Commercial Leases and Risk

The lease agreement is one of the most commonly utilized contracts in commercial transactions. Even in today’s mobile and technology-driven commercial landscape, a huge number of businesses and industries require the use of real estate to facilitate operations, and, for many, renting makes more sense than purchasing. Consequently, the lease agreement is an incredibly important component of many businesses’ operational picture, affecting monthly and annual budget costs such as rent and real estate taxes, insurance costs, and common area maintenance charges (“TICAM”), as well as the company’s long-term risk and liability profile.

Despite its importance, the approach to leases is far too often rushed or accomplished through “standard” terms or forms, focuses too much on “business terms” such as rent and TICAM, or defers too much to the landlord’s forms or demands. A prospective tenant’s exposure under a lease is often significant enough to dictate the success or failure of its business, particularly small and mid-size businesses. A prospective tenant should, therefore, pay proper time and attention to the true meaning and impact of a lease, which extends far beyond monthly rent.

The primary purpose of a commercial lease is the payment of rent and costs in exchange for the possession and use of a parcel or unit of real estate for a business purpose. Looking beyond rent, TICAM and square footage, however, the functional purpose of a commercial lease is to allocate risk between the landlord and tenant during the period of occupancy and use.

The majority of a commercial lease agreement deals with what happens and who is financially responsible if something unpleasant occurs.  The tenant will be in default of the lease for failure to pay rent on time or to perform its other contractual obligations. But for how much will the tenant be responsible and what rights will the landlord have against the tenant? Unsurprisingly, the tenant’s liability is typically detailed again and again throughout the lease.

Does the tenant, however, truly understand the scope of its exposure on default, or even what constitutes a default? Are there any arguments or offsets against tenant liability? What about if the landlord negligently causes damage to the premises or the tenant’s personal property? Will the landlord be financially responsible? One may be forgiven for expecting straightforward answers to those questions: if the landlord does something “wrong”, the landlord is responsible. The truth of the matter is more complicated, with numerous interdependent provisions designed at allocating risk and liability between the parties, the bulk thereof seeking to effectively eliminate landlord liability and assign responsibility to the tenant.

With that in mind, below is an introductory discussion on three risk allocation terms (or categories of terms) that are especially important in addressing a prospective tenant’s risk outlook: waiver of subrogation; indemnification; and limitation of liability clauses. These are incredibly important lease terms; but, despite their significance, these provisions are some of the most overlooked, underappreciated, and poorly understood lease clauses. Written in that form of English known as legalese, waiver of subrogation, indemnification, and limitation of liability clauses are very difficult to read, and even more so to understand. However, the implication and importance of each have very real and very applicable consequences to the commercial lease tenant. And while the entire lease should be carefully reviewed and negotiated before execution, these provisions demand particularly close attention.

Waiver of Subrogation

As written, this clause often reads something to the effect of “landlord and tenant, for themselves and anyone claiming through them, including their respective insurers, each releases any claims and waives any rights, including rights of subrogation, said party may have against the other for compensation for any loss or damage arising from any risk generally covered by the ‘all risks’ insurance required to be carried under the lease.” The actual clause will likely be much longer and wordier. Even in its simplest form, however, it is a complex provision, and many readers, including attorneys, may not really understand what it means. Reading commercial leases is a test of willpower, and the waiver of subrogation provision is as likely to cause your eyes to lose focus as any other provision known to contract drafters today.

Nonetheless, it is an incredibly important provision. Depending on the scope and wording of the provision, this may and potentially should include both release of claims language along with the actual waiver of subrogation. But, for the tenant’s protection, it must be a mutual provision and must release and waive certain rights of the landlord as well as those of the tenant.

As for its purpose and effect, the provision serves as a limitation of risk; it is a cut-off valve for liability. The commercial lease waiver of subrogation aims at preventing the application of the principle of subrogation by a party’s insurance carrier, removing the right of the insurer to “step into the shoes” of an injured party to whom it has paid insurance proceeds and sue the party that caused the harm to recover its losses. The provision’s release of claims language takes it one step further by waiving and releasing the right of the injured party to seek recovery for the claim itself. In essence, landlords and tenants who have agreed to release these “all-risk” claims and to waive the right of subrogation must look to their own insurance coverage and may not seek recovery for the released claims from the other party. The provision’s effect will vary with its wording, which must be carefully considered in light of other provisions in the lease, such as the insurance requirements, indemnification, and additional limitation of liability provisions.

This highlights the importance of having strong insurance coverage in place. The lease will likely have certain requirements for the tenant’s insurance, in scope and amount of coverage, and should also have strong requirements for the landlord’s insurance. Regardless of the express requirements, a tenant should discuss its options with its insurance carrier, determine adequate and appropriate coverage, and ensure that the insurer is willing to comply with the terms of the lease’s insurance requirements (such as a waiver of subrogation) before signing the lease.

Indemnification

Like the waiver of subrogation provision, this lease clause impacts and potentially limits or expands a party’s liability under the lease, allocating risk between the landlord and tenant upon the occurrence of certain preapproved incidents or categories of harm. The basic idea behind indemnification is a promise by one party to compensate another party for certain loss or harm. If a tenant agrees to indemnify the landlord for harm suffered as a result of the tenant’s breach of the lease therefore, the tenant has promised to compensate the landlord for any damages caused by that breach. As you may be able to see, this could have quite a substantial impact on a tenant’s liability outlook. Indemnification for breach is a basic requirement of most commercial leases, but the tenant’s indemnification promises could extend well beyond the failure to pay rent. As such, it should be carefully reviewed and negotiated.

This negotiation process should include limiting the scope of the tenant’s indemnification promises to a reasonable degree and bargaining for (somewhat) mutual promises by the landlord. Your typical landlord-friendly commercial lease could seek to impose quite expansive indemnification obligations on the tenant. With few exceptions, these should be limited as much as possible, depending on the circumstances. Typical obligations include indemnifying for harm caused by the tenant’s use of the operation of the premises, the tenant’s negligence and willful and wanton misconduct, and the tenant’s breach of the lease. Any promise will include actions by the tenant as well as the “tenant parties”, which will typically include the tenant and its owners, officers, managers, employees, contractors, and certain other actors. At a minimum, the landlord should also agree to indemnify for harm arising out of the breach of the lease or negligent or willfully and wanton misconduct of the “landlord parties”. It may be appropriate to seek to narrow negligence to gross negligence or to add or remove other promises of indemnification, depending on the overall scope of the lease provisions and the transaction itself.

Limitation of Liability

If I were a skeptical man, I’d say the entire lease is a limitation of the landlord’s liability (which it is), but there are certain provisions expressly serving that purpose in the lease. These include provisions terminating the landlord’s liability on the transfer of the property or other events, identifying certain occurrences for which the landlord will not be responsible even if it says otherwise elsewhere in the lease, limiting the remedies a tenant can pursue if the landlord breaches the lease or otherwise acts wrongfully, or limiting the property or interests of the landlord which the tenant may recover against. These provisions are typically littered throughout the lease. Pay close attention when reviewing the lease to make sure these limitation clauses don’t undercut or eliminate important tenant-friendly provisions or protections elsewhere in the lease.

Conclusion

These provisions are important in and of themselves, as well as in their respective relation to each other. The waiver of subrogation, indemnification, and limitation of liability provisions interact with one another in complex and far-reaching ways. If not carefully and comprehensively reviewed and negotiated, these provisions could drastically increase a tenant’s exposure under a lease in a one-sided manner. A commercial lease review should include a careful analysis of each provision, making sure the tenant is not giving away the house, so to speak, in terms of its own liability and the ability to meaningfully recover from the landlord. Never assume a lease negotiation begins and ends with the rent and TICAM, and certainly don’t accept a lease because you’re told it’s “standard”. Just what standard means differs on a case-by-case basis. The word is most typically used in a self-serving way, cutting off negotiations on important items that should not be brushed past.

Take your time, get proper representation, and negotiate a reasonable lease. The end product will likely still be landlord-friendly, but a good goal should seek a middle ground on most items, primarily in terms of risk allocation.