Can the Risk of Loss Doctrine Get You out of a Building Purchase?
A commercial purchaser should incorporate in the contract’s risk of loss clause the specific consequences of a pandemic.
For real estate purchasers and sellers, the risk of loss doctrine governs whether the seller or the purchaser assumes the risk of the property being damaged or destroyed between contract execution and closing.
In New York, for example, this doctrine is embodied in Section 5-1311 of the General Obligations Law (the “New York Risk Act”), which places the risk of destruction or material damage squarely on the seller, except in instances where the purchaser acquires possession of the property prior to the closing or is otherwise at fault. The parties can agree in the contract to a different allocation of the risk, but most sales contracts for properties in New York conform generally to the allocation scheme provided in the New York Risk Act (i.e., they also impose the risk of loss on the seller in the event that the property suffers destruction or material damage).
Pandemic Risks Not Covered
For commercial real estate purchasers, in particular, the fact that the risk of loss doctrine only pertains to physical damage to the property precludes them from utilizing this doctrine when the property suffers the consequences of a pandemic. So, for example, the creation of a containment zone, promulgation of shelter-in-place rules, or the curtailment of public transportation—any of which can severely impact access to the property or rent revenues—would not entitle the purchaser to terminate a contract executed prior to the onset of the pandemic. Yet this outcome is inconsistent with the principal tenet of the New York Risk Act (i.e., preserving the benefit of the purchaser’s bargain).
The New York Risk Act was created in 1936 with the adoption of the Uniform Vendor and Purchaser Risk Act published by the National Conference of Commissioners on Uniform State Laws (the “Uniform Risk Act”). The Uniform Risk Act was inspired by the scholarly work of Professor Samuel Williston, who promoted the use of contract law in analyzing risk of loss issues, specifically the “implied condition” principle. Applying this principle to risk of loss theory, Williston posited that if the risk were placed on the purchaser and a fire destroyed a material part of the property, the purchaser would be required to perform its promise—payment of the full purchase price—whereas the seller’s promise (implicit, if not expressed), to convey the property in substantially the same condition bargained for when the contract was executed, would not be fulfilled. This imbalance would constitute a failure of consideration, frustrating the purpose of the contract. Williston concluded that placing the risk of loss on the seller would rectify this imbalance and preserve for the purchaser the benefit of its bargain.
Expansion of Risk of Loss Contract Provision
In order to preserve the benefit of its bargain, a commercial purchaser should incorporate in the contract’s risk of loss clause the specific consequences of a pandemic, including, among others, the ones referenced earlier in this article. If the seller is amenable to such an expansion, it will likely want to impose qualifications, such as the duration of the event and the extent of the event’s impact on access, rent revenues, or the purchaser’s ability to conduct its business in the property. Before entering into negotiations, both parties should examine the tenants’ leases to determine if and to what extent the tenants have rent abatement or lease cancellation rights in the event they are required to shut down their businesses or vacate their premises, or their employees or customers are prohibited from gaining access to the building. The seller should also investigate whether its business interruption or other insurance policies cover the effects of a pandemic, and, if so, whether the insurance proceeds are assignable to the purchaser.
If the seller refuses to expand the risk of loss clause on the grounds that the duration of the triggering event, or its impact on access, revenue, or utility, may be difficult to measure, the purchaser should consider proposing a valuation condition, such that if the pandemic’s aftermath results in a reduction in the fair market value of the property below a designated percentage of the purchase price, the purchaser can terminate the contract. In addition to negotiating that percentage, the parties will, of course, have to agree upon the method for determining the property’s fair market value, as well as the definition of “pandemic.”
Commercial real estate purchasers and sellers need to contemplate how to incorporate the effects of a pandemic in the risk of loss provision, in a way that is fair to both parties while honoring one of the principal tenets of the doctrine—preserving the benefit of the bargain.
“Can the Risk of Loss Doctrine Get You out of a Building Purchase?” by Michael A. Scheffler was published in GlobeSt on April 9, 2020.
Reprinted with permission from the April 9, 2020, edition of GlobeSt © 2020 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For information, contact 877-257-3382, reprints@alm.com or visit www.almreprints.com.