Inadequate Due Diligence Left Bank Liable For $2.3 Million in Damages, Attorney Says

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By Logan Hollers

Nov. 20 — A recent case in California illustrates the importance of banks “fully understanding the costs potentially associated with a property before they either close the loan or take title,” an environmental attorney told Bloomberg BNA Nov. 3.

Larry Schnapf, of Schnapf LLC in New York, said that “many banks, especially community and smaller banks,” aren't performing adequate due diligence before taking title and selling property.

California Pacific Bank (CPB) failed to obtain a “no further action” letter from the San Francisco Bay Water Quality Control Board within three years following the close of escrow for property acquired when the borrower defaulted on the bank's loan. CPB was thus liable for damages of $2.3 million to the purchaser for loss of use of the property, loss of the ability to enter into other agreements and loss of the ability to sell the property, the First Appellate District of the California Court of Appeal ruled in July.

CPB had financed the purchase of a commercial real estate property, formerly the site of a dry-cleaning solvent packaging plant, which was heavily contaminated with perchloroethylene (PCE).

After removing contaminated soil and pumping out contaminated groundwater, the borrower's environmental consultant sought regulatory closure from the Water Board. The Water Board denied the request and ordered additional groundwater and soil remediation. Shortly thereafter, the borrower filed for bankruptcy and defaulted on the loan.

Borrower's Consultant Retained

CPB retained the borrower's consultant to complete the cleanup. The consultant told CPB that he could obtain Water Board closure for additional remediation in the amount of $45,000. The Water Board approved the revised work plan but required submission of a remedial investigation and proposed remedial action.

CPB then agreed to sell the property to the plaintiff, Huy Hoang, for $1.14 million. In the sale agreement, CPB agreed to fund remedial work up to $45,000. If additional remediation was required to obtain a no-further-action letter, CPB had the discretion to authorize remediation work up to $100,000, with plaintiff paying half the additional costs. Any costs in excess of $100,000 were the sole responsibility of CPB.

After multiple denials by the Water Board of requests for a no-further-action letter, the plaintiff filed a breach of contract action asserting that CPB failed to remediate the property within three years of the date of purchase.

CPB Made Numerous Mistakes 

“This is a heads up, primarily to banks, but also consultants and lawyers that represent those banks,” Schnapf said. “Banks tend to have the greatest exposure to environmental liability when they foreclose on property. If they fail to take reasonable steps to dispose of the property, they could find themselves saddled with environmental liability from the site,” he said.

Schnapf said the bank made several mistakes in this case. First, the bank failed to retain an independent consultant to verify the conditions at the site and estimates of remediation costs. The consultant hired by the borrower and later retained by CPB estimated that remediation could be completed for a total cost of $295,000. During the trial, however, multiple experts estimated that, based on contamination levels, remediation at the site would cost between $1 million and $3 million.

“Despite the high PCE concentrations, the bank accepted what proved to be a woefully inadequate estimate without retaining its own consultant to independently vet that estimate,” Schnapf said. “While another lender might have wondered if it was provided with a lowball estimate, CPB appears to have elected to proceed with the environmental equivalent of a ‘Hail Mary' pass.”

The bank then committed a second error when it approved an escrow equal to the estimated cleanup costs. When the borrower purchased the property, the seller placed a deposit of $250,000 in escrow to be used toward obtaining regulatory closure of the site. According to Schnapf, “The bank should have required the escrow to be larger.”

Traditionally, lenders set away “125-150 percent of estimated costs to obtain regulatory closure.” In this case, “The bank was controlling the escrow, so they should have had a number that was much higher than the consultant estimated,” Schnapf said.

Perform Due Diligence Early

Finally, Schnapf said, “before taking title to any property, banks should always perform due diligence” to ensure they are able to anticipate any contamination issues that may arise. CPB incurred contractual liability in connection with the sale of the property, and “that liability was particularly influenced by the inadequate due diligence prior to both taking the loan and also before taking title” to the property, he said.

Here, CPB may have qualified for the secured creditor exemption to liability because it held ownership of the property only to protect its security interest and didn't participate in management of the property.

“It's ironic that the bank may have qualified for the secured creditor exemption, but ended up having to pay for cleanup costs anyway based on a contractual agreement,” Schnapf said.

“This case is an illustration of what happens out in the real world. It's interesting because it's a reflection of what can happen in the marketplace” without proper due diligence, Schnapf said. “Sometimes it's the smaller loans where the liability can really be material—the smaller the loan, the more likely it is to be a smaller bank occupying this market,” he said.

To contact the reporter on this story: Logan Hollers in Washington at lhollers@bna.com

To contact the editor responsible for this story: Larry Pearl at lpearl@bna.com

The ruling by the California Court of Appeal in Hoang v. Cal. Pac. Bank is available at http://www.bloomberglaw.com/public/document/Huy_Hoang_v_Calif_Pac_Bank_No_A139139_2014_BL_204019_Cal_App_1st_.