In Lusk v First Century Bank, 2012 W. Va. LEXIS 241 (Sup. Ct. 4/27/12), the plaintiff/petitioners purchased a commercial property at an auction foreclosure sale. The Notice of Trustee’s Sale and Regency’s advertising notice stated that the sale was subject to “environmental regulations” and that the property was being sold in an “as is” condition. The Deed of Trust also provided that the property would be sold “without any covenant or warranty, express or implied.” Prior to the sale, the petitioners conducted a brief walk-through of the building but did not perform any further due diligence. The petitioners then submitted the high bid of $49,000 for the property.

As it turned out, the property had been used by businesses that cleaned and rebuilt electric motors that contaminated the site with a variety of hazardous substances, including PCBs. The last operator had been Lin-Electric who acquired the site from a local charity with a loan from First Century Bank. After Lin-Electric went out of business, the loan went into default which led to the subject foreclosure sale.

Shortly after taking title, the petitioners received a PRP notice from the USEPA. The petitioners then filed a lawsuit against the bank among others, claiming they relied on the representations made by the auctioneer and a Bank representative that the property was “clean”.

The trial court granted the bank’s motion for summary judgment on the claim that the bank intentionally failed to disclose the contamination, committed fraud and intentional misrepresentation, breached its duty of good faith and fair dealing, and violated the West Virginia Hazardous Waste Management Act by failing to disclose in the foreclosure deed that the property was previously used to store and dispose of hazardous waste materials.  The case then proceeded to trial on the remaining issues. At the close of evidence, the Bank moved for judgment as a matter of law on the claim that the bank negligently proceeded with the foreclosure sale with knowledge that the real estate was environmentally contaminated. The circuit court granted the Bank’s motion and the case went to the jury on the remaining claims. In February 2011, the jury allocated found the Bank and Regency had no liability and that petitioners was 60% at fault.

Petitioners filed a motion for a new trial, arguing that the circuit court erred in granting summary judgment in favor of the Bank because the bank as a seller of real estate had an affirmative duty to disclose latent defects or conditions of the property to a purchaser and that the failure to do so constituted constructive fraud.

In denying the motion for a new trial, the circuit court said that the bank as a trust creditor did not own an interest in the real property, and therefore was not required to make affirmative disclosures concerning the condition of the property. Moreover, the court said the petitioners purchased the property “as is” and with notice that the property was subject to environmental regulations.

On the claim of breach of duty of good faith and fair dealing, petitioners contended that that the foreclosure deed constituted a contract with the Bank and formed the basis for a claim for breach of duty of good faith and fair dealing. However, the the circuit court disagreed, finding there was no contractual relationship with the Bank. In the absence of such a relationship, the court said the bank had no duty of good faith and fair dealing.

The petitioners then appealed the grant of summary judgment and the order denying their motion for a new trial. Petitioners argued that a reasonably prudent bank would not have proceeded with the foreclosure sale of property that the bank knew was environmentally contaminated. Thus, they asserted that the bank’s decision to proceed with the foreclosure sale constituted negligence. However, the Supreme Court ruled in 4-1 decision agreed that a secured party at a foreclosure sale was under no duty to make affirmative representations about the condition of the property to be sold. Without a duty, the court said, there could not be any negligence. Accordingly the court affirmed the decision of the circuit court.

It is no secret that distressed debt investors are eagerly looking for opportunities to purchase defaulted or underwater loans. One strategy used by investors with a healthy risk appetite is to purchase promissory notes secured by contaminated property at deeply discounted pricing. The investor then brings an RCRA 7002 action seeking an order requiring the responsible party to remediate the site. If the investor prevails, the investor can then either sell the note at full face value or foreclose on the remediated property and sell it for a significant profit. Moreover, the prevailing plaintiff/investor can recovery its attorney fees under RCRA 7002.

RCRA 7002 is not the only remedy available to pursue this business model. Investors may be able to use state common laws such as nuisance to seek injunctive relief. However, courts in a number of states have ruled that holders of notes do not have sufficient interest in the property to bring nuisance actions (known in legal parlance as “standing”). A recent example of this line of cases is Cox v. Louisian, 2011 Cal. App. Unpub. LEXIS 3207 (Ct.App-2^nd Div 4/27/11).

In this case, Douglas Oil Company (Douglas) constructed and operated a gas station from 1964 until 1980 when Douglass old the property to the Harpers who subsequently conveyed the site to the Bodamer Family Trust (the Trust). It appears that the property continued to be operated as a gas station during this period.

In 1991, the Trust sold the property to the current owners. As part of this transaction, the current owners executed a promissory note to the Trust (the Note), secured by a deed of trust (the California version of a mortgage). Sometime around the turn of the century, the current owners abandoned the property.  The Los Angeles Department of Public Works (DPW) issued written notices to the current owners in 2002 and 2003 advising them that they had improperly abandoned the gas station without removing the underground storage tanks

In July 2004, the plaintiff purchased the Note and received an assignment of Deed of Trust. The face value of the Note was approximately $467K but it is unclear if the plaintiff purchased the Note at a discounted price. Upon learning that the property was scheduled to be sold at a tax auction, the plaintiff filed a lawsuit asserting a variety of common law claims including nuisance, strict liability and negligence against Douglas and its parent corporation, ConocoPhillips (Conoco). The plaintiff sought a preliminary injunction requiring Douglas and Conoco to remove the USTs and remediate the contamination. The plaintiff argued that was prevented from proceeding with a judicial foreclosure because of the existence of the USTs and associated contamination, and that his security interest would be extinguished if he did not foreclose and the property was sold at auction. Of course, there was nothing PREVENTING the plaintiff from foreclosing. Instead, the plaintiff simply wanted to AVOID becoming liable for the cleanup.

The trial court denied the plaintiff’s motion for a preliminary injunction, concluding that the plaintiff failed to present evidence that it was likely to prevail and also that the plaintiff as a mere note holder did not have standing to bring a nuisance action. The appeals court affirmed the denial of the motion.

Plaintiff argued that Douglass and Conoco had failed to comply with the state Underground Storage Law (UST Law) that had been enacted two years after the property was sold, and that this violation constituted a nuisance. The appeals court ruled that there was no evidence that Conoco ever owned, leased, occupied or controlled the Property. In addition, the plaintiff had not established any basis to hold Conoco liable for its subsidiary under a corporate veil piercing theory.

Turning to Douglas, the court said that there was no evidence that the legislature intended the UST Law to impose retroactive obligations on former owners or operators of USTs. Moreover, the court said the plaintiff had failed to produce any admissible evidence of the existence of leaks or release of hazardous materials at the Property during the period Douglas owned and operated the property.

More importantly, the court held that the plaintiff failed to show that it had standing to pursue its nuisance claim. Since a private nuisance involves an unreasonable and significant interference with the use and enjoyment of land, the court said the plaintiff had to prove that it owned, leased, occupied or controlled real property. However, the court said the plaintiff had failed to cite to any authority that a holder of a deed of trust can maintain a private nuisance cause of action. The court said a person with a security interest in real property does not “use and enjoy” real property, and thus lacks the kind of interest in real property that is protected by a private nuisance cause of action. Furthermore, the court ruled that while the UST Law did allow for issuance of preliminary injunction or permanent injunctions without a showing of irreparable damage, this exception did not apply to a private person with a security interest in real property.

The court also noted that a preliminary injunction was intended to preserve the status quo but granting the preliminary injunction would have resulted in plaintiff receiving the ultimate relief it sought-a cleanup. Also weighing against the preliminary injunction was that the preliminary injunction would have caused Douglas to spend a significant amount of money and time dealing with a potentially serious environmental problem at a site it had not owned in 30 years and that Conoco had never held an interest. The court said Douglas and ConocoPhillips in all likelihood would have been compelled to incur the significant costs and that this task would have been further complicated by the apparent lack of cooperation of the current owners, who abandoned the Property long ago.

Finally, the plaintiff’s task was further complicated by a problem that has been frequently encountered in the wake of the credit crisis-namely, the plaintiff could not locate the Note. Without the Note, the court explained, there was no evidence if its terms so the plaintiff could not prove when payments were due, whether the owners have defaulted or the balance due on the Note. In addition, the plaintiff had not produced any evidence about the fair market value of the property. Thus, the court reasoned, there was no way to determine if the proceeds from a foreclosure sale would cover the balance due, if any, under the Note. Without this information, the court explained, the plaintiff could not prove that the alleged nuisance has caused him any injury.

It is unclear why the plaintiff did not consider bringing a RCRA 7002 action instead of proceeding under state law. It may be the plaintiff determined that while the contamination constituted an “unreasonable” interference with the use of the property, it did not rise to the level of an “imminent and substantial endangerment” given that the plaintiff took six years to file its action.

From a purely legal standpoint, the recent ruling In Tennessee v. Roane Holdings Ltd., 2011 U.S. Dist. LEXIS 143703 (E.D.TN 12/14/11) was not unusual. The court ruled on a motion to dismiss that a party who had entered into an administrative order on consent could not bring a cost recovery action under CERCLA section 107 but instead was limited to bringing a section 113(f) contribution action. This opinion was consistent with decisions that have been entered by the 2^nd, 3^rd and 8^th Circuits.

Instead, the reason this case caught my attention was that it was the identity of one of the third party defendants- Citigroup, Inc. This case was the latest example of the banking conglomerate becoming ensnarled in CERCLA litigation because of legacy liabilities it incurred from prior acquisitions.

Much of the environmental due diligence performed for commercial real estate and multifamily properties transactions is a result of requirements imposed by banks as conditions for issuing loan commitments. In many ways, lenders frequently act as surrogate regulators, requiring borrowers to investigate and remediate contamination.

However, when it comes to their own transactions, lenders sometimes follow the old adage “Do as I say, not as I do” and may perform a level of due diligence that is less rigorous than they would require of their borrowers.

Perhaps the most glaring example involved the White Swan Cleaners superfund site in Sea Girt,New Jersey. The White Swan Laundry and Cleaners had operated at the site located in Wall Township,New Jersey. PCE had been was discharged from the dry cleaner into two on-site septic systems where it subsequently migrated into the groundwater.

Sometime after dry cleaning operations ceased, the property was acquired by Summit Bank who converted it to a bank branch. Fleet Bank then took title to the property when it acquired Summit Bank. Apparently, neither bank appeared to perform the kind of environmental due diligence that they customarily expect from their borrowers. They decided to not do any diligence-not even transaction screens on the branch offices. Had the banks examined the historical use of the property, they would have learned about the dry cleaner and also that the property had a septic system.

In any event, after Fleet took title to the property, the New Jersey Department of Environmental Protection (“NJDEP”) then conducted its own investigation and detected PCE in one of the municipal wells used byWallTownship. Elevated levels of PCE vapors were also detected in the basements of several residential and commercial properties.  Interim remedial actions have been implemented at the site including installation of vapor control systems, and site characterization is underway. Needless to say, the bank is paying dearly for its decision not to do any diligence on this branch office.

Turning back to Citigroup, the company has become involved in a number of federal superfund sites because of its merger with 1998 Travelers, Inc. Under the leadership of Sandy Weill, Travelers had gone on an acquisition binge in the 1990s that brought along with those investments lots of CERCLA liability.

For example, in 2003, Citigroup entered into a $7.2MM settlement resolving the liability of S.W. Shattuck Chemical Company (“Shattuck”) for a former radium-processing plant located inDenver. Citigroup Inc. became involved in this site through its merger with Travelers who, in turn, had acquired Salomon Inc in 1997. Salomon had acquired Philbro Resources Corporation in 1981. Philbro was a spin-off of Phillip Brothers, which had been acquired by Englewood Minerals and Chemicals. Salomon (renamed Salomon Smith Barney after it was acquired by Travelers in 1997) had issued corporate guarantees of Shattuck’s obligations in 1993 and 2000.

In June 2009, Citigroup subsidiary, MRC Holdings, agreed to implement a groundwater cleanup estimated to cost $6,700,000 at the MRI Superfund Site in Florida. This followed a December 2001 settlement where the firm agreed to perform a soil cleanup estimated at $2,130,111, and to reimburse the federal government nearly $1MM in past costs. MRC Holdings was a successor to American Can Company which became Primerica in 1986. Primerica acquired Smith Barney in 1987, Commercial Credit Corporation acquired Primerica in 1988 and the combined company became Primerica which merged with Travelers in 1993.Citigroup then merged with Travelers in 1998.

MRC Holdings is also the reason that Citigroup was named as a PRP in 2010 at the Gowanus Canal Superfund Site in New York City. Citigroup/MRC Holdings is part of the PRP group that agreed to perform the remedial investigation at this site.

Turning back to the Roane Holdings case, Citigroup was brought into the litigation as a successor to Phillip Brothers which had manufactured ferroalloys at the site when it was by Engelhard Minerals and Chemical Corporation (“Engelhard”). As discussed above, Engelhard spun off as Philbro in 1981 which then merged with Salomon, Inc. In 1997, Salomon was acquired by Travelers which then merged with Citibank in 1998.

The manufacturing operations at theTennesseesite generated slags along with bag house dust from pollution control equipment. These waste materials were stockpiled on the site during ownership of a number of entities. After operations ceased, decommissioning activities occurred. In 1987, the Tennessee Department of Health and Environment (the “TDHE”) commenced an investigation following complaints about discoloration and high pH in Cardiff Creek. The site was added to the state superfund list in 1989 and remedial actions were implemented.

Following sediment sediments in 2003, the state requested additional remedial measures to prevent migration of wastes from the site.  Additional investigation was performed that resulted in Administrative Consent Order (the “AOC”) in January 2009 to implement remedial measures.

In November 2010,Tennessee filed a cost recover action against Roane Holdings which resulted in the entry of a Consent Decree where Roane agreed to reimburse the state for its past response costs. In February 2011,  Roane filed a third party complaint Citigroup and others seeking cost recovery and contribution.

Environmental due diligence in corporate transactions often resembles a good mystery novel or an investigative journalism piece. The environmental lawyers and consultants have to review the corporate history and identify potential liabilities associated with the various iterations of the company being acquired including owner or operated sites as well as sites where wastes may have been sent. Then, we have to trace the liabilities through the various transactional agreements and evaluate which liabilities were conveyed in prior transactions, what liabilities may have been retained but the company received an indemnity, if that indemnity is associated with a viable entity, if the terms and conditions of the indemnity remain in effect, and finally what liabilities have followed the target company. After the liabilities are understood, then the negotiating and drafting can occur though for me that tends to be less fun than the detective work.

As the nation slowly lifts itself out of the effects of the Great Recession, lenders are beginning to increase the pace of foreclosures on commercial properties. The volume of foreclosures is likely to significantly increase during the next few years as the loans that were orginated during the height of the credit bubble become due. With real estate pricing averaging 50% below the peak of 2007, many borrowers simply will not be able to refinance their loans.   

We have a number of posts in our “archived” section about the heightened risks that lenders face during workouts and foreclosures, and we encourage readers to review those posts. By way of a quick summary, though,  the secured creditor exemption of CERCLA and RCRA provide a safe harbor to lenders who do not participate in the management of a borrower’s operation. However, the scope of the liability protection is less clear when a bank forecloses on a property. 

After foreclosure, the federal secured creditor exemptions require a lender to take commercially reasonable steps to sell the property. Unlike the EPA lender liability rule that was vacated by a federal court in 1994, the CERCLA and RCRA statutory language does not contain a “bright line” test for what constitutes commercially reasonable steps to sell foreclosed collateral. The lender cannot reject a “bona fide” offer but who really knows what that means when real estate prices are 50% below peak values and many of the interested buyers are only interested in acquiring property at rock-bottom prices.

In addition, many states have their own seciured creditor exemptions that may not only have more specific instructions on what constitutes commercially reasonable efforts to divest foreclosed property but also have limits on how long a lender may hold title without being deemed to not taking commercially reasonable steps to sell the property. Not surprisingly, the acceptable time periods vary by the state. And then there are those nasty local ordinances that are imposing new maintainance obligations on lenders that take take title to abandoned property.

Because a lender will not know if it has satisfied the secured creditor exemption until after it has been sued and a court has ruled on the issue, we advise our lending clients to act as if they the secured creditor exemption is not available and to make sure they take steps necessary to assert the CERCLA and/or state landowner liability protections such as the innocent landowner and bona fide prospective purchaser’s defenses. This means that the lender will have to do a phase 1 and comply with the post-acquisition appropriate care or due care requirements. It is also often advisable to include an environmental compliance component to the due diligence to make sure the lender does not inadvertantly find itself subject to fines and penalities for violations of environmental laws.  

For these and other reasons, foreclosing lenders are motivated to sell properties as quickly as possible. One tool that lenders are increasingly turning to to maximize their return and minimize liability is to combine the phase 1 with an “as is” sale coupled with an assignable environmental insurance policy. The lender will not indemnify the buyer and the seller has to agree to a hold harmless provision along with a waiver of all rights under environmental and common law. The “as is” contract nature of the contract allows the lender to avoid later breach of contract claims in the event the property turns out to be contaminated as well as not have to reflect any liability that could be associated an indemnity on its books. The environmental insurance softens the impact of the “as is” nature of the contract. In addition, the lender will agree to have the policy assigned in exchange for no discount in the purchase price. 

In the deals we have seen, the insurance  generally has only been available for suspected environmental conditions based on historic use of the property such as a strip mall that had dry cleaner in the past. The insurance is not generally available  to cover known conditions. However, there are some indications that some insurers may be more willing to work with lenders and purchasers to fashion some coverage for known contamination to satisfy the increased demand for this product as tje volume of foreclosures increases. Of course, having a good understanding of the known condition or  enrolling in a state voluntary cleanup program with an approved cleanup plan or a state dry cleaner/UST program along with transacting parties who are flexible with their demands is crucial to successfully implementing this risk management strategy.  

It seems like there were a lot of cases in 2011 involving commercial properties impacted by methane gas from former landfills. A recent case involved a novel question if the owner of a hotel damaged by methane gas migrating from a landfill could seek administrative claim status in a chapter 7 bankruptcy case.

In the case of In Re Resource Technology Corp, 2011 U.S. App. LEXIS 22022 (7^th Cir. 10/31/11), Congress Development Company (Congress) owned and operated a landfill in Hillside, Illinois. From 1992 to 1996, Congress used a flare system to control landfill gases. In 1996, Congress contracted with Resource Technology Corporation (RTC) to construct and operate a gas collection and control system (GCCS) that would replace the flare system. RTC, in turn, would convert the gas to electricity and then sell the electricity to power companies. In 1999, RTC filed a chapter 11 bankruptcy petition and continued to operate the GCCS as a debtor in possession (DIP) until 2003 when the bankruptcy court appointed a Chapter 11 trustee.

In October 2002, Markwell Hillside LLC (Markwell) purchased a Holiday Inn hotel located next to the landfill. As it turns out, Markwell’s purchase was ill-timed as conditions at the landfill significantly deteriorated in 2002. According to an expert in the bankruptcy case, RTC did not properly operate or maintain the GCCS during its time in bankruptcy. The problems included a history of high-pressure gas readings, broken fittings, broken valves, broken wellheads, and broken sampling ports.

In September 2005, the bankruptcy court converted the RTC case to a Chapter 7 liquidation proceeding. A chapter 7 trustee was appointed and given operational control over RTC’s was its business operations were wound down. Four days after the chapter 7 trustee assumed control, the GCCS failed. Landfill gases migrated into the hotel through electrical outlets and floor cracks. The odors sickened guests and employees, resulting in a disastrous fall off in the hotel’s business for a period. Markwell subsequently filed its own chapter 11 proceeding.

The Illinois Environmental Protection Agency (IEPA) issued notices of violation to Congress and RTC after receiving odor complaints. The Chapter 7 trustee responded that the estate lacked the financial resources to fix the GCCS and estimated even if it had the funds, it would take a year to bring the GCCS into compliance. In January 2006, the bankruptcy court lifted the automatic stay and allowed Congress to take control of the GCCS. Congress then terminated its contract with RTC and began to rebuild the GCCS.

Landfill gas continued to enter the hotel. Markwell discovered explosive levels of methane gas at the hotel in February and March of 2006. This was apparently the final nail for Maxwell reorganization hopes. In September 2006, Markwell’s trustee sold the Holiday Inn for 20% of the value had there not been a methane problem.

In May 2006, Markwell’s trustee filed an administrative claim against RTC’s Chapter 7 estate seeking compensation for damages. Markwell alleged that RTC’s negligent maintenance of the GCCS had created a nuisance that damaged Markwell’s property and caused economic loss. The Markwell estate assigned its claim to Samuel Roti, Markwell’s sole member. Roti then amended the Chapter 7 claim, requesting compensation for out-of-pocket costs, loss of hotel revenue, damage to the land, and diminution in the hotel’s market value.

Creditors in a chapter 11 bankruptcy may seek administrative claim status for post-petition environmental claims on the basis that the chapter 11 DIP or trustee has an obligation to comply with environmental laws under 28 U.S.C. 959. However, Markwell never filed a claim against the chapter 11 estate. Instead, Roti sought what it characterized as a post-petition administrative claim against the chapter 7 trustee on the basis that it “operated” the GCCS for nearly four months.

The United States District Court for the Northern District of Illinois rejected the request for administrative priority status and the Court of Appeals for the Seventh Circuit affirmed. The appeals court noted that the trustee had been operating RTC’s system for only four days when the failure occurred. The court said the failure resulted from years of RTC’s neglect, there was no evidence that the chapter 7 trustee was aware of that neglect, did not exacerbate the problem, could not have done anything to prevent the failure within the few days that it had nominal control of the system, and could not have done anything to mitigate the damage afterward. The court is was possible that the Chapter 11 trustee may have had some responsibility for the neglect of the GCCS but there was no longer a Chapter 11 estate from which Roti could seek relief.

The appeals court acknowledged that the nuisance matured into a claim when the Chapter 7 trustee had possession of the GCCS and therefore could be viewed as occurring post-petition. However, since the acts causing the nuisance occurred prior to the time the chapter 7 trustee assumed control, the court said the trustee was “no more personally responsible for it than the owner of an apartment house is responsible for the murder of one of his tenants by another tenant.”

After concluding that the Chapter 7 estate and not the trustee was the proper tortfeasor, the court examined if the claim should be afforded administrative expense priority. The court said that while the chapter 7 trustee was given operational control, it was not the kind of operational control seen in chapter 11 cases where a trustee is managing an ongoing business to preserve and enhance the value of the bankruptcy estate. Instead, the court said, the trustee had neither the mandate nor resources to do anything but liquidate the estate.

Roti argued that estate had generated from revenue from the sale of energy and was therefore continuing the operation of the business.  However, the appeals court said the trustee did not operate the GCCS in any meaningful way during the brief period it was in charge. While there was some revenue generated from energy sales, the court said the proceeds were less than 10% of its normal revenue and insufficient to cover the GCCS operating costs. The court concluded that the continued operation of the GCCS in its diminished state should be more properly viewed as simply the exercise of the estate’s obligation to prevent further contamination. Thus, while Roti as assignee of Markwell, was simply a general creditor.

Commentary: When companies encounter financial difficulties, spending on environmental compliance is often one of the first expense items to be slashed. Even during a chapter 11 bankruptcy when the estate has obligations to comply with environmental laws, debtors will often spend the absolute minimum on environmental compliance to preserve estate cash. As a result, parties considering purchasing corporate assets in a bankruptcy proceeding should carefully assess review environmental compliance prior to acquiring the assets. Lenders also need to scrutinize environmental compliance before exercising rights that could provide them with control over a defunct borrower’s facility. There have been many cases where lenders have become saddled with the costs of disposing of hazardous wastes. We have several archived posts that discuss the potential risks facing lenders during bankruptcy proceedings

The title of this post sounds like a teaser to a bad joke but unfortunately it refers to the latest round of motions in two sprawling lawsuits involving a defunct planned community that was to be developed on what proved to be a part of a world war 2 bombing practice range. The defendants include the project developer, the bond underwriter, bond counsel, the district established to issue the bonds, the appraiser, the title company and the seller of the property.

Several motions for summary judgment were recently decided by the federal district court for the eastern district of Louisiana. Coves of the Highland Community Development District v McGlinchey Stafford, 2011 U.S. Dist. LEXIS 109187 (E.D.LA. 9/26/11); SCB Diversified Municipal Portfolio v Crews & Associates, 2011 U.S. Dist. LEXIS 136177 (E.D.LA 11/28/11) and SCB Diversified Municipal Portfolio v Crews & Associates, 2011 U.S. Dist. LEXIS 141987 (E.D.La. 12/9/11). A third related case, MGD Partners v First American Title Insurance Company, 2011 U.S. Dist. LEXIS 18699 (E.D.La 09/08/11), was recently dismissed and will not be discussed in this post. The Cove of the Highland Community Development District is scheduled to go to trial in January while the SCB trial is scheduled for February.

Common Facts

In March of 2006, MGD Partners (“MGD”) purchased 324 acres of real property (the “Property”) inTangipahoa Parish,Louisianato build a planned residential community known as The Coves of theHighland(the Project”). MGD did not perform a phase 1 environmental site assessment (Phase 1 ESA). A MGD partner testified in a deposition that he did not order a phase 1 ESA because he had lived in the area and the property had timber or farmland for all his life. He did say that he was aware that there had been a World War 2 practice bombing and gunnery range in the area but believed it was about a mile to the east of the Project. Moreover, the title abstract indicated that the practice range was on a different parcel. In addition, the bank that financed the acquisition of the property, First Guaranty Bank, did not require a Phase 1 ESA.

In June 2006, MGD retained Defendant McGlinchey Stafford (McGlinchey) to a special municipal district known as the Coves of the Highland Community Development District (the “District). The purpose of the District was to finance and manage the Project infrastructure. MGD transferred title to the District who then issued tax-exempt bonds to finance certain infrastructure improvements such as roads, utilities and sewers. The District had five board of supervisors. Three of the board supervisors were partners of MGD. The other two board members were the attorney who served as the District’s general counsel and the consulting engineer for the Project.

On November 1, 2006, the District entered into a Development Agreement with MGD to facilitate development approvals and infrastructure financing. MGD represented there were no violations of any Environmental Laws or any material environmental claims affecting the property. MGD also agreed in section 3.10(b) that it would take all remedial actions necessary to clean up or remove of any hazardous materials discovered on the Property.

The District also entered into a Master Trust Indenture with Regions Bank, as trustee, for the issuance of up to $30MM in tax exempt bonds. Defendant Crews and Associates (“Crews”) was the underwriter of the bonds to be issued by the District. Crews worked with MGD to assemble a 480-page “Due Diligence Binder” to support the bond offering. To develop this binder, Crews gave MGD a “Due Diligence Checklist”.

The District issued $7.695MM in bonds that were sold through a prospectus called a ‘Preliminary Limited Offering Memorandum (“PLOM”) and a “Limited Offering Memorandum” (“LOM”). Bond investors typically use the PLOM to make purchase decisions with the bond pricing left blank. After the bond purchases are confirmed, the LOM is then issued with the only changes typically being the pricing information.

Defendant Breazeale, Sachse & Wilson (“BSW”) prepared both the PLOM and the LOM. The PLOM contained a paragraph titled “Development” that stated the developer had provided a number of documents including a Phase 1 ESA. This paragraph also stated that although the information furnished was believed to be reliable, “the neither District, the Underwriter nor their counsel have independently verified the information provided by such parties.” The PLOM also had a section title “Phase 1 Environmental Site Assessment” that stated a phase 1 with the date left blank had been performed and no RECs had been identified. When the LOM was issued, the phase 1 section had been deleted but the “Development” section still stated that a phase 1 had been one of the documents furnished by the developers. BSW issued an opinion letter to Crews stating that the firm was not aware of any information that caused it to believe that the LOM contained any untrue statement of material fact or omits to state any material fact.  The LOM also contained the standard bold boilerplate that investors should not rely on any investigations by any party to the transaction

Greystone Valuation Services (“Greystone”) was retained by MGD to prepare a feasibility study known as a marketing study which was attached as an appendix to the LOM. McGlinchey issued Bond Counsel Opinion, Supplemental Opinion and opinion to the District. The opinions were delivered on November 16, 2006, the date of the closing of the issuance, sale and delivery of the Bonds.

Crews purchased the bonds pursuant to bond purchase agreement drafted by McGlinchey. Crews then sold the bonds to several series of the Sanford C. Bernstein Fund Diversified Municipal Portfolio (“SCB”), a municipal mutual fund for the face amount of the Bonds. In connection with the SCB closing, BSW issued an opinion letter to Crews stating that the LOM did not contain any misrepresentations or omissions of facts.

Discovery of the Former Bombing Range

As it turns out, the property was part of the Former Hammond Bombing andGunneryRange(“HBGR”) that the federal government had leased from 1942 to 1945. The 1943 deed expressly stated that the property was being leased to the United States Army Air Corp for “a practice bombing and gunnery range.” The HBGR was subsequently designated as a “Formerly Used Defense Site” (“FUDS”) and in 1995 the Army Corps of Engineers (“Corps”) conducted an assessment to determine if the site was eligible for funding under the Defense Environmental Restoration Program for Formerly Used Defense Sites (DERP-FUDS). The inspection revealed physical evidence of ordnance and explosive waste consisting of old bomb craters and pieces of shrapnel. The Corps also concluded the existence of bomb craters suggested a high probability of buried unexploded ordnance (“UXO”) as well as munitions and explosives of concern (“MEC”) on the HBGR. In August 1996, the Corps determined the site was eligible for DERP-FUDS inclusion, based on the likely presence of UXO and MEC. In 1996, a local historian wrote a book “Hammond Army Air Field and Early Aviation in the Hammond Area” which contained extensive detail about the HBGR and interviews with former military personnel who had used the HBGR. Indeed, the Corps used this book to locate some of the target areas.

After Sept. 11, 2001, Congress took a particular interest in the approximately 10,000 FUDs across the country because their potential for terrorist activity. In connection with this initiative, the Corps returned to the HBGR in 2002 and performed an extensive physical, historical and risk assessment analysis. The results were published in the March 2003 Archives Search Report for the formerHammondBombingRange(“2003 ASR”).

In 2005, the Corps issued a contract to Parsons Infrastructures and Technology Group, Inc. (“Parsons”) to conduct a Site Inspection at the HBGR to further define the scope and extent of munitions, including any UXO and MEC, remaining on or at the HBGR, and to determine what, if any, further action would be required to remove this material from the HBGR. Parsons issued a draft report in December 2008 which showed that the Project was located within the HBGR.

By the spring of 2009, the District had completed the 120-acre phase 1 of the Project consisting of 264 home lots, installed streets, street lights, sewer and water lines, eight acres of ponds, and a one acre sewage plant that was capable of serving 2500 homes. MGD was preparing to close on $2.5MM in lot sales when the Corps published a public notice in the local newspaper advising of the results of the site inspection. The study contained maps showing that a portion of the Project was located within the outer boundary of the former strafing target area, rifle range, multiple use target area, and three of the five munitions response sites located within the HBGR. The Corps said that the munitions used at the HBGR included 100-pound general purpose bombs, 100-pound practice bombs, 100-pound concrete practice bombs, 2.25” practice rockets, spotting charges, .50-caliber machine gun ammunition, 3-pound practice bombs, 4.5-pound practice bombs and general arms ammunition. The Corps indicated that it would probably not begin remediation work until 2030 depending on Congressional funding.

Following publication of the notice, the Tangipahoa Parish Engineer issued a building moratorium until the risk of UXO and MEC contamination had been fully investigated and remediated. As a result, development of the Project ceased, the lots could not be sold and the District defaulted since the bond payments were to be funded from assessments. There were also allegations in the briefing for the various motions that the Project had been encountering financial difficulties. Reportedly, MGD as well as its principals had to borrower an additional $1.3MM in late 2008 money to fund the work. In 2009, MGD allegedly was behind on its assessment payments, interest payment for the bonds and an installment payment on a promissory note for land that was to be used for the other phases of the Project.

The District Litigation

After the District defaulted on the Bonds, the District filed a lawsuit against McGlinchey and BSW alleging violations of federal securities law and state claims for professional malpractice The District said that under the bond offering documents and CERCLA, the District and MGD were obligated to remediate the property at an estimated cost of $1,3MM

Specifically the District argued that as its bond counsel, McGlinchey had strict “due diligence” duties to conduct a reasonable investigation into the facts supporting its opinion letters, including performing basic environmental due diligence. The District also claimed McGlinchey had failed to alert its client’s attention that the LOM inferred that the Developer had obtained a Phase I ESA when in fact no such environmental site assessment had been performed. As a result, the District said the LOM was misleading and subjected it to securities litigation with the bond purchasers. The District also asserted that McGlinchey had a duty to review the abstract of title obtained by its general counsel or should have ordered its own abstract of title.

McGlinchey filed a motion to dismiss and in 2010 arguing as bond counsel it had no obligation to investigate environmental issues and that its engagement letter expressly stated that the firm would be relying on information provided by the District and MGD. In an October 2010 opinion, the court noted that documents such as the engagement letter outlining the scope of the firm’s services seemed to contradict or undermine the District’s allegations. While concluding that the allegations raised sufficient questions to defeat a motion to dismiss, the court said it was skeptical of the alleged expanded scope of the law firm’s representation. Therefore, the court said it would welcome an appropriately-supported motion for summary judgment after sufficient discovery had been completed.

The law firm also argued that the complaint that had been filed on November 10, 2009 was barred by the three-year statute of limitations. The court agreed that any claims relating to any alleged misrepresentations, errors, omissions, or misstatements of fact upon by McGlinchey that the District relied on to its detriment that occurred prior to November 10, 2006 were barred.

The District then sought permission from the court to file an amended complaint to clarify the misstatements, misrepresentations or omissions committed by McGlinchey that had been learned during discovery. However, the court denied this motion. Coves of the Highland Community Development District v McGlinchey Stafford, 2011 U.S. Dist. LEXIS 109187 (E.D.LA. 9/26/11)

The District also alleged that BSW committed legal malpractice when it (1) failed to advise the District that its bond offering memorandum referenced the Environmental Phase 1 study; (2) did not advise the District that this reference to an Environmental Phase 1 study amounted to a representation that an Environmental Phase 1 study had been performed; (3) failed to disclose to the District that an Environmental Phase 1 study had not been completed; (4) did not remove reference to the Environmental Phase 1 study in the LOM; and (5) did not advise the Plaintiff that an Environmental Phase 1 study should have been performed to protect against unknown conditions associated with the property that may delay the development or affect the Plaintiff’s ability to meet its debt obligations. The District also stated that the firm had a “duty” to evaluate the Plaintiff’s bond offering memorandum, disclose the terms of the memorandum, and advise the Plaintiff about the possible consequences of the memorandum.

SCB Litigation

SCB filed a complaint against the District, Crews and Greystone, alleging the LOM was also misleading because it failed to disclose the UXO and MEC contamination risks affecting the Property. SCB asserted the defendants had strict due diligence obligations in connection with the bonds that included environmental due diligence.

SCB Claims Against BSW

Specifically, SCB charged BSW with negligent misrepresentation for (1) failing to reveal relevant facts relating to the proximity of the HBGR to the Project; (2) failing to reveal that a Phase I Environmental Site Assessment had not been conducted on the property; (3) drafting the PLOM and LOM which allegedly contained misleading statements regarding a Phase I Environmental Site Assessment;” and (4) issuing an opinion letter to Crews which states that the PLOM and LOM did not contain misrepresentations or omissions of facts.

BSW filed a motion for summary judgment. The court said that even if it assumed BSW had a duty of disclosure and breached that duty, SCB have failed to establish justifiable reliance on any alleged misrepresentation. The court said SCB was essentially claiming that its financial analyst interpreted the reference to the section captioned “Phase I Environmental Site Assessment” meant a Phase I ESA had been performed on the Property and relied upon that statement in making the decision to purchase the Bonds. However, the court noted that SCB’s financial analyst who read the PLOM had testified that he had failed to notice that the caption “Phase I Site Assessment” was missing from the LOM. Since he was the only SCB representative who read the PLOM, the court ruled that SCB could not claim reliance on this alleged misrepresentation by BSW.

SCB also argued that BSW made misrepresentations in its opinion letter that the PLOM did not contain any misrepresentation or omission of material fact. However, the court said even assuming BSW had a duty of disclosure and breached this duty by making misrepresentations or omitting material facts in its opinion letter, SCB had not presented any evidence of justifiable reliance. In particular, the court noted that SCB’s financial analyst testified in his deposition that SCB did not rely on the opinion letter in purchasing the Coves Bonds. Accordingly, summary judgment was granted to BSW. SCB Diversified Municipal Portfolio v Crews & Associates, 2011 U.S. Dist. LEXIS 141987 (E.D.La. 12/9/11)

SCB Claims Against Greystone

SCB asserted claims against Greystone for negligent misrepresentation for failing to conduct an environmental investigation. SCB also argued that as a certified and licensed real estate appraiser, Greystone had a duty to obtain and review a title search to determine any historical issues regarding environmental contamination

The Marketability Study stated that was “a comprehensive analysis and review” of forces affecting the Project including “environmental (physical) and governmental features of the defined market area. SCB alleged that Greystone had a duty to discover and disclose the lack of a Phase I Environmental Site Assessment; had breached that duty; and that SCB had relied on such statements when it decided to purchase the Bonds.

In Greystone’s motion for summary judgment, the court said that SCB had failed to identify any source of law that could impose upon Greystone a duty to obtain an environmental assessment or to disclose is absence. Even assuming that Greystone had a legal duty, the Court said, Greystone did not breach that duty. The court said there was no mention of any environmental assessment in Greystone’s report. Moreover, the court said the Marketability Study contained several “Underlying Assumptions and Conditions” that make clear that the analysis was based on the Property being in full compliance with all applicable environmental and laws unless stated otherwise. Moreover, SCB’s financial analyst testified that he did not rely on the Greystone’s study. The court said it was undisputed that the SCB financial analyst understood from the PLOM that any Phase 1 ESA was supplied by the developers and not from any other source. Because SCB could not demonstrate justifiable reliance on the Greystone study regarding the existence of a Phase I Environmental Site Assessment, the court granted Greystone’s motion for summary judgment. SCB Diversified Municipal Portfolio v Crews & Associates, 2011 U.S. Dist. LEXIS 136177 (E.D.LA 11/28/11)

SCB Claims Against Crews

SCB asserts the LOM was misleading because it failed to disclose the Project was located on the HBGR and may contain UXO and MEC. Crews failed to disclose the above alleged material facts. SCB alleges that as the underwriter, Crews had a duty to inquire into the accuracy, truthfulness and completeness of the key representations of the District and had a duty to exercise reasonable care by conducting due diligence to investigate and disclose all material facts surrounding the issuance of the bonds. In particular, SCB claims that Crews had a duty to conduct basic environmental due diligence as to potential environmental contamination of the Project. SCB claims Crews knowingly and recklessly failed to verify or inquire into whether there was any basis for this representation even though a Phase I Environmental Study is a basic component of due diligence on a real estate transaction of this size. Crews has filed a summary judgment motion but the court has not yet decided the motion.

This case is just one of a number of high cases involving residential developments that were unknowingly constructed on former bombing practice ranges. In some instances, the parties were aware that a former bombing range had been located in the vicinity of the development but the developments were not close enough to the target areas to represent a significant risk. The underlying assumption in those decisions was that all of the bombs fell on the intended target. Given that these were PRACTICE ranges for new pilots, one has to wonder why the developers and their engineers assumed all of the bombs fell on the “x”! Discussions of the other cases are available from our Archived Posts.

It is also interesting that the District was dominated by the developer who made the decision not to conduct environmental due diligence. Call my cynical but it does seem somewhat repugnant that the District is trying to blame professional service providers who do not normally deal with environmental issues for the negligence of its own members.

Update on McGlinchey Lawsuit

In January, the court granted summary judgment to McGlinchey. The court said that the terms of the engagement letter provided that McGlinchey’s role in the venture was limited to assisting Plaintiff in its formation under Louisiana law and in issuing bonds. The court said the firm’s review of the PLOM did notinclude the section regarding the development, which is where the mention of a Phase I Environmental Site Assessment is located.

The court also rejected the District’s claim that McGlinchey had violated the rules of professional conduct for attorneys by limiting its representation without obtaining informed consent to such limited representation. The District had introduced expert testimony that any attorney representing, in any capacity, a client who is engaged in developing real estate must advise a client about the need for environmental reviews. However, the court said this  standard of practice was too broad, finding that environmental issues are outside the scope of bond counsel’s traditional role in municipal finance transactions. Since environmental due diligence was not in the scope of McGlinchey’s duty to Plaintiff, McGlinchey did not commit legal malpractice by reviewing the PLOM and failing to notice the mention of a Phase I Environmental Site Assessment-especially in this case where McGlinchey was retained after the client had acquired the property.

Of some concern to real estate lawyers, though, was the court suggestion that attorneys working on real property acquisitions would most likely have a duty to advise a client regarding environmental issues but this duty didnot extend to every attorney who comes into contact with a client developing real estate. SCB Diversified Mun. Portfolio v. Crews & Assocs 2012 U.S. Dist. LEXIS 754  (E.D.La. 1/4/12)

We have been sharing and commenting on articles discussing how lenders are becoming increasingly concerned about borrowers who lease their property to allow hydraulic fracturing (“fracking”). The operations permitted by the leases on what is typically rural or agricultural land include storage of hazardous substances and wastewater that likely would constitute defaults under the mortgages.

Now comes another article published by the New York Times that discusses how the bulk of the eight million oil and gas leases that have been entered nationwide often fail to adequately protect property owners from risks associated with what amounts to industrial activity on their property. http://www.nytimes.com/2011/12/02/us/drilling-down-fighting-over-oil-and-gas-well-leases.html?_r=1&ref=todayspaper

The article reports that the leases are often presented to property owners on a “take-it-or-leave-it basis” by the brokers who are retained by the energy companies. The article says that these agents, known as “landman” often try to pressure property owners to sign the leases by warning them that their neighbors have signed leases and that if the property owner does not sign the lease, the gas under its land will simply be drained by the adjoining operations.

The New York Times obtained copies of 110,000 leases used in Texas, New York, Pennsylvania, Ohio, Maryland and West Virginia. The vast majority of the leases were from Texas. Following are some of the key observations from the lease review.

•  Most of the leases reviewed did not require periodic sampling of drinking water. As a result, it is often difficult for property owners to link contaminated groundwater with the fracking operations;

•  Less than half of the leases required the companies to compensate landowners for contamination of groundwater. While eight states require energy companies to provide some sort of indemnification, the terms of the indemnity are to be negotiated;

•  When companies are obligated to provide alternative drinking water for properties with contaminated groundwater, the owner often has to pay the increased electric bills resulting from the need to prevent the water from freezing during the winter;

• Most leases do not establish “setbacks” from various structures or areas on a property but instead grant the companies broad discretion where to build roads, store chemicals and cut down trees;

• Most leases do not contain any disclosure about the potential environmental risks associated with the drilling activity;

• Many leases allow companies to store waste generated by the fracking operations in pits or underground. Indeed, some of the leases reviewed in the article allowed the energy companies to simply cap the waste;

• Those leases that did require the company to remove waste often offset those costs against the royalties to be earned by the property owner;

• Most leases contain clauses that enable companies to extend leases beyond the negotiated term which is typically three to five years in length. For example, some companies have invoked the “force majeure”  clause in New York because of the drilling moratorium that was established while the state Department of Environmental Conservation adopts fracking regulations;

• Less than 20% of the Texas leases and virtually none of the leases in the eastern states contained the so-called “Pugh Clause” which prevents leases from being indefinitely extended;

• Another clause that has been used to extend leases is the “preparations” for drilling provision. The article says the term is broadly construed by companies and cited to an example where an oil company sought to invoke the clause a day before a lease was to expire. The company had not yet drilled any wells but said it had engaged in “preparations” by locating a bulldozer near the  leased property and had surveying for an access road;

• Most leases allow the rights to be freely assigned to other companies without the prior approval of the property owner, thereby preventing an owner from terminating a lease that might be assigned to a company that may not be financially stable or perhaps does not have a good environmental track record.

The state attorney generals of New York, Ohio and Pennslyvania have published advisories about leasing land for drilling. While there are a number of websites that can assist property owners with such leases, the article should be a wakeup call to landowners to retain a lawyer before signing such a lease. Without legal review, you could be committing your grandchildren to the terms of an unfavorable lease.

The federal district court for the Southern District of New York denied a motion to dismiss filed by Morgan Stanley Mortgage Capital, Inc (MSMC)that it failed to adequately disclose environmental conditions at a shopping center and should not be required to buy back the $81MM loan. This case has some yummy nuggets.

In this case, MSMC originated a $81MM loan to City View LLC to finance the acquisition of a shopping center in December 2006. The shopping center had been constructed on a former landfill, was required to monitor methane gas and had been subject to a number of notices of violations. In 2006, Walmart which was the largest tenant of the shopping center and occupied nearly 29% of the net square footage began complaining about methane gas. Just before the loan was closed, Wal-Mart issued a Notice of Default accusing the seller of failing to manage the methane gas and alleging that methane gas levels had reached dangerous levels.  The seller of the property and Wal-Mart then entered into a series of letter agreements where seller agreed to address the methane problem. The seller and borrower also entered into a Walmart Indemnity Agreement where the borrower agreed to assume the obligations to cure the methane problem. On the day of the closing, Wal-Mart also sent the defendant an estoppel certificate identifying the methane problem and setting forth the landlord’s obligations to cure the problem. Eventually, Wal-Mart terminated its lease in 2009 and the borrower defaulted on its debt service payments.

The phase 1 had not identified any RECs. However, it had identified methane as an “item of concern”. It has also disclosed that the shopping center had been constructed on a landfill, that it was required to monitor methane and that there had been notices of violations that would require at least $100K to repair.

Meanwhile,  MSMC sold the loan in May 2007 to an affiliate entity pursuant to a Mortgage Loan Purchase Agreement (MLPA). The loan was then deposited into a Morgan Stanley CMBS Trust pursuant to a pooling and servicing agreement (PSA) with the plaintiff named as Trustee.

The MLPA contained an environmental warranty that an environmental assessment had been performed and that the MSMC had no knowledge of any material and adverse environmental conditions or circumstances affecting the property that was not disclosed in the report. MSMC also warranted that there were no material defaults.

The plaintiff through the special servicer filed a complaint seeking to require MSMC to re-purchase the loan. The complaint alleged that MSMC knew the loan was in default and failed to disclose it, and also failed to disclose the adverse environmental conditions affecting the property.  Interestingly, Phase 1 did not flag methane as a REC but as an “item of environmental condition”. In a motion to dismiss, MSMC asserted that it had disclosed all of the environmental risks associated with the property including that the property had been built on a landfill, required monitoring for methane, was under the supervision of the Ohio EPA and an escrow of $100K had been established tp resolve outstanding environmental violations.

However, the court disagreed, noting that the phase 1 said its purpose was to identify Recognized Environmental Conditions (RECs),  the report did not identify any RECs and characterized methane as an “item of concern”. The court said that an “item of environmental concern” was not congruent with a REC, and there was a material dispute if the phase 1 had disclosed the existence of a material environmental threat.  Bank of New York Mellon Trust Company et al v. Morgan Stanley Mortgage Capital Inc., 11-0505 (S.D.N.Y. 6/27/11)

After a dispute arose over the calculation of the damages, the court reduced the damage award to $248,928.61, consisting of $181,876,75 in out-of-pocket expenses and $67,051.89 in prejudgment interest. The plaintiff then appealed, arguing the trial court had improperly rejected its theory of damages but the appeals court affirmed.