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Controlling risk in fee management.

In today's economic climate, many developers are aggressively pursuing opportunities to earn fee income. They want to escape the uncertainties of equity ownership for the perceived safety of regular fees for providing development management, property management, asset management, or related services.

But, eager for business, developers often sign agreements with institutional owners that require them to assume potential liability far greater than the benefits to be gained from the management contract. Similar demands are also being made of third-party management firms.

Institutional owners defend this transfer of liability to fee managers by arguing that they are paying for a manager's expertise. Consequently, they feel that a manager should utilize that expertise to protect the owner from liability that may arise in the course of management activities.

These contrasting expectations of the owner and the manager usually do not surface until the business understanding is first documented. A win-lose debate often ensues, with each party trying to transfer liability to the other. However, most developers and fee managers lack the economic leverage to win that debate by direct confrontation.

Creatively approaching the allocation of risk in management contracts is vital for ensuring business survival. Several techniques are available:

* Limit the responsibilities of the manager.

* Shift risk to third parties.

* Negotiate all of the elements of an indemnification provision.

* Consider limitations on the applicability of the indemnity.

Limiting management responsibilities

First, limit potential risk by carefully defining the scope of management services. This can be presented as a non-controversial matter, yet will significantly reduce the potential liability borne by the manager. Keep these three general principles in mind:

* Third-party service providers should execute contracts directly with the owner, if possible. Otherwise, the owner's name should appear on all contracts, with the manager listed as agent.

* The manager's duties should be expressly limited to coordination and contract administration, with no responsibility for the actual work performed by the third party, Such provisions should eliminate a manager's liability for third-party acts.

* Avoid phrases such as: "Manager shall obtain all necessary entitlements," "Manager shall cause the project to be substantially completed by (date)," or "Manager shall ensure that the project complies with all applicable laws."

In each case, the manager should only agree to use commercially reasonable efforts to keep the owner informed, to make recommendations, and to implement the owner's decisions. If drafted in a manner that will reflect actual practice, restrictions on the manager's authority are a shield against liability, not an impediment to performance.

Try to negotiate workable reporting requirements and restrictions on the manager's authority, and then follow them. Unrealistic restrictions will be ignored, until trouble strikes and the owner looks to the contract.

Allocating liability to others

Second, shift the risk of liability to third parties. Owners know that managers and developers rarely have deep pockets. Both parties have an incentive to make sure insurance covers as many risks as possible.

It is always worthwhile for the manager's insurance adviser to review the owner's existing coverage as few non-specialists understand this area. Require the owner to carry all recommended insurance coverages, with reasonable deductibles and financially strong carriers. All insurance policies should name the manager as an additional insured and contain a waiver of subrogation so that the insurance company cannot sue the manager.

Even if the premiums cannot be passed through as a project cost, consider obtaining protection not offered by the owner's insurance. Your insurance adviser may suggest a fidelity bond, contractual liability coverage, or other cost-effective risk-shifting device.

A manager should verify that contractors, consultants, brokers, and other third-party service providers have appropriate licenses and insurance. Failure to do so, whether negligent or not, will often result in the owner looking to the manager to make good if a problem should occur.

Assigning indemnity

Third, indemnity provisions offer a spectrum of risk allocation--not a black or white choice. An indemnity provision involves one party agreeing to pay a second party's damages to a third party under specified circumstances.

Between the extremes of the owner indemnifying the manager for everything, except to the extent caused by the manager's gross negligence or willful misconduct, or the extraordinarily unfavorable formulation of the manager indemnifying the owner for everything except to the extent caused by the owner's actions, there are a number of compromise positions.

At a minimum, make sure the owner expressly indemnifies the manager for everything not caused by the manager's negligence or worse. This offers much more protection than a fair reciprocal indemnity in which each party indemnifies the other against its own negligence. Liability can arise even when there is no negligence.

People make mistakes. While a manager is frequently required to indemnify the owner against the manager's negligence, this standard can be watered down by requiring a showing of gross negligence or at least active, affirmative negligence.

Note, however, that statutes and court cases may not always allow exoneration of liability for negligence. This varies from state to state.

Indemnifying an owner for actions taken outside the scope of a manager's authority is less broad than, and thus preferable to, a blanket indemnity for the manager's breach of the agreement.

Any indemnity that the owner gives the manager should also include express indemnification language. Without this release, an owner may be required to indemnify the manager from lawsuits brought by third parties, but may still retain the right to recover damages from the manager.

An indemnity by the manager should be phrased so that the owner is protected only from foreseeable losses directly resulting from, and to the extent caused by, the manager's conduct that gives rise to the indemnification obligation.

Limiting Indemnity

Fourth, consider explicit and implicit limits on unfavorable indemnity provisions. Sometimes an impasse regarding the formulation of such a provision can be resolved by agreeing to the less favorable formulation in exchange for an express limit on its applicability.

Real estate is risky and mistakes happen. The manager's activities will often create profit he or she will not benefit from. By the same token, the manager may deserve some insulation from the risks of ownership, even if the loss is caused in part by the manager's actions.

Caps on economic liability may usually be formulated as a flat dollar amount, as all compensation earned to date by the manager, as all incentive compensation earned to date but excluding base compensation intended to cover the manager's overhead, or as any other formula that can be imagined. Again, public policy may prohibit specific forms of caps in some states.

A less controversial, but correspondingly less effective, limit on liability relates to the survival of the indemnity. Owners are often entitled to pursue a manager for indemnity years after the agreement has terminated.

The parties can agree that the manager's (but not the owner's) indemnification obligation will expire within a specified period following either the termination of the agreement or the occurrence of the event which results in indemnification.

Some owners are willing to assume the cost of defense until a claim by a third party is resolved. Legal costs in defending a claim can be crippling. An early unfavorable settlement can sometimes be avoided if the manager is not obligated to fund the costs of defense up front and is not required to pay for the cost of separate counsel for owner and manager.

Even if express limitations cannot be negotiated, state law will sometimes impose implicit limits on the enforceability of an indemnification provision. Certain indemnities will be unenforceable as a matter of public policy. More importantly, the statutes and case law of each state will result in certain loopholes and traps for the unwary.

Therefore, indemnification language must be carefully drafted. Sometimes a counterproposal to the indemnity language presented by the owner can be phrased to offerless than meets the eye.

Always remember that an indemnity is only as strong as the financial strength of the indemnitor. Financial covenants are rarely found in management agreements. A thinly capitalized corporation or single asset entity may provide ultimate protection against financial disaster.

Of course, this can cut both ways. An indemnity offered by a single asset owner with little equity in the project may offer small comfort to the property manager.


More and more owners will attempt to shift much risk of liability to the manager, thus endangering the benefits the manager expects to receive for his or her work. While risk allocation is ultimately a zero-sum situation, creative negotiation strategies can reduce confrontation and minimize risk.

David Burton is a partner at the Los Angeles law firm of Alen, Markins, Leck, Gamble & Mallory, where he specializes in real estate development and finance.

The Risk of Reallocation

As the market for property management services has become more competitive, owners are negotiating harder, resulting in downward pressure on fees and increased demand for services. As part of these negotiations, some institutional owners are seeking to transfer liability for environmental and operational risks, which has traditionally been borne by ownership, to the property manager,

For the property manager, assuming these increased liability risks creates potential time bombs. Although the cost may not appear significant in a financial statement, increased insurance premiums to cover additional liability may turn a profitable account into a marginal one.

Over the short run, retention of an unprofitable account may be necessary for strategic reasons, but if this reallocation practice becomes the rule, managers will gradually be forced out of business.

Owners need to understand that risk reallocation in the absence of reimbursement or additional compensation is a de facto fee reduction.

Some struggling managers may be tempted to offer a low bid and assume risk without adequate liability insurance. However, a contractual commitment is only as solid as the ability of the parties to perform. If a suit occurs, managers without enough resources to meet the liability may well be forced into bankruptcy. In such cases, the manager will default, and the owner will bear the entire risk.

Property managers must educate owners as to the long-term economic consequences of such proposed risk reallocations. As fewer management firms are able to absorb the cost of additional risk, ownership's choice of management will decrease.

The professionalism of the industry may be tarnished by the defaults of the managers who ignored economic tenets and bid contracts too low. In the end, owners may still bear the financial loss as marginal managers default.

--William S. Rothe, CPM President, Koll Management Services, Inc.
COPYRIGHT 1993 National Association of Realtors
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Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Title Annotation:includes related article
Author:Burton, David; Rothe, William S.
Publication:Journal of Property Management
Date:Sep 1, 1993
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