CMBS Special Servicer May Not Recover VI Test Costs Under Environmental Indemnity

Earlier this year, we discussed   the federal district ruling in Orix Capital Markets, LLC v Cadlerocks Centennial Drive, LLC, 2013 U.S. Dist. LEXIS 48424 (D. Mass. 4/2/13) where a special servicer was allowed to pursue a guarantor despite the presence of an environmental insurance policy and was awarded over $100K in environmental investigation costs.

This week, a three judge panel of the federal Court of Appeals for the First Circuit reversed the district court ruling on the environmental investigation costs and remanded the award of attorneys fees back to the district court. VFC v. Cadlerocks Centennial Drive, 2013 U.S. App. LEXIS 22816 (1st Cir. 11/12/13). This case should be particularly important to lenders and borrowers in the Commercial Mortgage-Back Security (CMBS) market since the decision interprets the scope of the free-standing environmental indemnity agreements commonly used in those transactions.

As more fully discussed in our prior post, Cadlerocks decided to obtain an environmental insurance policy naming the original Lender as the insured after a phase 1 ordered by the original lender reveal The original Lender conducted a Phase I Environmental Site Assessment (“1999 Phase I”) prior to the closing of the Loan revealed the potential presence of tetrachloroethylene (“PCE”) at the property from a tenant that pre-dated Cadlerocks acquisition of the site.

As part of the loan documentation, Cadlerocks entered into an Indemnity Agreement which provided, inter alia, that Cadle and Cadlerocks (the “Indemnitors”) would indemnify the Lender and its assignees and successors (“Indemnitees”) from:

all . . . costs, . . . demands, . . . expenses” and other liabilities “of any kind or nature whatsoever . . . sought from or asserted against Indemnitees in connection with, in whole or in part, directly or indirectly, . . . the presence, suspected presence,  release, suspected release, or threat of release of any Hazardous Material” on or around the Property.

The Indemnity Agreement further stated that applied to seven particular categories of liability including:  “the cost required to take necessary precautions to protect against the release of any Hazardous Materials in, on, or under the Property, the air, any ground water, waterway or body of water, any public domain or any surrounding areas to the Property.”

The original lender assigned the loan to a securitization trust in August 2000. Cadlerocks was unable to make the balloon payment when the loan matured in January 2010. Orix Capital Markets, LLC (“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 while the parties discussed the possibility of a loan modification. When these talks proved unsuccessful, Cadlerocks ceased making further payments. Orix then filed a notice of a foreclosure sale.

Cadle offered a “deed-in-lieu” in settlement of the Trust’s claims prior to foreclosure. As part of its routine due diligence during these negotiations, Orix retained an environmental consultant to conduct a new Phase I test (the “2010 Phase I”) which revealed the possible presence of PCE on the Property.  Based on the results of the test, Orix rejected the offer of the deed-in-lieu, postponed the foreclosure sale, and sought the appointment of a receiver. Cadlerocks did not oppose the appointment motion and the district court appointed a Receiver for the Property in December 2010.

Meanwhile, Orix ordered a Phase II, consisting of an integrity test of an underground storage tank on the Property and a soil vapor investigation of the exterior of the warehouse. The tank passed the integrity test but the soil vapor investigation identified the presence of PCE in the soil outside of the building. The phase 2 recommended indoor air sampling of the warehouse. The sampling was conducted in March 2011 and detected PCE in concentrations of 1.65 micrograms per cubic meter (μg/m³) in the portion of the building occupied by the daycare center.

After Orix notified the Receiver of the results, Receiver immediately authorized a second round of indoor air sampling which revealed PCE in concentrations of 1.16 μg/m³. The Receiver provided the results of the sampling to daycare center along with an analysis by a licensed environmental professional retained by the Receiver which indicated that the PCE concentration were two to five orders of magnitude below available short-term guidelines and did not represent an acute (short-term) risk. The LEP did go on to say that to evaluate the risk of chronic risk, a more thorough investigation was required. The LEP then collected eight-hour samples in June 2011 and twenty-four-hour samples on July 2011. None of the tests showed concentrations of PCE at hazardous levels.

The Receiver sought reimbursement from Cadlerocks for the costs of the 2011 investigation. When Cadlerocks did not respond, the Receiver requested payment from Orix who agreed that the Receiver could draw down on income and sales proceeds generated from the Property that otherwise would have been applied to pay down the debt.

In the fall of 2012, the Receiver authorized an additional round of indoor air sampling as well as soil and groundwater sampling to facilitate a possible sale of the property. However, the purchaser declined to pursue the sale.

The federal district court partially granted a motion for summary judgment by Orix. The ruled that Orix was entitled to recover the $102,536 under the Indemnity Agreement for its environmental investigation costs, finding that  the costs were reasonable and necessary since the Receivers needed to ensure that conditions were safe for the occupants of the day care facility on the premises. However, the court did not allow Orix to recover the costs of the 2010 phase 1 because Orix ordered phase 1 reports in connection with its standard pre-foreclosure due diligence situations and not in response to suspected environmental conditions. In a separate order, the court awarded Orix $50,000 in attorney’s fees and $5,609.75 in costs.

Cadle and Cadlerocks appealed the award of expenses related to the environmental testing. During the appeal, Orix assigned the Loan and Judgment to VFC. However, we continue to refer to Orix since because Orix was the loan servicer during the relevant time period.

The appeals court said that the district court interpreted the Indemnity Agreement too broadly when it ruled the environmental costs were covered as “reasonable and necessary” expenses conducted in response to suspected environmental hazards.

Orix had argued that because the Receiver demanded Orix to pay the costs and expenses related to the environmental investigation, these expenses fell within the Indemnity Agreement.  The appeals court first noted that the Indemnity Agreement only covered liabilities “sought from or asserted against” the Indemnitees. Thus, only those costs Receiver sought to recover from Orix after March 23, 2011 were potentially covered by the Indemnity Agreement.

The appeals court went on to find that the second sentence of paragraph four (beginning “Such Liabilities shall include . . .”) functioned as a limitation on the much broader preceding sentence. In addition, subclause (iv) of the second sentence limited the indemnity obligation to “the cost required to take necessary precautions to protect against the release of any Hazardous Materials” in or around the Property. The court said it must determine if the Receiver’s expenses fall within the enumerated categories of liability listed in the second sentence.

The Indemnitors argued that the environmental tests were not necessary, because “there was never a recognized immediate threat to public health at the Property.” Orix asserted that Cadlerocks and Cadle should be liable long as the tests were at least indirectly related to the suspected presence of a hazardous material. The court noted found that the test results that Orix gave to the Receiver on March 23, 2011 indicated a detectible presence of PCE already in the air but at a level unlikely to pose a health threat to the building’s occupants and that the PCE levels declined slightly in the second round of sampling. Because there was no evidence that a hazardous level of PCE was likely to be released into the air, the court found that the Receiver costs were not incurred to take steps to prevent such a release.  Instead, the court found that the testimony and exhibits all indicated that the purpose of the Receiver’s additional testing was to confirm that the known presence of PCE in the air was at concentrations that were safe for the daycare center and to facilitate the foreclosure sale.

The court there was no doubt that the Receiver acted reasonably and that the tests were undoubtedly necessary for Orix and the Receiver to ensure that the Property was free from harmful contaminants before selling it. However, the court concluded that Indemnity Agreement allocated liability for costs “necessary precautions to protect against the release of any Hazardous Materials”  and not for tests to confirm the safety of tenants or attracting buyers in a foreclosure sale. Accordingly, the court held that the Receiver’s environmental testing costs fell outside of the scope of the Agreement.

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