Take caution with operating expenses and escalation clauses

New York's highest court recently ruled in favor of tenants, determining that asbestos removal costs could not legitimately be passed onto the tenant as an "operating expense" under a commercial lease. The case involved the city of New York as the tenant of a 16-story commercial office building in Manhattan, where the city maintained a long term lease. The lease obligated the city to pay P.A. Building Co., the landlord, a monthly base rent, and as additional rent, a pro rata share of any increase in the building's annual operating expense. The lease contained an escalation clause, a provision allowing the landlord to raise the rent if the cost of operating the building went up. The lease further defined "operating expenses" to include costs charged to the landlord, "for services, materials and supplies, furnished in connection with the operation, repair and maintenance of the building." As tenants vacated building spaces, P.A. removed asbestos-containing pipe covering that existed throughout the building. P.A. also removed asbestos in mechanical areas that people inhabited. P.A. sought to impose the costs of this removal activity on the city under an omnibus clause that provided: "[a]ll other incurred costs and charges generally recognized as constituting operating expenses of a building." The city contended that P.A. had improperly billed them for expenditures for asbestos abatement. Reversing the Appellate Division which had found for the landlord, the NY Court of Appeals, in P.A. Building Co. v. City of New York, 10 N.Y. 3d 430,860 N.Y.S. 2d 1 (May 1, 2008), ruled that the cost of asbestos abatement could not be considered "repair or maintenance within the meaning of the operating expense ...clause." Indeed, the court went even further by interpreting a law passed by the city in 1985 which obligated landlords to carry out asbestos abatement in accordance with certain established procedures. The court found that when the New York City Council enacted Local Law No. 76, it contemplated renovation or demolition projects, not operation, repair or maintenance. Ironically, until this Court of Appeals ruling, the city found itself penalized for taking responsible legislative action to protect public health. Disturbing asbestos during renovation or abatement can create a health risk from exposure to airborne asbestos particles. Local Law No. 76 was intended to address this problem by specifying the protective procedures to be followed during asbestos removal. Reputable medical and scientific authorities have linked exposure to airborne asbestos fibers and particles to a significant increase in the incidence of diseases such as asbestosis, mesthelioma, and other malignancies. Substantial amounts of material containing asbestos have historically been used for fireproofing, insulation, sound proofing, for decorative and other purposes. A divided court, voting 5-2, concluded that P.A.'s asbestos abatement was not the result of damage or wear so as to require corrective action. Thus, the asbestos removal was not repair or maintenance, which could properly be considered an operating cost, rather the asbestos simply had to be removed, or otherwise abated. The dissent believed that the Appellate Division had decided the operating expense issue correctly, maintaining that escalation clauses are supposed to protect against unforeseen developments that make running a building more expensive. Those unforeseen developments include regulatory changes. Thus, following the dissenting opinion, had the landlord been required by a regulatory change, for example, to install window guards, those costs would not have been the landlord's responsibility alone. This case imparts a cautionary tale for landlords and requires extraordinary care in choosing what expenses the tenant pays as operating costs. Eileen Millett is a director in the Real Property & Environmental Dept. of Gibbons, P.C., New York, N.Y. and Newark, N.J.