Sidney Saltz

Thursday, 29 September 2005 06:56

Rent rules

Most commercial leases provide that the tenant’s rent abates after a fire or other casualty, at least to the extent that the premises are not tenantable or are not usable by the tenant for the conduct of its business. Remember that in many jurisdictions, rent does not abate after such an event unless the lease says it does.

It is not uncommon for the lease form to provide that the rent abates only if the tenant did not cause the loss. On the face of it, this seems like a reasonable condition. Why should the tenant benefit from its wrongful act? On closer examination, however, that provision makes no sense for tenants, and can adversely affect landlords.

Tenant troubles
Most landlords insure their property against loss by fire and other casualty. Most also carry rent loss insurance (known as business income insurance) to cover their loss of income during the period that the property is being reconstructed. In fact, the landlord’s mortgage probably requires that insurance covering the loss of rents. And who pays for the insurance? The tenant does, of course, either in its base rent or in pass-throughs.

Assume that the tenant’s employee accidentally started a fire, or even that a disgruntled employee deliberately started the fire. In either case, the landlord will collect the proceeds of its business income insurance to the extent of the landlord’s loss of rents.

But wait, this tenant’s lease provided that its rent does not abate because it caused the fire, and it is responsible for the acts of its employees. This gives the insurance company a defense against the claim for lost rents because the landlord has not suffered a loss of rents. Thus, the landlord has not benefited from the language in the lease; its insurer has. But who paid for that insurance? The tenant, of course.

Landlord losses
Tenants often carry business interruption insurance, which is also known as business income insurance. That insurance will pay, in the event of an insured loss, the cost to the tenant of moving out of the damaged space, the cost of the rent in temporary premises, the cost of moving back to the original space and the tenant’s lost profits. If the tenant has such coverage, then the landlord of the damaged premises can collect its rent from the tenant and the landlord suffers no loss. If, however, the tenant is marginal and does not carry that insurance, it will have to pay those expenses out of its own pocket, and it will also be obligated to pay the rent in the damaged premises. If the tenant cannot afford to pay all those costs, which creditor will it not pay?

Of course it will not pay the landlord in the damaged building, especially if it has no real intention of moving back. Let the old landlord try to mitigate its damages. Granted, the party most generally damaged by the language in the lease is the tenant, but the landlord has some risk here, as well. Language which provides that a tenant that damages the building cannot take advantage of rent abatement is not really based on economics, because neither party to the lease benefits from the language and one, perhaps both, are injured by it. So what is its real effect? One word —retribution. The landlord wants to punish the tenant for its acts, or those of its employees. Consider that most tenants are not sole proprietorships, but are companies with employees. Those companies are legally responsible for the acts of their employees, but that does not necessarily mean that the company — the tenant — is actually being bad. So why punish the tenant when there is no economic benefit to the landlord?

Sidney G. Saltz is a partner in the Business, Tax & Real Estate Department of Barnes & Thornburg LLP’s Chicago office. He concentrates his practice in the area of commercial real estate. Reach him at (312) 214-8324 or sid.saltz@btlaw.com.

Tuesday, 23 November 2004 09:04

Those pesky warranties

One of the most contentious issues in the negotiation of any real estate sale contract arises in connection with the seller's warranties.

It is the old tug of war. If the purchaser's lawyer drafts the contract, he or she will probably insert warranties which go from A to Z and beyond. Conversely, if buyer's lawyer drafts the contract, it may include a few innocuous warranties, such as the authority of the seller and buyer (which become moot anyway when the parties acquire title insurance).

Most troubling are condition warranties, those which cover the physical condition of the property. While it is possible that the transaction is to be a quick sale in which the buyer is not afforded an opportunity to perform a due diligence inspection of the property or the books and records of the seller, that situation is rare, and sellers customarily feel that, if the buyer has ample opportunity to do its due diligence, the property should be sold as-is, with no condition warranties at all.

On the other hand, the buyer may be concerned that its due diligence inspection may not turn up adverse conditions, which could result in costly future repairs. What if, for example, there is a foundation leak, which is not visible because of drywall, or it is not possible to determine how the air conditioning really works because the due diligence is conducted during the winter.

A frequent compromise is for the parties to agree that the seller will warrant that it has no knowledge of a particular adverse condition. A seller might warrant, for example, that it knows of no roof leak or that it knows of no hazardous substances on the property. It is a way for the buyer to get some comfort, but frankly, it is very little. There are a number of problems with that solution.

First, what type of knowledge is intended? Is it best of knowledge, actual knowledge or just plain knowledge? What do those words or phrases imply? Are they different? What degree of investigation is required for "best of knowledge"?

If the seller is an individual, the buyer knows whose knowledge it is getting. If the seller is an entity, is it bound by the actual knowledge of, say, a janitor, who saw hazardous materials being dumped 25 years earlier? If that seller which is an entity limits the knowledge warranty to specific persons, how does the buyer know it is getting someone who has access to the information?

Most important, it is easier to prove that there was a building code violation, for example, than it is to prove that the person referred to in the contract had knowledge of the situation.

The reader can readily see that there are more question marks than periods in the paragraph about knowledge warranties. Add an "as-is, where-is" section to the contract, in which the buyer concedes that it is relying on it own due diligence, and what happens to the knowledge warranties, even if that section begins, "Except as expressly warranted in this contract?"

What happens if there is a time limit on enforcing warranties? And why should such a time limit apply when a knowledge warranty is really a warranty that someone is not lying?

The knowledge warranty quandary is not limited to condition warranties. A seller might warrant that it knows of no defaults by its tenants, or that, to its knowledge, the books and records are accurate, or that the rent roll is true and correct. Sellers sometimes hide behind "knowledge" to limit liability as to matters which they really should know, and which cannot be relied upon without some assurance that what is shown during due diligence is not some cooked-up information.

There are no easy answers to the warranty questions. Each situation is different, and in each one, the parties have differing strengths and weaknesses. It is important to have advisers and counselors who understand the risks, the relative bargaining positions of the parties and the importance of the various warranties at issue, to advise the parties and help them to reach a solution which, while it never ideal, at least assists in reaching some resolution of the difficult issues involved.

Sidney G. Saltz is a partner in the business, tax and real estate department of the Chicago law firm of Barnes & Thornburg LLP. He can be reached at sidney.saltz@btlaw.com.