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Court Case Finds that a Lender’s Environmental Indemnity Agreement Did Not Cover Certain Costs Commonly Incurred by a Lender Following a Loan Default

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In the recently decided case of VFC Partners 26, LLC v. Cadlerocks Centennial Drive, LLC, 735 F.3d 25 (1st Cir. 2013), the First Circuit Court of Appeals considered whether a lender was entitled to recover certain costs associated with environmental testing of a property under an environmental indemnity agreement. The borrower owned a mixed-use commercial and industrial property occupied by a daycare center and other tenants. The borrower entered into a loan secured by a mortgage, together with a separate assignment of leases and rents, an exceptions to non-recourse guaranty, and an environmental indemnity agreement. The indemnity agreement provided that the borrower would indemnify the lender “from and against all … costs, … demands, … expenses” and other liabilities “of any kind or nature whatsoever … sought from or asserted against” the lender in connection with the presence, release, or suspected presence or release of any hazardous material on or around the property. It further 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 original lender conducted an environmental assessment prior to the closing of the loan which revealed the possible presence of PCE, a known carcinogen. The original lender later assigned the mortgage and all related loan documents and agreements to Wells Fargo Bank. The borrower then defaulted on the loan. Prior to foreclosure or taking a deed in lieu of foreclosure, Wells Fargo engaged in further environmental testing of the site. The tests identified the presence of small amounts of PCE in the soil and in the air, although none of the tests showed concentrations at hazardous levels. The lender unsuccessfully sought reimbursement for the cost of the tests from the borrower and then filed suit alleging breach of the various agreements related to the loan.
The District Court held that, under the indemnity agreement, the lender was entitled to recover the majority of the costs associated with its environmental testing. The District Court did not award the lender the costs of the original testing since such testing was conducted as part of the lender’s routine pre-closing due diligence, not in response to suspected environmental hazards. The District Court held the borrower liable for the lender’s subsequent post-default testing costs, which were “reasonable and necessary,” particularly given the need to ensure the safety of the daycare center at the property.

On appeal, the First Circuit Court of Appeals held that the District Court’s interpretation of the indemnity agreement was too broad. First, the Appeals Court found that the indemnity agreement only covered third party claims against the lender. Therefore, the lender could not recover the costs of its own environmental testing undertaken prior to taking over the property.

Second, the Appeals Court found that the environmental testing expenses incurred by the lender were outside the scope of the seven specific categories of costs listed in the indemnity agreement. Since the level of PCE detected was not likely to pose a threat to the building’s occupants and the lender never took steps to prevent a release of PCE, the Appeals Court found that the tests were not necessary as a precaution against the release of hazardous materials and, therefore, were not covered by the indemnity agreement. The Appeals Court acknowledged that, while the lender’s testing may have been prudent and necessary in order to ensure that the building was safe for the daycare center and to facilitate the future resale of the property, the language of the indemnity agreement did not extend to the lender’s costs conducted for these purposes.

Based on this decision, lenders carefully should review their forms of environmental indemnity agreements to make sure that they expressly cover post-default environmental costs incurred by the lender to assess the environmental condition of a property in connection with a foreclosure or the taking a deed in lieu of foreclosure (whether the testing occurs prior thereto or afterwards). Moreover, the forms should make clear that any list of types of environmental expenses are merely examples and are not exclusive of other expenses not otherwise listed. Borrowers, however, should strive to ensure that environmental costs incurred by the lender after foreclosure or deed in lieu of foreclosure are circumscribed and address only environmental conditions arising prior to the lender’s taking over the property.

This advisory was prepared by Robert A. Fishman and Beth H. Mitchell, members of the Real Estate and Finance Department at Nutter McClennen & Fish LLP. For more information, please contact Bob, Beth or your Nutter attorney at 617.439.2000.

This advisory is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.

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