United States: Shifting Business Interruption Risk Allocation In A Post-Sandy World

Landlords hit by insurance exclusions in the aftermath of Hurricane Sandy are hitting back by requiring tenants to use the proceeds of business interruption insurance to pay rent.

Before Hurricane Sandy hit the United States in October 2012, in the event of a casualty adversely affecting a tenant's ability to operate its business or access its premises, casualty provisions in commercial leases in New York City typically provided for an abatement of rent in proportion to the affected area of the premises. As a separate stand-alone covenant, tenants were often required to maintain business interruption insurance, which was usually equal to a fixed dollar amount or the sum of a predetermined number of monthly rent payments.

Notwithstanding the obligation for tenants to maintain business interruption insurance, there was no corresponding lease obligation requiring tenants to use business interruption insurance proceeds to pay rent to their landlord in the event of a casualty. In addition, landlords did not negotiate the specific terms of such policies. This meant they had no control over whether or not the business interruption insurance was paid to them and were unable to limit or restrict exclusions from coverage limiting a tenant's ability to collect on a claim. Instead, landlords maintained rent-loss coverage to protect against loss of income.

THE AFTERMATH OF THE STORM

Hurricane Sandy caused landlords and tenants to reassess the application of business interruption policies in commercial leases. As a result of catastrophic flooding and the cessation of public utilities, in many parts of Manhattan, particularly lower Manhattan and the Financial District, hundreds of buildings and dozens of streets were closed.

Landlords and tenants expected that they would be made whole by business interruption insurance policies (for tenants) and rent loss insurance policies (for landlords). Unbeknownst to both parties, however, many business interruption and rent loss insurance policies included numerous and broad exclusions limiting recovery for certain events including, without limitation, damages resulting from flooding, acts of God, natural disasters, unavailability of public utilities, the closure of an entire building, and the closure of the premises or building by governmental authorities.

Facing US$ billions in insurance claims, insurers exploited these exclusions and denied claims. For example, if a policy contained an exclusion for flood damage, the damage and loss was classified as being caused by a flood; if a policy contained an exclusion for natural disasters, the damage and loss was classified as being caused by a natural disaster. These exclusions enabled insurers to reject or limit otherwise legitimate claims.

Most landlords were unaware that their leases permitted, or did not expressly prohibit, exclusions from coverage, as certificates of insurance only provide broad overviews of the type and amount of coverage. They do not specify exclusions or limitations that would impact an insured's ability to collect following a casualty event. Even if a lease required that a tenant pay business interruption insurance proceeds to a landlord, which before Sandy was atypical, a landlord would remain exposed unless the casualty abatement was specifically conditioned upon a tenant collecting on business interruption insurance proceeds and paying them to the landlord. Effectively, in these circumstances, landlords would unintentionally secondarily insure tenants' business interruption policies and backstop tenants' loss of income as a result of a claim being rejected owing to specific exclusions from coverage. In these instances, tenants would receive an abatement of rent regardless of whether or not their landlord received the benefit of rent-loss or business interruption coverage.

To the extent that tenants were not required to pay their landlord their business interruption insurance proceeds as rent, landlords were forced to make a claim on their own rent loss policies, many of which were insured on a portfolio-wide basis with insurance limits equal to a fraction of the exposure caused by a building-wide catastrophe. Many landlords did not anticipate, or did not want to pay the premium to cover, the interruption of rental income for an entire building, and were thus under-insured and suffered significant losses.

MOVING ON

In the aftermath of Hurricane Sandy, some landlords have sought to mitigate their casualty exposure and "move the market" by shifting the allocation of risk for tenant business interruption insurance policies actually paying out in the event of a casualty. New York landlords still require tenants to maintain business interruption coverage, but in some leases landlords condition casualty rent abatements upon the viability of a tenant's business interruption insurance policy. For example, if a business interruption insurance policy does not pay out because of an insurer enforcing an exclusion from coverage, there will be no abatement of rent.

Post-Hurricane Sandy, one prominent New York landlord now requires new tenants to assign proceeds of business interruption insurance to the benefit of the landlord under the following provision:

Notwithstanding anything to the contrary contained in this Article xx, (x) if Landlord or any mortgagee of the Building shall be unable to collect insurance proceeds (including rent insurance proceeds) for any reason other than a negligent act of Landlord, its employees, contractors or agents, there shall be no abatement of Fixed Rent or Additional Charges, and (y) Tenant's right to an abatement of Fixed Rent and/or Additional Charges shall only be enforceable if (i) such casualty renders the Premises partially or wholly unusable for a period in excess of twelve (12) months and (ii) Tenant has collected on (and paid to Landlord) Business Interruption Insurance proceeds for the twelve (12) months subsequent to the date of such casualty. For the avoidance of doubt, it is the intent of the parties that any proceeds available under Business Interruption Insurance must be exhausted prior to Tenant receiving any abatement for damage or other casualty to the Premises under this Lease.

This shift in allocation of risk means that a tenant may now be responsible for any gaps in coverage to the extent that an insurer refuses to honour a business interruption policy, on the basis that a tenant is in the best position to negotiate and understand specific exclusions to their coverage. As a result, in these instances exclusions will now be the responsibility of a tenant rather than the landlord, and if a policy does not provide sufficient coverage, or contains too many exclusions, a tenant can elect to pay an additional premium to eliminate those exclusions.

As most tenants are not in the insurance business, and most tenant's lawyers are averse to changes in what is considered "market", this paradigm shift in risk allocation has faced vociferous opposition from tenants and their counsel. Some landlords are, however, aggressively seeking to frame the risk allocation issue in terms of which party is better suited to backstop a rejected claim and act as the secondary insurer of a business interruption policy. Landlords that are successful in this pursuit will be in a much stronger position to weather the storm and protect vital streams of rental income following a major casualty event.

Shifting Business Interruption Risk Allocation In A Post-Sandy World

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