Passive Lessor Liability from Terrorism: A New Era of Higher Risk

After 9/11, the dramatic impact of that heinous event disrupted leasing, insurance and investment markets in the United States. Many insurance companies canceled or imposed exclusions on terrorism coverage in their insurance policies. Previously, the coverage had often been provided as a free addition to other insurance coverage. The unexpected losses of nearly $40 billion for the insurance industry as a result of 9/11 changed this coverage. As a result of high pricing, insufficient coverage or unavailable coverage, an estimated $15 billion or more of real estate and other projects dependent on such insurance ground to a halt in 2001. The Terrorism Risk Insurance Act of 2002, signed into law on November 26, 2002, increased the availability of terrorism insurance, but it did not resolve the risk of terrorism for lessors or other investors in capital assets and real estate.

The General Definition of Terrorism

To address the risk of terrorism, it is useful to define the concept and nature of terrorism risk. Terrorism generally means activities of domestic or foreign groups or individuals against persons, organizations or property in violation of the U.S. criminal laws of a nature that involves the following or preparation for the following: (i) use or threat of force, ransom or violence, (ii) the commission or threat of a dangerous act, or (iii) the commission or threat of any act that interferes with or disrupts an electronic, communication, information or mechanical system. The intended effect of such acts is to (i) intimidate or coerce a government, or to cause chaos among the civilian population or any segment of the economy; or (ii) intimidate or coerce a government, or to seek revenge or retaliate, or (iii) further political, ideological, religious, social or economic objective or to express opposition to a philosophy or ideology.

The Risks Lessors Face

A myth may exist for some lessors that only high-profile assets face terrorism risks. However, terrorism experts have identified a wide variety of assets that may be subject to acts of terrorism such as fire or explosion, or even biological and chemical attacks. Most of these assets could be subject to leases. These assets include power plants, water treatment facilities, aircraft (commercial and business aviation), chemical production plants, technology and communications equipment (including computers), real estate premises (office buildings, shopping malls, etc.), transportation assets (tractors, trailers, tank cars, railcars, etc.), and water, fuel storage or other tanks. The conclusion for lessors is clear. Terrorism risk affects a wide array of leased property including lessors' financial interests relating to that property. Terrorism risk is not limited to high-profile assets, such as 'trophy real estate.'

How can this be so when lessors only act as passive owners of large facilities or other types of assets? Such lessors exercise no operational control of leased property. They remain 'once removed' if not legally distant as a passive owner and investor. The risk of loss is generally insurable. What other risks do lessors face?

Lessors should not assume that lessees can obtain adequate or affordable terrorism insurance coverage. Although insurance markets have recovered somewhat since 9/11, they have not, and likely will not soon, return to the levels that existed before 9/11. The market-driven costs of terrorism coverage have risen significantly and will probably remain relatively high in relation to the cost of primary insurance lines for the foreseeable future. Further, lessors should focus on potential liability to third parties as a separate concern from property loss. Each exposure involves different methods to mitigate risk and different amounts and types of financial protection. A single liability event of even a small fraction of the cost of 9/11 could easily exhaust insurance policy limits and the net worth of any lessee or lessor.

Lessors should examine closely the potential for legal liability they face to determine how to manage each risk exposure. For the purposes of this article, it is assumed that most lessors decide at the inception of a lease that the potential loss of property will not exhaust the credit, insurance and collateral protection available from the lessee or a lessor's own insurance coverage. However, liability to other parties arising from a terrorist attack creates a much different potential level of exposure for lessors. An attack need not occur on a lessor's leased property. The proximity of an event to the leased property from other property poses the similar risks or loss or liability. Regardless of the probabilities of an attack, which no one can predict, lessors should not ignore the risk or financial exposure that could arise from lawsuits and claims following a terrorist attack on or near a lessor's leased property.

Theories of Lessor Liability

Current law varies by state as to potential liability for terrorism. A review of such laws is beyond the scope of this article. Consequently, lessors should closely review the laws applicable to each lease transaction. Generally, the laws of the states should not impose liability on passive owner/lessors for terrorist act, but the law of terrorism liability will evolve with each terrorist act. Lessors should, therefore, assume that claimants would test several existing and potentially new bases of liability after a terrorist event. Such legal bases of liability could include (i) negligence, (ii) contractual or warranty liability and (iii) strict liability.

Under normal circumstances, most lessors do not worry much about liability from their own acts or failures to act regarding leased property. They remain inactive and passive, a source of money, not a manager or operator of leased property. While these old notions may hold up, those who are harmed by a terrorist act may try old and new theories of negligence to capture lessors in their liability net.

For example, an injured party may assert the following basic application of negligence as applied to terrorism: A lessor has a duty of care to prevent a foreseeable terrorist act at or affecting leased property that the lessor owns. Such a foreseeable act could cause injury to people or loss of property. As the owner of the leased property, the lessor's act or failure to act to prevent foreseeable injury or loss through terrorism constitutes a breach of the lessor's duty of care, creating an action in negligence. A lessor must pay for the injury or loss as a result of such negligence.

Plaintiffs have already made negligence allegations of this type. Lessors and their counsel should consider the specific allegations of negligence, resulting from an alleged breach of the lessor's duty of care, including, by way of limited illustrations, the following:

• 
  
• Alleged lessor liability for the failure of the lessor to prevent harm when it knew or should have known of conditions leading to inchoate tort claims (terrorist attack ignited fuel stored in rented building). See: Industrial Risk Insurers v. The City of New York, 2003 N.Y. Misc. Lexis 252 (N.Y. Sup.Ct., March 19, 2003);
  
• Alleged liability of a lessor for the failure of the lessor to foresee and use reasonable care to prevent a criminal act of a terrorist placing a bomb in leased property. See: Danielenko v. Kinney Rent A Car, Inc., 84 A.D. 159; 445 N.Y.S.2d 464 (N.Y. 1st App. Div., Jan. 1982), rev'd at 57 N.Y.S.2d 198; 441 N.E.2d 1073; 455 N.Y.S.2d 555 (Court of Appeals of New York, Oct. 1982) (no duty exists where terrorist bombing of rented vehicle not foreseeable.); and
  
• Potential liability of a lessor for its failure to require an adequate security design and/or construction of leased property, employee screening and security plan to prevent terrorism at the leased property.
  
  

Other theories of liability exist. Lessors could have contractual liability arising from any promise or warranty by a lessor/landlord regarding premises or leased property. While facility and equipment lessors generally avoid such promises, if commercial real estate comprises a part of a project or investment, then each potential action required by a lessor/landlord should be scrutinized for potential liability for terrorist acts.

Lessors could also be held liable under theories of strict liability, which involve lessor liability without fault. For example, in one type of aircraft liability analysis, the Rome Convention contains a limited concept of strict liability for operators of aircraft (which may include the owner of aircraft) for things falling from the sky or damage caused on the ground. While the Rome Convention provisions should not impose liability on lessors for terrorism, the issue is whether theories of strict liability could extend strict liability to lessors as a result of a terrorist act. See: Convention on Damage Caused By Foreign Aircraft To Third Parties On The Surface (Rome Convention 1952).

The Terrorist Risk Conundrum

Lessors face a conundrum of how to proceed to manage terrorism risks. On one hand, if lessors take steps to mitigate and manage terrorism risk, will they actually create and/or increase their own duty of care and potential liability to others? If such a duty of care exists, could such lessors reasonably foresee a breach of the duty as a basis for a negligence action against them. On the other hand, if the lessors do not take steps to protect themselves and their leased property initially in a transaction, will their failure to do so increase their potential liability?

This conundrum exists in most lease transactions. The solutions require lessors and lessees to engage in a balancing act. They must weigh the perceived risk or probability of terrorism against the potential value of solutions in their lease transactions. The transaction considerations include: (i) calculating the cost to mitigate that risk through insurance and other means, (ii) using the best transaction structure and documentation to minimize the risk, (iii) determining acceptable asset risk generally (such as accepting risks of leasing a chemical production facility versus a water treatment plant), and (iv) evaluating the ability of the lessee's 'credit' and resources to withstand a terrorist event.

Lessors would be well served by creating interdisciplinary teams of finance, structuring, legal and insurance professionals as well as risk managers to determine the optimal approach to coping with terrorism regarding significant leased property. No right answer or approach exists. However, one basic idea seems appropriate. In today's higher-risk world, as a matter of prudent risk management, lessors should understand and realistically address the potential for terrorism in each lease transaction. Having done so, lessors should not view the risk of terrorism as an impediment to investment in leased property.

David G. Mayer is a partner in the Dallas office of Patton Boggs LLP. He is the author of 'Business Leasing For Dummies' and the publisher of 'Business Leasing News,' which is available at: http://www.pblaw.com/newsletters/bln. Mr. Mayer is a frequent speaker on various leasing and related financing topics for the ELA and other sponsors.

What terrorism risks do passive owner/lessors face regarding their leased property? Have lessors changed their views or analysis of how to protect their lease investments from terrorism since 9/11 and the war in Iraq?

We now live with increased risk of terrorism affecting U.S. interests worldwide. The question for lessors is whether lessors perceive their investments or their balance sheets to be at risk from terrorist acts. The premise of this article is that terrorism can affect leased property and that lessors should understand the nature of their legal risk in order to protect their investments.

Impact on Capital Investment After 9/11

After 9/11, the dramatic impact of that heinous event disrupted leasing, insurance and investment markets in the United States. Many insurance companies canceled or imposed exclusions on terrorism coverage in their insurance policies. Previously, the coverage had often been provided as a free addition to other insurance coverage. The unexpected losses of nearly $40 billion for the insurance industry as a result of 9/11 changed this coverage. As a result of high pricing, insufficient coverage or unavailable coverage, an estimated $15 billion or more of real estate and other projects dependent on such insurance ground to a halt in 2001. The Terrorism Risk Insurance Act of 2002, signed into law on November 26, 2002, increased the availability of terrorism insurance, but it did not resolve the risk of terrorism for lessors or other investors in capital assets and real estate.

The General Definition of Terrorism

To address the risk of terrorism, it is useful to define the concept and nature of terrorism risk. Terrorism generally means activities of domestic or foreign groups or individuals against persons, organizations or property in violation of the U.S. criminal laws of a nature that involves the following or preparation for the following: (i) use or threat of force, ransom or violence, (ii) the commission or threat of a dangerous act, or (iii) the commission or threat of any act that interferes with or disrupts an electronic, communication, information or mechanical system. The intended effect of such acts is to (i) intimidate or coerce a government, or to cause chaos among the civilian population or any segment of the economy; or (ii) intimidate or coerce a government, or to seek revenge or retaliate, or (iii) further political, ideological, religious, social or economic objective or to express opposition to a philosophy or ideology.

The Risks Lessors Face

A myth may exist for some lessors that only high-profile assets face terrorism risks. However, terrorism experts have identified a wide variety of assets that may be subject to acts of terrorism such as fire or explosion, or even biological and chemical attacks. Most of these assets could be subject to leases. These assets include power plants, water treatment facilities, aircraft (commercial and business aviation), chemical production plants, technology and communications equipment (including computers), real estate premises (office buildings, shopping malls, etc.), transportation assets (tractors, trailers, tank cars, railcars, etc.), and water, fuel storage or other tanks. The conclusion for lessors is clear. Terrorism risk affects a wide array of leased property including lessors' financial interests relating to that property. Terrorism risk is not limited to high-profile assets, such as 'trophy real estate.'

How can this be so when lessors only act as passive owners of large facilities or other types of assets? Such lessors exercise no operational control of leased property. They remain 'once removed' if not legally distant as a passive owner and investor. The risk of loss is generally insurable. What other risks do lessors face?

Lessors should not assume that lessees can obtain adequate or affordable terrorism insurance coverage. Although insurance markets have recovered somewhat since 9/11, they have not, and likely will not soon, return to the levels that existed before 9/11. The market-driven costs of terrorism coverage have risen significantly and will probably remain relatively high in relation to the cost of primary insurance lines for the foreseeable future. Further, lessors should focus on potential liability to third parties as a separate concern from property loss. Each exposure involves different methods to mitigate risk and different amounts and types of financial protection. A single liability event of even a small fraction of the cost of 9/11 could easily exhaust insurance policy limits and the net worth of any lessee or lessor.

Lessors should examine closely the potential for legal liability they face to determine how to manage each risk exposure. For the purposes of this article, it is assumed that most lessors decide at the inception of a lease that the potential loss of property will not exhaust the credit, insurance and collateral protection available from the lessee or a lessor's own insurance coverage. However, liability to other parties arising from a terrorist attack creates a much different potential level of exposure for lessors. An attack need not occur on a lessor's leased property. The proximity of an event to the leased property from other property poses the similar risks or loss or liability. Regardless of the probabilities of an attack, which no one can predict, lessors should not ignore the risk or financial exposure that could arise from lawsuits and claims following a terrorist attack on or near a lessor's leased property.

Theories of Lessor Liability

Current law varies by state as to potential liability for terrorism. A review of such laws is beyond the scope of this article. Consequently, lessors should closely review the laws applicable to each lease transaction. Generally, the laws of the states should not impose liability on passive owner/lessors for terrorist act, but the law of terrorism liability will evolve with each terrorist act. Lessors should, therefore, assume that claimants would test several existing and potentially new bases of liability after a terrorist event. Such legal bases of liability could include (i) negligence, (ii) contractual or warranty liability and (iii) strict liability.

Under normal circumstances, most lessors do not worry much about liability from their own acts or failures to act regarding leased property. They remain inactive and passive, a source of money, not a manager or operator of leased property. While these old notions may hold up, those who are harmed by a terrorist act may try old and new theories of negligence to capture lessors in their liability net.

For example, an injured party may assert the following basic application of negligence as applied to terrorism: A lessor has a duty of care to prevent a foreseeable terrorist act at or affecting leased property that the lessor owns. Such a foreseeable act could cause injury to people or loss of property. As the owner of the leased property, the lessor's act or failure to act to prevent foreseeable injury or loss through terrorism constitutes a breach of the lessor's duty of care, creating an action in negligence. A lessor must pay for the injury or loss as a result of such negligence.

Plaintiffs have already made negligence allegations of this type. Lessors and their counsel should consider the specific allegations of negligence, resulting from an alleged breach of the lessor's duty of care, including, by way of limited illustrations, the following:

• 
  
• Alleged lessor liability for the failure of the lessor to prevent harm when it knew or should have known of conditions leading to inchoate tort claims (terrorist attack ignited fuel stored in rented building). See: Industrial Risk Insurers v. The City of New York, 2003 N.Y. Misc. Lexis 252 (N.Y. Sup.Ct., March 19, 2003);
  
• Alleged liability of a lessor for the failure of the lessor to foresee and use reasonable care to prevent a criminal act of a terrorist placing a bomb in leased property. See: Danielenko v. Kinney Rent A Car, Inc. , 84 A.D. 159; 445 N.Y.S.2d 464 (N.Y. 1st App. Div., Jan. 1982), rev'd at 57 N.Y.S.2d 198; 441 N.E.2d 1073; 455 N.Y.S.2d 555 (Court of Appeals of New York, Oct. 1982) (no duty exists where terrorist bombing of rented vehicle not foreseeable.); and
  
• Potential liability of a lessor for its failure to require an adequate security design and/or construction of leased property, employee screening and security plan to prevent terrorism at the leased property.
  
  

Other theories of liability exist. Lessors could have contractual liability arising from any promise or warranty by a lessor/landlord regarding premises or leased property. While facility and equipment lessors generally avoid such promises, if commercial real estate comprises a part of a project or investment, then each potential action required by a lessor/landlord should be scrutinized for potential liability for terrorist acts.

Lessors could also be held liable under theories of strict liability, which involve lessor liability without fault. For example, in one type of aircraft liability analysis, the Rome Convention contains a limited concept of strict liability for operators of aircraft (which may include the owner of aircraft) for things falling from the sky or damage caused on the ground. While the Rome Convention provisions should not impose liability on lessors for terrorism, the issue is whether theories of strict liability could extend strict liability to lessors as a result of a terrorist act. See: Convention on Damage Caused By Foreign Aircraft To Third Parties On The Surface (Rome Convention 1952).

The Terrorist Risk Conundrum

Lessors face a conundrum of how to proceed to manage terrorism risks. On one hand, if lessors take steps to mitigate and manage terrorism risk, will they actually create and/or increase their own duty of care and potential liability to others? If such a duty of care exists, could such lessors reasonably foresee a breach of the duty as a basis for a negligence action against them. On the other hand, if the lessors do not take steps to protect themselves and their leased property initially in a transaction, will their failure to do so increase their potential liability?

This conundrum exists in most lease transactions. The solutions require lessors and lessees to engage in a balancing act. They must weigh the perceived risk or probability of terrorism against the potential value of solutions in their lease transactions. The transaction considerations include: (i) calculating the cost to mitigate that risk through insurance and other means, (ii) using the best transaction structure and documentation to minimize the risk, (iii) determining acceptable asset risk generally (such as accepting risks of leasing a chemical production facility versus a water treatment plant), and (iv) evaluating the ability of the lessee's 'credit' and resources to withstand a terrorist event.

Lessors would be well served by creating interdisciplinary teams of finance, structuring, legal and insurance professionals as well as risk managers to determine the optimal approach to coping with terrorism regarding significant leased property. No right answer or approach exists. However, one basic idea seems appropriate. In today's higher-risk world, as a matter of prudent risk management, lessors should understand and realistically address the potential for terrorism in each lease transaction. Having done so, lessors should not view the risk of terrorism as an impediment to investment in leased property.

David G. Mayer is a partner in the Dallas office of Patton Boggs LLP. He is the author of 'Business Leasing For Dummies' and the publisher of 'Business Leasing News,' which is available at: http://www.pblaw.com/newsletters/bln. Mr. Mayer is a frequent speaker on various leasing and related financing topics for the ELA and other sponsors.