Environmental contamination and the related liability can have a significant impact on the value of real estate held by a financial institution as collateral. Of particular concern are situations when an institution is either held directly liable for court-ordered cleanups of hazardous substance contamination or when either collateral value declines or a borrower cannot meet debt obligations after funding contamination cleanups, thereby hindering an institution from collecting on loans. Because environmental liability can affect a substantial number of loans to borrowers who reside in different industries and localities, it is important for institutions to understand the nature of any environmental liability associated with hazardous substance contamination and to take the necessary prudential actions to identify, measure, monitor, and control the risk.
This article provides an overview of environmental contamination legislation and recently issued final implementing rules, and it explains how these final rules will impact financial institutions and what measures institutions should take to reduce their credit risk exposure.
Overview of Environmental Protection Agency Guidelines
In 1980, Congress enacted the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), more commonly known as Superfund, in response to increasing concerns over the improper handling and disposal of hazardous materials.1 The act created an avenue for federal authority to tax chemical and petroleum industries and provided a broad federal authority to directly respond to releases or potential releases of hazardous substances on the general public. Fundamentally, CERCLA:
In 2002, amendments to CERCLA were made with the Small Business Liability Relief and Brownfields Revitalization Act (Brownfields).2 This act clarified CERCLA liability provisions for certain landowners and established additional protections relative to cleanup liability for landowners who qualify as contiguous property owners, bona fide prospective purchasers, or innocent landowners. To meet the statutory requirements for any of these landowner liability protections established by Brownfields, landowners must meet certain threshold requirements and comply with certain ongoing obligations.
Brownfields also required the EPA to develop implementing regulations, including a definition of the activities that constitute an all appropriate inquiry (AAI), a term used to describe the environmental due diligence standards and practices needed to qualify for any of the landowner liability protections.
An AAI must be performed on or before the date on which the property was purchased to qualify for liability protection. An interim rule implementing Brownfields was issued, which included a list of criteria for establishing standards and practices for conducting AAIs, and the final rule was published in November 2005 and became effective on November 1, 2006.
The final rule is not significantly different from the interim standards, and while the interim rule laid the groundwork for ASTM International (ASTM) to revise its standard for the Phase I environmental site assessment process, the final rule does the following:
Implications for Financial Institutions
Knowledge of environmental conditions, whether or not environmental contamination is present, or a claim of a lack of knowledge of previous contamination can be contributing risk factors that an institution should consider in granting a loan or in making a real estate purchase. Brownfields represents a significant change in environmental law and places a much heavier burden on a prospective property purchaser and lenders to put forth a claim for landowner liability protection.
While financial institutions are not legally obligated to perform more stringent AAI reports under the final rule, conducting an AAI investigation will allow financial institutions to gain more insight on the property held as collateral and any related environmental concerns. The potentially adverse effect environmental contamination can have on the value of real estate property should be factored into all evaluations involving real estate transactions and loans secured by real estate.
As part of the institution's environmental risk analysis of a particular loan extension, the institution should determine whether it is appropriate to require the borrower to perform an environmental evaluation that meets the AAI standards and practices contained in the final rule. It should be noted that many financial institutions also sell commercial mortgages on secondary markets, for which stricter environmental assessments may be required.
Financial institutions should establish adequate safeguards and controls to mitigate any risk exposure to environmental liability. Implementing and maintaining an environmental risk program that evaluates the aforementioned adverse effects can serve as an effective risk mitigation tool. It is important for institutions to investigate and monitor any environmental risks and potential liabilities that exist for real estate held as collateral or transferred, as in a foreclosure. The key in analyzing and addressing these concerns is to recognize and understand the different relationships, including compliance obligations, that an institution may have in connection with real estate. For example, financial institutions may incur environmental liabilities such as:
To supplement an institution's ongoing credit monitoring process, an AAI should be conducted to determine and ensure that real estate taken as collateral is not contaminated, particularly when an institution is taking titles to these properties or when it is making foreclosure decisions.
Elements of an Environmental Risk Program
Institutions are encouraged to become familiar with the Brownfields amendments and to incorporate an environmental risk program into their overall risk management processes, commensurate with the institution's size, complexity, risk profile, and operations. In addition to establishing clear and comprehensive procedures, an effective environmental risk program could incorporate the following:
Keep in mind that individuals involved in real estate or corporate real estate transactions should have a comprehensive understanding of the 2005 ASTM standard requirements, as transactions of this nature must follow 2005 ASTM or AAI standards in order to be eligible for liability defense under CERCLA and similar state laws and regulations.3
Other Regulatory Considerations
Under CERCLA and other state statutes, institutions may be permitted an exemption from environmental liability if it is determined that they only hold a security interest in the real estate property taken as collateral. When monitoring a loan for potential environmental concerns, an institution should evaluate whether its actions constitute a participation in managing the business that is located on the property. If the institution's actions are considered a participation in management, then the institution may lose its exemption from liability under CERCLA and similar state regulations.
Exposure to environmental liability can potentially undermine an institution's lending program, prospectively causing significant financial losses and legal liabilities. The board of directors is ultimately responsible for reviewing, approving, and adopting policies and procedures that include an environmental risk program. To that end, senior management should appropriately implement these policies and procedures and ensure that lending practices comply with bank and regulatory guidance.
If you have questions on matters related to environmental contamination guidance in general or to recent CERCLA revisions, please contact your primary regulatory agency. For those institutions supervised by the Federal Reserve Bank of Philadelphia, please contact Ivy M. Washington (firstname.lastname@example.org) at (215) 574-6642.
The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.