Lenders' Environmental Due Diligence

Lenders’ due diligence can be just as thorough as buyers’.

OVER THE PAST few years, many lenders have demonstrated the willingness to fully understand the risk profile of their borrowers’ environmentally challenged properties.

Evolving Approaches

Two projects a few years apart illustrate this trend. A few years ago, one lender declined to provide financing for a Mountain State office building, believing that the presence of a dry cleaner across the street from the building presented a risk of indoor air quality impacts. Having identified the potential risk, this lender had no appetite to evaluate the situation any further. This resulted in an opportunity for a second lender, which had its law firm investigate the risk of indoor air quality impacts. Based on that investigation, the lender became comfortable with the level of risk involved, and provided the financing.

Tom Mounteer

In contrast, a fairly traditional Midwest-based national lender recently took a very searching approach on a construction loan from the outset. The bank was considering providing a construction loan for a mixed-use development straddling a busy commercial street in a West Coast city. The construction site was affected by contaminants from both a gas station and a dry cleaner. The dry cleaner had operated in a building on one side of the street, while the gas station had been located on the other side of the street. Both buildings had already been demolished.

A few other facts complicated the situation. Dry cleaner solvents had migrated in the groundwater from the parcel on one side of the street to the parcel across the street. Because redevelopment plans called for a mix of uses, with residences above retail space, the lender had to be especially sensitive to the risk of indoor air quality problems caused by vapor intrusion. At the time the bank was being asked to provide construction financing, neither the dry cleaner nor gas station cleanup had been completed to the satisfaction of supervising government regulators.

One might have thought this complex situation would have deterred the Midwestern bank, in the same way that the dry cleaner risk had deterred the first bank in the Mountain State office building situation. Instead, the Midwestern bank asked its law firm to review over a dozen cleanup documents to help it understand what remained to be done to satisfy regulators and what risks the bank faced in the interim. This review found that residual levels of dry cleaner solvent in the groundwater were no greater than those allowed in the approved cleanup plan, so that eventual regulator satisfaction was assured. The bank provided the construction loan.

Common to All Types of Lenders

From a legal perspective, it’s interesting to note that all types of lenders are engaging in this searching environmental due diligence. One might have expected secured lenders to take comfort in a liability exemption available to lenders who take security interests in property (i.e., mortgages). Secured lenders who avoid participating in a borrower’s operations are exempt from hazardous substance release liability under a number of federal statutes. If the secured lender strays too far into the management of the borrower’s operations, especially with respect to environmental functions, it could face liability for those operations. And if a lender foreclosed on the mortgaged property, it could be strictly liable as the property owner.

Mezzanine lenders who protect their loan by taking a right to convert to an ownership, or equity, interest and asset-based lenders who take security in, for example, inventory or accounts receivable, but not real property, aren’t eligible for this exemption.

Despite the liability exemption available to them, secured creditors seem to be just as interested in investigating their borrowers’ potential environmental liabilities as non-real property asset-based and mezzanine lenders. All lenders placing mortgages want to know the value of their collateral, including the effect contamination has on that collateral. And all types of lenders want to know if their borrower is going to be saddled with cleanup costs that will affect its ability to repay its loan.

Voluntary Cleanup Challenges

As developers have pursued rewarding opportunities redeveloping urban and industrial sites, lenders have had to become more adept at assessing the environmental conditions those sites present. In this context, entirely voluntary cleanups present a particular challenge to lenders.

Obtaining a “no further action” determination from a government agency is generally considered to be the “gold standard” with respect to cleaning up releases of hazardous substances. The determination constitutes the judgment of the government agency charged with protecting the general public that all cleanup work has been performed satisfactorily. When a borrower shares the results of its due diligence investigation of once-contaminated property but does not include such a determination, a lender’s adviser will typically ask the borrower why not, and whether the release was reported to the government.

A lender’s inquiries when a borrower fails to provide a “no further action” letter may sometimes appear overzealous. In connection with helping one developer/borrower obtain a property acquisition loan, the borrower’s counsel was presented with a Phase I environmental site assessment prepared for the lender by a well-known and generally respected environmental consulting firm.

In the assessment, the lender’s consultant recommended soil sampling in an area that had once contained an above-ground fuel storage tank. A photograph in the consultant’s report showed visibly stained soil beneath the site where the storage tank had stood. The borrower claimed to have already cleaned up the area. The lender’s consultant wasn’t convinced that the borrower’s contractor had removed all of the impacted soil. This seemed like a minor condition, one that would not normally call for sampling.

Fortunately, the borrower’s contractor had taken a photograph of the area after it had removed a few buckets of soil with a backhoe. That photo convinced the lender not to pursue the testing recommended by its consultant. By enabling everyone to see the soil conditions at the bottom and along the sides of the excavated area, the photo further minimized the staining’s significance.

The existence of the photograph was critical and makes an important point about voluntary cleanups. Even for cleanups with no governmental involvement, written reports, preferably with photos, can be very helpful. It may be hard to get lenders to sign off on environmental conditions without a governmental “no further action” letter. In some cases, like the one above, the pictures in the report can tell a pretty clear story.

A lender will typically consult with its counsel about the reasonableness of the borrower’s having performed the cleanup without government oversight and the soundness of the conclusion that all of the required work had been performed. The success of such an approach, however, may be limited to properties with very minor environmental issues.

By Tom Mounteer, partner, Paul Hastings LLP, Washington, D.C., and professor, George Washington University Law School, tommounteer@paulhastings.com