Financial Services Report: Spring 1998

FTC to Audit Bank Web Sites

Lenders and Sellers Beware: Pitfalls for the Unwary Under California Code of Civil Procedure Section 580b

California law now provides lenders with significant protection against liabilities for hazardous materials on the real property of a borrower. Effective January 1, 1997, a newly enacted Chapter 6.96 of the California Health and Safety Code ("Chapter 6.96") largely insulates lenders from liability for cleanup costs and damages associated with a borrower's contaminated property, provided certain conditions are satisfied. The new law covers not only the originating lender, but those who acquire or service a loan. It shields lenders from various types of liabilities under state and local laws, including cleanup orders, fines, compensatory and punitive damages, and actions for cleanup cost recovery.

Lenders familiar with the new federal law on lender liability will recognize many of the concepts present in Chapter 6.96; the California law essentially copies the main provisions contained in the federal law. The most obvious similarity is the condition in both laws that lenders must not "participate in the management" of a borrower in order to remain eligible for protection.

Conditions of Eligibility

There are many nuances to Chapter 6.96; the following provides a few highlights of the major provisions:

The concept of "participation in management" under Chapter 6.96 and federal law grew out of cases under the federal Superfund law which attempted to distinguish between innocent lenders and those which should be held liable by virtue of "operating" the enterprise associated with the hazardous materials contamination. As embodied in Chapter 6.96, this condition of eligibility requires that lenders restrict their activities to lending and loan policing, as opposed to operational control of the borrower's business. Specifically, the term "participation in management" means the exercise of actual decision-making control over the environmental affairs of the borrower, or over substantially all of the operational aspects of the borrower's enterprise.

In contrast, the term "participation in management" as defined in Chapter 6.96 specifically excludes: i) an act or omission prior to making, acquiring or holding a loan; ii) undertaking or requiring an environmental inspection; iii) requiring the borrower to remediate the property or come into compliance with any applicable law; iv) loan policing activities, including inspecting the property or requiring the borrower to comply with the terms of the loan; v) loan work-out activities, including restructuring or renegotiating the loan, requiring additional payments, exercising forbearance, providing financial or other advice, or exercising other rights under the loan; and vi) undertaking a necessary environmental response action. In this fashion, the new law gives lenders the ability to closely monitor a borrower's environmental compliance without fear of incurring liability itself.

Another important condition of eligibility in the new law is strict compliance with specific post-foreclosure procedures. Upon foreclosure, a lender must divest itself of a contaminated property "reasonably expeditiously" using "commercially practicable" means. Generally speaking, if the lender lists the property with a broker or advertises the property in a suitable publication within 12 months, and does not outbid, reject or fail to act upon an offer of fair consideration, it will satisfy this requirement.

In addition to expeditious divestiture, Chapter 6.96 requires lenders to undertake a number of affirmative measures when necessary after foreclosure. For example, the lender must suspend activities in an area of a suspected hazardous materials release, secure the release, and make the appropriate notifications. A lender must also comply with any operation and maintenance requirements previously established under a state cleanup order. This could obligate the lender to carry on groundwater monitoring in certain situations. A foreclosing lender must also take care to comply with all disclosure requirements pertaining to the property to remain protected under Chapter 6.96. The most relevant of these is found at Health and Safety Code section 25359.7, which requires a property owner to notify purchasers and lessees that hazardous materials have come to be located at the property.

Exclusions

There are certain liabilities against which Chapter 6.96 does not shield lenders. Again, the following illustrates just some of the major issues.

Lenders are not protected under Chapter 6.96 from liability that may attach under the California Hazardous Waste Control Law ("HWCL"), the state equivalent of the federal Resource Conservation and Recovery Act ("RCRA"). The HWCL, like RCRA, regulates the handling of "hazardous wastes," a specially regulated category of materials. In light of this exclusion, lenders should take particular care in due diligence to identify borrower properties where HWCL-regulated activities are occurring. While these properties should not be automatically excluded from loan consideration, they do warrant heightened scrutiny.

Another area of liability excluded from Chapter 6.96 is liability where the lender "made, secured, held, or acquired the loan primarily for investment purposes." There is no California state guidance on the scope or meaning of this exclusion. However, the language of the exclusion is identical to the language in federal law on lender liability. The federal EPA's guidance on lender liability indicates that the "investment purposes" exclusion normally would not apply to lenders who purchase loans in the secondary market. Instead, EPA cites the example of a foreclosing lender seeking a resale price for the property that is greater than that which it is entitled or otherwise obligated to obtain. EPA views such behavior as "investment" rather than the protection of a security interest.

Chapter 6.96 also contains a number of exclusions that should not affect lenders, save under unusual circumstances. Among these are an exclusion for gross negligence in conducting a cleanup, causing or contributing to a release, transporting hazardous substances, or structuring a loan to evade liability. All of these should not pertain to normal lending activities.

In conclusion, lenders should derive significant comfort from the new protection against liability under California law. With a good bit of due diligence and attention to the requirements of Chapter 6.96, lenders should be able to steer clear of most hazardous materials liabilities.

FTC TO AUDIT BANK WEB SITES
Jonathan B. Wilson

The FTC has been auditing the Internet web sites of various companies, including banks and financial institutions. The FTC's audit, which was announced in a press release in late February, springs from the FTC's Public Workshop on Consumer Privacy on the Global Information Infrastructure. (See Footnote 1.)

Most of the FTC's concerns are based on consumer privacy. Software programs exist (sometimes called "cookies") that allow web site operators to collect the Internet addresses of persons who visit their sites. These Internet addresses can be compiled into electronic mailing lists and sold to Internet advertisers, who can send unsolicited advertisements to the email accounts of persons on the list. This practice (sometimes called "spamming") has been a source of frustration and complaints from many Internet users.

Any future FTC regulations concerning the commercial use of Internet sites, and the collection of consumer data, could have a significant impact on the commercial development of the Internet. As FTC Chairman Robert Pitofsky noted in a recent speech, commerce on the Internet almost doubled from between $500 million to $750 million in 1996 to between $800 million and $1.5 billion in 1997. (See Footnote 2.)

Much of the commercial success of the Internet over the last few years can be attributed to the relative lack of regulation of Internet activities. With the growth of Internet commerce, however, concerns have arisen regarding the potential for fraud and abuse. Some have argued that existing laws, including existing FTC regulations regarding unfair and deceptive practices, do not adequately protect against fraud on the Internet.

The FTC's audit of commercial web sites springs from many of the statements made by commercial web site operators that they will begin to place privacy notices on their web sites. These privacy notices will alert users to the manner in which the web site operators may utilize the personal information of users, if at all. Two organizations have made claims regarding self-regulation, including the Individual Reference Services Group ("IRSG") and the Direct Marketing Association. (See Footnote 3.)

Their privacy policies, generally, require participating members to notify web site visitors how, if at all, their electronic information may be collected and used. The Direct Marketing Association's policy also requires that consumers have the ability to elect not to have their information used for future commercial solicitations.

The FTC is likely to summarize the results of its audit in a report or testimony to Congress in the summer of 1998. It remains to be seen how Congress and the public will react to this information and whether that reaction will prompt calls for regulation of the use of consumer data on the Internet.

1/ Staff Workshop on Consumer Privacy on the Global Information Infrastructure, (December, 1996) (available at http://www.ftc.gov/reports/privacy/privacy1.htm). return

2/ Speech of Robert Pitofsky at Cyberbanking and Electronic Commerce Conference (February 2, 1998) (available at http://www.ftc.gov/speeches/pitofsky/rpfeb298.htm). return

3/ Id. return

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LENDERS AND SELLERS BEWARE: PITFALLS FOR THE UNWARY UNDER CALIFORNIA CODE OF CIVIL PROCEDURE SECTION 580b
Shelly J. Darby

Anyone familiar with California's antideficiency statutes knows that many obstacles bar real property lenders from pursuing a deficiency judgment against a borrower after foreclosure. Additionally, ambiguity in the depression-era antideficiency legislation has led to unpredictable application of these statutes by the courts in nonstandard or sophisticated lending transactions. It is therefore crucial that lenders recognize potential pitfalls before either committing to loans that are riskier than they appear, or foregoing legitimate opportunities to pursue deficiency judgments against defaulting debtors. In particular, section 580b of the California Code of Civil Procedure, which bars deficiency judgments in many purchase money transactions, can trap the unwary lender or seller in a nonstandard transaction.

Section 580b Protection

In addition to broadly restricting deficiency judgments on residential properties, 580b restricts a seller of real property who finances any part of its purchase price from pursuing a deficiency judgment on that obligation. The classic scenario involves a buyer who finances the purchase of residential or commercial property with a bank loan and a note secured by a second trust deed carried by the seller. When the bank forecloses, the seller finds he is not only a "sold out" junior lienholder, but also barred by 580b from pursing the buyer for the deficiency.

Examples under 580b

Following are a few examples of nonstandard transactions and the somewhat surprising consequences under 580b:

• The seller of Parcels A and B assists the buyer in financing Parcel B by taking a note secured by a second trust deed on Parcel A; eventually the senior lienholders foreclose on both Parcels. The seller avoided 580b by placing the trust deed for Parcel B purchase money on Parcel A, right? Wrong. Even though the second trust deed on Parcel A did not secure the purchase of Parcel A, the courts have characterized it as a purchase money transaction and barred a deficiency judgment.

  Lesson learned: Securing a note representing purchase money with a trust deed on property other than the property purchased does not change its character as a purchase money trust deed.

• A seller, X, conveys commercial real property to Buyer A and takes back a junior trust deed, eventually holding a first trust deed when other loans are extinguished. When Buyer A begins having trouble, he finds Buyer B to take over the property. X, now holder of a first trust deed, accommodates the deal between A and B by taking cash and a note secured by a second trust deed on the property in satisfaction of A's original obligation. When the senior lienholder later forecloses, X pursues the deficiency under the second trust deed, believing he is essentially a third-party lender on a commercial property with respect to the second transaction. Unfortunately for X, a court characterized him as a seller and barred the deficiency action even though he did not own the property when he took the second trust deed.

  Lesson learned: A lender who is a necessary party to a sale can be characterized as a seller under 580b even if he does not own the property when the trust deed is created.

Fortunately, a seller or lender is not always barred from pursuing a deficiency judgment in a nonstandard transaction. For instance, where a seller takes back a note secured by a trust deed and agrees to subordinate it to a construction loan, the seller is not barred from pursuing a deficiency judgment against the buyer in the event the construction lender forecloses. The rationale: the courts have said that where the use of the property substantially changes, and therefore the future value of the property is particularly speculative, the risk of development should fall on the developer, not on the seller. In this example, both the construction lender and the second trust deed holder would be able to pursue a deficiency against the buyer.

These are only a few examples, but they illustrate the important point that form may not prevail over substance when it comes to a court's characterization of a transaction under 580b. Even a carefully crafted lending arrangement can fail to achieve its objective of providing maximum protection for a lender or seller.

Therefore, it is incumbent upon sellers and lenders to consider the applicability -- or inapplicability -- of section 580b under the particular circumstances of each and every real estate financing opportunity before the true risk involved can be assessed.