CMBS Special Servicer May Pursue Guarantor Despite Environmental Policy

ORIX Capital Markets, LLC v. Cadlerocks Centennial Drive LLC, 2013 U.S. Dist. LEXIS 6081 (D. Mass. 1/15/13) involved a relatively small commercial loan but offers lots of lessons for borrowers, their counsel and environmental consultants.

In this case, Salomon Brothers Realty Corp. (Solomon) extended a ten-year loan in the amount of $1.925MM to Cadlerocks Centennial Drive LLC (Cadlerocks) in December 1999 that was secured by a mortgage on a 4.63-acre parcel located in Peabody, Massachusetts that was occupied by a 50,000 square foot warehouse that had been constructed in 1964. The loan was non-recourse to the borrower but the president of the sole member of Cadlerocks, Douglas Cadle, executed an Environmental Indemnity Agreement (“Environmental Indemnity”) and Guaranty Agreement (“Guaranty”) that made him personally liable for all amounts due on the Environmental Indemnity. Solomon subsequently assigned the loan and associated documents to Wells Fargo as trustee to a securitization trust in August 2000.

Prior to the loan closing, a Phase I Environmental Site Assessment (“ESA”) had identified recognized environmental conditions (RECs) based on the historic use and storage of degreasing agents by a former long-term tenant. In lieu of performing a Phase II inspection, Cadlerocks obtained a secured creditor environmental insurance policy for approximately $21K.

Cadlerocks was unable to pay off the loan when it matured in January 2010. ORIX as special servicer issued a Notice of Default to Cadlerocks who acknowledged the default and entered into a Pre-Negotiation Letter. Cadlerocks continued to make monthly principal and interest payments until August 2010 when it ceased making any further payments. Following default, ORIX filed a notice of a foreclosure sale.

As part of ORIX’s routine pre-foreclosure due diligence prior, ORIX ordered a Phase I ESA. The phase 1 identified RECs associated with the prior use of the property.  Then in a classic case of obfuscation, the consultant said it “did not identify evidence of significant leaks, spills or the improper handling of petroleum or hazardous substances that might impact the environmental condition of the Subject Property”. In the “Hazardous Substances/Petroleum Products” space in Assessment Summary Table, the report found “No concerns identified”.

Because ORIX was considering foreclosure, it commissioned a Phase II that consisted of an integrity test of the 10,000-gallon heating oil underground storage tank (“UST”) and collecting soil gas samples from the exterior of the building. The UST passed the integrity test but the soil vapor sampling identified PCE. As a result, ORIX authorize indoor air samples that detected PCE in the tenant space occupied a daycare center at a concentration of 1.65 ug/m3, which was above the Massachusetts Department of Environmental Protection (“MADEP”) advisory limit for residential indoor air quality of 1.4 ug/m3.

Cadlerocks offered to transfer the property to ORIX through a deed-in-lieu of foreclosure but ORIX refused.  ORIX then cancelled the foreclosure sale and filed a complaint asserting, inter alia, that the property had “multiple recognized environmental conditions that require investigation and possible remediation, including the presence of cutting oils, lubricants and solvents from an industrial machine shop that formerly operated on a portion of the Property, an underground storage tank and asbestos.” At the same time, ORIX filed a motion for obtained appointment of a Receiver to take custody of the property. Cadlerocks did not object to the appointment of the Receiver.

ORIX advised the Receiver of the soil gas sampling results. The Receiver immediately retained an environmental consultant to collect 8-hour indoor air sample from the tenant space occupied by a daycare. This sampling detected concentrations of 1.16 ug/m3, slightly below the MADEP advisory limit. The Licensed Site Professional (LSP) who performed the sampling advised the Receiver that the PCE levels did not pose an acute or short-term risk but further sampling would be required to determine if there were long-term or chronic risks. The Receiver shared the indoor sampling results with the operator of the daycare center and then authorized collection of 24-hour air samples in the daycare center with the ventilation turned off to simulate the “worst case” scenario to which occupants might be exposed. PCE was again detected but below violated MADEP advisory limits.

The Receiver requested that Cadlerocks pay the Receiver’s costs related to environmental testing. When Cadlerocks did not reply, the Receiver requested that ORIX pay all of the Receiver’s costs and fees with respect to testing for the presence of PCE on the Property. ORIX agreed that the Receiver could draw down on income and sales proceeds generated from the Property that would otherwise have been applied to pay down Cadlerocks’ debt.

The defendants claimed that they should not be responsible under the Environmental Indemnity because the plaintiff failed to mitigate its damages by first seeking recovery from the insurance policy.  However, the court agreed with the plaintiff argued that section 7 of the Environmental Indemnity (Independent Remedies) and Section 6 of the Guaranty (Election of Remedies) expressly allowed it to pursue Cadle for damages notwithstanding the availability of insurance.

Moreover, the court found the defendants had proffered inconsistent evidence regarding the term of coverage under the Insurance Policy. Defendants produced an Executive Summary of the loan closing memorandum that indicated that the borrower has provided the Lender with a 15 year AIG Secured Creditor Impaired Property Policy but also produced an unsigned insurance policy with a 10-year term which would have expired well before the plaintiff suffered the damages asserted. Without a signed copy of the actual Insurance Policy the Court said it could not determine the length of coverage. Consequently, the court held that the defendants have failed to prove their affirmative defense that reliance on Insurance Policy would have mitigated plaintiff’s claimed environmental damages.

The defendants further alleged that the costs and fees of the environmental testing and analysis should be offset by the proceeds from the sale of the Property. However, the court said this ignored the fact that both the Guaranty and Environmental Indemnity contain Election of Remedies clauses that allowed ORIX to recover from defendants without having to proceed directly against its collateral to satisfy the amounts due under the Environmental Indemnity. Further, the Court concluded the based on letters of intent from prospective buyers, it was unlikely that the Property could be sold for more than the outstanding loan balance.

Turning to the count that the defendants breached the Environmental Indemnity, the court found  the environmental testing conducted at the Property was reasonable and necessary, particularly given the Receiver’s need to ensure that conditions were safe for the occupants of the day care facility on the premises. The court also concluded that the follow-up testing in 2012 was also reasonable so the Receiver could to provide potential buyers with up-to-date information regarding environmental conditions. Thus, the court ruled that the plaintiff is entitled to recover the reasonable costs for that testing and analysis.

However, the court ruled that ORIX could not recover the $2,650 cost for the Phase I. The court found that ORIX had ordered the phase 1 as part of its standard pre-foreclosure practice. Since the phase 1 was not conducted in response to specific environmental hazards at the Property, the court said the fee for the Phase 2 was not covered by the Environmental Indemnity Agreement.

One takeaway lesson for borrowers is  not to assume that a lender or servicer will look to the insurance policy to recover their costs. Here, the Servicer had pointed out how the indemnity was far broader than the insurance policy. Thus, a borrower should try to include language in loan docs (especially an environmental indemnity or personal guaranty) that limit the election of remedies. In other words, the lender should be required to look to the insurance policy first before it can enforce the indemnity or guaranty.

Also-it is important for the borrower to make sure it gets the final copy of the policy. Often times, the borrower obtains a premium indication prior to the closing with the actual policy issued after the closing. Here, the borrower only had a summary of the policy and an unsigned draft policy.

Another lesson is how presence of day care centers can change the risk calculation for properties. We will be covering this topic in a later post.

Finally, this case also shows why many lenders use apply more stringent diligence approaches during pre-foreclosure. The insurance policy was acceptable when the loan was originated for securitization. However, both the Special Servicer and Receiver decided they needed to collect samples to determine if here was a risk that needed to be managed.

In a subsequent proceeding, the court awarded plaintiff $104, 106 in damages and $50K in attorney fees. ORIX Capital Markets, LLC v Cadlerocks Centennial Drive, LLC, 2013 U.S. Dist. LEXIS 48424 (D.Mass. 4/2/13)

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