Why does the commercial real estate industry do environmental due diligence during a transaction? What are some of the laws that created the need for environmental scrutiny, and why is a Phase 1 Environmental Site Assessment often required?
For those that may not be familiar, below is a brief background on where all these requirements came from (and a whole bunch of acronyms that go with them).
Genesis of Environmental Due Diligence: Superfund, CERCLA, AAI and ASTM
You may have heard of Love Canal or Valley of the Drums, which were two major pollution sites discovered in the 1970s that caused public outrage and were the impetus for significant federal environmental regulation to hold polluters accountable for contamination and cleanup costs.
Also known as the “Superfund” law, the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) was enacted in 1980 and, among other things, gave the federal government the ability to respond to releases or threatened releases of hazardous substances, and to pursue polluters (“responsible parties”) or potential polluters (“potentially responsible parties”) for the cleanup of contaminated sites.
CERCLA created the need to conduct “all appropriate inquiry” prior to a property transaction to qualify for exemption from CERCLA liability for cleanup costs.
All Appropriate Inquiry or “AAI” is defined by ASTM and EPA (through CERCLA) as the process of conducting inquiry “into the previous ownership and uses of the property consistent with good commercial or customary practice…that will qualify a party to a commercial real estate transaction for one of the threshold criteria for satisfying the LLPs to CERCLA liability.” Essentially, conducting all appropriate inquiry consists of environmental due diligence conducted prior to a property transaction to determine whether a property may have been contaminated by past or current activities, in order for a user (for example, the prospective purchaser) to be exempt from liability for contamination that existed on a property prior to the property transaction.
The AAI obligation originated from the CERCLA or “Superfund” law of 1980, and was refined by several later laws: the Superfund Amendment and Reauthorization Act (SARA) in 1986; the Asset Conservation, Lender Liability and Deposit Insurance Protection Act in 1996; and the Small Business Liability Relief and Brownfields Revitalization Act (“Brownfields Amendments”) in 2002. The most recent ruling regarding what constitutes AAI was decided in 2005 by the EPA’s Final Rule on All Appropriate Inquiries.
While the EPA’s rule sets out the requirements for All Appropriate Inquiry, the prescriptive standard for conducting and reporting environmental due diligence was created by the ASTM E1527 standard (the Standard Practice for Environmental Site Assessments: Phase 1 Environmental Site Assessment Process), which was designed specifically to meet the AAI requirements. The ASTM (or American Society for Testing and Materials) E1527 standard was first released in 1993 and most recently updated in 2005. The E1527-05 standard is the industry accepted scope of work for the Phase 1 ESA and for meeting the AAI requirements to be protected from CERCLA liability either as an innocent landowner, a contiguous property owner, or a bona fide prospective purchaser.
Owners, Operators and Lenders in Due Diligence
So it sounds like a lot of this applies to protecting owners / potential owners and operators from environmental liability… what about lenders? Why do lenders do environmental due diligence? Technically, lenders are exempt from CERCLA liability (the “secured creditor exemption”) if they foreclose on a property, so long as they don’t take steps to manage the property and sell the property in a reasonable timeframe (but this can be trickier than it seems). A good discussion of the secured creditor exemption can be found here.
Nevertheless, lenders conduct environmental due diligence as part of sound risk management practices: to gauge whether environmental issues may be present that could cause a borrower financial hardship; for CERCLA liability protection during a foreclosure (to be on the safe side); or to gauge whether a property might have a reduced selling price due to contamination, to name a few reasons.
Additionally, while the CERCLA law was the main genesis for why the CRE industry does environmental due diligence, many other laws can impose liability on a property owner, operator or lender, such as the Resource Conservation and Recovery Act (RCRA), the Toxic Substance Control Act (TSCA), Clean Water Act (CWA) and numerous state and local laws.
Environmental Due Diligence Options
There are other forms of environmental due diligence that are both less and more comprehensive than the Phase 1 ESA (such as an Environmental Transaction Screen or a Phase 2 Environmental Site Assessment with soil and/or groundwater sampling), that are appropriate depending on the situation. For example, a lender may choose to order a limited-scope report (perhaps an Environmental Transaction Screen) on a low-dollar loan and a “low risk” property, or a purchaser may choose to conduct a Phase 2 Subsurface Investigation to be more confident that contamination is not present on the property.
The “environmental” is just one piece of the due diligence pie – refer to Maura O’Connor’s overview of the many facets of CRE due diligence.