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Post-Default Environmental Risk Management for SBA Lenders

February 2, 2021 Banking & Financial Services Industry Legal Blog

Reading Time: 11 minutes


If a borrower defaults on a SBA loan, the lender or CDC must assess the environmental risk of contamination before conducting any liquidation action that could result in a loss, or otherwise increase the risk of loss, due to the actual or alleged presence of contamination. Lenders and CDCs assess the environmental risk of contamination by conducting an Environmental Investigation, which may include an Environmental Questionnaire, Records Search with Risk Assessment, Transaction Screen Analysis, Phase I Environmental Site Assessment (“Phase I ESA”), and/or a Phase II Environmental Site Assessment (“Phase 2 ESA”). Environmental Investigations are required, for example, before a lender or CDC can acquire the title to commercial real property collateral by purchasing it at a foreclosure sale or accepting a deed-in-lieu of foreclosure, or taking over the operation of a borrower’s business that uses a hazardous substance. The consequences for failure to conduct proper environmental due diligence can be critical.

environmental risk of contamination sba loan contaminated commercial real property collateral environmental site assessment

What Are Environmental Risks?

“Environmental Risks” are the risks associated with contaminated commercial real property collateral (“Property”). Property is “Contaminated” if there is a presence of a substance, material or waste, which is regulated by the Comprehensive Environmental Response, Compensation and Liability Act of 1980, 42 U.S.C. §§ 9601 et seq. (“CERCLA”) or any other applicable law (“Hazardous Substances”), including any Hazardous Substances that migrated to or from the Property, in such quantities or under such conditions as to render the Property subject to, or potentially subject to, a directive or order from a government entity. SOP 50 10 5(E), Appendix 2.

For SBA lenders and CDCs, Environmental Risks include, for example:

(a)  An impairment of the borrower’s ability to repay the loan due to the high cost of remediation, regulatory fines, and penalties;
(b)  Diminishment of the value and marketability of the collateral;
(c)  Direct liability for tort claims and remediation by becoming an owner or operator of the Property; and
(d)  Loss of lien priority if a governmental entity cleans up the Property.

SOP 50 57 2; SOP 50 55.  

Post-Default Environmental Investigation Process

Environmental Investigations must be conducted before conducting any liquidation action that may result in a loss, or increase the risk of loss, due to the actual or possible presence of Contamination. SBA lenders and CDCs should conduct a post-default Environmental Investigation to obtain adequate information to make a prudent, informed decision regarding the risks of Contamination. The amount of due diligence in conducting a post-default Environmental Investigation depends on the Property’s appraised value, the amount owed on senior liens, the SBA loan balance, the activities conducted at the Property, the results of previous Environmental Investigations, access to the Property, and the cost and time involved. Environmental Investigations must be conducted by a qualified environmental professional, except for Environmental Questionnaires. The environmental professional must complete an Environmental Investigation Report, accompanied by a Reliance Letter. The Environmental Investigation Report must be kept in the loan file, and can only be relied upon for 180 calendar days. SOP 50 57 2; SOP 50 55.

Generally, SBA lenders and CDCs should conduct the following steps in its environmental due diligence:

Step 1: Order an Environmental Site Assessment (“ESA”)

If the risk of Contamination appears to be high, lenders and CDCs must begin with a Phase I ESA. Generally, the risk will be high if, for example, a past Environmental Investigation concluded that the Property is Contaminated. Phase I ESAs must be AAI compliant, and be conducted by a qualified environmental professional. The SBA requires that all Phase I ESAs contain an opinion as to whether the inquiry has identified conditions indicative of any release of a Hazardous Substance, and contain a conclusion that either: (1) the risk of Contamination at the Property is so minimal that no further investigation is warranted; or (2) the risk is sufficient to warrant an additional investigation. SOP 50 10 5(E), Appendix 22; SOP 50 57 2; SOP 50 55.

If the risk of contamination appears to be low, lenders and CDCs can begin with a Transaction Screen, or an Environmental Questionnaire with a Records Search with Risk Assessment. If the lender of CDC conducts a Transaction Screen, the process includes: (1) interviewing the owner or operator of the Property; (2) visiting the Property; (3) completing an environmental questionnaire; and (4) reviewing government records and historical sources. The SBA also requires that a qualified environmental professional supervise the site reconnaissance and make a conclusion as to whether: (1) the risk of Contamination at the Property is so minimal that no further investigation is warranted; or (2) the risk is sufficient to warrant an additional investigation. On the other hand, an Environmental Questionnaire is used to determine the likelihood that the Property may be Contaminated. At a minimum, lenders and CDCs must make inquiries into the following areas:

(a)  Past and present uses of the Property and adjoining properties, with particular attention paid to those uses by environmentally sensitive industries;
(b)  Past and present identification of any Hazardous Substances at the Property and any adjoining properties;
(c)  Storage, generation, treatment, emission or disposal of Hazardous Substances at the Property and adjoining properties;
(d)  Possession of permits to use, store, generate, treat, emit, or dispose of Hazardous Substances by businesses operating at the Property and adjoining properties;
(e)  Evidence of Contamination at the Property and adjoining properties;
(f)  Potential sources of Contamination at the property and adjoining properties;
(g)  Knowledge on the part of the borrowers, seller, or lender/CDC of any past evidence of Contamination or sources of Contamination at the Property and adjoining properties;
(h)  Knowledge on the part of the borrower, seller, or lender/CDC of any past, threatened, or pending lawsuits or administrative proceedings concerning any release of Hazardous Substances at the Property or adjoining property;
(i)  Existence of any regulatory actions by any governmental entity for environmental conditions at the Property and adjoining properties;
(j)  Identification of any previously performed environmental risk studies environmental documents pertaining to the Property; and
(k)  Presence of lead paint, asbestos, or Polychlorinated Biphenyls at the Property.

SOP 50 10 5(E), Appendix 2; SOP 50 57 2; SOP 50 55.

It is important to note that the SBA requires Environmental Questionnaires to be signed by the current owner or operator of the Property. If the current owner or operator will not sign the Environmental Questionnaire, the lender or CDC must obtain a Transaction Screen instead. SOP 50 10 5(E), Appendix 2.

Step 2: Conduct Additional Necessary, Cost-Effective Inquiries

If Step 1 does not produce enough information to make an informed, prudent lending decision, lenders and CDCs should conduct any additional, cost-effective inquiries that are recommended in the Environmental Investigation Report, or that are needed to produce enough information to make a prudent, informed decision. SOP 50 57 2; SOP 50 55.

Step 3: Additional Requirements for Gas Stations and Dry Cleaning Businesses

 If the Property is or was associated with a gas station, commercial fueling facility, or dry cleaner that uses/used Hazardous Substances, lenders and CDCs must conduct a Phase I ESA. If, after obtaining a Phase I ESA, additional information is required to make a prudent, informed decision, lenders and CDCs should also:

(a)  Have an independent qualified environmental professional with three years of full-time relevant experience, who holds a current Professional Engineer’s or Professional Geologist’s license, conduct a Phase II ESA;
(b)  Conduct any further investigation recommended in the Phase I ESA or Phase II ESA Report;
(c)  Make an estimate that covers the method, cost, and time required for completion of any recommended remediation; and
(d)  Test the equipment related to the operation of the business.

SOP 50 57 2; SOP 50 55.

Step 4: Extra Requirement if Taking Over Business Using Hazardous Substances

If a SBA lender or CDC plans on taking over a borrower’s business that has Hazardous Substances present, the lender or CDC should:

(a)  Conduct an environmental regulatory compliance audit prior to taking over the operation of the business; and
(b)  Have a receiver appointed by the court to take possession of the collateral and operate the business on the lender/CDC’s behalf, to avoid losing the secured creditor liability exemption.

SOP 50 57 2; SOP 50 55.

Taking Title to or Control Over Contaminated Property

(a)  The appraised value of the Property, including a post-default appraisal;
(b)  The estimated liquidation value of the Property and supporting explanation;
(c)  The SBA loan balance, including a copy of the transcript of account or other evidence of the loan balance;
(d)  A list of senior liens against the collateral, including senior liens and tax liens, and the amount owed on each, including a copy of:

1.  Schedule B of the post-default title report;
2.  A current UCC lien search if the request includes personal property collateral or taking over the operation of a business;
3.  Any senior lienholder agreement, landlord lien waiver, subordination agreement, or other loan document that establishes the priority of the liens against the collateral; and
4.  Transcript of account, or similar proof of compliance with any provision in the foregoing documents that requires a senior lender to subordinate any portion of the senior loan to the SBA loan.

(e)  A list of the foreclosure costs, including extraordinary expenses;
(f)  A summary of the nature and extend of the Contamination, supported by copies of the Environmental Investigation Report(s);
(g)  An indication of whether remediation is required or on-going, and:

1.  If remediation is not required, attach a copy of the letter indicating no further action is required, closure letter, or functional equivalent from the responsible government entity;
2.  If remediation is recommended, attach a copy of any document that: (a) provides a description of the recommended method and cost of remediation and anticipated completion date; (b) establishes the identity of those responsible for remediation; or (c) demonstrates the ability of the responsible party to pay for the cost of remediation.
3.  If remediation is on-going, attach a copy of any document that shows the progress of the clean-up, or that the person conducting the clean-up has sufficient financial resources to complete it.

(h)  Provide a list of applicable liability exemptions that the person who will take title to the Property qualifies for the bona fide purchaser exemption under the CERCLA Sections 101(4) and 107(r), or the involuntary acquisition by a government entity exemption under CERCLA Section 101(20)(D);
(i)  List any mitigating factor(s) and attach copies of any relevant supporting documents. For example, an escrow account that was set up to cover the costs of a remediation plan approved by the responsible government entity is a mitigating factor;
(j)  Provide information regarding the status and anticipated outcome of any known tort litigation as a result of the Contamination;
(k)  Review Schedule B of the post-default title report and indicate whether there is any recorded covenant, deed restriction, or other exception to title that will have a negative impact on the Property’s recoverable value;
(l)  List and analyze the feasibility of alternative methods of collecting the loan balance that involve less risk. At a minimum, this should include: (1) the estimated recovery from other collateral and the obligors; and (2) alternative methods of liquidation that do not require taking title to the Contaminated Property;
(m)  Provide a description of the plan for disposing of any collateral to be acquired, which includes the holding and resale costs, as well as an explanation of how easy or difficult it will be to resell the collateral;
(n)  List and discuss any other loan-specific relevant facts. For example, remediation by the lender or CDC, and receivership proceedings; and
(o)  Provide the estimated net recovery from taking the proposed action based on the analysis of all of the factors listed above.

Conclusion

SBA lenders and CDCs must comply with environmental laws and SBA requirements when dealing with Contaminated, or possibly Contaminated, Property. Due to the complexity of environmental laws, and the risks involved, it is recommended that lenders and CDCs obtain legal advice before conducting any remedial action on the Property, or otherwise taking title or control over a borrower’s business that has risk of Hazardous Substances present.


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