Environmental due diligence for lenders

Environmental due diligence for lenders

Steve Luzkow

This article considers the basic components of environmental risk management, the various factors considered by most lenders, and the information needed to facilitate the closing of the transaction. Although loans may be secured through various means, the author focuses on transactions secured by real estate or real property.

Conducting environmental due diligence–whether a Phase I environmental site assessment or Phase II subsurface study–is the mainstay of the environmental consulting industry. Much of this due diligence is conducted on behalf of either a lender or a purchaser and, in almost every instance, is done to obtain a financing decision. However, consultants generally have little understanding of how the lending industry uses the data they collect. What they do see is the variability in how each lender applies policy, procedures, and use of the consultant’s work product. Lenders can ensure receiving the information they need to fulfill their due diligence requirements by making their wants known to the consultant.

Due Diligence Ensures Collateral

Each institution administers loan policy a bit differently, although with the same goal of due diligence. Generally, due diligence is required when a loan is supported by real estate or real property. This way, in the event of a default and subsequent foreclosure, the institution can sell the real estate or property and repay the debt. In such instances, the real estate or real property becomes the collateral. Loans also may be secured by personal guarantees, accounts receivable outstandings, inventory, marketable securities, and other non-real-estate or non-real property, and these may even be cross-collateralized with real estate or real property.

Let’s take a closer look at the lending process and the varied approach by some lenders, followed by some suggested “do’s” and “don’ts.”

Varied Due Diligence Objectives

Each party in a real estate loan transaction has its own reason for conducting due diligence, but all share the objective of executing the transaction:

* Lenders need to be informed of the borrowers’ known and potential liabilities to measure their ability to repay in the event funds are diverted for environmental purposes. Moreover, lenders need to ensure that the collateral is marketable at a value exceeding the loan amount in the event of default.

* Borrowers may desire to make an informed decision or establish an “innocent purchaser defense” (1) for new purchases, or they may be compelled to perform due diligence by their lender for reasons cited above.

* The consultant, who may be retained by a borrower or a lender, conducts due diligence for any of the reasons above.

On top of meeting the needs of borrowers and lenders, the consultant must contend with varying degrees of risk tolerance and lender experience, as well as differences in due diligence policies.

Loan Criteria

A lender provides funds to a borrower only after being assured that a loan can be repaid and that there are sufficient assets or guarantees pledged to cover the loan amount in the event of default. Therefore, lender environmental policy and procedures should be integral to the credit, asset, collateral, and foreclosure analysis process.

Environmental Credit Review

The primary focus of the environmental credit review is to identify the potential, or known, environmental liabilities that could divert the borrower’s cash flow to address environmental problems. Liabilities may include:

* Expenditures for engineered controls to prevent unacceptable exposure.

* Third-party agreement transfer of environmental cleanup liability to the borrower.

* Strict joint and several liability (for example, PCB cleanup under TSCA or RCRA liability–large quantity generator sites with incomplete or ongoing cleanups).

* Legal claims for cleanup nr other damages, such as replacing a municipal drinking-water well.

* Consent or administrative order obligations.

* Health and safety (unacceptable exposure from site operations).

* Compliance or other violations.

Foreclosure Analysis

Before recovering the property through the foreclosure process, or taking a deed-in-lieu, the lender needs to ascertain the following factors at the time the credit review is conducted.

* Potential direct liability to the lender.

* Expenditures to prevent unacceptable exposure while property is on the market.

* Potential purchaser liability.

* Projected purchaser expenditures to conduct continuing or different operations on the property.

* All of the credit review issues as they may relate to an existing tenant, if applicable.

Due Diligence Tools

Due diligence tools to assess known or potential liabilities may be used by a consultant, the lender’s staff (if so qualified), or any combination of assignments by the lender or borrower. Such tools may include:

* Internet database search (e.g., a state’s list of contaminated sites).

* Environmental database information providers (e.g., regulatory databases and government-listed sites).

* Government records reviews.

* Phase I Environmental Site Assessment–ASTM 1527 (government records review, site inspection, and interviews).

* Phase II Environmental Site Assessment (soil, water, or air sample collection and analysis).

* Interviews.

* Site inspection.

* Asbestos studies.

* Mold studies.

Basis for Policy

Even though the liability variables and data-gathering tools largely do not vary by jurisdiction or state, the environmental policies and procedures vary from lender to lender to the extent that even the most experienced borrower and consultant cannot predict the level of effort and amount of information required by a lender for a given transaction. Even the FDIC provides that a program be established with no set criteria. On the other end of the spectrum, the Small Business Administration (SBA) provides detailed, conservative guidance for SBA-guaranteed transactions. For example, SBA will provide a certain percentage of funds to the lender in the event of a default. This lack of regulatory guidance creates a free-for-all attitude, whereby lenders are forced to establish their own policies, thresholds for the degree of due diligence conducted, and procedures. The lack of standardization breeds confusion in the market and inconsistent practices, resulting in two basic types of lenders:

1. Lenders with no in-house specialists, or lenders assigned to administer the bank policy who are so conservative they won’t take any risk or so liberal they don’t recognize risks.

2. Lenders with in-house staff specialists having environmental backgrounds, where any of the following circumstances may exist:

* Adequate staff, but they lack the appropriate authority.

* Inadequate staff and inadequate review time.

* Adequate staff with the appropriate levels of authority and responsibility.

It is no wonder that consultants and their client-borrowers are perplexed by the lack of consistency from one lender to the next. It is no less burdensome for the lender, who not only must conduct due diligence to determine the risk to the credit and predict foreclosure expenditures, but must do so while providing customer service in a highly competitive environment.

Policy Components

Is it possible to find a balance that minimizes borrower expenditures while maximizing the information lenders need? Let’s look at three components that may be used singly, or in combination, to formulate a lender’s policy. These components are: 1) type of loan; 2) collateral risk category; and 3) loan amount.

Type of loan. For new purchases, the lender should be able to take advantage of information obtained from a borrower’s due diligence while, at the same time, a borrower can take advantage of an innocent purchaser defense. However, requiring a borrower who is refinancing real estate to expend funds that only benefit the lender is a hard sell and warrants a separate procedure.

When a loan is being refinanced, the borrower has no opportunity to improve its existing position (i.e., innocent purchaser defense). Therefore, due diligence is conducted for the interest of the lender only. Some lenders may use the ASTM1528 Phase I criteria, as it is a well-known means to obtain available information from existing records and databases. These lenders may have limited ability or staff to develop an alternative means of evaluating the borrower’s position. Other lenders may focus on collecting information that addresses whether the borrower will be subjected to cleanup or violations and how the property’s marketability will be affected. Because this evaluation benefits the lender only, it provides the lender with the opportunity to develop a due diligence process tailored to its risk tolerance. The ASTM inquiry components can then be used selectively to meet this need.

Because the use of information and benefits to the borrower are different for the two types of transactions (new purchase or refinance), lender procedures should be different for each. In turn, asset-based loans not secured by real estate may require due diligence when the asset itself may present a liability to the lender or borrower. These factors form the basis of establishing policy according to the type of loan (e.g., new purchase, refinance, or asset-based).

Collateral risk category.

This is just what it says: Is the site considered high risk or low risk based on site operations and use? The risk category should consider historical as well as current operations, as well as housekeeping practices.

Loan amount. Some lenders have only loan amount thresholds for determining when and what type of due diligence is required.

Putting It Together to Form Policy

The components of lender policy described above can be depicted as matrix tables. Note that the actual thresholds and type of due diligence tools used depend on each lender’s individual risk tolerance. For example, a lender may require that any loan above $500,000 require a Phase I. Others may vary the degree of due diligence with the amount of the loan, as in the following example:

Amount of Loan ($)


Due diligence tools identified here

The most comprehensive policy may include all three components, as seen in the figure below.

Some Do’s and Don’ts for Lenders and Consultants

* Lenders should not direct the borrower’s due diligence for a new purchase by retaining the consultant. The ASTM Phase I tasks are customarily used to provide an innocent purchaser defense for the borrower. At a minimum, if the lender is going to engage the consultant, the borrower should be able to rely on the document, and the lender should be indemnifiable for any claims of damages.

* Lenders should not conduct Phase IIs on behalf of the borrowing entity under any circumstances.

* Consultants should advocate completing the new-purchase due diligence scope of work to the degree necessary to achieve an innocent purchaser defense for the purchaser.

* Lenders and consultants should educate their customer on the due diligence process.

* Lenders and consultants should evaluate the environmental factors that could represent a discount to value in the event of foreclosure (e.g. engineered controls).

* Consultants should not be retained by any party that receives incentives for bringing the transaction to a close. This group may include brokers, realtors, or bank relationship managers.


There is confusion in the lending community owing to numerous factors: 1) inconsistencies and variable interests of the parties to a transaction; 2) variable risk tolerances of lenders; 3) the variety and discretionary uses of due diligence tools; 4) lack of regulatory guidance material; 5) inconsistent expertise in the lending and service provider sectors; and 6) inconsistent approaches by regulators. This article attempted to provide an overview of the principal variables of a transaction secured by real estate or real property and how those variables are integrated into policy components. Although there currently is no standard reference from which a lender can develop a due diligence policy, perhaps this information can help the lender aid the consultant in evolving from task provider to transaction facilitator.

Amount of Loan ($)

Loan Type Risk Category $X-$XX $XX-$XXX $XXX-$XXXX

New Purchase Vacant Land


High-Risk Due diligence tools

Refinance Vacant Land identified here




(1) In response to complaints that the limited defenses under CERCLA (Comprehensive Environmental Response, Compensation and Liability Act of 1980, aka Superfund) would seldom provide any protection to purchasers, Congress passed the Superfund Amendments and Reauthorization Act of 1986 (SARA), which, among other things, created a special defense that became known as the “innocent purchaser defense.” This defense requires the purchaser to have exercised “due diligence” to determine whether there was any hazardous waste on the property at the time the purchaser acquired the property. The purchaser must be able to prove that it exercised “all appropriate inquiry into previous ownership and uses of the property consistent with good commercial and customary practice” before accepting a deed to the property. The purchaser must also be able to prove that it “did not know, or have reason to know” that the property was contaminated when it accepted the deed. If the purchaser satisfies this burden of proof, then the purchaser will not be liable for cleanup of any contamination that existed at the time the purchaser acquired the property. (From the Web site of Koley Jessen PC, Omaha, Nebraska, see www.koleyjessen.com/html/resources.cfm.

Contact Steve Luzkow by e-mail at Steve.luzkow@abnamro.com

Steve Luzkow is the Environmental Risk Manager for Standard Federal Bank N.A., Troy, Michigan.

COPYRIGHT 2004 The Risk Management Association

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