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Avoiding Lender Liability
published June, 2002, Howard County Business Monthly
Financial lending institutions, such as banks and mortgage companies, are
constantly reviewing and redefining their risk analysis and management policies
so that risks can be detected before they become liabilities. Because of
numerous laws and regulations that have been enacted, potential investment
projects must undergo great scrutiny from the environmental aspect to the design
and construction phases of the project to insure that the investment is viable.
While each lending institution has its own level of risk tolerance in agreement
with company policy, the common goal is to reduce the potential for lender
liability. The first step in reducing lender liability is follow acceptable and
appropriate environmental due diligence procedures in all transactions.
The purpose of environmental due diligence is to assess the
environmental condition of a property to determine the level of environmental
risk associated with a transaction and to evaluate possible constraints on the
planned use of the property imposed by the environmental condition of the
property or nearby properties.
Environmental Risk Control
Environmental due diligence can involve the completion of
either a Phase I Environmental Site Assessment (ESA) or a Transaction Screen
Process (TSP). A Phase I ESA involves a thorough review of permits, compliance
records, and governmental regulatory files concerning the property in question,
and the evaluation of any off-site waste management facilities used by the
facility. A title search dating back to 1940 is completed to
determine the prior uses of the property and waste disposal practices. It also
includes a geologic review and a historical
review using aerial photographs, topographic maps, and various other
documents. A visual inspection or site reconnaissance of the property is
completed to identify obvious signs of problems with past disposal practices,
such as stained soil or rusted and deteriorating drums, or the presence of
underground storage tanks.
A Transaction Screen Process (TSP) is similar to Phase I ESA
in that a regulatory review and a limited historical search are conducted, but
during the site visit, the owner completes visit a transaction screen
questionnaire. TSP's are ideal for properties where the owner has
extensive knowledge of the previous property uses. These are the
minimum requirements stated in the environmental due diligence guidelines issued
by the American Standard for Testing and Materials E 1527 and E 1528 (ASTM),
which has become the standard for most organizations and involved parties. Some
lending institutions have more stringent requirements including a visual
inspection for lead based paint, asbestos, PCB containing electrical equipment,
radon, and wetlands. Not only is environmental due diligence important to loan
application process prior to settlement, but must be constantly monitored
throughout the life of the loan.
Construction Risk Control
In addition to environmental risks, risk analysis and management must
also be conducted for projects involving construction period investment.
Risks associated with the general contractor and project architect's
capacity, quality, performance, change orders, production, and operations and
maintenance during construction can be just as harmful if not more so than the
environmental aspects. Risk control actions that should be
completed by the lender to ensure the viability of general contractors and
architects are to evaluate the number of years of business, balance sheet, prior
annual income, and experience with similar work and funders. The lender should
also confirm the developer's receipt of references from the last three clients.
Additional confirmations made should be the bondability of the contractor for
the contract amount and the ability of the architect to obtain professional
liability coverage for greater of $250,000 or 10% of the hard costs.
Construction contract documents including plans, specifications, and
form of contract should be reviewed to ensure completeness, adequacy, and
appropriateness. Recommendations of unit prices should be made for
possible change order items. Local market conditions, construction type, season,
and the ability of the contractor to complete the project should be reviewed.
Contractor performance risk controls include a 10% retainage
requirement until substantial completion, release of liens and title updates
with each draw request, and require performance and payment guarantees.
Construction production risk can be reduced by requiring a monthly review of
construction level of completion (per draw requests), quality, conformance to
plans and specifications, adequacy of remaining funds, and time to complete the
These general control measures are only a small representation of risk
controls for construction period investments. They can vary from low to moderate
to high cost to the lender/owner depending on the size of the project. Combined
with environmental due diligence, lenders can significantly reduce, to
completely eliminate, risk over the course of the project construction and