New York Risk of Loss Doctrine after the Coronavirus
The risk of loss doctrine has evolved over the centuries, reflecting changes in corresponding legal theories. The doctrine needs to continue its evolution, this time to reflect the “new” risks of our post-coronavirus world.
The unimaginable has happened: the “coronavirus,” a worldwide pandemic.
Transactional lawyers try to anticipate all likely scenarios that might impact a particular transaction. Yet no one could have anticipated that this contagion would cause such a cataclysmic disruption to our lives, businesses, institutions and public transportation, partly due to governmental measures implemented in order to stem the spread of the virus.
However, now that the coronavirus contagion has occurred, and there is an increased likelihood of more pandemics, it is incumbent upon lawyers to analyze the legal ramifications and safeguard their clients appropriately.
Real estate lawyers, in particular, need to examine whether the current contractual and statutory schemes for allocating the risk of loss in real property sales transactions are adequate to address pandemics and their aftermath—the “new” risks in our post-coronavirus world. This article is intended to guide lawyers and their clients as they navigate this new terrain.
Risk of Loss Doctrine
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, this doctrine is embodied in §5-1311 of the General Obligations Law (the New York Risk Act), which places the risk of destruction or material damage squarely on the vendor (seller), except in instances where the purchaser acquires possession of the property prior to the closing or is otherwise at fault. The pertinent language in the statute is:
… When neither the legal title nor the possession of the subject matter of the contract has been transferred to the purchaser: (1) if all or a material part thereof is destroyed without fault of the purchaser … the vendor cannot enforce the contract, and the purchaser is entitled to recover any portion of the price that he has paid … (2) if any immaterial part thereof is destroyed without fault of the purchaser … neither the vendor nor the purchaser is thereby deprived of the right to enforce the contract; but there shall be, to the extent of the destruction … an abatement of the purchase price… .
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.
Now imagine the following:
A pandemic strikes again, affecting the following properties as described below, and each property is being sold under a contract executed prior to the onset of the pandemic:
- “Property 1”: A manufacturing facility is being purchased by a company to conduct its operations, and the facility is located in a “containment zone,” thereby drastically reducing access for supplies and labor.
- “Property 2”: An office building whose tenants, all deemed “non-essential” businesses, are mandated by the city to close for an indeterminate period, and many of them stop paying rent.
- “Property 3”: A downtown retail complex whose customers and workers live on the city’s outskirts or in surrounding suburbs, many of whom rely upon public transportation to reach the complex, and the city suspends the operation of all public transportation (except for emergencies).
- “Property 4”: An apartment building in which many individuals have tested positive for the virus, and all tenants, required by the city to vacate the building pending a major decontamination and testing program, have stopped paying rent.
Each building suffers a precipitous drop in revenue (or utility in the case of the manufacturing facility) because of the foregoing consequences of the pandemic, and a concomitant sharp decline in value.
Each purchaser wants to terminate its contract, but the risk of loss clause only permits termination if the building is physically damaged or destroyed, and there are no contract provisions entitling the purchaser to terminate due to a reduction in rental income, or a material adverse change in the financial condition or utility of the property.
Purchasers Are Not Entitled To Terminate
Since none of the hypothetical properties has been physically damaged or destroyed, the risk of loss provision does not entitle the purchaser to terminate its contract. Yet this result is inconsistent with one of the principal legal theories that spawned the modern risk of loss doctrine, i.e., preserving the benefit of the purchaser’s bargain.
At its inception, in early Roman law, the risk of loss doctrine imposed the risk on the purchaser, yet around the 13th century, English law shifted the risk of loss to the seller (see Samuel Williston, “Williston on Contracts” §933A (3d ed. 1963)). However, in 1801, Paine v. Meller, 31 Eng. Rep. 1088 (Ch. 1801), applied the “equitable conversion” theory (i.e., equitable title passes to the purchaser upon contract execution, with seller retaining legal title only to secure payment of the purchase price) in establishing a new risk of loss rule under English law, placing the risk on the purchaser because it was deemed to be the “owner” upon execution of the contract. American courts adopted the English rule in the late 19th century, and it soon became the “majority rule” in America, followed by many states, including New York.
One of the leading opponents of the majority rule was Prof. Samuel Williston. Williston promoted the use of contract law in analyzing risk of loss issues, and believed, in particular, that the “implied condition” principle should be applied to this analysis. This principle dictates that a party’s promise to fulfill its contractual obligation is conditioned upon the other party’s performance of its promised obligation, resting on the fact that the first party had bargained for the other party’s promise in exchange for its own. Applying this principle to risk of loss theory, Williston posited that if the risk were placed on the purchaser and a fire or other casualty 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.
Williston’s scholarly work formed the basis for the Uniform Vendor and Purchaser Risk Act by the National Conference of Commissioners on Uniform State Laws (the Uniform Risk Act), which was adopted in 1935, and enacted by New York in 1936 as the New York Risk Act.
By adopting the Uniform Risk Act, the New York state legislature endorsed its main premise, that the purchaser should not be deprived of the benefit of its bargain, which principle also forms the basis for the standard contractual risk of loss provision. There is no question that each purchaser in the four scenarios depicted above understood that it would assume certain risks, such as, for example, deterioration of the property’s condition through normal wear and tear, a general economic downturn, and tenant defaults. It is very unlikely, however, that any of the purchasers expected to assume the risk of a sudden, severe and potentially long-lasting reduction in the value or utility of the building due to a pandemic.
Lawyers representing purchasers, in an effort to preserve the benefit of their client’s bargain in the event of a pandemic, should consider expanding the risk of loss provision to afford the purchaser a termination right when faced with circumstances similar to those confronting the purchasers described in this article. So, for example, events triggering the termination right might include the creation of a “containment zone” over an area in which the building is situated, government-mandated closings of retail businesses, the long-term suspension of public transportation, or the “contamination” of the building requiring all tenants to vacate for an extended period of time.
Lawyers representing sellers should advise their clients how to respond to such a proposed expansion of the typical risk of loss provision. Matters that may shape the response include: (1) 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 or inhibited from gaining access to the building; (2) if the seller has insurance coverage for the effects of a pandemic, and the insurance policy or proceeds are assignable to the purchaser; or (3) if the contract contains other provisions protecting the purchaser, such as a closing condition that there shall have been no material adverse change in the financial condition of the property.
Sellers willing to accept such an expansion will likely want to impose qualifications, such as the duration of the triggering event or the extent of the event’s impact on access, rent revenues or the purchaser’s ability to conduct its business in the property.
Some sellers, however, may refuse to expand the risk of loss provision, on the grounds that the duration of the triggering event, or its impact on access, revenue or utility, may be difficult to measure. In that event, 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” (including whether the pandemic must be global or just national).
The risk of loss doctrine has evolved over the centuries, reflecting changes in corresponding legal theories. The doctrine needs to continue its evolution, this time to reflect the “new” risks of our post-coronavirus world. The operative terms used in the New York Risk Act, and the standard risk of loss clause, i.e., “destruction” or “damage,” do not encompass the dire effects of a pandemic, such as a material diminution in the value or utility of the property. 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.
“New York Risk of Loss Doctrine after the Coronavirus,” by Michael A. Scheffler was published in the New York Law Journal on April 9, 2020.
Reprinted with permission from the April 9, 2020, edition of the New York Law Journal © 2020 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For information, contact 877-257-3382 or firstname.lastname@example.org or visit www.almreprints.com.