The Impact of COVID-19 on Commercial Leases

The economic fallout from the COVID-19 pandemic is forcing commercial landlords and tenants to confront a host of difficult business decisions and legal questions concerning their relationship. Now is the time for these parties to scrutinize their leases to determine how best to protect their respective interests. This alert addresses some of the key contractual provisions and legal doctrines that landlords and tenants should consider as they assess their options. It concludes by encouraging the parties to engage in dialogue and negotiation, either directly or through counsel, when appropriate.

New York landlords currently have little ability to pursue legal claims against defaulting tenants. New York State has halted all nonessential court functions, including evictions, until further notice, and has instituted a 90-day moratorium (from March 16) on residential and commercial evictions.^[1] Landlords may serve rent demands, but they cannot commence litigation against tenants, such as eviction proceedings.^[2] New York City has expressly warned that tenants are not excused from paying rent during the COVID-19 crisis, even if their revenues have declined precipitously. However, a bill that has been introduced in the New York State Senate — but has not yet been enacted — would “suspend rent payments and certain mortgage payments for certain residential tenants and small business commercial tenants for ninety days.”^[3] Other states, such as New Jersey, have put certain other moratorium relief in place.^[4]

Given these restrictions and the current economic challenges, commercial landlords and tenants should consider how their respective leases allocated the risks stemming from business interruptions, such as those caused by COVID-19, as well as their own business goals. Because landlords cannot commence eviction proceedings for the immediate future, they may wish to consider what other legal remedies are still available to them. Even though a tenant may benefit from a moratorium on certain enforcement actions, the lease may still be in default (subject to the application of certain legal arguments discussed below) and potentially lost as an asset once the COVID-19 crisis subsides. As such, tenants should evaluate the consequences they might face if they default on their leases, and engage in discussions to seek rent reductions or even lease terminations. When making these assessments, the specific terms of the lease agreement are paramount.

Additional Security Commonly Available in Leasing Arrangements

In many commercial leasing arrangements, tenants (or their principals or affiliates) provide one or more forms of security to their landlords. These provisions generally reflect the parties’ prenegotiated allocation of risk for business interruptions. For example, many leases (or the economic obligations thereunder) are guaranteed by tenants’ principals or affiliates. Similarly, tenants often provide standby letters of credit or cash security deposits to their landlords. Depending on the terms of these specific documents, liability to parties affiliated with the tenants may be triggered, and landlords may be able to collect money on account of rent, notwithstanding the moratorium on new legal proceedings and evictions. Before defaulting on the payment of rent, tenants may want to consider whether they, their principals or their affiliates are financially exposed.

In the case of guaranties, it is quite common for the guarantors to agree to a broad waiver of defenses that might otherwise have been available to the tenants. Thus, even if tenants might have arguments concerning force majeure, constructive eviction, impracticability or frustration of purpose (which doctrines are discussed below), it is quite possible that their guarantors cannot invoke these doctrines as defenses to payment and would be liable under the guaranties. In addition, it is generally not necessary for a landlord to commence legal proceedings in order for liability on a guaranty to be triggered. The words of the guaranty itself will govern what is required and must be reviewed. Of course, it may be necessary to commence legal proceedings to collect on a guaranty, and the commencement of such proceedings may presently be barred, such as in New York. But it is not necessary to commence legal proceedings to make the demand for payment on guaranties, and the mere demand (or ability to make such a demand) may alter the leverage and dynamic among the parties in negotiating rent reductions or forbearances.

Relatedly, depending on the language of the parties’ agreements, it is likely not necessary for landlords to commence legal proceedings before drawing down on letters of credit or offsetting against security deposits.^[5] In both instances, however, it is important to adhere precisely to the agreed-upon requirements of the applicable documents to avoid a potentially costly and successful challenge to these “self-help” remedies. Both landlords and tenants should consult with legal counsel as they navigate these complex issues.

Other Relevant Lease Provisions and Legal Doctrines Affecting Payment of Lease Obligations

Tenants seeking to permanently or temporarily excuse their performance may wish to consider one or more of the following approaches (which landlords should also anticipate and assess):

Many leases include force majeure clauses, which excuse a party’s performance if an unforeseen, external event beyond its control has prevented it from being able to perform its contractual duties. A typical force majeure clause might read:

The occurrence of any of the following events shall be referred to herein as “Force Majeure” and shall excuse the obligations of Landlord or Tenant as are rendered impossible or reasonably impracticable as a result of the event(s) in question to the effect such event continues to render performance impossible or reasonably impracticable: strikes, lockouts, or labor disputes; acts of God; inability to obtain labor, materials, or reasonable substitutes therefor; governmental restrictions, regulations, or controls; judicial orders; war, invasion, riot, or acts of terrorism; fire, flood, or earthquake; and other causes beyond the reasonable control of the party obligated to perform (excluding financial inability). Notwithstanding the foregoing, the occurrence of such events shall not excuse Tenant’s obligations to pay Rent. Landlord and Tenant shall use all commercially reasonable efforts to mitigate the consequences of any event of Force Majeure.

Whether a force majeure clause will apply to COVID-19 depends heavily on the specific terms of the clause. The above clause, for example, is likely to excuse lease obligations that cannot be performed due to closings ordered by the government, but will not excuse the tenant’s obligations to pay the specifically identified rent obligations. Such clauses may also define what events constitute a force majeure, the causal nexus required between the event and the ability to perform, and what rights and remedies the nonperforming party has if a force majeure event occurs. A force majeure clause might refer expressly to pandemic, epidemic or disease or, instead, to events similar to ones caused by COVID-19, such as a declaration of a national or regional emergency, labor stoppages, or government actions (which might include travel bans or executive orders mandating shelter in place). The provision may also specify what particular performance is excused and for how long. Further, a force majeure clause may require the parties to mitigate damages in these circumstances. Typically, the party seeking to enforce such a clause must demonstrate that it made reasonable efforts to exhaust alternatives to nonperformance^[6] and provided agreed-upon notice to the other party.^[7] In addition, under New York law, courts generally interpret force majeure clauses narrowly to excuse performance only where the clause specifically includes the event that prevented a party’s performance.^[8]

Over the coming months and years, courts in New York and across the country will confront the question of whether particular force majeure clauses in commercial leases apply to COVID-19. This will provide some guidance for commercial parties, though we expect that these decisions will turn on the precise terms of a given lease (and, thus, how the parties agreed to allocate the risk of business interruptions) and facts underlying the nonperformance at issue. Some previous cases addressing force majeure clauses may be instructive. In the aftermath of the 2008 financial crisis, a number of parties attempted to rely on force majeure clauses to excuse nonperformance and were, for the most part, unsuccessful in doing so. For example, in Route 6 Outparcels, LLC v. Ruby Tuesday, Inc., 88 A.D.3d 1224 (3d Dep’t 2011) (applying Pennsylvania law), a property owner brought action against a commercial tenant, alleging breach of a ground lease, after the tenant failed to construct and open a restaurant. The tenant argued that its nonperformance was excused under the lease’s force majeure provision, which referred to “all labor disputes, governmental regulations or controls, fire or other casualty, inability to obtain any material, services, acts of God, or any other cause, whether similar or dissimilar to the foregoing, not within the control” of the parties. Id. at 437. The court rejected the tenant’s argument that this clause covered the 2008 global economic downturn, writing:

Here, although the parties did, after identifying particular force majeure events, agree on a fairly broad clause by including the language “any other cause, whether similar or dissimilar to the foregoing,” they still expressly limited the contemplated force majeure events to those beyond the control of the nonperforming party. While defendant, of course, had no control over the world economy, the decisions it made with respect to how to cope with the financial downturn—notwithstanding that its options may have been limited—remained within defendant’s power and control. Defendant made a calculated choice to allocate funds to the payment of its debts rather than to perform under the subject lease. Economic factors are an inherent part of all sophisticated business transactions and, as such, while not predictable, are never completely unforeseeable; indeed, financial hardship is not grounds for avoiding performance under a contract.

Id. at 438 (internal quotation marks and citation omitted).

Even if a lease has no force majeure clause (or that clause is inapplicable), tenants may still seek to excuse performance based on other, similar common law doctrines. However, tenants should first review their leases for provisions waiving common law defenses because such provisions are typically enforceable (except where expressly prohibited by statute or against public policy).^[9]

Absent such a waiver, a commercial tenant could argue that COVID-19 has made performance of a lease impossible. The defense of impossibility applies when either the subject matter of the contract or the means of performance has been destroyed.^[10] The impossibility “must be produced by an unanticipated event that could not have been foreseen or guarded against in the contract.”^[11] A tenant might argue that it can no longer perform its contractual duties in light of COVID-19 and the governmental actions taken in response to it. New York courts have held that “contract performance is excused when unforeseeable government action makes such performance objectively impossible.” Bush v. Protravel Int’l, Inc., 746 N.Y.S.2d 790, 795 (Civ. Ct., Richmond Cty. 2002). In Bush, the court found that there was a genuine issue of material fact about whether government restrictions imposed after the Sept. 11 attacks made it impossible for a customer to cancel her contract on time. Id. at 794-98. The court emphasized that “New York City was in the state of virtual lockdown with travel either forbidden altogether or severely restricted,” id. at 795, which may be analogous to the current COVID-19 situation.

A similar common law principle that a tenant could rely upon is the frustration of purpose doctrine. This doctrine applies when both parties to a contract can still perform but, because of an unexpected event, one party’s performance becomes valueless to the other party, thereby negating the reason that party signed the contract in the first place. Reduced profits or increased costs alone will generally not suffice to establish a “frustrated purpose.” Instead, the parties to the lease must have understood that the frustrated purpose was a foundation for the invoking party to enter the agreement. A contract may specifically state a party’s purpose for entering the contract, or, absent such language, there may be other evidence demonstrating that a party communicated its purpose to the other side prior to the agreement. A tenant typically cannot rely on the frustration of purpose doctrine if the lease specifies that the tenant can use the space for another lawful purpose,^[12] or if a court deems that COVID-19 or the events it caused were “reasonably foreseeable.”^[13]

Commercial landlords and tenants should also consider whether their lease agreements or factual scenarios might support a number of other legal arguments:

• A co-tenancy provision could allow tenants to pay a reduced rent or even terminate the lease. Typically, such a provision is triggered by the failure of a retail space to meet a specific occupancy threshold. For example, a lease for a tenant in a shopping mall may contain a cotenancy provision stating that if a certain percentage of stores in the shopping mall close, the tenant would pay a reduced rent, such as a fixed percentage of that tenant’s gross sales.
  
  
• A commercial tenant may also argue that the relevant premises have suffered damages from a casualty in the form of COVID-19, though casualty clauses often only address physical damage to premises, and it is uncertain whether an argument that potential contamination by the virus will qualify as physical impairment. A typical casualty clause reads:
  
  If the demised premises are partially damaged or rendered partially unusable by fire or other casualty, the rent, until such repair shall be substantially completed, shall be apportioned from the day following the casualty, according to the part of the demised premises which is usable. If the demised premises are totally damaged or rendered wholly unusable by fire or other casualty, then the rent shall be proportionately paid up to the time of the casualty, and thenceforth shall cease until the date when the demised premises shall have been repaired and restored by Owner.

• Depending on the specific terms of its lease, a tenant may be entitled to a rent abatement and/or to terminate its lease if such tenant’s premises are taken by a governmental authority for use, for example, as a COVID-19 testing site, and such use by the governmental authority continues beyond a certain period of time. If, however, a governmental authority requires that the tenant cease operating in its premises for a reason relating to the pandemic, but such authority does not actually take over such premises, unless the lease specifically affords the tenant an abatement and/or termination right in that specific circumstance (which is unlikely), it is a difficult argument for the tenant to make that the condemnation provisions of its lease are applicable.
  
  
• Finally, tenants may be able to hold landlords liable for failing to adequately protect tenants. This legal argument is likely only viable if landlords were negligent with respect to ensuring the health and safety of tenants in a building. A tenant could invoke the constructive eviction doctrine or claim that a landlord breached the implied covenant of quiet enjoyment, which may also be expressly stated in the leases.

Dialogue and Negotiations

A word of caution to both landlords and tenants: While it is certainly important to be mindful of one’s legal rights, in this unprecedented situation, parties should strongly consider dialogue and negotiations. The courts — when they reopen — will likely be inundated with claims. Accordingly, litigation may be slow and more expensive than usual. Both landlords and tenants should be wary of overplaying their respective hands. Landlords may find themselves with unwanted vacancies, little ability to collect, and a reduced revenue stream to pay their own expenses. Tenants may be temporarily emboldened by the eviction moratorium, but they will eventually be called upon to pay rents, and will not want to be threatened with eviction and other financial consequences when economic activity returns. (Tenants may also seek bankruptcy protection, which will further complicate enforcement rights, especially with common law defenses to performance being litigated in bankruptcy court, which is a court of equity.) Importantly, courts are more likely to look favorably upon parties whom they believe have acted reasonably under the circumstances as compared to those whom they may view as profiteering or otherwise acting opportunistically. Levelheaded discussions among the parties, often aided by their respective counsel who are versed in the above legal concepts, are quite likely to be the best way to achieve results that are economically feasible and acceptable to all.

^{[1] NYS Exec. Order No. 202.8 at 2 (“There shall be no enforcement of either an eviction of any tenant residential or commercial, or a foreclosure of any residential or commercial property for a period of ninety days.”). As of now, New York civil and housing courts will continue to address (1) tenant lockouts, (2) serious code violations, (3) serious repair orders and (4) post-eviction relief. Chief Judge Marks Admin. Order No. 78, AO/78/20, Exh. A (Mar. 22. 2020).}

^{[2] Id.; see also NYS Exec. Order No. 202.8 at 2 (“There shall be no enforcement of either an eviction of any tenant residential or commercial, or a foreclosure of any residential or commercial property for a period of ninety days.”).}

^{[3] NYS Senate Bill 8125.}

^{[4] New Jersey has instituted a moratorium on residential evictions and foreclosures, but, unlike New York, “proceedings may be initiated or continued” during the crisis. NJ Exec. Order No. 106 at ¶¶ 1-2 (Mar. 19, 2020). Pennsylvania and Connecticut courts, like those in New York, are closed except for essential functions. Penn Judicial Admin. Dkt. Nos. 531 and 531 at 1 (Mar. 18, 2020), Conn. Exec. Order No. 7G at ¶ 2. Pennsylvania has also expressly halted residential evictions, Penn Judicial Admin. Dkt. Nos. 531 and 531 at 9 (Mar. 18, 2020), while Connecticut has stayed “all issued executions on evictions and ejectments.” Judge Abrams Admin. Order (Mar. 20, 2020) (emphasis added).}

^{[5] Certain rights may be implicated if the tenant files for bankruptcy, such as an offset of security deposits. Bankruptcy typically does not affect collection rights against third parties, such as issuing banks under letters of credit or guarantors (assuming the guarantor is not in bankruptcy).}

^{[6] See Rochester Gas & Elec. Corp. v. Delta Star, Inc., 2009 WL 368508, at *7 (W.D.N.Y. Feb. 13, 2009) (“the non-performing party must demonstrate its efforts to perform its contractual duties despite the occurrence of the event that it claims constituted force majeure”) (citation omitted).}

^{[7] See PT Kaltim Prima Coal v. AES Barbers Point Inc., 180 F. Supp. 2d 475, 482 (S.D.N.Y. 2001) (force majeure clause required that nonperforming party provide notice and try to minimize the effects of the force majeure).}

^{[8] See Reade v. Stoneybrook Realty, LLC, 63 A.D.3d 433, 434 (1st Dep’t 2009) (“Interpretation of force majeure clauses is to be narrowly construed and ‘only if the force majeure clause specifically includes the event that actually prevents a party’s performance will that party be excused.’”) (citation omitted).}

^{[9] See 159 MP Corp. v. Redbridge Bedford, LLC, 33 N.Y.3d 353, 367 (2019).}  

^{[10] See Kel Kim Corp. v. Cent. Markets, Inc., 70 N.Y.2d 900, 902 (1987) (“Impossibility excuses a party’s performance only when the destruction of the subject matter of the contract or the means of performance makes performance objectively impossible.”).}

^{[11] Id.}

^{[12] See Restatement (Second) of Property: Landlord & Tenant § 9.3.}

^{[13] Gander Mountain Co. v. Islip U-Slip LLC, 923 F. Supp. 2d 351, 360 (N.D.N.Y. 2013), aff’d, 561 F. App’x 48 (2d Cir. 2014); accord In re Schenck Tours, Inc., 69 B.R. 906, 911 (Bankr. E.D.N.Y.), aff’d, 75 B.R. 249 (E.D.N.Y. 1987) (“If a contingency is reasonably foreseeable and nonetheless the agreement fails to provide protection in the event of its occurrence, the party adversely affected will be deemed to have assumed the risk.”)}