EPA’s All Appropriate Inquiry (AAI) Rule... WHO NEEDS IT?

The Environmental Agency promulgated a law (40 CFR Part 312) relative to the practice of environmental due diligence and the standard of care that must be met if a purchaser wants to enjoy a "safe harbor" from future environmental liability at the federal level. The law established the type of due diligence that is expected and the qualifications of the people performing the service for the Purchaser.

While this was going on the American Society of Testing and Materials (ASTM) also decided to publish a new Phase I Environmental Site Assessment Standard (ASTM 1527-05) that closely reflects the EPA’s AAI law.

These two changes in environmental due diligence practices a number of issues for a Lender trying to formulate its environmental policy such as:

The new ASTM Standard and EPA’s AAI rule take longer to complete, adding about 5 to 10 business days to the process and delaying closings
The new standards are more expensive (about 25 to 35% more expensive)
The new standards will undoubtedly result in more recommendations for Phase II investigations to close "data gaps" and to further investigate historical recognized environmental conditions
If a Lender fails to adopt the new ASTM standard, it fails to acknowledge the legitimacy of an organization who heretofore was the standard bearer for appropriate environmental due diligence requirements. This may have some legal issues associated with it down the road.

Having said this, Environmental Due Diligence Departments within banks also face a number of "real world" issues with Loan Officers:

The increased fees for the new standards may put the Lender at a disadvantage in a very competitive market place
The increase in Phase II investigations will be costly and time consuming to the Borrower and the Lender.
The regulation provides protections to purchasers only; if the property is already owned by the borrower, it provides no protections. Similarly, it provides no protections to the bank except in those rare instances where the bank is the purchaser. (Foreclosures and obtaining a deed in lieu of foreclosure are not covered by the regulation.)
AAI in and of itself does not protect Borrowers from State liabilities but only protects the Borrower from Federal CERCLA liability (wherein petroleum contamination is not considered a hazardous material). Therefore, adoption of the AAI standard seems insufficient in protecting a Borrower and it does not fully disclose to a Lender potential liability issues not covered under CERCLA.
Where ASTM 1527-05 does address State and Federal liabilities (that is, it includes petroleum products), it still provides no State liability protection unless the state has specifically modified its regulations to do so. Furthermore, it is unclear whether or not such extensive due diligence is really necessary for a Lender to implement since the Lender already enjoys CERCLA liability protection under the 1996 Lender Liability Exclusions to CERCLA.

To put things in perspective, LCS offers the following:

Some Background...

President Bush signed into law the Brownfield Re-development act a few years back. As part of that legislation, the EPA was instructed to promulgate a regulation/law for the investigation of real estate that may be environmentally impaired. The regulation and law was to have two specific purposes.

First, the law was to provide a safe harbor for purchasers (interested in resurrecting Brownfield sites and any other property) from CERCLA liability by providing them with either an "innocent purchaser’s defense", "bona fide purchaser’s defense" and/or a "contiguous property owner’s defense".

Secondly, it was to set out the means and manner in which a property must be investigated to gain the aforementioned protections and set the level of training, experience and expertise for those engaged to provide such investigations.

The law does NOT mandate that AAI be utilized when purchasing a property, nor does it have any enforcement provisions for those who do not practice AAI. Further, there are no requirements to file the reports with the EPA as there are for so many other EPA regulations such as AHERA and Super Fund projects.

In a nutshell, if a purchaser chooses to engage the services of a consultant to provide a Phase I Environmental Site Assessment with All Appropriate Inquiry attached, the purchaser will enjoy relief from CERCLA liability if and only if an environmental condition is discovered at some future point in time.

To Add More Confusion... Enter the ASTM!

The American Society of Testing and Materials (ASTM) has long been the gatekeeper of the standards by which environmental investigations are to be conducted. They developed the ASTM 1527-93, -97 and -00 standards for Phase I reports as well as the ASTM 1528-97, -00 and 06 Transaction Screen process.

The ASTM created a new standard (replacing all other Phase I standards) that essentially mirrors the EPA law but with one important difference... it became effective immediately.

The "one-up-manship" by the ASTM has further clouded the environmental due diligence landscape by leaving Lenders and Consultants in a position of not being able to determine what requirements to follow.

However, to be fair, the ASTM does NOT state that the ASTM 1527-05 Standard is the Alpha and Omega of environmental due diligence practices. ASTM clearly states the following in the new standard at Section 4.1 Uses:

"No implication is intended that a person must use this practice (ASTM 1527-05) in order to be deemed to have conducted inquiry in a commercially prudent or reasonable manner in any particular transaction."

What About State Regulators?

What the EPA law does not do is offer the purchaser protection from state environmental regulations and/or agencies. As petroleum is not covered by CERCLA, the AAI regulation provides no protection from underground storage tanks, gasoline stations, etc. The EPA will not "police" the practice of AAI by purchasers of real estate. Rather, the issue will likely arise when or if a problem at the site is discovered post-closing and during re-development. If AAI was practiced, the purchaser could claim an innocent landowner defense and request to be held harmless from federal liabilities; if AAI were not practiced, the purchaser could be named as a responsible party to the cleanup by nature of ownership.

The state regulators would still be free to enforce their regulations and standards on the developer, regardless of whether or not a purchaser practiced AAI.

The new ASTM standard does allow for more protection to the Borrower and the Lender as it includes a review and analysis of environmental issues of concern to the state and local levels of government rather than only at the Federal (EPA) level.

What Are Other Lenders Requiring?

Lenders and Banks are protected from CERCLA Liability under the Lender Liability Exclusions amendment to CERCLA dating back to 1996. Therefore, one of the most compelling reasons to require an AAI Phase I really is not applicable to protecting Lenders from CERCLA liabilities.

A lender needs enough due diligence information to make an informed business decision in determining the risks associated with environmental issues that may be present at the site and the impact such conditions may have on the value of the property and transaction such as:

Will the environmental conditions impact the borrower’s ability to repay the mortgage?
Are the estimated costs for further investigation and/or remediation out of balance with the loan to value ratio, market and/or appraised value?

Most banks will likely recommend the purchaser consider the use of the AAI Phase I report when purchasing a new property. However, it is doubtful that any lender will require a purchaser to engage an AAI Phase I as a normal course of business; particularly if the transaction is a re-financing of a property in the bank’s portfolio. Since a lender is not the "purchaser" of the site, there is little value in requiring the AAI Phase I by the bank.

Most every bank we have spoken with and with whom we consult has stated they will not require AAI Phase I’s as a normal course of business. Most will adopt a "variation" of the new ASTM 1527-05 standard by being a bit creative in meeting some ASTM standard requirements and adding out of scope items. More on this later.

There is a strong case to be made for engaging AAI and ASTM 1527-05 Phase I reports to anyone purchasing real estate. There is an equally strong case NOT to recommend AAI or ASTM 1527-05 to Borrower’s refinancing a mortgage that involves real estate as collateral.

A purchaser must be aware of the challenges that may result from an AAI Phase I as the purchaser is the User of the report and therefore has certain legal obligations under the AAI standard. These obligations extend through the ownership of the property and do not end with the completed due diligence report. The same holds true to a lesser extent under ASTM 1527-05 wherein this standard, while not being a federal law, does commit the user to certain obligations.

If recognized environmental conditions are determined to be existent on site, should the purchaser proceed? Is a re-negotiation of the sales price in order and if so how much is reasonable? Also understanding the potential cost of remediation is critically important. Is the property eligible for Brownfield tax credits? Can the property be remediated in the timeframes necessary for re-development and occupancy? How much will "soft costs," such as legal, regulatory agency involvement and environmental insurance, impact the deal? What about tenant concerns going forward or any "stigma" now associated with the property and re-development?

Purchasers should always ask for and seek out all previous environmental reports on a site as an initial step in the acquisition process. A purchaser should expand their initial due diligence practice by including participation by an environmental professional qualified to analyze previous reports and to provide a quick assessment of the property through environmental databases, municipal research and historical maps. These "quick assessments" may provide enough data for a developer to decide how best to proceed with their "formal" (AAI or ASTM 1527-05) due diligence at significantly lower initial fees.

We have encouraged some of the Lenders to take the ASTM 1528-06 Transaction Screen Standard and add additional scope items in an effort to make the Transaction Screen Standard consistent with to the former ASTM 1527-00 Phase I ESA standard. This will allow the Lender to acknowledge the legitimacy of the ASTM by using their Transaction Screen standard while getting the same level of due diligence they have become comfortable with for the last six years and at the same fees previously enjoyed.

In any event Purchasers should be very careful in deciding what level of due diligence they require.

Conclusion...

Perhaps the best manner to approach the EPA and ASTM changes is to look at each site on a case-by-case basis both now and after November 2006. In some cases, the purchaser will not require any further level of due diligence than perhaps a desk top database review, simple site inspection and an analysis of previous reports.

AAI Phase I reports may be the only alternative when dealing with former industrial properties, abandoned buildings and/or properties that are listed significantly under market value.

Compliance to 40 CFR Part 312 will be important to any purchaser seeking the safe harbor under CERCLA’s innocent purchaser’s defense. The question will be when is it appropriate to engage these services and when is it appropriate to do less.

Lenders will generally allow the purchasers to decide what level of due diligence is appropriate, but will also likely require that the purchaser sign off on a statement regarding AAI Phase I reports if not selected by the purchaser.

Pre-qualifying an environmental consultant, assuring that the level of insurance coverage offered by the firm is adequate, case-by-case risk assessment by the purchaser, knowledgeable environmental and real estate counsel, understanding a lender’s policy requirements, review and analysis of previous environmental reports and "quick assessments" are all tools designed to protect the developer in this new era of environmental due diligence.

Best practices will include all of the aforementioned and of course...good old fashion common sense!

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