Lender's Perspectives on Hazardous Waste and Similar Liabilities

Thomas M. McMahon

Editors' Summary: Although NEPA requires the preparation of an EIS for every major federal action significantly affecting the environment, federal agencies often decide in particular cases that compliance with NEPA is satisfied by preparation of EAs. The decision not to prepare an EIS is usually based on a finding of no significant impact. When an agency's threshold NEPA decision is challenged in court, what is the appropriate standard of review? The federal courts of appeals answer this question in at least two different ways: some circuits use the "arbitrary and capricious" standard, while others inquire into the "reasonableness" of the agency's decision. Several courts have expressed doubt that there is any genuine distinction between the rival standards, and the Supreme Court has so far declined to settle the issue. The author of this Article surveys the federal case law on this question, exploring the approach of each circuit and taking issue with those who maintain that the difference between the standards is illusory. The vital difference, the author argues, is that courts using the reasonableness standard are more likely to substitute their own judgment for that of the agency, while courts adopting the arbitrary and capricious standard tend not to second-guess an agency's decision. Because he sees an important difference between these two approaches, the author urges the Supreme Court to grant certiorari to resolve the circuit split.

Thomas M. McMahon is a partner with Sidley and Austin in Chicago, Illinois.

[18 ELR 10368]

I recently came across a little publication entitled, "Sue the Lender." It was the script for a video training program prepared for lending officers. As I glanced through it, I noticed that it said nothing about environmental liability.

This example illustrates two points. First, lenders are just beginning to recognize their important environmental liability. Second, lenders are being sued for many reasons in many different substantive areas, of which environmental law is just one. The business relationship that lenders maintain with their borrowers has exposed and is continuing to expose them to liability.

I am currently trying to help corporate clients structure deals that take into account the current state of the law. For lenders, uncertainty about liability abounds, legally and factually. In the environmental area alone, CERCLA¹ is just one of the laws with which lenders and their associates must contend. The ECRA² statutes can expose another related problem: building contamination. We are now handling a case in which the building contamination problems present a $ 10 million liability. Other issues include worker exposure and product liability.

With regard to CERCLA, a basic problem is created by the concept of strict liability. Strict liability applies to, among others, the owner of the property and the generator or the "releaser" of the hazardous substance. From a lender's perspective, both the property — the collateral in a deal — and the borrower — the lender's business partner — may be subject to strict liability. While one might dispute that the land itself is subject to strict liability, there can be no doubt that it is encumbered by the contamination, and strict liability applies. Thus, while the lender may not be strictly liable per se, the standard exerts a powerful influence over his own level of risk.

Environmental liability can be quite substantial. The average Superfund cleanup is now $ 12 million; under SARA,³ that figure may triple to $ 36 million. In a transaction where the parties are attempting to quantify what they are buying, potential liability of this magnitude obviously has a big impact.

The problem is exacerbated by the extent to which liability is unknown at the time of the deal. The very nature of this type of liability is that it "arises" in the future. Toxic tort claims and underground burial of wastes both have long latency periods. It often takes a long time even to discover the buried waste problem; then it can take one to two years [18 ELR 10369] just to do the study that provides a degree of quantification. In terms of predicting when and how liability will arise, perhaps the closest analogy can be found in the asbestos insurance cases.

This uncertainty has given rise to an aphorism: Superfund-type problems are more easily managed than they are sold. Many companies have Superfund problems which can be studied and remedied over time, even if it eventually costs $ 12 million or $ 36 million. With the passage of time, it becomes clearer what the problem is and how it can be handled and paid for. In a transactional sense, though — sales or mortgages — because of the initial unquantifiability, the problem remains quite difficult. Quantification of liabilities lies at the heart of any transaction.

In my view, CERCLA imposes by far the strictest liability mechanism of any health or environmental laws. This fact leads me to ask: Is the hazardous substance issue more severe than, for example, automotive emissions, in its effect on society? While I don't know the answer to that question, the Environmental Protection Agency (EPA) has recently conducted some studies suggesting that perhaps the priorities should be realigned. Nonetheless, since Congress appears unlikely to change the present system in the near future, we must be content with whatever judicial glosses we can obtain upon liability under CERCLA.

Within the concept of strict liability, lender liability is not a complete mystery. If the lender forecloses and takes title, he becomes an owner. The owner, in turn, is liable under CERCLA. If the lender takes over the operation of the site, he also becomes liable. There is precedent in the nonenvironmental area for such an imposition of strict liability, through either an ownership nexus or a control nexus.

In addition, lenders must keep in mind that almost everybody else involved with the site also runs the risk of being swept into this strict liability scheme. While generators, owners, operators and transporters have commonly been included, cases are now holding others liable. EPA itself has been held liable. SARA contains a whole new section imposing liability on contractors, including consultants. Real estate brokers and bankruptcy are similarly exposed.

We are currently advising the executor of the estate of a man who owned all of the stock in a company with a poor environmental record. The executor — a bank — is now managing that company, trying to conserve the assets of the estate. We have cautioned the bank that by doing so it is exposing itself to CERCLA liability.

Are attorneys potentially liable under CERCLA? While I am unaware of any cases so holding, I expect to see one soon.

With regard to lenders, does the length of time that title is held affect liability? While some have suggested that if one holds it for a short period of time one is protected, I am inclined to disagree. It should be borne in mind, though, that foreclosure by itself does not constitute the taking of title. Under many state laws, the lender need not take title in order to foreclose. In such cases, foreclosure may allow at least minimal protection of his interest.

Another important question relates to control. What kind of control will subject a lender to liability? There is a substantial body of nonenvironmental precedent on this question, so it should not be an issue of first impression.

Some questions remain, however. Should the amount of control relate to the harm? While the nexus may be sufficient as to on-site, owned properties, it is less clear with regard to off-site problems, which constitute the typical Superfund cases.

With regard to the innocent landowner concept, it will probably have little applicability to lenders. Again, however, some questions arise. At what point in time must the "due diligence" be made? Clearly, regardless of whether one is seeking innocent landowner status, it is helpful to meet the due diligence standard. As a commercial matter, it is virtually a necessity. At the time the loan is made, due diligence speaks to the economic viability of the borrower. If one seeks to foreclose, one must employ due diligence to discover whether one will own a piece of property that is heavily contaminated. Both of these steps are required, not so much as a legal matter, but as a practical necessity.

On the related question of whether the lender has a legal duty to monitor the borrower's ongoing environmental compliance, I suspect the answer is no.

Government liens also must be considered. There are state superliens, and there is a new federal lien under SARA. As a practical matter, how significant are these liens to the lenders? The property value is reduced by the liability itself, regardless of the lien.

Some lenders may view the possibility of a government cleanup as a potential windfall, because they assume that the government will clean up the site to their benefit. There is a distinction, however, between a cleanup sufficient to protect against an imminent hazard, and a full cleanup, in which the waste material is removed and the remedy is permanent. If the government sees that a lender may get a windfall benefit, it is likely to preserve its own resources and seek an interim solution. It will do just enough to protect the public health and other sensitive environmental concerns and then let the chips fall where they may.

All of these points raise the question of whether lenders should be entitled to a different standard of liability. While in my view Superfund generally contaminates the whole deal and all of the "partners" involved, it remains a valid question. Notions of basic fairness, of innocence, are at stake. Also, lender liability schemes tend to devalue the property, the asset. As a result, loans become scarcer and smaller. In the end, there is less money available in that business for — among other things — the cleanup.

Government agencies have declared their intent to hold as many different parties liable as possible. It seems self-evident, therefore, that if the lender is the only deep pocket, the government will probably sue the lender.

Let me briefly discuss ECRA-type statutes. An ECRA statute is a state statute requiring, as a condition precedent to a transaction, that the seller accept liability for any hazardous substance problems on the site. These ECRA statutes clearly affect lender liability. Quantification and cleanup are required by ECRA statutes, and liability is allocated to the seller. This statutory scheme protects the buyer and thus, quite substantially, its lender. How will this fact affect the future of ECRA statutes in the various states?

Another matter to be considered is that the loan itself — or the merger or acquisition transaction even if it does not involve a loan — is a new "trigger" for environmental problems. Many of the problems now arising in the transactional context could have remained latent for a number of years. The loan investigation or buyer's investigation, the due diligence that as acommercial matter is becoming a practical necessity, calls this problem to everyone's attention. Once the problem is identified, action is almost always [18 ELR 10370] accelerated. The pressure for such acceleration may come from the buyer, who may view a seller's indemnity as insufficient and demand a cleanup. Moreover, one cannot look just at the cleanup liability. In a recent toxic tort case, a $ 12 million judgment was rendered for the contamination of a drinking water well by a hazardous waste site. Ultimately, the toxic tort liability related to that hazardous waste site will far exceed the cleanup liability. Thus, buyers tend to look not only at how much it will cost to clean the site up, but, also, when that will happen. They want to remove these additional sources of liability.

Also, once these problems are identified, sellers may want to get the site cleaned up for the same reason. The seller may incur future liability if the person to whom it sells the property responds improperly to the problem. Peculiar as it may seem, many sellers are now declaring their intent to clean up property before — or even after — they sell it.

There is another reason why the transaction itself may accelerate the liability. Once one is aware of an imminent risk of injury or damages, in many cases one must act to prevent it. The alternative is exposure to punitive damages or even criminal liability.

From a practical standpoint, CERCLA's strict liability system is very effective — brutally so. One can focus on the "brutal" aspect or on the "effective" aspect. For many observers, the end does justify the means.

The lender community has been galvanized by this development. They now view it as a practical problem of risk management. How can we, as lawyers, help them manage that risk? One approach, when one is lending into an underlying buy/sell transaction, is to examine the indemnity from the seller to the buyer. Frequently, the lender does not become involved until after the deal is struck, and the seller is reluctant to agree to any changes. The lender, however, can simply tell the seller: "If I'm going to make this loan so that you can get your money, you'll have to provide some indemnity." Many deals have been restructured precisely because of such insistence by the lender.

Leaving legal solutions aside, though, how does one reduce that risk? A common risk management practice is first to assess it. An environmental consultant can be sent out before the deal is closed. Such protection may be somewhat illusory, though, as many mistakes are currently being made. Assessment of environmental risks, particularly those underground, is a relatively new field. The mistakes are exacerbated by the speed with which these transactions often must be completed. While one can assess these risks, it can only be done through very careful use of an on-site investigation.

In closing, while there remain some very tricky and interesting legal questions about lenders' environmental liability, in many ways we are moving beyond them. Buyers and lenders are insisting on quantification, indemnity and cleanup. It is a challenging exercise in risk allocation.

DISCUSSION

PARTICIPANT: I agree with much of what you have said. In Massachusetts, where I practice, in addition to looking at the real estate, one must quantify the risk, and then the lender examines the total security package. Often one does not look to the real estate as 100 percent of the loan value. The lender seeks other collateral to protect himself in case of surprise — notwithstanding the site assessment. Stock, a partnership interest, letters of credit or guarantees might serve as additional security.

Also, on deals that are typically without recourse, we've been advising our lender clients to carve out environmental indemnification by the borrower from the nonrecourse clause, and even to insist that this condition survive the payoff of the debt. While extreme, it's a good first-draft position. It makes for some interesting discussions.

McMAHON: Very definitely.

PARTICIPANT: I am curious what you think of the following theory — with which I disagree: It is suggested that a public purpose is served by having lenders and the insurance industry held liable in this arena because they serve as private attorneys general. A lender, for instance, refuses to make a loan until a project is suitably clean; an insurance company declines to underwrite a risk until a positive risk assessment has been undertaken. These adjuncts to the formal enforcement mechanism could be seen as contributing to the prompt cleanup of contaminated property.

McMAHON: It becomes a somewhat semantic question. I tried to address it when I said that this scheme is brutally effective. I do not view lenders as private attorneys general. The system is brutally effective because it focuses so directly on the economic viability of the deal. Lenders are saying: "I'm in this to make money, and if I'm going to be saddled with any unforeseen liability, I had better know about it." It accomplishes the same objective as a private attorney general but from a simple economic motivation.

PARTICIPANT: As a practical matter, in providing protection for the buyer at the time of the transaction that the seller will either clean up the site or arrange to have it done, what mechanisms are used to indemnify the buyer, to ensure that the seller complies with that obligation? Are they using performance bonds?

McMAHON: It is a pure economic issue that depends on the viability of the seller. One would be more secure in relying on a General Motors or an IBM indemnity than on that of a company that might no longer exist when it came time to perform on that indemnity. In such a case, one should escrow a sufficient sum or get a bond posted.

PARTICIPANT: While it may make sense in a $ 2 million or $ 20 million transaction to require these assessments and risk-avoidance mechanisms, it seems less logical to make them part of the requirements for one's home loan. While the marketplace will not permit lenders to require it in every house loan, if it did, most of my lender clients would like to require a clean bill of health for every deal they do.

McMAHON: It is troubling for lenders to lend into even a house deal where contamination might be involved. Homeowners may have more contaminants in their garages than many companies subject to multimillion dollar cleanups have on their grounds. They could do virtually anything with that stuff. It is a problem.

1. Comprehensive Environmental Response, Compensation and Liability Act (Superfund), 42 U.S.C. §§ 9601-9657, ELR STAT. 41941.

2. Environmental Cleanup Responsibility Act, N.J.S.A. 13: 1K6 et seq.

3. Superfund Amendments and Reauthorization Act of 1986, Pub. L. No. 99-499, 100 Stat. 1613 (1986).