According to a recent survey by the Federal Reserve, the strengthening economy has increased business and consumer loan demand and led to improvements in many real estate markets. As a result, some banks have eased the terms and standards for all types of commercial real estate loans where markets are coming back.

While this is good news for business, a recent court decision illustrates the need for banks to exercise caution when granting new loans on property that is or has the potential to become contaminated.

On Feb. 4, the U.S. Court of Appeals for the District of Columbia Circuit nullified the Environmental Protection Agency's lender liability rules in Kelley v. EPA.

Established in April 1992, these regulations spelled out the circumstances under which a "secured creditor" could protect itself from liability for cleaning up contaminated property under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980

Conflicting Case Law

In making its decision, the Kelley court has turned back the clock two years, saying that the EPA does not have authority to define the scope of lender liability - that Congress meant this to be a decision made by the courts.

Thus, banks once again will have to rely on conflicting case law, giving them significantly less certainty about their exposure to the environmental act when structuring loans, managing or operating secured properties, directing remediation activities, or foreclosing on contaminated properties.

But all may not be lost. The Clinton administration recently released its long-awaited Superfund reauthorization proposal - the "Superfund Reform Act of 1994."

Squre One

It contains language that explicitly grants the EPA authority to introduce regulations that define the terms of the act as they apply to lenders and other financial services providers, property custodians, trustees, and other fiduciaries.

If the administration's proposal is accepted in toto, EPA could reinstate its lender liability rule and add a trustee/fiduciary liability rule. The administration also has proposed that fiduciaries, like security interest holders, should be exempt from the "owner or operator" status, and therefore protected from liability under the environmental act.

Meanwhile, unless and until the court's decision is overturned or the act is amended, lender liability issues will be governed by new court decisions or those which predate the EPA's lender liability regulation.

So the Kelley ruling has taken lenders back to square one. Under the environmental act, private parties and the EPA can sue those responsible for releasing hazardous substances into the environment to recover the cost of cleanup. All prior and present "owners or operators" of hazardous waste sites or contaminated properties are held strictly liable.

However, congress created an exception within the definition of "owners or operators" for secured creditors, as long as they held their indicia of ownership primarily to protect their security interest in a facility or vessel without participating in its management.

Despite this safe harbor provision, courts wrestled with the scope of the exclusion. In fact, application of the secured creditor exemption became one of the most controversial issues in Superfund.

Review Is Needed

In particular, it was not clear whether the exemption protected secured creditors from operator liability or only from owner liability. How the exemption applied to loan workouts, foreclosures, and other activities also was unclear and there was very little legislative history for guidance.

Due to this uncertainty in the courts, banks didn't know to what extent they could get involved in the management and operations of their secured properties without opening themselves up to potential liability.

Furthermore, banks were concerned that their exemption would be forfeit if they foreclosed, since plaintiffs argued that this would convert lenders' security interest into actual ownership.

EPA's lender liability rule settled many of these questions. It established standards of conduct so than lenders could work within the boundaries of the exemption as they dealt with widespread loan defaults, restructurings and foreclosures against a backdrop of increasing environmental regulation.

Now that the Kelley court has struck down the lender liability rule, banks need to review former cases if they are to successfully negotiate the secured creditor mine field and protect their exempt status.

Day-to-Day Management

Early case law shows that a lender who foreclosed on contaminated property would not be held liable unless it participated in the facility's day-to-day management.

For example, in United States v. Mirabile, the court held that one lender was not liable because its activities to prevent vandalism were "prudent and routine steps to secure the property" rather than day-to-day management involvement.

However, a second lender was held liable because it created an advisory board to monitor the borrower's operations, advised on business matters and visited the property regularly - activities that the court considered day-to-day management, outside the scope of the environmental act exemption.

In another case, United States v. Nicolet Inc., the court found that mere participation in the financial affairs of the borrower such as inspections of the property, loan refinancing and financial advice did not negate the exemption.

To add to the confusion, other courts found lenders liable for a variety of reasons. In United States v. Maryland Bank and Trust Co., the lender was considered liable because it held title at the time of the cleanup. The court concluded that the owner/operator liability referred, without exception, to all current owners, no matter how theycame to own the property.

In another case, Guidice v. BFG Electroplating and Manufacturing Co., the court admitted that the bank was entitled to the security interest exemption prior to foreclosure. However, it said that after foreclosure the bank owned the facility and the security exemption did not apply because it held the property for eight months before selling.

Fleet Factors Case

The leading case establishing the scope of lender liability under the environmental act was United States v. Fleet Factors Corp. The Fleet Factors case was the first time an appellate court reviewed the security interest exemption. The case concerned both an attempted loan workout and, ultimately, a foreclosure.

During the workout, the lender approved the shipping of goods, controlled employment decisions, supervised office activities and undertook other management functions.

The court said that the lender had injected itself into the management, operations, and finances of the borrower to such an extent that it exceeded the parameters of the "owner or operator" exemption.

In fact, the court concluded that the lender's involvement in the facility's financial management inferred that it also could influence the borrower's treatment of hazardous waste at the site.

Reaching well beyond the limits of earlier decisions, the court found that a secured creditor did not have to actually be involved in the day-to-day operations of the facility, or to participate in management decisions relating to hazardous waste to expose itself to liability.

To confuse the issue further, in a subsequent case, Bergsoe Metal Corp., another appellate court found that the lender had to actually participate in managing the foreclosed property to be liable as an "owner or operator."

More Cause for Concern

A 1993 case has highlighted the fact that trustees and fiduciaries also need to be concerned about their potential liability, since they currently have no exemption. In the City of Phoenix v. Garbage Services Co. case, the court said that a bank holding property in a fiduciary capacity was liable for contamination.

Now that the kelley ruling has taken lenders back to the unsettled pre-EPA lender liability rule days, the Fleet Factors decision and its progeny take on added importance because these rulings have greatly narrowed the scope of the environmental act's secured creditor exception and increased bank exposure to the possible risk of liability.

Thus, lenders are strongly advised to investigate thoroughly the waste treatment and policies of potential borrowers before granting new loans.

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