The current economic climate has made the commercial lending market extremely challenging. Given these conditions, lenders and borrowers both need to have a firmer understanding of the potential risk associated with environmental issues and the exposure to environmental liability. To that end, lenders are reviewing their existing environmental due diligence procedures and placing greater emphasis on this aspect of the loan process. Meanwhile, there is a growing need for insurance programs that protect the lender's interest and address potential environmental risks.
In the current economic situation, a number of commercial lenders are finding that environmental insurance programs can allow them to accept additional exposure on properties previously considered riskier. Interest rates have declined in recent years, and commercial lending margins have been reduced substantially. As a result, there is less room for "error" resulting in unexpected costs, such as those for environmental cleanups, if a foreclosure occurs. Lenders also need to be able to provide a faster turnaround time from loan application to closing, and to be able to receive adequate environmental due diligence to protect their interest, as well as to fulfill their requirements under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA).
Environmental Due Diligence
Traditional forms of environmental due diligence often can be time consuming and expensive. The traditional due diligence process does not provide today's commercial lenders with the ability to protect their interest adequately or allow for a reliable transfer of environmental risk to third parties.
Phase I Assessments. Phase I environmental site assessments (hereinafter "Phase I") are the most commonly used form of environmental due diligence, both for lenders and their borrowers. The use of Phase I came about as a result of the Fleet Factors decision that helped establish CERCLA as a serious threat to commercial lenders. In that decision, the court ruled that a lender had liability for environmental cleanup based on the fact that the lender had the ability to influence the borrower's environmental compliance, even though the lender didn't necessarily exercise that ability.
Subsequent amendments in 1996 to CERCLA clarified and affirmed a limited exemption from liability for commercial lenders under defined circumstances having to do with the lender's pre-loan due diligence and post-foreclosure activities. A key component of these requirements is that some form of comprehensive environmental due diligence be conducted prior to the closing of a real-estate-backed commercial lending transaction ("all appropriate inquiry"), to determine if any past or present environmental exposure exists. For about a decade now, commercial lenders have relied upon the Phase I to fulfill these requirements.
A Phase I consists of a historical review and a present environmental qualitative evaluation of a property without soil or groundwater sampling or analysis. Essentially, it is a snapshot in time, without quantitative data. If it fails to identify the existence of a recognized environmental condition (the parlance for these conditions listed in the American Society for Testing Materials (ASTM) industry standard for Phase I assessments), it provides no protection for future exposure, assuming the consultant who performed the audit did so in compliance with the ASTM standard (currently E1527-00). Even if a consultant failed to perform the audit in conformance with the ASTM standard, a lender's recourse against the consultant is often limited by the following.
Limitations on liability that consultants often include in their contracts (although most sophisticated lenders do not allow this in their contracts)
The scope, limits available, and financial conditions of the consultant's professional liability (errors & omissions) insurer
The consultant's financial strength and condition at the time a loss occurs
Even if the Phase I was performed in compliance with the ASTM standard, changes in environmental site conditions after the loan is closed are not the purview this type of audit. As a result, the lender has absolutely no recourse against anyone but the borrower when new spills or releases occur after the loan is consummated. In most cases, the lender does not discover the existence of an environmental condition that will require a costly cleanup until after it has foreclosed on the site. At that point, recourse against the borrower (who defaulted) is no longer possible anyway.
A Phase I, which is paid for by the borrower, can be costly and take 2-5 weeks to complete. Without knowing if an environmental condition exists, the lender is unable to make a decision on whether to complete the loan process. As a result, it is not uncommon for a lender to invest substantial internal resources underwriting a loan while waiting on the results of the Phase I, only to determine that the loan cannot be made upon receipt of the Phase I report weeks later. At this point in the process, these internal costs cannot be recouped from the borrower as no loan will be completed.
Although Phase I findings may vary, most properties fall into one of three general categories: the property is perceived to be clean (i.e. "no recognized environmental condition" exists); an environmental exposure had existed, but no further action is required; or there is a recognized environmental condition and further testing of soil and/or groundwater is recommended. The first two categories are usually sufficient to meet a lender's environmental requirements, allowing them to finalize the transaction and close a loan.
Phase II Assessments. The most troublesome situation for the lender is the third category, particularly when the borrower is a key banking client. The lender now must make a decision whether to require the borrower to get a Phase II environmental site assessment (the next level of environmental due diligence) or decline the loan as a high-risk property. At present, approximately 50 percent of all transactions waiting approval have some form of environmental exposure associated with the site. If a lender requires a Phase II, it means a substantial additional cost to the borrower (from a few thousand dollars to mid-five figures or more) and can take several more weeks to be completed.
A Phase II is an extensive environmental evaluation that includes the sampling of soil and underlying groundwater. It is similar to a Phase I in that it is a snapshot in time, providing no protection going forward and for which recourse against the performing consultant is limited. Depending on the outcome of a Phase II, a property can be deemed clean or within acceptable levels and a lender can proceed with the loan closing. If a property comes back contaminated, a lender might consider it as having a high potential for exposure. This puts the lender in a difficult position of having to pass on a possibly good source of revenue based on credit scoring just to avoid potential risk and liability. Once again the environmental due diligence has extended the loan process and has become the factor determining whether a lender should proceed.
Limitations of Phase I and II Assessments. Phase I and II environmental site assessments only assess past and present exposure, and do not provide a solution. They are site reviews and not long-term forecasts of possible future exposures that may occur during the term of a loan through operation or encroachment from an adjacent site. In the event of default, the lender maybe held responsible for the cleanup costs and environmental damages during the foreclosure process.
Lender Liability Policies
How does a lender in today's economic climate address these issues? Through the use of environmental insurance programs, lenders now can approach commercial real estate lending confidently, without fear of environmental liability or having to foreclose on environmentally impaired properties through the use of insurance programs such as lender liability, also known as secured creditor environmental insurance. These programs are specifically designed to protect the interest of the lender.
Lender liability policies are designed to protect commercial real estate lenders from financial loss due to default and the existence of a pollution condition at actionable levels. These programs also provide lenders and their investors with the ability to transfer environmental risks protecting their interests after the loan has closed. Should there be a default and a pollution condition at actionable levels, the policy benefit allows for the payment of the remaining unpaid balance of the loan and any accrued interest from the point of default to payment of the claim. Once the lender has received payment, the insurance company takes the lender's position on the note, thereby providing a complete transfer of the risk.
Coverages under Lender Liability Policies. Lender liability policies are designed to provide three separate, but distinctive, coverages, as follows.
Coverage A pays for the outstanding commercial loan balance when a loan is in default and the default is accompanied by a pollution condition at or above an actionable level. Another version of the program is available under which Coverage A pays the lender the lesser of the principal loan balance outstanding at the time of default or the site's environmental cleanup costs.
Coverage B protects lender's cash flow by providing coverage for third-party claims for bodily injury, property damage, and/or cleanup costs resulting from on- and off-site pollution conditions at insured properties. Coverage B protects lenders whether they merely hold indicia of ownership to protect their collateral interest, or they have actually foreclosed on environmentally impaired sites.
Coverage C provides coverage for on- or off-site cleanup on insured properties where the lender foreclosed with (under the "lesser of" version) or without ("loan balance only" version) knowledge of the environmental condition at the site.
Benefits of Lender Liability Policies. In contrast to Phase I environmental site assessments, lender liability policies are less expensive and more time efficient. The cost of a Phase I can run from $1,700 to $2,500 depending on geographic location, and is a fixed cost regardless of whether the loan closes. There is no cost to the lender associated with a lender liability policy. If the loan closes, there is a one-time premium that protects the lender through the life of the loan. This premium is then passed on to the borrower as a single line item on the closing statement. The borrower can avoid the up-front cost of a Phase I audit without knowing whether the lender can close the loan. When listed on the closing statement, the premium charged to the borrower should be less than the borrower's cost of obtaining a Phase I. This coverage can be underwritten in 5 to 7 business days, therefore bringing the environmental due diligence to the front of the loan process. This enables a lender to close loans faster.
In some cases, lender liability programs are being used to streamline the commercial lending process. Some lenders have borrowers complete a lender liability questionnaire at loan application, forward them directly to the underwriters, and receive a bindable quote within 5 working days. This eliminates the 3-5 week waiting period for a Phase I.
The case study outlined in Exhibit 1 illustrates this approach.
Exhibit 1 Case Study: Streamlining the Commercial Lending Process
A $34 billion asset bank conducts commercial business banking in seven regions. An expanded bank lending policy required environmental due diligence on all real estate loans $500,000 and higher. The home office Corporate Risk Management unit always had ordered, reviewed, and interpreted Phase I site assessments for loans $1.0 million and higher. Given the much higher loan volume, this unit admitted it could not keep up due to the new requirement. The process for all loans was taking 4-6 weeks. The bank's regional presidents felt they could not compete in today's market for faster loan commitments. The bank's chief credit manager enlisted one of the insurance companies to develop a program that supports an environmental due diligence alternative for loans between $500,000 and $1 million. A lender liability banking program was implemented that allowed each of the seven banking regions to work directly with an assigned environmental underwriter and technician to complete environmental due diligence within a standard of 5 working days. Lender liability insurance has enabled Corporate Risk Management to support this expanded bank lending policy without additional personnel and has freed the unit to continue focusing on lending transactions it deems more critical.
Lender liability policies can also be used as a low-cost alternative to costly traditional forms of environmental due diligence. A Phase I cost is a fixed price regardless of loan size. Lender liability premium established by the underwriters generally is based upon loan size, property usage, and the term of the loan. Lender liability coverage might also be structured on a portfolio basis, so that a cross-section of loans can be protected with discounted pricing.
The following case study in Exhibit 2 describes the use of lender liability as a low-cost alternative.
Exhibit 2 Case Study: Providing a Low-Cost Alternative
A community bank historically originated small-balance loans and loans collateralized by low-risk properties with little or no environmental due diligence because its management suspected the likelihood for environmental liability was low compared to the high cost of due diligence. After foreclosing on a $250,000 loan that ultimately cost $300,000 to remediate and led to potential future third-party liability, the bank wanted these loans included in an environmental risk transfer program. A lender liability portfolio program was created that provided the coverage, speed, and cost needed to compete for these loans. With lender liability, the bank was able to step up to a uniform, consistent, and auditable program.
Lender liability policies can also help eliminate the need for a Phase I and in some cases avoid a Phase II, altogether, as described in Exhibit 3.
Exhibit 3 Case Study: Eliminating Phase I Assessments
A $5 billion regional bank focused on growing its commercial real estate loan portfolio by winning refinance business. The existing environmental due diligence protocols dictated that a refinance required a new Phase I site assessment. The bank knew that reducing the time and cost of environmental due diligence would attract new clients. In conjunction with a lender liability portfolio policy, the lender gained the flexibility to accept old and/or out-of-scope Phase I reports from new borrowers and close the loans quickly.
Lender liability policies have been recognized by the leading credit rating agencies; Moody's, Fitch ICBA, and Standard & Poor's have all endorsed the programs to be used in lieu of or in conjunction with a Phase I ESA. They have also stated that environmental insurance is an effective means of securing a strong credit rating and an advantage to lenders involved in the commercial mortgage-backed securities (CMBS) market.
Exhibit 4 Case Study: The Advantages of a Lender Liability Portfolio Policy
A specialty lender that closes 75-100 stand-alone franchise loans per year recognized that speed and expertise were his firm's competitive advantages. However, his environmental due diligence process had begun taking 3-5 weeks and generating the same red-flag environmental issues over and over again. The lender needed a solution that was fast, convenient, and recognized in the secondary and CMBS market. A lender liability portfolio policy was created to cover all his new loan originations. Now, the lender's environmental process is complete within 5 business days, environmental issues are resolved up front, and the firm's competitive advantage has been restored.
In conclusion, environmental insurance programs are more than just policies that protect the interests of the commercial lender. They are also being used as a tool to help facilitate the commercial loan process. They allow a lender to be more competitive in the present marketplace by transferring undesirable risk, providing a faster turnaround time while lowering cost, and providing a more comprehensive form of environmental due diligence and protection than provided by traditional forms.
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