Wednesday, April 29, 2009

Thoughts on Other Environmental Insurance Products

The one environmental insurance product I have never used is the secured creditor policy. There are several fundamental problems with this policy from my prospective. The first problem is that it protects just the bank and leaves the customer out. The customer pays for a policy that only protects the interests of the bank and only pays if the customer defaults. (If the policy pays in it’s most simplistic representation.) Secondly, there are issues with the time value of money, accrued money and controlling the manner in which a problem loan is worked out. Whether the insurer will pay at all, may be impacted by whether the environmental issue is a primary or secondary issue with a default. The current worsening downturn in commercial properties will provide a true market test of the product.

Collateral can be environmentally impaired and not at all saleable with known or suspected contamination, but without an order from the regulators. These policies do not pay for “grey” problems. In the current market, any impairment may be perceived to be material. Priority with state and or federal regulators is also becoming a bigger issue. Regulatory resources are limited especially in this time of state budget shortfalls.

In the secured creditor policy the interests of bank and borrower are at odds with each other. It is in the Bank’s interests under the insurance policy to push for regulatory investigation while the customer is still viable. A Phase II site investigation would have to be performed at the first sign of deterioration when the borrower is trying to reduce expenses. Does a bank have liability for reporting a customer to the regulators if there is no eminent endangerment to the public or workers? How about forcing a borrower to search for a problem that ultimately resulted in a loss of property or the business? What is the price and renewal risk for portfolio policies? These are all questions the current credit environment will ultimately answer. With twenty-twenty hind sight, it appears that lending pools are better served by performing an appropriate level of due diligence on the portfolio. Though at the moment, there appears to be no market for collateralized loan obligations. Without individual property information, it is impossible to break up and sell a busted pool of commercial loans.

If it actually comes to a cleanup under a policy, the insurer or their representatives will negotiate the level of cleanup. Interests of the regulators, bank, community and insurance company are often at odds. At least when a Bank negotiates a clean up level they should be thinking of selling the property and residual liability issues that may make a more conservative cleanup more desirable. The insurance company, however; will perform the cheapest cleanup that it can get past the regulators. It practically goes without saying that risk based clean-ups; institutional controls and land use covenants will be used to reduce the costs of remediation. This level of cleanup does not best serve the marketability of a property or compliance with these covenants and controls.

At commercial properties and multi-residential properties that do not have ongoing oversight there are simply no mechanisms to ensure compliance with these restrictions. Exclusionary permanent zoning just does not exist. There is no way to assure that a cleanup that did not meet industrial clean up goals and required the maintenance of a site cap and land use covenants does not end up as a daycare center with playground. Without a mechanism to recall and enforce them, land use covenants and institutional controls and the insurance products have been an excuse for regulators to approve second-rate cleanups. Most entities are just not geared up to maintain ongoing knowledge of these types of controls. There is no insurance product to make sure that the intent of these controls is met.

In addition, depending on the policy, if a foreclosed site is cleaned up under the insurance policy then sold; does lender loose their lender protections under the law? And if land use covenants and institutional controls are used is the lender responsible for ensuring these controls remain in place. If the cleanup is bad enough then do banks purchase another insurance product to protect them from the ramifications of the first insurance product? How do regulators actually determine that land use covenants and engineering controls are actually being enforced? I hope the regulators are not intending that the insurers are checking, because remember it’s the cleanup order that invokes the insurance policy.

The size of the project and type of user still determines how cost effective a policy actually is. As we learned with site characterization, there are fixed costs involved with characterizing a site, and determining the appropriate balance of remediation, exposure control and liability control mechanisms for a particular site.

The existence of insurance products is not a substitute for site investigation or prudent action. Insurance properly used is a powerful liability control mechanism. Their use can have an impact on the form of financing for a project and on the property cost and value it’s self. However, the full scope and magnitude of the contamination must be known. Not just that there is contamination. Otherwise, it is impossible that a cost estimate can be given, and it is unknown if the property is worth more than the cleanup cost. The full cost to remediate the site needs to be estimated. This way the bank knows that there are adequate funds to pay for the cleanup and a cost cap insurance policy can be properly used. Regardless of insurance, I do not feel Banks should be involved with transactions that do not make economic sense. Those kinds of transactions are much too likely to result in litigation.

Remembering that in normal market times only 1%-2% of commercial loans actually default and less than 25% of these loans actually have any environmental issues, environmental insurance is actually designed to be a backstop. The current economic climate will severely test these products as the real estate downturn begins to impact commercial real estate loans in the coming year or two. Overly broad promises and a failure to use common sense and appropriate due diligence could result in risk shifting to a degree that may cause the product to fail to perform.

Tuesday, April 28, 2009

The Lenders Perspective on Environmental Insurance Products

The perceived risk associated with a Brownfield transaction is both market driven and very real. That perceived risk has increased with the downturn in real estate in general. In the early 1990’s environmental risk was seen as the boogieman. The perceived risk was blown out of proportion to the real risk, as a result; there were properties to be cherry picked at quite a discount. Then the pendulum swung the other way. All real estate was seen as forever rising in value and any risk was acceptable . Today, the market is reevaluating all risk and environmental risk is once more of concern. Somewhere in between the extremes is a rational model of risk evaluation.

Environmental insurance can be a viable tool. Some of the most aggressive insurers in the market are no longer underwriting risk. Using environmental insurance as a liability control mechanisms is one of several tools available to the lender or commercial real estate purchaser. Using environmental insurance in selective situations where it is an enhancement, not the dependant source of repayment, appears the most appropriate use and a very powerful one. For example; an appropriate use of insurance is where the estimated cleanup costs are place in escrow or otherwise held back, there is an approved work plan, but to eliminate uncertainty “Cleanup Cost Cap” insurance is added to the package because the financial flexibility or additional available resources are limited. A Second example is would be obtaining pollution liability insurance on a site that has received closure and does not have an environmental indemnity (this could be an instance when the bank is selling REO property, or simply acting as a lender), or where there may be concern for the quality of the cleanup, the regulatory risk of a closure, or the resources of the indemnitor.

Adding insurance to some situations can have an impact on the form of financing for a project and on the property cost and value itself. The insurance product appropriately used can restore impaired value due to “stigma” after a remediation has been completed or substantially completed. We are only now rediscovering “stigma” may exist after all. Remember though, value impairment due to maintenance of engineering controls are dollar value discounts that have to be paid and can not be restored through insurance. Value loss, due to use restriction cannot be restored with insurance. Also, negligence and stupidity are just not insurable conditions.

Insurance, like land use covenants and institutional controls, has been used to facilitate the financing and remediation for the redevelopment of Brownfields and the sale of REO. However, these are not appropriate in all situations and their use should not be taken to extremes. In truth, the market has grown as all markets do at first exponentially during a period when real estate values were growing at an incredible rate. As the real estate market got hotter in what was perceived as a waning regulatory environment, there was less and less concern for environmental impairment. Now are we seeing a shift in the real estate market, the increase in non-performing loans and a strengthening in the regulatory environment. In the next few years we may see, how some of these insurance products actually perform against expectations and promises. Whether they indeed provide the perceived protection is about to be seen.

Tuesday, April 21, 2009

Bona Fide Prospective Purchasers and the AAI Standard

On January 3, 2002 congress passed the “Small Business Liability Relief and Brownfields Revitalization Act.” As part of this act congress created a legal protection for future owners of portions of CERCLA sites called the Bona Fide Prospective Purchaser that exempts the Bona Fide Prospective Purchaser from liability for the historic contamination and any underlying groundwater plumes if the conditions of the act are met:
  • All disposal of hazardous substances at the facility occurred before the “person” acquired the facility.
  • All appropriate inquires into the previous ownership and uses of the facility were made.
  • The “person” is in compliance with all land use restrictions and institutional controls established or relied on.
  • The standards of cooperation, assistance, and access, care and notices as cited in the CERCLA amendment are complied with.
  • Acquired property after January 11, 2002
This past winter, EPA expanded these protections to tenants using “Enforcement Discretion Guidance.” It is unclear how these guidelines will impact synthetic leases and land leases. It may be prudent for tenants to establish their own eligibility as a BFPP.

The AAI standard is an ASTM 1527-05 standard Phase I ESA. This consistent standard for AAI provides a way to ensure that the protections of a "Bona Fide Prospective Purchasers" under CERCLA are in fact obtained and a "good" due diligence is available when necessary. Before the 2005 revisions to the ASTM 1527 standard the quality of Phase I ESA reports had deteriorated significantly in the market place. Though there were always quality firms producing good product, much of the industry became price driven.

In order to compete on price for a market primarily driven by lenders (no one seemed to get a Phase I ESA unless they were trying to obtain a loan) more and more cursory reports were generated. As with the deterioration in underwriting standards less and less qualified individuals were performing less and less due diligence and calling it a Phase I ESA. Various lender regulatory organizations required Banks to have an environmental risk management policy, and the Bank examiners verify the consistency of application of the policy. However, no quality control of the actual due diligence was performed. Banks’ loan policies required performing an environmental due diligence, unless there was central control of quality and intent, the field found the cheapest way to meet that requirement with the least likelihood of finding a problem (can’t book a loan if the collateral is impaired). The low I observed was when someone slapped a cover on a database report and called it a Phase I ESA. The AAI standard ASTM 1527-05 restores the Phase I ESA report to a useful product.

The problem with AAI can be the cost for smaller properties that were once a portion of a larger site. With this standard available, the Bona Fide Pre Purchaser route has effectively become the only way to obtain the necessary protections of a CERCLA release from liability to make a property viable as collateral. For a known and complicated NPL site the cost of meeting the AAI standard for a small parcel could be prohibitive. Trying to obtain the protections provided under the by the amendments to CERCLA under the Bona Fide Prospective Purchaser for a very small property in that will occupy a tiny portion of a former industrial site. Because of the requirement under the AAI to review all government records and the size of the regulatory files for the site, the costs associated with AAI can be prohibitive in the instance when it will provide true protection. What we really need is for the responsible party or redevelopment agency to provide the AAI for these small parcels and certified summary of the file history so any future additions to the file can simply be reviewed on a new report. It should also be recalled that this protection only applies to CERCLA liability. There are other forms of environmental liability and causes of environmental impairment that are far more common and have nothing to do with CERCLA.