Entrust Me, Man: Landlord’s Due Diligence in Screening Tenant Results in Application of “Entrustment Exclusion” For First-Party Claim Arising Out Of Marijuana Operation

In United States Specialty Insurance Co. v. Barry Inn Realty, Inc., 2015 U.S. Dist. LEXIS 119450 (SDNY September 8, 2015), a federal judge for the Southern District of New York granted a commercial property insurer summary judgment finding no coverage for a claim of extensive property damage caused by a marijuana-growing operation conducted by the policyholder’s tenant.

The policyholder leased the subject premises to the tenant for the purposes of operating a bar/restaurant. Prior to executing the lease, the policyholder did a background check on the prospective tenant, including patronizing another restaurant and bar the tenant owned. The tenant made timely rent payments. During the tenancy, the policyholder never exercised its right to access and inspect the property. Thus, the policyholder was unaware that the tenant had made structural alterations to the building, such as a sprinkler system installation and electrical wiring changes, for the purpose of growing marijuana. Moreover, the tenant created an atmosphere of extreme humidity, which caused significant property damage.

The policyholder submitted a claim to its commercial property insurer, which denied coverage based on a policy exclusion “for loss or damage caused directly or indirectly by…[d]ishonest or criminal acts by…anyone to whom [the policyholder] entrust[s] the property for any purpose…” Since there was no dispute that the damage was caused by the tenant’s criminal acts, the issue before the court was whether the policyholder had entrusted the property to the tenant. Although the policyholder conceded that it entered into a lease with the tenant, it argued that it only did so because it was deceived. The court explained that entrustment relationships have been found to exist even where the recipient exhibited fraudulent intent if the “parties have had a course of dealing or the insured had reason to trust the recipient independent of the recipient’s own representations.” The court also noted, however, that there is no entrustment relationship where there is “deceit from the outset, not only as to intent, but as to identification of the recipient.”

Applying those rules to the matter before it, the court found an entrustment relationship because the policyholder had questioned the tenant, conducted a background check, visited the tenant’s other bar, and engaged in a three-month negotiation process. Since the policy holder “acted with care and deliberation” in accepting the tenancy, the court held there was entrustment. Accordingly, the court found that there was no coverage under the policy and granted the insurer’s motion for summary judgment.

This holding may put policyholders in a bind. Here, the policyholder was careful in its acceptance of the tenancy and was, nevertheless, deceived. This is a rare factual scenario where the policyholder’s due diligence led directly to a finding of no coverage.