Environmental contamination can threaten loan repayment. The presence of contamination will affect the value of the property and the ability of the borrower to repay the loan. The measure of the impact will depend on the nature, time and cost associated with the problem.
Failing to observe conditions at the asset can lead to unexpected problems for the lender. The Office of the Comptroller of the Currency (OCC) has published a revised version of the Commercial Real Estate Handbook in 2013. The requirements for banks’ monitoring of environmental risk have changed significantly. I’m going to discuss some key points from the OCC CRE Handbook’s advisory to banks dealing with contaminated collateral.
The risk to the value of the loan from contamination may often happen when the bank fails to account for the Federal, state and local laws, rules and regulations that apply at the time of loan origination.
Real Estate Lending Standards
OCC states that environmental contamination should be one of the concerns in overall portfolio management.
Among many other things, the bank’s file should include copies of environmental reports, such as Phase I Environmental Site Assessments, for the collateral.
Environmental Risk Management
Federal statutes CERCLA, SARA, Brownfield and State statutes define the potential liabilities of holders of contaminated properties. They provide exclusions for cleanup to banks who only a hold security interest in the facility, provided they do not “participate in the management of the facility.” This is defined in detail in the Handbook.
The EPA issued the “All Appropriate Inquiry” Rule in 2005 (AAI). This provides the property owner some protection against liability provided they perform a proscribed due diligence investigation prior to taking possession. One way this can be accomplished is by having an Environmental Site Assessment performed using ASTM E 1527-13 Standard (prior version was ASTM 1527-05) by an environmental professional (this is also described in the rule)
While the lender’s exemption from liability under CERCLA may exempt them from cleanup, it does not protect the borrower from the cleanup costs if contamination is discovered after the borrower takes possession. This also may impact the borrower’s ability to pay back the loan. The exemption doesn’t protect against diminution of value due to the stigma of the presence of contamination. The OCC states that an AAI study can provide the best information of a property’s environmental condition, potential liability for a borrower, and future procedures if the property is foreclosed on.
The OCC’s Environmental Risk Management section includes a number of bullet points for how to create a well-defined program. These should be reviewed in detail. Broadly speaking, they cover: the initial decision making process; evaluation of the available information; deciding on the appropriate level of due diligence (whether or not an AAI report is necessary); obtaining proper documentation; determining what liability might affect recovery of funds in the event of a foreclosure; understanding the regulatory framework and monitoring the borrower’s business activities to see if they contribute to the contamination.
Minimizing Environmental Risk in Lending Practices
The lender should be aware that industrial properties pose the highest risk of environmental contamination and need close watch on past and future tenants (read more about this in my previous blog, “Dirty Industries: Controlling Environmental Problems at Industrial Properties“.
There is a greater emphasis on environmental risk in the new CRE Lending Handbook, and under Appraisals and Evaluation in the Risk Management section you’ll find a list of items to evaluate when doing the appraisal, one of which is environmental contamination. The 2014-2015 version of the Uniform Standards of Professional Appraisal Practice (USPAP) contains Advisory Opinion 9 “The Appraisal of Real Property That May Be Impacted by Environmental Contamination”. This is the guidance document for appraisers to address the issue.
All of the responsibilities for the bank are pretty well summarized in the ‘Examination” section of the Handbook. In short, lenders are advised to carefully identify, evaluate, document and monitor environment risk as it relates to the lending operations. The OCC Commercial Real Estate Booklet recommends that banks should have procedures in place to select the appropriate level of due diligence to protect their operations. They should evaluate the effect of environmental contamination on the value of the collateral, consider the potential for foreclosure, and determine if and when the advice of an environmental professional is required to adequately screen for environmental concerns at the contaminated site.