More Prominent Role for Environmental Risk Management in Revised OCC Handbook

The Office of the Comptroller of the Currency (OCC) has been updating its Comptroller’s Handbook to reflect changes to supervisory policy as well as to implement the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010. The Comptroller’s Handbook is a collection of booklets divided into five handbook series that contain OCC procedures for the examination of national banks, federal savings associations, and federal branches and agencies of foreign banks.

In August, the OCC  issued a revised “Commercial Real Estate Lending” (CREL) Handbook booklet which  replaces the “Commercial Real Estate and Construction Lending” booklet issued in 1995 and the OCC Advisory Letter 2003-7 “Guidelines for Real Estate Lending Policies” (August 8, 2003). The CREL booklet is located in the “Assets Quality” tab of the “Safety and Soundness” handbook series.

Banks are required to comply with the “Real Estate Lending Standards” set forth in subpart D of 12 CFR 34 (national banks) or 12 CFR 160.101 (federal savings associations). This rule requires banks to adopt written real estate lending policies that are consistent with safe and sound banking practices. It applies to all extensions of credit that are secured by liens on or interests in real estate. It also includes loans made for the purpose of financing the construction of a building or other improvements whether or not secured by real estate. Examiners will review the bank policies and practices to determine if the bank’s real estate lending program satisfies with the rule, is consistent with safe and sound banking practices, and reflects an appropriate consideration of the “Interagency Guidelines for Real Estate Lending Policies” contained in appendix A to subpart D of part 34 (national banks) and the appendix to 12 CFR 160.101 (federal savings associations).

Loans guaranteed or insured by the federal government, its agencies or backed by the full faith and credit of a state government are exempt from the rule provided that the amount of the guaranty or insurance is at least equal to the portion of the loan that exceeds the applicable LTV limit. Also exempt are loans that are to be sold promptly after origination, without recourse, to a financially responsible third party.

A bank’s real estate lending policies should be appropriate for the bank’s size, the nature and scope of its operations, and should reflect the level of risk that is acceptable to its board of directors. The board of directors must review and approve the bank’s real estate lending policy at least annually.

The 1995 Commercial Real Estate and Construction Lending contained a general statement encompassing a half-page of the Compliance Risk section that banks should have policies or procedures to protect the bank from liability for any environmental hazards associated with real estate that it holds as collateral. The 1995 booklet handbook recommended that a bank should identify environmental risks before funding a loan or offering any type of commitment to lend. If the bank discovered that it held contaminated property as collateral, the 1995 booklet said the bank should monitor the situation for any adverse effects on credit risk as well as take steps to minimize any potential liability to the bank. Finally, the handbook suggested that a bank seek the advice of environmental risk experts if it believes the environmental problems are serious particularly when deciding whether to foreclose on a contaminated property and to help preserve its “innocent landowner” defenses

Environmental risk has been elevated to a more prominent position in the 2013 CREL booklet. The CREL booklet identifies environmental liability as one of five credit risks that effect ability of the borrower to repay its loan. The booklet states that “contamination may decrease the collateral’s value or render the collateral worthless. Furthermore, the cost that may be imposed on a responsible borrower for the remediation of a contaminated property may severely impair the borrower’s ability to repay the loan.

Moreover, the CREL now has a separate environmental risk management topic that extends for three pages. It begins by stating that a bank’s loan policy should establish a program for assessing the potential adverse effect of environmental contamination and ensure appropriate controls to limit the bank’s exposure to environmental liability associated with real estate taken as collateral. For these reasons, the CREL says, a bank should evaluate a borrower’s or tenant’s business activities and any property taken as collateral before funding a loan and before taking title in satisfaction of debt. The CREL further states this evaluation should be commensurate with the risk of loss that collateral contamination or borrower liability poses to the bank.

The section then goes on to explain the scope of the secured creditor exemption but cautions that while exemptions may limit a lender’s direct liability for cleanup, it does not protect the lender from the decline in value due to contamination nor protect a borrower from liability for cleanup that could severely impair its ability to repay the loan. The CREL also states that banks do not need to comply with the AAI rule to qualify for the secured creditor exemption during loan origination, it suggests that an AAI-compliant investigation can be useful in assessing of a property’s environmental condition, the potential liability for a borrower, and disposition strategies upon foreclosure.

OCC says an appropriate environmental risk management program should reflect the level and nature of the bank’s real estate lending activities, its risk profile, and consideration of applicable environmental laws. The program should be reviewed and approved with its lending policies annually by the bank’s board of directors or a designated committee of the board.

The CREL then describes specific components that should be contained in an effective environmental risk management program. To satisfy the CREL standards, a bank should:

  • develop policies and procedures that reflect potential environmental risks associated with lending in markets and to industries served by the bank. The procedures should clearly specify the bank’s requirements for determining potential environmental concerns. For example, procedures should include guidelines that the lending staff should follow in conducting an initial analysis of potential environmental impact and when a more detailed environmental assessment should be conducted by a qualified professional.
  • provide environmental risk assessment reports be reviewed before a bank issues its final loan commitment.
  • establish procedures for assessing environmental concerns associated with assets before acquisition by the bank in workout or foreclosures as well as the bank’s investment in real estate assets for its own use.
  • ensure that qualified persons evaluate the environmental risk possess and specify selection criteria to evaluate and monitor the performance of third-party professionals, such as environmental experts or legal counsel, who may be consulted to assess environmental risk.
  • provide guidelines that the lending staff should follow for monitoring potential environmental concerns for the duration of loans held in the bank’s loan portfolio. These guidelines should focus on changes in business activities that might result in an increased risk of environmental contamination associated with the property, thus adversely affecting the value of the collateral.
  • maintain guidelines for loan documentation to protect the bank from  environmental liability such as ensuring rights of access to perform AAI-compliant investigations.
  • The bank’s policies and procedures should reflect adequate consideration of the EPA’s AAI rule.

OCC stats that the environmental risk management should incorporate certain key elements, including;

  • an analysis of current environmental laws and due diligence requirements for borrowers and the bank.
  • a level of due diligence internally required in all real estate loan transactions.
  • risk thresholds based on property type, use and loan amount for determining when and what type of due diligence is required.
  • varying due diligence methods depending on the type of loan, the amount of the loan and the risk category, including borrower questionnaire or screening, site visit, government records review, historical records review, testing or inspections using qualified professionals.
  • the potential for significant impact resulting from the presence of hazardous building material such as asbestos and lead-based paint.
  • appraisal requirements for disclosing and taking into consideration any environmental risk factors.
  • criteria for evaluating environmental risk factors and costs in the loan approval process.
  • criteria for determining the circumstances in which the bank would normally decline loan requests based on environmental factors.
  • collateral monitoring and periodic inspection requirements throughout the loan term for properties with higher environmental risk.
  • procedures of evaluating potential environmental liability risk and environmental factors that could impact the ability to recover loan funds in the event of a foreclosure.
  • guidelines for maintaining the secured creditor exemptions and for qualifying for CERCLA defenses including the landowner liability protections if the bank acquires ownership of the property.

OCC also states that loan documentation should contain certain environmental provisions. For example, commitment letters should set forth the extent of due diligence required, borrower costs, approval contingencies, reporting obligations, documentation requirements, etc. The loan documents should contain representations and warranties, inspection requirements, reporting requirements, lien covenants, indemnification provisions, and provisions allowing for the acceleration of the loan, refusal to extend funds under a line of credit, or exercise other remedies in the event of foreclosure.

For the most part, the 2013 CREL booklet reflects the core elements of the environmental risk policies that have been adopted by the more sophisticated financial institutions. Perhaps the most notable provision is that the risk management policy should provide that real estate appraisals take into account impacts from contamination. This requirement may require a change in the instructions that banks provide to appraisers when making valuation assignments.

Under its Guide Note 6 “Consideration of Hazardous Substances in the Appraisal Process” to the Uniform Standards of Professional Appraisal Practice (USPAP), the Appraisal Institute recommends that appraisers should issue a disclaimer or limiting condition to the effect that the appraisal is predicated on the assumption that hazardous substances do not exist when there are no known or suspected hazardous substances associated with the property.

However, where the appraiser discovers reason to believe there may be hazardous substances associated with the property, USPAP recommends that the appraiser should immediately notify the client to address the situation. According to the Guide Note 6, the appraiser may develop a value opinion for the property that excludes the consideration of known hazardous substances. Such an appraisal would be based on a hypothetical condition that the property is not impacted by known hazardous substances (“as if” unimpaired).

Finally, the USPAP Guide Note cautions that when the appraiser is asked to develop a valuation based the presence of contamination, the value of a property impacted by hazardous substances may not be measurable simply by deducting the typical remediation cost, or discovery cost from the total value, as if “clean.” The possibility of other changes affecting value, such as a change in highest and best use, marketability, and stigma, should be considered.  the appraiser must correctly employ those recognized methods and techniques that are necessary to produce a credible appraisal

It should be noted that the USPAP Guide Note 6 also indicated that if the appraiser is provided with a Phase I, Phase II, or Phase III report that indicates the possibility of contamination, the appraiser should note this information with the amount of further investigation that is required by customary business practice as well as necessary to establish the “innocent purchaser” defense.

Advisory Opinion 9 “The Appraisal of Real Property That May Be Impacted by Environmental Contamination (AO-9) issued by The Appraisal Standards Board (ASB) of the Appraisal Foundation states that an appraisal that includes the effects of environmental contamination on its value usually requires data that is not typically used in an appraisal of an otherwise similar but uncontaminated property or an appraisal of a potentially impacted property using either a hypothetical condition or an extraordinary assumption that it is uncontaminated. AO-9 states that relevant factors that might have to be considered would be if the contamination discharge was accidental or permitted, regulatory compliance status of the property, the remediation lifecycle stage when the appraisal is conducted, the type of contamination constituents (petroleum hydrocarbons, chlorinated solvents, etc), the media impacted, if the property is the source of the contamination, the cost and timing of any remediation, potential limitations on the property use based on the approved remedy and potential or actual off-site impacts. In developing a valuation, the ASB states that the appraiser consult with environmental experts as well as appropriate regulatory authorities to confirm the presence or absence of contamination.

AO-9 states that in some assignments, the appraiser may be asked to appraise a property known to be contaminated under the hypothetical condition that the real estate is free of contamination. In other situations, AO-9 states the appraiser may be asked to appraise a property believed to be free of contamination or when the environmental status is uncertain due to the lack of information or conflicting information. For these assignments, AO-0 states that the property may be appraised under the extraordinary assumption concerning assumed factual information about its environmental condition and status.

It appears that use of an “as if” valuation based on a “hypothetical condition” or “extraordinary assumption” would not comply with 2013 CREL. Thus, banks may need to provide copies of phase 1 and other environmental report to their appraisers to ensure that the valuation will be based on the “as -is” condition of the property with full consideration of the effects of environmental contamination.