Foreclosures on commercial properties are decreasing. The average percentage of an institution’s overall environmental due diligence that was for foreclosures fell from 17% in 4Q11 to 9% in 4Q12. Additionally, 38% of respondents expect to see lower foreclosure volume in 2013, and another 45% expect levels to remain this year as last year. Even as commercial real estate foreclosures stabilize or decrease, lenders need to remain vigilant about their environmental risk exposure when foreclosing on commercial properties. Without a clear pre-foreclosure policy, a bank becomes especially vulnerable. If the property securing a loan transaction has environmental issues, there are a number of downsides, which is why most lenders require some type of environmental screening as part of their underwriting, particularly in today’s risk-averse climate. In general, environmental issues on properties used as collateral can:
• expose the bank to direct liability for cleanup costs as well as probable litigation;
• cause buyers to default if they are forced to divert cash flow to pay for cleanup; and
• damage a bank’s reputation, brand and image.
Environmental due diligence takes on even greater significance for lenders in cases of foreclosure. Most lenders require some type of environmental screening as part of their underwriting for new loan originations; most commonly following or requiring their borrowers to follow AAI/ASTM E 1527-05 protocol at origination. It is less common for financial institutions, especially small community banks, to have policies that dictate environmental requirements specifically for pre-foreclosure situations. The purpose of this Technical Brief for lenders is to explore how lenders’ policies for foreclosures are different than for other types of bank activities (i.e., new loans, refinancing, etc.).
When Lenders Become Owners
What makes foreclosures unique and potentially problematic is that they essentially turn lenders into owners, subjecting them to the same environmental liability that property owners face under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), even if they did not cause the contamination, and even if they sell the property quickly. As a result, regardless of whether or not they conducted (or required the borrower to conduct) environmental due diligence at origination, lenders should address it before foreclosing on a commercial property. Usually this is by having a Phase I environmental site assessment performed in accordance with the U.S. Environmental Protection Agency’s All Appropriate Inquiry (AAI) Rule or its equivalent, ASTM’s E 1527-05 standard.
A look at EDR Insight’s recent survey on commercial property foreclosures reveals that:
• 87% of lenders have some form of environmental due diligence requirements pre-foreclosure.
• 56% have a different scope of work for foreclosures vs. new originations/refis.
• 28% have vapor intrusion screening requirements pre-foreclosure.
When it comes to pre-foreclosures, banks typically have more stringent environmental due diligence (EDD) policies than for originations or refis.
In the case of originations, in general, the loan amount determines the level of EDD. In the case of pre-foreclosures, a Phase I ESA is required regardless of property value. “Any and all commercial real estate asset for which we are considering taking title (friendly or otherwise), we require a Phase I ESA as the initial EDD.” “What is truly different is the manner of interpretation. A ‘pre-lending analysis’, while thorough in its own regard, is largely intended to support the financial underwriting by facilitating ‘an informed business decision’. A ‘pre-foreclosure evaluation’ by contrast must consider potential liabilities that may occur if the tenets of Secured Creditor exemptions are inadvertently violated.” In addition, Phase II ESAs are generally more common pre-foreclosure. Banks face greater environmental risks in foreclosures. As a result, most banks will be quicker to progress to a Phase II than they would in pre-lending situations, according to a regional bank. Additionally, the likelihood of a bank conducting a Phase II “is greater for bank assets that have been acquired through a merger/acquisition,” because the level of environmental due diligence at origination is unknown, notes one risk manager from a Fortune 500 Bank. Whatever the reason, reliance on Phase II ESAs have been on the rise. The likelihood of “needing further intrusive investigation had historically been 17% to 23%.” “Through the end of 2012, the ‘hit rate’ had been closer to 30% to 35%, reflecting a need to be truly cognizant of any and all environmental concerns for purposes of valuation, as well as liability protection. The numbers in 2013 have largely shown a return to the historic lower levels of situations requiring Phase II ESAs.”
The High Cost of Contamination
If a bank forecloses on a contaminated property, cleanup costs can be considerable. Contaminated property can also be difficult if not impossible for a financial institution to sell. In one case, a bank originated a loan on a strip mall that once housed a dry cleaning facility, but conducted no testing on the property at the time of loan origination. When the bank later foreclosed on the property and conducted due diligence, the investigation detected significant soil vapor contamination and possible groundwater impacts. In the end, the total cost of the cleanup amounted to a significant one-third of the appraised value of the property. In developing a pre-foreclosure policy, banks should consider all types of environmental risks. Vapor migration/intrusion is one issue that is getting a significant amount of attention. Some environmental consultants automatically include consideration of vapor intrusion (VI) as part of their Phase I ESAs, while others do so only at a client’s request. Foreclosures present extremely different liability concerns for lenders than just extending credit, primarily because the lender is essentially becoming the unwilling owner of the property with all of the potential liability that carries. This is very different than being able to assert a secured creditor defense in a case where the borrower holds title to the site. As such, banks should define clear plans for pre-foreclosure environmental due diligence to effectively manage their risk exposure and avoid unwelcome environmental surprises in trying to resell the property.
In writing policies to manage their liability exposure when foreclosure appears imminent, lenders should consider:
• Writing a pre-foreclosure policy that is more stringent than those used for new loan originations, given the added risk exposure to the financial institution.
• Starting with an AAI/ ASTM E1527-05-compliant Phase I ESA to ensure the institution can qualify for CERCLA liability protection.
• Having a site visit conducted before tensions with tenants escalate and site access becomes an issue.
• Consulting with a trusted, qualified environmental professional to set triggers in bank policy for which loans would merit adding inspections for other environmental issues, like mold, asbestos, lead-based paint or vapor intrusion.
Why is an Environmental Risk Evaluation Important?
Potential environmental concerns associated with real property collateral represent a significant risk exposure. Although lenders may have secured creditor liability exemptions, in order to qualify for the exemption, lenders must demonstrate proper due diligence prior to lending and foreclosing. Even if the liability exemption is valid, the collateral may not be worth its appraised value and banks may have difficulty selling a contaminated site (if not cleaned up) without a significant discount or indemnity. Most importantly, the clean-up liability exemptions provide no protection from third party liability. Furthermore, remediation obligations may impair the borrower’s ability to repay the loan. Therefore, it is critical to evaluate environmental concerns identified in due diligence reports, establish risk control mechanisms, and manage the lender’s exposure to environmental liability.
What You Can Do
When reviewing environmental due diligence reports associated with collateral, the following considerations should be evaluated:
• Ensure that the proper level of due diligence was conducted based on the Environmental Risk Policy.
• Ensure that the due diligence report covers the entire collateral.
• Ensure that environmental reports are prepared by qualified environmental professionals and are conducted consistent with standard industry practice and federal guidelines for environmental due diligence.
• Conduct an all-inclusive review taking all aspects of the deal into consideration, such as: type of loan (purchase, refinance, SBA, pre-foreclosure, trust asset acceptance), loan amount, proposed changes to land use, environmental provisions of the Purchase and Sale Agreement, indemnity agreements, Provide an opinion as to the environmental condition of the collateral, provide a summary of environmental concerns and potential mitigants to assist credit management in their evaluation.
• Understand and summarize any ongoing environmental regulatory requirements, remediation activities, and/or continued obligations that may be required over the life of the loan.
• Evaluate potential implications associated with environmental risk/liability to the lender.
Evaluating environmental risks in real estate transactions
Evaluating environmental risks associated with real estate transactions is a standard, and often standardized, practice for sophisticated real estate practitioners. However, in light of several recent developments the uptick in transactions from the nadir of the recession, recent changes to risk evaluation standards, and a renewed regulatory emphasis on environmental compliance and enforcement in light of recent, high profile environmental releases now is an appropriate time for an update on identifying, evaluating, and minimizing environmental risks. In this context, the term “environmental risks” refers most often to risks stemming from environmental conditions of a property; however it may also refer to risks based on regulatory programs concerning a property or resource limitations. The specific environmental risks associated with a particular real estate transaction vary greatly depending on the property in question and type of transaction. Generally speaking, every property should be evaluated for potential soil and groundwater contamination, both onsite and on surrounding properties. Historical records, regulatory files, and possible resource or use restrictions should also be studied, depending on the nature of the transaction and the party’s particular interest.
Initial Risk Evaluations: Phase I Environmental Site Assessments and
Often, a Phase I Environmental Site Assessment is the first and only environmental risk evaluation conducted for a real estate transaction. The objective of a Phase I assessment is to identify the presence or likely presence of hazardous substances or petroleum on, in or at a property due to a contaminant release or under conditions that pose a material threat of a future release. In real estate transactions, Phase I’s are generally done for two reasons:
• to evaluate, on a limited basis, environmental risks associated with a property; and
• to satisfy one of the requirements for certain defenses to liability under the Comprehensive Environmental Response, Compensation, and Liability Act (“CERCLA”), such as the “all appropriate inquiries” requirement of the bona fide prospective purchaser (“BFPP”) defense.
For parties who would prefer to conduct an initial evaluation that is even more limited than a Phase I, a Transaction Screen is an available option. ASTM just recently completed revisions to the standard for Transaction Screens, ASTM 31528-14, in February 2014. Among the revisions, one of the most significant is to make abundantly clear that a Transaction Screen is not a Phase I and will not provide CERCLA liability protection and may not provide a definitive evaluation of the presence or absence of environmental contamination at a given property. Specifically, the Transaction Screen is “intended for use on a voluntary basis by parties who wish to assess the environmental condition of commercial real estate where a Phase I Environmental Site Assessment is, initially, deemed to be unnecessary by the user and the parties do not seek CERCLA [BFPP or other Landowner Liability protections].” ASTM E1528-14, § 4.1. The prime candidates to obtain a Transaction Screen in lieu of a Phase I are commonly lenders or other parties who believe they already have CERCLA liability protections without needing to conduct all appropriate inquiries.
Environmental Risk for Lenders: CERCLA’s Limited Lender Liability Protection
While lenders are generally exempt from liability arising from the contamination of the property prior to the date on which title vests in the lender-owner, the exemption applies only so long as the lender does not participate in the management of the property and holds indicia of ownership primarily to protect its security interest. It is important to note that lender liability protections are not absolute. For example, lenders are not protected from CERCLA liability if they are deemed to participate in the operational management of the property, or if they arrange for offsite transport or disposal of hazardous materials. Furthermore, lenders can lose liability protections after taking title through foreclosure or another mechanism. The lender liability protections apply only to liabilities created by CERCLA, and possibly by a corollary state statute, if one exists. These provisions provide no protection against tort liability or liabilities created under other statutory provisions. Accordingly, prior to taking title, lenders who want to preserve as many future options as possible with regard to the ownership and operation and/or sale of the property should conduct a Phase I, at a minimum, to evaluate environmental risks associated with the collateral at issue. While a Phase I or a Transaction Screen serve important functions, both are limited tools. Neither addresses many potential non-CERCLA- or petroleum-related risks that may need to be considered at a particular property. These “non-scope” considerations include asbestos-containing materials, mold, wetlands, regulatory compliance, water resources, cultural and historic resources, endangered species, and occupational health and safety. Often, a Phase I will cover asbestos or mold, but few address many other non-scope considerations. Depending on the real estate in question, these additional risks can be quite significant and evaluating them requires careful consideration of the unique factors for the property in question. While either a Transaction Screen or a Phase I can be a good starting point, it often needs to be supplemented with a more thorough evaluation that assesses other potential risks, which may lead to liabilities, transaction delays, and additional costs associated with owning, holding title to or operating an impaired property, and in some cases even limit future exit strategies.
All summed up, from the lenders’ perspective, here are likely the most significant points to consider for your environmental process.
• Policy: You must have a written policy specific to your organization’s lending practices, it must be approved and annually reviewed by the board of directors, and there must be a knowledgeable senior officer responsible for its implementation. You must be able to document that you followed your policy, whatever it says, during an examination.
• Level of Effort: You should vary your level of effort for environmental due diligence based on the specifics of the transaction. You can use both in-house staff and third parties to complete the due diligence but the third parties must be monitored and their products evaluated by a knowledgeable person before making a lending decision based upon them.
• Beyond the Standard: Beyond ASTM and AAI, you should consider other liabilities associated with real estate not included in the standards. Further, you should look at potential environmental issues unrelated to real estate when devising your environmental policy.
• Pre-Foreclosure: Don’t participate in management or foreclose without appropriate environmental due diligence.
• Monitoring: You must monitor your portfolio, especially those environmentally risky properties.
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