Here is the nightmare scenario: A financing institution (the low-income housing tax credit [LIHTC] investor) lends money to an affordable housing project, often becoming the majority shareholder in the limited partnership owner, and sometime during development, contamination of the soil, soil vapor, or groundwater at the property is discovered. Whether it be a historic dry cleaners or gas station, an abandoned sump suddenly discovered in the basement, or an underground storage tank that the foundational piling just pummeled straight through and petroleum is now leaking into the groundwater, an owner, developer, and lender may find themselves in the middle of an environmental remediation project to clean up contamination that may cost millions, not mentioning its diminutive effect on the valuation of the real property and its ability to ever actually house low-income tenants. Typically, the real property owner is the initial responsible party for the costs of remediation. As the typical majority interest in that real property owner, this is bad news for the lender. There may be an indemnity obligation that is then triggered to force the developer, typically the general partner and minority interest in the real property owner, to take responsibility for such remediation. But what if that developer is a single purpose LLC with inadequate funding, is bankrupt, or simply refuses to act? Rest assured that the regulatory agency will find the deep pockets—or at least every pocket it can get its hands into. Accordingly, a basic understanding of a party’s potential exposure to the monster of environmental liability can help that party to prevent against all, or at least most, liability.

The monster’s origin is the 1980 Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA or “Superfund”), which gave the U.S. Environmental Protection Agency (EPA) the authority to respond to human health and environmental hazards posed by hazardous substances at real property. EPA was given the choice of either “enforcement first,” requiring that liable parties conduct the cleanup, or conducting the cleanup themselves and subsequently seeking cleanup costs from liable parties. As a side note, many Superfund-type cases are managed by state agencies under state CERCLA counterparts, which may vary from the federal liability scheme in key ways, including different definitions for owner and operator and modifications to the secured creditor exemption discussed below.

Under the federal CERCLA liability scheme, the current owner(s) and/or operator(s) can be required to conduct this cleanup or be held jointly and severally liable for EPA’s costs associated with this cleanup. The owner and/or operator may then seek contribution, often using their own funds, from past persons who owned or operated the property at the time of disposal of hazardous substances and persons who arranged for the disposal, the treatment, and/or the transportation of hazardous substances that contributed to the contamination, if they can be located and are solvent.

CERCLA defines the term “owner or operator” broadly to mean “any person owning or operating” a facility. See CERCLA Section 101(20)(A). For example, an LIHTC investor in an affordable housing project may hold the majority interest in the limited partnership, which is the real property owner, or in the master tenant entity with a long-term lease on the real property. In the former, the investor may be held liable as an “owner,” even if it did not place the hazardous substances on the site or contribute to their release. In the latter scenario, if that master tenant exercises control over the site by managing, directing, or conducting operations and/or if it directs a contractor to move around contaminated soil during the construction process, it may be held to be an “operator” and thereby liable for environmental liabilities. Similarly, a developer could be held liable as an “owner” or “operator” due to its interests or actions on the site.

In short, lenders, developers, and other involved parties may be interpreted to be an “owner” or “operator” depending on the transaction’s structuring and, specifically, depending on the amount of security and control the party has over the real property at issue.

Coming to save the day is the “secured creditor exemption” from liability found at Section 101(20)(A) of CERCLA. The provision specifically excludes from the definition of an “owner or operator” any “person, who, without participating in the management of a … facility, holds indicia of ownership primarily to protect his security interest in the … facility.” A party “participates in management” if the party exercises decision-making control regarding environmental compliance related to the facility and, in doing so, undertakes responsibility for hazardous substance handling or disposal practices; or exercises control at a level similar to that of a manager of the facility and, in doing so, assumes or manifests responsibility with respect to day-to-day decision-making on environmental compliance, or all, or substantially all, of the operational (as opposed to financial or administrative) functions of the facility other than environmental compliance. See 42 U.S.C. § 9601(20)(F)(i)-(ii). Therefore, it is very important that a party not “participate in management” of the real property. Of course, this is more easily said than done, especially in a foreclosure scenario where a lender will often be forced to participate in management activities and lose the “secured creditor exemption,” allowing it to be held jointly and severally liable for remediation costs.

Thus, the first step is avoidance—make sure the real property you are lending money to, developing, or assuming ownership in either has none or minimal contamination or, if there is some residual contamination, that the appropriate mechanisms are in place to protect against potential liability. A party avoids this liability, first and foremost, by conducting an All Appropriate Inquiry (AAI). Conducting an AAI allows an owner, developer, and/or lender to escape strict liability for the costs of remediation by claiming the “innocent purchaser” defense. To qualify for this defense, the party must be able to satisfy the AAI requirements, analyzing the previous ownership and uses of the property prior to its acquisition. What this means is that a certified environmental professional must conduct an environmental site assessment, also known as a Phase I, to meet the primary industry standard, which, as of Oct. 6, 2015, will be the American Society for Testing and Materials (ASTM) Standard Practice E1527-13. As in all professions, there is a level of expertise among professionals, so it is very important that an environmental lawyer review and verify that the Phase I meets the standard and raises any concerns that may have been missed by the consultant. That same lawyer can then brief you about the sufficiency of the report, the remaining environmental risks, and the liability precautions available. In short, a little up-front work before the deal is financed, may open up options, protect against risk, and save a lender millions later. In other words, a little environmental due diligence may just keep that monster in the closet.

Alison B. Torbitt is in the Energy and Environmental practice group at Nixon Peabody. She works in the law firm’s San Francisco office.