Legal View: When business interruptions occur, whose liability is it?

 Tracey M. Stockton, The Daily Record Newswire

The recent spate of weather-related casualties has caused many business owners to re-examine their business interruption insurance coverage, and now even the most bottom-line-focused entrepreneurs are thinking inclusion of this type of coverage may be money well-spent. 

The allocation of risk of loss under a commercial lease is fairly well settled. Exposure for rent loss is not always addressed in a commercial lease document, and, if it is, it is subject to negotiation, with landlord and tenant volleying back and forth as to who is responsible for mitigating the risk through the provision of insurance.

While an event of casualty is seldom a positive occurrence for tenant or landlord in a multi-tenant setting, both can take steps to mitigate their loss exposure and, for the small to mid-size tenant, provide for the continued viability of the business following an event of loss, in both cases, through the maintenance of business income insurance coverages.

A well-drafted lease will require both parties to carry the water on this topic and here’s why:

To the extent a tenant-favorable lease termination right is not triggered by the event of casualty giving rise to a business interruption claim, the liability for the tenant to continue to honor the terms of the lease, including the payment of rent, is ongoing.

If the tenant’s business is adversely affected by the casualty, certain operating expenses remain constant, yet operating revenues may sharply decline. Business income insurance provides a safety net for tenants facing this exposure subject to coverage amount limitations, co-insurance requirements and related parameters.

Thoughtfully crafted business income coverage can provide a small business owner conducting its business from a multi-tenant office building with the ability to continue to meet its rent obligation pursuant to the terms of the lease agreement, identify replacement premises (if required given the nature of the damage), and relocate to the replacement premises, all without relying on retained earnings or cash flows that may not be at optimal levels following a casualty event.

For relatively small business owners who can satisfy the conditions precedent to the issuance of a business owners policy, business income coverage is included within the suite of coverages afforded by this type of policy and claims are satisfied to the extent of actual loss sustained over a given time period (in many instances, a 12-month period).

A seldom recognized fact is that, provided the event of loss occurs prior to the lapse of a given policy, a business income policy will continue to provide its stated benefit to the insured, even if the coverage expires midway through the reinstatement or replacement premises process.

A smart landlord requires each tenant to carry business income coverage in order that each can fulfill its respective lease obligations in the event of a casualty affecting the tenant’s ability to use and enjoy its premises.

In that way, the landlord risk associated with a dip in rental revenue is mitigated and the liability imposed by a single tenant or group of tenants is not spread across the entire building through the increase in insurance expense pass-throughs, attributable to a rise in loss experience with respect to the building, shared by the entire building tenant population.

In our current economic climate, expense pass-throughs are carefully scrutinized, and most commercial landlords have pared down building operating expenses to satisfy very taut service to value models; each tenant is mindful of increasing costs and the per-tenant risk burden for the payment of rent following a casualty is correctly placed on each tenant to the extent of the lease provision therefor.

In negotiating the rent loss provision, each tenant is well-advised to carefully consider the period that the landlord is allowed for reinstatement following an event of casualty, the condition in which the landlord is required to deliver the restored premises to tenant, and the basis for termination of the lease as to the tenant and landlord.

On the flipside, landlords also carry business income coverage, in most instances under a business income “rental value” policy. Rental value coverage is limited to the value of the rental revenue associated with a given property, subject to coverage amounts, co-insurance requirements and additional parameters.

In that manner, landlords mitigate exposure for lack of rental revenue on a macro-scale and in those instances in which all or a portion of the building is affected by casualty of a magnitude required to trigger lease terminations.

From the landlord perspective, the landlord is the middle man, balancing the needs of each of the tenant and lender constituencies. In many instances, the debt on the building has been securitized and the landlord is required to maintain many safeguards, including business income coverage, to preserve the fiction that the business of operating one office building is homogeneous with all other office buildings, thereby preserving the credit rating of a pool of mortgage-backed securities.

Many landlords look to the pre-Commercial Mortgage-Backed Securities days with nostalgia, as a time when direct relationships with a mortgage lender was a reality and the ability to run a building as an independent enterprise was a source of pride.

Today, lenders require maintenance of numerous reserves for expense items, many of which are not considered pass-throughs under tenant lease agreements, further constraining cash flows derived from building revenues.

Similar to the mitigation afforded tenants through the provision of business income insurance, business income “rental value” coverage mitigates exposure to the landlord for loss of revenues associated with a building casualty of a magnitude necessary to trigger a claim thereunder.

Tenants who remain operational following an event of casualty of the requisite magnitude necessary to trigger a loss under the landlord’s “rental value” coverage are able to rely on continued building service levels (to the extent not curtailed due to casualty) through disbursements of insurance proceeds derived from “rental value” coverage.

While many obligations arising under a commercial lease can be specifically allocated to the landlord or tenant, when it comes to business interruption insurance coverage, both parties have a role to play.

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Tracey M. Stockton is an attorney at Sherin & Lodgen in Boston. She can be contacted at tmstockton@sherin.com.

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