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Emerging from uncertainty.

Emerging from Uncertainty

With the release of a proposed rule clarifying the Secured Creditor Exemption under Superfund, lenders can enjoy some new-found relief from liability for toxic cleanup costs.

LENDER LIABILITY for environmental risk has been one of the most interesting, long-playing and inconclusive legal sagas of the 1980s and early 1990s. With the passage of the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA, or "Superfund"), soon followed by a host of additional federal, state and local laws, the liability of the lending community for the environmental sins of its borrowers was "in play."

It's not that Congress or the various legislative bodies that passed these laws necessarily thought that lenders should be liable for cleaning up contaminated property, as much as it was their belief that the complexity of these statutory schemes had created ambiguity. Faced with the possibility that the public would have to shoulder the cost of cleaning up contaminated properties when the real culprit could not, the environmental enforcement agencies and the courts have seen this ambiguity as a way to perform shotgun marriages between unsatisfied liabilities and deep pockets.

Sure enough, the lender is often the only deep pocket in sight. The result has been that in cases like United States v. Maryland Bank and Trust Co., (632 F. Supp. 573 [D. Md. 1986]); United States v. Mirabile, (15 ELR 20994 [E.D. Pa. 1985]); and United States v. Fleet Factors Corp., (901 F. 2d 1550 [11th Cir. 1990]); the judiciary has found ways to impose environmental liability on lenders.

The pendelum has swung back and forth a number of times during the past decade on lender liability, as one court or another has struggled with CERCLA and its kin. At this writing, the pendulum may be finally swinging back in favor of the lending community--an adjustment long overdue and, in fact, an adjustment necessary to the achievement of our nation's environmental goals and aspirations.

CERCLA's Secured Creditor Exemption

The Environmental Protection Agency (EPA) released its long-awaited proposed rule on lender liability under CERCLA in June (56 Federal Register 28798, June 24, 1991). Within the limitations of existing statutory authority, the EPA has proposed a significant step forward in providing clear guidance concerning the liability of lenders that are innocent of causing contamination. The proposed rule (including a detailed preamble) protects many normal activities in originating and administering loans and working out problem loans and foreclosing. It also sanctions some environmentally responsible activities of lenders in the course of these normal business activities.

Lenders will find this proposed rule a welcome means of addressing lender liability under the federal Superfund law. While a number of issues should be clarified before the proposed rule is finalized, lenders should encourage EPA to make the rule final as soon as possible.

CERCLA imposes a harsh liability scheme on several classes of potentially responsible parties (PRPs), including owners and operators of contaminated sites. Liability under CERCLA is imposed regardless of the innocence or guilt of the parties in causing the contamination. Liability for the entire cost of cleaning up a site may be imposed on any one of the potentially responsible parties, causing a tendency to look for those PRPs perceived as having the deepest pockets to address the problem. Liability is retroactive to contamination caused before CERCLA's enactment. It can also be imposed on parties who clean up a site by taking hazardous substances to a disposal site if contamination is found on the disposal site. Cleanup costs can far exceed the value of the property. The EPA has estimated the average costs of investigating and cleaning up a site on the National Priorities List--the agency's list of properties with high priority for cleanup--at $30 million. Thus, liability under CERCLA is strict; joint and several; retroactive; perpetual; and, for practical purposes, unlimited.

CERCLA contains an exemption to liability for owners or operators of a contaminated site, if, without participating in the management of a vessel or facility, they hold indicia of ownership primarily to protect a security interest in the property. Known as the Secured Creditor Exemption, this exemption was intended by Congress to protect holders of security interests, such as secured lenders.

The scope of the Secured Creditor Exemption has been enormously controversial. What can a lender do--and not do--and remain within the protective ambit of this statutory exemption? What is clear is that the Secured Creditor Exemption has been eroded by the courts during the past several years. In 1986, in U.S. v. Maryland Bank & Trust, the court held a lender liable as an owner of a property on which it had foreclosed, notwithstanding the Secured Creditor Exemption.

Concern over the scope of the exemption reached fever pitch in 1990 with the decision in U.S. v. Fleet Factors, in which the Eleventh Circuit held a lender who had foreclosed on personal property (but not on real property), liable because it had "participated in the management" of the property sufficiently to trigger liability. The pernicious suggestion of the court in Fleet Factors, that the mere capacity to influence a facility's treatment of hazardous waste could result in Superfund liability, exacerbated existing concerns over the scope of the exemption. The chilling effect arising from the uncertainty surrounding these issues clearly has had a substantial and materially adverse effect on the operation of the financial market.

In the late summer of 1990, facing the possibility of congressional action, EPA promised a regulatory fix to the problem. During deliberations within the administration, two drafts were widely leaked and caused serious concerns to the lending community. A number of parties worked on the proposed rule, including the FDIC and the Resolution Trust Corporation (RTC), both of which have a serious interest in the outcome of this proposal. The draft of the proposed rule published in the Federal Register will govern EPA's enforcement activities until the final rule is published, after public comments have been received.

"Allowable participation" defined

According to its terms, the Secured Creditor Exemption is lost if the security holder "participates in the management" of a property. The proposed rule governs what is and is not considered participation in management sufficient to trigger liability, and acknowledges that the determination will depend on the facts of each case. Note that the proposed rule places the burden of proof on the party asserting that another's actions constitute material participation. As a practical matter, placing this burden on the moving party significantly enhances the protection of the proposed rule.

The proposed rule defines participation in the management as "actual participation in the management or operational affairs by the holder of the security interest, and does not include the mere capacity, or ability to influence, or the unexercised right to control facility operations." In a stroke of reassuring common sense, the latter part of this sentence abandons the onerous dicta in U.S. v. Fleet Factors which suggested that the mere capacity to influence the disposal of hazardous substances could trigger CERCLA liability. However, the language: "actual participation in the management or operational affairs...." lays out a broad basis for liability.

Lenders can examine this "participation in management" clause by considering such "participation" during the stages of a loan.

Origination--According to the proposed rule, no act or omission prior to the creation of a security interest can trigger liability. The proposed rule emphatically states that requiring or conducting an environmental inspection cannot serve as the basis for liability, nor can the lack of an environmental inspection.

In addition, the preamble to the proposed rule notes that the security holder who requires an environmental assessment and who then "knowingly takes a security interest in a contaminated facility" will not sacrifice the protection of the proposed rule. Thereby, the notion that the Secured Creditor Exemption is held hostage to the lender's adoption of the mantle of "environmental cop" has thankfully been put to rest.

Loan administration--The proposed rule lays out alternative tests for activities that are sufficient participation in management to serve as a basis for liability while the borrower is in possession of the security. Such liability-inducing activities would include:

* exercising decision-making control

over the borrower's environmental

compliance, such that the security

holder has undertaken

responsibility for the borrower's waste disposal

or hazardous-substance-handling

practices that result in a release or a

threatened release; or * exercising management-level

control encompassing environmental

compliance responsibilities,

comparable to that of a manager of the

borrower's enterprise. This control

would be established by

implementing or maintaining the policies and

procedures that encompass the

day-to-day, environmental compliance

decision-making of the enterprise.

Under these circumstances, the security holder will be denied the safe harbor of the Secured Creditor Exemption and may be liable as an owner or operator under CERCLA.

In addition, the proposed rule specifies a non-exclusive list of activities that are "consistent with protecting a security interest" and thus will not trigger liability. Examples include requiring the borrower to clean up the property; requiring the borrower to comply with federal, state and local environmental and other rules and regulations; securing authority to monitor or inspect the property or the borrower's business and financial condition; and any other requirements or conditions reasonably necessary to police the security interest. Warranties, covenants, representations or promises in any documents cannot be the basis of liability.

Workouts and foreclosure--Under existing interpretations of the Secured Creditor Exemption, lenders are concerned that although the exemption may protect them with performing loans, the protection would evaporate upon engaging in workouts or exercising the customary remedy of foreclosure.

The proposed rule allows workout activities structured to protect and preserve the security interest in an effort to prevent default or diminution in the value of the security. These activities include such common workout practices as providing financial or other advice or similar support to a distressed borrower; restructuring or renegotiating the terms of the obligation; payment of additional interest; extension of the payment period; and giving specific or general financial advice, suggestions, counseling or guidance.

While workout activities are often initiated after borrowers default, the proposed rule fails to recognize that workout activities may cure or mitigate default, as well as prevent default. This oversight is one of the items requiring correction in the final rule.

The preamble clearly states that the exercise of decision-making control over the operational affairs is not consistent with the exemption's safe harbor (contrast this with the ability of the lender to exercise such control post-foreclosure). It also states that the security holder may not act as an operator under the guise of a security holder during workout activities. Interestingly, in restating the litany of permissible activities during workout, the preamble includes specific operational advice--a category not mentioned in the proposed rule itself.

The proposed rule specifically allows a lender to acquire title by foreclosure, or its equivalent, provided it is the intent to hold the property temporarily for subsequent disposition.

The proposed rule embraces the common-sense notion that the Secured Creditor Exemption survives acquisition of fee title and treats post-foreclosure ownership of property as an organic part of the secured lender-borrower relationship. Specifically, several means by which the security holder temporarily acquires, for subsequent disposition, possession of the borrower's collateral are deemed indicia of ownership--held primarily to protect a security interest under the proposed rule. Some of these include acquiring full legal title through foreclosure; purchase at foreclosure sale; acquisition or assignment of title in lieu of foreclosure; acquisition of a right to title or other agreement in settlement of the loan obligation; or any other formal or informal manner of acquisition.

The preamble provides additional guidance on the scope of permissible post-foreclosure activities. For instance, winding up a business's operation is construed to include those actions necessary to close down, secure the site, and otherwise protect the assets for subsequent liquidation properly and responsibly. Steps taken to prevent or minimize the risk of a release of hazardous materials are also considered consistent with the exemption, as are mitigative actions taken with regard to the presence of hazardous substances known to be present.

Inclusion of the lender's right to operate the property as a protected activity is one of the most important departures from prior drafts of the proposed rule. This provision recognizes that secured parties must be able to continue to operate foreclosed properties if the rule is to have any practical value. Note that in the post-foreclosure venue, the proposed rule provides that "operation of the enterprise" is within the scope of the safe harbor. Such conduct before foreclosure could, however, trigger liability. While somewhat anomalous, this appears to be the clear import of the proposed rule.

A bright line is provided for a security holder to demonstrate that it is intending to dispose of the property--provided that the security holder meets certain requirements. The security holder must list the property for sale with a broker or agent within 12 months following foreclosure; begin monthly advertising of the property for sale within 12 months following foreclosure; and may not reject, or fail to act upon, a written, bona fide, firm offer of fair consideration. If these conditions are met, the burden of proof will be on the opposing party to show that the security holder is holding the property for investment, rather than disposition, and does not fall within the Secured Creditor Exemption. (This bright line fails to recognize that a lender may have legal impediments to selling the property, and the final rule should provide that the deadlines run from resolution of legal impediments.)

An offer of fair consideration is defined as an amount equal to or in excess of the sum of the outstanding principal owed to the security holder, plus any unpaid interest and penalties (whether arising before or after foreclosure). It also includes all reasonable and necessary costs, fees or other charges incurred, less amounts received. This definition is good as far as it goes. Some clarifications should be made in the use of the term "fair consideration," including its failure to address the reasonableness of the terms of a purchase offer (e.g., unreasonable warranties, conditioning an offer on seller financing) and inconsistent uses of the term.

Citing the "good-samaritan" provision of CERCLA, the preamble to the proposed rule states that security holders will be protected when they undertake mitigative or preventive measures that are environmentally responsible--even if such actions result in the release or threatened release of a hazardous substance--so long as the actions are consistent with the National Contingency Plan or are taken at the direction of an on-scene coordinator. (Developed by EPA pursuant to CERCLA, the National Contingency Plan provides procedures for responding to contamination and provides for on-scene coordinators.) This provision is under the heading of "Foreclosure and Liquidation" in the preamble, and thus, it is not clear whether it applies to origination, administration or workout of a loan. Although included in the preamble, this provision is not included in the text of the rule itself. This oversight should be corrected in the final rule.

Who qualifies for the Secured Creditor Exemption

According to the proposed rule, those who qualify for the Secured Creditor Exemption are those whose indicia of ownership are held for the purpose of securing payment or performance of an obligation. This definition covers nonmonetary as well as monetary obligations that are particularly important in the environmental context (e.g., borrower covenants to clean up contamination or to comply with environmental laws).

This definition specifically includes successors in interest to the initial security holder, including a subsequent purchaser on the secondary market, loan guarantor or insurer or other person who holds a security interest under the applicable law governing the transaction.

Those who hold ownership interests in property held for investment purposes, or for any purpose other than protection of a security interest, are not covered. This provision fails to note that some state laws define mortgage interests as investment interests, and it should be made clear that lenders are entitled to the protections of the Secured Creditor Exemption notwithstanding such state laws.

When lenders may not be protected

The definition of a security holder may leave lenders unprotected in several instances.

Fiduciaries--Most notably, the proposed rule does not cover fiduciaries. Lenders, particularly depository institutions, frequently serve in the capacity of a trustee or other fiduciary for individuals and estates, as well as for business entities. It is difficult to see how EPA could encompass fiduciaries in a regulation interpreting the Secured Creditor Exemption, because fiduciaries are not those who hold indicia of ownership to protect a security interest in a property.

Third parties--Many private parties sue lenders under the two CERCLA provisions authorizing private parties to do so. CERCLA provides incentives for them to look for parties with deep pockets--one incentive being the reduction of their overall liability--and no disincentive to pursue such action. When lenders are named as parties in these suits, they often incur significant investigation and litigation costs, and some lenders have found it more cost-effective to contribute significant amounts in settlement of suits by private parties than to litigate. By including its interpretation of the Secured Creditor Exemption in the National Contingency Plan, EPA has made an effort to have the rule, when finalized, apply to private parties who sue lenders pursuant to CERCLA. There is a question of whether or not a court would enforce the rule in private-party suits.

Lessors as holders of security interest--In many transactions, lenders technically have the title of lessors of a property or facility when, for practical purposes, they are serving in the capacity of a security holder. The proposed rule addresses this issue only obliquely by including in its list of recognized security interests "some forms of leases."

Receivers, keepers and conservators--An important remedy often exercised by lenders is the appointment of a receiver, keeper or conservator to oversee a troubled loan or to manage a property when a borrower is being irresponsible. In some states, it is only by these means that lenders may exercise their rights without incurring liability under other theories of law (e.g., trespass). The proposed rule does not address receivers, keepers or conservators.

Possession without extinguishing the security interest--It is common for a security holder to take title to property securing an obligation (usually by means of a deed in lieu of foreclosure) in its own name or in the name of a subsidiary or affiliate without extinguishing the security interest. Under the proposed rule, it is unclear whether a security holder may do so and still qualify for the exemption.

Subsidiaries and affiliates--Another important remedy commonly exercised by lenders is to have a property transferred to a subsidiary or affiliated entity when foreclosing or accepting a deed in lieu of foreclosure. The proposed rule covers successors in interest to the security holder. Subsidiaries or affiliates may not technically be considered successors in interest to the lender when title passes directly to them, rather than having the title transferred first to the security holder. Subsidiaries and affiliates in these positions should be entitled to the same protection as other secured creditors.

Alternative lending transactions--A specific provision of the proposed rule states that whether sale/leasebacks, conditional sales, or installment sales or any other transactions will qualify, will be a question of fact and will be determined by whether or not a security interest is created under applicable law. Equity kickers and shared-appreciation mortgages are not addressed. Thus, it is unclear whether the proposed rule protects lenders in these frequently occurring situations. Consequently, substantial caution must be exercised in dealing with such complex financial structures.

Lenders as arrangers or transporters of hazardous substances--The proposed rule addresses only liability of lenders as current or past owners or operators of contaminated sites. It specifically cautions that it does not exempt lenders from liability under the remaining two classes of potentially responsible parties under CERCLA: those who arrange for disposal or treatment of hazardous substances, and those who accept any hazardous substances for transportation to sites where contamination may be found. Lenders should seek the advice of counsel before arranging for disposal or treatment of hazardous substances or arranging for its transportation, even when these activities are essential to cleaning up a site.

EPA is, in effect, giving notice that the Secured Creditor Exemption is not unlimited and does not provide lenders with global protection from environmental liability. The consequence is that while the proposed rule may be protective for lenders in many types of transactions, in certain circumstances its protection may be illusory.

Laws in addition to CERCLA

The proposed rule covers only liability under CERCLA. There are many other federal laws that impose strict liability on parties who are innocent of causing contamination, notably the Resource Conservation and Recovery Act (RCRA). In addition, many states have laws similar to CERCLA under which lenders may be liable for contamination they are innocent of causing. Thus, once a lender holds title and control of a property, the Secured Creditor Exemption may not insulate the lender from liability under other environmental laws and regulations.

No one should assume that the protection of the proposed rule is absolute, and extreme care must be taken in designing post-foreclosure behavior to fit within the relatively narrow confines of the proposed rule. At the time this article was written, the proposed rule was still being considered by EPA following its 30-day comment period, and some changes should be expected. The EPA's proposed rule is not a panacea and does not vitiate the need for further legislation. But it does provide a significant measure of certainty to lenders, which has been sorely needed.

Developments in Congress

While EPA's lender liability rule has been taking center stage in the debate over lender liability, there has been considerable action in Congress, with hearings progressing on a number of bills important to the lending community. Two bills have been introduced that would restore the original intent of Congress in enacting the Secured Creditor Exemption. As of late August, the Senate bill, sponsored by Senator Jake Garn (R-UT), had been incorporated as Title X of the Senate banking bill, S. 543 (which provides for significant changes in the regulation of commercial banks). Prior to that, the original Garn bill, S. 651, had 30 consponsors. The House bill, H.R. 1450, sponsored by Representative John LaFalce (D-NY) had more than 260 cosponsors in late August.

Storm clouds

While developments at EPA and on Capitol Hill bode well for the lending community, all is not sunny. By late summer, the lending community had identified a number of significant changes necessary for the proposed rule to deliver the full measure of certainty promised by EPA. Further, it is not certain what the courts will do with the rule and whether it will finally put an end to the judicial inclination to use lenders as a deep pocket to solve the nation's environmental problems. Moreover, the legislative fervent on the Hill is far from over.

Finally, one other factor deserves mention. While the focus in recent years has been on the lender's exemption to liability under CERCLA, this is not the only environmental risk faced by the lending community today. As long as the enforcement community and the judiciary are saddled with the unhappy job of imposing unsatisfied cleanup costs on the public fisc, they will be powerfully motivated to look for deep pockets to clean up environmental problems. Regrettably, lenders will remain an attractive target in that hunt. The creativity that may be brought to bear in achieving this goal should not be underestimated.

A recent Rhode Island case, O'Neil v. O.L.C.R.I., Inc., (750 F. Supp. 551 [D.R.I. 1990]) raises the possibility that lenders may be held civilly liable for borrowers' violations of environmental laws. It rests on the common law theory of "aiding and abetting" borrowers in violating federal statutory law and state statutory and common law. In this case, the state of Rhode Island was allowed to amend its suit against a borrower because the lender allegedly knew of the contamination and could have made the loan contingent upon fixing the sewer system--the source of the contamination.

It is particularly disturbing that this case extends liability to the lender for such a broad category of laws as common law nuisance. While parties might expect liability for aiding and abetting violations of criminal law, imposing liability on lenders for aiding and abetting violations of civil law is a disturbing development.

This is, of course, an isolated case. The case has received enormous celebrity because it is so unique. It may not remain an anomaly for long. If owner/operator theories of liability must be laid aside because of EPA rulemaking or legislation, other theories such as aiding and abetting, arranging for the disposal of contamination (as in U.S. v. Aceto Agr. Chemicals Corp., [872 F. 2d 1371 8th Cir. 1989]) and the like may well take their place as the enforcement agencies and the judiciary seek to restore lost ground.

Margaret V. Hathaway, Esq., is counsel with Thacher, Proffitt & Wood, Washington, D.C., and is former staff representative to the Environmental Subcommittee of MBA's Commercial Real Estate Finance Committee. Richard D. Jones, Esq., is a partner with Pepe & Hazard, Hartford, Connecticut and is a former vice chairman of the Environmental Subcommittee of MBA's Commercial Real Estate Finance Committee.
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No portion of this article can be reproduced without the express written permission from the copyright holder.
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Title Annotation:proposed rule gives lenders relief from liability for toxic cleanup costs
Author:Hathaway, Margaret V.; Jones, Richard D.
Publication:Mortgage Banking
Date:Sep 1, 1991
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