March 31, 2020 – Hartman Simons & Wood
Faced with the unprecedented fall out from COVID-19, our real estate owners, landlords, tenants, lenders, borrowers and other clients are making real-time decisions based on the economic, governmental, public health and legal realities of the current situation. The environment is ever-evolving. In some instances, government authorities have mandated the closure of businesses. More mandated closures may be forthcoming. Office buildings are empty as employees work from home, malls are shuttered, and many retail tenants are not operating. Tenants are deciding whether to pay next month’s rent, and many are already proactively requesting rent abatement from their landlords. Landlords have ongoing expenses and must pay their lenders, who are also fielding requests for payment deferrals and loan extensions. Nevertheless, mass evictions and foreclosures are not the preferred outcome (and evictions themselves have been put on hold by courts in many jurisdictions.) To assist with the difficult decisions faced by our clients at this time, we wanted to provide some context for the current legal framework within which these negotiations will likely play out.
Force majeure, a once obscure legal doctrine that is Latin for “superior force”, is a hot topic. Many commercial leases contain force majeure clauses which may or may not be mutual and may favor one party over the other. The typical force majeure clause excuses a party’s nonperformance if based on an “act of God” or an improbable, external, uncontrollable event preventing performance. Even if mutual, many force majeure clauses require a tenant to continue paying rent while excusing performance of other terms of the lease. Yes, a tenant might be excused from operating, but a landlord may assert force majeure to excuse delivery obligations, co-tenancy provisions, exclusives, and the like.
Each situation is different, but for force majeure relief to be available, there must be a direct causal link between the unforeseen event and the nonperformance. For example, force majeure is likely applicable where a business is unable to obtain supplies necessary to operate its business or complete construction, but not where the mere threat of the virus is causing a shut down. Documenting and retaining any evidence demonstrating the causal link between COVID-19 and any inability to perform is important. Thus, in the example above, the business should request and retain communications from its suppliers documenting the unavailability of supplies due to COVID-19.
In the commercial leasing context, courts typically enforce the lease agreement as written. Most force majeure provisions do not directly address a pandemic or public health emergency, but many such clauses reference governmental action and include a catch-all provision such as “other matters outside the reasonable control of the party.” While there is little case law in most jurisdictions regarding the interpretation of force majeure provisions, and some courts have been loath to excuse a party’s nonperformance where the event is not specifically listed in the force majeure provision, there may well be pressure on courts to reevaluate this position and construe force majeure clauses more broadly than prior decisions would suggest.
Finally on this point, landlords and tenants should be careful to comply with any notice requirements of a commercial lease when invoking a force majeure provision. A party may not be able to excuse performance due to force majeure if it does not provide sufficient and timely notice. Even if not expressly required by the lease, a party would be wise to give prompt notice of the force majeure event. Going forward, for any new leases or lease amendments, we recommend including the following events in the force majeure provision: “outbreak of disease, epidemic, pandemic, or other declaration of public health emergency and quarantine restrictions.”
OTHER COMMERCIAL LEASE PROVISIONS:
Other lease provisions have also been recent topics of discussion amongst our attorneys. In the case of a government-mandated closure, the parties must comply with the law, and a lease generally requires the tenant do so. Accordingly, a government mandate may excuse or postpone a landlord’s meeting of a delivery date or tenant’s performance under a continuous operation covenant or a requirement to open for business.
Many leases set forth a covenant of tenant’s quiet enjoyment of the leased premises. Quiet enjoyment typically means the undisturbed right to enjoy the premises free of hostile claimants. Some tenants may argue that COVID-19 and its effects have interfered with their right quiet enjoyment rights. Even so, many commercial leases do not provide an unfettered right of quiet enjoyment; rather a tenant may only excuse performance if the landlord or landlord’s agents interfere with a tenant’s right of quiet enjoyment, in which case the general effects of COVID-19 have nothing to do with landlord.
There are casualty clauses in most commercial leases, and many tenants may seek relief under these provisions. These clauses, however, typically address situations where the leased premises is damaged due to fire or natural disaster and contemplate a period of time when it is uninhabitable, but being restored. Insurance is often involved. The effects of the COVID-19 pandemic may inhibit the productive use of leased premises, but they have not damaged most leased premises, there will be no period of restoration, and many commercial property and business insurance policies do not cover the impacts of a disease or virus outbreak (see below).
Tenants may also contend that the effects of COVID-19, including government-mandated closures, constitute an event of eminent domain that permits the abatement of rent or altogether termination of the lease. Eminent domain, however, typically involves a government “taking” of property for a public purpose in exchange for which just and adequate compensation is paid. Here, it may be a stretch to argue that a mandated closure constitutes a public appropriation of private property. Indeed, there are no reports of governmental payments equivalent to just and adequate compensation to landlords who shutter office buildings, malls, shopping centers, etc.
Under the typical lease, rent is due without notice, demand or setoff and, legally, is considered an independent covenant. As a result, the tenant has an ongoing obligation to pay rent (subject to the potential legal defenses discussed below). A review of the pertinent lease terms (including the notice requirements and dates for performance) is necessary, and communication between the parties on these issues is critical.
LEGAL DOCTRINES POTENTIALLY EXCUSING PERFORMANCE:
There are a number of legal doctrines that a party may attempt to invoke to excuse non-performance of a contractual obligation – frustration of purpose, commercial impracticability, and impossibility. For example, a bar in a jurisdiction that has mandated closures of drinking establishments may invoke the doctrine of frustration of purpose because the basic assumption by landlord and tenant (when entering into the lease) was that the sale of alcohol would be legal. Impossibility concerns an unforeseen event that prevents a party from performing its contractual obligations such as weather conditions, natural disaster and governmental law making performance illegal. The less common doctrine of commercial impracticability excuses performance if it has become exceptionally and unforeseeably more difficult. The existence and interpretation of these interrelated doctrines varies by jurisdiction. The unavailability of financing, price increases and general economic conditions would most likely not provide a basis for any of these doctrines. Such risks are considered foreseeable, and the contract allocates such risk between the parties as they have agreed. Typically, when and if these other legal doctrines apply, remaining performance under the contract would be excused on both sides and the lease would terminate.
BUSINESS INTERRUPTION INSURANCE:
Business interruption insurance typically provides coverage for loss of income due to interruption in operations caused by a casualty event such as a fire or natural disaster. Since the SARS epidemic, however, insurers have routinely excluded viral or bacterial outbreaks from coverage. Even so, it is worthwhile to review your commercial insurance policies for coverage that may potentially be available. For example, “civil authority” provisions may provide coverage for losses resulting from a government mandate prohibiting access to a business location. To preserve their rights, parties should consider filing an insurance claim in case the insurance companies are later required to provide coverage because COVID-19 is deemed to be “physical damage.” Preserving such rights must be weighed against the potential increased premium for future coverage based on the filing of the claim.
MATERIAL ADVERSE CHANGE PROVISIONS IN COMMERCIAL PURCHASE AND SALE AGREEMENTS:
A “material adverse change” provision is typically included in a purchase and sale agreement for the buyer’s benefit and in loan agreements for the lender’s benefit. The definition of a material adverse change will be unique to each contract and may even be determined by the party benefitting from the provision. If there is a material adverse change, the buyer may refuse to close on the sale of the property, and the lender may be able to declare a default, accelerate the loan payments, foreclose on any collateral and/or refuse to fund the loan or to make advances under the loan documents.
With regard to purchase agreements, the inability of the buyer to obtain funding will not typically qualify as a material adverse change, and the buyer most likely must perform unless the purchase agreement is expressly contingent on the buyer’s ability to obtain financing. Property buyers may not be successful in excusing their nonperformance based on a contractual limitation to those material adverse changes affecting the property itself. If the purchase agreement does not contain a “time of the essence” provision, however, the buyer may have more leeway in delaying the closing. In practice, many parties are navigating this crisis by pragmatically negotiating concessions, and we are able to provide assistance with drafting any modifications to contracts necessitated by COVID-19. Even so, many lenders are refusing to fund commercial real estate loans at this time, and, as a result, buyers are simply unable to close.
Given the economic realities of the crisis, many landlords and lenders are providing payment concessions to tenants and borrowers. This may be in the form or deferral, forbearance, abatement, and/or application of a security deposit. Such concessions could be made, for example, on a month-by-month basis with deferred repayment over a period at a later date. Some landlords and tenants may choose to apply tenant security deposits. The prompt application of a security deposit often benefits a landlord if a tenant ultimately files for bankruptcy. All parties are wise to carefully document these new terms so that there is clarity and certainty. Further, in making concessions, landlords must ensure that any notice to and approvals from any lenders are obtained as required by any loan documents.
Another issue is whether the landlord can pass through any costs it has incurred in connection with COVID-19 to its tenants. For example, a landlord that has ordered a “deep clean” of the premises and has increased maintenance to combat the spread of germs, and has incurred additional expenses as a result, may be able to pass that along to tenants as part of Common Area Maintenance (“CAM”) or Direct Operating Expenses (“DOE”).
We have also been asked whether a landlord or business is obligated to inform its tenants, employees, and customers if they have been made aware that a person who has tested positive for COVID-19 has been on the premises, lives in the building, or has been at the office. Our typical response is that notice should be given, but the identity of the positive-tested individual should never be disclosed and the landlord or business owner would be wise to inform of their efforts to sanitize and maintain the premises and retard the spread of COVID-19. We do not foresee liability unless a property owner or business is careless in its maintenance of the premises or disregards the well-being of its employees, customers, or tenants.
Finally, if the situation requires litigation, note that many courts have declared a state of emergency and are continuing or postponing civil cases, including evictions. Some jurisdictions are postponing foreclosures or evictions altogether. There, these remedies may simply be unavailable for the duration of the COVID-19 crisis.
The specific words used in each contract, the specific facts of each case, the lack of development of this area of law, the potential variability in judicial interpretation, the potential for governmental intervention, and the evolving scope and impact of the COVID-19 pandemic have prompted great uncertainty for our real estate owners, landlords, tenants, lenders, borrowers and other clients. Please contact us if we can provide assistance with any issue you may be facing. We would welcome the opportunity to navigate these uncharted waters with you. We hope this update finds you and your family healthy.