By Jones Osborn II

In recent years commercial lenders and anyone else holding a note secured by real property have been justifiably concerned about the possibility of environmental contamination on the property that is their collateral.

The concern is well-founded, and is two-fold: (1) the value of the collateral is diminished by the existence of contamination, and (2) there is the possibility of the lender becoming personally liable for clean-up costs, particularly if it forecloses on the property but in some cases even if it doesn't.

Value of Collateral. Once the loan is made, there is little that can be done to solve this problem, aside from requiring the borrower to clean it up. This suggests two things — one, the lender should always have an environmental assessment done on the collateral before making the loan or acquiring the mortgage, and two, the loan documents should always contain a provision requiring the borrower to immediately cure any environmental problems.

Personal Liability. If the lender or mortgage holder can be held personally liable for the costs of clean-up, the consequences can go far beyond the loss of collateral value. The property which the lender took as security can suddenly become less than worthless — it can turn into a large liability, or what might be called "negative security."

This can occur either before or after foreclosure.

Before foreclosure — that is, before the lender takes title to the property — the lender's liability depends largely on the extent to which the lender can control the property or its owner. Until recently, there were conflicting court decisions on when a lender could be held liable. The most far-reaching of these decisions held that a lender could be held liable if it had the ability to influence decisions regarding the contamination, whether it did so or not. Because many loan agreements give the lender broad powers of control over the borrower, it was often possible to argue that the lender was liable even if it never foreclosed or took any other action with respect to the contaminated property.

However, EPA regulations now impose personal liability before foreclosure only if the lender actually (1) exercises decision-making control over the borrower's environmental compliance, or (2) exercises control over environmental compliance at a level comparable to a facility manager. It is specifically provided the lender does not incur liability by inspecting the property or by requiring clean-up before making or acquiring the loan. It can also enforce the terms of the loan documents without liability; for example, it can enforce a loan provision requiring the borrower to cure environmental violations without risking liability.

After foreclosure — that is, after the lender has acquired title to the property — the rules are a little different. Originally, the lender simply became liable as an owner. However, the EPA regulations now provide that the lender will not become personally liable as a result of foreclosing as long as the lender disposes of the property in a reasonably expeditious manner by commercially reasonable means. What does reasonably expeditious mean? Initially, there is a six-month grace period. Thereafter, the lender must accept any reasonable offer for the property. Finally, within a year it must attempt to auction off the property or otherwise dispose of it in a public manner, and may not reject any offer received. The problem, of course, is that the buyer of the property will probably become personally liable, so that in the worst cases it will simply be impossible to dispose of the property at any price, but at least the lender won't have personal liability. Apparently, the lender will be required to own the property in perpetuity in its contaminated state, hoping someone will eventually come along to take it off its hands.

Conclusion. The EPA regulations provide some relief, but are no substitute for the exercise of due care, both before lending and before foreclosing. In addition, the EPA regulations are being challenged in court, and it is possible that they may be modified or found invalid.