Commercial tenants are often perplexed when they realize that under the terms of their lease, they are responsible for damages that occur on the leased premises even if caused by the landlord’s own negligence. In most cases, the landlord’s liability for just about any scenario is limited to gross negligence and willful misconduct. Landlords typically insist that all liability shift to tenants because tenants have control over the leased premises. Tenants are then required to adequately insure against all liabilities whether or not it’s the landlord’s fault. The idea that tenants should be responsible for a landlord’s negligence seems counter intuitive. Landlord’s simply argue that they do not want to get caught up in battles over who may or may not be negligent. In their view, the simpler solution is for tenant’s to indemnify landlords for all liabilities while maintaining adequate insurance coverage (including insurance covering the landlord’s negligence). Whether or not one buys into the argument, the practical reality is that most landlords in California will insist on indemnification clauses requiring tenants to defend, indemnify and hold landlords harmless except in cases of the landlord’s gross negligence or willful misconduct. As a practical matter, excepting gross negligence and willful misconduct from indemnification clauses is not problematic for landlords because under California law they are already unable to contractually shift liability for their own gross negligence or willful misconduct. Willful misconduct is intentional misconduct. But what is “gross negligence”?
In layman’s terms, negligence is often referred to as carelessness. In legal terms it refers to the failure to meet an accepted standard of conduct. For example, a surgeon that accidentally leaves a sponge in a patient would clearly be careless thereby breaching the “standard of care” expected from surgeons generally. Gross negligence refers to a level of negligence that is greater than standard negligence but falls short of an intentional act to harm. Leaving the sponge in the patient on purpose because the surgeon didn’t like the patient’s constant complaining would be an intentional act. In California, gross negligence is defined as misconduct that demonstrates either a want of even scant care or an extreme departure from the ordinary standard of conduct. Gross negligence falls somewhere between a careless accident and an intentional act. Perhaps a nurse reminded the surgeon twice that the sponge was still in the patient but the surgeon decided to respond to a text message. Being warned about the sponge and texting while operating reflects a more careless act and in this case arguably rises to the level of gross negligence. Defining the contours of what is and what isn’t gross negligence however is easier said than done. Proving gross negligence then, at least in California, depends on making a factual determination as to what is scant care and/or an extreme departure. This is a highly subjective standard. The finder of fact (the jury in most cases) is tasked with determining what the standard of care is and then what level beyond this standard rises to gross negligence. In short, proving gross negligence is difficult in almost any circumstance.
To learn more about landlord liability and indemnification clauses, contact a San Diego commercial lease lawyer today.
The terms of commercial leases vary significantly depending on the type of commercial property being leased and the specific business goals of both landlords and tenants. “Option clauses,” also known as “renewal terms,” are provisions in a commercial lease agreement that allow a tenant to extend the term of the lease for an additional term after the initial term has expired. Tenants prefer option clauses because they reduce the risk of having to relocate an established business after the expiration of the initial term.
While option clauses are prevalent in commercial leasing, most landlords would probably prefer not to have to deal with them. This is especially so where the rental rate during the option period is fixed. Option clauses prevent landlords from leasing the premises on the open market and ultimately obtaining the highest possible rent. Options give tenants a choice which necessarily reduces a landlord’s flexibility. Once a tenant exercises its right to the option term, the terms of the option clause govern regardless of how good the market is at the time. That is why most landlords prefer that the rental rate during the option period be determined by the actual market rate for the premises at the time the option is exercised. This is generally a fair approach for both landlords and tenants because each side is equally exposed to the vagaries of the market.
A market rate would benefit tenants if the leasing market is especially soft when it comes time to exercise the tenant’s option. Moreover, in soft markets, tenants may be tempted to explore better options leaving landlords with empty space. To hedge against this uncertainty and in exchange for including an option clause, landlords will usually require that there be a floor to the new rental rate during the option period (usually no less than a 3% increase over the rental rate immediately preceding the option period). This provides landlords with the best of both worlds – a minimum increase in rent even if the leasing market is dismal or an increase in rent equal to the higher market rate should the market be strong. In such circumstances, tenants are better off with predetermined fixed increases in rent usually consistent with the annual increases in rent during the initial term of the lease. Either way, option clauses are inherently valuable to tenants and how the rental rate is determined during any option period under the terms of the lease will depend on the tenant’s bargaining power during commercial lease negotiations.
Indemnity clauses in general are designed to shift liability for claims asserted by third parties from one party to another. In the commercial lease context, tenants typically agree to both indemnify landlords and to defend and hold them harmless for all claims arising out of tenant’s operation of business on the leased premises, tenant’s maintenance of the premises and the negligence and/or misconduct of the tenant or its representatives, employees, agents and contractors (and sometimes even the tenant’s customers). In essence, the tenant agrees to defend the landlord for specified damages or claims. While it may seem absurd to a prospective tenant, commercial leases sometimes contain language requiring tenants to indemnify landlords for claims for liabilities arising out of occurrences in the common areas controlled by landlords and even for those liabilities arising out of the landlord’s own negligence.
Most importantly, under California law, these types or indemnification clauses are generally enforceable, at least in the commercial lease context. Of course, there are public policy considerations even where commercial leases are concerned. For instance, landlords cannot contract against future claims for their own intentional misconduct or gross negligence. It is advisable, given this limitation, for tenants to seek reciprocal indemnification language for any intentional conduct or gross negligence by landlords. Moreover, depending on the parties’ relative bargaining power, some landlords may be willing to indemnify tenants for their own negligence and even the negligence of those under their control where the damages arise from occurrences in the common areas.
From the landlord’s perspective, the idea is to shift liability to the tenants who conduct business on the premises daily. This reallocation of risk is guided by the parties respective insurance coverage. From a practical standpoint, the shift in responsibility is a shift in insurance obligations. If the lease shifts liability for “any and all” claims arising out of anything to tenant, it becomes incumbent upon the tenant to insure against “any and all” claims. In fact, most commercial leases specifically require suitable coverage. As such, allocation and the actual procurement of adequate insurance coverage is essential for both landlords and tenants.
Landlords routinely request estoppel certificates from their tenants. Tenant estoppel certificates are signed statements requested by third parties (typically lenders or prospective purchasers of commercial real estate) in order to verify certain terms between the current tenant and landlord of the commercial real estate property, things that cannot be ascertained by simply reading the commercial lease agreement.. The estoppel certificate confirms that a valid lease exists, that the lease remains in full force and effect, that neither the landlord nor tenant are in default and that the rent is paid up. This allows for instance a prospective buyer of a shopping center to better evaluate the shopping center’s performance. Once a tenant verifies these details in the estoppel certificate, they cannot be later disputed. Potential purchasers of the commercial property rely on the certificates to evaluate the risks associated with purchasing the property and to determine an appropriate offering price.
What Information is Included in a Tenant Estoppel Certificate?
Typically, an estoppel certificate will ask a tenant to verify the following:
- The date of the commencement of the lease;
- That the lease has been unmodified and is in full force and effect or that it has been modified;
- The most current date in which rent is paid through; and
- That there are no defaults by the tenant or the landlord.
Other information that may be requested in an estoppel certificate includes the financial health of a tenant, the amount of any security deposit paid, the tenant’s ownership structure, or whether there is any ongoing litigation related to the tenant. Most of the time, but not always, landlords will attach a form of the estoppel certificate as an exhibit to the actual lease agreement to help avoid disputes that may arise in the future regarding what information should be provided by the tenant. It is in a tenant’s best interest to negotiate which information should be included in the estoppel certificate prior to entering into the lease. For example, information that can be determined by reading the lease or statements that modify the lease agreement in any way should be avoided.
A Tenant Improvement Allowance (TIA) is a landlord incentive designed to assist new tenants with the build-out of their space. Build-outs are improvements to leased space to make the space usable for a particular tenant’s needs. Whether or not a landlord will offer a TIA and how much the landlord will offer depends on a variety of factors including the relative bargaining power of prospective tenants, the current market for commercial space, the current condition of the premises, the extent to which the current condition suits a prospective tenant’s needs, the tenant’s desirability, the base rent and other key terms being negotiated. Often, new business owners are surprised when a TIA is offered and may over estimate its significance. While TIAs are important landlord incentives, landlords are careful to minimize the true costs. In most cases, tenant improvements are capital improvements that provide a long term benefit to the property. Even where the improvements are specific to a tenant’s needs, landlords most often build the cost of TIAs into the base rent. However one looks at it, TIAs are an important factor in commercial lease negotiation. If a tenant improvement allowance is being offered, the associated lease language is critical for both landlords and tenants. When negotiating TIAs and associated lease terms, it is important that the parties have a clear understanding of the improvements needed and their likely cost.
Two Common Approaches – The Stated Dollar Amount Approach and the Turn-Key Approach:
With a stated dollar amount, the landlord offers a fixed sum to the tenant for the build-out. The tenant must absorb any additional costs that exceed the fixed sum. In some cases, landlords will require any excess monies be returned after completion of the job. Where landlords do not require the return of excess funds, they are more likely to allow soft costs such as architectural and engineering fees. Again, ensuring that these issues are clearly addressed in the lease avoids any potential future conflict. The stated dollar amount method is fairly straight forward. The landlord knows the precise amount it will be responsible for and tenants (who typically oversee the build-out) retain control of the process. It is also possible for landlords to offer a fixed sum while retaining control of the build-out process.
With the turn-key approach, the landlord allowance covers certain specified work which the landlord typically oversees (i.e. build out of a new kitchen or bathroom, erection of interior walls and partitions, installation of new doors and windows, new flooring and ceilings, etc.). Any additional work would be considered extra work to be absorbed by the tenant. Some new business owners may prefer the turn-key approach so that they may remain focused on other important aspects of forming their new business. Overseeing construction while simultaneously focusing on licensing, trademarks, dbas, incorporation, employees, inventory, insurance and other business responsibilities can be daunting. However, it’s important that new business owners understand the downside to landlord control of build-outs. When landlords control the process, they are motivated to limit expenses. They may not have the same quality goals and may take short cuts the tenant wouldn’t be willing to take. Tenants will want to ensure that they get the most work possible with the allowance provided, that the landlord warranty the work, that the work be completed by a specified date and that the tenant have a reasonable opportunity to inspect the work to be sure the work was done properly including retaining the ability to submit a punch-list of things that need to be completed after taking possession. In addition, it’s helpful to ask landlords to undergo a competitive bidding process where sealed bids are opened in the tenant’s presence.
In some cases, landlords will allow tenants to control the build-out process choosing their own architects and contractors (subject to landlord approval). However, the tenant’s expenses would be limited by the allowance. If the tenant goes over budget, the tenant would be responsible for the excess costs.
Most commercial leases in California are triple net leases. With a triple net lease, tenants contribute to the payment of the landlord’s operating expenses, such as building insurance, taxes, repairs, maintenance, and utilities in addition to base rent. Typically, these expenses are referred to as Common Area Maintenance Expenses (CAMs). As one might imagine, what should and shouldn’t be included as an operating expense is an important part of lease negotiation. Depending on the parties’ relative bargaining positions, tenants are often able to negotiate for a list of CAM exclusions.
Under Generally Accepted Accounting Practices, capital expenditures are defined as the costs of obtaining items that last beyond the current accounting period and increase the value or the life of an asset. Capital expenditures include things like additions, improvements, renovations, repairs and upgrades to existing facilities, and can be thought of as investments that are intended to yield long-term benefits. Commercial leases deal with capital expenditures in a variety of ways. Many, but not all, commercial leases contain a general capital expenditure exclusion that excuses tenants from having to contribute to the costs of such expenditures with two major exceptions: expenditures necessary to comply with new laws and improvements that reduce operating expenses. In some cases, these lease exclusions will also exempt those capital expenditures when the costs of replacing equipment (an HVAC system for instance) would be greater than the replacement cost of the equipment.
Negotiation in this area is important to both landlords and tenants because capital expenditures can be significant. The issue is often a point of heated dispute. Tenants contend that their contribution towards the capital expenditures unfairly confers a permanent benefit on the landlord. Landlords argue that tenants benefit from adequately maintained facilities, repairs to existing equipment and additions that make the property more attractive. For the most part, capital expenditures benefit the property overall. As such, it is generally accepted in the commercial leasing community that such costs should be built into base rents.
It is more common than one might imagine for a commercial tenant to pack up and leave the premises rather than negotiate with its landlord for lease termination. This is most often because the business owner/tenant is far behind in rent and doesn’t believe that there are any other options available. It is also most likely that, for whatever reason (whether a past history of conflict, landlord bureaucracy or tenant complacency), a lack of communication between landlord and tenant has contributed greatly to the problem. Whatever the reason, landlords and tenants should be careful about how they approach lease termination and abandonment.
The best way to avoid dealing with abandonment is to maintain open lines of communication. Business owners who better understand available alternatives are more likely to consider agreeing to a payment plan with respect to past due rent and/or voluntarily turning over possession of the premises to the landlord on some fixed date. Landlords are in turn better able to gauge the tenant’s position and ultimately to avoid costly litigation. Depending on the circumstances, landlords will often find that it makes more economic sense to agree to a lesser amount owed and to release the tenant from future obligations. It is surprising how often simple communication (even with lawyers involved) leads to a peaceful and voluntary turnover of possession. Better yet, in some cases, the parties are able to work out an arrangement that results in a continued tenancy.
While it seems sometimes lost on landlords, there is a significant benefit to retaining long time tenants with a proven track record. This is usually due to bureaucracy in this writer’s view. There are systems in place, and managers tend to let the systems control. For example, it is not uncommon for corporate landlord’s to serve three-day notices demanding rent and then to ignore tenant inquiries regarding the problem whether or not they actually intend to pursue eviction. The result is to encourage abandonment. This is not necessarily problematic for landlords. If the circumstances clearly warrant eviction as soon as possible, the cost of abandonment isn’t so great. However, even in the worst of scenarios, communication tends to reduce friction.
When Is a Property Considered Abandoned?
So when is a commercial property considered abandoned? This is an important question for landlords. First, the tenant must be at least 14 days behind in rent. Second, the landlord must have a reasonable belief that the tenant has abandoned the property. It may seem obvious in most cases: the tenant is closed for business; hasn’t been seen on the premises for more than a month and has stopped paying rent and communicating in any way. While intuitively this seems like clear abandonment, the law is a bit more complicated. There must be a demonstrated intent to abandon the premises taking all circumstances into account . The standard is one of a reasonable belief – such that a reasonable landlord would believe that there was an intent to abandon. In the above example, the property may not be considered abandoned if for instance after investigation, the landlord discovers that all of the tenant’s property remains and/or that utility bills are still being paid. Some facts that tend to show abandonment include accumulating mail and newspapers, disconnected utilities, no one answering the door, out of business signs and premises empty of personal property. In more obvious cases, a tenant might actually tell the landlord he is abandoning the premises.