As “stay at home” orders now apply to over 200 million Americans, and unemployment claims skyrocket to levels not seen since the Great Depression, scores of commercial landlords and their business tenants ask: Is rent on leased, but now largely unused, commercial space still due? The answer: It depends …
This article addresses some of the common contractual provisions and legal doctrines commercial landlords and tenants should consider as we, as a society, navigate the complex and ever shifting terrain of COVID-19 economic survival. As a necessary disclaimer, this article describes general contract and real estate principles; it is not intended to serve, nor be relied on, as a definitive guide applicable to the law of any particular state. For advice on particular situations, affected individuals and businesses are strongly urged to seek advice from knowledgeable legal counsel.
First, to address a widespread and common misperception, temporary moratoriums on residential and commercial evictions, such as those imposed by the Governors of California and Nevada this past week, DO NOT suspend a tenant’s obligation to pay rent. Instead, a tenant’s obligation to pay rent is governed by two things: (1) the language in the parties’ lease, and (2) state law.
Many leases contain language spelling out when a landlord or tenant will be excused from performance. For purposes of this article, it is assumed the landlord kept its “end of the bargain” by initially delivering the leased premises in a satisfactory condition. It is further assumed no material “defaults” in the landlord’s performance existed before the COVID-19 outbreak: e.g., there was no basis for a tenant to claim constructive eviction or demand a rent abatement due to anything the landlord did or failed to do. Rather, the focus here is whether because of COVID-19 or the government’s response in combating it a viable contract defense now exists, either under a particular lease as written or governing legal principles, that operates to reduce or eliminate a tenant’s duty to pay rent or, alternatively, permits either a tenant or a landlord to walk away: i.e., cancel the lease.
At the outset, it is important to identify and understand the parties’ goals. Is a tenant looking to permanently end its lease obligations or, alternatively, merely looking for temporarily relief: e.g., a “rent holiday” or a rent deferment while “stay at home” orders restricting normal operations remain in effect? Conversely, is a landlord looking to use a tenant’s failure to pay rent as justification to get rid of a perpetually troublesome tenant? Or, alternatively, is the landlord seeking to preserve its rent rolls and, in so doing, willing to provide some level of negotiated relief or rent deferment?
If a tenant’s goal is temporary relief, or a landlord hopes to maintain its rent rolls (among other things, to avoid a technical default in the landlord’s likely mortgage covenants), invoking certain defenses would be devastatingly counterproductive. This is because, if successful, such defenses would permanently and irreversibly terminate all reciprocal lease obligations, including the tenant’s right to remain in possession and the landlord’s right to receive future rent.
Regardless of their goals, landlords seeking to enforce, and tenants looking to avoid or at least delay performance of, lease obligations should first look to the express language in their lease. This is because leases commonly contain language contemplating the future occurrence of catastrophic events. These are commonly labeled force majeure (or, literally, “Act of God”) clauses. The reason leases, and other contracts, contain such clauses is the law encourages parties to identify and freely allocate future risks. Hence, some force majeure clauses allow both tenants and landlords to walk away if an identified catastrophic event occurs; some give either the tenant or the landlord this right; others expressly state no Act of God or catastrophic event will relieve a tenant, its landlord, or both, of their continuing lease obligations (so called, “hell or highwater” clauses.) Likewise, there is no standard list of catastrophic events. Parties are free to define them any way they wish. Many leases include government shutdowns as a basis for lease termination; others do not.
In short, there is no “one size fits all.” Unfortunately, many parties fail to understand the consequences of force majeure clauses, and their application to situations such as that now gripping our nation, until it is too late.
For a further explanation of force majeure clauses, and how modern courts interpret them, please see Everything Has Shut Down … Is My Contract Still Enforceable? and Does Your Contract Cover Pandemics?
If a particular lease does not contain a force majeure clause or its equivalent – meaning the parties did not specify in advance who would bear the risk of a given catastrophic event – or if a particular force majeure clause does not include pandemics or governmental shut downs within its list of expressly or impliedly anticipated catastrophic events, it will be left to the courts to apply state statutes and common law to determine whether performance should be excused. The three common law doctrines courts most frequently used to decide such matters are those of “impossibility,” “impracticability” and “frustration of purpose.”
Generally speaking, the doctrine of impossibility applies when physical performance becomes “objectively” impossible. For example, if leased property burns to the ground, by any measure it then becomes objectively impossible for a landlord to deliver, or continue to deliver, that property in acceptable condition for use by a tenant. In some states, the concept of “illegality” is woven into the doctrine of impossibility. For example, if a tenant signs a commercial lease with the intent of opening and operating a restaurant, the landlord knows this, and zoning laws later prohibit that type of business activity, such intervening governmental action would, in some jurisdictions, meet the modern (as opposed to traditional) definition of impossibility.
Impossibility, however, can be difficult to prove. This is because most published cases and treatises interpreting this defense say the party asserting it (typically the tenant) must prove complete and permanent impossibility. The current “stay at home” orders include a variety of exceptions. In many instances, they do not completely prohibit the use of leased space; rather, in many areas, they merely require tenant occupants to observe “social distancing” requirements. Some restaurants shut down continue to operate on “skeleton” crews preparing take-out meals. Some vacant movie theatres and other entertainment complexes are now being temporarily converted for other uses. Given the “stay at home” orders are of limited duration, they are not apt to meet the definition of permanent (although some courts say prolonged periods of impossibility can, in some situations, be considered permanent.) Finally, it remains unclear whether, and to what extent, local and state officials issuing such “orders” really have the constitutional right to enforce them.
In short, under current circumstances, it is doubtful either a tenant or landlord could prove the continued occupancy of leased premises has become objectively, completely and permanently impossible.
Enter the doctrines of impracticability and frustration of purpose …
Generally speaking, under these doctrines, performance of a contract (including a commercial lease) will be excused when (1) the occurrence of a condition (e.g., a pandemic resulting in “stay at home” orders), the nonoccurrence of which was a basic assumption of the contract, (2) renders performance extremely expensive or difficult, (3) the condition was unforeseeable, and (4) the contract does not otherwise allocate risk for the occurrence of that condition.
Frustration of purpose applies a similar test, but further requires one party to have known the other party’s “special purpose” for entering into the lease. In the previous example, the landlord would have to had known the tenant’s sole purpose was to open and operate a restaurant. Common “boilerplate” lease language permitting a tenant to use leased premises for “any lawful purpose” could nonetheless scuttle an attempt to use this particular defense. Similarly, as suggested above, some contracts contain “hell or highwater” clauses (in or outside a force majeure clause.) In such cases, courts are apt to find one or both parties “waived” their right to assert impossibility, impracticality (extreme hardship) or frustration as defenses.
Fortunately, large scale pandemics (and associated “stay at home” orders) are extremely infrequent. Unfortunately, this results in a dearth of published court decisions applying these doctrines in the context of short-term, government interference with the performance of commercial lease agreements.
Landlords and tenants should also consider the present practical difficulties involved in enforcing a tenant’s continuing obligation to pay rent. As noted above, many states have now issued moratoriums on evictions. Virtually all California trial courts have likewise shut down their non-emergency civil (non-criminal) operations until late April to early May. When courts re-open for non-emergent business, litigants can expect a torrent of new COVID-19 related case filings, along with an unprecedented backlog of civil cases awaiting postponed hearings and trials. All this portends a “Perfect Storm” of judicial inability to timely hear and decide cases seeking monetary awards.
Landlords and other creditors are also encouraged to consider the often-overlooked peril of driving temporarily cash-strapped tenants into otherwise avoidable bankruptcies. As explained in our article entitled Why Overly Aggressive Creditors Are Likely To Compound Their Problems When Their Debtors Later Declare Bankruptcy, doing so can result in landlords being forced to hire counsel to defend complex “preference” actions in bankruptcy court and, possibly, being ordered to pay back, or “disgorge,” some or all rent paid 90 days or less before the tenant filed for bankruptcy.
For their part, tenants are urged to consider the equally often-overlooked possibility that co-tenancy provisions might serve to abate, or at least partially reduce, rent obligations as neighboring tenants fail or vacate owing to COVID-19 and “stay at home” orders.
Finally, both commercial landlords and tenants are urged to consider other means of possible rent payment/recovery including, but not limited to, business interruption or other casualty insurance claims, SBA Economic Injury Disaster loans (see https://www.ecg.law/blog/covid-19-small-business-loan-programs and https://covid19relief.sba.gov/#/) and immediate application for the recently authorized Payroll Protection Plan loans (see https://www.ecg.law/blog/does-my-business-qualify-for-an-immediate-loan-under-the-new-cares-act).
In sum, when armed with a clear understanding of the law and their rights, most prudent landlords and tenants probably will want to work out cooperative “shared pain” solutions to survive this unprecedented World-wide crisis.
Enterprise Counsel Group is a full-service business litigation, transactional and appellate law firm located in Irvine, California. For more information, please visit www.ecg.law.
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