Factoring Enviromental Issues into Banking Decisions: The Role of ISO 14001

Thea D. Dunmire

The environmental issues factored into banking decisions are changing. With the specter of multi-million dollar CERCLA liability, and the intense pressure from environmental groups on international banks to proactively consider environmental issues in their lending decisions, banks are changing the way in which they factor environmental issues into financing decisions. Banks are shifting from a narrow focus of establishing an "innocent landowner defense" at the time of financing to a broader focus of ensuring the borrower’s long-term environmental compliance by requiring environmental management plans or systems, such as ISO 14001. This evolution to a broader focus may provide greater protection to lenders in a cost-effective manner.

Environmental Practices in United States Banks

Today, most United States banks consider environmental factors in their decision-making process for commercial loans by determining whether the collateral property is environmentally contaminated at the time the loan is made. This determination is usually based on the results of a Phase 1 Assessment prepared by an environmental consultant.

In the American banking world, a Phase 1 Assessment means an environmental site assessment performed in accordance with ASTM Standard E1527 Standard Practice for Environmental Site Assessments: Phase 1 Environmental Site Assessment Process. This ASTM standard describes how an environmental assessment is to be performed and specifies the content and format of Phase 1 Site Assessment Reports. Generally, a Phase 1 Site Assessment evaluates the potential for environmental contamination of the property and surrounding properties based on information gathered from government databases and files, interviews of site personnel and a site visit.

However, a Phase 1 Assessment performed in accordance with the ASTM E1527 Standard has a limited scope. It is designed solely to satisfy one of the requirements to qualify for the "innocent landowner defense" to CERCLA liability. That is, it is to constitute "all appropriate inquiry into the previous ownership and uses of the property consistent with good commercial or customary practice" as provided in 42 U.S.C. § 9601(35)(B). An ASTM Phase 1 Site Assessment is not intended to address all environmental, safety and health concerns which may exist on a particular piece of property, such as whether a company has all of the environmental permits required to continue operating.

As banks have become more sophisticated about environmental issues, many have concluded that focusing solely on the condition of collateral property prior to the establishment of a banking relationship does not provide sufficient assurances. First, environmental issues that are not included in a Phase 1 Assessment can cause serious financial impacts later on.

Second, and more importantly, environmental conditions change continuously. Simply because no environmental concern exists when a loan is initially made, there is no guarantee environmental problems will not develop in the future. Business operations change; environmental conditions evolve; regulatory priorities change. All of these changes impact the environmental status and ultimately, the financial viability of a borrower’s business.

As a result, banks have developed additional mechanisms for monitoring the environmental status of their borrowers. These additional mechanisms fall into three categories: 1) requesting that potential borrowers provide additional information about their environmental issues; 2) adding language into the bank’s loan documentation package to require borrowers to inform the bank about environmental issues on an on-going basis, and 3) establishing periodic reviews of the borrower’s environmental programs.

Each of these mechanisms has limits. First, having additional information reviewed by an outside consultant can be costly. Furthermore, if this review is only done when the loan is made, it does not address the need for assurances on an on-going basis. Adding language into the bank’s loan documentation package to require that all environmental records be provided on an on-going basis can act as a disincentive to borrowers who find such additional requirements burdensome. More importantly, requesting additional information on an on-going basis or establishing periodic environmental reviews can quickly inundate the bank with documentation, much of it extremely technical in nature.

It is an open question how cost-effective these various mechanisms are in addressing the environmental concerns raised in commercial lending. What is clear is that they do not necessarily promote the development of sound environmental management practices.

Environmental Practices in the World Bank

The World Bank’s policy concerning environmental issues has changed dramatically in the past two decades. In the past, projects funded by the World Bank caused significant environmental damage. Today, the World Bank expressly considers environmental sustainability in its lending decisions and specifically targets funds to improve environmental conditions in developing countries; its portfolio of such projects amounts to some $15 million.

One item considered by the World Bank in its lending decisions is whether the potential borrower has an environmental management system ("EMS") that conforms to ISO 14001. "The implementation of an EMS, and particularly of the ISO 14000 system, is seen as a way to demonstrate an acceptable level of environmental commitment." (Environmental Management Systems and ISO 14000, Pollution Prevention and Abatement Handbook, World Bank Group effective July 1998).

Increasing Reliance on ISO 14001

The World Bank’s use of environmental management plans or systems, such as ISO 14001, to demonstrate sound environmental practices on the part of its borrowers is consistent with the initiatives of other entities. On September 21,1999, both Ford Motor Company and General Motors issued press releases stating that their suppliers would be required to have ISO 14001 environmental management systems in place within three years – by July 1, 2003 for Ford Motor Company suppliers and by December 31, 2002 for General Motors. U.S. EPA has developed several guidance documents dealing with environmental management systems and is examining what role ISO 14001 certification should play in its enforcement strategies.

ISO 14001 is a different approach to dealing with environmental issues than the compliance-focused approach of the past. It focuses on managing environmental issues just as a company manages the other important facets of its business such as product quality, operational productivity and financial responsibility. Although a company can self-certify its conformance to ISO 14001, most companies seek certification by a third-party registrar for additional credibility. Third-party registration requires that an independent certified auditor evaluate the effectiveness of the company’s environmental program. This registration process is similar to the independent evaluation that certified public accountants perform in evaluating the financial systems of a company.

The ISO 14001 standard has eighteen substantive sections which outline the requirements a company must meet to achieve registration. ISO 14001 requires that the company have a written environmental policy. To conform to ISO 14001, the company must develop a comprehensive environmental management program. As part of this program the company must identify its environmental aspects and the legal requirements triggered by its activities, products, or services. It must establish documented environmental objectives and targets. Procedures must be developed to train employees, to deal with operations with significant environmental aspects and to measure and monitor its operations with environmental impacts. The company must periodically audit its program and establish a procedure to correct any deficiencies found. Environmental documents and records must be maintained in accordance with established procedures. Top management must define environmental responsibilities and review the environmental management system on a periodic basis.

United States banks are just beginning to realize the important role ISO 14001 certification can play in their lending decisions. They are recognizing that companies who have achieved ISO 14001 certification are more likely to have dealt effectively with their environmental issues. ISO 14001 requires top management commitment to regulatory compliance and pollution prevention. ISO 14001 certification also provides a mechanism for an independent third-party review of a borrower’s environmental program without the bank having to expend additional money or impose on its loan officer’s time for environmental reviews.

In addition, provided the company maintains its ISO 14001 certification, periodic reviews of the company’s environmental program will continue to be done in the future at no cost to the bank. Under the rules that govern ISO 14001 registration companies, companies must demonstrate conformance to the ISO 14001 Standard on an on-going basis in order to keep their certification.

As the World Bank has found, public pressure will continue, and probably increase, for environmental issues to play a more prominent role in lending decisions. As government agencies increasingly focus on the importance of environmental management systems, this trend for promoting sound environmental management through lending decisions will no doubt continue to grow. One solution for banks is to use ISO 14001 certification in their lending decisions.

Thea D. Dunmire is the President of ENLAR Compliance Services, Inc. and author of Legal Pitfalls on the Path to ISO 14001 Registration. Expanded information about the use of ISO 14001 in lending decisions can be found at http://www.ENLAR.com.