LENDERS CONTINUE TO FACE EXPOSURE FOR ENVIRONMENTAL LIABILITY
By Larry Schnapf*

With the enactment of the “Asset Conservation, Lender Liability, and Deposit Insurance Protection Act of 1996 (the “Lender Liability Amendments”) and the passage of state lender liability laws, many financial institutions have become less concerned about environmental issues associated with the lending transactions. Indeed, some lenders have begun to relax their environmental due diligence requirements. However, several cases decided during the past year call into question the wisdom of this lax approach to environmental liability. These decisions show that banks can continue to be exposed to environmental liability even when they comply with the requirements of the Lender Liability Amendments or state lender liability laws. This article will examine those recent lender liability cases..
Overview of Lender Liability
The principle federal environmental laws of concern to financial institutions have been the Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”) and the Resource Conservation and Recovery Act (“RCRA”). Most states have enacted their versions of these statutes.
CERCLA  imposes strict and joint liability on four classes of potentially responsible parties (“PRPs”) for the cleanup and reimbursement of costs associated with releases of hazardous substances. The four classes of PRPs include past and current owners of facilities and vessels (i.e., tanks, equipment, etc.), past and current operators of facilities and vessels, generators of hazardous substances and transporters of hazardous substances.  The definition of “owner or operator” does contain an exclusion which states that any person who “ holds indicia of ownership primarily to protect his security interest” in a vessel or facility will not be liable as an owner or operator if that person does not “participate in the management” of the facility or vessel. EPA has issued a CERCLA Lender Liability Rule in 1992. The rule was vacated by a federal appellate court in 1994.
RCRA regulates the generation, storage, handling , transportation and disposal of hazardous waste. Owners or operators of RCRA-regulated facilities must comply with certain operating standards and are also required to undertake corrective action to cleanup contamination caused by hazardous or solid wastes. RCRA contains a secured creditor’s exemption is similar to the CERCLA provision except that it is limited to underground storage tanks (“USTs”). The RCRA secured creditor’s exemption provides that a lender who has indicia of ownership in a UST system (i.e., one or more USTs) or property containing a UST system will not be liable as an owner or operator of the UST system if (i) the indicia of ownership is held primarily to protect a security interest, (ii) the lender does not participate in the management of the UST system and (iii) the lender is not engaged in petroleum production, refining and marketing (42 U.S.C. 6991(b)(h)(9)).  The EPA issued a RCRA Lender Liability Rule interpreting the scope of the RCRA secured creditor’s exemption in 1995. 
The Lender Liability Amendments added new provisions to the CERCLA and RCRA secured creditors exemptions and codified the principles contained in the two EPA lender liability rules. Those regulations essentially provided that a lender must exercise actual day-to-day control over a borrower’s operation before it will be considered  “participating in the management of a facility”. Moreover, lenders were allowed to foreclose on property without becoming liable as an owner so long as they expeditiously take steps to sell the property and comply with environmental laws while they are in possession of the property. 
However, as we warned lenders last year, the Lender Liability Amendments fall short of providing complete immunity from environmental liability because they do not provide relief from claims brought under state environmental and common laws. 
 Mattingly v. First Bank of Lincoln
A contaminated gasoline station was at the center of the controversy in this case. In July, 1983, a construction crew installing a new sewer line in the center of Lincoln, Montana discovered a pocket of gasoline floating on top of the groundwater. An investigation by the state Water Quality Bureau (“WQB”) identified three gasoline stations as the source of the contamination. One of the gasoline stations responsible for the contamination was an Exxon station owned by August Habet. Another source was the Handi-Mart which was owned and operated by a director and active board member of the First Bank of Lincoln (“FBOL”). The WQB determined that the leading edge of the groundwater extended to the FBOL office site and obtained permission from the FBOL president to excavate a portion of the FBOL site to determine the extent of the zone of contamination. 
Four years later, the plaintiff agreed to purchase the Exxon station for $79,000. Habet did not inform the plaintiff about the contamination and the plaintiff did not conduct any investigation. When the plaintiff applied for a loan from FBOL to finance the purchase of the station, FBOL did not require a formal real estate appraisal because of the large down payment. Instead, it hired a real estate inspector to make an visual inspection of the property “to obtain an impression” of the property’s value. The inspector was relatively new to the area but had some general knowledge about the contamination.
When the FBOL loan committee met to act on the plaintiff’s loan application, both the FBOL president and the director who knew about the contamination raised the contamination issue. Two months after FBOL approved the initial loan request of $56,000, the plaintiff applied for a second loan in the amount of $127,000 to remodel and expand the service station. However, FBOL denied this loan request and the plaintiff obtained an SBA-guaranteed loan of $105,000. The plaintiff used the proceeds of this loan to pay off the balance on his FBOL loan and to remodel the station.
The plaintiff learned about the contamination in July, 1991 when he tried to sell the property and the sale fell through because the purchaser became aware of the contamination. One year later, the state Department of Health and Environmental Services notified the plaintiff that he was potentially liable for remediating the groundwater contamination. The plaintiff then sued Habet and also FBOL on the grounds of constructive fraud, negligence and negligent misrepresentation. The trial court found Habet liable to the plaintiff for $435,000 but granted summary judgment to FBOL. The plaintiff then appealed to the Montana Supreme Court which reversed the lower court ruling.
On the negligent misrepresentation, the court said that the FBOL appraisal and approval of the loan constituted an affirmative representation that the property was worth at least the value of the loan but there was a material question of fact whether the plaintiff had relied on that representation.
On the question of constructive fraud, the court said that FBOL had peculiar knowledge of the contamination associated with the site which may have created a special duty to disclose that information to the plaintiff. Not only did FBOL fail to disclose the contamination to the plaintiff but it is possible, the court said, that a trier of fact could determine that FBOL created a false impression about the existence of the contamination by its words and conduct. Moreover, the court held there was a material fact whether FBOL had gained an advantage by failing to disclose the existence of the contamination. In so ruling, the court observed that FBOL had taken back a  mortgage from Habet which was paid off from the proceeds of the sale to the plaintiff. Finally, the court also reinstated the plaintiff’s claim for punitive damages since it was possible that a jury could find that FBOL was guilty of actual fraud or actual malice by failing to disclose what it knew about the contamination.
While the facts of this case are somewhat unusual because of the manner in which the two members of the loan committee obtained information about the contaminated property, the case does provide an important lesson to lenders regarding environmental due diligence. Many lenders now routinely order environmental site assessments on property before approving a loan. This case shows how important it is for lenders to disclose what they know about the environmental conditions of a property not only to prospective borrowers but also to any other banks who may be contemplating purchasing all or part of a loan. Although many banks only want to review reports that are less than a year old, it is important that a lender planning to sell all or part of a loan review its files and provide the prospective purchaser with copies of all existing environmental reports in its possession since it is possible that there may be information contained in the older reports that was overlooked in the more recent report.
MidSouth Rail Corporation v. Citizens Bank & Trust Company
The lender was more fortunate in this case but just barely. Here, the plaintiff had entered into a lease with Gulf Coast Sulphur Company (“GCSP” )which allowed to build a sulphur processing plant along land bordering the plaintiff’s railway line. GCSP soon ran into financial difficulties and began dumping raw sulphur at the site. GCSP then obtained a $150,000 working capital loan from Citizens Bank and Trust Company (“CBT”). As collateral for the loan, the CBT took back an assignment of the lease, personal guarantees and liens on accounts receivable and inventory, including the raw sulphur. 
GCSP continued to encounter financial difficulties, though. The primary shareholder and other stockholders then formed a new company, Gulf Coast Sulphur Corporation (“GCS”) which assumed the assets and liabilities of the old company. CBT extended a new $200,000 loan accommodation. The purpose of the loan was to refinance the old CBT loans and to pay off $50,000 in GCSP overdrafts. CBT apparently inspected the premises and knew the prior operation had a history of environmental violations liability but determined that the collateral value was sufficient .  
	In 1988, GCS filed for bankruptcy and abandoned the facility, leaving approximately 5,000 tons of sulphur on the ground, In 1989, the sulphur caught fire and destroyed the facility. The state Department of Environmental Quality which had responded to the emergency and ordered MidSouth to remediate the property. After incurring $160,000 in cleanup expenses, MidSouth sought reimbursement from CBT who then filed a declaratory judgment to determine its liability. MidSouth filed a counterclaim that CBT was liable as the assignee of the lease and was liable for contribution under the state Superfund law. 
	Because of perceived ambiguities in the lease assignment, the trial court took extensive testimony regarding the intent of the parties before dismissing MidSouth’s lease claims. On the statutory contribution claim, however, the court found that CBT could be liable for contribution because the Mississippi mini-Superfund law imposed liability on “any person creating, or responsible for creating... an immediate necessity for remedial or cleanup actions”. The court then that CBT had consciously and purposefully allowed the GSC to continue running an operation that created the “immediate necessity for remedial action” and that the CBT’s motive was to ensure that its old loan was paid off. Because CBT’s actions enabled another to create an immediate necessity for cleanup,  the court found the bank liable for ten percent of the remedial costs at the site. 
	On appeal, the Mississippi Supreme Court in a 2-1 decision ruled for the lender on both claims. On the contract claim, the court noted that the general rule was that assignee’s of a contract do not normally incur the obligations under the lease in the absence of an express provision but that an assignee can take on the obligations of covenants that run with the land. In this case, the lease required the lessee/assignor to comply with environmental laws. While the court found that the language in the assignment was overbroad and could be read to transfer the lease obligations to CBT, the court ruled that the testimony introduced in the trial court showed that the intent of the parties was that the assignment was simply a collateral assignment to protect CBT’s security interest. Another factor that influenced the court was that CBT never paid any rent to MidSouth and never took possession of the property.
	On the statutory contribution claim, the Supreme Court held that the statute was penal in nature and, therefore, had to be construed narrowly. Moreover, the court said that the trial court’s broad interpretation would expose innocent lenders to a plethora of lawsuits simply because they provided capital to a company who committed environmental harm. Accordingly, the court reversed the lower court decision.    
	This case was an extremely close call for the lender which could have had potentially broad ramifications since a number of state mini-Superfunds define liable parties to be  persons who are “responsible” for the discharge. In these states, a party such as a lender that does not fall within one of the traditional four categories of  PRPs, could still be liable as a “responsible party” under a state environmental law. More importantly, the case should be a warning to lenders and their counsel to take a careful look at those standard lease assignments that they have been using. Lenders should insert language in those assignments that clearly indicate that they are not assuming any environmental obligations under the lease especially where the underlying lease has covenants requiring the lessee and its assignees to comply with environmental laws.
	Given the poorly drafted assignment and the environmental covenants in the lease, it is quite likely that the court would have ruled against the bank had it exercised control of the property. Thus, this case should also sent a strong signal to lenders to carefully review their procedures for taking possession of collateral and a borrower’s facility following default. 
 F.P Woll & Company v. Fifth and Mitchell Street Corporation 
The case illustrates the dangers that lenders may face when they repossess collateral and exercise control over a facility to effectuate the sale of that collateral. The case also shows how difficult it can be for a lender to procedurally remove itself from a case even where the  lender may have complied with the requirements of the Lender Liability Amendments and a state lender liability law. 
In F.P Woll & Company v. Fifth and Mitchell Street Corporation, Eaton Laboratories, Inc. leased a laundry and dry cleaning compound manufacturing facility. In December, 1985, Philadelphia National Bank (”PNB”) declared Eaton in default of its loan. PNB foreclosed on Eaton’s assets (including the inventory of hazardous substances located on the property) and promptly sold them to another defendant, D.C. Filter and Chemical. The current landowner filed suit seeking to hold PNB and others liable for the contamination at the site. The plaintiff asserted that PNB was liable as an operator at the site because it took actions that constituted “active management” at the site. PNB then filed a motion to dismiss arguing that it could not be liable either under the Lender Liability Amendments or the Pennsylvania Economic Development Agency, Fiduciary and Lender Environmental Protection Act of 1995. Under the federal rules of civil procedure, a court is required to accept as true all allegations contained in a complaint and may not dismiss a complaint unless it appears beyond doubt that the plaintiff cannot prove sufficient facts to support its claim. The court found that the complaint contained sufficient allegations which could not be disregarded without additional facts that would have to be developed later in the case. Accordingly, PNB’s motion was dismissed. While PNB may ultimately prevail on the merits, it will have to incur the costs of additional litigation to establish the necessary factual background before it can dismissed from a case. 
	As with the previous case, this decision shows that lenders must proceed with great caution and before a detailed site inspection before they foreclose on the assets of a defaulted borrower. Besides these last two cases, there have been a number of unreported instances where lenders have been issued administrative orders by governmental agencies and have had to pay to perform a cleanup when lenders have taken control of a site after a borrower has gone out of business. Often times, a bank takes control of the facility in order to sell off the inventory, fixtures and machinery and equipment of the borrower which is subject to the bank’s lien. The bank typically does not take title to the property but simply hires an auctioneer to conduct the sale of the personal property. Usually, there are barrels or drums of hazardous waste strewn about the facility and there may be Underground Storage Tanks (“USTs”) located at the site as well. In order to avoid any suggestion that the bank or the auctioneer had any control over hazardous wastes, the auctioneer will often rope off the area where the drums or barrels are found.  In some cases, the bidders are actually allowed to cherry-pick barrels containing useful raw materials. After the auction is conducted, the drums and barrels are then left in the abandoned facility. At some point, government authorities find out that there are abandoned drums at the facility and have ordered the lender to pay for the removal of the materials.
By taking control of the site, lenders may also unwittingly be asserting control over the USTs and expose itself to a claim from the landlord especially where there may be environmental covenants imposing obligations on the borrower or where the borrower had the right to use or control the USTs under its lease. 
As a result, financial institutions should consult with environmental counsel prior to taking possession of a former borrower’s facility or conducting any auction at a manufacturing facility. It would be advisable for lenders to retain an environmental consultant or environmental attorney to inspect the facility prior to taking control of the facility in order to evaluate the possible environmental liabilities that might be associated with the auction. In addition, the lender should have its counsel review the both the lease and the state UST registrations to determine who is responsible for the USTs. If the USTs are registered in the name of the borrower, the lender should discuss the status of the USTs with the landlord. If the owner believes that the existence of the USTs enhance the marketability of the site, the lender may be in a good position to negotiate a satisfactory resolution to the UST issue prior to assuming control of the site for the purpose of conducting an auction of the former borrower’s assets.
Another practice that can expose a lender to liability is the hiring of guards. Often times, lenders conclude that they must hire a guard to protect inventory or equipment until an auction may be conducted. More times than not, the guard is posted at the entrance to the plant and will not allow access to the property without the approval of lender. There have been a number of reported instances when the lender’s guard denied access to a local government inspector who wanted to confirm that the abandonment of the facility did not pose a risk of danger or explosion. By exercising such control over a facility, a lender could be deemed to be an operator of the facility and be held responsible for remediating environmental problems at the site. To minimize this possibility, a lender should have its guard posted in or outside the building where the collateral is located instead of a the gate leading to the entire facility. 
The lender may also want to have an environmental consultant be present at the auction to make sure that hazardous materials remaining at the property are not disturbed or spilled. If any materials are inadvertently spilled, the consultant could take immediate steps to contain and cleanup the spill and document those actions. 
Over two dozen states have enacted their own lender liability statutes or promulgated lender liability regulations which can vary with the federal requirements. Thus, in order to minimize potential liability, lenders should review the specific requirements of those state laws or regulations in addition to the practical guidelines mentioned above before they take possession of their collateral. 

* Larry Schnapf is the chairman of the Environmental Law Department of  Pryor Cashman Sherman & Flynn. He is an adjunct professor at New York Law School where he teaches “Environmental  Problems in Business Transactions.” He is also the author of “Environmental Liability: Managing Risks in Real Estate/Corporate Transactions and brownfield redevelopment” published by Lexis Legal Publishers.