Lenders’ Frequently Asked Questions about Environmental Risk Management

General Environmental Due Diligence

1. Is environmental due diligence necessary?

   Yes. Current federal and state environmental laws can impose significant liabilities on a broad spectrum of parties. Under the most stringent federal environmental law, the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), current and former owners or operators of facilities may be held liable for cleanup; cleanup liability can even be imposed on owners or operators who were not responsible for—or did not know about—contamination. Done early enough in the transaction, thorough environmental due diligence can help parties manage business risk. Sellers can identify and resolve issues before they become negotiating points, and buyers can protect themselves from liability, use the information to negotiate a better deal, obtain environmental insurance, etc.

2. What types of properties are generally associated with a high risk of contamination?

   Although any site can be contaminated, as a rule certain property types always merit close inspection. These include gas stations, dry cleaners, industrial sites, and auto repair/body shops. Electronics manufacturers, printing facilities, woodworking operations, nurseries, and agricultural land that has been subjected to crop dusting are also potential areas of concern.

3. What are the features of a comprehensive environmental risk policy?

   Lenders should create an environmental policy that reflects their bank’s risk tolerance level. Key components of the policy include: (1) support from credit and senior management and a willingness to enforce the policy; (2) identification of transactions or collateral types subject to the policy, along with a clear description of who has the authority to enforce or waive requirements; and (3) the creation of a tiered approach to environmental due diligence. Additionally, everyone involved in the bank’s environmental risk management program should have a basic understanding of the types of environmental risks that tend to create losses; the tools used to mitigate such losses, and an understanding of when losses are created. Lenders should also cultivate relationships with experienced environmental professionals and at least one attorney experienced in environmental law. Bottom line: The goal of an environmental risk policy is to identify environmental risk and then factor it into the overall credit analysis. If information necessary to quantify a potentially significant concern is not available, investigate further.

4. What qualifications should I look for in an environmental professional?

   Effective November 1, 2006, EPA’s new All Appropriate Inquiry (AAI) rule set minimum qualifications for environmental professionals, and this mandate is driving scrutiny by banks on their list of approved environmental consultants. When hiring a consultant to conduct an AAI-compliant Phase I, he or she must meet the minimum requirements outlined in Table 1. Although the rule allows for consultants who do not meet the new definition of environmental professional to conduct an AAI-compliant Phase I (as long as they are supervised by someone who does), some lenders have adopted more stringent policies that require qualified consultants for every element. Bottom line: Hire an EP with adequate qualifications and experience in the work you are seeking to have performed. Look for consultants who have worked with a variety of environmental conditions. Ask for resumes, referrals and project summaries before committing. And, if you are contracting for an AAI-compliant Phase I, make sure the EP meets those qualifications listed below.
   Table 1. “Environmental Professional”
   Qualifications (EPA’s AAI Rule)
   Professional/Educational Qualifications Relevant
   Experience
   Professional engineer or geologist license/registration; 3 years
   Federal or state license/certification to perform environmental inquiries; 3 years
   B.A./B.S. degree or higher in any science or engineering degree; OR 5 years
   No B.A./B.S. degree 10 years

Commercial Lending under EPA’s New AAI Rule

1. What are the motivations behind EPA's new AAI standards?

   As part of the 2002 Brownfield Amendments, EPA ordered Congress to define “all appropriate inquiry,” CERCLA’s vaguely defined term that refers to pre-purchase environmental due diligence. Prior to the AAI rule, all appropriate inquiry was satisfied with an ASTM E 1527-compliant Phase I environmental site assessment. Today, only a Phase I environmental site assessment (ESA) that complies with the EPA’s AAI rule (or its ASTM counterpart, the updated E 1527-05 Phase I ESA standard), will qualify a purchaser for CERCLA liability protection. Additionally, under the AAI rule, property purchasers must comply with post-purchase continuing obligations or risk losing their liability protections.

2. How is the AAI rule different from the ASTM E 1527-00 standard, the previous protocol?

   For starters, to conduct an AAI-compliant assessment, an environmental professional must meet new federal qualifications or be under the supervision of someone who does. (See table 1). Also, the AAI rule requires additional research and documentation, raising the bar for environmental records review, acceptable gaps in data, and report shelf life. Under the new rule, the user (borrower) also has responsibilities—he or she must search for environmental cleanup liens, consider specialized knowledge about the property, and consider the relationship of the property’s purchase price to the fair market value of the property, if not contaminated. Out of the 10-step AAI process, the user has responsibility for three of those steps; two additional steps are shared between the user and the EP.

3. Who must follow AAI?

   The AAI rule is written for the property purchaser—not directly for lenders. Any parties, either on their own or because a lender requires it, who are seeking CERCLA liability protection under one of three avenues (innocent landowner, contiguous property owner, or bona fide prospective purchaser) must complete the 10-step AAI process.

4. Are institutions still protected by CERCLA’s secured creditor exemption?

   Yes.

5. What have bankers' experiences been with the new rule?

   So far, lenders’ reactions to the AAI rule cross a broad spectrum. Among lenders who have already made a determination as to how AAI will affect their environmental due diligence policies, at one extreme are those who do not intend to change their environmental due diligence policies at all. This decision is based on the protection afforded banks under the secured creditor exemption—or a determination that the banks’ already stringent environmental due diligence policy is sufficient. Other lenders are requiring compliance with the AAI rule on every transaction. In the middle are banks that will require AAI compliance on a case-by-case basis—on properties believed to have the potential for environmental contamination, or where a bank is faced with foreclosure. It should be noted that awareness about the new AAI rule is still far from widespread, so the effects AAI will have on the lending community largely remain to be seen.

Environmental Due Diligence Tools

1. What are the components of a high-quality Phase I?

   Phase I ESAs can vary greatly in price, depth and scope. Typically, the focus of a Phase I is to identify areas of environmental concern that could pose a problem on the property. A high-quality Phase I will include an on-site visit to view present conditions; an evaluation of the risks of neighboring properties; interviews with past and present owners, site managers, etc.; a review of government records for the property and its surrounding area, and detailed information on historic property use and clear explanations as to why things are or are not considered recognized environmental conditions. The assessment should be done by a qualified professional who can interpret the collected information, access and analyze it, draw conclusions, and provide recommendations regarding the property’s conditions, its clean-up (if necessary) and the transaction.

2. Do I need a Phase I for every transaction?

   Many lenders require a Phase I for every large-cap loan (i.e., above $1 million to $2 million threshold) and for certain loans perceived as posing a high environmental risk. But, in scrutinizing their environmental due diligence policies in light of the new AAI rule, even the most risk-averse banks are now asking themselves whether a Phase I is always necessary. Some experts say yes, reasoning that in many cases lower-value loans often have the highest risk of default, which could result in the bank foreclosing on the site and having some accountability for potential contamination. A Phase I would identify issues and assist the bank in determining whether smaller-value loans with higher default potential are worth the risk. Other experts say that, at a minimum, a desktop review of existing documentation should be performed, and, based upon the findings, an appropriate scope for further investigation, if necessary, should be determined. Lenders should note that, under the new AAI rule, the usefulness of past Phase I reports is limited. All information must have been collected or updated to within one year of the property transaction; certain elements (e.g., site visit, government records review, etc.) have only a 180-day shelf life.

3. What does a Phase I cost and how long does it take?

   Today, the average cost of an AAI-compliant Phase I is around $2,700. Add-on assessments like mold and lead-based paint screenings can drive up the cost. Most EPs require a minimum of two weeks and as many as six weeks to complete an AAI- or ASTM E 1527-05-compliant Phase I. Discussing the schedule upfront can avoid misunderstandings down the road; any change in the typical timeframe generally impacts cost. Lenders who are in a hurry can help save time if they facilitate access to the site.

4. Should I add non-scope considerations to the Phase I?

   CERCLA liability protection is often not the primary driving force behind a Phase I. For lenders, the primary concern has more to do with whether environmental issues will impact the property’s value or the borrower’s ability to repay the loan. As such, it is not uncommon for a Phase I’s scope to expand beyond CERCLA hazardous substances to include other environmental risks, like lead-based paint, asbestos and mold. The decision on whether to include these non-scope issues depends on how the client will use the Phase I report. If the borrower is planning to reconfigure or renovate the property in any way that may result in the excavation of soil, impact on asbestos, etc., the Phase I scope should be expanded. Although asbestos and other non-scope issues are not specified as considerations under CERCLA, the presence of asbestos, for instance, may present a significant cost to the user during renovation or redevelopment. If asbestos is identified correctly and quantified during due diligence, these costs can be accounted for when evaluating the purchase of the site and whether the planned use is financially viable.

5. What can I expect if contamination is discovered?

   The first step is to quantify the potential cost to clean up the property, either through a rough estimate using what is known, or, if greater certainty is needed, by conducting further investigation. Based on this information, the deal may proceed with funds in escrow for the cleanup, the loan may be delayed to allow cleanup to occur, or other options may be pursued. It is important for both lenders and consultants to understand whether there is a non-disclosure agreement in place should the loan not proceed. This would determine whether the borrower can be told of the release, potentially obligating them to report it to the state. Lenders can also ask their EP to help evaluate the business risk posed by the contamination. Remember, contamination is not necessarily a deal-breaker.

6. Besides Phase I ESAs, what other environmental due diligence tools are available to lenders?

   Whether federal regulators’ recent warnings cause bankers to reexamine their environmental policies or AAI prompts a reevaluation, the good news for lenders who are updating, or even writing an environmental policy for the first time, is that today there are more options for conducting environmental due diligence than ever before. In many cases, there continues to be no substitute for a high-quality Phase I ESA. In other instances, there are now simple, cost-effective tools for evaluating environmental risk that return results quickly. These tools, often used for low-value loans or on properties that normally would receive no due diligence, afford banks avenues for achieving peace of mind while still maintaining a competitive edge. They include:
   • Transaction Screen
     Typically performed by an environmental professional and primarily used for lower-risk properties, the transaction screen no longer satisfies its original purpose of qualifying a purchaser for CERCLA liability protection. However, because it contains a site visit, which can answer questions about the current condition and past operations of a property raised during the historical research and government records search portion of the review, the transaction screen can be a highly effective tool. At an average cost of $750 to $1,000, the screen is also cost-effective.
   • Database Reports
     When a full-scale environmental investigation is not warranted, lenders can still learn a great deal about their business risk exposure by ordering reports of government records and historical information for the property in question (e.g., EDR LoanCheck). Most of these reports are priced under $500, and are useful in that they can uncover such issues as leaking underground storage tanks, landfills, or former high-risk operations (e.g., dry cleaners or industrial facilities) on the target property or operations of concern on adjacent properties. These reports are ideal for screening seemingly low-risk properties that might otherwise receive no environmental due diligence. If no red flags are found, the lender has peace of mind; if potential risks are uncovered, the lender can address them early in the transaction by taking environmental due diligence to the next level, say by conducting a site visit or hiring an environmental consultant to do a complete Phase I ESA.
   • Online Data Services
     A new tool for lenders is the online data service (e.g., EDR Collateral Screen). Designed for low-value loans or low-risk properties, these services allow subscribers to tap into environmental databases from their desktops. A quick address entry will return results for the property, alerting the lender to environmental concerns that may require further investigation.