Environmental Due Diligence for Lenders

ENVIRONMENTAL RISK MANAGEMENT

by Steve Luzkow his article considers the basic components of environmental risk management, the various factors considered by Tmost lenders, and the information needed to facilitate the closing of the transaction. Although loans may be secured through various means, the author focuses on transactions secured by real estate or real property. onducting environmental they need to fulfill their due dili- may be secured by personal guar- due diligence—whether a gence requirements by making antees, accounts receivable out- CPhase I environmental site their wants known to the consult- standings, inventory, marketable assessment or Phase II subsurface ant. securities, and other non-real- study—is the mainstay of the estate or non-real property, and environmental consulting industry. Due Diligence Ensures Collateral these may even be cross-collater- Much of this due diligence is con- Each institution administers alized with real estate or real ducted on behalf of either a lender loan policy a bit differently, property. or a purchaser and, in almost every although with the same goal of Let’s take a closer look at the instance, is done to obtain a due diligence. Generally, due dili- lending process and the varied financing decision. However, con- gence is required when a loan is approach by some lenders, fol- sultants generally have little supported by real estate or real lowed by some suggested “do’s” understanding of how the lending property. This way, in the event of and “don’ts.” industry uses the data they collect. a default and subsequent foreclo- What they do see is the variability sure, the institution can sell the Varied Due Diligence Objectives in how each lender applies policy, real estate or property and repay Each party in a real estate procedures, and use of the consul- the debt. In such instances, the loan transaction has its own reason tant’s work product. Lenders can real estate or real property for conducting due diligence, but ensure receiving the information becomes the collateral. Loans also all share the objective of execut-

28 The RMA Journal November 2004 Environmental Due Diligence for Lenders ing the transaction: could divert the bor- • Lenders need to be informed rower’s cash flow to Even the FDIC provides that a due of the borrowers’ known and address environmental diligence program be established potential liabilities to measure problems. Liabilities their ability to repay in the may include: with no set criteria. On the other end event funds are diverted for • Expenditures for of the spectrum, the Small Business environmental purposes. engineered con- Administration (SBA) provides Moreover, lenders need to trols to prevent ensure that the collateral is unacceptable detailed, conservative guidance for marketable at a value exceed- exposure. SBA-guaranteed transactions. ing the loan amount in the • Third-party agree- event of default. ment transfer of • All of the credit review issues • Borrowers may desire to make environmental cleanup liabili- as they may relate to an exist- an informed decision or estab- ty to the borrower. ing tenant, if applicable. lish an “innocent purchaser • Strict joint and several liabili- defense”1 for new purchases, ty (for example, PCB cleanup Due Diligence Tools or they may be compelled to under TSCA or RCRA liabili- Due diligence tools to assess perform due diligence by their ty—large quantity generator known or potential liabilities may lender for reasons cited above. sites with incomplete or ongo- be used by a consultant, the • The consultant, who may be ing cleanups). lender’s staff (if so qualified), or retained by a borrower or a • Legal claims for cleanup or any combination of assignments lender, conducts due diligence other damages, such as replac- by the lender or borrower. Such for any of the reasons above. ing a municipal drinking- tools may include: On top of meeting the needs water well. • Internet database search (e.g., of borrowers and lenders, the con- • Consent or administrative a state’s list of contaminated sultant must contend with varying order obligations. sites). degrees of risk tolerance and • Health and safety (unaccept- • Environmental database lender experience, as well as dif- able exposure from site opera- information providers (e.g., ferences in due diligence policies. tions). regulatory databases and gov- • Compliance or other violations. ernment-listed sites). Loan Criteria • Government records reviews. A lender provides funds to a Foreclosure Analysis • Phase I Environmental Site borrower only after being assured Before recovering the proper- Assessment—ASTM 1527 that a loan can be repaid and that ty through the foreclosure process, (government records review, there are sufficient assets or guar- or taking a deed-in-lieu, the site inspection, and inter- antees pledged to cover the loan lender needs to ascertain the fol- views). amount in the event of default. lowing factors at the time the • Phase II Environmental Site Therefore, lender environmental credit review is conducted. Assessment (soil, water, or air policy and procedures should be • Potential direct liability to the sample collection and analy- integral to the credit, asset, collat- lender. sis). eral, and foreclosure analysis • Expenditures to prevent • Interviews. process. unacceptable exposure while • Site inspection. property is on the market. • Asbestos studies. Environmental Credit Review • Potential purchaser liability. • Mold studies. The primary focus of the • Projected purchaser expendi- environmental credit review is to tures to conduct continuing or Basis for Policy identify the potential, or known, different operations on the Even though the liability vari- environmental liabilities that property. ables and data-gathering tools

29 Environmental Due Diligence for Lenders largely do not vary by jurisdiction authority and responsibility. information from existing records or state, the environmental poli- It is no wonder that consult- and databases. These lenders cies and procedures vary from ants and their client-borrowers are may have limited ability or staff lender to lender to the extent that perplexed by the lack of consis- to develop an alternative means even the most experienced bor- tency from one lender to the next. of evaluating the borrower’s posi- rower and consultant cannot pre- It is no less burdensome for the tion. Other lenders may focus on dict the level of effort and amount lender, who not only must con- collecting information that of information required by a duct due diligence to determine addresses whether the borrower lender for a given transaction. the risk to the credit and predict will be subjected to cleanup or Even the FDIC provides that a foreclosure expenditures, but violations and how the property’s program be established with no must do so while providing cus- marketability will be affected. set criteria. On the other end of tomer service in a highly competi- Because this evaluation benefits the spectrum, the Small Business tive environment. the lender only, it provides the Administration (SBA) provides lender with the opportunity to detailed, conservative guidance Policy Components develop a due diligence process for SBA-guaranteed transactions. Is it possible to find a balance tailored to its risk tolerance. The For example, SBA will provide a that minimizes borrower expendi- ASTM inquiry components can certain percentage of funds to the tures while maximizing the infor- then be used selectively to meet lender in the event of a default. mation lenders need? Let’s look at this need. This lack of regulatory guidance three components that may be Because the use of informa- creates a free-for-all attitude, used singly, or in combination, to tion and benefits to the borrower whereby lenders are forced to formulate a lender’s policy. These are different for the two types of establish their own policies, components are: 1) type of loan; 2) transactions (new purchase or thresholds for the degree of due collateral risk category; and 3) loan refinance), lender procedures diligence conducted, and proce- amount. should be different for each. In dures. The lack of standardization turn, asset-based loans not Type of loan. For new pur- breeds confusion in the market secured by real estate may chases, the lender should be able and inconsistent practices, result- require due diligence when the to take advantage of information ing in two basic types of lenders: asset itself may present a liability obtained from a borrower’s due 1. Lenders with no in-house to the lender or borrower. These diligence while, at the same time, specialists, or lenders factors form the basis of establish- a borrower can take advantage of assigned to administer the ing policy according to the type an innocent purchaser defense. bank policy who are so con- of loan (e.g., new purchase, refi- However, requiring a borrower servative they won’t take any nance, or asset-based). who is refinancing real estate to risk or so liberal they don’t expend funds that only benefit Collateral risk category. recognize risks. the lender is a hard sell and war- This is just what it says: Is the 2. Lenders with in-house staff rants a separate procedure. site considered high risk or low specialists having environ- When a loan is being refi- risk based on site operations and mental backgrounds, where nanced, the borrower has no use? The risk category should any of the following circum- opportunity to improve its exist- consider historical as well as cur- stances may exist: ing position (i.e., innocent pur- rent operations, as well as house- • Adequate staff, but they chaser defense). Therefore, due keeping practices. lack the appropriate diligence is conducted for the authority. Loan amount. Some lenders interest of the lender only. Some • Inadequate staff and have only loan amount thresholds lenders may use the ASTM1528 inadequate review time. for determining when and what Phase I criteria, as it is a well- • Adequate staff with the type of due diligence is required. known means to obtain available appropriate levels of

30 The RMA Journal November 2004 Environmental Due Diligence for Lenders

Putting It Together to Form • Lenders should not conduct and 6) inconsistent approaches by Policy Phase IIs on behalf of the regulators. This article attempted The components of lender borrowing entity under any to provide an overview of the policy described above can be circumstances. principal variables of a transaction depicted as matrix tables. Note • Consultants should advocate secured by real estate or real prop- that the actual thresholds and type completing the new-purchase erty and how those variables are of due diligence tools used due diligence scope of work integrated into policy compo- depend on each lender’s individ- to the degree necessary to nents. Although there currently is ual risk tolerance. For example, a achieve an innocent purchaser no standard reference from which lender may require that any loan defense for the purchaser. a lender can develop a due dili- above $500,000 require a Phase I. • Lenders and consultants gence policy, perhaps this infor- Others may vary the degree of due should educate their customer mation can help the lender aid diligence with the amount of the on the due diligence process. the consultant in evolving from loan, as in the following example: • Lenders and consultants task provider to transaction facili- should evaluate the environ- tator. ❐ Amount of Loan ($) mental factors that could rep- $X - $XX $XX-$XXX $XXX-$XXXX resent a discount to value in Contact Steve Luzkow by e-mail at Due diligence tools identified here the event of foreclosure (e.g. [email protected]. engineered controls). Notes The most comprehensive pol- • Consultants should not be retained by any party that icy may include all three compo- 1 In response to complaints that the limited receives incentives for bring- defenses under CERCLA (Comprehensive nents, as seen in the figure below. Environmental Response, Compensation and ing the transaction to a close. Liability Act of 1980, aka Superfund) would sel- This group may include bro- dom provide any protection to purchasers, Some Do’s and Don’ts for Congress passed the Superfund Amendments Lenders and Consultants kers, realtors, or bank rela- and Reauthorization Act of 1986 (SARA), which, tionship managers. among other things, created a special defense • Lenders should not direct the that became known as the “innocent purchaser borrower’s due diligence for a defense.” This defense requires the purchaser to Conclusion have exercised “due diligence” to determine new purchase by retaining the whether there was any hazardous waste on the consultant. The ASTM Phase There is confusion in the property at the time the purchaser acquired the lending community owing to property. The purchaser must be able to prove I tasks are customarily used to that it exercised “all appropriate inquiry into provide an innocent purchaser numerous factors: 1) inconsisten- previous ownership and uses of the property cies and variable interests of the consistent with good commercial and customary defense for the borrower. At a practice” before accepting a deed to the proper- minimum, if the lender is parties to a transaction; 2) variable ty. The purchaser must also be able to prove risk tolerances of lenders; 3) the that it “did not know, or have reason to know” going to engage the consult- that the property was contaminated when it ant, the borrower should be variety and discretionary uses of accepted the deed. If the purchaser satisfies this due diligence tools; 4) lack of reg- burden of proof, then the purchaser will not be able to rely on the document, liable for cleanup of any contamination that and the lender should be ulatory guidance material; 5) existed at the time the purchaser acquired the inconsistent expertise in the lend- property. (From the Web site of Koley Jessen PC, indemnifiable for any claims Omaha, Nebraska, see of damages. ing and service provider sectors; www.koleyjessen.com/html/resources.cfm.

Amount of Loan ($) Loan Type Risk Category $X - $XX $XX-$XXX $XXX-$XXXX New Purchase Vacant Land Low-Risk High-Risk Due diligence tools Refinance Vacant Land identified here Low-Risk High-Risk 31