Loan Documents: The Environmental Escrow Clause.
As many reading this article will know, a fair number of commercial banks will lend money for a real estate purchase or a construction loan, even if the underlying real estate securing the loan is contaminated.
However, that loan is typically conditioned upon:
The bank having a fair handle on the environmental risk associated with the parcel;
That risk being quantified in terms of a dollars-impact; and
Employing some mechanism to address, pay for and rectify that environmental impact, post-closing the loan, so the risk can be eliminated.
The Phase I and Phase II process (sometimes requiring multiple Phase II investigatory rounds) typically answer Item Nos. 1 and 2 above, respectively; the environmental escrow clause in the loan closing documents addresses No. 3.
We are going to focus on No. 3 in this summary.
A proper environmental escrow clause will typically have the following terms and conditions.
Escrow Amount & Contingency Factor: The amount of money estimated by the bank's environmental consultant typically constitutes the escrow dollar amount. But, depending on the nature of the environmental risk, this amount is typically increased by a safety, or contingency, factor. This factor usually ranges from 10% above the consultant's estimate to 100%, or even 200%, above said estimate. Why such a large contingency range? The answer is twofold. One is dependent on the bank's overall appetite for environmental risk; the second is the nature of the contamination itself. By way of example, if the risk is usually readily quantifiable (say asbestos abatement), the contingency factor is usually on the lower end of that percentage range; if the risk is less quantifiable at the time of loan closing (say an underground storage tank that has leaked and impacted both soil and groundwater), the time and cost to secure regulatory closure is subject to the effects of future remedial work, which is inherently inexact. In this latter case, the contingency can be as much, if not more, than the consultant's overall estimate. It is not a one-size-fits-all process, each contingency factor should be based upon the specific environmental risks associated with the loan in question.
Itemized Remedial Scope of Work, with Defined Assumptions: The escrow budget should be based upon a detailed, written scope of work and itemized budget, in which future billing can be tracked, typically in a spreadsheet format (similar to construction loan tracking). It is vitally important when setting up the escrow, to understand from the consultant who formulated the work plan and budget the specific assumptions and conditions upon which that work plan and budget were based. How risky or conservative those assumptions and conditions are will largely dictate how large or small the contingent factor should be. Beware of the assumptions are simply too rosy (which commonly occurs, if the consultant is attempting to reduce the budget figure as much as possible on behalf of their borrower/client), the scope may need to be amended to more realistic scenarios. This can become an iterative process.
Replenisher Cause: While most bank environmental escrow clauses contain a contingency factor of some sort, many seem to lack the mechanics of a basic replenisher clause. Such a clause requires the borrower to replenish the escrow if a floor amount is reached and the remediation is not yet at the percent-complete that corresponds to the floor amount. By way of example, if a $100,000 escrow is set, and a floor amount of $25,000 is reached, but more than 25% of the remedial work remains to be done, then the escrow needs to be replenished to a level satisfactory to address the remaining work, along with any associated contingency percentage applied atop that figure. On longer, more complex remedial projects, where changed and/or previously unknown conditions are routinely encountered, the escrow may need to be revisited and replenished more than once. If you are a bank, be sure your loan documents include such a clause; you don't want to deal with a depleted escrow, with work still-to-be-done, and have no defined way to ensure the borrower proactively address same.
Is it Working Escrows: Most bank escrow accounts are working escrows, meaning the borrower completes the work and then gets reimbursed via an escrow draw (or the escrow pays the environmental firm directly). However, the bank can set the escrow mechanics so that the borrower uses secondary funds to pay for the cleanup, and the escrow gets released, in toto, when the work is finalized. This is not as common a setup for commercial bank loans, but this is a common method employed when a regulatory agency (such as the New Jersey Department of Environmental Protection [NJDEP]) requires an environmental posting by a party conducting a clean-up.
Escrow Drawn Approvals: Typically the borrowers’ consultant will make a draw request to the bank; the bank's environmental consultant will review the invoicing and opine as to whether the work was successfully/correctly completed and if the draw is reasonable (similar to a construction loan draw request/approval). The escrow typically pays the reviewing consultant's fees as well, so this cost must be built into the escrow (or it is commonly absorbed into the contingency factor). Many times the borrower will utilize the bank's own consultant to undertake the environmental work to avoid the third-party billing review; many banks allow this, and encourage it, since the reviewing consultant is already on the financial institution's approved list, or is a known entity to the bank. But both set-ups are routinely employed.
In summary, if you are a bank, work with your counsel and consultant to employ environmental escrow clauses in your loan documents that incorporate the basics above, and ensure it is in line with your institution's overall environmental risk policy. If you are a borrower, or represent a borrower in a planned transaction, understand such a clause is likely included in the loan documents that will be signed off on by the borrower, especially if the property in question has some environmental issues to address. On occasion, the terms of this clause can be negotiated with the bank, if deemed onerous by the borrower.
If you have questions on environmental escrow clauses, or would like to see one or more representative clauses that incorporate the terms and conditions above, contact Glenn Brukardt at glenn.eikon@gmail.com or 908-813-2323, Ext. 36.