Before we evaluate the new coverages, we should briefly examine the weakness of the old coverage. The 1975 policies were designed with a simple operating lease in mind. If the holder of leased space was dispossessed as a result of a defect in either the landlord's title or the lease itself, the title policy would indemnify the holder for the increased cost of leasing an alternate space and give some "Miscellaneous Items of Loss" as well. ALTA® may have seen the market in 1975 as the market for simple operating leases of offices and store bays in shopping centers, but leaseholders in those markets did not sense enough coverage in the leasehold policy to make it a worthwhile hedge to the risks they faced. Consequently, the ALTA® leasehold policy was never popular. The policy missed the developing markets in real estate leasing. Leases have been used as a financing tool for decades. Sale-leaseback transactions have been commonplace since the 1960s in my own experience. In the past two decades leasing transactions have become even more significant. We see leveraged leasing of build-to-suit projects, ground leases with tenant build-to-suit projects, and synthetic leases, to name some of the recent applications. The ALTA® Forms Committee spent most of its time developing the ALTA® 13 Leasehold Owner's Endorsement and then quickly conformed the ALTA® 13.1 Leasehold Loan Endorsement. Definitions. The original leasehold owner's policy added only two new definitions to the ALTA® Owner's policy. "Leasehold estate" was added as Section 1(h) of the Conditions and Stipulations. The term "personal property" was not added to the definitions in Section 1 but appears in Section 15(a) because the concept of personal property only applied to the "Miscellaneous Items of Loss." The ALTA® 13 added five new definitions to the leasehold coverages and placed all seven in its first section. I will discuss two of these new definitions in detail in this article. Here is a look at Section 1 of the ALTA® 13:
1. As used in this endorsement, the following terms shall mean: a. "Evicted" or "eviction": (a) the lawful deprivation, in whole or in part, of the right of possession insured by this policy, contrary to the terms of the Lease or (b) the lawful prevention of the use of the land or the Tenant Leasehold Improvements for the purposes permitted by the Lease, in either case, as a result of a matter covered by this policy. b. "Lease": the lease agreement described in Schedule A. c. "Leasehold Estate": the right of possession for the Lease Term. d."Lease Term": the duration of the Leasehold Estate, including any renewal or extended term if a valid option to renew or extend is contained in the Lease. e. "Personal Property": chattels located on the land and property which, because of their character and manner of affixation to the land, can be severed from the land without causing appreciable damage to themselves or to the land to which they are affixed. f. "Remaining Lease Term": the portion of the Lease Term remaining after the insured has been Evicted as a result of a matter covered by this policy. g. "Tenant Leasehold Improvements": Those improvements, including landscaping, required or permitted to be built on the land by the Lease that have been built at the insured's expense or in which the insured has an interest greater than the right to possession during the Lease Term. The definition of "lease" has changed in the ALTA® 13. The Leasehold Policy limited the definition as "subject to any provisions contained in the lease which limits the right of possession." The limitation was dropped because it received so much resistance from customer groups consulted in the drafting process. Although title insurers do not intend to protect policyholders from the consequences of their own agreements, the limitation in the policy definition of "lease" was not the only provision giving the title insurer this protection in the policy. The insurer is also protected by the "acts of the insured" Exclusion 3(a). The remaining definitions in Section 1 are reasonably straightforward. They should require no additional explanation. Valuation. Although the valuation provision of the ALTA® 13 does not appear until Section 3 of the endorsement, it is the most significant change in the ALTA® leasehold coverages.
3. Valuation of Estate or Interest Insured
If, in computing loss or damage, it becomes necessary to value the estates or interests of the insured as the result of a covered matter that results in an eviction, then that value shall consist of the value for the Remaining Lease Term of the Leasehold Estate and any Tenant Leasehold Improvements existing on the date of the eviction. The insured claimant shall have the right to have the Leasehold Estate and the Tenant Leasehold Improvements valued either as a whole or separately. In either event, this determination of value shall take into account rent no longer required to be paid for the Remaining Lease Term.
The most significant feature of Section 3 is its abandonment of the measure of damage specified in Section 14 of the Leasehold Policy. In short, Section 14 restricted the insured to damages measured as the "present worth of the excess, if any, of the fair market rental value of the estate or interest, undiminished by any matters for which claim is made, for that part of the term stated in Schedule A then remaining plus any renewal or extended term for which a valid option to renew or extend is contained in the Lease, over the value of the rent and other consideration required to be paid under the Lease for the same period." The constraints of that standard were the most significant impetus for changing the coverage in the leasehold policy. The new standard in Section 3 almost goes to the other extreme. There is no method specified for valuing either the Leasehold Estate or the Tenant Leasehold Improvements. It does recognize that the Leasehold Estate and the Tenant Leasehold Improvements can be valued independently. It limits the insured's recovery to the values, less any "salvage value" and excluding rent "no longer required to be paid for the Remaining Lease Term." The endorsement gives no definition of "salvage value" or a method for reaching it either. In short, the methods for valuing a loss and its deductions under this new endorsement are left to negotiation between the insured and title insurer when adjusting a claim. The ALTA® 13 does not eliminate the liability provisions of Section 7(a) of the ALTA® Owner's Policy, so Section 7(a) still applies if it is not inconsistent with the ALTA® 13. Section 7(a)(ii) imposes a standard for indemnification for actual loss, but does not go so far as to impose a method of valuing the estate or interest. Indeed, it is the more flexible standard that many leasehold title insurance customers sought by ordering an owner's policy instead of the leasehold policy. It provides:
7. Determination, Extent Of Liability, And Coinsurance.
This policy is a contract of indemnity against actual monetary loss or damage sustained or incurred by the insured claimant who has suffered loss or damage by reason of matters insured against by this policy and only to the extent herein described. (a) The liability of the Company under this policy shall not exceed the least of: (i) the Amount of Insurance stated in Schedule A; or, (ii) the difference between the value of the insured estate or interest as insured and the value of the insured estate or interest subject to the defect, lien or encumbrance insured against by this policy.
In addition to leaving the method for valuation largely to negotiation, the new Section 3 expressly gives the insured a choice of valuing the Leasehold Estate and Tenant Leasehold Improvements either together or separately. Combined with the standard rule of construction of the policy against the insurer, these features should give the insured the upper hand in a negotiation. Coinsurance. The 1970 ALTA® Owner's Policy had no coinsurance provision. The 1975 ALTA® Leasehold Owner's Policies, which were built on the foundation of the 1970 Owner's Policies, also had no coinsurance provisions. The coinsurance provisions were added to the ALTA® policy forms in the 1987 revision, but the Forms Committee did not identify the difficulty that application of a coinsurance provision would have on determining the value of a leasehold estate. It is the most persistent problem in insuring leasehold estates, and nobody has found a policy to resolve it. We can develop formulas based upon the present value of the rent payments capitalized at a specified interest rates, but almost any method of valuation is an arbitrary, imprecise, but convenient rule to develop an essential element of the insurance contract—the amount of insurance. There is an exception. If the lease has a very long term—say 99 years—we can say that the present value of the remainder interest is almost negligible, so the value of that leasehold interest approximates the value of the land. Most leasehold interests are shorter than 99 years, so applying the coinsurance provisions of Section 7(b) makes little sense in the leasehold endorsement. The values we must use for insuring most leasehold estates are imprecise, at best. We don't have a convenient arm's length purchase price as we do in most real estate conveyances. In the ALTA® 13, the Forms Committee corrected its lapse in 1987 and made the coinsurance provision inapplicable to Leasehold Estates. It provides:
2. The provisions of subsection (b) of Section 7 of the Conditions and Stipulations shall not apply to any Leasehold Estate covered by this policy.
However, Section 2 of the ALTA® 13 may mislead the incautious insured. It does provide that the coinsurance limitations on coverage contained in Section 7(b) of the policy do not apply to the Leasehold Estate but does not make Section 7(b) inapplicable to Tenant Leasehold Improvements. If Leasehold Estates and Tenant Leasehold improvements are independent, primary items of loss, then Section 7(b) still must apply to the Tenant Leasehold Improvements. This shouldn't be too alarming. If the insured owns or builds Tenant Leasehold Improvements at the outset of the leasehold estate, it should have an investment or purchase value for those assets. It has not bargained to rent them for the term of the leasehold estate. I think the coinsurance limitations are a lot more benign than their reputation suggests. Section 7(b) does not limit the title company's duty to defend if Section 7(b) applies, and the insured is not obligated to share in the costs of its defense. That duty of the title insurer is not as clear when the coinsurance provisions are missing. Indeed, there is an argument that a title insurer could deny a claim if there is no coinsurance provision in the policy by claiming that information material to the risk (the value of the property sets the magnitude of the risk) was withheld from it when the policy was issued. The title insurer cannot do that under Section 7(b). The worst that can happen under Section 7(b) is that a loss may be prorated if the title insurer is liable to pay a loss, or the title insurer may seek a contribution toward settlement of a claim. If the insured worked a savings on its title insurance premium at the outset by undervaluing its exposure, it seems fair to prorate its recovery under the policy if a claim arises. You will not find a provision corresponding to Section 2 of the ALTA® 13 in the ALTA® 13.1, but leaving it out was no oversight. ALTA® Loan policies do not have coinsurance provisions. Consequently, there is no need to include a corresponding coinsurance section in the ALTA® 13.1. Tenant Leasehold Improvements. In many transactions the tenants may have substantial investment in real estate improvements built on the leasehold. That investment is not protected by a policy that merely covers the difference in the rent on the insured premises and the rent on the replacement premises. The trend in the last twenty years or so indicates that leasehold title insurance customers were moving away from the leasehold policies in leasehold transactions, preferring the ALTA® Owner's policy instead. Although it contained no explicit coverage for tenant leasehold improvements, title insurance customers thought they had a better chance of recovering their investment in the owner's policy than they did in the leasehold owner's policy. It wasn't perfect, but it was the best they could do with the tools offered by the title insurance industry. As we have seen, Section 1(g) of the ALTA® 13 added a definition of Tenant Leasehold Improvements to protect the insured's investment in these assets. It defines Tenant Leasehold Improvements as:
"Tenant Leasehold Improvements": Those improvements, including landscaping, required or permitted to be built on the land by the Lease that have been built at the insured's expense or in which the insured has an interest greater than the right to possession during the Lease Term.
The definition encompasses any improvements, including landscaping, taking a lead from the ALTA® 9 Endorsement, that protects interests in "lawns, shrubbery or trees" in several sections. Recognizing landscaping as "improvements" is not unique but certainly a new development for leasehold coverages. The definition of "eviction" in Section 1(a) of the endorsement includes eviction from Tenant Leasehold Improvements as well as eviction from the land, so it is possible to trigger a loss without a full eviction from the leasehold. Although it may be difficult to envision an eviction from the Tenant Leasehold Improvements without an eviction from the land, this definition of eviction establishes the Tenant Leasehold Improvements as a primary interest insured by the policy. It is not an "Additional Item of Loss" as we find in Section 4 of the endorsement. Of course Section 3 of the ALTA® 13 brought a recognition of damage or loss to the Tenant Leasehold Improvements to leasehold title insurance. In addition, supporting the conclusion that loss to Tenant Leasehold Improvements is a primary coverage, Section 3 empowers the insured to elect whether to have the Leasehold Estate and Tenant Leasehold Improvements valued together or separately. However, there is one other provision for valuation of Leasehold Tenant Improvements that was added in the ALTA® 13. Determining the value of Tenant Leasehold Improvements becomes really difficult if the tenant is in the process of building a significant structure on its leasehold when its right to possession is challenged. This isn't just a case of bad luck. The risk of a challenge to title is greatest during the construction of improvements because the evidence of the construction announces the tenant's claim to the land to any who see it. An appraiser will not give a high value to incomplete improvements. Indeed, many times an incomplete project may actually reduce the appraised value of land. If the incomplete structure must be demolished as useless, the cost of removal must be deducted from the market value of the raw land. Even if the construction is only interrupted, it often costs substantially more to resume and finish the construction than it would if the construction had progressed without the interruption. If a leasehold was insured with either a leasehold or owner's policy, the title insurer might reduce or deny a claim for the value of the tenant's invest-ment in the leasehold improve-ments by asserting that the incomplete project had little or no value. This problem with valuation of improvements under construction is not confined to leasehold estates. It applies to any project under construction. Title insurance had never addressed this problem in a standard policy or endorsement coverage until ALTA® 13 addressed it in Section 4(g) of Additional Items of Loss:
4. Additional Items of Loss Covered by This Endorsement:
If the insured is Evicted, the following items of loss, if applicable, shall be included in computing loss or damage incurred by the insured, but not to the extent that the same are included in the valuation of the estates or interests insured by this policy. . . . g. If Tenant Leasehold Improvements are not substantially completed at the time of eviction, the actual cost incurred by the insured, less the salvage value, for the Tenant Leasehold Improvements up to the time of eviction. Those costs include costs incurred to obtain land use, zoning, building and occupancy permits, architectural and engineering fees, construction management fees, costs of environmental testing and reviews, landscaping costs and fees, costs and interest on loans for the acquisition and construction.
Section 4(g) allows the insured to recover its investment in the construction, as well as those "soft costs" it expressly lists. It significantly expands the measure of damages under a title insurance policy, and the only reason for confining this coverage to leasehold estates is the greater difficulty that title insurers have experienced in breaking into the leasehold title market. We should expect pressure to migrate this type of coverage into fee ownership development transactions as well.
The Eviction Trigger
Section 15 of the old leasehold Policy also used the terms "Evict" and "eviction," though it did not define them. The definition added to the ALTA® 13 in Section 1(a) of the endorsement should allay any concerns that the words imply a requirement for a judicial proceeding:
a. "Evicted" or "Eviction":
(a) the lawful deprivation, in whole or in part, of the right of possession insured by this policy, contrary to the terms of the Lease or (b) the lawful prevention of the use of the land or the Tenant Leasehold Improvements for the purposes permitted by the Lease, in either case, as a result of a matter covered by this policy.
Under this definition "eviction" may be either a lawful deprivation of the right of possession under the lease or the lawful prevention of the use of the land "for the purposes permitted by the lease." That's an additional nugget for the insured. Title insurance policies do not usually insure land use issues without an endorsement like the ALTA® 3.1, but the ALTA® 13 requires a prudent title insurance underwriter to compare the uses specified in a lease with the land use regulations that apply to the land to avoid losses under this definition. The definition does create a coverage trigger. You must have an eviction before you can show a loss under this policy. It is important to recognize that this is no mere definition, even though it is included in Section 1 of the endorsement. Additional Items of Loss. When the first Leasehold policies were adopted in 1975, their best feature was a set of unusual consequential damage provisions in Section 15 titled "Miscellaneous Items of Loss." This title suggests that these provisions were an afterthought. However, they were revolutionary for the title industry for their time. Title insurers avoid recognizing consequential damages as "loss" because consequential damages are so open-ended. The new title invites the policyholder to read Section 4 to find those additional coverages. Section 15(a) of the old "Miscellaneous Items of Loss" allowed payment of the costs of relocating personal property removed from the insured land to a replacement leasehold, but the title insurer would only pay for cost of transportation for the initial 25 miles. The idea was to limit the insured to relocations in the same area as the insured land. I think this meant that the title insurer would pay for all the removing and relocating operations that take place at the origin and destination, but if the distance between the two exceeds 25 miles, the insurer would pay for the first 25 miles of travel, and the insured must pay for any additional travel. The Section 15(a) expanded the radius from 25 ti 100 miles. There are perhaps two reasons for this wider radius. First, title insurers have experienced very little, if any, losses based on Section 15(a), so the Forms Committee saw little risk in expanding the range to 100 miles. Secondly, a 100 mile radius is more attractive to title insurance consumers than a 25 mile radius, and the Forms Committee saw an opportunity to make the ALTA® 13 more appealing than its predecessor. This change is substantive but not very material. If our experience with Section 15(a) of the Leasehold Policy is any measure, few, if any, policyholders will realize a benefit from the change. Of course, all policyholders are better off for the change because we cannot tell at the outset who the few will eventually be. For title insurance customers with bond leases with "hell or high water" provisions that require the lessee to continue paying its rent even after it has been evicted from the premises, Section 4(c) provides protection against that risk. I am mildly astonished that so few of these customers raise this issue and seek this coverage. In recent years many have demanded ALTA® Owner's Policies instead of leasehold policies and have let the coverage slide in making the requirement. It should not be necessary with the ALTA® 13. Two new provisions were added to the Additional Items of Loss in the ALTA® 13. We examined the valuation provisions for a new project under construction in new Section 4(g) in the discussion of Leasehold Tenant Improvements. Section 4(f) is also new and reimburses the policyholder for the expenses to get a replacement Leasehold Estate. Like Section 4(g), Section 4(f) introduces the prospect of including "soft costs" into the computation of an insured's damages. The new "Additional Items of Loss" include:
4. Additional items of loss covered by this endorsement:
If the insured is Evicted, the following items of loss, if applicable, shall be included in computing loss or damage incurred by the insured, but not to the extent that the same are included in the valuation of the estates or interests insured by this policy. a. The reasonable cost of removing and relocating any Personal Property that the insured has the right to remove and relocate, situated on the land at the time of eviction, the cost of transportation of that Personal Property for the initial 100 miles incurred in connection with the relocation, and the reasonable cost of repairing the Personal Property damaged by reason of the removal and relocation. b. Rent or damages for use and occupancy of the land prior to the eviction which the insured as owner of the Leasehold Estate is obligated to pay to any person having paramount title to that of the lessor in the Lease. c. The amount of rent that, by the terms of the Lease, the insured must continue to pay to the lessor after eviction with respect to the portion of the Leasehold Estate and Tenant Leasehold Improvements from which the insured has been Evicted. d. The fair market value, at the time of the eviction, of the estate or interest of the insured in any lease or sublease made by the insured as lessor of all or part of the Leasehold Estate or the Tenant Leasehold Improvements. e. Damages that the insured is obligated to pay to lessees or sublessees on account of the breach of any lease or sublease made by the insured as lessor of all or part of the Leasehold Estate or the Tenant Leasehold Improvements caused by the eviction. f. Reasonable costs incurred by the insured to secure a replacement leasehold equivalent to the Leasehold Estate. g. If Tenant Leasehold Improvements are not substantially completed at the time of eviction, the actual cost incurred by the insured, less the salvage value, for the Tenant Leasehold Improvements up to the time of eviction. Those costs include costs incurred to obtain land use, zoning, building and occupancy permits, architectural and engineering fees, construction management fees, costs of environmental testing and reviews, landscaping costs and fees, costs and interest on loans for the acquisition and construction.
The Forms Committee now turns its attention to some new projects, most notably the adoption of an ALTA® future advance endorsement and a comprehensive review and revision of the 1992 Loan and Owner's policies. The future advance endorsement might be ready for adoption in October 2002. The revision of the loan and owner's policies could take years, but the process is underway. The process of developing new leasehold coverages is on hold for the moment, but the choice of switching to an endorsement format instead of a policy format will make future variations in leasehold coverages easier to develop. There are still some unresolved issues. After Enron it may be unnecessary to develop synthetic lease coverages. Many companies that had placed properties into synthetic leases are unwinding those transactions in favor of more conventional financing because they are uncomfortable with off-balance sheet financing right now. However, others continue to pursue a synthetic lease strategy, and we may see a resurgence of synthetic leasing if the outrage against off-balance sheet financings wanes. There is no pressure for a synthetic lease endorsement right now. I think there are still some issues for the leasehold loan coverages. If a tenant places a mortgage on its leasehold to secure repayment of a loan and later modifies or terminates its lease with the landlord but without the consent of the insured lender, the ALTA® 13.1 does not insure that the lender can foreclose on the leasehold interest as it existed before the modification or termination. Although that would appear to be crucial coverage for a lender, the modification or termination is a post- policy events. The law on this issue is sketchy, and there was not sufficient time to resolve the issue before the Forms Committee submitted the ALTA® 13.1 to the 2001 Annual Meeting. If there is pressure to add this coverage to the endorsement and if the Forms Committee finds suficient authority to become comfortable with issuing the coverage, we might see an amendement to the ALTA® 13.1 or a third leasehold endorsement adopted for this risk. The new ALTA® endorsements are a step forward both in substance and in form. The substance of the new coverages should make title insurance more attractive to the leasing markets. The endorsement form gives ALTA® the flexibility to react to new leasing formats and demands for additional coverages.
Bob Bozarth is vice president and senior underwriting counsel for LandAmerica Financial Group and a member of ALTA®'s Title Insurance Forms Committee. He can be reached at email@example.com or 804-267-8037.