Unintended Consequences in Purchase and Sale Agreement Drafting: Liability Caps

In most commercial real estate transactions, one issue that is often heavily negotiated is the caps on seller’s potential post-closing liability. Although the title company is rarely involved in these negotiations, seller often tries to structure the caps in a way that may limit buyer’s title insurance coverage. Therefore, buyer should take steps to avoid this potential unintended consequence.

In most commercial real estate purchase and sale agreements, seller insists on capping its post-closing liability at a specific amount, typically 1-5% of the purchase price, and/or for a specified period of time, typically 6-12 months after closing. Such limitations are generally considered “market” and allow Seller to distribute closing proceeds and dissolve entities knowing its maximum potential post-closing liability.  Seller typically wants such limitations to apply to all of its representations, warranties, covenants, indemnifications and obligations in the purchase and sale agreement as well as any closing documents, including the deed.  Buyer may push back for certain carveouts to which the liability cap will not apply, such as post-closing reconciliations, broker fees, attorney fees and Seller’s fraud.  However, the liability caps usually extend to closing documents, including the deed.

Buyer must tread carefully in negotiating these liability caps as their effect on a buyer’s right to make future claims under its title insurance policy is often overlooked. A core principle of title insurance is that, upon payment of a claim, the title company subrogates to the rights of the insured (Buyer) to pursue claims against third parties (Seller), including actions for a breach of title covenants contained in a deed.  However, the title company only steps into the shoes of Buyer and its subrogation rights are therefore subject to the agreed-upon liability caps.  In a worst case scenario, a complete failure of title, the title company might be required to pay the entire policy amount to Buyer (usually the purchase price), but it might only be entitled to collect the capped amount from Seller, or nothing at all if the claim is made after the expiration of the survival period.

Although this specific concern has not yet been adjudicated, it is easy to see a scenario that ends up in litigation.  The title company could argue that it is not liable to buyer for the entire claim amount since the ALTA policy jacket expressly provides that the title company will not be liable for loss or damage voluntarily assumed by the insured in settling any claim without the prior written consent of the title company.  By agreeing to liability caps that apply to the deed, buyer essentially pre-settled a claim without the title company’s consent.  In response, buyer could argue that the title company cannot negate its duty to independently research the title to the property by denying a claim on such a basis and that the liability caps were agreed to in advance of (but not in settlement of) a claim.  Furthermore, if the title company signs the purchase and sale agreement as escrow agent, buyer can also argue that the title company implicitly consented to the liability caps and cannot deny coverage on that basis.

While buyer may prevail in a dispute using these arguments, it is preferable to avoid the dispute altogether by considering one of the following steps to address the issue:

Buyer can create a carveout to the liability cap for any claim for a breach of deed covenant to the extent a title insurance claim is denied as a result of the cap.  During negotiations with seller, Buyer could argue that the essence of a real estate transaction is for Seller to provide good title to the Property, and, therefore, the deed covenants should not be subject to a liability cap.  Seller may not agree to such a carveout because it will prevent seller from limiting its potential exposure and Seller will want to stay out of any dispute between buyer and the title company.

In jurisdictions where the title company will insure title based on a release deed, buyer can have seller provide a release deed at closing instead of any type of warranty deed.  With a release deed, buyer will need to rely on its title insurance for any title issues that arise, but since Seller is making no covenants under the deed, the title company would not be able to claim that Buyer affected its subrogation rights by agreeing to the liability caps.

To the extent the title affidavit seller delivers to the title company at closing includes a statement regarding seller’s ownership of the property, buyer can have the title company rely on the affidavit instead of its subrogation rights under the deed.  In these circumstances, the title company will have a direct claim against Seller under the title affidavit that wouldn’t be subject to the liability caps that buyer negotiated.

Buyer can have seller provide a warranty deed subject to all matters of record, making the title company responsible for disclosing matters of record and otherwise rely on the title affidavit for “off-record” matters (a hybrid of the second and third points raised above).

Buyer can require the title company to acknowledge the liability caps prior to closing.  However, since the claims department at the title company may be loathe to agree in advance to potentially restrict the title company’s rights under the title policy, this may require some negotiation with the underwriters at the title company.

Creating broad liability caps in purchase and sale agreements for commercial real estate can have a significant impact on potential title insurance claims.  It is important for all parties involved to understand the potential pitfalls and consider the positions of each party involved in the negotiations.  Addressing these issues upfront will help avoid unnecessary litigation down the road.

Louis Monti is a partner in the Sullivan & Worcester. The views expressed here are the author’s own and not that of ALM.