A. General Rule. Most leases adequately address the allocation of loss between landlord and tenant in the context of a casualty to the building or the tenant’s premises. Often, the landlord has the right to cancel the lease if the damage will take more than a stated period to repair (which period is often tied to the minimum period of the landlord’s rent loss insurance coverage). Some tenants have the right to cancel the lease if the tenant is displaced from its premises by a casualty for more than a stated period. If neither the landlord or tenant is given the right to cancel the lease following a casualty, the landlord usually is obligated to repair the building and the tenant is usually obligated to pay for the repair of the tenant alterations, personal property and equipment in the space. Such casualty provisions will operate as expected in the case of a catastrophic loss from any cause, including a terrorist act.

B. Application of Casualty Clauses In the case of the World Trade Center attacks, for those buildings throughout the area that were damaged but not destroyed, or for buildings where access and utilities were cut off even if there was no direct damage to the building, the operation of the casualty clauses in the leases may be unclear. Landlords need to evaluate whether the casualty clause of their leases allows them to cancel leases where there is no direct damage to the building, when the landlord is unable to operate the building because of damage to the immediate area around the building. More likely, the tenants in such buildings are evaluating their leases to see if they have the right to cancel the leases based on the casualty to the surrounding buildings, which right would be leverage to get out of an over-market lease, or to permit the tenant to relocate out of an area that will be in a state of repair for many years.

C. Tenant Obligations If the lease requires the landlord to rebuild the building, the tenant will be obligated for the cost of repair and reconstruction of the alterations, personal property and equipment in and to the premises. This is a recourse obligation of the tenant which may expose the tenant to significant liability beyond the rent under the lease. Tenants need to be sure that their own insurance program covers this exposure even with respect to loss caused by a terrorist act, unless the tenant decides to risk its own net worth in lieu of insuring this risk.

D. Coordination with Insurance. The damage and destruction provisions of each lease must coordinate with the insurance provisions in terms of allocating risk between the landlord and the tenant.

A. Recent Changes in Coverage In the past few months and continuing through the middle of this year, most landlords must deal with the first renewals of their existing insurance policies following September 11, 2001. As their policies are being renewed, landlords must address the need for terrorism insurance as a new and separate coverage from the standard “all risk” or “causes of loss-special form” coverage usually maintained by owners on their buildings. Prior to September 11, 2001 in the United States, the “broad form” or “all risk” policy forms covered loss from acts of terrorism (but not from acts of war by a sovereign nation). With the attacks on September 11, 2001, most insurers quickly revised their policy forms to exclude acts of terrorism as covered risks. The National Association of Insurance Commissioners recommended that insurers be allowed to exclude terrorism risk from their “all risk” policies. All of the statesexcept California, New York and Connecticut have agreed to allow some exclusions for terror losses in policies written in their states. Insurers offering casualty insurance in any of the three states mentioned above may face a requirement from the state insurance department that their policies include risk of terrorism. This issue has yet to be tested in any reported case in those states.

B. Terrorism Risk Policies New policies are now being offered to cover the terrorism risk. These terrorism policies are being offered by AIG, Lexington Insurance Co. (a subsidiary of AIG), Berkshire Hathaway and others. These policies were not addressed in most, if any, leases before last year. As current leases are now being drafted, counsel for landlords and tenants have to consider whether and how to address terrorism insurance.

C. Definition of Terrorism. First and foremost, the party purchasing a terrorism policy should understand the definition of a terrorist act that is covered by the policy in question. The Insurance Services Office (ISO) defines terrorism for purposes of the exclusion from a standard insurance policy as follows:

This definition is very broad and could be used by insurance companies in the future to characterize criminal or sociopathic acts in order to avoid coverage under standard “all risk” policies. Note that this definition of terrorism has not yet been adopted by New York or California commissioners of insurance for purposes of the approved insurance forms in their states.

D. Landlord Right to Purchase Insurance. Landlords generally want the right, but not the obligation, to maintain terrorism insurance and to pass through to tenants the cost of terrorism coverage. Most leases give the landlord broad latitude to carry the types and amounts of insurance that the landlord or its lender deems appropriate and to pass the cost of that insurance through to the tenants. In most cases, landlords will have adequate textual support in their leases to permit them to purchase terrorism coverage and to pass through the cost of that coverage to tenants.

E. Landlord Insurance Requirements. In those leases where the landlord has agreed to carry certain types or limits of insurance, the landlord must analyze whether the lease requires that it carry terrorism insurance, and if so, for what limits of coverage. For example, how should the landlord interpret a clause which states that the landlord must maintain in effect ”insurance which is “all risk” coverage for the full replacement cost of the building”, or “insurance which is comparable to the types of insurance being maintained by comparable buildings in the vicinity”? Landlords may not want or be able to purchase terrorism coverage for the full replacement cost of their buildings. Like earthquake coverage, terrorism insurance is being purchased for a portion of the replacement cost of the building, since full replacement cost coverage is not commercially reasonable (and the expectation is that there is a low probability of a complete catastrophic failure of a building as happened with the World Trade Center).

A landlord seeking to comply with the requirement that it maintain full replacement cost “all risk” coverage will have difficulty purchasing full replacement cost coverage for terrorism risk and will have to take the position with its tenant either that it is not required to carry any terrorism coverage at all, since it is maintaining the current form of “all risk” or “causes of loss-special form” coverage that is then being offered by the insurers, or that purchasing terrorism coverage for the full replacement cost is commercially unreasonable and would not be an obligation that a court would enforce. As discussed above, since the landlord’s obligation to rebuild may be tied to the amount of insurance proceeds it collects from its insurers following a casualty, the inability to cover the full replacement cost of the building may have direct consequences to the parties, giving either or both the landlord and the tenant the right to cancel the lease following a casualty from terrorism.

A landlord required to maintain coverage comparable to that of other comparable building owners may have to purchase terrorism insurance to the extent such coverage is being purchased by its competitors in the local marketplace. Ultimately, the amount of terrorism coverage to be maintained by landlords will not be a function of their lease obligations to tenants, but instead will be driven by their loan documents and the lenders’ interpretations of the insurance requirements in the loan documents.

Tenants must realize that their landlord may lack sufficient funds to rebuild or repair its building following a terrorist attack even if the landlord does maintain some level of terrorism coverage, since no terrorism policy is likely to cover the full replacement cost of the building and may have a substantial deductible or co-insurance amount (many terrorism policies are carrying deductible amounts of 5%, which can amount of tens of millions of dollars in the case of major commercial properties). Most landlords are either special purpose single asset entities with no other resources to pay for repair or rebuilding beyond the insurance proceeds, or, the lease exculpates the landlord from recourse liability to the tenant for the repair of the building beyond the value of the building itself.

F. Limitations on New Types of Coverage. In those leases where the tenant has negotiated a restriction on the ability of the landlord to pass through the cost of new types of insurance that were not being carried at the outset of the lease, the landlord will have to assert that the terrorism coverage is not, in fact, a new form of insurance since it was always covered by the prior “all risk” policies and that the tenant is obligated to pay for the terrorism coverage as a replacement for the coverage previously provided by the “all risk” form of coverage. Such a tenant will argue that the terrorism coverage is, in fact, a new form of policy since there was never a separate charge for this terrorism coverage in the past, and that the landlord is not entitled to pass through the cost of a new form of insurance.

G. Base Year Issues. Even if the landlord is able to pass through to its tenants the cost of terrorism insurance, the parties will have to analyze whether:

Such a base year stabilization provision would require the landlord to adjust the base year amount (used as a benchmark to measure escalations in operating expenses during the lease term) to reflect the additional cost that would have been included if the landlord had provided the same type of insurance coverage in the base year. If such a provision is construed to protect the tenant against the pass through of terrorism policies that were not in place during the base year, then the tenant would only pay for escalations in the cost of the new policy over what that policy would have cost in the base year, but the tenant will not pay for the full cost of the new insurance coverage that was not provided in the base year. However, the landlord in such a case will take the position that the terrorism risk was insured against in the base year under the “all risk” policy in place during the base year and that the cost of the terrorism coverage is truly incremental over the original insurance cost and that the tenants have to bear the full cost of the terrorism insurance without adjustment in the base year.

A related problem for landlords with gross leases is to avoid the possibility that the cost of insurance spikes only in the tenant’s base year (for example a 2001 base year for a new lease where the landlord renewed its coverage after September 11, 2001) and then the cost drops in subsequent years as the market stabilizes, yielding a windfall for the tenant in the form of a built-in buffer against future increases in other operating expenses. Landlords can avoid giving this windfall to tenants by making sure that the amount of operating expenses attributable to insurance costs never decreases below the base year amount, so that if there was a spike in such costs in the base year, that excess insurance cost is deemed to be ongoing throughout the lease term.

H. Market Forces Affecting Cost Pass Through. In the case of a lease giving the landlord the right to carry such insurance as the landlord or its lender determines is appropriate and requiring the tenant to pay for such coverage as a pass through, the only restriction on the landlord’s ability to pass through the cost of the new terrorism policy will be the market forces in the area: i.e., are other landlords passing such costs through and/or are they absorbing some or all of such insurance costs? Even if the landlord elects not to pass through the full cost of a terrorism risk policy due to market considerations, the tenants may not be so lucky if the lender forecloses on the building and takes over the landlord’s position: in such situations, the foreclosing lenders may not share the same market sensitivity as the original owner when it comes to passing through operating costs to tenants.

I. Lender Requirements. The recent lawsuit in Hennepin County District Court in Minneapolis between GMAC Commercial Mortgage and Simon Property Group, Inc. involving the requirement for terrorism coverage on the Mall of America in Minnesota is the first in a series of disputes that will arise between building owners and lenders on the issue of terrorism coverage. In this case, the servicer for the existing mortgage on the Mall of America sought to force the mall owner to maintain stand alone terrorism insurance on the mall, and if the owners of the mall failed to do so, the servicer was going to force-place the insurance and require the mall owner to pay for the coverage. Simon Property Group, Inc. sought a restraining order against GMAC Commercial Mortgage to bar it from force-placing the insurance. The owner claimed that the terrorism coverage was not commercially reasonable, given that the terrorism policy would have cost almost three times the mall’s “all risk” property insurance premium for 2002, which would have had a significant adverse impact on the mall’s tenants. In late March, 2002, the dispute was settled by Simon Property Group, Inc. purchasing terrorism coverage of $100 million on the mall as a stand alone policy. GMAC has accepted this insurance as being acceptable under its mortgage and the lawsuit was settled. This was a situation where the property owner sought to protect its tenants from the high cost of a terrorism policy being forced by the lender, where the impact on the tenants would have been materially adverse. This case involves a retail property, where the risk of catastrophic failure from a terrorist act is minimal and where the financial impact on mall tenants would have been severe.

Given that many commercial mortgages require the owner to maintain “all risk” or similar forms of insurance on a full replacement cost basis or require the owner to maintain “commercially reasonable” insurance, there will be a number of disputes between lenders and owners as to what these provisions mean in light of the post-September 11, 2001 insurance market. At some point, judges will be forced to decide whether it is commercially reasonable to maintain terrorism coverage for a percentage of the replacement cost of the building even though full replacement cost coverage may be available at a substantial excess cost, or to decide if the reference in a mortgage to “all risk” forms of coverage is deemed to refer to the form of “all risk” coverage as it may be available from time to time, or if it refers to a given list of perils and risks that should always be insured against during the term of that mortgage.

In addition, since terrorism risk insurance is presently only offered on a cancelable basis by the insurers providing the primary layer of coverage (allowing the insurer to cancel the policy on 30, 60 or 90 days notice), landlords are facing a significant risk of being in default under their loan documents if the insurer cancels the coverage and the landlord cannot purchase replacement terrorism coverage to comply with its loan covenants (since a cancellation by the insurer will presumably happen in the context of a further terrorist act that freezes up the insurance market around the world). It will be critical for owners to carefully analyze the requirements of their loans to determine what grace periods may apply on the obligation to maintain the insurance before the lender can declare a default and to see if such obligation is subject to a commercially reasonableness or other standard. Landlords will clash with their lenders in cases where the terrorism coverage is not offered or is offered only on terms that the landlord finds to be commercially unreasonable.

J. Impact on Tenant Insurance Requirements. The uncertainty concerning coverage for terrorism risk also affects the insurance that each tenant is required to maintain under its lease. Most leases require the tenant to maintain casualty coverage for its tenant improvements, alterations and additions, as well as the tenant’s personal property, fixtures, furnishings and equipment. If a tenant’s own casualty policies exclude terrorism risk, the tenant will be uninsured for the cost of replacing the improvements and personal property in its premises following a terrorist act. This makes the tenant a “self-insurer” for the cost of replacing such improvements and property, and may result in the tenant being financially unable to repair or replace its improvements and personal property following a terrorist attack. Thus, the terrorism risk exclusion in casualty policies will negatively affect both the landlord’s ability to rebuild the base building and the tenant’s ability to restore tenant improvements in its premises following a terrorist act. Landlords must now address whether and to what extent their insurance requirements for tenants will specifically require terrorism coverage, taking into consideration the high cost of the coverage and the tenant’s financial ability to handle the risk.

K. Government Action. In the last quarter of 2001, the House of Representatives passed a bill (HR 3210) that set up a one (1) year federal risk-sharing loan program to provide up to $100 billion in aid to the insurance industry. The program would have made loans to cover 90% of the industry losses of between $1 billion and $20 billion. Loans would be repaid from an assessment of 10% of a company’s capital surplus and premiums. The insurance industry did not back this bill and instead asked that the federal government act as a 90% re-insurer for events causing between $10 billion and $100 billion in losses, rather than a loan to the industry. The Senate bill that would have adopted this approach has failed. While Congress continues to discuss the method of back-stopping the insurance industry, many owners will be unable to purchase the insurance they require or want for a commercially reasonable cost. As time goes on, and as the insurance market moves toward a more stable approach to insuring the terrorism risk, the pressure on Congress to pass legislation to back-stop the issuance of terrorism insurance is being relieved, at least for now, and most observers do not foresee federal action to assure the availability of such coverage unless and until there is another major terrorist act that effectively shuts down the market for terrorism coverage.

L. Impact of Terrorism Risk on the Market. There will be a differentiation in the marketplace between the owners of high rise “trophy” buildings, where terrorism coverage will be a significant factor in the financing and ownership of the buildings, and the owners of low or mid rise buildings, especially in suburban locations, where the perceived risk of terrorism is not as great, the costs of coverage are not as high, and the level of attention by lenders and investors to terrorism insurance is not as intense. This differentiation will have the effect of increasing the cost to tenants of leasing space in high rise trophy buildings as compared to more suburban locations, unless landlords are willing to accept lower net rents to absorb some or all of the incremental cost of terrorism coverage for the high rise buildings.

A. Failure to Provide Access or Services. Most leases allow the tenant to abate its rent during the period that the landlord is unable to provide services, utilities or access to the building if the failure to provide access, utilities or services is within landlord’s control. If the failure to provide such access, services or utilities is a result of causes “outside of the landlord’s control”, the tenant must rely on its own business interruption insurance to cover the risk and the tenant is not generally entitled to claim a constructive eviction by the landlord or to abate its rent.

B. Definition of Causes Outside Landlord’s Control For purposes of the lease provisions governing the obligation to provide access, services and utilities, landlords need to define causes “outside of landlord’s control” to include acts of war, terrorism and bio-terrorism. Furthermore, the events of September 11, 2001 in New York should cause all landlords to expand the list of causes “outside of landlord’s control” to include:

All of these conditions were experienced by the buildings in downtown Manhattan for many days following September 11, 2001, resulting in the inability to provide access or services and utilities to many of the tenants in the buildings in the area.

C. Rent Abatement. The recent terrorism policies of insurance offer coverage for rent loss arising from a casualty to the building caused by a terrorist act, so that landlords can be covered for at least part of the lost rent if tenants are entitled to abate their rent following a terrorist act. Note that landlord-oriented leases limit the tenant’s right to abate rent to the amount of rent loss insurance proceeds received by the landlord, so that the landlord is never exposed to an uninsured loss of rents. Landlords and tenants need to review this type of provision in the post-September 11, 2001 environment and determine if it is an appropriate allocation of the risk of a terrorist act between them, especially in light of the limitations in terrorism risk policies that reduce the coverage for building repairs by the amount of rent loss covered by the policy.

Landlords can certainly argue that the tenant should only abate its rent to the extent that the loss is covered by insurance since the tenant could be charged a higher pass through if the landlord opted to cover rent loss for the maximum amount and for all risks.

Tenants can argue, at least in the case of policies where rental loss from terrorist acts is not made available at the time of renewal of the policy or at an effective cost, that the rental loss from a terrorist act is not insurable in a commercially reasonable manner, that this is the type of risk that a building owner should take, and that the tenant should be entitled to the rental abatement regardless of the insurability of the loss.