Probate & Property Magazine

How Alligators Hidden in Leases Can Eat a Client's Bottom Line- Damage and Destruction Provisions

By Patrick T. Sharkey

Real estate lawyers enjoy an uplifting sense of accomplishment on the conclusion of a commercial lease negotiation. The intellectual stimulation of analyzing the legal and practical ramifications of the lease terms and negotiating those terms into the most advantageous text for a client provides a tremendous degree of job satisfaction. Lurking in the depths of most commercial leases, however, are provisions erroneously considered "boilerplate" clauses. They might well be referred to as "alligator clauses," because issues left unaddressed in them could eat up the economic benefits of a lease transaction. Some of those alligator provisions concern the condition of the leased premises on the occurrence of a fire or other casualty. This article addresses some of the substantive issues that a lawyer should consider when advising a client about the legal and economic impact of these lease terms. By careful attention to those clauses, efficient negotiation and skilled drafting, a lawyer can avoid the alligators.

Misdirected Negotiations 

The approach that a landlord and tenant use to discuss the damage and destruction provisions of a lease is frequently misdirected and usually results in extensive and sometimes needless negotiations. In dealing with provisions such as what happens at the beginning and end of the lease term, the parties and their lawyers focus on things that are certain or at least expected to happen. In negotiating damage and destruction provisions, however, the parties find themselves focusing on something that they neither want nor expect to happen-a catastrophe, such as a fire.

The proper analysis of the damage and destruction provisions of a lease, sometimes called the "fire clause," involves many different and often conflicting concerns of the landlord, the tenant and their respective lenders. Unfortunately, the fire clause frequently turns into a battleground over ways to terminate the lease or to keep it from being terminated, depending on a particular party's viewpoint and the type of lease involved. For example, in the case of a shopping center in which the landlord is the party that will repair or rebuild the premises, the fire clause in the landlord's lease form will usually include many conditions under which the landlord alone may elect either to terminate the lease or to repair or rebuild the premises. Sometimes the landlord's option to terminate the lease is easily activated to give the landlord more flexibility in deciding to terminate or to repair or rebuild. Even if under limited conditions the landlord is obligated to repair or rebuild the premises, the lease will usually be very general as to the rebuilding procedure and the timetable for completing repairs or reconstruction. The tenant will try to restrict the landlord's right to terminate the lease, to enlarge the landlord's obligation to repair or rebuild the premises, to set deadlines for beginning and completing repairs and restoration and perhaps to provide for a mutual right to terminate the lease under certain conditions. The landlord's lender will generally oppose any tenant termination right and will want the mortgage provisions governing damage or destruction and the use of insurance proceeds to control over the lease provisions so that the lender, at its option, may apply insurance proceeds to the mortgage debt.

The problem is that all parties are reluctant to commit contractually to a certain course of action that a catastrophic event may trigger. Rather than spelling out the respective rights and obligations of the parties up front, the parties tend to opt for as much flexibility as possible so that they can make the decision when the catastrophe occurs. This apprehensive approach frustrates the preservation of the relationship between the landlord and the tenant and usually produces a fire clause riddled with conditions and exceptions that may result in a fortuitous termination of the lease.

Lease Termination 

The conditions under which either or both parties may want the right to terminate the lease will usually depend on who is ultimately obligated to repair or restore the premises. That obligation, in turn, generally depends on the type of lease. In the case of a full net lease of a freestanding, single-tenant building, the tenant may be obligated to repair or restore the premises and continue paying rent without abatement. Under these circumstances, it will be up to the tenant to negotiate exceptions to its obligation to repair or rebuild the premises. If a lease of the same premises is made on a gross basis, the landlord may be obligated to repair or rebuild the premises. In the case of a shopping center or office space lease, regardless of the gross or net nature, the landlord is usually required to repair or rebuild the premises.

Once a party has assumed the obligation to repair or rebuild, that party will usually try to limit that obligation with a right to terminate the lease or to relax the reconstruction provisions to eliminate any deadline for beginning and completing the restoration. Although there is no rule of thumb for determining if and when the lease should be subject to a right of termination, lease termination clauses usually involve the following considerations: (1) whether the damage to the premises is substantial, measured either in terms of a specified percentage of the estimated replacement cost of the building or the number of days of work it will take to repair; (2) whether the peril causing the damage is one that is insurable (or was actually insured) under the insurance policy required under the lease; (3) whether the damage is near the end of the lease term; (4) whether the insurance proceeds are unavailable or insufficient because of an election by the landlord's lender to apply the proceeds to its mortgage debt; and (5) whether the damage is to portions of the building or the shopping center other than the premises.

Why should either party have a right to terminate a lease under a fire clause? One commentator has a very logical and persuasive argument against indiscriminately terminating shopping center leases when the lease has more than three or four years to run. 1 Emmanuel B. Halper, Shopping Center and Store Leases ¶ 12.03[4] (rev. ed. 1996). The argument is that, assuming that the credit of the tenant is good and the unexpired lease term is long, the most equitable way to handle the cancellation issue is to provide that neither the landlord nor the tenant may cancel. In that case, it is in the best interest of all parties, including the landlord's lender that based its loan on the tenant's creditworthiness, to preserve the relationship between the landlord and the tenant under the lease and keep the income stream unimpaired.

Despite the persuasiveness and logic of that view, one party may find it difficult to convince the other that the lease should not have some form of termination feature in the fire clause, other than one that arises near the end of the term. Why should the landlord's income stream end abruptly under a full net lease in which the tenant has basically assumed the ownership obligations of the building during the lease term? In that case, the tenant might be able to reconstruct the building and be back in business within six months after the casualty and compensate the landlord with proceeds of rent or business interruption insurance during the period of restoration. Nevertheless, it is entirely reasonable for the tenant in this case to have an exception to its restoration obligation if the damage-not just any damage but, for example, damage to at least x% of the replacement cost of the building-occurs near the end of the lease term (e.g., during the last two years).

In other types of leases under which the landlord is obligated to restore the premises, the landlord will customarily have one or more termination rights in the fire clause. The tenant should ensure that the termination clauses are fair. For example, if the landlord has a right to terminate in the event of damage to the premises, the tenant should be sure that the termination clause really is triggered by significant rather than insubstantial damage. Why should the landlord have the right to terminate the lease because of an uninsurable $500 loss? Leases should define substantial damage in terms of a certain percentage (e.g., at least 50%) of the estimated replacement cost or in terms of damage that will take a substantial period of time to repair. A smaller percentage of estimated building replacement cost, such as 25-30%, should trigger the landlord's right to terminate when the casualty occurs near the end of the lease term. If, however, the tenant has unexercised options to renew the lease, the tenant should have the right to nullify the landlord's termination right by exercising its renewal option. 

If the landlord insists on a right of termination because of an uninsurable catastrophe, the tenant should negotiate changes. The tenant should consider the effect of the deductible under the landlord's insurance policy, the effect of any self-insurance program that the landlord has implemented and what happens if the landlord has failed to maintain the insurance coverages required by the lease. The landlord's form may provide for self-insurance by the landlord or for a limitation of the landlord's restoration obligation to collectible insurance proceeds.

If the lease gives the landlord a right of termination or otherwise limits the landlord's restoration obligation based on the insufficiency of insurance proceeds, the tenant should also consider asking for the right to keep the lease alive by paying the deficiency toward the cost of repairing or rebuilding the premises. In that case, the lease should provide that, if the landlord terminates the lease because of insufficient insurance proceeds, the tenant may nullify that termination by giving the landlord written notice, within a specified period of time after the tenant receives the landlord's termination notice, that the tenant will pay the amount of the deficiency toward the restoration of the premises. This feature probably works best in the case of a freestanding, single-tenant building. The parties can handle insufficiency of insurance proceeds due to the application of proceeds to the landlord's mortgage debt in a similar fashion, assuming, of course, that the lease is subordinate to the mortgage or that the tenant is not strong enough to have obtained the lender's agreement to permit the lease terms rather than the mortgage to govern the use of the insurance proceeds.

In the case of a shopping center or office lease, the landlord will customarily have a right to terminate the lease if other portions of the center or building are damaged. Most experienced tenants will insist that, if the landlord terminates the tenant's lease because of damage to other portions of the project, the landlord must also terminate the leases of all other project tenants. At least the tenant will know that the landlord's termination right under its lease is not being selectively enforced against the tenant or just a few project tenants.

From the tenant's perspective, any non-default termination clause, whether automatic or optional, should provide that the rent will be apportioned as of a particular time (e.g., the date of damage or destruction) and that the landlord will refund to the tenant any rent paid in advance beyond that date. A tenant's lawyer will often overlook this proration concept on the assumption that the termination of the lease entitles the tenant to a refund of any prepaid rent. Because this assumption is contrary to the general rule that rent does not accrue from day to day but that an entire installment accrues on the day it is payable, the tenant's lawyer should avoid any questions by addressing the apportionment issue in the fire clause.

Many fire clauses use multiple terminating events that are sometimes awkwardly incorporated as conditions, exceptions and exceptions to exceptions. If the parties contemplate more than one instance in which the landlord or the tenant will have a right of termination under the fire clause, the better approach is to use a two part clause. The first part should provide that, except as provided in the second part, the lease will not terminate if the premises are damaged or destroyed by fire or other catastrophe. It should then set out the procedure for restoring the premises. The second part should isolate all of the events that may give rise to a termination if the premises are damaged or destroyed, such as substantial damage, damage caused by an uninsurable peril, damage near the end of the lease term, insufficiency of the insurance proceeds and damage to other portions of the building or the shopping center, if applicable. This two part approach eliminates much confusion. 

Rent Abatement 

Should rent abate during restoration and, if so, on what basis? In the case of a full net lease of a freestanding, single-tenant building, it is not uncommon for the lease to require that the rent will continue to be paid, without abatement, if the premises are damaged or destroyed. Assuming that the tenant carries rent loss or business interruption insurance coverage and has taken the cost of this insurance coverage into account in negotiating the rent, the tenant should have no problem with the absence of any rent abatement under the fire clause. Assuming that the tenant is actually charged with the responsibility of restoring the premises, the tenant will have control over the timing of the restoration work and should be able to carry sufficient rent loss or business interruption insurance to cover the period during which it is unable to operate its business at the premises.

Nevertheless, in a gross lease of the same type of structure, the landlord may have the obligation to restore the premises, and the fire clause will usually provide for the abatement of rent. The landlord, which will be maintaining its own insurance on the building, can then obtain rent loss insurance coverage in the policy covering the building. Similarly, most shopping center and office leases, even though not gross leases, will contain rent abatement clauses. In those cases, however, the cost of the landlord's rent loss insurance is passed through to the tenants under the lease insurance pass-through or operating expense escalation provision.

A lease may express rent abatement in several ways. Some leases are very general and provide that rent will abate "as is just and equitable under the circumstances." Other leases are more specific and base the abatement of rent on the amount of area affected by the peril. Still others abate the rent in the proportion that the area rendered unusable bears to the entire area of the premises. The rent abatement will usually continue throughout the period of restoration plus, in the case of a retail tenant, some additional period to allow for restocking and refixturing of the premises, unless the tenant begins using the premises before that time. In addition, although only a portion of the premises may be damaged, a retail tenant may not be able to operate its business in any of the premises before the damage is repaired. For example, if only a part of the premises is damaged but that part housed a department or segment of the tenant's business that produced a major share of store revenues or represented the primary draw for its customers (e.g., the video rental department in a music store), the tenant may believe that it is not feasible to continue business operations until the damage is repaired. In that case, all rent should abate until the earlier of a specified time after the damage has been repaired or the tenant resumes the conduct of its business in the premises.

Restoration 

Once the parties have addressed the circumstances under which the lease will continue in the event of damage or destruction, they will need to address the restoration procedure. As mentioned above, a landlord's lease form that places the restoration obligation on the landlord will usually be very general about the restoration procedure, providing that the landlord will proceed to repair or rebuild "with reasonable diligence." A tenant's lease form is often not much better. It may impose unrealistic deadlines on the landlord for commencing and completing the restoration, all without regard to the time involved to settle the insurance claim and unavoidable delays. In the case of a full net lease of a freestanding, single-tenant building, the lease may impose the restoration obligation on the tenant, and the landlord will be the party who will impose deadlines on the tenant for commencing and completing the restoration. In that case, the restoration provisions may require that all insurance proceeds be escrowed with the landlord and released to the tenant during the progress of the restoration work and on satisfaction of other disbursement conditions similar to those of a construction loan.

When negotiating lease restoration provisions, the parties should try to balance the concerns they both have in arriving at reasonable deadlines for beginning and completing the restoration. Simply stated, the lease should not be open ended on these points. Even if the tenant has not been able to negotiate its own right of termination in the event of damage or destruction, at a minimum, the tenant should be able to negotiate an outside date by which the landlord must complete its restoration. The lease should clearly state that this outside date will not be subject to the general force majeure clause of the lease. If the completion date is subject to extension due to force majeure, the lease should limit the total amount of time that the deadline may be extended. In addition, the parties may agree that the party having the restoration obligation should begin the restoration work by a certain time, usually within a certain number of days after the occurrence of the damage or destruction. When negotiating this provision, the parties should choose a date that will allow sufficient time to settle the insurance claim or calculate the time period from the date when the insurance claim is settled and the insurance company pays loss proceeds.

Conclusion 

With a proper understanding of a landlord's and tenant's competing concerns, lawyers representing them should be able to resolve conflicts regarding the fire clauses in a manner that meets the legitimate needs of both parties.

 


Patrick T. Sharkey is a member of Jenkens & Gilchrist, a Professional Corporation, in Houston, Texas, and is a member of the Real Property Division's Decisions (A-2), Asset Management (G-1), Condition of the Premises (K-1) and Remedies and Miscellaneous Clauses (K-5) Committees.  

 


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