After The Fire – Will The Landlord And Its Tenant Still Love Each Other? The Issue With Damage/Destruction Lease Clauses

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The biggest single factor in determining how things will turn out after a fire, flood, explosion or some other damage-causing event is whether the landlord and tenant still love each other. Do they want to cooperate and get back in business together, or do they want to divorce? If they want to get the property restored as quickly as can happen so that the tenant’s cash register starts ringing and rent checks begin to flow again, they will make that happen and things will work out. If they each want to end the tenancy, they’ll make that happen pretty easily – the issue might be money, and if that is the case, believe it or not, money issues are the easiest to work out. Basically, if a landlord and its tenant share the same post-damage goal, they’ll work it out.

What about the third alternative − where you have a landlord who wants to get rid of a tenant that wants to stay − or you have a tenant wanting to leave while its landlord wants it (and the rent) back? What they will do is spend a lot of time trying to achieve their respective outcomes by exploiting the deficiencies in their common lease.

So, to predict whether and how quickly a property will be restored, look for the parties’ motivations and look for “trust” between the parties. Perhaps, we should say “among” the parties because if a lender’s motivation is to retire the mortgage loan, trouble looms. Yes, the commercial leasing relationship is a like a three-legged stool, one leg being the landlord, another being the tenant, and the third being the lender. If any leg is short or missing, the stool “don’t work too good, if at all.”

Let’s summarize where we’ve gotten so far. If the landlord, its lender, and its tenant don’t want to cooperate, damage becomes disaster.

Very few of us lease negotiators, loan negotiators, landlord principals, tenant principals, and lender principals have any meaningful experience with “real” destruction. Those who do, almost certainly have very limited experience. If you’ve only seen one such situation, be wary of making what might be called a “single point extrapolation” from that experience. A “single point extrapolation” is kind of an engineer or scientist inside joke. What it means is that you can point your data trend line in any direction through your single experience and think that by doing so you can predict how the next disaster will “work out.”

Those who have seen two fires or other destruction-causing events don’t have it much better. While they will be able to gain some lessons from common features of each event, more likely they will learn to appreciate how each situation seemed totally different from the other one, and thus how they are not much better off planning for a third experience.

Can one ever be able to negotiate workable rules within a lease, loan or other document to deal with serious property damage? Ruminations isn’t sanguine that it can be done. We think there are too many variables. If this posting were about mathematics, we might be saying that this is an equation with 35 variables and 41 unknowns.

Most of the problems faced when negotiating a lease’s damage and destruction provision arise out of a fundamental conflict between the landlord and its tenant. Other than in unusual circumstances or in long-term ground leases, a landlord, rightfully, wants to hold its tenant at the property for as long as possible unless, along the way, the landlord decides it would like to “dump” the tenant. That’s called “protecting” the landlord’s interest. Not to be undone, tenants would like the freedom to terminate their leases if, at the time of the fire or other destruction causing peril (or at any later time before restoration is completed), a better opportunity comes along. Call that the opportunity to close a store or the opportunity to move down the block. That’s what is known as “protecting” the tenant’s interest.

Except for problems caused by intentional or unintentional drafting (that sums it up), the conflict between a landlord’s interests and those of its tenant appears to be minimal where the damage is slight or minor, best described as damage that doesn’t take too long to fix. Most parties, when reaching their lease agreement, don’t blatantly seek to include a “trap door” to allow them to terminate a lease in such a situation. What can happen, however, is that poor drafting (perhaps, poor thinking) can create “wiggle room” for creating a “trap door” once the leased premises or some other part of the property is damaged. By way of example, and we think we’ve provided this example before, here is such an actual situation.

A lease provided that if the leased premises were totally damaged, either party could terminate it. On its face, that seemed reasonable. What happened later was that flood waters covered several inches of the entire floor area. Simply understood, that was total damage in that every contemplated usable square inch of the leased premises was rendered unusable. Even though adjacent stores, including a supermarket, were similarly inundated, they were able to return to full operation within 5 to 10 days. This particular tenant, citing this lease provision, gave its notice of termination. Doing so would give that tenant even better relief than the reduced rent concession it had previously obtained. One could argue a lot of things, including a breach of the covenant of good faith and fair dealing or that only the lower several inches of the leased premises were damaged, not the parts above the water, but you still have a problem. You’re going to litigate or settle.

This example illustrates the problem. Both parties “knew” what they intended when writing the lease. Both parties expected that the lease would benefit each other. But, at the time of the flooding, only the landlord wanted to “make the deal.” Its tenant, having learned that the location was a “loser,” took us to the “third alternative” above, where the tenant wants to leave while its landlord wants it to stay and keep paying rent.

What should they have done? Ruminations is too lazy this week to post a “clause,” but will share its thoughts on the subject. That should have the advantage of making readers think this issue through each and every time it is encountered in lease negotiations (or when preparing a suggested form lease).

Whenever a lease needs to speak of a particular “quantum” of damage, it should speak of BOTH time and money. The degree of damage, as far as it affects the parties’ ability (not subjective willingness) to get the original benefit of its bargain, depends on those resources. If reconstruction by a landlord will make its entire project “stupid,” perhaps it should be able to get out of the deal. If the tenant, by hanging on (or by being stuck) to the lease would be losing a reasonable opportunity to restore its business elsewhere for the benefit of the same customer base (or would lose a hard-to-obtain customer base to competitors), then it should be able to get out of the deal. Without elaboration, these concepts bear a relationship to two legal theories by which a party may get out of a contract: impossibility of performance, and even more germane, frustration of purpose. We’d be happy to discuss this at length and defend our paraphrase-like comparison, but the hour grows late, and Gandalf the Grey rides to Isengard seeking [our] counsel. [We have no idea what that means, only having seen the movie, but never having read the book.]

Basically, total destruction is that which would require more than “X” days to restore or more than “Y” dollars (or “Z” percent of the cost for a new building) to restore.

That’s not the whole story. It is one thing to carefully establish the definition of the quantum of damage that would allow either party to terminate a lease (and that quantum could be different for the two parties). It is another thing to deal with what actually happens after the “fire.” The problem in this regard is that most leases measure the trigger-defining “quantum” before reconstruction begins and never again. In some cases, the parties might add a “circuit breaker,” i.e., a time period beyond which, regardless of cause, one party or the other can terminate.

Here’s the set-up. A lease, as is common, says that if show-stopping damages happens, and it is estimated (by someone – who is not important for this purpose) restoration will take more than 6, 9, 12, “you pick” months, then one party or the other (or either party) can terminate the lease. Yes, there are a lot of ifs, ands and buts in these provisions, mostly because of a lack of trust (or natural differences in motivation), but those aren’t relevant today. Now, as is common (one hopes), assume that the restoration work is honestly estimated to take less time than the termination “trigger.” For simplicity, the lease sets the termination right at 9 months, and the honest estimate is completion within 7 months following our hypothetical fire.

After 5 months, nothing has happened. Call it permitting problems; call it a meticulous architect; call it a contractor who has been kidnapped and can’t be located; call it anything – it just ain’t moving. In fact, let’s postulate that everyone knows it will take exactly 6 more months from this point in time until the work is done. That would make it 11 months after the fire.

This delay probably doesn’t give the landlord much grief. Its business income insurance coverage (what some readers might have called “rent insurance”) is 12 months; so, it is covered in that regard. And, it knows that when the space is restored, it has a tenant. Not one in the bushes, but one in the hand.

On the other hand, the tenant expected that it would have no choice but to hang around for 7 months, and conceded that it would be bound for up to an estimated 9 months. Perhaps, when agreeing to a 9 month lease termination trigger, it thought: “(a) what’s the big deal, it will take us at least 9 months to find a nearby location, do a lease, fix the place up, and move in; and (b) it would take a competitor, starting from scratch, at least that period of time if the competitor hadn’t already decided to come into the same market.” So, as to (b), the burned-out (burned-up) tenant was thinking that even if a competitor decided to come into the market because, as a result of the fire, no one else now was selling the same goods or delivering the same services in the market, the burned-out tenant would be back and running before its customers were all “stolen.”

Now, if it will take 11 months, that hypothetical competitor may be ready to open or may even be open, and the clock is ticking.

The Uniform Commercial Code (UCC) provides a process wherein a buyer can make a demand for adequate assurance of performance. Under Section 2-609 of the UCC, “[a] contract for sale imposes an obligation on each party that the other’s expectation of receiving due performance will not be impaired. When reasonable grounds for insecurity arise with respect to the performance of either party the other may in writing demand adequate assurance of due performance and until he receives such assurance may if commercially reasonable suspend any performance for which he has not already received the agreed return.”

But, Article 2 of the UCC only governs the sale of goods, not real property leases. Even though many courts have absorbed some Article 2 concepts and judicially applied them to the sale of services and even to real property matters, UCC Article 2 is not the law. Landlords have no obligation to respond to that kind of demand from a tenant. Thus, a tenant can’t be assured of the right to terminate a lease even if its reasonable expectations are being thwarted.

A more simple analysis, the kind all but the most receptive judges are likely to follow, is that the parties agreed to measure their obligations by an “estimate.” The estimate was honest. The parties took the risk that an honest estimate was wrong.

So, what can or should be done? Here’s our short suggestion. In addition to setting an absolute outside limit beyond which the parties need not be bound any longer (and the same time limit need not be applicable to both parties), set some benchmarks. For example, say that if the plans are not ready within 2 months (after something) or all construction permits aren’t obtained within 3 months or if physical construction (beyond demolition) isn’t started within 4 month or if the “envelope is not completed within 7 months, then one party or the other or either can give notice of termination and if the benchmark isn’t hit within 10 days, then the termination would be effective.

Of course the parties should be obligated to act diligently, the failure to do so being a breach for which damages might be available or for which the breaching party (usually, a landlord) would (judicially) lose its termination right. The landlord’s right could be based on a different set of target dates than those triggering its tenant’s rights. The tenant could have the right of self-help – seeking the permits; finishing the drawings; doing the construction, if it chose to do so.

We’re not urging any particular approach or favoring either landlords or tenants. Today, as is often the case, the goal of Ruminations is to get all of us thinking about these issues and the approaches that can be taken to solve these problems – ones that address each party’s legitimate needs without crippling the other party.

If this topic intrigues you, then come to this year’s ICSC Shopping Center Law Conference in San Diego from October 16 through 19. We’ll be there with John K. Kim, Esq., corporate counsel for Westfield, the shopping center developer. We and John will be leading a workshop: Will Your Lease Stand Up to a Real Fire or Will it Be Collateral Damage? (Reflections from after the Fact) on Thursday, the 17th, from 12:45 until 2 pm. If you can make it, be well-armed; this will be a workshop and we’ll be trying to steal as many of your good ideas as we can and then later take credit for them ourselves. Just kidding. Maybe not.

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Comments

  1. Joel Hall says:

    Ira: I approach that particular issue – delay in rebuilding – this way. If Landlord’s contractor estimates that it will take less than a specified time, from casualty to completion of landlord’s restoration obligation, say 6 months for example, then the tenant should be bound (unless the 6 months would run into the last year of the term). If the estimate exceeds 6 months, say 9 months, the tenant can either cancel now or wait the 9 months. If Tenant decides to wait and it actually takes more than 9 months – no force majeure or insurance proceeds extension (except for another casualty) – then tenant gets another shot at cancellation. You may use this at the law conference.

  2. Good Article. It mentions the lender being 3rd leg of stool, but doesn’t mention the importance of the tenant getting the lender to agree to honor the restoration obligations in the Lease- usually contained in the SNDA (assuming T is large/important enough to warrant one).

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