Disaster-proofing Damage or Destruction Clauses in Leases

Introduction

Recent severe hailstorms, heavy rain and destructive winds in New South Wales are salient reminders of the potential for lost time and costs, if parties do not give appropriate consideration to the oft-forgotten damage or destruction provision in leases

This article provides a refresher on key points to consider when negotiating damage or destruction provisions. Getting the basic provisions right will minimise uncertainty and provide a platform for more complex provisions, depending on the tenant's type of business and the commercial significance of the building or premises.

This article does not address retail and residential leases as those leases are separately dealt with in most of the relevant legislation in each jurisdiction.

Frustration of contracts

The first key question to consider is whether the common law doctrine of frustration applies when premises are damaged or destroyed. Is the damage or destruction of property a frustrating event allowing the parties to suspend rent and other monetary obligations, and potentially terminate the lease?

The difficulty is that at common law, a lease conveys an interest in land. As such, the initial grant of the interest in the land from landlord to tenant remains and is not affected by any damage or destruction of the improvements on the land.¹ The obligation to pay rent continues, despite the tenant being unable to use the premises.

Although there has been no clear guidance in case law, it is generally understood that leases are capable of being frustrated, but only in rare circumstances.²

Implied statutory covenants

In New South Wales, section 84(1)(a) of the Conveyancing Act 1919 (NSW) includes provision for an abatement of rent if the premises is destroyed or damaged by fire, flood, lightning, storm, or tempest or shall suffer war damage so as to render the premises unfit for the occupation and use by the tenant. Property legislation in Queensland and the territories contain similar provisions.³ Other states do not imply such provisions.

However, it is common for landlords to exclude implied covenants in leases and replace them with more landlord-favourable clauses.

Given the doctrine of frustration has a limited application to leases and the common practice of negating statutory-implied covenants, the negotiated terms of the lease are paramount and lawyers should give careful consideration to damage or destruction provisions, particularly when acting for tenants.

The framework

Basically, ensure that all leases include a damage or destruction mechanism.

To the extent possible, all matters beyond the parties' control need to be within the parties' control:

• clearly define the "trigger" event;
• address abatement of all monetary obligations;
• allow sufficient time to consider options and next steps;
• address make good obligations and the performance of other obligations; and
• address termination rights.

Trigger events

The damage or destruction clause should apply if the premises are wholly or partially damaged or destroyed as to render the building or the premises wholly or substantially inaccessible or wholly or substantially unfit for the tenant's use and occupation of the premises for the permitted use.

A tenant-friendly clause should provide for circumstances where the premises are wholly or partially inaccessible, even though the premises or the building itself are not damaged or destroyed (e.g. due to a government directive, health or safety reasons, or for police or insurance investigations). Recent examples of this include:

• After the Brisbane River broke its banks during the Queensland floods in 2010/2011, there were mass evacuations in the Brisbane CBD due to possible flooding.
• During the Martin Place siege in December 2014, office workers above the Lindt café and nearby offices were evacuated, whilst a number of streets around the area had been closed and an exclusion zone subsequently put in place around Martin Place. A number of public buildings were also evacuated, including the Sydney Opera House despite its distance from Martin Place.

However, the landlord should ensure that the clause cannot be triggered if the damage or destruction is caused or contributed to by the tenant or its agents.

What clauses should be included in a lease?

Abatement of rent and other monetary obligations
If the premises is totally unfit for the tenant's use or totally inaccessible, the tenant should not be liable to pay the rent and other monetary obligations (e.g. outgoings, services, rates and taxes) until the premises become fit for use or accessible.

If the premises are still useable or accessible, but the useability or inaccessibility is diminished, the rent and other monetary obligations should reduce in proportion to the reduction in useability. Consider if the abatement period should extend to the tenant's fitout period (if the landlord agrees to reinstate the building).

The landlord can require that the premises must remain unfit or inaccessible for a certain period before monetary obligations abate.

Include a provision to address disputes between the parties regarding the abatement amount. The parties can agree to appoint an expert or valuer to determine the dispute and to apply a mechanism for that appointment when they cannot agree on the expert or valuer.

Termination rights
Whether termination rights are available will depend on the precise wording of the clause.

For example, termination rights can be triggered when the landlord decides not to repair or rebuild; or the landlord does not begin repairing or rebuilding within a certain period despite being asked to do so by the tenant.

Tips for landlords
A landlord should require the tenant to initiate the process by providing notice, within a specified period after the damage or destruction occurs, requesting the landlord to repair or rebuild the premises.

The next step is for the landlord to respond to the tenant within a further specified period and state the landlord's intentions. Include a clause allowing an extension of the deadline to respond to the tenant, if the landlord fails to meet the deadline.

The clause should provide flexible timeframes, allowing the landlord sufficient time to consider its options, both legally and commercially. For example, it may be more appropriate for the landlord to terminate the lease if:

• the landlord cannot obtain council or other approvals to rebuild, or the approval conditions imposed are unacceptable to the landlord (or to the tenant);
• if rebuilding would be too costly or unprofitable;
• if rebuilding would take too long; or
• the landlord wants to use the opportunity to replace the tenant.

The landlord should ensure that it negotiates a realistic timeframe to assess its position, including insurance claims and the possibility of selling the property.

The landlord should retain the discretion to terminate at any time if it considers that reinstatement of the premises would be impractical or undesirable.

Resist attempts by the tenant to include a requirement that the landlord must reinstate the building or the premises, and/or pay compensation to the tenant.

Consider limiting the tenant's termination right to situations where the landlord fails to rebuild within the agreed period. Perhaps the landlord could also limit the tenant's right to terminate by requiring the tenant to continue using any part of the premises that is reasonably safe, useable and accessible.

Tips for tenants
A reasonable clause that balances the rights of both parties allows either of them to terminate within a short period of time if the building or premises is totally damaged or destroyed.

To gain commercial certainty, the landlord should give the tenant a notice, within a reasonable (and specific) time after the damage or destruction occurs, about the tenant's right to abatement, and indicating the landlord's intentions to either reinstate the premises or terminate the lease.

The tenant should determine an appropriate timeframe by which the landlord must give such a notice, depending on the premises' significance to the tenant's business and the tenant's bargaining power.

The tenant should have a right to ask the landlord to reinstate the premises and the landlord should be obliged to commence works within a certain period. If the landlord fails to do so, the tenant should have a right to terminate.

This is important if the premises forms a major part of the tenant's business, for example a major distribution centre or the tenant's headquarters. A waiting period of 6 to 12 months for the building or the premises to be reinstated could significantly affect the tenant's business operations.

Additional tips and risk mitigation measures

In addition to abatement and termination rights, consider the following:

• The relevant insurance and damage or destruction clause should be given to each of the landlord's and tenant's respective insurers for review to ensure appropriate coverage is in place for the building and the premises.
• The lease should contain clauses allowing for emergency access by the landlord to enable evacuations and inspections to take place without notice or the tenant's consent.
• The make good provisions should not apply to any damage caused by force majeure events as the damage or destruction provision should apply instead.
• Consider the suspension of other rights and obligations (e.g. the obligation to keep the premises open).
• A force majeure event should not be limited to natural disasters. Consider including events caused by aircraft or other aerial devices, civil commotion and terrorist attacks. Include a "catch-all" description.
• Consider addressing rights and obligations set out in side agreements (e.g. incentive deeds).

Aftermath practical tips

Clear communication
There should be clear communication between the parties from the beginning to minimise unnecessary disputes.

To avoid being in breach of the lease, prior to abating monetary obligations, the tenant should formally notify the landlord of the damage or destruction and its effect on the tenant's premises.

The lease remains
The landlord may want to take control of the premises to assess the damage for insurance and rebuilding purposes.

However, if the lease has not been terminated, the parties are required to continue to observe the lease terms.

Accordingly, advise a landlord client to proceed carefully when accessing the premises because the lease remains in place and the tenant is still entitled to exclusive possession of the premises.

If the landlord requires access to the premises, the landlord should check the lease provisions and take steps to gain access with the tenant's co-operation.

This may mean the landlord must comply with the tenant's security requirements or be accompanied by a representative of the tenant.

Final comments

A thoroughly negotiated damage and destruction clause will not anticipate every eventuality. However, in a world when 'time is money', it is paramount that there is an appropriate framework in place which progresses decision-making, and clarity over each party's responsibility, so that they can get back to business as expeditiously as possible.

This article first appeared in the Australian Property Law Bulletin (September 2015, Vol.30. No.8)