the final rule. The final rule explicitly provides that if the security holder does not participate in management prior to foreclosure and complies with the postforeclosure provisions of the rule, during periods following foreclosure, the security holder can only be held liable under the provisions of CERCLA imposing liability on those who arrange for disposal, treatment or transportation of hazardous substances ("arranger liability," 42 USC 9607[a][3]) and on those who accept hazardous substances for transportation to a disposal facility or site ("transporter liability," 42 USC 9607[a][4]).

Although the final rule is effective upon publication in the Federal Register, it is uncertain whether the final rule will govern proceedings in progress. For practical purposes, this uncertainty is relevant primarily to private party actions because the rule will clearly govern EPA's enforcement actions.

The final rule, like the proposed rule, does not address trustees or other fiduciaries. However, the preamble to the final rule states that EPA does not believe that a trustee is personally liable under CERCLA merely because it holds legal title to property, although the assets of a trust generally are available for cleaning up property held in trust.

Unsecured creditors are not covered by the rule.

The final rule covers liability only under CERCLA. Many states have laws similar to CERCLA that are not covered by the rule. Although some states have enacted legislation protective of lenders, others are likely to continue to pursue lenders. The federal Resource Conservation and Recovery Act (RCRA) imposes strict liability on parties and has a provision similar to the secured creditor exemption in Subtitle I governing underground storage tanks, but the final rule does not address liability under RCRA or other federal laws. In the preamble, EPA reports that it has initiated work on regulations relevant to the secured creditor exemption under Subtitle I of RCRA.

Because fiduciaries unsecured creditors, other federal laws, and state laws fall outside the language of the secured creditor exemption, EPA has valid reasons for not addressing them in this rule. In summary, the rule is extremely helpful to lenders. Although they cannot be oblivious to its test for participation in management, with a reasonable amount of care they can stay on the safe side of the test for participation in management and retain the secured creditor exemption to CERCLA liability. Because the rule is so helpful to lenders, they have every incentive to defend the rule when it is challenged in court. They should be preparing to do so because challenges must be filed by the end of July 1992.
COPYRIGHT 1992 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
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Title Annotation:Environmental Protection Agency
Author:Hathaway, Margaret V.
Publication:Mortgage Banking
Date:Jul 1, 1992
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