Unknown environmental problems are a far greater source of loss to lenders than fire, vandalism, theft, or title risks. This article examines the importance of environmental liability for all financial institutions and investors that hold or invest in loans where real estate is used as collateral.
Environmental liability is a critical issue for all financial institutions and investors that hold or invest in loans in which real estate is used as collateral. Unknown environmental problems are a far greater source of loss to lenders than fire, vandalism, theft, or title risks.
When a collateral property turns out to be contaminated, its value will plummet, placing the lender at financial risk. In negotiating a workout scenario in the event of a loan default, a lender may have a few options. It might choose to foreclose and liquidate the contaminated property. In this case, because of the reduced property value, the lender stands to recover as little as a fraction of the loan balance.
Alternatively, the lender may foreclose on the property and clean up the known contamination. Here, the lender ultimately still may not recover the loan balance due to the combination of the cleanup costs and the potential that the property's market value will remain reduced after the cleanup because of difficulty selling a previously contaminated property.
Notwithstanding recent court cases and regulatory actions, lenders that take control of collateral properties may incur substantial cleanup costs, third-party damages, and legal fees if the property is contaminated. The main trigger for liability is based on "participation in management control," i.e., oversight of a business during a workout scenario. If a lender decides not to foreclose on the property, it can try suing the borrower, but will probably have little hope of recovering the loan value if the borrower has financial problems.
Lenders can reduce their environmental risks in several ways, including the following.
Require environmental assessments as part of the mortgage application process
Lend only in classes of properties that do not have an increased risk
Require an indemnity agreement
Require the borrower to purchase environmental insurance
Purchase lender liability insurance that protects the financial institution
A Phase I assessment or environmental site assessment (ESA) involves an environmental consultant evaluating a property without soil or groundwater samples. Phase I assessments typically cost a few thousand dollars and are completed in 2 to 3 weeks. For many properties, a Phase I assessment will be sufficient to meet the lender's due diligence. Unfortunately, however, these assessments generally are conducted by junior consultants, involve only visual inspections, and have high error rates. They could lead to incorrect evaluations of a site's environmental risk.
During a Phase II assessment, the consultant completes a more extensive evaluation of the site, which can include sampling of the soil and underlying groundwater. Phase II assessments can be much more expensive and time-consuming than Phase I assessments. The type of assessment done depends on several factors, including the past and present uses of the property and any history of environmental problems in the area.
Environmental assessment contracts typically include provisions to limit the consultant's liability for failing to detect the contamination to the original cost of the Phase I or Phase II. Also, the environmental assessment is a review of a site at a point in time and not a prediction of a new condition that might occur during the loan period caused by operations at the site. So, in the event of a default, the lender may have to bear expected cleanup costs and environmental damages during the foreclosure process or choose not to foreclose.
A lender may decide not to lend on properties that are in high-risk categories. Unfortunately, this may prevent loan officers from being competitive with other financial institutions in certain market areas. Further, denying loans to certain classes of business may not fully protect the lender from borrowers who misrepresent their business operations.
Some lenders require borrowers to sign indemnity agreements that spell out the borrower's responsibilities if environmental contamination is found on the collateral property. These agreements deal with issues including, but not limited to, the following.
The conditions that trigger the indemnity, such as the knowledge of a contamination problem
Deductibles and limitations on the amount of recoverables damages
Restrictions on the scope of liabilities covered
The time period covered by the agreement
Indemnity agreements should also include a financial assurance mechanism to ensure that the borrower has adequate resources to cover future environmental claims. This may take the form of escrows, reserve amounts, or letters of credit.
Each mechanism has its drawbacks. Escrows can be difficult to administer, and small or limited liability companies may have limited funds to purchase a letter of credit or to place into escrow or reserve accounts. In addition, the lender and borrower may disagree about the length of time the asset should be held in reserve before it is released or returned.
Borrowers' Environmental Insurance
A lender can protect itself by having the borrower purchase an environmental liability policy, which is more widely called a "pollution legal liability policy." This policy provides coverage for a variety of exposures, including the following.
Third-party claims arising from sudden and gradual pollution conditions
Onsite and offsite cleanup due to contamination
Claims of first- or third-party business interruption
Owner or vendor transportation
Nonowned disposal sites
For lenders, the drawbacks to this type of protection are as follows.
The policy will not cover known conditions except with a high retention.
The lender will have to foreclose on the property in order to collect.
The policy may not have sufficient limits for the exposure.
Other sites may be included under this policy, thereby diluting coverage.
The policy term may not encompass the entire loan period.
The lender may not be aware of a change to the policy, including cancellation, after the policy inception. (In order to be protected, a lender must be named as an additional insured.)
Lenders' Liability Insurance
Lender liability environmental insurance policies are being used by lenders as a lower-cost substitute for, and supplement to, traditional environmental due diligence. Lender liability insurance can protect lenders for unknown or undisclosed environmental conditions, as well as for conditions disclosed by a Phase I assessment, provided those disclosures do not represent policy coverage exceptions. Lender liability insurance also provides coverage against new environmental conditions that may appear during the loan term.
There are two types of lender liability policies.
Policies that provide coverage for the lesser of the outstanding loan balance or the pollution condition
Policies that pay the outstanding loan balance
Both types of policies require borrower default and the existence of a pollution condition covered by the policy before a claim is paid. When either policy pays for the outstanding loan balance, it will also include any accrued interest from the date of default and any related outstanding obligations.
Lender liability policies provide coverage for losses arising from a default by a borrower that are accompanied by a pollution condition on a commercial real estate loan secured by an insured property. They will pay the lesser of either the outstanding balance, in which case the insurer will indemnify the insured, or cleanup costs, in which case the insurer will pay on behalf of the insured. For this coverage to apply, onsite pollution conditions must be discovered by the insured during the policy period. However, preexisting conditions can be included by endorsement if there is a responsible party actively cleaning the site.
The policy also pays for losses that the insured becomes legally obliged to pay as a result of claims made against the insured and reported to the insurer during the policy period. The losses covered under the policy include bodily injury, property damage, or cleanup costs resulting from onsite or offsite pollution conditions. In addition, the policy provides legal defense coverage for the lender whether the property is in possession of the lender or not.
The lender liability policy can be written on a single-site or on a portfolio basis. The portfolio policy may be underwritten on a business segment, type of loan, a portfolio acquired from another lender, or a block of properties that encompass loans with the largest risk. Lenders can choose any criteria they feel are appropriate.
The benefits of the lender liability policy include the following.
The policy provides a competitive edge for lenders regarding standard environmental due-diligence techniques. A Phase I assessment does not provide protection when an environmental claim is made.
The policy can replace or augment a lender's own due-diligence process.
Properties with known environmental conditions can be included.
The policy enables lenders to provide faster turnaround on loans because the insurer may perform all of the environmental due diligence in-house to add the loan(s) to a policy. The average turnaround time for an underwriter approval is 3-4 days.
Policy terms are available for up to 20 years.
The policy provides for retrospective and prospective coverage.
It provides protection for the insured for Comprehensive Environmental Response Compensation and Liability Act (CERCLA) lender liability claims.
The policy can provide a waiver of subrogation against the borrower
The lender liability policy protects the collateral value of each and every property insured against unforeseen environmental conditions. It allows lenders to foreclose on contaminated property they might otherwise not foreclose on because the policy would pay the cleanup costs or the loan balance, whichever is less. If the insurer pays the cleanup costs, the lender gets the collateral in the form of a clean, marketable property. If the insurer pays the loan balance, the lender receives collateral back in the form of money.
The next article in this series will focus on environmental insurance as it relates to exposures of owners, developers, and contractors associated with Brownfield redevelopment in the United States.
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