Market Insight: Guest Articles
A Tenant’s Practical Guide to Managing the Risk of Terrorism
by Douglas Van Gessel, Esq.
The unprecedented nature and magnitude of the September 11 terrorist attacks on the World Trade Center will result in some very significant changes in the real estate and the insurance industries. For a tenant of commercial space, whose lease often gives the landlord the right to make all decisions regarding property management issues, including changes to building security, property insurance and repair of the building—at the tenant’s expense—it will be important to bargain for some level of control over the magnitude of such changes so as to avoid bearing the full cost of unnecessary or inappropriate changes. The chief concerns of tenants will be: (i) the greatly increased costs of insurance (both the payment of their own insurance premiums and reimbursement of their landlords’ premium costs); (ii) the impact of a reduction in available insurance coverages on the ability of landlords and tenants to perform various basic obligations created by their leases; and (iii) the need to work with their landlords to develop a sensible and cost-effective approach to improving building security. Each of these concerns is further discussed below.
- Increased Insurance Premiums. The September 11 attacks resulted in claims made on a broad array of insurance policy types: liability, property, rental abatement, worker’s compensation, employer’s liability, construction risk and automobile insurance. As a result, landlords and tenants can expect the premium cost for each of these types of insurance policies to increase.
- Insurance Required of Tenant. A lease typically requires the tenant to carry: (i) anywhere from $1,000,000 to $10,000,000 in general liability insurance; (ii) property insurance equal to the replacement value of the tenant’s personal property and alterations to the premises; (iii) worker’s compensation insurance; and (iv) possibly, automobile and/or business interruption insurance. Sometimes a lease allows the landlord to require additional amounts or types of insurance upon the landlord’s request. A tenant should work closely with its insurance brokers or risk management department to price its insurance options, and should resist the landlord’s request for additional insurance unless the request is reasonable or the tenant intends to obtain such insurance anyway. A larger tenant may wish to bargain for the right to self-insure, or insure through blanket coverage, in order to control its insurance costs.
- Insurance Required of Landlord. A lease typically requires the tenant to reimburse the landlord for a pro-rata share of the premiums associated with the landlord’s property insurance (on the building shell, core and tenant improvements), liability insurance, rental abatement insurance and any other insurance carried by the landlord relating to the building. Unfortunately, a tenant seldom has any control over the amount and type of insurance carried by the landlord, which are usually set by the landlord or the landlord’s lender. Thus, a tenant usually writes something of a blank check for such insurance premiums. A tenant should at least consider discussing any increase in existing premiums with its landlord. In single tenant leases, a tenant might negotiate approval rights, agreed upon parameters, or expense caps on its landlord’s insurance premiums. A tenant might consider investigating whether it can obtain such insurance on behalf of its landlord if the tenant can do so at less expensive premiums.
- Pass-Through of Deductible. It is very likely that the deductible portions under insurance policies will also increase, unless significantly higher premiums are paid for the related policies. Increases in deductibles may affect a tenant in two ways. First, many leases require that the deductible portion of the tenant’s insurance policy not exceed a certain amount. A tenant should make sure that its insurance deductible does not violate the applicable maximum amount. Second, landlords typically pass through the deductible portion under their insurance policies to their tenants as an operating expense. The pro-rata share of the deductible charged to larger tenants could be quite substantial. A tenant might consider negotiating a cap (as a percentage or absolute amount) on the amount of its landlord’s deductible that the tenant is obligated to pay and/or provide for an amortization schedule for payment of the deductible to the landlord over the remaining term of the lease, thus lessening the immediate effect on the tenant’s cash flow.
- Reduction in Available Coverage. The Insurance Services Office (ISO) and reinsurance industries are already far into the process of modifying standard form property and liability insurance policies to, among other things, create an exception to coverage for terrorist events and expand the existing “pollution” exceptions to coverage to include anthrax and other bioterrorist substances, resulting in a lack of insurance coverage for such events. In order for those policy changes to become effective, the insurers must file such proposed exceptions with the insurance department of each state in which they conduct business. When new reinsurance contracts are issued to insurance companies on January 1, 2002, any insurance carriers not already creating such exceptions to coverage will surely file for such exceptions. Ultimate approval of those exceptions probably will not occur until the states see the final reaction of the federal government to the events of September 11. The following provisions of a typical lease are most likely to be affected by such potential exceptions:
- Damage and Destruction.
- Tenant’s Obligation to Rebuild Alterations. A commercial lease typically requires the tenant to rebuild tenant’s alterations (e.g., tenant improvements) made to the tenant’s premises after an event of damage or destruction. Since, presumably, a tenant will look to its property insurance in order to obtain the proceeds to accomplish such rebuilding, the tenant should spend some time with its insurance broker or in-house risk management department to ensure that there are no recent reductions or eliminations of coverage which might prevent the tenant from receiving the necessary proceeds to rebuild its alterations.
- Landlord’s Obligation to Rebuild Building Shell, Core and Tenant Improvements. A commercial lease frequently provides that a landlord is not obligated to rebuild the building shell, core or tenant improvements to the extent that (i) they are injured by an event of damage or destruction which is not covered by insurance, or (ii) the landlord does not receive sufficient proceeds from the insurance company to cover the full cost to repair the damage. In other instances, a lease may provide that a landlord is obligated to rebuild, but only to the extent of the insurance proceeds that it receives. It is important for tenants to realize that potential new reductions in available insurance coverage may result in reduced restoration obligations of landlords to the extent that the reductions in available insurance coverage trigger any of the lease provisions described above. Therefore, a tenant should negotiate for either (a) a lease covenant that the landlord will carry property insurance covering all risks covered by a “special purpose” policy at commercially reasonable premiums, or (b) the right, in the event that the landlord’s insurance proceeds are insufficient, to prevent the landlord from terminating the lease by paying the shortfall in insurance proceeds and offsetting such amounts against future rents due under the lease.
- Tenant’s Ability to Terminate Lease Due To Casualty. While a commercial lease typically provides a landlord with the right to terminate a lease if the building is sufficiently damaged by a casualty, tenants frequently do not obtain such a right. While landlords and/or their lenders often resist tenant termination rights, a tenant should negotiate for the right to terminate a lease soon after the occurrence of a significant casualty event if it is clear that the damage cannot be repaired promptly. The tenant’s initial termination right should be supplemented by a later right to terminate the lease if the damage is not repaired by landlord in the time period agreed upon by the parties in the lease. Finally, if the damage occurs during the last 18 months of the lease term and is significant (i.e., will take longer than 60 days to repair), the tenant should have the right to terminate the lease in any event.
- Effect on Rental Abatement. A tenant should recognize that a lease frequently provides that if the premises are damaged by casualty and are unusable, then the tenant’s rent abates only to the extent that the landlord receives the rent for the premises under landlord’s rental abatement insurance. Since payments under rental abatement insurance are only made by the insurer if the relevant casualty is itself an insured event, such a provision creates a substantial injustice if the tenant cannot use the premises but must continue to pay rent because the casualty is not an insured event. A tenant should negotiate for an absolute abatement in rent if the premises are unusable, regardless of the availability of rental abatement insurance.
- Allocation of Risk Provisions. A tenant should realize that the typical landlord is a limited partnership or limited liability company whose sole asset (and source of income) is the building in which the premises are located. Thus, when a landlord covenants to perform its obligations under the lease or to indemnify the tenant, those covenants are only valuable to the tenant to the extent landlord has sufficient equity in the building, the building is in good condition and producing revenue, or the landlord maintains adequate insurance-otherwise, the tenant may have no effective remedy. Therefore, a tenant should take into account the effect of inadequate insurance on the following typical lease provisions:
- Indemnities. It is typical for a commercial lease to provide that the tenant indemnifies and holds harmless the landlord with respect to events such as personal injuries and damage to property in the premises, regardless of whether the injuries or damage are caused by the tenant, or by third parties other than the landlord. Often, the landlord indemnifies and holds harmless the tenant for such injuries or damage occurring in the hallways or other common areas. Such indemnity claims are almost always handled by tendering the claim to the relevant party’s (i.e., tenant’s or landlord’s) insurance company. However, if there are gaps in the insurance coverage maintained by the indemnifying party, then such claims must be handled, and paid for, by the indemnifying party itself. A tenant should ensure that there are no gaps (other than the standard policy exclusions) in its insurance policies which would render the tenant’s indemnities uninsured, thereby requiring the tenant to come out of pocket for amounts that are payable under its indemnities. A tenant should negotiate a requirement in the lease that the landlord carry sufficient insurance with appropriate coverages so that there are no gaps (other than the standard policy exclusions) in landlord’s insurance policies that would render the landlord’s indemnities uninsured.
- Waiver of Subrogation. Most lease forms provide that both the landlord and the tenant should obtain for each other’s benefit a waiver of subrogation from their respective insurance companies. This is an agreement by the insurance companies not to step into the shoes of the insured party and sue the party who acted wrongfully in order to recover any insurance proceeds paid as a result of the judgment. In previous turbulent times, insurance companies have discussed eliminating such waivers or charging additional premiums for them. A tenant should make sure that its landlord’s insurance policies include such waivers in order to protect the tenant from potential future lawsuits from the landlord’s insurer.
- Damage and Destruction.
- Need for New Security and Obligation to Pay. In the wake of the events of September 11, many landlords have significantly increased the security precautions for their buildings. Such increases have commonly come in the form of increased security guards, the installation of barriers and additional security checks. Other owners are pursuing yet more ambitious agendas, including monitoring electronic communications, mail and other deliveries coming to and from their buildings and reconfiguring parking garages. While, generally speaking, many tenants have been appreciative of such efforts and are willing to pay the additional common area maintenance charges associated with them, most tenants have little to no control over how their landlords choose the additional security measures and the commensurate costs of such additional security measures that are passed through to the tenants as common area maintenance charges. Although small occupants of multi-tenant buildings are unlikely to have an active say in such matters, the resulting costs from additional security measures should be rather slight for such smaller tenants. For larger tenants, or single tenant occupants, it may be useful for such tenants to communicate their preferences to building management or, in the case of new leases, to negotiate in the operating expense pass-through section for some sort of cap or limitation on the types of security precautions that may be introduced at the tenant’s expense.