Write It Right In The First Place – It’s Not A Game Of Chance: Insurance, Good Faith, Fair Dealing.

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Last week, for a “nugget” of wisdom unrelated to the substance of the dispute, we cited the decision in Boston Market Corporation v. Hack. This is an unpublished New Jersey appellate decision that can be seen by clicking HERE. We’ve known about this case for six years and that wrongly made us think, subconsciously, so did everyone else. Well, we’ve woken up to the reality and thought this week would be a good chance to “share.”

On a superficial level, this is an insurance coverage case – an allegation by a landlord that its tenant wasn’t carrying the required insurance coverage. A simple factual understanding can be gleaned from these words from the court itself: “The central dispute involves the proper interpretation of the parties’ lease agreement and, more particularly, whether the insurance obtained by [the tenant], with high deductibles of up to one million dollars, constituted self-insurance or no insurance at all… .”

Peeling back some layers reveals that it is also about the implied covenant of good faith and fair dealing, about what happens after a purported breach may be used to analyze the purported breach, and about how those who don’t understand a substantive subject shouldn’t be drafting documents that rely on what they don’t really understand.

To get most readers on the same plane, we’ll quote various statements from the court’s opinion about the “covenant of good faith and fair dealing” as it applies in New Jersey. We say “in New Jersey” because, although the covenant is part of the law in every jurisdiction, it isn’t enforced (or applied) to the same degree everywhere, and New Jersey is probably the leading edge when it comes to giving life to this ancient covenant, implied in (nearly) every agreement. So, study-up on the following:

“Although the implied covenant of good faith and fair dealing cannot override an express term in a contract, a party’s performance under a contract may breach that implied covenant even though that performance does not violate a pertinent express term.”

“A party exercising its right to use discretion in setting price under a contract breaches the duty of good faith and fair dealing if that party exercises its discretionary authority arbitrarily, unreasonably, or capriciously, with the objective of preventing the other party from receiving its reasonably expected fruits under the contract.”

And, most relevant to those who believe that all answers come from the text of an agreement, whether a lease, mortgage or otherwise, we recommend that the following be read and internalized:

“A party’s purported exercise of discretion to attempt to terminate a lease for an asserted breach is likewise subject to scrutiny to determine whether that action is arbitrary, unreasonable or capricious.”

At this juncture, that’s all there is going to be by way of background because we’re going to delve into the substantive dispute about whether the tenant in Boston Market violated its lease when it came to complying with agreed-upon insurance requirements.

A chain restaurant was the tenant under a lease that required it to carry, in part, the following insurance coverages:

(1) Insurance against loss or damage by fire, lightning, explosion, smoke damage and other risks from time to time included under “extended coverage” endorsements in amounts sufficient to prevent Landlord or Tenant from becoming a co-insurer of any loss under the applicable policies but in any event in amounts not less than 100% of the full insurable value of the Leased Premises.

(2) General public liability insurance against claims for bodily injury, death or property damage occurring on, in or about the Leased Premises and the adjoining streets, sidewalks and passageways, with limits of not less than $500,000 with respect to bodily injury or death to any one person, not less than $1,000,000 with respect to any one accident, and not less than $500,000 with respect to property damage.

All such insurance shall be written by companies of recognized financial standing … such insurance shall name as the insured parties Landlord, Tenant . . . .

Aside from its use of antiquated insurance coverage terms (see HERE if you are interested in that subject), take note that it speaks not of deductibles [or Self-Insured Retention limits – see HERE for more]. The tenant had a one million dollar deductible on its commercial general liability (CGL) insurance policy as well as on its commercial property insurance policy. Now this gets a little “insurance complicated,” but might be useful information for readers who aren’t “that deep” into how insurance “can” work.

As to the CGL insurance policy, even though it had a million dollar deductible, the carrier obligated itself to pay claims from “dollar one.” If it made a payment, its agreement with the tenant, not an uncommon one for large insureds, was that it would be reimbursed for whatever part of the million dollar deductible it had to pay out on a claim. In this case, that reimbursement promise was backed up with a letter of credit of about ten million dollars from the tenant, in favor of the insurance carrier.

The commercial property insurance policy deductible of one million dollars was entirely the tenant’s risk. To understand that, realize that property damage claims are paid to the insured. So, why would a carrier write a million dollars check to its insured to pay for the insured’s damaged property, and then turn around and ask its insured to reimburse it for the million dollars? During the course of the dispute between the tenant and its landlord, the tenant reduced the property insurance deductible to $25,000. Again, for readers who aren’t “that deep” into how insurance “can” work, here’s how that was done. At first, the tenant got its carrier to cover all but the first $25,000 of the million dollar deductible, retroactively, by agreeing to indemnify the carrier. Because this did not actually reduce the deductible to $25,000, it then got its carrier to reduce the deductible to $25,000, retroactively, yes, retroactively.

None of that made the landlord happy, probably because, as the trial judge stated and the appellate tribunal republished: “The real motivation here is to escape from a lease that is economically disadvantages to [the] landlord and becoming more so over the years.” Basically, the landlord took the position that where a lease does not expressly set forth any permissible insurance deductibles for a tenant’s insurance coverage, then no deductibles are permitted.

Each court disagreed with the landlord’s “no deductibles permitted” position.

First, as the lower court said, it is “not uncommon for there to be some deductible amount on the risk insured against in order to economize on the premium.” Thus, as the appellate court pointed out, absent agreement to the contrary, a deductible is “not only permissible; it [is] reasonably to be expected.”

OK, but what size deductible?

This is where a lesson is to be learned for those who undertake to write leases or other agreements wherein one party or the other will be required to carry insurance. Absent inclusion of a “number” in the document, the answer is: “It depends.” It depends on the risk and it depends on the ability of the insured party to pay for the deductible loss. So, the deductible amount “answer” turns on, as in this case, a tenant’s creditworthiness and “other factors bearing upon the risk of loss or damage to which [a] landlord might be realistically exposed… .”

The landlord argued that even if the deductible amounts were “safely covered by its tenant’s financial resources” [our characterization], the coverage wasn’t “insurance,” it was “self-insurance.” The court dismissed that argument, pointing out that: “Though a deductible is frequently referred to as self-insurance, its functional purpose is simply to alter the point at which an insurance company’s obligations to pay will ripen.” That’s an important point, one that we mentioned above when we told you that the CGL insurance carrier would pay the entirety of a third party’s claim (up to the policy limit), and then seek reimbursement for the deductible from its insured.

Now, to return to the beginning of today’s posting, where does the covenant of good faith and fair dealing fit in? According to the lower court, and as endorsed by the appellate court, this “insurance dispute was, at worse, technical and … did not relate to a material breach that would justify termination of the lease.” Search as you may within the appellate court’s opinion, even though the court used several pages to describe the implied covenant, there is no direct connection in it tying the covenant into the result. To Ruminations, that’s instructive: the court didn’t need to connect the dots because the covenant of good faith and fair dealing just permeates judicial philosophy. It was apparent to the court what was going on, and it wasn’t going to allow the landlord to “exercise its discretionary authority arbitrarily, unreasonably, or capriciously, with the objective of preventing [its tenant] from receiving its reasonably expected fruits under the [lease].”

What about the title’s promise: “Write It Right In The First Place – It’s Not A Game Of Chance”? Well, here’s a recurring Ruminations theme. Those who wrote this lease are responsible for allowing this dispute to have any legs at all. This was a vigorously litigated matter (read that: big law firms; lots of time; big bills). At the time of the dispute, the tenant was far more than amply able to cover any losses, even those well beyond the required insurance limits. Pardon any offence, but in football parlance, this was a “Hail Mary” effort by the landlord. We hope the cost was worth it; we’re sure the experience was not. And, that’s not to leave the tenant off the hook. Perhaps, it looked pretty good to leave the issue of deductible amounts “silent” because that would give the tenant “flexibility,” but the tenant was never going to save much money doing so. What it wound up doing was to involve the tenant in an expensive law suit with the risk, albeit slight under the circumstances, of losing a “cheap” lease.

And, lastly, tenants with more limited resources might not be so lucky given that what constitutes a “reasonable” deductible depends on what kind of resources the insured party can demonstrate to a court.

Yes, “Write It Right In The First Place – It’s Not A Game Of Chance.”

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