As the U.S. economy stumbles toward a likely recession in 2023, foreclosure activity is beginning to rise.

Over 32,000 homes went into foreclosure in October 2022, representing a 57% rise over the same month a year prior. And although foreclosure rates are still well below pre-pandemic levels, the combination of rising mortgage rates, sky-high inflation and a slowing economy will likely result in increased foreclosure activity through 2023 and beyond.

Foreclosure serves as an important risk management tool for lenders. But if the process is not managed carefully, foreclosure actions can result in unintended consequences, such as the discovery of preexisting environmental contamination. In certain cases, these risks can transfer to the lender once they take title on the subject property, resulting in additional costs and higher loan losses.

For these reasons, it’s a good time to review your current environmental due diligence processes and procedures, to ensure your lending institution isn’t creating an undue risk of loss as you pursue foreclosure to protect your loan portfolio.

Environmental Risks Can Transfer During Foreclosure

The Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) imposes strict criteria under which parties may be held responsible for environmental contamination and hazardous materials discovered at a subject property.

Under certain circumstances, lenders can be held liable for environmental contamination of a property if it is determined that the lender is acting like an owner or operator or otherwise participates in property management activities.

These risks are potentially higher when a lender takes possession of a property through the foreclosure process.

Section 107 of CERCLA defines a liable party as:

• The current owner and operator of a contaminated property;
• Any owner or operator at the time of disposal of any hazardous substances;
• Any person who arranged for the disposal or treatment of hazardous substances, or who arranged for the transportation of hazardous substances for disposal or treatment; or
• Any person who accepts hazardous substances for transport to the property and selects the disposal site.

Under Section 101(20)(A) of CERCLA, a person is an “owner or operator” of a facility (or property) if that person: (1) owns or operates the facility or (2) owned, operated or otherwise controlled activities at that facility immediately before title to the facility, or control of the facility, was conveyed to a state or local government due to bankruptcy, foreclosure, tax delinquency, abandonment or similar means.

CERCLA Offers Some Lender Protections

CERCLA does contain certain lender liability protections, both prior to and during foreclosure. Specifically, “CERCLA Section 101(20) contains a secured creditor exemption that eliminates owner or operator liability for lenders who hold ownership in a CERCLA facility primarily to protect their security interest in that facility, provided they do not ‘participate in the management of the facility.’”

According to the EPA, “participation in management does not include actions such as conducting property inspections, requiring a response action to address contamination, providing financial advice or renegotiating or restructuring the terms of the security interest.”

Further, “the secured creditor exemption also provides that foreclosure on a property does not result in liability for a bank, provided the bank takes ‘reasonable steps’ to divest itself of the

property ‘at the earliest practicable, commercially reasonable time, on commercially reasonable terms.’ Generally, a bank can maintain business activities and close down operations at a property as long as the property is listed for sale shortly after the foreclosure date or at the earliest practicable, commercially reasonable time.”

This all sounds well and good, but in a worst-case scenario, environmental risk can transfer to a lender during foreclosure, and result in direct costs that exceed the property’s market value, adding to losses the lender may sustain from the transaction.

These costs can add up very quickly, and include those related to direct environmental cleanup and disposal; liability for exposure to asbestos, radon and other hazardous substances; and potential governmental fines. 

So, how can your lending institution best protect itself from lender liability risk during (or prior to initiating) a foreclosure proceeding?

Mitigating Environmental Risk During Foreclosure

“The best defense is a good offense” is an oft-cited saying attributed to everyone from Sun Tzu to George Washington and Bill Belicheck. As in war and football, when it comes to environmental due diligence, it pays to be proactive. It’s never prudent to cut corners in your pre-deal environmental due diligence steps, because it’s much easier to address potential issues before the ink is dry on the loan documents, rather than after a borrower relationship has gone sour.

As a best practice, we recommend performing a comprehensive environmental review starting with (at minimum) a Phase I environmental site assessment. If any potential risk is uncovered during this assessment phase, it would likely warrant a Phase II, as well.

Limited-scope environmental reports like desktop reviews and transaction screens do serve a role as part of a well-appointed due diligence toolkit. They can be useful, economical alternatives for less risky deals, such as those with low-risk collateral, smaller borrowing amounts or low LTVs.

But it’s important to recognize that only a full Phase I ESA provides adequate liability protection. If a lender chooses to take title on a property, in the absence of a Phase I, the lender may not be assured of liability protection from CERCLA.

Look Before You Leap

When the time comes to consider options related to a non-performing loan, lenders should take certain steps before beginning foreclosure proceedings, to ensure a clear-eyed view of the risks and benefits. These steps include:

• Assessing whether proper environmental due diligence was performed at time of closing;
• Determining whether the environmental report covers the entire property used as collateral;
• Ensuring the assessment was conducted in accordance with standard industry practice and all federal and state guidelines;
• Reviewing all aspects of the deal, including: the type of loan, loan amount, environmental provisions of the Purchase and Sale Agreement, indemnity agreements, and current property conditions and market value; and
• Obtaining a current opinion of the environmental condition of the collateral, including a summary of any potential environmental concerns and mitigants.

Foreclosure is an important tool lenders have to recover potential losses on non-performing loans. It also serves as a deterrent to borrowers who refuse to pay back their loan or choose to violate their credit covenants. But foreclosure is a delicate dance that requires a high level of due diligence and preparation to ensure risks are mitigated and the lender remains protected.

By researching environmental risks at the time of loan origination, lenders can anticipate and address potential issues well before taking title on the loan, at which point it may be too late to avoid costly losses.         

The best strategy is to work with a trusted risk management consultant that understands the environmental due diligence process, regulations and best practices from the inside out. A little work upfront can help ensure that potential environmental issues don’t become giant headaches down the road.