Rethinking Boilerplate

A boilerplate limitation of landlord liability clause typically looks something like this (in boldface type or all caps depending on conspicuousness requirements of applicable state law):

Tenant agrees that in the event Tenant shall have any claim against Landlord or Landlord's Related Parties under this Lease directly or indirectly arising out of the subject matter of this Lease, Tenant's sole recourse shall be against Landlord's interest in the Property for the satisfaction of any claim, judgment or decree requiring the payment of money by Landlord or Landlord's Related Parties as a result of a breach hereof or otherwise in connection with this Lease, and no other property or assets of Landlord, Landlord's Related Parties or their respective successors or assigns, shall be subject to levy, execution or other enforcement procedure for the satisfaction of any such claim, injunction or decree.

Tenant Modifications to the Limitation of the Landlord Liability Clause

Tenants may want to evaluate this boilerplate provision in light of the reduction in property values. Suppose, for example, that a landlord purchased an office building in 2006 for $25 million and was able to obtain financing equal to 80% of the purchase price. Further, assume that the loan only required the landlord to make payments equal to the accrued interest on the loan until maturity. When the lease was signed, this provision, while providing substantial protection to the landlord, gave a tenant $5 million of landlord equity to pursue in the event of tenant claims. Assume, however, that because of the downturn, this property suffered a 30% decline in value. As a result, the landlord now owns a property that is only worth $17,500,000, but still has a loan balance of $20 million. A tenant that signed a lease with this landlord containing this boilerplate provision now effectively has no remedy for monetary damages against its landlord as a result of this provision of the lease without added protections.

How can a tenant protect itself? The first thing that tenants can do is to conduct some due diligence on their landlords. Tenants could run a title search at a nominal cost on the property they are seeking to lease. The title report will show a prospective tenant when the property was purchased by the landlord, and, where state law requires that the consideration paid be stated on the face of a deed, the amount that the landlord paid for the property. Further, a title report will disclose whether any lenders have liens on the property as well as the principal amount of the original indebtedness owed by the landlord. Unless a property is owned by a landlord outright, prospective tenants should be cautious if the landlord purchased the property between 2005 and 2008.

What the limitation on liability provision calls into question is whether the landlord has the financial wherewithal to meet its potential obligations under the lease. In most cases, a prospective tenant will find that the landlord is a single-asset limited liability company or limited partnership that only owns the property. Where this is the case, a prospective tenant needs to look at the chain of ownership to find out where this particular landlord's money flows and is held. If a tenant's landlord is a single-asset entity and its only asset is underwater, the tenant effectively may not have recourse under its lease for a claim for money damages against the landlord.

Once prospective tenants understand the lay of the land, they have the information necessary to negotiate this boilerplate lease provision. Depending on the results of a tenant's due diligence, a tenant has a number of ways to attack this boilerplate provision to protect itself. Where the tenant discovers that the landlord has no equity in the property because of a decline in the value of the property, tenants can propose that the limitation of landlord liability be modified to be the greater of a specified dollar amount or the landlord's equity interest in the property. Because market price declines do not necessarily affect a property's rent stream or the amount that a particular landlord has in cash reserves, this revision to the limitation of landlord liability clause may be an appropriate compromise for both a landlord and a tenant. An example of a clause changed to incorporate this concept is below:

Tenant agrees that, in the event Tenant shall have any claim against Landlord or Landlord's Related Parties under this Lease requiring the payment of money or which directly or indirectly arises out of the subject matter of this Lease, the liability of Landlord shall be limited to the greater of (i) [SPECIFY DOLLAR AMOUNT], or (ii) the interest of Landlord in the Property.

The amount specified in the clause above would need to take into account the aggregate rental payments to be made by the tenant under the lease, the cost of any landlord work, the amount of any tenant improvement allowance, and the tenant's other rights in the lease such as offset rights. In the event that the landlord in question is a single-asset entity that holds no assets other than the property, a tenant should consider requiring that the landlord's parent or other appropriate related entity agree to guarantee some or all of the obligations of the landlord. This can be accomplished by having the entity execute the lease with an acknowledgement similar to the following:

Subject to Section ___ [Limitation of Landlord Liability Clause], Parent Co. hereby executes this Lease for the sole purpose of evidencing Parent Co.'s agreement to be jointly and severally liable to Tenant [pursuant to Section(s) ____ of the Lease] for any claim, judgment, or decree against Landlord or Landlord's Related Parties requiring the payment of money while Landlord owns the Property.

Landlord Modifications to the Limitation of Landlord Liability Clause

Tenants are not the only parties to a lease that should be concerned with the effect of this particular boilerplate lease provision. Landlords, too, need to assess their positions to see if this clause is actually shielding them from significant liability to their tenants. Whether or not a landlord is a single-asset entity, if the landlord owns the property outright or if there is only a nominal amount of leverage on the property in question, a landlord may be more exposed to liability than it realizes. Landlords in this position can address this issue in two ways. For smaller tenants, a landlord may want to break away from the standard limitation of the landlord liability clause altogether and opt instead for a clause that limits the landlord's aggregate liability under the lease to a specified dollar amount. A second way to deal with this issue would be to modify the provision to provide that the landlord's liability is limited to an amount equal to the lesser of the landlord's actual equity interest in the property or the equity interest that the landlord would have in the property if the landlord had obtained financing on the property equal to a specified percentage of the property's value. Both of these potential modifications are discussed in more detail below.

Consider, for example, a landlord that owns a 300,000 square-foot shopping center that is entering into a lease with a small restaurant. The restaurant will be leasing 2,000 square feet for a 10-year term at $30 per square foot per year and also will pay its pro rata share of operating expenses, taxes, and insurance. The landlord initially purchased the property in 2006 for $100 million with financing equal to 70% of the purchase price of the property. The landlord's loan only required monthly payments of accrued interest prior to maturity. Because of market declines, the property is now only worth $80 million, which means that the landlord has an equity interest in the property of $10 million. If a landlord continues to include the boilerplate limitation of the landlord liability clause in its lease with this restaurant tenant, the landlord is offering $10 million in potential liability for a tenant that is only paying the landlord $600,000 in aggregate base rent over the term of the lease. The gross allocation of risk to the landlord is only exacerbated where a landlord owns this same property outright. In that case, the landlord has $80 million of potential liability to a tenant that is only paying it $600,000 in base rent. In situations like this, it is appropriate to abandon the standard limitation of the landlord liability clause in favor of a strict dollar cap. In this same context, it might also make sense (subject to any loan covenants) for a landlord to remove a tenant's ability to make any claim against the property whatsoever and instead specify a different asset, such as the property's operating account or a separate account created for this purpose, as the sole asset that can be attacked by a tenant to satisfy claims for money damages. An example of this type of clause is set forth below:

Tenant agrees that, in the event Tenant shall have any claim against Landlord or Landlord's Related Parties under this Lease requiring the payment of money or which directly or indirectly arises out of the subject matter of this Lease, Tenant's sole recourse shall be against the amount in Landlord's [Operating/Other] Account from time to time during the Term of this Lease, but in no event to exceed [$___________] (“Liability Cap”), for the satisfaction of any claim, judgment, or decree requiring the payment of money by Landlord or Landlord's Related Parties or as a result of a breach hereof or otherwise in connection with this Lease, and no other property or asset of Landlord (including, without limitation, the Premises or the Property), Landlord's Related Parties or their successors or assigns, shall be subject to the levy, execution, or other enforcement procedure for the satisfaction of any such claim, judgment, injunction, or decree.

Even for larger tenants, modifications to the boilerplate limitation of the landlord liability clause are appropriate also. A major tenant may not accept a low liability cap amount, but may accept as a general market condition that there is an acceptable and expected amount of leverage that landlords place on their property. Because the boilerplate provision ties a landlord's aggregate liability to the landlord's equity interest in the property, landlords that do not maintain a relatively high amount of leverage on their properties are disadvantaged when compared with landlords that do. Because the limitation of landlord liability clause is so standard in leases, landlords with substantial leverage on their properties are still able to include these provisions in their leases with large tenants notwithstanding the significant impact that these clauses have on a tenant's rights and remedies. Landlords that maintain less leverage on their properties should not be punished for doing so and should consider modifying the standard limitation of landlord liability clause to put themselves on par with their more-leveraged counterparts. These landlords can protect themselves by placing a ceiling on their liability which is tied to the prevailing amount of leverage placed on similar properties in the market. Here is an example of a limitation of landlord liability clause which is so modified.

Tenant agrees that, in the event Tenant shall have any claim, judgment, or decree against Landlord or Landlord's Related Parties under this Lease requiring the payment of money or directly or indirectly arising out of the subject matter of this Lease, the liability of Landlord shall be limited to the lesser of (i) the equity interest Landlord would have in the Property if the Property was encumbered by debt in an amount equal to [___]% of the value of the Property (with the value of the Property being determined as of the date of this Lease), or (ii) the interest of Landlord in the Property.

Conclusion

After decades of tenants and landlords negotiating leases, boilerplate provisions such as the standard limitation on the landlord liability clause have become an accepted part of leasing transactions. However, if boilerplate provisions are not considered in light of the positions of the respective parties to a leasing transaction, a party can be left exposed to substantial liability or without a remedy for the rights it has so carefully negotiated. While either outcome is unintended, these results can be avoided by considering the relative positions of the parties to a lease, and crafting a provision which incorporates the concept boilerplate provisions intend to address while still meeting the legitimate risk-allocation concerns of both landlords and tenants.

Jane Snoddy Smith, a member of this newsletter's Board of Editors, is a partner in Fulbright & Jaworski's Austin, TX, office. She focuses on transactional law with a concentration in commercial real estate. Bryan Wesley Patrick is a senior associate in the same office, where he is a member of the firm's real estate group and practices in the areas of commercial real estate and leasing.

As the United States economy begins to create renewed demand for office and retail space, landlords and tenants have the opportunity to take the lessons learned from the recent downturn into their next lease negotiation. While there are a number of hotly contested business and legal points in any negotiation, it is easy to forget the boilerplate provisions buried at the end of a lease. These boilerplate provisions are often unquestioned simply because they are standard; however, many of these provisions deserve a fresh look before being incorporated into new leases. There is a clause that has the ability to allocate risk grossly to one party or the other. If left unmodified, this clause ' the landlord liability clause ' can also leave a tenant without a meaningful remedy for the rights that it has so carefully negotiated. This article explores the limitation of the landlord liability clause.

Limitation on Landlord Liability Clauses

Most, if not all, leases will contain a standard provision limiting a landlord's liability to a tenant to the landlord's interest in the underlying property. These provisions deserve additional scrutiny by both landlords and tenants as they enter into new leases. Given the reduction of value that has occurred over the past several years across commercial properties of every type, tenants have to be concerned that this provision actually negates any meaningful remedy against a landlord when a landlord is highly leveraged. Landlords, on the other hand, may want to review this clause in light of the heightened lending standards currently prevailing in commercial real estate. Where this clause used to provide landlords a great deal of cover, this provision now may actually expose a landlord to substantial liability, e.g., if the landlord recently refinanced property or acquired property with the help of new financing, the lender likely required more equity. In addition, landlords that have the luxury of owning their properties outright need to pay special attention to these clauses as the standard limitation of landlord liability provision provides those landlords with no substantive protection.

A boilerplate limitation of landlord liability clause typically looks something like this (in boldface type or all caps depending on conspicuousness requirements of applicable state law):

Tenant agrees that in the event Tenant shall have any claim against Landlord or Landlord's Related Parties under this Lease directly or indirectly arising out of the subject matter of this Lease, Tenant's sole recourse shall be against Landlord's interest in the Property for the satisfaction of any claim, judgment or decree requiring the payment of money by Landlord or Landlord's Related Parties as a result of a breach hereof or otherwise in connection with this Lease, and no other property or assets of Landlord, Landlord's Related Parties or their respective successors or assigns, shall be subject to levy, execution or other enforcement procedure for the satisfaction of any such claim, injunction or decree.

Tenant Modifications to the Limitation of the Landlord Liability Clause

Tenants may want to evaluate this boilerplate provision in light of the reduction in property values. Suppose, for example, that a landlord purchased an office building in 2006 for $25 million and was able to obtain financing equal to 80% of the purchase price. Further, assume that the loan only required the landlord to make payments equal to the accrued interest on the loan until maturity. When the lease was signed, this provision, while providing substantial protection to the landlord, gave a tenant $5 million of landlord equity to pursue in the event of tenant claims. Assume, however, that because of the downturn, this property suffered a 30% decline in value. As a result, the landlord now owns a property that is only worth $17,500,000, but still has a loan balance of $20 million. A tenant that signed a lease with this landlord containing this boilerplate provision now effectively has no remedy for monetary damages against its landlord as a result of this provision of the lease without added protections.

How can a tenant protect itself? The first thing that tenants can do is to conduct some due diligence on their landlords. Tenants could run a title search at a nominal cost on the property they are seeking to lease. The title report will show a prospective tenant when the property was purchased by the landlord, and, where state law requires that the consideration paid be stated on the face of a deed, the amount that the landlord paid for the property. Further, a title report will disclose whether any lenders have liens on the property as well as the principal amount of the original indebtedness owed by the landlord. Unless a property is owned by a landlord outright, prospective tenants should be cautious if the landlord purchased the property between 2005 and 2008.

What the limitation on liability provision calls into question is whether the landlord has the financial wherewithal to meet its potential obligations under the lease. In most cases, a prospective tenant will find that the landlord is a single-asset limited liability company or limited partnership that only owns the property. Where this is the case, a prospective tenant needs to look at the chain of ownership to find out where this particular landlord's money flows and is held. If a tenant's landlord is a single-asset entity and its only asset is underwater, the tenant effectively may not have recourse under its lease for a claim for money damages against the landlord.

Once prospective tenants understand the lay of the land, they have the information necessary to negotiate this boilerplate lease provision. Depending on the results of a tenant's due diligence, a tenant has a number of ways to attack this boilerplate provision to protect itself. Where the tenant discovers that the landlord has no equity in the property because of a decline in the value of the property, tenants can propose that the limitation of landlord liability be modified to be the greater of a specified dollar amount or the landlord's equity interest in the property. Because market price declines do not necessarily affect a property's rent stream or the amount that a particular landlord has in cash reserves, this revision to the limitation of landlord liability clause may be an appropriate compromise for both a landlord and a tenant. An example of a clause changed to incorporate this concept is below:

Tenant agrees that, in the event Tenant shall have any claim against Landlord or Landlord's Related Parties under this Lease requiring the payment of money or which directly or indirectly arises out of the subject matter of this Lease, the liability of Landlord shall be limited to the greater of (i) [SPECIFY DOLLAR AMOUNT], or (ii) the interest of Landlord in the Property.

The amount specified in the clause above would need to take into account the aggregate rental payments to be made by the tenant under the lease, the cost of any landlord work, the amount of any tenant improvement allowance, and the tenant's other rights in the lease such as offset rights. In the event that the landlord in question is a single-asset entity that holds no assets other than the property, a tenant should consider requiring that the landlord's parent or other appropriate related entity agree to guarantee some or all of the obligations of the landlord. This can be accomplished by having the entity execute the lease with an acknowledgement similar to the following:

Subject to Section ___ [Limitation of Landlord Liability Clause], Parent Co. hereby executes this Lease for the sole purpose of evidencing Parent Co.'s agreement to be jointly and severally liable to Tenant [pursuant to Section(s) ____ of the Lease] for any claim, judgment, or decree against Landlord or Landlord's Related Parties requiring the payment of money while Landlord owns the Property.

Landlord Modifications to the Limitation of Landlord Liability Clause

Tenants are not the only parties to a lease that should be concerned with the effect of this particular boilerplate lease provision. Landlords, too, need to assess their positions to see if this clause is actually shielding them from significant liability to their tenants. Whether or not a landlord is a single-asset entity, if the landlord owns the property outright or if there is only a nominal amount of leverage on the property in question, a landlord may be more exposed to liability than it realizes. Landlords in this position can address this issue in two ways. For smaller tenants, a landlord may want to break away from the standard limitation of the landlord liability clause altogether and opt instead for a clause that limits the landlord's aggregate liability under the lease to a specified dollar amount. A second way to deal with this issue would be to modify the provision to provide that the landlord's liability is limited to an amount equal to the lesser of the landlord's actual equity interest in the property or the equity interest that the landlord would have in the property if the landlord had obtained financing on the property equal to a specified percentage of the property's value. Both of these potential modifications are discussed in more detail below.

Consider, for example, a landlord that owns a 300,000 square-foot shopping center that is entering into a lease with a small restaurant. The restaurant will be leasing 2,000 square feet for a 10-year term at $30 per square foot per year and also will pay its pro rata share of operating expenses, taxes, and insurance. The landlord initially purchased the property in 2006 for $100 million with financing equal to 70% of the purchase price of the property. The landlord's loan only required monthly payments of accrued interest prior to maturity. Because of market declines, the property is now only worth $80 million, which means that the landlord has an equity interest in the property of $10 million. If a landlord continues to include the boilerplate limitation of the landlord liability clause in its lease with this restaurant tenant, the landlord is offering $10 million in potential liability for a tenant that is only paying the landlord $600,000 in aggregate base rent over the term of the lease. The gross allocation of risk to the landlord is only exacerbated where a landlord owns this same property outright. In that case, the landlord has $80 million of potential liability to a tenant that is only paying it $600,000 in base rent. In situations like this, it is appropriate to abandon the standard limitation of the landlord liability clause in favor of a strict dollar cap. In this same context, it might also make sense (subject to any loan covenants) for a landlord to remove a tenant's ability to make any claim against the property whatsoever and instead specify a different asset, such as the property's operating account or a separate account created for this purpose, as the sole asset that can be attacked by a tenant to satisfy claims for money damages. An example of this type of clause is set forth below:

Tenant agrees that, in the event Tenant shall have any claim against Landlord or Landlord's Related Parties under this Lease requiring the payment of money or which directly or indirectly arises out of the subject matter of this Lease, Tenant's sole recourse shall be against the amount in Landlord's [Operating/Other] Account from time to time during the Term of this Lease, but in no event to exceed [$___________] (“Liability Cap”), for the satisfaction of any claim, judgment, or decree requiring the payment of money by Landlord or Landlord's Related Parties or as a result of a breach hereof or otherwise in connection with this Lease, and no other property or asset of Landlord (including, without limitation, the Premises or the Property), Landlord's Related Parties or their successors or assigns, shall be subject to the levy, execution, or other enforcement procedure for the satisfaction of any such claim, judgment, injunction, or decree.

Even for larger tenants, modifications to the boilerplate limitation of the landlord liability clause are appropriate also. A major tenant may not accept a low liability cap amount, but may accept as a general market condition that there is an acceptable and expected amount of leverage that landlords place on their property. Because the boilerplate provision ties a landlord's aggregate liability to the landlord's equity interest in the property, landlords that do not maintain a relatively high amount of leverage on their properties are disadvantaged when compared with landlords that do. Because the limitation of landlord liability clause is so standard in leases, landlords with substantial leverage on their properties are still able to include these provisions in their leases with large tenants notwithstanding the significant impact that these clauses have on a tenant's rights and remedies. Landlords that maintain less leverage on their properties should not be punished for doing so and should consider modifying the standard limitation of landlord liability clause to put themselves on par with their more-leveraged counterparts. These landlords can protect themselves by placing a ceiling on their liability which is tied to the prevailing amount of leverage placed on similar properties in the market. Here is an example of a limitation of landlord liability clause which is so modified.

Tenant agrees that, in the event Tenant shall have any claim, judgment, or decree against Landlord or Landlord's Related Parties under this Lease requiring the payment of money or directly or indirectly arising out of the subject matter of this Lease, the liability of Landlord shall be limited to the lesser of (i) the equity interest Landlord would have in the Property if the Property was encumbered by debt in an amount equal to [___]% of the value of the Property (with the value of the Property being determined as of the date of this Lease), or (ii) the interest of Landlord in the Property.

Conclusion

After decades of tenants and landlords negotiating leases, boilerplate provisions such as the standard limitation on the landlord liability clause have become an accepted part of leasing transactions. However, if boilerplate provisions are not considered in light of the positions of the respective parties to a leasing transaction, a party can be left exposed to substantial liability or without a remedy for the rights it has so carefully negotiated. While either outcome is unintended, these results can be avoided by considering the relative positions of the parties to a lease, and crafting a provision which incorporates the concept boilerplate provisions intend to address while still meeting the legitimate risk-allocation concerns of both landlords and tenants.

Jane Snoddy Smith, a member of this newsletter's Board of Editors, is a partner in Fulbright & Jaworski's Austin, TX, office. She focuses on transactional law with a concentration in commercial real estate. Bryan Wesley Patrick is a senior associate in the same office, where he is a member of the firm's real estate group and practices in the areas of commercial real estate and leasing.