Limit Liability in Lease with Environmentally Risky Tenant

If an environmentally “risky” tenant, such as a dry cleaning business, gas station, or auto service center—which all use chemicals that could contaminate your property—will be lucrative enough to make taking the risk of potential damage worth it, it’s crucial that you protect yourself from liability and shift responsibility for any mistakes to the tenant. You don’t have to let a great lease deal go out of fear that you’ll be left with an environmental nightmare if the tenant fails to clean up a spill or leaves other damage behind.

Don’t let the environmental aspect of such a deal drive the entire transaction. The environmental issues surrounding an environmentally risky tenant are just one aspect of many that need to be addressed up front during the due diligence stage and then ultimately negotiated and included in the lease. If you cover troublesome environmental issues that you could encounter before the lease term, during the lease term, and after the tenant moves out of the space, you can mitigate your risks.  

Perform Thorough Pre-Lease Due Diligence

Part of a thorough due diligence process will involve establishing the health of your property prior to the tenant’s term. Although it may sound relatively simple to hire an expert to find out whether there is any existing contamination, the results can become complicated for you if they show that the property is more contaminated than you expected it to be.

“The counterbalance to finding out the property’s health before a new tenant moves in is that the owner must be prepared to fix what it finds,” says Pennsylvania attorney David Rockman. He points out that owners might want to weigh their level of concern against the profitability of the deal. That is, ask whether the lease is lucrative enough that you’re willing to find yourself with an expensive liability obligation.   

If you’ve determined that you should test the property, remember that the exact nature of the tenant will dictate the type—and scope—of the testing that’s performed. For example, if there’s a gas station or dry cleaning business currently on the site prior to the new tenant, you absolutely want a baseline of the environmental conditions on the site—that is, the soil and groundwater. That way, you’ll be able to distinguish which tenant caused what damage. For example, if you conduct a baseline study that shows that the property has no contamination at the time the new tenant moves in, any damage found later can be attributed to the new tenant. You can avoid an argument from the tenant that it’s not liable for the problem because an old tenant caused it.  

Whether the property is a so-called “green field” that has no prior use or a “brown field” that has been leased in the past to an environmentally risky tenant or that has preexisting damage, it’s critical to get a baseline of conditions for the soil, groundwater, and surface water to determine what’s there when your prospective risky tenant will use or store chemicals at the site. And if there’s a building already on your property, you should also get a baseline of environmental issues in the building. For example, are there asbestos, lead-based paint, polychlorinated biphenyls (PCBs), or underground storage tanks?

If it’s not an inherently risky business—that is, one that by its very operation poses environmental risks—and the tenant will be leasing just space in the building, you may not need to do an environmental site assessment to get a baseline on soil and groundwater, but you’ll still want to know whether there are environmental hazards in the building itself—if you don’t already.

“Typically, an owner should already know the risks when it comes to asbestos or lead paint in its building,” says Rockman, who points out that there’s a preexisting duty to make sure that Occupational Safety and Health Administration (OSHA) standards for asbestos-containing material are being complied with. A new owner or one who’s leasing space to a tenant for the first time should be aware that existing hazards must be in compliance with applicable laws, such as legal requirements for dealing with lead paint in space where children under the age of 6 will spend time.

For example, a daycare center for children can be very risky because environmental hazards in the building can harm their customers, potentially culminating in litigation if it’s alleged that your failure to neutralize certain risks, such as lead poisoning, led to injuries. Having a baseline of substances like lead in your building is helpful in defending a claim if it shows that the hazard had to have been in another location. Being able to provide documentation that your building is certified lead-free is very valuable. So, depending on the nature of the tenant, you’ll want to explore whether lead, asbestos, radon, and other substances are present.

It’s important to talk with your attorney about compliance because many laws are state specific and you may also be subject to local laws. A plan for dealing with environmental risks at a commercial property isn’t one size fits all. The right due diligence is different for every owner.

Even basic testing can be expensive. You can save time and money by working with the tenant and other parties to the lease, like its lender, to come up with one expert to evaluate the property and do necessary environmental studies. When several parties hire their own consultants, the process can be redundant. Instead, agree on the environmental consultant and the scope of work. It’s important to have influence over the scope, though, which could mean that you’ll have to pay for the testing.

“While coordination limits the overall cost, there is a delicate push and pull between who is paying for that cost and who is controlling the scope of the investigation,” Rockman stresses. Often, it’s the same person. And whether it’s out in the open or an unspoken agreement between the hired investigator and the party paying the bill, that party probably gets to call the shots to a greater degree than the party who isn’t paying.

“Absent sitting down and hammering out specific issues regarding the scope of the investigation, at some point, one of the parties will have primary responsibility for giving general direction to the contractor conducting the investigation,” Rockman points out. And that can result in some intentional or unintentional favoritism. Rockman notes that there can also be a breakdown in the process if the tenant asks for an investigation with a scope so broad that the cost exceeds what the owner thinks is reasonable. “The cost of the investigation becomes especially important when you compare it to the overall leasehold value,” he says.

There are several steps that owners should follow after an investigation. First, get an oral report so you know if you have any major issues right away that need to be dealt with quickly to let lease negotiations continue and get the deal done. You should also demand a written draft that all parties have the opportunity to make comments on. (Any disagreements should be worked out in the draft.) The final written report should be included as an exhibit to the lease. It’s important to keep the process moving efficiently because there may be a financing or inspection contingency that’s going on while the lease is being drafted. The due diligence should be done up front, during the LOI or lease negotiations stage.

In the event that there are significant findings of environmental non-compliance, property owners should be aware that the EPA and some state environmental agencies have voluntary self-disclosure policies under which fines and penalties for non-compliance are waived if there is voluntary disclosure of non-compliance discovered through an environmental audit. “Self-disclosure policies are a valuable tool to limit risk, but they require an up-front strategy of auditing and information management in order to make sure that all of their requirements are met, including a typically short time frame in which to make any disclosure,” says Rockman.

Get Protection from Dangers Arising During Lease Term

During the lease, environmental damage or issues can happen in your building itself or on the property. You’ll want to make sure that you’re protected from liability for both if you didn’t cause them. In your lease, negotiate the following requirements:

Don’t disturb hazards. You may discover hazards in your building that don’t need to be removed as long as they are in good condition. But you also want to make sure the tenant isn’t disturbing them illegally, for example, by chipping away at lead paint or disturbing asbestos-covered pipe insulation in the basement. Educate the tenant about where hazards are, emphasize that they can’t disturb them, and demand that they notify you if they are disturbed.

“Don’t expect to shift liability for all environmental issues to tenants—they rarely will take on liability for soil and groundwater contamination issues that pre-date their leases,” says Rockman. “However, it’s reasonable to shift liability to a tenant whose improper actions inside a building that doesn’t need remediation creates a real hazard out of only a potential hazard,” he adds. That tenant should be on the hook for items that become a regulatory issue as a result.

Provide notification of spills. If the tenant has a spill, it should be required to notify you immediately and the appropriate regulators in whatever time frame is required by law. Under environmental law, owners of real property can be responsible for contamination whether or not they caused it. But even if you say in the lease that the tenant is responsible for it, environmental agencies can force you to clean it up if the tenant fails to. You can protect yourself by building provisions into the lease that give you a self-help right allowing you to enter the property and bring it into compliance at the tenant’s cost if the tenant doesn’t notify you of contamination or doesn’t properly or promptly do the necessary cleanup.

You should try to make sure your tenant isn’t imposing undue risks on you, but it’s important to avoid being overly controlling as to how it operates its business. Under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA), commonly known as Superfund, owners already have some responsibility for what happens at their properties just because of their status as owners. “If you assert too much control over how the tenant conducts its business, you’re shifting some liability to yourself from the tenant if there were a situation that led to contamination and cleanup costs,” Rockman warns. “Don’t risk ‘operator liability’ on yourself,” he stresses.

Get appropriate insurance coverage. Make sure that the tenant has the right insurance for its risky business. For example, a gas station has underground storage tanks. There are insurance requirements in most states that the tenant must carry insurance on those tanks as protection in the event of a spill. And there are various forms of environmental insurance in the marketplace, so owners and tenants can tailor policies that meet their needs, even if there isn’t a standard policy for their situations.

“Especially when the owner is dealing with preexisting contamination, a tailored insurance policy should make the parties comfortable,” says Rockman. He notes that it’s wise for an owner to consult with its attorney or insurance broker to make sure that the insurance provides adequate protection and meets the requirements of the lease. “An owner will want someone with more than just business experience to review items like special pollution coverage, instead of relying on a leasing agent or property manager,” he adds.

Comply with laws. Make sure that your tenant complies with all of the laws—federal and state—that apply to its environmentally risky business. Specify in the lease that the tenant is responsible for legal compliance. Emphasize to all tenants that they must tell you if they are considering using materials or chemicals that are environmentally unsafe. If a tenant that doesn’t operate an environmentally risky business at the outset of the lease later decides to use a material or chemical that poses a danger in its space, it could give your property an environmental status with regulators that would impose other requirements.

However, avoid banning all chemicals across the board. “The goal for your lease is to have terms that are well developed, appropriate for the specific circumstance, and show recognition of what it takes for the tenant to do business,” says Rockman. “That’s why having a blanket requirement that the tenant ‘shall not bring onsite any hazardous materials’ without permission—or at all—raises problems; it’s impossible to have a modern business without using some hazardous materials like cleaning supplies, copier toner, and printer ink,” he explains. But those items aren’t a risk if they’re used in compliance with laws and, in the normal course of business, no one is being harmed by these products, he adds.

Rockman notes that specifying in the lease that the tenant won’t bring any of those items to the site creates room for an argument later that the owner couldn’t actually have meant that it expected the tenant to stick strictly to the hazardous materials provisions. By including provisions that allow a tenant to use “reasonable equipment and supplies” and “consumer products” you can avoid being slapped with the argument that, because they are so restrictive, you didn’t expect to hold the tenant to the terms in the lease in the first place, he points out. (You can include this caveat even if you’re using the tenant’s lease template.)

Hold Tenant Liable After Lease Ends

Ideally, your environmentally risky tenant won’t have any spills or other incidents that contaminate or otherwise compromise your property. But what happens if you discover down the road, after the tenant has moved on, that there’s damage? One way to protect yourself is to do another due diligence or baseline report before returning the tenant’s security deposit, to show what the tenant may have done to your property. A post-tenancy due diligence will help to identify any damage the tenant has left behind. Rockman suggests negotiating upfront who will pay for the cost of a baseline report to figure out what condition the post-tenancy property is in; you don’t know what will happen over the course of the tenancy or exactly how long the tenancy will last.

And try to negotiate these provisions that protect you from liability for environmental damage that’s discovered after the lease is over:

Make indemnity survive. In your lease, make sure that the indemnity that the tenant gave you doesn’t expire at the end of the tenancy; make it survive for as long as possible and at least a few years after the lease ends. Remember that, as with most lease provisions, bargaining power will determine the length of the survival. A tenant with more leverage will push back; at most you may get only one to two years for the survival period. You’re more likely to get the upper range—seven to 10 years—from a smaller tenant.

Ask for statute of limitations survival. A statute of limitations survival is ideal because it often isn’t triggered for several years after the discovery of a chemical or waste spill, not just the actual date on which the spill took place—giving you a longer window of time to hold the tenant responsible for its damage. If you can’t negotiate a statute of limitations, try to get at least two years, and during that time thoroughly inspect the property and building so you can go after the tenant during the indemnity period.

Broaden Protections in Lease

A large part of protecting yourself from the damage that an environmentally risky tenant could cause is understanding your own property, and the impact that the tenant’s specific business could have from an environmental standpoint.

Owners shouldn’t negotiate lease terms for environmentally risky tenants that are so onerous that no tenant will lease the property—rather, the goal is to fairly allocate the risks. A sophisticated tenant won’t want to accept liability for damage that happened before it came to the property, and it’s fair for it to want to be protected from things that happened there before the lease.

But at the same time, you want to be protected for things that happen during the lease with the tenant—and that includes damage caused by the tenant’s guests, invitees, and vendors. So make sure that you broaden your provisions to cover additional parties that will have access to the property through their dealings with the tenant. Aim for making sure the right risks are allocated to the right parties in the lease so everyone is treated fairly in the deal.

Insider Source

David Rockman, Esq.: Eckert Seamans Cherin & Mellott, LLC, 600 Grant St., Fl. 44, Pittsburgh, PA 15219; www.eckertseamans.com.