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Testing the Limits: Environmental Indemnity Agreements and Managing Risk

When a lender loans money for a real estate transaction, the lending entity must account for potentially hazardous environmental conditions in or on the secured property.

February 2015

Travis J. McDermott

When a lender loans money for a real estate transaction, the lending entity must account for potentially hazardous environmental conditions in or on the secured property. Frequently, lenders enter environmental indemnity agreements which identify how the risk of any such conditions will be parceled out.  Such indemnification agreements make it possible for the parties to allocate risk, determining at the outset of a transaction that, for example, one party may be held harmless for any environmental liabilities associated with the property. But, according to the First Circuit Court of Appeals, gone are the days of using broad boilerplate language in these indemnity agreements. Rather, courts are now encouraged to scrutinize the language of environmental agreements to determine the validity and scope of any indemnification.  A recent decision—VFC Partners 26, LLC v. Cadlerocks Centennial Drive, LLC[1]—highlights the necessity of using precise language while embracing express limits on the breadth of any indemnification.

 

In VFC Partners, the First Circuit Court of Appeals determined that the lender was not fully protected by the environmental indemnity agreement included in its mortgage-secured loan with a borrower. The parties’ agreement provided that the borrower’s principal and a related entity would indemnify the lender from all costs and liabilities “of any kind or nature whatsoever . . . sought from or asserted against [the lender] in connection with, in whole or in part, directly or indirectly . . . the presence, suspected presence, release, suspected release, or threat of release of any Hazardous Material” on or around the financed property.  The indemnity agreement listed seven specific categories of liability, including “the cost required to take necessary precautions to protect against the release of any Hazardous Materials” in, on, or under the property.

 

The background facts of the case are not at all unusual. As part of its due diligence, the lender conducted environmental testing at the property prior to the closing of the loan, which revealed the potential presence of tetrachloroethene on the site. The lender later assigned the mortgage to a second lender (the “assignee-lender”). When borrower defaulted on the loan, the assignee-lender conducted environmental testing at the property before initiating foreclosure.  The assignee-lender then sought reimbursement for the cost of its pre-foreclosure testing, but the borrower refused to pay, and the assignee-lender filed suit alleging, among other claims, that borrower’s refusal was a breach of the environmental indemnity agreement.

 

The agreement language sounds sufficient to indemnify the assignee-lender, right? Wrong—at least, not according to the First Circuit Court of Appeals. The Court parsed the specific language of the agreement, applying what it deemed “common sense” and general principles of interpretation. Specifically, the Court held that: (a) the plain terms of the agreement covered liabilities “sought from or asserted against” the assignee-lender, which would only include costs sought by a third party and not costs the assignee-lender incurred on its own (i.e. the pre-foreclosure testing costs); and (b) in any event, listing seven categories of liability in the agreement was an indication that the seven categories were exclusive, and thus environmental testing expenses incurred by the lender for purposes other than the seven specific categories were outside the scope of the agreement. Unfortunately for the assignee-lender, the Court then denied the assignee-lender recovery of the environmental testing costs. 

 

In the wake of the VFC Partners decision, lenders should ensure that environmental indemnity agreements make express the expectation that a borrower will indemnify a lender for post-default environmental assessment costs incurred in connection with a foreclosure or deed-in-lieu. Additionally, lenders should carefully draft their environmental indemnity agreements so as to avoid any list of expenses being construed as exhaustive. 

 

The other key consideration in allocating environmental risk is, of course, insurance coverage.  Most entities have one or more liability policies to protect against the various types of claims that could arise in their operations. However, most modern general liability policies exclude some, if not all, claims for injury or damage arising from pollution, including the cost of clean-up. When an entity obtains a commercial property insurance policy that provides coverage for clean-up costs, such coverage is often subject to limits that provide little relief for a substantial release of pollutants. Environmental indemnity insurance can be used to buttress the allocation of risk associated with lender-borrower indemnification agreements.  Many types of environmental insurance products exist on the market—each with its own pros and cons—and those products can often be customized to create specialized coverage packages based on the risks of a given property.  Allocating risk through a combination of an indemnification agreement and specialized environmental insurance allows parties to have flexible and creative protection against environmental liabilities.

 

It’s clear from VFC Partners that boilerplate language in connection with the substantial risks of environmental liability must be carefully reviewed and precise language used to expressly allocate such costs. At the outset of a transaction, parties should perform a thorough analysis of available and appropriate environmental insurance coverage.  Environmental indemnity agreements can, and should, be creatively drafted to fit the needs of the particular transaction, because the use of one-size-fits-all environmental indemnity language invites unexpected costs down the line.  Of course, the parties’ indemnification expectations and agreements should vary depending on the size and scale of the deal, the type and size of the property, the historic and current operations on the property, and the existing insurance coverage of the parties. 

 

Ignoring the potential for environmental costs until a problem arises just isn’t worth the risk.

 


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