Risk Allocation in Commercial Leases

A fire breaks out in a commercial property. After the fire is extinguished and ensuring that no one was hurt the question becomes: who pays for the damages? The Landlord? The Tenant? More importantly, is it the insurance company for the Landlord or the Tenant?

In general, landlords and tenants foresee this risk and agree between themselves on how to allocate responsibility in case of fire in the form of a covenant in the commercial lease (“the Lease”). Often, the Lease includes a provision that renders it mandatory for the Landlord to obtain fire insurance and for the Tenant to contribute towards the cost of the Landlord’s insurance.

In cases where the Landlord is required to obtain fire insurance, and when the fire is caused by the Tenant’s negligence, the Landlord’s insurer pays for the damages and then pursues the Tenant for indemnification since, after all, it is the Tenant who caused the fire by its own negligence.

One would think that the above scenarios captured by air tight clauses in the Lease are easily enforceable. However, to the Landlord’s and its insurer’s dismay, courts have interpreted such clauses in ways that led to unanticipated results. Indeed, historically, courts have deemed that by expressly agreeing to take out fire insurance on the commercial property, the Landlord has agreed to assume the risk of fire alone and therefore, has no right of pursuing the Tenant for any damages irrespective of who’s fault or negligence caused the fire.

The courts’ reasoning? If the Lease includes an express clause that obliges the Landlord to take out fire insurance or a clause expressly stating that the Tenant will contribute to the Landlord’s cost of insurance, then that signals an underlying acceptance on the part of the Landlord of assuming the risk of damage alone, including damage caused by the Tenant’s negligence. This might come as a surprise to many landlords especially since taking out an insurance policy pursuant to an express clause in the Lease is standard practice.

What can the Landlord do to avoid such an outcome? The interpretation brought forward by the courts is deeply entrenched in the case law such that it is immensely difficult to override, but it is not impossible. It is possible for a landlord or their insurer to pursue a negligent tenant for damages but only in the clearest and most unambiguously-drafted leases in which the parties have unequivocally agreed that the Tenant will contribute to damages it caused by its own negligence.

An examination of the manner courts have dealt with the legal jargon used in several leases across the country yields inconsistent results. In Lee-Mar Developments Ltd. v. Monto Industries Ltd. [2000] O.T.C. 250, the Ontario Superior Court of Justice deemed that the terms of the Lease met the threshold of establishing that a negligent Tenant can be pursued in case of a fire while in Sooter Studios Ltd. v. 74963 Manitoba Ltd 2006 MBCA 12, the Manitoba Court of Appeal reached an opposite conclusion in similar circumstances. A few sporadic decisions have ruled that landlords and their insurers can redeem damages from negligent tenants, but the Supreme Court of Canada’s recent dismissal of the appeal in Deslaurier Custom Cabinets v. 1728106 Ontario Inc. 2017 ONCA 293 confirms that these cases are the exception rather than the rule.

A determining factor in all of the cases is whether the Lease includes a clause expressly obligating the Landlord to take out fire insurance on the property. If it does, then in all likelihood a landlord or its insurer are barred from pursuing a negligent Tenant.

In conclusion, the part of the Lease that tackles risk allocation should be a crystal clear reflection of the parties’ intentions to avoid surprises down the line. If the Landlord wishes to be indemnified by a negligent Tenant for damages, then the Lease must be carefully drafted to reflect that intention without a shadow of a doubt. In order to avoid an unwanted outcome, it would be prudent for landlords and tenants to consult a commercial leasing lawyer who will make sure to draft clauses in a way that avoids inconsistencies or conflicting meanings.

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