In the following article, Brock Johnston explores the mysteries of subrogated claims and the risk of getting the insurance provisions of the standard commercial lease wrong. This important area leads to much confusion in the drafting of leases and to surprising results when the parties have not thought through the allocation of risk and their respective insurance obligations. While the topic may seem dry, it is of importance to anyone who deals with commercial leases.

Leases, Insurance Covenants and Subrogated Claims

By Brock Johnston

Brock Johnston

One of the murkiest areas in lease negotiations relates to the interplay between the damage and destruction obligations of the landlord and tenant, their respective insurance obligations and who is to benefit from the protection of insurance policies which the landlord or tenant obtain. Two recent cases highlight the importance of "getting it right" in the lease. They are the British Columbia Court of Appeal decision in North Newton Warehouses and Alliance Woodcraft Manufacturing and the Manitoba Court of Queen's Bench decision in Sooter Studios Ltd. v. 74963 MB Ltd. et al (cited as 2005 MBQB 114, Winnipeg Centre).

It is worth reviewing basic lease principles in this area.

Under most commercial leases, the landlord is responsible for repair and replacement of the building and will insure risks for multi-tenant buildings which may damage the building. The tenant is responsible for the leased premises and contents and the will insure against the risk of damage to the leased premises and contents. As most commercial leases are "fully net", the landlord will require the tenant to reimburse the landlord for the costs of managing and operating the building, including the cost of the landlord's insurance.

Also, commercial leases typically contain provisions pursuant to which the tenant covenants to repair and to indemnify the landlord with respect to any loss or claim arising out of the use of the premises by the tenant or anyone else allowed onto the premises by the tenant during the term of the lease. Despite such repair and indemnity covenants, many tenants make a dangerous assumption: because they are effectively paying for the building to be insured, if the building is damaged due to the negligence of the tenant or its employees, the landlord's insurance will compensate the landlord and there will therefore be no claim against the tenant. This is not a safe assumption to make.

It is at this point that we must consider the principle of subrogation. Effectively, subrogation is the substitution of one person for another so that the same rights and duties which attach to the original person attach to the substituted person.

In the context of insurance, if an insurance company makes its policyholder whole with respect to a loss, the insurer may then step into the shoes of the insured and enforce the same rights against whoever caused the loss or damage as the insured person would have had if the insurer had not made good on the loss. In the case of a lease, if the tenant's contents are destroyed due to the landlord's negligence and the tenant's insurer indemnifies the tenant for the loss, the tenant's insurer might make a subrogated claim against the landlord. Or, if a building is burned down due the negligence of one of its tenants, and if the landlord's insurer pays the landlord for the loss, the landlord's insurer might have a subrogated claim against the tenant.

The classic way of dealing with subrogated claims is for the parties to require that the landlord and the tenant provide to each other a waiver of subrogation by their respective insurers. Another way of dealing with subrogated claims is for each of the landlord and the tenant to release the other from any claims in respect of which the landlord or the tenant is required to maintain insurance. As subrogation puts one party into the shoes of the other, such a release would be effective to extinguish the claims of the insurer. Not surprisingly, insurers resist giving waivers of subrogation and do not like it when the insured releases third parties from insured claims. Obviously, the insurer would prefer to receive the premium for the policy and still reserve the right to recover the cost of any payments under the policy. The insurer might argue that preservation of its subrogated rights will actually serve to keep the cost of premiums down.

In the face of these conflicting interests and competing lease provisions, it is not surprising that the courts have been asked to rule upon whether or not an insurer can properly bring a subrogated claim against a landlord or a tenant. Note that in many of these cases (such as Alliance), the issue effectively becomes a battle of insurers, as the party which is facing a subrogated claim will often turn to its liability insurer for protection. The courts have considered a number of factors, and arrived at different conclusions depending on the wording of the lease in each case, including:

The current state of the law is that only an express covenant by either a landlord or tenant to insure its own property will immunize the negligent party from a subrogated claim by the other's property insurer. The mere payment by one party of the other's property insurance premiums, will not immunize the negligent party from a subrogated claim by the other's property insurer, in the event of negligently caused loss or damage to the building, leased premises or contents. On the other hand, a covenant on the part of either a tenant or landlord to indemnify the other from loss will not give rise to a subrogated claim on the part of the insurer of the party which suffers a loss if such party has covenanted to insure.

In the context of garden variety commercial leasing, particularly by unsophisticated tenants, it is quite possible that no one turned their mind to these issues at the time the lease was settled, negotiated and signed. In fact, many leases do not properly coordinate the rights and obligations of the parties, leading to further uncertainty and unexpected outcomes. However, it is of critical importance that landlords and tenants consider the possibility of subrogated claims against them and ensure that their leases deal with the issue. As well, particularly for landlords, that they insure their property to its full value and all potential insurable risk, including bylaw upgrades and other contingencies. If this is not done, not only may the landlord suffer an uninsured loss but the landlord may also be barred from suing the negligent tenant for any shortfall that was not covered by the landlord's policy of insurance.

Brock Johnston