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Toxic-cleanup laws and real estate transactions.

Toxic-cleanup laws and real estate transactions

The real estate industry is entering a new era of state and federal toxic-cleanup laws that cover a tremendously broad scope. Recent federal and California legislation has significantly expanded the potential liability of all participants in real estate transactions with the real possibility of serious financial penalties and, in some circumstances, criminal sanctions.

The breadth of the new laws seems virtually unlimited. "Potentially responsible parties" can include persons who are faultness in the traditional sense. They could cover present or past owners, lenders who foreclose, individual corporate officers, and even inactive partners or joint venturers.

In every real estate transaction, there are multiple parties. Here are some protections which prudent participants in commercial transactions should consider.

The seller

The seller will want to know of any potential toxic or hazardous substances on the property in order to determine what types of representations, warranties, conditions, and indemnification provisions to include in the sales contract. Ordinarily, the fewer representations and warranties about the condition of the property the seller can make, the less the potential liability will be. Almost all sellers would prefer to sell property in an "as is" condition with no affirmative representations or warranties, provided the sales price is not adversely affected.

However, even with an "as is" provision, a sales contract cannot preclude a claim of fraud against the seller if the seller conceals known defects, such as toxic problems. Going beyond traditional concepts of fraud, a recently enacted California statute mandates written disclosure of hazardous substances by a seller if the seller merely has "reasonable cause to believe" that such hazardous substances exist on the property. Other states are passing similar laws.

In sum, the Latin phrase caveat emptor (let the buyer beware) is no longer applicable to protect the seller. To avoid the risk of rescission and/or damages in most transactions, a seller should conduct a toxic investigation to identify and disclose the existence of any hazardous substance risks. The careful seller must rely on the negotiation process to attempt allocation of the cleanup risks to the buyer without reducing the purchase price. The seller must also limit any preclosing buyer rights relating to hazardous substances to contract termination without damages.

The buyer

To minimize risks, the buyer, even more than the seller, should be sure the property will not be a toxic problem. The buyer should make a preliminary site investigation to identify any obvious signs of toxics, such as underground storage tanks, metal containers for chemical storage, discoloration of soil or floors, and so forth.

The buyer should investigate current and previous uses to determine the likelihood of present or past hazardous-substance use. Adjacent areas should be evaluated for potential hazardous-substance usages which might have migrated to the parcel.

The buyer should check with all local, state, and federal agencies which may have issued environmental permits to determine whether or not the parcel or neighboring property has been subject to any environmental enforcement investigations or actions.

Most importantly, a "due diligence" investigation of solid and ground water contamination on the site should be conducted to accomplish two purposes: first, to evaluate the contamination risks attaching to the property and, second, even if no contamination is found, to satisfy the "innocent landowner" defense under certain toxic cleanup laws if contamination is subsequently discovered and cleanup liability asserted against the buyer.

The cost of an in-depth toxic investigation can be quite substantial. Unless this cost is already reflected in a lower purchase price, the buyer should attempt to negotiate some type of reimbursement with the seller. This is especially important if the investigation leads to the discovery of toxic substances and the buyer terminates the purchase agreement.

Certain types of contractual provisions should be carefully considered before signing the purchase contract. Some of the most important include a preclosing right of inspection and testing, a no-contamination condition to closing, representations from the seller as to the exact extent of hazardous-waste conditions on the property, indemnification covenants (should post-closing claims be made against the buyer), and contractual assurances of adequate security to support the seller's otherwise naked indemnification covenants.

The buyer should clarify that seller indemnification obligations cover all toxic liabilities not caused by the buyer, not merely those caused by the seller.

The lender

Because toxic contamination will substantially reduce the value of a lender's security for the buyer's loan, the lender will be a partial ally of the buyer. The lender must assure that the buyer takes all necessary precautions in negotiating the purchase transaction and/or investigating all reasonably foreseeable risks before entering into (or closing) a purchase agreement.

While the lender is exempt from toxic liability for cleanup responsibilities when the property merely serves as security for its loan, foreclosure on the property upon buyer default could make the lender liable for such cleanup. Consequently, foreclosure upon a parcel with toxic characteristics may not be in the lender's best interests.

Apart from foreclosure, excessive involvement in the buyer's business activities before or after loan defaults creates a risk of being labeled an "operator" under the toxic liability laws, again exposing the "deep pocket" lender to potential cleanup liability.

The lender must insist on contractual provisions in the loan documents which allocate all toxic risks to the borrower or to some other solvent party. For significant transactions, the lender may wish to obtain its own environmental consultants to evaluate the toxic-liability risks and to make investigations to supplement the borrower's analysis. The lender may insist that the seller's toxic representations, warranties, and indemnification promises run to the lender, as well as to the buyer.

In addition to securing a covenant from the borrower to comply with all environmental laws, the lender will want to reserve the right to test and inspect the property for contamination prior to any foreclosure and to prohibit the buyer or the buyer's tenants from activities which create toxic or environmental risks.

Alternative and imaginative security provisions should be considered to reduce the lender's risk in the event the borrower becomes insolvent and the value of the secured real estate becomes suspect due to contamination. Reliable third party guarantees covering cleanup obligations as well as the primary debt may be feasible. The lender may wish to consider recourse financing.

The landlord

The landlord's position in negotiating with its tenant is in many ways the same as the buyer's or the lender's. Besides representations and warranties, conditions, indemnifications, environmental-compliance covenants, and reliable security or guarantees for toxic non-compliance, the landlord should insist upon removal of any toxic materials or fixtures at the expiration of the lease.

The landlord should also reserve the right of entry in order to conduct appropriate environmental investigations during the term of the lease. Possibly the landlord will want to negotiate a significant deposit, bond, or other security to assure toxic compliance by the tenant.

The tenant

If a tenant does not intend to use hazardous substances in its business, it normally will be in the same position as the buyer in negotiating its lease and should seek similar toxic protections from the landlord, especially if the lease value is significant. On the other hand, if a tenant intends to handle toxic materials, it will be in much the same position as would be a seller of contaminated property.

All tenants should be aware of a California statute which mandates disclosure of any such toxic usage by the tenant under the extreme and unwelcome penalty of lease voidability. Other precautionary measures, including negotiating strategies and specific contractual provisions similar to those discussed above for the seller, should be considered.

The broker

A real estate broker will not usually be held liable under federal or state toxic-cleanup statutes. Nevertheless, as the agent for one (or sometimes both) of the participating parties, a real estate broker risks toxic-related liability, especially where there is a possible claim of fraud or nondisclosure.

The broker as agent must be extremely careful to avoid potential liability based on actual or even presumed knowledge of toxics on the site. Full disclosure and indemnification promises from the principal or principals of the sale will help reduce that risk.

Unlike traditional tort liability, liability under recently enacted toxic-cleanup laws can be absolute and unrelated to fault. All participants in a commercial real estate transaction, whether in lease, sale, or financing transactions, should carefully investigate the site and evaluate all toxic risks before any contract is executed. Each party should attempt to negotiate contractual provisions which will allocate the risk of toxic liability to the one or more parties who are primarily responsible for the existence of the toxics, bearing in mind that such indemnification provisions will have little or no value if the indemnitor becomes insolvent.

Under extreme circumstances, a party should consider rejecting a deal outright because of the nature of the risk, the danger of indemnitor insolvency, and the specter of joint and severe liability even for the innocent parties.

Stephen E. Clark is a partner with the San Francisco firm of Marron, Reid and Sheehy, which specializes in the legal problems of business. He has had extensive experience in the practice of business law, including title insurance, zoning, and real estate law, and general business risk analysis and counseling. Mr. Clark is a graduate of Yale University and Harvard Law School.

Mary Lu Everett has over 15 years of legal experience in real estate law, including sale and purchase of real property, commercial and shopping center development and leasing, and major financing transactions. Ms. Everett received both her undergraduate and law degrees from the University of California at Berkeley. She is a partner with Marron, Reid and Sheehy.
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Title Annotation:Legal Corner
Author:Clark, Stephen E.; Everett, Mary Lu
Publication:Journal of Property Management
Date:May 1, 1989
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