by Nick Mann; Associate, Waller Landsden Dortch & Davis, LLP
Hurricanes Harvey, Irma, and Nate recently wreaked havoc across the South, prompting many tenants to dry off their leases and determine how to deal with a damaged or destroyed store. As some tenants probably discovered, casualty provisions in leases are often lumped into the “boilerplate” category and overlooked during lease negotiations. While this provision does not need to be the focus point of negotiations, ensuring it is tailored to the deal on the front-end can prevent a casualty from becoming a disaster down the road. The main, overarching elements of a casualty provision typically include: (1) a method to determine if the casualty results in a partial loss or a total loss; (2) remedies and restoration obligations based on the extent of the loss; and (3) allocation of the insurance proceeds.
Partial vs. Total Loss
While there are a variety of methodologies to determine if there is a partial or total loss to the premises, one common methodology is based on the length of time it will take to restore the improvements. If the improvements cannot be repaired or restored within such time-frame, then the casualty may be considered a total loss. However, if the improvements can be restored within such time-frame, then the casualty will be considered a partial loss regardless of the extent of the damage. A tenant should request that the timeline commence on the date the casualty occurred, as opposed to the date that permits are obtained, or insurance proceeds are distributed. A tenant should also want the ability to make a determination very soon following the casualty as to the likelihood of the restoration being completed prior to the restoration deadline. This way a firm time-frame can be established up-front and the tenant can more quickly determine if the restoration deadline can likely be met. If the tenant has to wait until permits or insurance proceeds are available, precious time may be wasted just to determine that the restoration deadline ultimately cannot be met. In this scenario, because the determination whether the restoration can be timely completed is being made prior to commencement of construction, any construction delays will be unknown when the decision is made.
Another common methodology to determine if there is a partial or total loss is a subjective test based on the tenant’s ability to use the improvements for their intended use. Not surprisingly, landlords and tenant often battle to become the party that gets to make such determination. A tenant with significant bargaining power will retain this right in its sole discretion, and conversely, a landlord with significant bargaining power will retain this right in its sole discretion. Often, however, the determination becomes a matter of creating a formula based on the number of leasable square feet that were damaged. In order to properly negotiate any such formula, a tenant should have advanced knowledge of the maximum number of square footage it can lose before become unprofitable.
Remedies and Obligations
Once the extent of the loss is determined, the lease should then describe the parties’ rights and responsibilities. If the casualty is determined to create a total loss, ideally the tenant (not the landlord) should have the ability to terminate the lease, but should not be required to terminate the Lease. If the tenant elects to terminate the lease, the tenant should still retain the right to remove the destroyed improvements in order to protect its brand image. However, if either (a) the tenant elects not to terminate the lease, or (b) the casualty is determined to create a partial loss, the lease should outline which party is responsible to restore the improvements, as well as the standards of restoration. It is worth noting here that the party required to maintain the casualty insurance on the improvements is typically the party that is required to restore the improvements, though that is not always the case. Additionally, with a few exceptions, the landlord will typically maintain casualty insurance for the improvements but the tenant will be required to maintain casualty insurance for its interior improvements, fixtures, and equipment. As a result, the landlord will likely be responsible for restoring the improvements, while the tenant is responsible for restoring its interior improvements, fixtures, and equipment. In a “triple-net” or ground lease scenario, it is typical that the tenant is responsible for maintaining casualty insurance on the improvements as well as its internal improvements, fixtures, and equipment. Accordingly, the tenant will likely be responsible for restoring the improvements, as well its internal improvements, fixtures, and equipment.
If the landlord is required to restore the improvements following a casualty event, in addition to the restoration deadline used to determine the extent of the casualty, the lease should contain an outside completion deadline and a requirement that the landlord restore the improvements to its condition immediately preceding the casualty. With these protections, if the landlord fails to either complete the restoration by the outside completion deadline, or fails to restore the improvements to the required condition, the tenant will have remedies at its disposal such as termination or self-help rights. If the tenant is required to restore the improvements, an outside completion deadline is less appropriate because a delay will typically only impact the tenant unless the tenant is required to pay percentage rent or if the tenant is large enough to implicate co-tenancy provisions by remaining closed for a prolonged period. Unlike the time-frame used to determine the extent of the casualty, it is reasonable to commence the time-frame for restoring the improvements to the receipt of all required permits.
Distribution of Insurance Proceeds
Finally, the lease should determine how the insurance proceeds will be distributed. The distribution will depend on how the lease is treated following the casualty. If the lease is terminated by tenant in connection with a total loss, the insurance proceeds will likely be retained by, or payable to, the landlord. The tenant, however, may retain the insurance proceeds applicable to tenant’s fixtures and equipment. The possible exception to this distribution is a ground lease scenario. A tenant under a ground lease can argue that the insurance proceeds for the improvements should be payable to the tenant so long as the tenant removes the destroyed improvements following the casualty. The tenant’s rationale is that (a) the tenant is the owner of the improvements during the lease term, and (b) the landlord merely leased the land to the tenant and therefore the landlord should only expect to receive the land at the end of the term. However, as deals have evolved, this ideology has begun to shift because landlords no longer tend to view ground lease transactions as simply a leasing of the land, but instead, landlords now tend to expect that upon the expiration of the term it will receive the land, together with properly maintained improvements thereon. Accordingly, landlords have begun to insist that the insurance proceeds for the improvements be payable to the landlord when the ground lease is terminated in connection with a total loss. This arrangement is more of a deal term than a legal concept, but legal counsel should be aware of this distinction and ensure that the distribution corresponds with their client’s expectation of the deal structure.
In a partial loss situation, the insurance proceeds should be applied first to the restoration of the improvements with the remainder being retained by the party who is obligated to carry the insurance pursuant to the lease. If the landlord is required to restore the improvements, the landlord will typically insist on language providing that the landlord is only required to restore the improvements to the extent of the insurance proceeds actually received. Because it is not the tenant’s fault if the landlord failed to maintain adequate insurance or fails to prosecute a claim diligently, when faced with this request a tenant’s first position should be that the landlord is obligated to restore the improvements regardless of the insurance proceeds actually received. That being said, one can be sympathetic to the idea that even if a landlord has maintained proper insurance, there are unforeseen situations where the insurer will pay an amount that is less than expected. Accordingly, but only if necessary, a tenant may agree to reduce the landlord’s restoration obligations to the extent of the insurance proceeds actually received, but the lease should include language providing that this limitation only applies if the landlord actually carries the insurance required under the lease and uses all means necessary to recover the full amount of such proceeds. Additionally, if this limitation is included, the lease will need to address what happens if this scenario comes to fruition and the landlord does not receive enough funds to restore the premises completely. In such event, the lease will typically provide the landlord with a termination right; however, if the landlord elects not to terminate the lease, the landlord should then be required to fund the deficiency.
If you need to repair or restore your casualty provision, please feel free to contact Nick Mann at [email protected].