Real estate companies: here’s the need-to-know about management and professional liability
The real estate industry truly knows the meaning of highs and lows. When the market is strong, deals are abundant, revenue growth is prolific and competition is fierce. When the market is weak (or worse, recessed), investors are both timid and scarce, receivables are uncertain…and growth can stagnate.
But regardless of the market direction, companies in the real estate sector face the constant threat of legal liability. The market direction dictates the nature of the threats that arise.
For example, when conditions are good, competition brings with it tortious interference allegations. More work can also mean a higher chance of errors or omissions in your work.
On the flip side, when conditions are bad, financially strained investors are more likely to file lawsuits. Tenants unable to meet their obligations can lead to torpedoed deals or risky eviction proceedings.
Our intent here is to explore a few of the key risks faced by real estate companies. We’ll also look at the insurance products that can mitigate those risks and allow companies to focus on their core business and long-term goals.
Let’s take a look at three broadly defined classes of business in the real estate industry:
- Property managers – you are the boots on the ground at a completed property. You oversee everything from rent to staffing to reporting to maintenance.
- Real estate developers – you oversee the process from planning to construction to sale. You’re in charge of the design and execution and your business is high risk, high reward.
- Property owners and investment vehicles – the buck stops with you. You oversee the financing, contracts and legal structure. Acquisitions/sales, reports to investors and partners and the supervision of your property manager are among the many jobs that land on your desk.
For businesses such as these, insurance is probably already on the radar. They may have explored insurance policies mandated by state law or contract, such as workers’ compensation and general liability.
While these are absolutely necessary coverages by themselves, they can leave glaring holes in a company’s risk management program. Workers’ Comp and GL provide fundamental protections from risks such as an employee injured on the job site, damage to third-party property, or a slip-and-fall at the office.
However, they do little to address the many risks that exist outside of simple liability, from bodily injury or property damage. Like the following scenarios:
- Structural defects in an apartment complex lead to tenants suing a developer for failing to properly supervise the construction process
- Personally identifiable information of tenants is stolen, misused, or leaked
- A limited partner files a suit against the general partner for overcharging fees
- An allegation rises regarding a misrepresentation of the strength of the fund or the value of an investment
These scenarios share two common facts:
- They’re all real-life scenarios that have happened in the past and will happen in the future.
- They are all insurable risks.
Let’s look at three common insurance policies in the real estate industry and review why they are so important for managing risk and ensuring the survival of your business.
Types of insurance policies
Directors & officers insurance
High Level: This policy covers executives and the company if they are named in a lawsuit or regulatory action. Claims include allegations of breach of fiduciary duty from investors, investigations from regulatory bodies such as the SEC, unfair trade practice suits from competitors and claims of misrepresentation or fraud (as long as it is unfounded) from vendors.
These policies are frequently offered with additional coverages such as employment practices liability and fiduciary liability insurance. Employment practices liability insurance covers suits from employees (and sometimes third-parties) alleging harassment, discrimination, wrongful termination and other employment disputes. Fiduciary liability insurance protects the company from its exposure as the sponsor of an employee benefit plan.
Professional liability insurance
High Level: this policy covers the company in the event of lawsuits that allege it was negligent in its duties as part of an ongoing professional relationships. These can be suits from clients alleging breach of contract, suits from tenants claiming discrimination or suits from limited partners who feel there were errors made during a fund’s distribution process.
For property owners and investment vehicles, the best practice is to purchase a directors & officers policy that blends in coverage for professional liability claims. The right policies are specifically designed to account for the unique aspects of these businesses, such as the possibility of an investor claiming an error or omission in the provision of their investment management service.
They also include features that allow for automatic coverage of the many limited partnerships and LLC’s created during any given year (something that may not be available in an off-the-shelf D&O policy).
Cyber liability insurance
High Level: This policy protects the company from litigation and other expenses associated with a cyber attack or data breach.
Any company that collects individuals’ personally identifiable information (PII) has a responsibility to protect that info. PII includes obvious high-risk data such as social security numbers and credit card, but it doesn’t end there. Names, phone numbers, email addresses — even IP addresses — can all be considered PII.
If an unauthorized party gets access to this information via a company’s systems, that company may have to bear the cost of civil suits and regulatory fines and penalties.
It’s important to remember that a company’s liability begins much earlier than the moment a criminal steals someone’s identity. An event as simple as a the loss of a thumb drive has been enough for companies to be on the hook for millions in legal costs and fines.
A cyber liability policy is designed to cover these costs. This includes coverage for suits from affected individuals and costs associated with a regulatory investigation.
Some policies also include “first party” coverages which include the costs of:
- notifying your customers and providing credit monitoring for them
- business interruption after a cyber-attack locks up your systems
- forensic investigation into the source of the breach
Possible claim scenarios
Let’s look at some practical examples:
Example 1: A prospective tenant of a unit in an apartment building is working with a property manager to secure a lease. After a lengthy back-and-forth regarding terms, prior-landlord references, and financial records, the applicant is outraged upon discovering that the unit was given to another individual who was ready and willing to provide the requested information.
The outraged applicant alleges she was told by the manager that the unit was basically hers and that they just had to “dot the i’s”. The applicant files suit against the property manager and building owner alleging discrimination based on race and gender, failure to process the lease in a timely manner, bad-faith negotiating, and mental anguish.
Which policy could pay for this: Professional Liability
Example 2: A real estate investment trust acquires a shopping center anchored by a big-box retail store. The REIT reports to investors that it anticipates strong returns based on low tenant turnover, a great location and high foot-traffic.
Six months after the acquisition, the big-box tenant announces falling earnings and decides to reshape their geographic footprint. This tenant breaks its lease and shuts down the anchor location. Economic conditions make finding a new anchor tenant more difficult than initially thought. With that, the once promising shopping center begins what will become steady decline to unprofitability.
As the REIT’s shareholders watch their investment erode, they sue the CEO, CFO, CIO and board of directors for misrepresentations, breach of fiduciary duty and negligence.
Which policy could pay for this: Directors & Officers
Example 3: A real estate private-equity fund has a diverse portfolio which necessitates a complex structure of limited partnerships, LLC’s, and SPV’s.
As the fund winds down, a group of investors sue the fund and its partners, alleging that they overcharged management and performance fees and gave special treatment to one of the larger limited partners (who also happened to have various sidecar investments with the GP).
Which policies could pay for this: Directors & Officers and Professional Liability
Example 4: A developer is given the job of overseeing the construction of a cutting-edge, “green” building.
The developer’s proposal is significantly more expensive than the investors’ target but the developer convinces the investors that reduced energy costs and higher rent will increase their ROI in the long run.
As the project is underway, complications in reconciling the aesthetic with various “green” features leads to a redesign. This adds to the construction costs of the project and the time to completion since new permits are now needed.
The investors sue the developer for negligence in the design process and failure to properly supervise the construction company.
Which policy could pay for this: Professional Liability
Example 5: The employee of a property manager brings his laptop home with him after a late night at the office. When he walks out the next morning, the passenger window of his car is shattered and the bag containing his laptop has been stolen.
Since the laptop’s hard drive contained tenants’ names, addresses, phone numbers and email addresses, the manager has a problem on his or her hands. Concern snowballs as it’s discovered that the employee can’t remember whether or not he is auto-logged in to the online rent receivables platform.
Now there is a chance that the thief has access to banking information as well. The manager reports the theft to police and, in order to comply with state data privacy laws, takes on the cost of formally notifying all tenants of the potential theft of personally identifiable information.
Tenants file suit against the property manager and building owners alleging a failure to properly secure sensitive data. The court orders compensatory damages as well as the provision of ongoing credit monitoring services for the tenants and a 24-hour help line for potentially affected individuals. The state then imposes fines and penalties for failure to comply with the relevant data privacy statutes.
Which policy could pay for this: Cyber Liability (with coverage for first-party expenses)
Summing it up
Every business has to deal with the double-edged sword of success: as your company grows, so too does your legal liability. This is no less true with real estate companies. With every new tenant, project and investment, your increased potential for profit is matched by your increased potential for litigation.
One thing that is crucial to remember when considering these types of policies. It doesn’t take much for someone to file a lawsuit against you or your company. Even borderline frivolous claims will cost you in the form of both time and legal costs. If there is some perceivable merit to the allegations, your costs will skyrocket.
Properly designing your risk management practices around the unique exposures faced by your business is crucial to creating scalable growth. While it is understandably tempting to limit your insurance costs to whatever policies are required by statutes or contracts, this mentality could be considered dangerously shortsighted.
The types of claims described above are not just possible, they’re common. The right insurance policy will absorb the costs of lawyers’ bills, investigation costs, judgements/settlements and the various expenses associated with a data breach. This will allow you to put more focus on running your business and less on a tumbling bottom line.
For this reason, these policies should be viewed as an investment (rather than an expense) in the future of your company.