As a result of government-mandated shutdowns, landlords, who often come from a position of strength, can find themselves vulnerable in this COVID-19 economy as many tenants can’t or won’t pay their rent. Issues related to common area maintenance charges, tax, and other charges compound the issues. In this environment, there are various viable legal defenses which may provide relief for tenants from what are otherwise ironclad commercial leases. A commercial real estate attorney can help identify the ideal defense to move forward with.
The current situation was complicated in California, when governor Newsom issued an executive order allowing local governments to impose restrictions on commercial lease evictions through September 2021. Myriad California cities and counties have acted on this newly granted authority and enacted temporary eviction moratoriums. While landlords are impacted by the cessation of lease payments, the executive order and location restrictions only delay payment and defer default.
Tenants who are unable to pay rent are asking if landlords can still recover all payments due under the lease and what defenses, if any, they have.
7 Commercial Lease Defenses
1. Force Majeure Clauses
Force majeure clauses excuse one or both parties from their contractual obligations. For a force majeure class to be enforceable, the unforeseen circumstances must be beyond the control of the parties and make performing their obligations within the contract impossible or impractical. The determination about enforceability of a force majeure clause depends on the language within the contract. Force majeure clauses that explicitly account for pandemics are automatically triggered but few commercial leases contain such language. More often the clauses provide for “acts of God” and “Order from government bodies”. It’s hard to imagine a more fitting act of God than a global pandemic and the applicability of “order from government bodies” given the myriad executive orders on State and local levels.
While there is yet a consensus in the courts on the application of these force majeure clauses during COVID-19, early decisions support the application of force majeure “acts of God” and “Order from government bodies” clauses in the context of COVID-19. However, force majeure clauses in commercial leases often contain an exclusion for rent obligations and tenants therefore need to rely on other defenses for relief.
Contract law in California does not limit force majeure clauses to only acts of God. Instead, when determining if a force majeure clause is enforceable, a court will determine if the circumstances keeping one party from fulfilling their obligations could have been prevented with reasonable diligence, care, and prudence.
As was found in Butler v. Nepple, expenditure increases are also not considered enough to excuse a party from fulfilling contractual obligations. An extreme and unreasonably difficult injury, expense, or other loss must have occurred that kept one party from performing their duties as outlined within a contract.
According to the language within a specific contract, a party may also be required to provide adequate notice prior to invoking a force majeure clause. When this type of language is included and a party does not provide sufficient notice, it could preclude the successful invocation of a force majeure clause.
2. Covenant of Quiet Enjoyment
Every commercial lease includes an implied, and often express, covenant that the tenant has the right to possession, occupancy, and beneficial use of every portion of the leased premises. COVID-19 regulations place burden on commercial tenants to comply with social distancing standards and landlords may be required to modify the premises to make it safe from “dangerous conditions.” If the premises condition is such that it renders its unsuitable for the purpose for which it was leased or seriously interferes with the beneficial enjoyment of the property, the tenant may be entitled to abatement of rent.
3. Frustration of Purpose
A “frustration of purpose” defense occurs when performance remains possible, but the purpose for which the tenant entered into the lease – to open and operate a business – is “substantially frustrated.” The failure of that principal purpose may wholly discharge tenants from their lease obligations. Frustration of purpose does not require that the tenant cannot comply with terms of the lease (i.e., “impossibility”). As such, the defense is available even if a tenant could pay its rent, but the purpose of such payment has been defeated.
To have a valid frustration of purpose claim, a tenant must show: (i) A supervening event that severely impaired the value or worth of the purpose for which the agreement was entered (ii) The supervening event was through no fault of the tenant (iii) Non-occurrence of the supervening event was a basic assumption of the contracting parties and (iv) The contract language or surrounding circumstances did not indicate that the tenant assumed a heightened duty to perform. In other words, if government-mandated closures or health and safety regulations have substantially impaired tenant’s principal ability to conduct business in the leased space, the tenant may be permitted to terminate the lease. Note that if the tenant is only limited in its use – e.g., for takeout versus dine-in service – then the landlord may be able defeat a frustration defense.
4. Co-Tenancy
Tenants value a space based on the presence of major retailers, often anchor tenants, or even a promise of a particular volume of foot traffic. The landlord may project or even represent certain foot traffic to attract new tenants. Co-tenancy clauses in commercial lease provide tenants with certain rights under the lease if certain stores are not open or operating. As shopping centers see stores closing their doors and retailers declaring bankruptcy, co-tenancy clauses may give tenants a basis to reduce their rent or even terminate their lease.
5. Businesses Interruption Insurance
While tenants and landlords may carry business interruption insurance policies, whether they apply to losses incurred as a result of Covid-19 is currently being litigated. Many business interruption insurance policies only cover physical loss or damage and specifically exclude pandemics or communicable diseases from coverage. However, some policies include “civil authority coverage,” which may allow landlords and tenants to recover from government-mandated business closures.
6. Bankruptcy Lease Rejection
If a resolution cannot be reached with the landlord, bankruptcy may be the only or best option for tenants. Under section 502(b)(6) of Chapter 11 of Title 11 of the United States Code, a tenant has the option to reject the lease. When a lease has been rejected, the claims allowable to the landlord under the lease are capped. Any recovery by the landlord would be limited to either one year or 15%, not to exceed three years, of the remaining lease term following the earlier of the petition date or the date on which the landlord repossessed, or the debtor surrendered the property. If the landlord refuses to release the tenant from the lease and the tenant is seriously contemplating bankruptcy as an option, landlord and tenant may use the lease rejection cap as a point of negotiation prior to bankruptcy filing.
7. Lease Modifications
As the pandemic continues to impact the commercial lease industry and uncertainty of new legislations, landlords and tenants are well advised to examine the long-term view of their business. As stores continue to close doors at a rapid pace, landlords may be willing to modify lease terms by reducing rental rates for the promise of a long-term tenant or tenant’s affirmation of the remainder of the term of the lease.
Speak to a California Commercial Real Estate Attorney Today
The pandemic has caused immense stress for business owners throughout the state, and many have been left unable to fulfill their contractual obligations. If you need to enforce a force majeure clause, or you need to draft a contract that will protect your interests at all times, our Santa Monica business lawyers at Klein Law are here to help. Call us today at (310) 295-2261 to schedule a meeting with one of our skilled attorneys and to learn more about how we can help.
