Building Consultants, Inc.


Avoiding Lender Liability
Joseph F. Boyd
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 work.

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 loan.

Joseph Boyd

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