Financial institutions that foreclose on commercial properties may find themselves liable should a site require an environmental cleanup, a problem made worse by the financial crisis.

Experts say smaller financial institutions, including mid-market firms, often lack the deep pockets of their larger counterparts should such a liability arise.

Under the U.S. Comprehensive Environmental Response, Compensation and Liability Act, better known as the Superfund law, owners or operators of properties containing hazardous materials are required to dispose of them or provide for their treatment. The 1996 Asset, Conservation, Lender Liability and Deposit Insurance Protection Act amended CERCLA, providing a secured creditor exemption eliminating owner/operator liability for lenders — provided they do not “participate in the management of the facility.”

“As long as banks avoid participating in the management of the foreclosed property, they are pretty well protected from liability,” said Neal Glazer, a partner and head of the environmental and toxic torts group at New York-based law firm D'Amato & Lynch L.L.P. “They should not influence or control the day-to-day environmental treatment of waste or hazardous materials at the contaminated site.” Active, day-to-day management of a site “could open the door to exposure,” he said.

While the 1996 amendment grants some protection for lenders, “there is still confusion on how to navigate this exemption and what is considered participating in the management of the on-site operations as well as other liabilities or costs a lender may face,” said Debra Hausser, Greenwood Village, Colo.-based financial institutions leader of environmental site and specialties products at Zurich North America.

Delinquency rates continued to decline for commercial and multifamily mortgage loans in the fourth quarter of 2012, according to the Mortgage Bankers Association's Commercial/Multifamily Delinquency Report.

This good news might be temporary, however.

According to an April Wall Street Journal article, citing estimates from research firm Trepp L.L.C., about one-third of commercial mortgage loans coming due by the end of 2016 was under water as of mid-2012. Some $276.2 billion of nonresidential commercial property loans, many of which were extended during the recession, are expected to come due this year, more than any previous year, according to Trepp (see chart).

“The concern for lenders is, should they take ownership of a property and then be involved in the use of that property or its operations, they could very well be liable for any environmental problems associated with that site,” said Richard Sheldon, environmental practice leader at Willis North America Inc. in New York. “The legal interpretation of the property's "management' is the crux of the issue.”

Lenders also could face “third-party liabilities for bodily injury and/or property damage from either on-site tenants, or an adjacent property owner” for contamination that may have migrated to their property, Ms. Hausser said. “Additionally, the lender could incur defense costs associated with the third-party claims.”

The issue requires superior due diligence — not just of the potential for a site's past or future contamination, but also of the lending document contractual language.

“We're seeing banks be more strict and cautious in their preloan due diligence, and particularly with regard to refinancing,” said Chris Smy, managing director and global environmental practice leader in New York at Marsh Inc. “Banks have gotten on the wrong side of this in past. There have been cases where they assumed too much operational responsibility, such as determining how funds are spent, which then exposed them to liability.”

Ed Morales, vice president and environmental risk officer at Spokane, Wash.-based Sterling Savings Bank, said insurance is one way the financial institution that serves mid-market and small commercial businesses in the Pacific Northwest protects itself from such liabilities (see box).

Craig Richardson, Atlanta-based senior vice president of environmental risk at Ace USA, cited a situation where a bank provides a loan to a condominium complex that is foreclosed in the middle of construction.

“If it is determined that the site is contaminated — perhaps the developer failed to properly install environmental technologies — and the lender undertakes a cleanup of the site to resell it, it may inherit the liability associated with this contamination,” Mr. Richardson said.

“We have seen situations where banks and other financial institutions have purchased commercial properties in bulk, like hotels and condo complexes that have been foreclosed, with plans to renovate and resell them,” Mr. Glazer said. “The downside is that they are often contaminated by mold, which requires cleanup before sale.”

Aside from prudent due diligence and superior contract risk management, banks can buy environmental impairment liability, pollution legal liability, secured creditor impaired property insurance and lender's collateral environmental insurance.

“Banks tend not to buy these (insurance) products because they have strict credit underwriting criteria and departments dedicated to doing environmental due diligence. They also have legal requirements, like the CERCLA exemption. Thus, when it comes to providing the loan, they feel they're generally OK,” said Veronica W. Benzinger, London-based senior vice president in Aon Risk Solutions' environmental practice.

A financial institution also can protect itself from liability by having it named as an insured on the borrower's policy.

The converse also holds true.

“We've seen situations where the borrower suggests that the bank buy the environmental insurance to cover the property in question, with the policy written in the name of the bank and the borrower paying the premium,” said Ms. Benzinger said.

Ken Cornell, New York-based executive vice president and chief underwriter of environmental lines at Aspen U.S. Insurance, said some banks will add the name of a potential buyer to the policy as an enticement, which he said protects both parties. “Another strategy is to get the buyer to purchase the insurance and name the bank as an insured, with the ultimate cost of insurance a point of negotiation,” he said.

“Insurance can help facilitate comfort with regard to taking title to a foreclosed property. Once we find a purchaser, we can then extend the coverage to the new owners,” Sterling Saving Bank's Mr. Morales said.

There may, however, be times when a bank wants to take on the environmental liabilities of a foreclosed property, Ms. Hausser said.

“They may choose to incur the costs to clean up the property because if the owned/foreclosed property is not cleaned up before the lender tries to sell it, the lender would most likely have to sell the property at a discount due to the environmental contamination and thus, may not be made whole even after selling the property,” she said.