Forced to close their businesses or severely restrict operations as a result of the COVID-19 outbreak, financially distressed tenants of commercial properties are taking a closer look at their leases to find any potential protection for nonpayment of rent. Though lease obligations remain in force, the extraordinary circumstances ushered by the pandemic are prompting tenants to seek at least temporary relief from landlords.
What to look for in a lease
Before starting a dialogue with their landlords, tenants should carefully scrutinize the language of their leases to determine if there are any provisions that might give them grounds for requesting relief. Among common lease provisions that may potentially be relevant are the following:
- Force majeure
Force majeure clauses allocate risk between the parties to a contract if an event occurs that is outside the control of the parties and makes performance of the contract impossible or impractical. COVID-19, because of its official designation as a pandemic by the WHO and the country-wide shutdown of gatherings and businesses, should qualify as a force majeure event in all but the most restrictive of force majeure clauses. The question then becomes what specific performance is excused when there is a force majeure event. The specifics of each contract need to be reviewed, but generally speaking, there will be limits to what performance is excused due to a force majeure event. Often commercial tenants will still be required to pay base rent during the occurrence of a force majeure event.
- Continuous use/go dark/operating hours provision
Ability to pay rent is not the only concern for commercial tenants during the COVID-19 pandemic. Many retail leases require tenants to be open and operating businesses and often to operate within certain hours. These provisions are of particular concern during government-mandated shutdowns but are also the precise provisions that force majeure clauses are meant to help. Most tenants will likely not be in default under any continuous use or similar provision due to COVID-19 because they probably have force majeure protection.
Further, tenants may be able to rely on the legal theories of frustration of purpose or impossibility of performance. Frustration of purpose is an excuse for non-performance of a contract that applies when a later unforeseen event impedes one party’s purpose for entering into the contract, and, at the time of entering into the contract, the second party knew non-performing party’s purpose. Impossibility of performance is an excuse for non-performance that applies when a particular condition, which both parties to a contract assumed to continue, ceases to exist as a result of an unforeseeable supervening event occurring without the fault of either party. Both of these theories are common law theories and have been applied differently by courts in every state. It is therefore important to review state law for specific application of these theories.
- Quiet enjoyment provision
Most leases contain express provisions that as long as the tenant complies with all provisions of the lease, the landlord will not interfere with the tenant’s use and occupancy of the leased premises. Given the fact that many commercial tenants are unable to open their businesses or are at least partially restricted, it seems reasonable that tenants could rely on the protections of the quiet enjoyment provision of their lease. However, most states require a tenant to demonstrate a wrongful act on the part of the landlord to show a violation of the covenant of quiet enjoyment. This will be hard to demonstrate when the government requires the closure. Tenants may have a better case if they could show that their business would stay open, or reopen, on condition that the landlord takes certain action (such as increasing cleaning, hiring security, etc.), but the landlord has refused to take such actions. Further, tenants should review the quiet enjoyment language of their lease because some are drafted broadly to include loss of quiet enjoyment due to actions of a third party.
- Business interruption insurance
Business interruption insurance is included in the insurance requirements of many commercial leases. It is intended to cover losses due to direct interruptions to a business’ operations and generally covers loss of revenue as well as fixed expenses such as utility fees and rent. However, as with most insurance policies, insurance companies include a number of limits and exclusions from coverage. First, parties will have to review their insurance to confirm whether there has been a loss triggering the policy. Most insurance policies cover direct physical loss of, or damage to, the covered property. The specific language of each policy must be closely analyzed to determine whether loss from COVID-19 constitutes a direct physical loss. Courts in various jurisdictions have treated this question differently. If it is determined that there is a loss triggering coverage, it must be determined whether there is an exclusion to coverage. Unfortunately, many policies (particularly newer policies) tend to include a specific exclusion for losses caused by a virus or other micro-organism. If this exclusion exists in a policy, it is very unlikely that the insurance company will provide any coverage over COVID-19 based losses.
Negotiating temporary lease modifications – potential approaches
We have seen many approaches taken, as both counsel for tenants and for landlords. The efficacy of any of them depends on a number of factors, including relationship of the parties (a friendly, longstanding relationship will generally help tenants claim more concessions); relative bargaining power of each party (for example, an anchor tenant in a shopping center will have more power than a tenant of a small outlot); and landlord financing (does the landlord have a lender, and will they allow the landlord concessions on loan repayment?).
Rent abatement or deferral options
Among the relief options that may be used are
- A full abatement of rent for a certain period (the period of government mandated closure would be a logical choice);
- A partial reduction in rent such as
- Abatement of percentage rent, but payment of base rent;
- Payment of half rent;
- Payment of additional rent only (taxes, CAM fees, insurance fees, etc.);
- Abatement by the percentage loss in sales from 2020 to 2019 from the prior month, for businesses that can stay partially open, such as restaurants that maintain carry-out services or restaurants with drive-thrus (for example, if April 2020 sales decreased by 25% over April 2019 sales, May 2020 rent would be reduced by 25%); or
- Deferment of rent for a period, followed either by payment as additional rent split over the remaining months of the lease or by deferment in consideration for a term extension of the lease.
State or municipal relief
Many states and municipalities are putting a hold on any evictions. Tenants and landlords should consult their legal representatives, who will be up to date on the frequent changes of local law. The legal environment is shifting every day, and it is important to stay abreast of the changes to quickly take advantage of any relief opportunities provided, particularly because many of those opportunities may be limited in scope.
Both parties should keep their sights on the long-term outlook. Tenants could press the argument that the landlord might sacrifice a few months’ rent in exchange for keeping a tenant with a viable business that can effectively pay rent through the remaining term of the lease. Landlords should perform an analysis of the likelihood of finding a new tenant if the current tenant is evicted or pushed into bankruptcy. Having any tenant with an operating business, even at less than peak efficiency, may well be preferable to having no tenant at all.
Actions prior to negotiations
Discuss the situation with your lender to determine if/to what extent your loan agreement allows for temporary lease modification. If necessary, involve the lender in the negotiations. Be prepared for tenants to ask for concessions and perform an analysis ahead of time of what concessions are possible, if any.
If needed, consult an experienced advisor to examine the relevant language of the lease. Be prepared to disclose your financials and cash-flow projections to landlords (and lenders) to assure transparency.
It is important for both parties to prepare to document any agreements properly. Tenants will want to make it clear what relief they have been granted and landlords will want to make it clear what rights they have reserved.