10 INSURANCE PROBLEMS IN COMMERCIAL REAL ESTATE LEASES (AND HOW TO FIX THEM) By Jay Radov, Pegasus Insurance Consulting, Inc. – December 2009 A prospective tenant’s commercial real estate lease is a major factor in determining that tenant’s entire insurance program. A business cannot be properly insured unless the provisions in the executed lease are consistent with the commercial insurance policies of the tenant. Since the tenant’s insurance policies are usually in force BEFORE the proposed lease is executed, the best way to protect the interests of the prospective tenant is to make sure that the proposed lease (a) is not inconsistent with the prospective tenant’s existing insurance policies; (b) does not impose unnecessary financial costs, in terms of requiring more coverage or additional policies, upon the prospective tenant; and (c) does not expose the prospective tenant to additional potential liability – which might be insurable only at an excessive cost or completely uninsurable. Commercial real estate leases frequently use language that is outdated, PROBLEM # 1: ambiguous and irrelevant. Ten (10) examples of such language include the following: 1. fire and extended coverage or extended coverage endorsement 2. full insurable value 3. public liability insurance 4. contractual liability insurance 5. additional named insured, named insured, or coinsured 6. cross liability endorsement 7. broad form comprehensive general liability endorsement 8. broad form property damage endorsement 9. commercial general liability policy with a combined single limit of $_________ 10. boiler and machinery insurance For example, some of the above language appears in these actual clauses of leases: a. At all times during the term, Tenant will carry and maintain fire and extended coverage insurance covering the Premises; Page 1 of 16 b. Tenant shall keep in full force and effect during the Term a policy of general accident and public liability insurance with respect to the Premises and the area adjacent to the Premises and the business operated by Tenant with a combined single limit for bodily injury, including death, to any person or persons, and for property damages, of not less than One Million Dollars ($1,000,000); and c. Tenant agrees to keep said premises insured to the extent of its full insurable value. These outdated phrases and clauses create significant issues. Many businesses insure their property on a replacement cost basis with an 80% coinsurance clause. This provision means that as long as the business maintains insurance on its property equal to at least 80% of the full replacement cost of such property at the time of loss, the insurance company (a) will not impose a penalty when the business files a valid property insurance claim and (b) will pay the claim (up to the policy’s Limit of Insurance) on a replacement cost basis, without subtracting for depreciation. But what does “its full insurable value” (referred to above) mean? Does it mean: (1) that any coinsurance condition must be satisfied; (2) that actual cash value is not a permissible method of valuation; or (3) that the business must insure its property on a replacement cost basis with a 100% coinsurance condition? The current terminology for the 10 outdated, ambiguous and irrelevant terms SOLUTION # 1: found above is listed below: 1. basic causes of loss form; broad causes of loss form; or special causes of loss form 2. on a replacement cost basis and in an amount sufficient to satisfy the application of a ___% coinsurance condition 3. commercial general liability insurance 4. commercial general liability insurance 5. additional insured 6. included in commercial general liability insurance 7. commercial general liability insurance 8. commercial general liability insurance 9. commercial general liability policy with: (1) a general aggregate limit of $_________; (2) a products‐completed operations aggregate limit of $_________; Page 2 of 16 (3) (4) 10. subject to the general aggregate limit, a per person or per entity limit of $______ for Tenant’s personal and advertising injury liability; and subject to the general aggregate limit or products‐completed operations aggregate limit (whichever is applicable), an each occurrence limit of $______ for bodily injury and property damage liability and medical expenses. equipment breakdown insurance Unilateral waivers of subrogation should be avoided by the Tenant. PROBLEM # 2: Black’s Law Dictionary defines “subrogation” as “the right of one who has paid an obligation which another should have paid to be indemnified by the other.” Commercial liability and property insurance policies (except for workers’ compensation insurance policies and most “claims‐made” policies) permit policyholders to waive their rights of subrogation before a loss. The typical insurance policy provides that: If any person or organization to or for whom we [the insurance company] make payment under this Coverage Part [policy] has rights to recover damages from another, those rights are transferred to us [the insurance company] to the extent of our [the insurance company’s] payment. That person or organization must do everything necessary to secure our rights and must do nothing after loss to impair them. But you [the policyholder] may waive your rights against another party in writing: 1. Prior to a loss . . . (emphasis added). See the language in Section I. and in Section 8. of Exhibit 1 attached hereto. In virtually every lease, Landlord requires Tenant to waive subrogation. Typical language states that “All policies procured by Tenant shall contain an endorsement or clause containing an express waiver of any right of subrogation by the insurance company against Landlord.” 1 This provision is a unilateral waiver of subrogation because the lease only requires that Tenant waive subrogation. Hypothetical # 1: Most leases require that Landlord maintain, repair and replace the roof. Suppose Landlord’s employee negligently repairs the roof and after the next significant rain storm, water leaks from the roof and destroys $25,000 of Tenant’s business personal property. Tenant files a claim with its insurance company, which pays the claim after Tenant satisfies the $500 deductible. Tenant’s insurance company is prohibited from seeking the $24,500 (as reimbursement) from Landlord because Tenant waived its right of subrogation. 1
As noted previously on this page, workers’ compensation insurance policies are one exception in that they do not automatically permit the policyholder to waive its right of subrogation. Rather, such policyholder must ask its workers’ compensation insurance company for permission to waive subrogation. The decision whether or not to waive subrogation in workers’ compensation policies is thus up to the discretion of the workers’ compensation insurance company. Consequently, the waiver of subrogation clauses found in commercial leases should be modified to reflect this fact. Page 3 of 16 Hypothetical # 2: Suppose that Tenant’s employee, while laying cable in the premises, negligently drills into the building’s sprinkler system which results in $50,000 of water damage to the walls, ceiling and flooring of Tenant’s premises. Landlord files a claim with its insurance company, which pays the claim after Landlord satisfies its $1,000 deductible. Landlord’s insurance company then sues Tenant for indemnification of the $49,000 that Landlord’s insurance company paid to Landlord. Tenant should insist upon a mutual waiver of subrogation. If the lease had SOLUTION # 2A: contained a mutual waiver of subrogation, then Landlord’s insurance company would have been prevented from seeking indemnification from Tenant. (What is good for the goose is good for the gander.) A mutual waiver of subrogation requires both Landlord and Tenant to waive their rights of subrogation. A typical mutual waiver of subrogation might provide that: Landlord and Tenant each hereby waives subrogation and all of its rights of recovery against the other party and any other person or entity claiming subrogation or rights of recovery by, under, or through such other party. If Tenant cannot get Landlord to agree to a mutual waiver of subrogation 2 , then SOLUTION # 2B: Tenant must purchase a Legal Liability Coverage Policy 3 – a separate insurance policy, which obviously costs money – to protect itself. Commercial general liability (CGL) insurance policies provide liability coverage to Tenants when they act negligently and cause property damage by FIRE to premises rented to them. But the CGL provides no coverage for non‐fire perils when Tenants negligently damage the premises rented to them. 4 The Legal Liability Coverage Policy, however, does provide such coverage. In Hypothetical #2, Tenant’s employee negligently damaged the premises and the cause of loss was water – not fire. If fire had been the result, Tenant’s CGL would have provided coverage. But since water was the cause of loss, Tenant’s CGL does not provide any insurance coverage. Even if the lease contains a mutual waiver of subrogation, Tenant still faces PROBLEM #3: potentially catastrophic liability. 2
In a minority of states, the law provides that generally in a landlord‐tenant relationship, the landlord’s insurance company has no right of subrogation against the tenant, and thus automatically provides the desired landlord’s waiver of subrogation. See Sutton v. Jondahl, 532 P.2d 478 (Okla. Ct. App 1975). That is not the law in Maryland. See Rausch v. Allstate Insurance Company, 388 Md. 690, 882 A.2d 801 (2005), attached hereto as Exhibit 2. For a list of the law in each state on this subject, see Exhibit 3 attached hereto. 3
This type of policy is attached hereto as Exhibit 4. 4
The CGL provides in relevant part that “this insurance does not apply to: ‘Property damage’ to property you own, rent or occupy, including any costs or expenses incurred by you . . . [but that exclusion does] not apply to damage by fire to premises while rented to you or temporarily occupied by you with permission of the owner.” See the language in Section 2.j.(1) and at the end of Section 2.q. of Exhibit 5 attached hereto. Page 4 of 16 Hypothetical # 3: Suppose that Tenant occupies a suite in a multi‐story building and that Tenant’s employee negligently causes a fire in Tenant’s premises which then spreads to several other parts of the building. Suppose further that Tenant has $1,000,000 of liability insurance per occurrence; that Landlord has $10,000,000 of property insurance on the multi‐story building; that the actual damages to the building are $12,500,000; and that Landlord’s insurance company has paid Landlord $10,000,000 (Landlord’s Limit of Insurance) to repair and/or replace the damage. Because Landlord, in the lease, has waived its right of subrogation against Tenant, Landlord’s insurance company is prohibited from suing Tenant for any of the $10,000,000 that it, the insurer, has paid to the Landlord. However, Landlord’s actual damages are $12,500,000 – or $2,500,000 more than it has collected from its insurance company, and Landlord then sends Tenant a demand letter (and ultimately sues Tenant) seeking indemnification for the $2,500,000 in damages over and above the $10,000,000 that Landlord has already collected. Nothing in the lease has prohibited Landlord from seeking recovery over and above the payment made by Landlord’s insurance company. Tenant should include a (mutual) release of liability in the lease. An example of SOLUTION # 3: such language is the following: Landlord and Tenant hereby agree to release and hold harmless each other and any other person or entity claiming by, under, or through either or both of them, whether by way of subrogation or otherwise, from any and all liability, loss, claims, judgments, damages, costs, fees (including reasonable attorneys’ fees) , expenses, or responsibility suffered by such party, whether or not covered by any insurance, even if such liability, loss, claims, judgments, damages, costs, fees (including reasonable attorneys’ fees), expenses, or responsibility shall have been caused by the recklessness or negligence of the other party or any person or entity for whom such party may be legally liable. Whether or not Tenant can successfully add the above language to the lease will largely depend upon the bargaining strength of each party. If Tenant is not successful in having a (mutual) release of liability added to the PROBLEM # 4: lease, then the indemnification provisions of the lease must be very carefully written to limit Tenant’s liability. Four points need to be made regarding indemnification provisions in SOLUTION # 4: commercial real estate leases. If these four points are correctly addressed, then Tenant’s indemnification of Landlord will successfully limit Tenant’s potential liability. First, any indemnification provisions should be mutual and symmetrical. That is, Landlord should indemnify Tenant to the same extent that Tenant indemnifies Landlord. It is not the case that only Tenants (or their agents) can be negligent in ways that can impose liabilities, costs, damages and expenses upon Landlords for which Landlords would seek indemnification from Tenants. Landlords (or their agents) can also be negligent in ways that can impose liabilities, costs, damages and expenses upon Tenants for which Tenants would seek indemnification from Landlords. Page 5 of 16 Second, the indemnification language should be written so that Tenant only indemnifies Landlord for the negligent actions or omissions of (a) Tenant, (b) Tenant’s employees acting within the scope of their employment, and (c) any other person (or entity) for which Tenant is legally liable. Leases frequently provide that Tenant shall indemnify and hold Landlord harmless from claims, damages and expenses caused not only by Tenant but also by Tenant’s employees, agents, contractors, servants, lessees, or invitees. Here is a sample of such indemnification language: Tenant will indemnify Landlord and save it harmless from and against any and all claims, actions, damages, liabilities and expenses (including reasonable attorneys' fees) in connection with loss of life, personal injury and/or damage to property arising from or out of any occurrence in, upon or at the Premises, or the occupancy or use by Tenant of the Premises or any part thereof, to the extent occasioned wholly or in part, by act or omission of Tenant, its employees, its agents, contractors, servants, lessees, or invitees. Under the law, Tenants are liable for the actions of their employees when such actions are performed within the scope of their employment. The problem occurs with having Tenant indemnify Landlord for the actions of Tenant’s agents, contractors, servants, lessees, or invitees. Under the legal concept of vicarious liability 5 , Tenant might or might not actually be liable for the conduct of such persons or entities – it depends upon the particular facts and circumstances of the case. However, because of this indemnification language in the lease, Tenant becomes (contractually) liable for the actions of these agents, contractors, servants, lessees, or invitees when, in fact, Tenant might not be liable for their negligence (in the absence of such indemnification language). The third point that needs to be made regarding indemnification provisions in commercial real estate leases is that Tenant should only indemnify Landlord when (a) Tenant or anybody for which Tenant is legally liable is negligent and (b) Landlord and anybody for which Landlord is legally liable is not negligent. Fourth, Tenant should both (1) limit the AMOUNT of the damages, costs, and expenses for which it indemnifies Landlord to Tenant’s limits of liability under its commercial general liability (CGL) policy and (2) limit the TYPE of the damages, costs, and expenses for which it indemnifies Landlord to those which Tenant’s CGL policy applies. An example will demonstrate the importance of Tenant limiting the AMOUNT of the damages, costs, and expenses for which it indemnifies Landlord in the lease. Let’s refer back to the facts of Hypothetical # 3. Recall that Tenant had $1 million of liability insurance; that Landlord had $10 million of property insurance on the multi‐story building in which Tenant’s premises were located; that the actual damages to the multi‐story building were $12.5 million; that Landlord’s insurance company paid Landlord $10 million; that Landlord sought indemnification from Tenant for Landlord’s unreimbursed $2.5 million; and that Tenant (despite having a mutual waiver of subrogation in the lease) faced $1.5 5
Vicarious liability arises from the common law doctrine of agency and holds one party liable for the actions of another party when the first party has the authority, ability, or duty to control the actions of the other party – despite the fact that the first party has no active involvement in the activities of the other party. Page 6 of 16 million of uninsured, out‐of‐pocket expenses (namely, the $2.5 million in indemnification sought by Landlord minus the $1 million of insurance provided by Tenant’s CGL policy). Now, however, using the same facts of Hypothetical # 3 but with a properly‐worded indemnification agreement that limits the amount of damages for which Landlord can seek indemnification from Tenant, Tenant’s liability would be capped at $1,000,000, its limit of liability under its CGL, all of which would be paid by Tenant’s CGL insurance company. The result is far better for Tenant!! A different example will demonstrate the importance of Tenant limiting the TYPE of the damages, costs, and expenses for which it indemnifies Landlord in the lease. 6 Hypothetical # 4: Shortly after 5:00 PM on Friday, after the Tenant, a manufacturer, ceases business for the week, two of its employees clean several of the large pieces of equipment on the factory floor. After cleaning the equipment, in a rush to begin the weekend, they accidentally spill several gallons of ammonia and various other chemicals outside. Shortly thereafter, local governmental authorities order the Landlord to test the groundwater for ammonia and these other chemicals and to remove and clean up any of these “pollutants” that have seeped into the groundwater. Landlord’s cost to perform such tests and to remove and clean up such “pollutants” is $1,000,000. Landlord seeks indemnification from Tenant. 7 Unfortunately for Tenant, its CGL policy excludes coverage for this type of environmental claim. However, if Tenant had insisted upon a properly‐worded indemnification agreement that limits the type of damages for which Landlord can seek indemnification from Tenant, then Tenant would have had no liability since its liability would have been limited to those claims, damages, costs and expenses to which Tenant’s commercial general liability policy applies! An example of indemnification provisions which satisfy these four points is attached hereto as Exhibit 6. In a commercial real estate lease, it is unusual for Tenant to require that PROBLEM # 5: Landlord maintain sufficient commercial property insurance on the premises and the building(s) of which the premises are a part. In the lease, Tenant should include language which requires that Landlord SOLUTION # 5: maintain sufficient commercial property insurance on the premises and the building(s) of which the premises are a part. An example of such language is attached hereto as Exhibit 7. 6
One might think that limiting the AMOUNT of the damages, costs and expenses is sufficient, but it is not. Suppose that the monetary cap is $1,000,000. If that indemnification expense is not covered by insurance, then the indemnitor faces a potential uninsured indemnification expense of $1,000,000. The indemnitor needs to make sure that this potential $1,000,000 indemnification expense is covered by its insurance. 7
If Landlord really expects Tenant to indemnify Landlord for environmental claims not covered by Tenant’s commercial general liability policy, then Landlord should, in the lease, require Tenant to obtain an appropriate pollution liability policy. Tenant would then have the option of obtaining such policy or of refusing to obtain such policy. Once again, the bargaining power of Landlord and Tenant is key. One way to bridge the possible disagreement between Landlord and Tenant about limiting Tenant’s liability in the indemnification provisions would be for Tenant to consider offering to obtain an excess and umbrella liability policy (or offering to increase the limits of its existing excess and umbrella liability policy). Page 7 of 16 There are three reasons why Tenant should require Landlord to maintain such insurance. First, Tenant has a strong interest in making sure that if the premises and/or building(s) are damaged by a covered cause of loss, Landlord has enough insurance proceeds to completely repair and/or replace the premises and/or building(s). The last thing Tenant wants is for Landlord to terminate the lease because Landlord did not have enough insurance proceeds to repair and/or replace the premises (and/or the building(s) of which the premises are a part). Moreover, if Landlord does have sufficient insurance proceeds, Tenant wants Landlord to repair and/or replace the premises (and/or the building(s) of which the premises are a part) as quickly as possible because the longer it takes Landlord to repair or rebuild the premises and/or building(s), the more expensive it becomes for Tenant – both in terms of Tenant’s lost revenue and the additional expenses that Tenant must incur, whether or not Tenant must temporarily relocate. 8 Second, as Maryland’s highest court explained in the Rausch decision (see Exhibit 2 attached hereto), when the lease contains language requiring Landlord to maintain sufficient property insurance, that is strong evidence that Landlord has waived subrogation against Tenant which, as noted above, prevents Landlord’s insurance company from seeking reimbursement from Tenant for such insurance company’s payment to Landlord. Thus, a provision in the lease requiring Landlord to maintain sufficient property insurance on the premises and/or building(s) is especially important when Landlord refuses to waive subrogation in the lease. Third, by requiring that Landlord maintain sufficient property insurance on the premises and/or building(s), Tenant reduces the probability (a) that Landlord will be underinsured in the event of a covered loss and (b) that Landlord will seek indemnification from Tenant because Landlord was underinsured. For example, recall again Hypothetical # 3 in which Landlord sought indemnification from Tenant for Landlord’s unreimbursed $2.5 million and Tenant was faced with $1.5 million of uninsured, out‐of‐pocket expenses (equal to the $2.5 million in indemnification sought by Landlord minus the $1 million of insurance provided by Tenant’s CGL policy). What if, because of language in the lease which had required Landlord to maintain sufficient property insurance, Landlord had maintained $13 million (rather than $10 million) of insurance on the multi‐story building? In that case, Landlord’s property insurance company would have paid the entire $12.5 million of actual damages and Landlord would not have had any unreimbursed costs or expenses for which it could seek indemnification from Tenant. It is neither surprising nor unusual for Landlords of commercial real estate to be underinsured. Landlords are often underinsured for three reasons. First, the less insurance Landlords have, the less money Landlords pay for insurance (even though Landlords pass their insurance expenses on to their Tenants) 9 . Second, to the extent that Landlords believe (or know) that they can successfully seek indemnification from their negligent Tenants who cause damage to the premises and/or building(s), Landlords have less incentive to insure their buildings at 100% of replacement cost. Third, as is 8
Tenant should have time element insurance coverage (business income, extra expense and extended business income) to minimize its financial impact from fire, and any other covered cause of loss, to the premises. 9
Of course, to the extent that Landlords have vacancies in their buildings, Landlords bear that insurance expense themselves. But it is true that the more expensive Landlords’ insurance is, the greater are the passthroughs to their Tenants and thus, comparatively speaking, the more expensive it becomes for prospective Tenants. Page 8 of 16 discussed below in PROBLEM # 9, the most common reason that Landlords are underinsured is because Landlords don’t increase their insurance to accurately reflect the costs of the improvements and betterments made for Tenants which have become part of the building(s). Commercial real estate leases frequently contain “Surrender of Premises” PROBLEM # 6: provisions which impose unacceptable obligations upon Tenant. One common form of a “Surrender of Premises” provision reads as follows: At the expiration or earlier termination of this lease, Tenant shall peacefully surrender the premises to Landlord, in the same condition as the premises were upon the commencement of the term of this lease, ordinary wear and tear excepted. The problem with the above “Surrender of Premises” language is that Tenant now becomes obligated to maintain, repair and replace the premises from virtually any cause of loss ‐‐ such as fire, explosion, water, hurricane, burglary, etc. Suppose that lightning strikes the building in which the premises are Hypothetical # 5: located and that the premises suffer severe damage from fire caused by that lightning. Since this sample “Surrender of Premises” language requires Tenant to surrender the premises “in the same condition as the premises were upon commencement of the term of [the] lease, ordinary wear and tear excepted”, Tenant must repair and/or rebuild the premises. That is, in effect, what the above “Surrender of Premises” language says! Moreover, notice that the above sample “Surrender of Premises” language imposes these obligations upon Tenant even if Tenant were totally without fault – as in the lightning strike example of Hypothetical # 5. SOLUTION # 6: Appropriate language must be added to the “Surrender of Premises” provision which eliminates these obligations from Tenant. Thus, the above sample “Surrender of Premises” premises should be altered to read as follows: At the expiration or earlier termination of this lease, Tenant shall peacefully surrender the premises to Landlord, in the same condition as the premises were upon the commencement of the term of this lease, except for (a) ordinary wear and tear, (b) acts of God, (c) fire or (d) any other cause of loss. (emphasis added) Tenant receives one additional, and important, benefit when the “Surrender of Premises” provision is amended to include an exception for fire [and any other cause of loss]. In the Rausch decision, Maryland’s highest court ruled that whether a Landlord has waived subrogation against a Tenant for a fire caused by Tenant’s negligence depends upon the intent and reasonable expectations of the parties as ascertained from the lease as a whole. The Maryland Court of Page 9 of 16 Appeals then noted that the existence of language excepting fire from Tenant’s responsibility to return the premises “in a good state and condition” is indeed evidence that the parties had intended that Landlord waive subrogation against Tenant. Thus, Tenant can, essentially, get Landlord to waive subrogation against Tenant via the “Surrender of Premises” provision by making sure that the lease contains this additional language excepting fire [and any other cause of loss]. Of course, many Landlords realize this too. Thus, those Landlords which do not want to waive subrogation against Tenant and are aware of this issue will resist adding the fire [and any other cause of loss] language to the “Surrender of Premises” provision. Therefore, it is not uncommon to see commercial real estate leases (which of course are initially prepared by, or on behalf of, Landlords) completely omit the “Surrender of Premises” provision. Commercial real estate leases typically require that Tenant maintains (and, thus PROBLEM # 7: implicitly or explicitly, repairs or replaces) various parts of the premises. But Tenant cannot realistically properly insure these parts of the premises. Below is a typical maintenance provision in a commercial real estate lease: Tenant agrees that it will take good care (including repair and/or replacement) of the premises, fixtures, and appurtenances, including exterior doors and windows, window frames, meters, plumbing, heating and air conditioning equipment (including that on the exterior of the premises exclusively serving the premises) and keep the same in good order. Given the above typical maintenance provision, Tenant cannot properly insure the premises or its fixtures, exterior doors and windows, window frames, meters, plumbing, or heating and air conditioning equipment. Why not? The answer is because Tenant does not own any of these items which are (or have become) part of the building, and Tenant does not own the building. As indicated in the language in Section A.1.b. of Exhibit 8 attached hereto, Tenant can insure Tenant’s business personal property. But none of the items listed in this typical maintenance provision are Tenant’s business personal property. Rather, these items are (or have become) Landlord’s building property. The problem is that Tenant has no insurable interest10 in these building items, and thus no insurance company would pay a claim filed by Tenant for these items. 10
It is a fundamental tenet of insurance that in order to insure something, the person or entity seeking insurance must have an “insurable interest” in that something. Basically, an “insurable interest” is a financial interest. Owners of property have financial (or insurable) interests in their property. Lenders have financial (or insurable) interests in the property for which they lend money, at least to the extent to which they have provided such money. Contracts can also create financial (or insurable) interests. Thus, for example, a lessor can require that a lessee insure a particular property. Page 10 of 16 Could Tenant properly insure the fixtures, exterior doors and windows, window frames, meters, plumbing, and heating and air conditioning equipment of the premises which Tenant might like to do since the lease’s typical maintenance provision requires Tenant to maintain, repair and replace such items? The answer is that it would be necessary to create an insurable interest by Tenant in these items. Creating this insurable interest could be done if Tenant paid for such items, because Tenant’s use interest in fixtures, alterations, installations or additions which are (1) a part of the building occupied (but not owned) by Tenant and (2) paid for by Tenant would make such items Tenant’s business personal property. (See PROBLEM #9 below for a discussion of the definition of Tenant’s improvements and betterments.) However, this is not a realistic approach. 11 Tenant can simply agree to maintain (and repair or replace) the premises and its SOLUTION # 7A: fixtures, exterior doors and windows, window frames, meters, plumbing, and heating and air conditioning equipment without obtaining any insurance on such items. In that event, Tenant should ask Landlord what Landlord thinks it would cost Tenant to repair and/or replace each of such items. Tenant should then include in the lease a provision limiting Tenant’s liability for repair and/or replacement of these items to a specific dollar amount. It is very important to note that Landlord, in its property insurance policy on the SOLUTION # 7B: premises and the building(s) of which the premises are a part, is already insuring the premises and its fixtures, exterior doors and windows, window frames, meters, plumbing, and heating and air conditioning equipment! 12 Realizing that fact, in the lease, Tenant could (a) agree to maintain the premises and its fixtures, exterior doors and windows, window frames, meters, plumbing, and heating and air conditioning equipment but (b) NOT to repair or replace any of such items. 13 The only exception to the preceding sentence might be that Tenant could agree to repair and/or replace the fixtures, exterior doors and windows, window frames, meters, plumbing, and heating and air conditioning equipment only if such repair or replacement becomes necessary due to a cause of loss for which insurance would not provide any coverage. 14 11
What Tenant (and Landlord) would agree that Tenant will pay for the premises’ fixtures, exterior doors and windows, window frames, meters, plumbing, and heating and air conditioning equipment so that Tenant could obtain insurance on such items? Moreover, as PROBLEM #10 below discusses, if a claim for any of these items occurs, Tenant might indeed have difficulty receiving the payment it anticipates from its insurance company for any such claim. The other way, of course, to create an insurable interest by Tenant in these items is for the lease to (contractually) require that Tenant insure the building. For obvious reasons, this is usually not a viable option. 12
This fact is yet another reason why Tenant should insist that the lease include language requiring Landlord to maintain sufficient commercial property insurance on the premises and the building(s) of which the premises are a part. See Solution # 5 above. 13
If Tenant covenants to maintain such items (and Tenant probably is also required by the lease to have an HVAC maintenance agreement with a contractor acceptable to Landlord) and Landlord has sufficient property insurance covering these items, then Landlord is protected. 14
One example in which insurance would not provide coverage is if an item (such as the HVAC system) needs to be repaired or replaced due to ordinary wear and tear. Page 11 of 16 Moreover, given the significant cost of repairing or replacing some of these items, Tenant should still include a provision in the lease limiting Tenant’s liability for repair and/or replacement of these items to a specific dollar amount. Commercial real estate leases typically provide that Tenant’s insurance PROBLEM # 8: company must give Landlord at least 30 days advance written notice before such insurance company cancels or non‐renews any of Tenant’s commercial insurance policies. 15 This requirement is inconsistent with the language of (unendorsed) commercial insurance policies. Below is a sample provision concerning prior written notice of insurance found in leases: All of Tenant’s insurance required by this lease shall contain a clause or endorsement prohibiting cancellation or failure to renew without the insurer first giving Landlord thirty (30) days prior written notice of such proposed action (no less than ten (10) days prior written notice for cancellation or failure to renew for nonpayment of premium). Commercial insurance policies provide that insurance companies will mail or deliver to the (first named) insured written notice of cancellation at least (a) 10 days before the effective date of cancellation in cases of nonpayment of premium and (b) 30 days before the effective date of cancellation if cancellation occurs for any other reason. See the language in Section A.2. of Exhibit 9 attached hereto. Moreover, in two circumstances, an insurance company will provide written notice to a person or entity other than the (first named) insured. First, an insurance company will provide written notification to a mortgageholder at least (a) 10 days before the effective date of cancellation in cases of nonpayment of premium; (b) 30 days before the effective date of cancellation if cancellation occurs for any other reason; and (c) 10 days before the expiration date of the policy if the insurance company elects not to renew the policy. See the language in Sections 2.f. and 2.g. of Exhibit 10 attached hereto. Second, an insurance company will give the same advance written notice to a loss payee whose interest as a creditor has been established by a written agreement; provided, however, that the insurance policy has been properly endorsed to include a lender’s loss payable clause.16 See the language in Sections D.1., D.3 and D.4. of Exhibit 11 attached hereto. 15
This 30‐day requirement is frequently changed to 10 days for cancellation or non‐renewal due to Tenant’s failure to pay the premium. 16
A lender’s loss payable clause is a particular type of loss payable clause which gives the loss payee substantially greater rights than a loss payee receives from a typical loss payable clause. Page 12 of 16 Since Landlord is neither a mortgageholder nor a loss payee of Tenant, the standard (unendorsed) commercial insurance policy will not give any notice to Landlord of such insurance company’s intent to cancel or non‐renew Tenant’s insurance policy. 17 The provision in leases which requires Tenant’s insurance company to provide SOLUTION # 8: prior written notice to Landlord before cancelling or non‐renewing Tenant’s insurance policy should be either (a) amended to comply with the terms of insurance policies or (b) deleted. 18 If amended, the sample provision concerning prior written notice of insurance in leases could read as follows: All of Tenant’s insurance required by this lease shall contain a clause or endorsement prohibiting cancellation or failure to renew without the insurer having provided Tenant with at least the number of days of prior written notice required by applicable state law. Tenant covenants and agrees to send any and all of such notices to Landlord within one business day after Tenant’s receipt of each such notice. Commercial real estate leases frequently don’t have specific provisions PROBLEM # 9: regarding tenant’s improvements and betterments (TIB). This silence in leases regarding TIB can create a number of problems, the first of which is: “Will Landlord or Tenant pay to insure the TIB?” Commercial (property) insurance policies define TIB as the following kind of “Business Personal Property”: Your [the tenant’s] use interest as tenant in improvements and betterments. Improvements and betterments are fixtures, alterations, installations or additions: (a) Made a part of the building or structure you [the tenant] occupy but do not own; and (b) You [the tenant] acquired or made at your expense but cannot legally remove See the language in Section A.1.b.(6) of Exhibit 13 attached hereto. 17
Until September 2009, the insurance industry’s standard Certificate of Insurance that was used to provide proof of liability insurance (Acord 25) stated that: “Should any of the above described policies be cancelled before the expiration date thereof, the issuing insurer will endeavor to mail ___ days written notice to the certificate holder named to the left, but failure to do so shall impose no obligation or liability of any kind upon the insurer, its agents or representatives.” Despite the fact that an insurance company will not provide notice of cancellation or non‐renewal of Tenant’s insurance policy to Landlord, some insurance agents crossed out the words “endeavor to” when preparing these Certificates of Insurance. In September 2009, Acord revised Form 25 to eliminate this possibility. See the language regarding ‘Cancellation’ at the bottom of Exhibit 12 attached hereto. 18
Deleting such provision will not have any impact upon either Tenant or Tenant’s insurance company because the insurance policy still retains these advance written notice requirements. Moreover, the insurance law in each state mandates a specified number of days of prior written notice to the policyholder in the case of cancellation or non‐renewal, and these statutory provisions override any inconsistent contractual language. Page 13 of 16 Thus, Tenant can insure its TIB. Landlord can also insure TIB in Landlord’s commercial property insurance policy as part of the “Building”. Moreover, even if the improvements and betterments were not paid for by Tenant, in which case such improvements and betterments are not defined as TIB, then Landlord can still insure these improvements and betterments as part of the “Building”. See the language in Section A.1.a. of Exhibit 14 attached hereto. Tenant signs a 10 year lease with Landlord. In order to get better Hypothetical # 6: financial terms in the lease, Tenant agrees to spend $250,000 on improvements and betterments to the premises. Because Tenant paid for these improvements and betterments, they satisfy the insurance policy’s definition of TIB. If Landlord insures these TIB for $250,000, then Landlord would increase the amount of its “Building” insurance by that amount to reduce/eliminate the possibility that Landlord’s insurance company might impose a coinsurance penalty upon Landlord if its property is subsequently damaged by a covered cause of loss, such as fire, leakage of water from the roof, wind, etc. 19 It is important to note that failure by landlords to include the value of TIB (as well as other additions, alterations, improvements and betterments made to Landlords’ buildings at their own expense which are not technically defined as TIB) in their business insurance policies is the most common reason that coinsurance penalties are imposed upon landlords in the United States. Alternatively, if Tenant insures these TIB for $250,000, then Tenant would increase the amount of its “Business Personal Property” insurance by that amount to reduce/eliminate the possibility that Tenant’s insurance company might impose a coinsurance penalty upon Tenant if its property is subsequently damaged by a covered cause of loss, such as fire, leakage of water from the roof, wind, etc. 20 Landlord would then “save” money because it would not have to insure this $250,000 of TIB. 21 SOLUTION # 9: If Tenant agrees to pay for improvements and betterments to the premises, then the lease should specify (a) the dollar amount of these TIB and (b) whether Landlord or Tenant will insure these TIB. Commercial real estate leases frequently don’t have specific provisions PROBLEM # 10: regarding tenant’s improvements and betterments (TIB). This silence in leases regarding TIB can create additional problems, including the following: “If Tenant is insuring the TIB and a covered cause of loss – such as fire – occurs, (a) what happens if the TIB are repaired or replaced and (b) what happens if Landlord terminates the lease because of the fire?” 19
In this Hypothetical # 6, if Landlord insures the TIB, then Tenant can reduce the cost of its business insurance by using a specific endorsement, entitled “Additional Property Not Covered”, to exclude coverage for these $250,000 of TIB. 20
Tenant can reduce its cost of insuring these $250,000 of TIB by using another special endorsement, entitled “Your Business Personal Property – Separation of Coverage”. This special endorsement allows Tenant to reclassify these TIB as “Building” (rather than “Business Personal Property”); this reclassification saves Tenant money because it is cheaper to insure “Building” than “Business Personal Property”. 21
There is certainly no reason for both Landlord and Tenant to insure the same TIB for $250,000. Page 14 of 16 Hypothetical # 7: Tenant signs a 10 year lease with Landlord. In order to get better financial terms in the lease, Tenant agrees to spend $250,000 on improvements and betterments to the premises. Because Tenant paid for these improvements and betterments, they satisfy the insurance policy’s definition of TIB. Throughout the term of the lease, Tenant has maintained $250,000 of insurance on the TIB. Five (5) years into the lease, a fire destroys the building which contains the premises. Now let’s look at four different scenarios. Scenario # 1 – assume that Tenant promptly replaces the TIB. In this case, per the Tenant’s insurance policy, Tenant’s insurance company will pay Tenant the replacement cost of the TIB. 22 See the language in Section 7.e.(1) of Exhibit 15 attached hereto. Scenario # 2 – assume that Landlord rebuilds the premises (or the building containing the premises), which includes replacing the TIB. In this case, per the Tenant’s insurance policy, Tenant’s insurance company will pay Tenant nothing for the TIB since Tenant did not pay for the replacement of the TIB. See the language in Section 7.e.(3) of Exhibit 16 attached hereto. Scenario # 3 – assume that Tenant replaces the TIB but not promptly. In this case, per the Tenant’s insurance policy, Tenant’s insurance company will pay Tenant $125,000, or one‐half of its $250,000 original cost of the TIB, because, at the time of the fire, one‐half of the lease term (or 5 years of the 10 year term of the lease), had elapsed since the TIB were originally installed. See the language in Section 7.e.(2) of Exhibit 17 attached hereto. Scenario # 4 – assume that Landlord terminates the lease. In this case – as in Scenario #3 – per the Tenant’s insurance policy, Tenant’s insurance company will pay Tenant $125,000, or one‐half of its $250,000 original cost of the TIB, because, at the time of the fire, one‐half of the lease term had elapsed since the TIB were originally installed.23 See the language in Section 7.e.(2) of Exhibit 17 attached hereto. Tenant might not be happy to receive only $125,000 in Scenario #3 or Scenario #4. Tenant might argue that it should receive $250,000 since (a) it paid $250,000 for the TIB five years ago and (b) it has consistently been paying insurance premiums for $250,000 of TIB for five years. Despite Tenant’s possible objections, it is fair that Tenant receives only $125,000 in Scenario #3 or Scenario #4. It is fair because Tenant was insured on a worst case basis; thus, if the fire had destroyed the premises one day (rather than 5 years) after the TIB had been installed, Tenant would have received the entire $250,000 from its insurance company. 22
This result assumes that Tenant has chosen the replacement cost option. Alternatively, if Tenant has not chosen the replacement cost option, then Tenant would receive the actual cash value of the TIB, which equals replacement cost minus depreciation. Note that Tenant cannot promptly replace the TIB if Landlord does not promptly replace the remainder of the premises (or the building that contains the premises). Thus, Tenant would be wise add a provision in the lease requiring Landlord, after the loss, to promptly repair or replace the premises if Landlord decides not to terminate the lease. 23
To protect its investment in the TIB from cancellation of the lease by Landlord after a fire or other covered cause of loss, Tenant can, if it so desires, purchase another insurance policy. This other insurance policy is called a Leasehold Interest Coverage Policy and is attached hereto as Exhibit 18. Significantly, the Leasehold Interest Coverage Policy will provide coverage for Tenant’s TIB if Landlord cancels the lease as a result of a fire or other covered cause of loss when the premises are damaged and also when the premises are not damaged but the building(s) which includes the premises is (are) damaged. Page 15 of 16 SOLUTION # 10: Before Tenant can make an informed business decision about whether to pay for, and whether to insure, its proposed improvements and betterments to the premises, Tenant must be told how its insurance policies would respond in a variety of scenarios. Only then can appropriate provisions regarding improvements and betterments be included in the lease – provisions which will reduce uncertainty and will reflect the terms of the business transaction between Landlord and Tenant. Page 16 of 16