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Environmental Indemnity or Waste of Words?

On November 12, 2013, the First Circuit Court of Appeals handed down its decision in VFC Partners 26, LLC v. Cadlerocks Centennial Drive, LLC, slip op. (1st Cir., 2013). This decision serves as a reminder that courts will look carefully at the words used in a loan agreement’s environmental indemnity provisions to decide whether or how they apply. If the actual wording chosen (likely many years earlier) does not fit the environmental costs sought to be indemnified, the party pursuing indemnity may be greatly disappointed.

Cadlerocks rests on the interpretation of an Environmental Indemnity Agreement which was part of 1999 commercial loan package. The original lender (predecessor to the loan servicer who filed the instant court action) and the borrower negotiated the indemnity provisions with knowledge that environmental contamination might exist on the property, but without actually investigating the environmental status of the site. The Massachusetts district trial court used the indemnity provisions to hold the borrower/guarantor responsible for approximately $100,000 in costs from two Phase II Environmental Site Assessments (ESAs) and five rounds of indoor air sampling at a property contaminated with tetrachloroethylene (a/k/a perchloroethylene or PCE). The loan servicer had incurred the costs first, to confirm the presence and extent of PCE after a 2010 Phase I ESA again suggested the possibility of contamination, and second, in compliance with the Phase II ESA contractors’ follow-up advice regarding indoor air quality assessments because the property was used as a child day care center.

After examining the environmental indemnity provisions in depth, the First Circuit’s Cadlerocks court reversed the trial court. The appellate court summarized the environmental provisions (at page 8) as follows:

“The Indemnity Agreement provides in relevant part that Cadle and Cadlerocks would indemnify the Original Lender and its assignees and successors (“Indemnitees”) ‘from and against all . . . costs, . . . demands, . . . expenses’ and other liabilities “of any kind or nature whatsoever . . . sought from or asserted against Indemnitees in connection with, in whole or in part, directly or indirectly, . . . the presence, suspected presence, release, suspected release, or threat of release of any Hazardous Material” on or around the Property.[] It further specifies that ‘[s]uch Liabilities shall include’ seven particular categories of liability, only one of which is arguably applicable here: ‘the cost required to take necessary precautions to protect against the release of any Hazardous Materials in, on, or under the Property, the air, any ground water, waterway or body of water, any public domain or any surrounding areas to the Property.’

Based on this language, the Cadlerocks court determined that the “sought from or asserted against” wording limited the scope of the indemnity obligations to third-party claims (see page 11). Because the costs of the initial Phase II and the first two indoor air sampling events were intended to address the loan servicer’s own concerns regarding the environmental condition of the property, these costs were not covered by the indemnity obligation.

The First Circuit then concluded that the remaining costs were not incurred “to protect against the release of any Hazardous Materials,” and so, again, were not covered by the indemnity (see page 16). The second Phase II ESA and repeated indoor air sampling events had confirmed the presence of already-released PCE at the site, but at levels which did not require any future action and did not create a health risk or threat of future release. Although the Court specifically noted that the investigation and testing was reasonable from a business perspective and probably necessary to market and transfer the property, these activities were not intended to protect against a PCE release and so were not properly subject to the indemnity obligations of the loan agreement.

So, what are the take-aways from the First Circuit’s Cadlerocks opinion? We can suggest at least two. First, when negotiating environmental indemnity language, try to ensure that that the words chosen actually cover the scope of indemnity agreed to by the parties and anticipate the reality that facts and circumstances may change over time. Second, when reviewing an indemnity obligation after the alleged “trigger” event has occurred, again scrutinize the actual words contained in the document before concluding that the event is or is not covered by the indemnification. Spencer Fane’s Environmental Practice Group routinely assists and advises clients in drafting environmental indemnity language and similar provisions in Stock Purchase Agreements, Asset Purchase Agreements, loan agreements, and related contracts.