NY Case Illustrates Why Borrowers Should Not Simply Rely on Lender Approval of Phase 1

Lenders have long played a role as “surrogate regulator” in transactions. In many cases, lenders force potential borrowers to investigate suspected contamination and frequently require remediation under state oversight. Borrowers often balk at these requests any may even retain their own independent consultants to try to convince lenders that the work is not required or necessary.
However, borrowers usually do not exhibit such independence when the lenders are ok with the site conditions. Borrowers typically believe that a site is “clean” if a bank determines that a phase 1 is acceptable. However, what many borrowers do not realize is that lenders are positioned differently than property owners from a liability standpoint and therefore may have risk tolerances that are different from those who take title to potentially contaminated property.First, because of the secured creditor exemption under CERCLA and most state superfund laws, lenders will not be liable for remediation unless the borrower encountered financial difficulties and the bank either takes over the borrower’s operations or forecloses on the property. During the loan origination phase of a loan, borrower default seems remote to a lender since after all its willingness to lend is based on its belief that it has a viable borrower.Second, since most lenders no longer hold loans on their books but sell the mortgages for securitization, the originating lender is not really concerned about a future default. So long as the loan has been originated in accordance with the loan procedures and underwriting that is acceptable to the trusts that sell the CMBS loans to investors, the risk of a “comeback” to the originating loan is minimal.

We have previously reported on cases where borrowers have sued banks and consultants on grounds that lender misled them by approving the phase 1 or that the consultant failed to find contamination. In the traditional lender/borrower relationship, the lender usually prevails. The few cases where lenders have been found liable for misrepresentation have been where they sold the property to the plaintiff.

A recent case in New York illustrates the differing risk tolerance of lenders and the implications for property owners. In Ridge Seneca Plaza v BP Products, et al, 2011 U.S. Dist. LEXIS 47288 (W.D.N.Y. 5/2/11), First Allied agreed to sell shopping center to Sylvan Enterprises (Sylvan) in 2000. The consultant retained by Sylvan and its counsel prepared a phase 1 that discussed a 1994 tank failure at an adjacent gas station. Because the NYSDEC database showed that the spill was closed, the consultant determined the closed spill was not a REC (it is unclear if the closed spill was flagged as an HREC). However, the consultant did not identify a second spill reported that was reported in 1999 (a year before the current transaction) when the tanks were removed. The consultant also failed to identify former dry cleaner at shopping center b/c used wrong address.

Sylvan subsequently assigned the contract to purchase the property to the plaintiff who was an affiliated entity (owned by same principals). The plaintiff closed on the shopping center in 2001.  When the plaintiff refinanced its loan in 2002, the consultant updated the phase 1 but again did not mention the former dry cleaner or the active second spill.

In 2004, the plaintiff’s principals decided to refinance so they could take some equity out of the property. However, the 2004 lender was not comfortable with the proximity of the gas station and required a phase 2. The plaintiff’s principal discussed the concept of a phase 2 with the original consultant who said a phase 2 could “open a can of worms”. The plaintiff’s principal argued to no avail with the lender that the phase 2 was unnecessary.

Apparently, the favorable loan rate outweighed the risk of the phase 2 since the borrower agreed to do the phase 2. The investigation discovered floating petroleum product on a portion of the site near the gas station and PCE contamination from the former dry cleaner.

The plaintiff then filed a contribution action against the seller of the property alleging misrepresentation and fraud as well as a breach of contract and malpractice action against the consultant. In a series of rulings, the federal district court for the northern district of New York ruled that because the plaintiff had taken title pursuant to an assignment of an “as is” agreement, it could not maintain action against the seller. In addition, the court ruled that that there was no contractual relationship between the consultant and the plaintiff (formally known as “privity of contract”), the plaintiff could not bring a breach of contract action. Moreover, the court ruled that plaintiff could not bring a malpractice action because the plaintiff had no right to rely on the report and therefore consultant owed no duty to the plaintiff. And the court also said that even if the telephone conversations between the plaintiff’s principal (who also happened to be the principal of the assignor or originally contracting party) in 2004 about the phase 2 had created some enforceable relationship between the entities, the plaintiff had waited too long to bring its lawsuit.

A column in today’s NY Times discussing the book “The Deal from Hell” provides further examples of this situation. The article says the book illustrates a “breathtaking level of cynicism and self-dealing” by a particular investment bank, and excerpts some of the emails of bank analysts. My favorite excerpt is the following:

“There is wide speculation that [Tribune] might  have so much debt that all assets arent gonna cover the debt in case of (knock knock) you know what. Well, that’s what we are saying, too. But we’re doing this ’cause its enough to cover our bank debt: our (here I mean JPM’s) business strategy for TRB but probably not only limited to TRB is “hit and run'”

Borrowers should remember this the next time their lender says the phase 1 is ok. The borrower should independently determine if the phase 1 is acceptable to its needs. Remember that a borrower may be liable as the property owner while a lender who does not exercise control over the property or take title will be able to stand behind the secured creditor exemption.

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