Expect the unexpected: protecting your premises, your business and your finances from unforeseen costs

Artem, a General Counsel at a multinational catering corporation has a few hours to assess the legal position following a storm which damaged one of their leased kitchens. The renovation could potentially cost millions of roubles. Find out what four action points he needs to follow to make sure it costs what they expect it to cost.

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Managing budget expectations...

  • It is the middle of the night and Artem Ivanov, GC at a multinational catering corporation, gets a panicked call from the General Manager (GM) at their largest kitchen in Moscow, which they have leased for over eight years.
  • There has been a big storm raging, causing major damage across the region. The frantic GM explains that a tree has fallen on the building and destroyed the roof! The landlord said he needs to undertake extensive renovation to the entire block of kitchens and to resurface the entire car park owing to cracks that have appeared.
  • The crumbling old roof means that the facility is now falling short of critical health, safety and sanitary standards. Not only does the renovation mean that food production will have to stop with immediate effect but the landlord is also demanding that the company cover a percentage of the total renovation costs. The potential cost to the business could be millions of roubles.

It is up to the GC to assess its legal position, options for recovering the costs and solutions for keeping business operations running – by 9 am the next morning.

Three key risks keeping Artem awake at night…

Artem knows that he only has a few hours to pull together a strategy before his phone starts ringing off the hook and the staff begin to panic. He thinks through three key risks:

Key risk #1 – That the business will have to foot the bill for the repairs.

Key risk #2 – That, while the premises are out of action, the deadlines for their key commercial contracts will be missed and they will be forced to pay penalties and suffer damage to their reputation for reliability. They will also need to pay rent for alternative premises while continuing to pay rent here.

Key risk #3 – That the car park renovation will be pushed through the service charge. Some of the other kitchen units are vacant so the landlord may try to pin all the cost on them or argue that it is their responsibility entirely because they have a lot of heavy goods vehicles loading and unloading (there have been complaints in the past).

Artem’s three possible solutions…

Solution #1 – Artem pulls up the extranet, which contains copies of all the key documents for all their buildings. He can see that there are a few documents for this letting – a Lease (with addenda), a Premises Transfer Acceptance Statement, various consents and approvals, and all the due diligence they did at the time, including a survey and replies to enquiries. It is clear that the landlord is responsible for maintaining the roof (and the rest of the structure) in good repair.

Solution #2 – The lease is clear that the landlord is also responsible for procuring the property insurance. Checking the insured risks, Artem sees that storm damage should be covered. Checking the management information on the portal, Artem is reassured to see that the service charge (which also covers the Landlord’s property insurance costs) was paid on time so the landlord cannot claim any breach there. Not only does this mean that the lease’s rent cessation will come into play; it also means that the time will be ticking on the renovation being carried out. If they are not completed within six months, Artem’s company can terminate the lease and move elsewhere permanently. In the meantime, they can afford to find other premises and their own property insurance should cover any incidental costs.

Solution #3 – In the rights section of the lease, Artem sees that there is a specific provision for loading and unloading heavy goods vehicles across the car park and to the loading bays outside the unit. The service charge covers common areas, including the car park, but also sets an index-linked cap on the annual costs. Artem sees that the latest figure is X. Additionally, there are exclusions for capital expenditure so the landlord will only be able to claim back repair costs if they are genuinely required, rather than taking this as an opportunity to improve the service yard areas.

Four action points: Make sure it costs what you expect it to cost

  1. Russian legal regulation of sharing renovation and repair obligations between a tenant and landlord is quite generic. As a rule, the landlord is responsible for capital repairs (overhaul), primarily understood as repairs to structural elements of the leased property, while the tenant is responsible for the rremaining repairs and maintenance of the leased property. The parties are free to agree otherwise in the lease and it is strongly advisable in all cases to provide for more detailed regulation of repair obligations. It is a common practice for a lease to have a detailed attachment describing the split of repair and maintenance obligations with regard to structural and non-structural elements of the building, engineering systems and equipment (which are usually quite complex in modern buildings), common areas, etc.  
  2. To avoid potential disputes over defects in the premises and the parties’ obligations to remove them, make sure that the lease and/or a premises transfer acceptance statement covers such defects and all the issues raised by the survey. It may also be of great importance for determining the condition in which the property is returned to the landlord at the end of the lease.
  3. Although the Russian Civil Code offers some tenant protection around rent cessation and early termination, it is usually necessary to go to court, which requires time and money. Moreover, legal regulation is not specific and is subject to various interpretations. For this reason, you should include specific contractual provisions on suspension and abatement of rent in certain situations (e.g., power and/or other utility cuts, malfunction of HVAC systems, destruction of or damage to the leased property (irrespective of whether covered by insurance), etc.). The tenant’s unilateral termination rights without the need to apply to court should be expressly and precisely stipulated in the lease, otherwise there is a risk that unilateral termination of the lease might be challenged by the landlord.
  4. It is quite common on the Russian market for the service charge to be agreed as a fixed amount with a fixed annual indexation or, if calculated on an “open book” basis, then capped. Caps may not apply to property taxes and land payments customarily covered by the service charge. It is also strongly advisable to specifically exclude capital expenditures from a service charge calculated on an “open book” basis (e.g., cost of re-development or expansion of the property, replacement of structural elements of the building and/or building engineering equipment, though repairs to such elements and equipment may still be covered by the service charge). These measures will give the tenant better control over the costs associated with the lease.

The BCLP CRES ensures that you get the right commercial and legal advice, no matter where you and your property are in the world. If Artem’s HQ were based in the UK, Asia or the US there may be additional concerns he needs to consider. Lawyers from across the BCLP network provide their thoughts on some local issues.

     

The view from the UK…

Sam Silverman, a Senior Associate in BCLP’s London office, explains…  

The landlord is usually responsible for repairing, insuring and reinstating the building in multi let buildings. Storm damage would normally be covered as an insured risk in the UK and therefore, the landlord should be able to recover the cost of repair of the roof from its insurers. 

Whilst the cost of repair and maintenance is typically charged back to tenants via the service charge, tenants should ensure that the damage caused by insured risks and uninsured risks is specifically excluded from the service charge. Even if it is not excluded, the lease should prevent the landlord from claiming costs via the service charge where it has already received payment of these monies from a third party (in this case, its insurers). However, tenants should ensure that the landlord is responsible for covering any shortfalls, if it has underinsured, and is not able to charge these costs back to the tenant via the service charge. Provided Artem’s lease is in line with these principles, his company should not be liable for the carrying out or the cost of repair.

When negotiating service charge provisions in leases, tenants should ensure that the proportion that they are required to contribute cannot be increased where other parts of the building are vacant or occupied by the landlord. If Artem’s lease contains such a provision, his company will not be liable for a higher service charge contribution due to the fact that other units are currently vacant. However, landlords can sometimes take into account what would be fair and reasonable when calculating the tenant’s proportion (which could include looking at the tenant’s usage of common areas). Artem will need to check if the lease contains such a provision.

Where the damage caused by the insured risk makes the premises unfit for occupation and use, it is typical in the UK for the rent to be suspended until the earlier of the reinstatement of the premises and the expiry of the loss of rent insurance cover. As Artem will not be liable to pay rent during this period, he could use this money to pay towards the rent on temporary premises so as to enable his business to continue to operate and thus avoid penalties and damage to reputation (which he would not be entitled to claim from the landlord). Artem’s own business interruption insurance may cover the additional costs he will incur in moving etc.

Tenants should ensure that their leases include an ability to terminate where damage caused by an insured risk has not be reinstated within a certain period. Artem should check when this termination right arises so that he is able to plan decisions regarding longer-term alternative premises.

The view from Asia…

Andrew MacGeoch, Head of Asia Real Estate and Infrastructure, Ann Ho, Counsel and Raymond Sin, Associate from BCLP’s Hong Kong office say that Artem has many things to consider if the same issues occurred in a HK situation.

  1. Repair Obligations

In Hong Kong, understanding who will be obliged to improve, repair or maintain a leased property can be a web of complex issues. The key factual question will be whether the kitchens in question are part of a mixed use development under multiple ownership or a stand alone block with one owner/landlord.

The Hong Kong tenancy legislation does not impose any statutory repair/maintenance obligation on either the landlord or the tenant.  It is largely a matter of private contract between the landlord and the tenant. In other words, in the absence of any express agreement between the landlord and the tenant with regard to repair/maintenance, there is no implied duty under the tenancy agreement to compel either party to carry out repairs/maintenance the leased property. Although there is an argument that the landlord shall own an implied obligation to maintain the leased property to be “fit for habitation”, it only becomes applicable if the leased property is contractually required to be furnished or suitable for a specific use. It is therefore very common for tenancy agreements in Hong Kong to contain express provisions setting out clearly the repair/maintenance obligations between the parties.

Subject to the size (for instance, an en-bloc factory vs an office unit) and the type of business, permitted user and scale of operation of the tenant at the leased property (in which landlords and tenants would have entirely different expectations on the allocation of repair/maintenance obligations), the general tenancy market tends to split repair/maintenance obligations into structural and non-structural - tenants are to be responsible to repair/maintain the internal and non-structural matters of the leased property while the landlord is responsible to repair/maintain the structural element, for instance, the roof of the subject building (in case where the landlord is also the owner of such roof).

That said, the landlord, being the owner of the leased property, may however be under other statutory obligations to maintain the leased property. Among others, the Building Authority has powers under the Buildings Ordinance (Cap. 123 of the Laws of Hong Kong) to declare a building dangerous and/or to issue repair order to the owner (landlord) compelling him to remedy structural defects and to carry out the requisite repair/maintenance works. The Food and Environmental Hygiene Department has powers to require the owner (landlord) or occupier (tenant) to cleanse the leased property or take steps to deal with nuisances which are injurious to public health and food hygiene in general (for instance, water seepage originating from the leased property) under the Public Health and Municipal Services Ordinance (Cap.132 of the Laws of Hong Kong). Failure to comply with these laws would attract criminal sanctions, ranging from payments of fines to imprisonment. Separately, land grants in Hong Kong often contain general duties of repair/maintenance of buildings (to be) erected on the subject land lot, failure of compliance of which will trigger re-entry by the Government. If the leased property is part of a multi-storey building, the Incorporated Owners (or its management company) of the building is often empowered to demand the owner (landlord) or the occupier (tenant) to carry out the appropriate remedial works to rectify the nuisances or damage, for instances, dangerous structures, drain blockage and water seepage.

2. Obligation to Pay Rent

Again, this depends pretty much on the express provisions of the tenancy agreement. 

Check if the tenancy contains any provisions giving an alternative rent payment arrangement in unforeseeable events like the current one (for instance, destruction of the main roof due to a big storm).  In Hong Kong, it is not uncommon to have a clause to be included in the tenancy agreements that, in event that the leased property or the building (of which the leased property) or any part of the building shall at any time during the tenancy be destroyed or damaged or become inaccessible owing to specific circumstances then, in such circumstances, the rent reserved or a fair proportion of the rent according to the nature and extent of the damage sustained or order made shall be suspended until the leased property shall again be rendered accessible and fit for use. These circumstances typically include fire, water, storm, typhoon, defective construction, earthquake, subsidence of the ground or any calamity beyond the control of the landlord and not caused by the act or default of the tenant so as to render the property unfit for use or inaccessible.

Another example would be if at any time during the continuance of the tenancy the leased property shall be condemned as a dangerous structure or a demolition order or closing order shall become operative in respect of the leased property. If the leased property has not have been reinstated with the required time then either the landlord or the tenant may at any time after a period of time, for instance, six (6) months, from the occurrence of such damage or destruction or order give to the other of them notice in writing to determine the tenancy. At that time the tenancy agreement shall cease and be void as from the date of the occurrence of such destruction or damage or order or of the property becoming inaccessible or unfit for use.

3. Resurfacing Cost of the Car Park

Tenancy agreements in Hong Kong often set out clearly what the tenant is required to pay.  Again, it is entirely a matter of private contract.  Normally, the tenant is required to be responsible for paying expenditure of a non-capital and recurring nature only, while the landlord is required to be responsible for paying expenditure of a capital and non-recurring nature. In the absence of any express provisions as to who shall bear the resurfacing costs of the car park, which is more likely an expenditure of a capital and non-recurring nature, in normal landlord/tenant situations, the court tends to hold that it is the responsibility of the landlord. Again, the question of payment obligation, and its allocation and quantum, is a matter of private contract.

4. Insurance

As an aside the parties should of course review the insurances. Again these obligations will be set out in the TA and the obligations can vary quite significantly. Structural property insurance, however, is normally taken out by the landlord.  The tenant will need to insure for any interior aspects and contents as well as third party insurance. As a business it will also consider whether it wants to obtain business interruption insurance (BII). BII is often expensive and will contain many exclusions. A good broker will normally assist and then advise on coverage for situations such as these. 

The view from the US…

Jennie Wynne, a Counsel in BCLP’s St. Louis office, explains…  

In the U.S., while most state laws address a tenant’s rights in the event of casualty damage to the leased premises, the landlord and tenant usually agree to provisions in a commercial lease that will override those statutes, and a tenant will want to negotiate provisions that could help minimize interruption to business operations and costs in the event of a casualty.  It is not uncommon in the U.S. for tenants to have rights to terminate the lease in the event of a total destruction of the building or the premises.  A significant tenant may be able to negotiate additional rights to terminate in the event a portion of the premises or the common areas of the building, such as the parking facilities, is damaged or destroyed to such an extent that there is a material interference with tenant’s operations and/or where restoration of such portion of the premises or building is reasonably estimated to exceed an agreed upon period of time.  It also is typical for a tenant to have rent abatement rights in the event a casualty during the period the premises is untenantable, but landlords frequently will negotiate for such abatement rights to be lost if the casualty damage was caused by tenant. 

As in the case study, a tenant will want to be sure that a landlord cannot pass through to tenant the entire cost of rebuilding the building in the event of a casualty.  Commonly excluded from operating expenses that can be passed through to a tenant in the U.S. are costs of repairs or restoration that are covered by the insurance that is required to be carried by landlord under the lease or which would have been covered by such insurance had the landlord not elected to self-insure.  In addition, to the extent costs of capital improvements are permitted to be passed through as operating expenses, such costs generally are required to be amortized over the useful life of the improvement, and tenants frequently are able to negotiate limits on what types of capital improvement costs can be passed through, such as limiting such capital improvement costs to only costs of improvements that are intended to reduce operating expenses (and, in such event, only to the extent of such reduction) and costs of improvements that are required to comply with any laws that first apply to the building after the date of the lease.

For more information, please contact us at cres@bclplaw.com

 


This information is not to be considered legal advice. The primary purpose of these materials is informational only. Under the ethics and professional rules of certain jurisdictions, these materials may be construed as advertising or solicitation. For the purposes of advertising, BCLP designates St. Louis, Missouri, as its principal office and Kathryn DeBord as the responsible attorney.