Introduction
As the number of non-performing loans has dramatically increased over the past year, the ability of Special Asset Group (SAG) personnel to respond using traditional tools and methods has been severely taxed. In response to this demand, SAG staff has updated and amended policies and procedures, including environmental policies, and have added staff to meet this dramatic increase in work.
New Policies and Procedures to Meet Workout Demand and Cost
SAG staff are reviewing policies and procedures, including modified scopes of work for initial environmental due diligence (EDD), focused toward assessing risk and re-sale options. The reasons cited for the lesser scope for an initial environmental engagement are cost, delays and staff time. SAG staff also cite that traditional EDD does not provide an ability to assess the need for future EDD work (e.g. Phase II ESA, due care) and the cost and ability to re-sell the property. SAG staff has asked for a less costly initial EDD option that focuses on assessing the full EDD cost, overall environmental risk and how environmental conditions may impact re-sale.
Insights from BLDI’s Survey of SAG/Workout Professionals
As a result of our regular contacts with SAG staff in numerous Michigan lending institutions indicating that the traditional Phase I Environmental Site Assessment (ESA) was commonly not meeting their real needs to re-sell property, BLDI surveyed nine (9) lending institution to ascertain the commonality of the SAG experience and what might solve this frustration. A list of 15 questions was developed and personal meetings with the nine lending institutions were undertaken. The following provides a summary of the common insights from these discussions with SAG staff:
Workout groups are increasing in size due to vast increases in demand for services and pressure to resolve non-performing assets.
Some lenders have delayed foreclosure proceedings due to property management cost, lack of experienced SAG staff, and a poor re-sale environment.
Access to conduct appraisals and environmental work was reported as a common problem in pre-foreclosure and during redemption periods.
At least two (2) lenders reported using receivers for properties with more problematic environmental conditions.
Many workout groups have indicated that they have been approached by multiple small local purchasing groups. Most report these small local purchasing groups take up substantial SAG time with few resulting in actual sales of distressed assets.
Some SAG staff have not been conducting full EDD on lower valued sites of Commercial and Industrial (C&I) property mainly due to the cost for conducting EDD. A desire for a less rigorous initial environmental screen was expressed by a majority of workout professionals.
Workout groups indicate that they are using vendors with long track records in doing workout or foreclosure projects. These vendors include: appraisers, property managers, realtors, attorneys and environmental consultants.
Most workout groups report that files are commonly in poor condition, especially for loans originated in 2006-2007. Reports indicate that many of these files lack appraisals, proper title work, and very commonly include no EDD of any sort.
A majority of SAG groups indicated a desire to either update or conduct total revision of the environmental policy related to SAG management.
Several lenders indicated that for at least some properties in their portfolio full EDD was not conducted as part of the foreclosure either through oversight or risk analysis.
The returns from the sale of assets through use of the debt exchange (e.g. DebtX) were reported to be significantly lower in early 2009 than in the previous two years.
Lack of environmental work to include in information packages for asset sales is believed to be having a negative effect on bids.
The Traditional EDD Process for SAG/Workout
Traditionally, lending policies have required full EDD (Phase I ESA, Phase II ESA, Baseline Environmental Assessment (BEA) (Michigan)) for all property to be owned by the lending institution in any form, including foreclosure. These steps include:
Review the original Phase I ESA or other EDD documents. Recently, many SAG professionals have found that pre-loan EDD was not done, is otherwise incomplete or commonly did not rise to the level of a Phase I ESA where required by policy. Since the lender will become owner of the property upon foreclosure, a full Phase I ESA should be the standard prior to beginning the foreclosure process. Anything less than a Phase I ESA is generally counter to policy.
Timing of the pre-foreclosure EDD can be tricky due to access issues resulting from the often negative relationship between the lender and customer, the six-month window for a Phase I ESA to be considered current, and the redemption period.
If a Phase I ESA finds no recognized environmental conditions (RECs), as defined in the ASTM standard for Phase I ESAs, the lender is protected by the innocent landowner defense to cleanup liability. Failure to complete a Phase I ESA will result in the loss of the innocent landowner defense.
As is common in many classes of commercial and all too many industrial properties, the Phase I ESA will likely reveal RECs and other environmental issues. At this point the lender may have to pause to reconsider the property value and the benefit of foreclosure.
Once RECs are identified, the Phase II ESA (i.e. the sampling stage) is the next step. For many industrial properties the cost of the Phase II ESA all too often exceeds $10,000. The cost of the Phase II ESA plus other foreclosure costs is the reason cited by many lenders not to foreclose on the property but to consider other options.
Under Part 201 of Michigan Natural Resources and Environmental Protection Act (Part 201), a new owner (the lender in this case) can avoid liability for cleanup of pre-existing contamination by performing “All Appropriate Inquiry” (AAI) which may include conducting a Baseline Environmental Assessment (BEA).
Failure to conduct AAI will result in the loss of environmental liability protections provided under the federal CERCLA and Michigan’s Part 201 of the Natural Resources and Environmental Protection Act (NREPA).
The EDD package assembled for the bank (Phase I/II ESA, BEA) can be re-packaged for a prospective purchaser if within the prescribed time limits.
Initial Low Cost EDD Can Support Property Management and Sale:
As stated by the vast majority of lenders, the cost to conduct full EDD for many properties may not make financial sense. The reality is that all too many properties no longer have sufficient current re-sale value (i.e. low value properties) to make incurring all the management, tax and environmental expenses cost-effective. On the other end of the spectrum are some industrial properties with significant environmental issues (i.e. complex properties) that would require significant investment in engineering controls (e.g. new underground storage tanks, concrete barriers) and site characterization also making re-sale expensive and difficult. That is why many lenders cited that having a low-cost environmental scan of a property would help them develop a management and re-sale plan for such a property.
Complexities Incent Use of Environmental Alternatives
Lenders have indicated frustration with the Phase I ESA process whereby they expend significant efforts to gain site access and then get a Phase I ESA report that still only brings them to the next decision point, commonly without adequate information on the cost for follow up environmental work or the implications for property sale. Additionally, although it may be relatively straightforward for the bank to conduct EDD for many properties for their protection, the re-sale of that property to a purchaser for the same or similar use may present significant EDD complications and associated costs (e.g. Category “D” or “S” BEA, appropriate/due care), including epoxy sealing concrete, installing new pavement and other costly engineering controls.
Based upon these complexities SAG staff indicated that an initial “snapshot” of the environmental status of the property providing a projection of likely environmental costs and potential complicating issues was a significant benefit in dealing with such properties.
New Environmental Risk Method: Environmental RiskScan®
As a result of interviews with numerous SAG staff, a streamlined initial EDD product was developed which can be used for any type of property as an initial scan of environmental conditions. BLDI does not endorse these streamlined initial environmental scans as a stand-alone product, but as a risk management tool and as an initial “snapshot” of a property’s environmental status.
The initial due diligence product developed by BLDI is called Environmental RiskScan®. The Environmental RiskScan® provides a report based on a review of the following information:
- Superfund, Part 201, RCRA, Brownfields and other databases
- MDEQ UST/LUST Information
- MDEQ Hazardous Waste Generator Information
- Fire Insurance Maps (when available)
- City Directory Abstracts (when available)
- Aerial Photographs
The key benefits to conducting streamlined initial EDD, as cited by SAG staff, is the quick turnaround, low cost, risk rating, projected cost of full EDD and the ability to roll the cost of the initial EDD into the Phase I ESA. The use of these initial due diligence products (e.g. Environmental RiskScan®) allows the SAG staff to make decisions quicker and with more information on the whole EDD process and its implications on the management and sale of the property.
Case Study #1: Strip Mall Foreclosure
The subject property is a 25-unit strip mall constructed in the early 1970s in an urban area. As was common for many strip malls of this vintage was the presence during the property history of at least one drycleaner. The lender file did not contain a Phase I ESA for the property but only an environmental transaction screen (ETS) that was over 10 years old and that did not identify any RECs other than the then “Open” LUST release. The LUST release was “Closed” in 1999 after the date of the ETS.
A review of historical information indicated the presence of at least four property uses that meet the definition of a “sensitive industry” as defined by the U.S. Small Business Administration (SBA). Prior to conducting the Phase I ESA, a prospective purchaser approached the lender with an offer to purchase the property. The lender thought the offer too low and rejected it. Ultimately, the lender foreclosed after conducting a Phase I/II ESA and a Baseline Environmental Assessment (BEA).
Subsequent to conducting EDD for the property, the lender then held the property for over one year incurring the cost of a new roof, other significant building repairs, and property taxes. The lender indicated that they would have liked to have conducted an initial abbreviated Phase I ESA to “put his toe in the water” to check on the property environmental status as he believed that knowing “all” of the facts likely would have influenced his decision on accepting the initial purchase offer.
Case Study #2: Gas Station
Consider a gas station with single-walled fiberglass tanks installed in 1986. Double-walled piping was installed in 1999. Some limited environmental investigation was conducted during a transaction in 1999 which documented a release from the UST system, including the presence of product floating on the water table (free product). For unspecified reasons, a claim on the UST insurance policy was not made at that time.
In 2008, with the owner severely strained financially by new competition and low fuel margins, the lender assessed options for workout, including foreclosure. An initial screen of the site environmental conditions was provided by BLDI, including the state listing of the site and nearby properties, a summary of the UST system at the property and projected environmental tasks. After assessing the options for resolving the troubled asset, the lender chose to work with a new purchaser to move to a short sale without taking title. The lender indicated that the initial environmental screen was very helpful in putting all of the environmental issues and costs in perspective and helping support the SAG recommendations to bank management.
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