Articles / Publications

MultiFamily Executive, June 2003

Overexposed

Multifamily developers are confronted by broader legal exposures and an industry-wide liability insurance crisis. Identifying and managing operational risks has never been more difficult – or more important. Sophisticated developers are relying more and more on non-insurance risk management strategies. A new approach to managing liability exposures – such as residual risk analysis – can help developers of both rental and for-sale projects survive the current insurance crisis.

Insurance Challenges

Driven in part by aggressive plaintiff trial lawyers in many state, multifamily developers face a wide range of liability exposures. Bodily injury and property damage claims involving mold and indoor air quality are the lawsuits du jour. In addition, multifamily developers must deal with a host of other exposures, including construction defects, subsidence and earth movement losses, and non-disclosure claims.

Historically, successful developers employed a four-part approach to risk management: avoid, minimize or mitigate, shift, and insure. Although insurance has always been more expensive than non-insurance tools, multifamily developers generally could count on obtaining adequate coverage for comparatively tolerable premiums.

Today, however, liability insurance is not as available – and when available, it is far more expensive. At the same time, insurers are attaching exclusions that narrow coverage substantially, including exclusions for mold, pollution, earth movement, and known or prexisting injury or damage. In addition, insurers are excluding non-construction risks such as wrongful termination, harassment, and other employment-related liabilities.

Residual Risk Analysis

In this difficult environment, developers are seeking fresh views and new approaches to manage risks and reduce insurance costs. One such approach is a residual risk analysis, which compares the developer’s operational risks with the available insurance coverage. Residual risk analysis is a five-step process:

1.    Identify the major operational risks of the developer’s business.

2.   Prioritize the risks in terms of their danger to the company (i.e., measured by financial impact, negative publicity, and impact on relations with investors, lenders and governmental agencies).

3.   Determine which risks are not covered by the developer’s insurance policies.

4.   Select and implement appropriate non-insurance risk management strategies for each exposure, including those that remain insurable.

5.  Evaluate the results over time and pursue a process of continuous improvement of the non-insurance strategies.

Even if a risk is insurable, developers still are urged to apply non-insurance risk management tools. This makes solid business sense, because it should reduce the number and severity of claims, which otherwise would be reflected in the developer’s lost history. Fewer claims make a developer more attractive to insurers in the future.

Pre-Construction Risk Reducers

Each step in the development process offers opportunities for applying non-insurance risk management strategies. In fact, these strategies can and should be employed at each stage of a project’s life cycle. Among the main strategies available are careful entity structuring, effective due diligence in land acquisition, design and construction quality control, contractual risk transfer, protective provisions in consumer documents, and responsive customer service.

When structuring an organization, developers may use partnerships, corporations, or limited liability companies (LLC) – or any combination of the three. LLCs combine the tax sufficiency of a partnership with liability-limiting features of a corporation. A widely accepted organizational structure involves the formation of a separate LLC for each of the developer’s projects.

If properly structured and maintained, this organizational configuration should help isolate claims and losses to the specific project entity. However, like corporation, LLCs require developers to observe corporate formalities, such as regular board meetings, minutes, resolutions, and the like, as well as observation of the “separateness” of the entity. That is, each entity should be treated as a separate and independent business unit, even though it probably will have close affiliations with the developer’s related entities.

For example, separate bank accounts should be maintained for each entity, and inter-company loans, use of employees, and other transactions should be at arm’s length and documented appropriately. The objective of these steps is to avoid alter ego – the assertion that the LLC is not a separate entity, but rather an extension of the shareholders or members – and enterprise liability attacks by which a claimant might reach behind the entity protection and gain access to the assets of the members or affiliated entities.

After determining the right structure of the new entity, the next step is to find developable land. However, in most jurisdictions, land is increasingly becoming a scarce commodity. As a result, more multifamily developers are considering acquiring sites that carry special challenges, such as brownfields parcels, former military facilities, and urban infill locations. These sites have higher risk profiles, so developers are employing non-insurance tools such as more rigorous due diligence investigation and risk management planning.

During Construction Minimizers

In order to minimize construction defects – particularly water intrusion – developers are implementing comprehensive design and construction quality control (QC) programs. These may involve peer review of the proposed plans and specifications by an independent design professional experienced in forensic review and failure analysis. The QC program also should include inspections of the ongoing work (such as the moisture envelope and the structural elements) and documentation that the work has been completed correctly.

Another major non-insurance risk management tool is adding broad risk transfer provisions in construction contracts, which can include insurance requirements imposed on the other party, indemnification, compliance with laws, and performance standards. Local market conditions dictate the actual level of risk transfer that can be achieved in any particular contract. Because of frequent changes in law and practice, contractual risk transfer provisions should be reviewed and, if necessary, updated at least annually.

One of the best non-insurance risk management investments a developer can implement is a review and update of the its consumer documents, with the objective of including the broadest protective provisions allowed under state law. Virtually every consumer document – sales agreements; declarations of covenants, conditions, and restrictions; disclosures; warranties; and homeowner and homeowner association (HOA) manuals – offers opportunities for creative risk management approaches.

For example, in a rental project, a lease can include a specially-drafted mold provision or addendum. The addendum might include disclosure of the ubiquitous nature of mold, and the resident’s covenant to notify the property manager immediately of any water intrusion or leak so that the condition can be properly remediated.

In a for-sale project, protective provisions can include notice from the homeowner of an alleged defect, together with inspection and repair rights for the developer. The developer also should consider requiring the homeowner or HOA to be compliance with maintenance requirements. Another useful provision is alternative dispute resolution (ADR), such as binding arbitration of disputes.

Post-Construction Protection

In for-sale multifamily projects, one of the most important risk management tools is responsive customer service. A high percentage of construction defect lawsuits can be traced to a real or perceived failure of customer service to respond adequately.

Sophisticated developers are beginning to arm their customer service representatives with new tools, including specific protocols for high-risk claims such as mold. Under these protocols, representatives are trained to respond quickly and given guidance about when to use outside resources, such as an industrial hygienist or remediation constructor.

Developers will find that effective performance of residual risk analysis and implementation of non-insurance risk management strategies require an investment of time and resources, as well as the commitment of top management. But, the benefits far outweigh the costs. Disciplined use of these tools will help developers reduce their risks in the short term so that they can survive the current insurance crisis and position them to qualify for better liability insurance coverage at more competitive rates in the future.

Jeffrey Masters is a lawyer at Los Angeles-based Cox Castle Nicholson. He can be reached at jmasters@coxcastle.com. Peter Breitstone is president of Breitstone & Co. Ltd. He can be reached at peter@breitstone.com