Robert Szustakowski, The Lotis Engineering Group, PC

You ordered the Phase I (or Transaction Screen) and you are merrily moving toward closing. You have the appraisal in-hand, you have a good LTV, you have all of the final approvals and your lawyer is working on closing documents. Then it all comes crashing down with the suggestion of a Phase II from your consultant. Having been both a producer and a user of consultant’s environmental studies for lending has provided me with a unique perspective on such matters.


Two thoughts on timing.

First, why do so many bankers leave the environmental assessment to the end of their due diligence process? I appreciate that there is a concern that a property will not “appraise out,” meaning that there is insufficient value to make the deal “work” as proposed. This is understood in some instances, but not always. A purchase? If the value is not there, then the purchase price is too high. Cash out? You can reduce the amount of the cash provided. At a conference many years ago, Tony Buonicore, founder of EDR, stated “while your appraisal may change the amount that can be financed, it’s the environmental that can actually stop the entire deal” in his suggestion that environmental studies be done first. I’m a big fan of concurrently ordering the two reports. Keep in mind that it may well be required for the environmental results to be provided to the appraiser, if the environmental conditions may impact value.

Secondly, while at banks, I always told my consultants I never want to be surprised when I review your report. That is, if I hear nothing from you, I expect that your report will not identify issues warranting further assessment. As the liaison between the loan officer and the consultant, and knowing that the loan officer likely ordered the environmental report so it’s due the day before scheduled loan closing, the last thing I want is to find out that there are issues impacting the collateral on such a late date. The consultant should be providing regular updates, if necessary, on issues identified. “Managing expectations” as they say.

The Consultant Just Wants More Money, Right?

If you honestly think that, you have the wrong consultant! Statistically speaking, based on 30 years of doing this, about one in ten projects go to include further study. Non-scientific surveys with others suggest that 10% is likely a pretty good number. If your experience is significantly different from there, you may want to look into it.

One thing that could change this number is how conservative your consultant may be in their identification of Recognized Environmental Conditions (RECs) and their recommendations for further work. To some consultants, EVERYTHING is an issue. They are providing a very low-end product which, they perceive, as having very high risks. Their approach to handling this risk is to be very conservative in their approach, so they cannot be accused of missing an issue. This is where we see such items as parking lots staining from parked vehicles warranting further study.

If you have an in-house environmental staff that can “override” a consultant’s report conclusions, having such a conservative consultant is not an issue. As a bank employee, I often reviewed reports that I felt contained unreasonably conservative conclusions. In my role, with a better understanding of my employer’s risk tolerance, the value of the transaction, the strength of the borrower, etc., I had no problem deciding that no further study was warranted regardless of what the consultant suggested. This was my job.

However, if you don’t have access to trained staff, you are much more dependent on your consultant and that conservative approach may create issues in the way of unnecessary costs and delays to closing, irate borrowers, etc. While this is a very technical business in which I work, your consultant should be able to provide clear explanations for any work and, if you are not confident of its necessity, you should ask another consultant for their opinion.

One last word of warning. You can’t “override” a report for an SBA deal. EVERY issue raised by the consultant MUST be addressed, typically prior to closing, per their SOP. This may or may not be possible. For example, the consultant recommends proper disposal of two drums in the warehouse; good recommendation. But what if the borrower is buying the property from a party that has no money to do this? The borrower goes out of pocket to address issues on a property he/she does not even own? Solvable? Yes. But a pain. So, good communications with the consultant are required.

The Scope of Work

Appreciate that the purpose of the “first” Phase II is typically to answer “yes” or “no.” That is, to assess whether there is impact on-site. It often cannot tell you “nature and extent” of any impact, as the regulators call it. This is due to cost and unknowns. For example, let’s say a former gasoline station had a waste oil tank grave, two pump islands and a gasoline tank grave; that’s four separate potential areas for contamination to assess. The consultant spends one day on-site, doing 10 to 12 borings. That’s two to three two borings per location. If ANY impact is found, that’s about all we know; the consultant does not have sufficient information to assess extent (read cost to cleanup). A second study would be warranted concentrating on the location(s) impact was found.

The alternative would be to have the consultant complete further study immediately, in order to assess cleanup costs. Theoretically, the consultant can use field data (at least in the case of a gasoline station but not in every situation) to continue the initial Phase II, assessing the site until the extent is known. The cost of such study would be unknown at the beginning of such an approach, but is doable. This would really only be appropriate in “time of the essence” closings.

Beyond the “purpose” of any Phase II, the consultant should be able to put any issues to be addressed in the Phase II into perspective. My biggest concern is the “and then what” factor. For example, let’s say the consultant wants to sample some staining around drums. Make sense. But what will the consultant’s recommendations be? That the staining be removed and confirmatory soil samples collected to confirm. Why are we testing now? So we know how deep the impact is. Why don’t I just tell the borrower to clean it up and confirm with testing? Well, you could do that… [And save the borrower several thousand dollars.]

Another example is something that must be addressed to comply with law. Say that there is an abandoned tank on-site. The consultant recommends sampling around the tank. Again, a very reasonable suggestion. But then what? Well, you have to remove the tank. Even if the samples are clean? Yes; legally it has to be removed. Why don’t we remove it now? Because we don’t know what it will cost as we don’t know if it’s impacted. Again, a good point and time for the bank to assess the issue from a business perspective. If my borrower is a purchaser, can we just have the seller to remove the tank (and impact) before we close? If the borrower already owns the property, am I going to escrow to have the tank removed later? Is the borrower so strong that I wouldn’t escrow anyway? What is a “reasonable” cost to remove the tank, with or without impact? Your consultant can provide something, even if a range. Does it already make the deal impossible? I’ve seen deals that couldn’t handle even a $5,000 escrow.

My point is that if you already know the conclusion of the Phase II study, why do it if you can find a way around it?

Lastly, your borrower will ask, and so should you – if the report is “clean,” am I done? The answer should be yes. If the consultant properly scoped the project, and no impacts above standards are found, there should be no recommendations for more work. To those consultants who suggest that ANY impact should warrant further study “as they may not have found the worst of it,” I say, then you should have better placed your sampling locations.

Do I Have to Even Do a Phase II?

Your policy should explain how to handle these matters, at least to some extent. But you may have to replace “an issue on-site” to “may be an issue on-site,” as without the Phase II, we don’t know.

This should very much be a business decision and very much case-by-case. Here are some examples.

Listed Waste Site – I have had numerous situations where the borrower has provided for collateral a listed hazardous waste site (or portion thereof). The consultant recommends further study to assess site impacts. From a technical perspective, this makes perfect sense. But is the bank even willing to take a listed hazardous waste site as collateral even if it’s “clean?” The regulations on such matters are extremely complex and at that point, it likely needs to be in the hands of qualified environmental counsel, not your consultant. Certainly, I’ve had situations where the decision was made that the collateral posed no real concerns to the bank but other times, the bank was not interested. Again, business call.

Hunting Ghosts – This is the term that I use when we are searching for something so elusive, we have to assess whether it’s worth hunting. A regular example is finding an underground storage tank (UST) installed “somewhere” on a large property. Certainly, if there is a boiler room, we can look in that area, but does it make sense to look over the entire property if it’s not there? Chances are you won’t find it. Some consultants recommend a Phase II whenever a property was heated with oil and we don’t know if this was an above- or under-ground tank. Is this the best approach? In many areas, USTs were not allowed. Did we check the municipal records for the type of storage vessel? (Remember, checking municipal records are NOT part of a Phase I per ASTM.)

Very Strong Borrowers – This one is totally a business call as the consultant knows nothing of the borrower or his/her wealth. The consultant may recommend a Phase II to look for an old tank or to remove a tank. The bank may have a 50-year relationship with this borrower and knows that if the bank requires that a tank be removed post-closing, it will be properly addressed. Most banks may want some sort of “reasonable worst case” value to use in their write-up; the consultant should be able to provide something.

Risk Too Great to Consider – This is not a typical situation but has come up from time-to-time, including about two months ago for me. A bank client requested a Phase II quote, as a Phase II was recommended by the borrower’s consultant. While the site has been well studied, my review of the Phase I concurred the need for a Phase II to assess potential vapor intrusion (not assessed in prior studies). But then I noted that the report states “the extent of off-site impact has not been determined.” It turns out that this property was the source of groundwater contamination migrating off-site into a residential neighborhood. No work had been done in that neighborhood and at the property boundary, the contaminant concentrations were above vapor intrusion action levels, meaning that the state would require vapor studies in those adjacent residential buildings. This opened up the potential for third-party liabilities, liabilities that could not be quantified. [Per ASTM, this situation is not a Recognized Environmental Condition, REC, as the regulators were aware of the situation and were not (yet) requiring anything. So it was not even identified as an issue in the Phase I.] While this does not often happen, it was a “walk away.”

Modifying the Collateral – This option is surprisingly useful. It involves modifying your collateral so you do not accept the property with the potential issue. Recently, I reviewed a report for about a dozen lots, part of a multi-family portfolio. One of the lots was formerly a gasoline station, no information available beyond that. The consultant recommended a Phase II of that lot; perfectly reasonable. The lot was an overflow parking lot for one of the buildings. I asked the appraiser about value – next to nothing. I suggested that the bank merely remove that parcel from the collateral; it did not modify LTV and it was not necessary to the business. Problem solved.

Not in Bank’s Best Interest – Banks have to be careful about their strict policy requirements; further review may not be in the best interest of the bank. Case in point. Let’s say that a bank holds the mortgage on collateral owned by Borrower A. Borrower A is in Special Assets and the bank needs to consider moving against the collateral. Borrower B wants to purchase the property and have the bank finance their purchase with financing equal to or less than the outstanding balance to Borrower A. The bank is actually improving its collateral position by “refinancing” the collateral with Borrower B, as it will go from non-performing to performing. A Phase II may identify issues that will cause a problem with this transaction. I am not suggesting that anything be hidden from Borrower B; I’m only suggesting that the bank does its own due diligence, not the due diligence of your borrower. The facts are provided to Borrower B and if he/she is OK without a Phase II, go to closing without it.

There are many other examples.

Ramifications of the Phase II

One item that should always be discussed with the consultant is what are the legal ramifications of the results of the report. In many states, for many circumstances and many contaminants, there aren’t any. The most common concern raised by borrowers is a reporting obligation. However, under many jurisdictions, the obligations fall to the owner, and only if more than a “Reportable Quantity” (RQ) of a certain chemical was released. As it is next to impossible to assess the released amount during a Phase II, the reporting obligation is almost never triggered.

However, in New York State, for example, the petroleum regulations state that “anyone with knowledge” must report petroleum releases to the state regulators within two hours of discovery. This means that the reporting obligations falls onto the consultant – while still in the field! Consultants that “choose” not to abide by this regulation can be, and are, fined. Similarly, Connecticut has regulations that make reporting more common if contaminants exceed a certain concentration, based on the specific compound in question. Those reporting obligations are not as stringent and there is some time to formulate your reporting.

The other reporting obligation is due to the “potential for imminent human health risk.” This is not as codified as other reporting obligations but technically falls on all of us. If we are aware of a situation that, left unaddressed, could impact human health, there is at least a moral (and often a legal) obligation to report it. Historically, this almost never happened. In my first year in consulting, I had a situation where a client’s contamination was migrating off-site and toward an adjacent private supply well. My former employer told the client that if he did not report it, they would as they saw a health risk here as the adjacent property owner would be unknowingly consuming impacted groundwater.

This type of reporting obligations never happened to again until we started looking into the vapor intrusion issues; that is, groundwater and/or soil contamination under a property can result in elevated contaminant concentrations within the breathing air of that property’s building occupants. If you don’t actually do the vapor intrusion study, it’s all hypothetical – it MAY be impacting occupants – and you can suggest no reporting is warranted. However, once you do the study, it’s real and you have the data. You need to know what’s going to happen if you are presented with hard date that occupants are breathing air that the local Department of Health says is unhealthy. Does your consultant have an obligation to report? Do you?

The Report

Due to its technical terms, a layman may have difficulty reviewing a Phase II study. We consultants got our start writing reports for regulators; i.e., people familiar with our abbreviations and technical terms, and tend to use a bunch of words we learned in college. I think that this should change and we should write to our audience.

What you are looking for in a Phase II report is relatively simple. For essentially every compound analyzed, there is likely a state and/or federal standard that applies. [If not, why did the consultant sample for it?] Do you or do you not exceed an applicable standard or guidance? If not, are we done? If so, what are the implications?

Many states have standards but some, like New York, have “guidance values.” This means that they are not directly enforceable in most circumstances and the consultant is expected to provide some level of interpretation. For example, would I be OK with a retail property where some soil samples located beneath a parking lot have contaminant concentrations that exceed commercial but not industrial guidance values? Likely; the area is covered and there is no cleanup requirement. Would I be OK with a residential property where some soil samples located in a play area have contaminant concentrations that exceed residential but not commercial guidance values? Nope. Risk is too high when you are dealing with residential property. No one wants to be associated with even the perception that your property impacted children.

What I’m saying is that a report that simply states this sample exceeded that standard or guidance but that one did not is not overly useful to the layman. They should provide answer to the “so what” question.

Now What?

The hardest part is yet to come. What if you find impact but still want to close the transaction? Do I need further study? What could all of this cost? How long will this take? What about regulatory involvement? This is what separates the good consultants from the others.

About the Author

Bob has been completing environmental due diligence for lenders for 30 years. He has developed and managed environmental programs, as a consultant and bank employee, for some of the largest and smallest banks in the country. He has also devised bank programs for construction monitoring and routine property inspections.