Environmental Liability and “Fractional” Property Interests

Last week, we discussed due diligence for transactions involving purchases of equity interests in entities that own property that are in technical default of the mortgages. This post discusses potential environmental liability for fractional ownership interests in the underlying property.

First year saw students are taught in Real Property Class that property ownership consists of multiple rights that should be viewed as a bundle of sticks that may not necessarily all belong to the same person. Each stick represents a separate right or interest in the land such as the right to sell, lease or subdivide the land, convey mineral rights, construct buildings, harvest its resources and exclude trespassers. The sticks can be conveyed individually or collectively depending on the extent of the interest conveyed in a transaction. Thus, a landowner may lease surface rights to one person, transfer the underground mineral rights to another entity while still holding the remaining sticks in the bundle such as the right to sell the land, though the sale may be subject to rights extended to others. The government or community has increasingly been viewed as holding some of the sticks such as the right to tax, take property under eminent domain, and establish rules to regulate use or protect certain natural resources.

The past two decades have seen the emergence of complex real estate financing transactions that have enabled landowners to extract value by slicing the sticks of property rights into thinner and thinner twigs. Unfortunately, state and federal laws that impose liability on owners and operators of contaminated sites have not kept up with the creative and innovative forms of real estate ownership. For example, it is unclear if a commercial condominium could be considered a CERCLA owner by virtue of its fractional ownership in the land represented by the unit deed or could it deemed to have exercised sufficient control over the property to be considered a CERCLA operator? As a result of this uncertainty, environmental consultants are often if a REC identified on a property pertains to the particular fractional interest held by the client much less the significance of the REC to the client.

One of the more common scenarios where this issue arises is when a property contains a ground lease. For example, a consultant may be asked to perform a phase 1 on a shopping center and is advised that certain buildings should not be evaluated because they are subject to ground leases and are not of the property. While the structures are not the property of the landowner, they can still impact the property. In this situation, it would make sense to evaluate the structure as if it was an adjacent parcel under ASTM E1527-05.

A more difficult question is when the property to be investigated is the building on a ground lease. There are many scenarios when this structure may be used but it has frequently been employed when developing contaminated properties. Often times, a developer has developed the site and then a ground tenant then builds a structure. The consultant will often be told that it should just focus on the building issue since the client does not own the land. Many times, a land use control was required as part of a cleanup but may not have been properly recorded or the ground tenant is not even aware of the restrictions. If the land use control has not been recorded or an engineering control has not been maintained that could trigger a re-opener, who is responsible. Certainly the developer should be but it may be hard to find or perhaps was a limited liability corporation that no longer has any assets. Could the ground tenant be responsible? If the building is the primary development on the site, the building owner/operator could possibly be viewed as an operator of the site for purposes of CERCLA liability or state environmental laws.

A more complicated but common situation is where a hotel or office building occupies the air above the land pursuant to a development agreement. There may be a sub-surface garage that serves as an engineering cap and an easement granted in favor of the building so its occupants can use the garage. Does the owner of the building occupying the air above contaminated land have liability if the engineering control is not recorded or maintained? Again, if the building is the dominant structure on the land, it is quite possible that the building owner or manager could be liable as an operator of the site unless it has taken steps to obtain a formal covenant not to sue or other liability release from the appropriate state agency.

In the end, liability will be based on the particular facts of each case. However, the take away lesson for the consultant is that it continue to focus on the environmental issues associated with the land and leave it up to the lawyer to advise the client if the land beneath the client’s building poses a risk of liability.

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