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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   October 2007

The New Due-Diligence Bandwagon

Regulators are adapting to the All Appropriate Inquires rule -- so should your lenders

Almost a year has passed since the U.S. Environmental Protection Agency (EPA) officially implemented its All Appropriate Inquiries (AAI) rule last November. The rule updated the standard requirements for Phase I environmental site assessments. Soon thereafter, the American Society of Testing and Materials (ASTM) revised its Phase I assessment to meet the new federal requirements.ezovski1007

Today, the AAI standard and its ASTM equivalent, intended to reduce barriers to brownfield redevelopment, are the only means to secure protection from federal environmental-cleanup liability under the Comprehensive Environmental Response, Compensation and Liability Act.

And liability continues to be an issue for businesspeople involved in commercial real estate. The impact contamination can have on a business’s bottom line is well-documented. As a result, more lenders are revisiting their environmental policies and considering updating those policies to reflect the new AAI protocol.

If you’re working with lenders that have yet to revisit their environmental policies, you may be working with companies that are behind the curve. The liability issue may come back to haunt your borrowers.

Regulatory drivers

The AAI rule, aside from bringing sweeping changes in the environmental-due-diligence arena, is also making waves in the regulatory community. Most notably, for the first time in 13 years, the Federal Deposit Insurance Corp. (FDIC) updated its environmental guidance document to respond to AAI. FDIC’s reaction to the AAI rule triggered other agencies to follow suit. The Office of the Comptroller of the Currency is revising the environmental component of its “Construction and Commercial Lending Handbook.” The Office of Thrift Supervision has plans to respond to AAI. The National Credit Union Administration and the U.S. Small Business Administration are also revisiting their guidelines. Even the Federal Reserve System announced that an AAI review is in progress.

AAI’s snowball effect even reached Wall Street. Standard & Poors began asking for ASTM-compliant Phase I assessments soon after the new protocol was introduced. Most recently, Fitch Ratings published an updated version of its “Commercial Mortgage Criteria Report” on environmental site assessments and environmental insurance to include the new guidelines.

Heading off risk

Upon the release of AAI, federal regulators warned banks of the importance of effective risk management -- particularly in the face of record-high growth in banks’ commercial real estate concentrations.

This regulatory activity continues to impact banks’ environmental-risk-management practices. A sound environmental-due-diligence policy is one way banks can demonstrate that they’re being proactive in managing at least one type of real estate risk.

Some commercial lenders now require an AAI-compliant Phase I on every real estate transaction. Others make Phase I decisions on a case-by-case basis. Regardless of which option they choose, lenders should at least address the AAI rule in their environmental policies. 

FDIC’s examiners are asking more questions about environmental policies than ever before. Lenders and brokers should be prepared to address the issue when it arises.

Environmental awareness

Lenders are further scrutinizing their environmental-due-diligence practices because of an industry trend toward greater environmental awareness. A major driver of this trend is the high cost to clean up polluted sites -- it often exceeds the value of the loan and can leave the lender holding the bag.

Lenders that think they’re immune from cleanup liability need only consider a recent headline-making case: A lender was slapped with nearly $1 million in penalties and legal costs after failing to notify the state of New York that hundreds of drums, tanks and containers of chemicals were left behind after the lender seized the borrower’s funds.

The borrower didn’t clean up residual contamination after it declared bankruptcy and abandoned operations. The task eventually fell to the Department of Environmental Conservation and the EPA. Not only was the lender sued for cleanup costs, but it also had to implement an internal environmental-training program for bank employees.

What’s more, the redevelopment of brownfields brings banks face-to-face with the AAI rule. If developers wish to stay off the hook for cleaning up contamination left on-site from past operations, they must stay within the EPA’s guidelines.

Implementing the policy

Whether banks are large with a national presence and a staff of environmental experts or small without the luxury of a dedicated environmental staff, they must operate in the same regulatory climate. With regard to an environmental policy, lenders should ask themselves:

  • Is our environmental-due-diligence policy current?
  • Does our bank meet or exceed the thresholds set by the FDIC for commercial real estate lending, and are we subjecting ourselves to increased scrutiny?
  • Does our environmental policy reflect all available due-diligence options?

Luckily, just when the pressure to gather more information and close deals more quickly reaches an all-time high, more environmental-due-diligence tools than ever before -- some quick and inexpensive -- can be incorporated into a sound environmental-risk-management program.

When deciding a course of action, lenders and brokers should remember that the goal of a Phase I assessment is to understand the environmental risk posed by a property and should factor it into the overall credit analysis.

Lenders that don’t require AAI compliance on every loan should consider loan size, the borrower’s profile, time and cost constraints, property type, and the bank’s risk tolerance before proceeding. Recognizing potential environmental issues at the time the loan is originally underwritten will usually result in fewer headaches down the road.

•  •  •

Adoption of AAI by lenders has grown considerably in the past year. Indeed, a straw poll of more than 300 lenders taken this past November revealed that only 17 percent had adopted AAI. A similar poll eight months later saw that number nearly double.

To counter risks, your borrowers should work with lenders that have detailed and thorough environmental-due-diligence procedures. Policies must be updated to reflect the new standard of care. For those lenders who haven’t yet made the adjustment, it’s time to get on board. 


 


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