Commercial Real Estate Liabilities Are Amplifying. How COVID’s Playing a Key Role

By: Courtney Kasper | April 7, 2021

Courtney Kasper is Assistant Vice President, Financial Institutions Claims Practice Leader for QBE North America. She is responsible for handling directors and officers, employment practices and fiduciary liability claims for financial institutions. Courtney also has experience handling professional liability claims involving financial professionals, real estate agents, lawyers, long-term care providers, and insurance agents and brokers. Prior to joining QBE, Courtney began her career as an Attorney at Thompson, Coe, Cousins & Irons L.L.P. During her tenure, she focused on insurance litigation and coverage matters involving both standard and professional lines. Courtney earned a Bachelor of Arts degree in Political Science from Southwestern University and a Juris Doctorate from Southern Methodist University Dedman School of Law.

The COVID-19 pandemic has caused significant disruption to the economy and particularly the commercial real estate sector. As businesses and many public areas were closed and companies shifted to remote work arrangements and reduced staff, general business activities slowed.

In response to the economic situation, federal and state governments took certain actions to mitigate the impact on tenants, most notably halting evictions and suspending foreclosure proceedings. Additionally, mortgage forbearance measures have temporarily removed the obligation for some borrowers to make monthly payments.

As a result, the full impact of the pandemic on real estate asset managers, firms managing real estate investments for third party investors likely has yet to be fully realized.

Historically, real estate asset managers have typically faced lawsuits from three types of plaintiffs — investors, tenants and lenders. Firms will typically purchase a financial institutions management liability insurance policy to protect the firm and the assets under management from this exposure. As further detailed below, COVID-19 has resulted in a range of unique claims filed against real estate asset managers by the three plaintiff types.

Investor Claims

An investor bringing a claim against a real estate asset manager is nothing new.

These claims typically involve alleged improper handling of the underlying real estate investment. Common examples are the hiring of a substandard property manager or the failure to effectively monitor investment performance, resulting in unrealized investment returns.

The pandemic and its associated economic disruptions have driven an increase in claims resulting from the deferral of distributions to investors. Not surprisingly, the aforementioned eviction and forbearance actions have impacted rental revenue and thereby real estate investment performance.

This has forced some real estate asset managers to eliminate or adjust distributions to investors to preserve capital. While the asset managers will argue that the adjustments are in the investors’ best interest to protect and preserve the investment, some investors are asserting claims against real estate asset managers for making these decisions.

The pandemic’s impact on real estate values has also driven an increase in claims following the sale of real estate under management for a loss or for less than what investors see as full value.

In these situations, investors may take issue with the price obtained or may dispute the wisdom of the sale given the COVID-19 market conditions. These claims often involve allegations that the real estate asset manager breached its contractual obligations under the applicable operating agreement and/or breached its fiduciary duties by taking actions that are contrary to the best interests of the investors.

While there is no way to stop a disgruntled investor from making a claim, steps can be taken to help mitigate the exposure.

From a risk management standpoint, it is key for real estate asset managers to maintain transparency and open lines of communication with investors “early and often.” Providing regular reports to investors disclosing the impact the pandemic is having on the investments and addressing any adjustments to distributions can go a long way. Investment memoranda and operating agreements should also be reviewed to ensure risk factors relating to the pandemic and its potential impact on investments and distributions are appropriately disclosed.

Lender Claims

In situations where a significant part of the real estate investment has been financed, the pandemic has made it difficult for some to keep up with interest payments due in large part to the diminishing ability for many tenants, including commercial tenants like retail stores and office lessees, to pay rent.

According to Moody’s Investors Service, the delinquency rate on large commercial loans tied to real estate was 7.54% in December 2020, almost three times the rate from February 2020. Moody’s referred to the upward trend as a “huge spike,” noting that the hospitality and retail industries together accounted for 82% of the most serious delinquent loans.

While some lenders like large banks are expressing patience in the hope that asset managers can renegotiate their lease terms with commercial tenants to encourage a steadier cash flow, others like hedge funds and private equity funds providing billions of dollars in higher-interest financing have taken a different approach, suing the asset manager to foreclose and sell the property at auction.

Some judges delayed these actions and advised forbearance to the lenders in 2020, due to the severe impact of the pandemic. As courts reopen to hear this backlog of cases, an increase in lawsuits seeking judicial foreclosure is anticipated. For the asset manager, maintaining open lines of communication with lenders may result in less contentious outcomes when an asset can no longer service its debt.

Tenant Claims

The pandemic has resulted in a multitude of tenant claims by both residential and commercial tenants.

In the commercial space, an unprecedented number of tenants have sought to break their leases, arguing that the anticipated value of the premises has diminished because of the pandemic’s impact.

A particularly high-profile case involves Valentino S.p.A., an Italian fashion company whose flagship store in the U.S. is on Fifth Avenue in New York. The company sued the property owner in state court, alleging the lease was voided by the COVID-19 shutdown, which had “massively disrupted” its sales, the company’s complaint stated. Valentino U.S.A., Inc. v. 693 Fifth Owner LLC, Sup. Ct. N.Y. (June 21, 2020).

The complaint further alleged that the “social and economic landscapes [of Fifth Avenue] have been radically altered in a way that has drastically, if not irreparably, hindered Valentino’s ability to conduct high-end retail business at the premises.”

Other COVID-19 related lawsuits brought by tenants involve:

Rescission, termination and/or reformation of the lease agreement due to unforeseen circumstances; and
Alleged wrongful demands for rent and/or threats of eviction despite government moratoriums.

Given the rapidly changing legal and regulatory environment, it is imperative that real estate asset managers work closely with property managers to closely monitor jurisdictional changes related to COVID-19 and act appropriately.

Liability Insurance Ramifications

As of writing, additional programs are being discussed by the federal government that may mitigate the impact of interruptions in rental revenue.

However, to protect investments, real estate asset managers should have a specialized and comprehensive liability policy designed for financial institutions and specifically asset managers.

It is expected that once the current eviction moratoriums and foreclosure suspensions are lifted, a wave of additional lawsuits will be filed by investors, lenders and tenants. Real estate asset managers could be targets of that litigation.

As a result, it is critical that real estate asset managers reach out to their risk management partners (insurance brokers, legal advisors, compliance officers, etc.) to discuss these potential liabilities and take steps to mitigate the exposure.

This due diligence should include a review of the existing insurance program to ensure that the real estate asset manager has comprehensive liability coverages, including D&O, asset management, and potentially miscellaneous professional liability, with sufficient financial limits of protection. &

How a Carrier Partner Can Help Navigate a Challenging Management and Professional Liability Market

A combination of a choppy economy with increased claims frequency and severity could lead to rate increases in the Management & Professional Liability market.

Rates in the management & professional liability (M&PL) markets were on the rise from 2020 to early 2023 and are now falling rapidly.

M&PL divisions manage a number of different insurance products including management liability (D&O), professional liability (E&O), employment practices liability (EPL), fiduciary liability policies, cyber, etc. In 2023 and into 2024, a big influence on the marketplace has been the extremely aggressive and softening public company D&O market.

Though these rates have been softening for management liability, that may change over the next few years as companies continue to adjust their business models motivated by economic uncertainty. Layoffs were up nearly 200% last year, Forbes reported, even as other recession indicators, like the inflation rate, improved. A recession could lead to an increased claim activity and force carriers to raise rates.

“Whenever there is a meaningful downturn in the economy, we tend to see claim frequency pop up,” said George Schalick, Jr., senior vice president of the Management and Professional Liability Division at Philadelphia Insurance Companies (PHLY).

With continued fiscal uncertainty, businesses potentially already burdened with pandemic-related claims should seek a carrier with a long history in M&PL products. They will provide much-needed risk management guidance and be better positioned to support their insureds during market fluctuations.

Why Insureds Might See an Uptick in M&PL Claims

George Schalick, Jr., Senior Vice President of the Management and Professional Liability Division, Philadelphia Insurance Companies

The current soft market might come as a bit of a surprise as it does not track with previous underwriting cycles and economic conditions. Afterall, many privately held and non-profit organizations struggled during the early days of the pandemic with shutdowns and rapidly declining revenues. But the Government assistance programs, like the Paycheck Protection Program loans, helped keep many afloat during the tough times.

“During COVID many organizations stopped doing business until they were able to sort out all of the health and safety challenges,” Schalick said. “They were forced to lock down, but then all the government assistance programs allowed them to keep people employed. The increased volume of claims we anticipated we would see coming from the lockdowns and restrictions that were imposed upon businesses in the U.S. didn’t manifest at first.”

“Just because there wasn’t an onslaught of reported claims at the beginning of the pandemic, doesn’t mean the circumstances that would give rise to a claim being reported didn’t occur. Courts and the judicial system were closed or slowed and now that they are back open, we’re starting to see the circumstances that occurred during the COVID lockdowns becoming claims today,” Schalick said. “Litigation is progressing.”

Added to the delayed pandemic litigation is a concern over newer claims that might be filed as the country inches toward an economic downturn. Though a recession was avoided in 2023, experts think a soft dip could occur in 2024, with 76% of economists saying there’s a 50% or less chance of an economic downturn this year — that almost always results in more management liability claims.

“During the Great Recession in 2008, we saw an almost immediate spike in claims because of the economic conditions and the pressure it placed on organizations. They were making personnel changes with significant belt tightening almost immediately.” Schalick said.

What’s in Store for M&PL Policy Rates in 2024?

Despite an uptick in claims and increased economic uncertainty, management liability rates haven’t increased, resulting in market-wide pricing levels that may not meet the increased pressure of rising settlements and jury verdicts.

“Rates are going the other direction and settlement values are not falling,” Schalick said.

The mismatch between rates, claim frequency and severity is, in part, because carriers experiencing the dramatic soft market in the public D&O market are seeking premium gain in the private and non-profit market.

“In the public company market, the rates have been decreasing significantly. The rates were increasing in the private, not-for-profit market, and rightfully so, but there’s a desire to supplement overall mid-size D&O for carriers who also write private not-for-profit, and they see that as an opportunity to aggregate premium,” Schalick said. “So the always competitive landscape in the private, not-for-profit market has dramatically increased in the last 18 to 24 months.”

Still, companies of all sizes and types should be concerned about management liability rates in the future. Legal system abuse is resulting in increases in both the amount of litigation and the size of verdicts plaintiffs are receiving.

Certain areas of the country are particularly vulnerable to this type of legal system abuse. As a result, insureds in these localities are likely to be vulnerable to rate increases.

“The environment is so positive for the plaintiff that forces premium increases so carriers are able to stay in that market long term,” Schalick said.

Why a Tenured Carrier Partner Can Help Insureds Navigate An Uncertain Market

It’s clear that insureds are facing an uncertain M&PL market over the next few years. Fortunately, carriers with a long history in the M&PL space will be there to offer stability.

Philadelphia Insurance Companies has been supporting this market for 35 years. PHLY is committed to offering long-term rate stability, even as economic and claims trends start to push premiums upwards. They have an appetite for all sorts of companies, large and small, for-profit and nonprofit alike.

“We’ve been at this game for a long time and are one of the most tenured underwriters in this space,” Schalick said. “We like to stay very consistent.”

PHLY has worked with both for-profit and non-profit on management liability policies. With dedicated M&PL teams throughout the company’s 13 regions, PHLY provides the support agents and brokers are looking for on behalf of their clients. The teams know their regions well and can respond to local trends. They’re also dedicated to making the renewal process as easy as possible for their partners and policyholders.

“We have real confidence in our results, so we focus a lot on making the renewal experience as painless as possible for all agents and insureds,” Schalick said.

The company is also investing in tools to help insureds avoid losses. Earlier this year, they launched a new online risk management platform, PHLYGateway, which offers resources for insureds on how to create an employee handbook and trainings on issues such as recognizing workplace sexual harassment and discrimination.

If insureds have questions, they can consult a Best Practices Help Line, provided via the platform. That way, they can get on the spot risk management guidance to help them prevent claims.

To learn more, visit: https://www.phly.com/mplDivision/managementLiability/default.aspx.

This article was produced by the R&I Brand Studio, a unit of the advertising department of Risk & Insurance, in collaboration with Philadelphia Insurance Companies. The editorial staff of Risk & Insurance had no role in its preparation.