Coronavirus and Your Commercial Lease: A Primer on Lease Termination Issues Raised by COVID-19

The COVID-19 virus has devastated small businesses, which are the engine of the U.S. economy. A recent survey by Goldman Sachs titled US Small Business Owners Face Great Uncertainty; Over Half Say They Cannot Operate Beyond Three Months revealed that 51% of small-business owners said they could not sustain more than three months of the current economic downturn. In addition, ninety-six (96%) said they have already been affected by COVID-19 and 75% have seen reduced sales.

To cope with this pandemic, most state governors have promulgated “stay-at-home” executive orders that close all “non-essential” businesses, including restaurants, ban gatherings of more than 10 individuals, and otherwise restrict travel barring certain enumerated See Virginia Governor Northam’s Executive Order Number Fifty-Five (2020) Temporary Stay at Home Order Due to Novel Coronavirus (Covid-19).

The government mandated shut-down orders have particularly ravaged the restaurant industry. According to the National Restaurant Association (“NRA”), “since March 1, the industry has lost more than 3 million jobs and $25 billion in sales, and roughly 50% of restaurant operators anticipate having to lay off more people in April.” As a result, businesses of all sizes across various industries throughout the United States may be unable to operate at full capacity, or see a potentially crippling decline in revenues. Recently, The Cheesecake Factory and Subway informed their landlords that they would be unable to pay rent due to the unprecedented economic havoc wreaked by COVID-19.

This ongoing pandemic raises significant legal issues that are likely to confront courts all across the country, including the Commonwealth of Virginia.

We at Fox & Moghul have received several queries from commercial tenants regarding their obligation to pay rent when they cannot operate their businesses due to the government mandated shutdown. While the Virginia Supreme Court has temporarily stayed all evictions until April 6, 2020, the situation remains dire for most commercial tenants who see no short-term reprieve to the drastic decline in their businesses.

The coronavirus-driven economic hardships require an assessment of some of the legal issues that are likely to arise in the context of commercial leases. Therefore, this memorandum analyzes some questions that our firm has been receiving from both commercial landlords and tenants, and the applicable contract law doctrines that could potentially apply in these situations.

I. GOVERNMENT SHUT-DOWNS DUE TO COVID-19: EXPLORING THE APPLICATION OF THE DOCTRINES OF FORCE MAJEURE, FRUSTRATION OF PURPOSE, IMPOSSIBILITY/IMPRACTICABILITY OF PERFORMANCE AND OTHER RELATED DEFENSES IN COMMERCIAL LEASING CONTEXTS.

A. What Is the doctrine of Force Majeure?

Under certain circumstances, a party may be excused for failing to perform under the terms of the contract. “The traditional force majeure clause…has the effect of relieving both parties from their duties of further performances” See E. Allan Farnsworth, Farnsworth on Contracts § 9.9a, at 650 (2d ed. 1998). The doctrine applies when an unforeseeable disabling event occurring after the formation of the contract prevents one, or both, parties from performing.

Through the use of a force majeure clause, the parties can broaden or narrow the scope of the circumstances that would excuse nonperformance under the contract. “The parties may include in their contract a force majeure clause, which may have the effect of excluding nonperformance arising out of certain causes as unforeseeable or beyond the parties’ reasonable control or specified by the contract” See 77A C.J.S. Sales § 370.

Whatever the scope of such clause may be, it “is not intended to buffer a party against the normal risks of a contract…A force majeure clause interpreted to excuse the buyer from the consequences of the risk he expressly assumed would nullify a central term of the contract” See Langham-Hill Petroleum Inc. v. S. Fuels Co., 813 F.2d 1327, 1330 (4th Cir. 1987).

The extent to which such a clause can be relied upon by a commercial tenant to excuse nonpayment of rent under the current economic downturn will depend on the specific language employed in the commercial lease. Commercial leases generally contain a carve out from any force majeure event regarding a tenant’s obligation to pay rent. But even if a lease does not contain such an exception, some courts have applied a more restrictive interpretation of this doctrine.

• TEC Olmos, LLC v. Conoco Phillips Company, 555 S.W.3d 176 (Tex. App. Houston 1st Dist. 2018), petition for review filed (Aug. 15, 2018) (An economic downturn in the market for a product is not an unforeseeable occurrence that would justify application of a force majeure provision).
• Whole Foods Market Group, Inc. v. Wical Limited Partnership, 2019 WL 5395739 (Whole Foods’ argument that its delayed opening due to a rodent infestation was excusable under the force majeure clause was held to be a question of fact. Notably, Judge Lamberth of the D.C. Court observed that, “The contractual dispute in this case ultimately boils down to whether the infestation was out of Whole Foods’ control. If the infestation truly was out of its control, then the “act of god” language in the lease’s force majeure clause operates as an excuse. If, however, Whole Foods could have prevented the infestations, then the infestation was not an “act of God” and the force majeure clause is inapplicable).”

At a very minimum, a force majeure clause could potentially be used to excuse performance for certain non-monetary obligations under the lease, such as the requirement to keep the business open for a certain number of hours every day, or some maintenance related covenants. Conversely, the clause could also be invoked by the landlord to excuse performance for an otherwise valid covenant to provide access to the tenant to conduct business, or other similar covenants or obligations. Both commercial landlords and tenants will have to analyze the risks and potential defenses based on the language of their specific leases.

B. What is the doctrine of Frustration of Purpose?

The Restatement (Second) of Contracts § 265 (1981) defines the frustration of purpose doctrine as follows:

Where, after a contract is made, a party’s principal purpose is substantially frustrated without his fault by the occurrence of an event the non-occurrence of which was a basic assumption on which the contract was made, his remaining duties to render performance are discharged, unless the language or the circumstances indicate the contrary.

The frustration doctrine is used as a defense to a breach of contract action, and the contractual obligation is discharged if three conditions are met (see Restatement (Second) of Contracts § 265 (Comment a)):

1. purpose that is frustrated must have been a principal purpose of that party in making the contract.

2. frustration must be substantial.

3. non-occurrence of the frustrating event must have been a basic assumption on which the contract was made.

Stated differently, the supervening events must deprive the contracting party of any contractual benefit, and “The frustration must be so severe that it is not fairly to be regarded as within the risks that he assumed under the contract.” Id. Notice the difference in illustrations 3, 4 and 6 provided in the Restatement, which illustrate the application of this doctrine (emphasis added).

3. A, who owns a hotel, and B, who owns a country club, make a contract under which A is to pay $1,000 a month and B is to make the club’s membership privileges available to the guests in A’s hotel free of charge to them. A’s building is destroyed by fire without his fault, and A is unable to remain in the hotel business. A refuses to make further monthly payments. A’s duty to make monthly payments is discharged, and A is not liable to B for breach of contract.

4. A leases neon sign installations to B for three years to advertise and illuminate B’s place of business. After one year, a government regulation prohibits the lighting of such signs. B refuses to make further payments of rent. B’s duty to pay rent is discharged, and B is not liable to A for breach of contract.

6. A leases a gasoline station to B. A change in traffic regulations so reduces B’s business that he is unable to operate the station except at a substantial loss. B refuses to make further payments of rent. If B can still operate the station, even though at such a loss, his principal purpose of operating a gasoline station is not substantially frustrated. B’s duty to pay rent is not discharged, and B is liable to A for breach of contract. The result would be the same if substantial loss were caused instead by a government regulation rationing gasoline or a termination of the franchise under which B obtained gasoline.

Most commercial leases contain clauses addressing the specific use of the premises by the tenant. It is important to analyze this lease provision closely to evaluate what specific use, if any, is authorized, and more importantly, what uses are prohibited. If the use-clause in your lease states a specific use of the rental premises, say restaurant, then since the recent government shut-down order has made it impossible to operate a restaurant, one could argue that the very purpose of leasing the premises – to operate a restaurant – has been frustrated with the coronavirus-driven government mandated closure. Of course, this argument is stronger for commercial tenants whose leases are tied to a specific use. Given below is some case law culled from various jurisdictions across the United States on this issue.

• Pennsylvania State Shopping Plazas, Inc. v. Olive, 202 Va. 862, 862, 120 S.E.2d 372 (1961) (Rule excusing obligor from performance of contract when performance would violate zoning regulations is not applicable where zoning laws permit variance and some discretion may be exercised by proper authorities in granting permit for proposed use);
• 2814 Food Corp. v. Hub Bar Bldg. Corp., 297 NYS.2d 762 (N.Y. Sup. Ct. 1969) (court applied the frustration doctrine to excuse a tenant’s performance when city condemned property that had been leased for use as a supermarket);
• Gardiner Properties, Inc. v Samuel Leider & Son, Inc. (1952) 279 App Div 470, 111 NYS2d 88, reh and app den279 App. Div. 1046, 113 NYS2d 254, (federal order prohibiting construction of theater buildings was held to frustrate the purpose of the 99-year lease as long as tenant denied an exemption);
• Kang v. Roof, 24 Va. Cir. 193 (1991) (performance under the lease is excused because there was no serviceable use of the premises after application of zoning regulations without the plaintiffs’ assistance in obtaining a variance).
• Glass v O’Toole, 36 Ohio. App. 450 (1930)(held that the lease was not enforceable because of the landlord’s failure to secure a building permit as promised);
• Pierrepont Street v. Feist, 11 A.2d 727 (N.J., 1940) (where there is a serviceable use of the property after the application of zoning restrictions, a lease should be upheld);
• Burke v San Francisco Breweries, Ltd., 21 Cal App 198, 131 P 83(1913) (where lease only allowed use as a saloon and lodging house, tenant’s inability to renew liquor license was not valid defense because tenant failed to show it had requested permission to use the premises for other than salon purposes, and had failed to show that this deprived tenant of beneficial use of the premises).

One would have to evaluate the facts and circumstances of each case to determine the viability of such defense. Please feel free to contact us to discuss your specific situation.

C. What is the Doctrine of Impossibility/Impracticability of Performance?

According to the Restatement (Second) of Contracts, § 261, the related doctrine of impossibility or impracticability of performance is defined as:

Where, after a contract is made, a party’s performance is made impracticable without his fault by the occurrence of an event the non-occurrence of which was a basic assumption on which the contract was made, his duty to render that performance is discharged, unless the language or the circumstances indicate the contrary.

Stated differently, “the circumstances causing the breach has made performance so vitally different from what was anticipated that the contract cannot reasonably be thought to govern.” Eastern Air Lines, Inc. v. McDonnell Douglas Corp., 532 F.2d 957, 991 (5th Cir.1976); see also Restatement (Second) of Contracts, § 261(comments);⁵ Virginia Iron, Coal & Coke Co. v. Graham, 124 Va. 692 (1919) (excusing performance to mine ore because insufficient quantities of iron ore existed); see also Opera Co. of Bos. v. Wolf Trap Found. for Performing Arts, 817 F.2d 1094 (4th Cir. 1987);⁶ See Transatlantic Financing Corporation v. United States, 363 F.2d 312, 315 (D.C.Cir.1966). It is essentially an equitable defense that the terms of the contract should not be imposed on certain fairness and/or equity grounds.

A close analysis of the applicable case law suggests that the performance of the party seeking relief must not merely have been made difficult or burdensome under the circumstances to invoke this doctrine, but rather the performance can only be achieved at excessive or unreasonable cost.

In this analysis, the nature of the business, and whether such business can be conducted remotely or through telecommuting, albeit at a significant loss, is likely to be a significant factor in courts determining whether the performance under the lease is excused. Assuming that the purpose of the lease is tied to a specific use, a restaurant for example, then it stands to reason that the virus motivated shut-downs of all restaurants imposes an excessive or unreasonable cost upon tenants to pay rent.

Please feel free to contact us to discuss your specific situation.

D. What Is the Doctrine of Constructive Eviction and And Does It Apply In This Circumstance?

Constructive eviction is a “any wrongful act of the landlord, either of commission or omission, which may result in a substantial interference with the tenant’s possession or enjoyment, in whole or in part.” Taylor on Landlord and Tenant (9th ed.), sec. 309A); see also Cavalier Square L.L.P. v. Va. Alcoholic Beverage Control, 246 Va. 227, 231, 435 S.E.2d 392, 395 (1993). Even if one were to give this doctrine a hyper-liberal interpretation, we fail to see how governmental regulation mandating closure of all “non-essential businesses” could be an act or omission attributable to the landlord. However, the specific language in your lease would control.

E. What Is the Covenant of Quiet Enjoyment and Does it Apply In this Circumstance?

According to the Restatement (Second) of Property, Landlord and Tenant ‘6.1 (1977)) “[T]here is a breach of the landlord’s obligations if…the landlord, or someone whose conduct is attributable to him, interferes with a permissible use of the leased property by the tenant.” Comment d further states that “the conduct of a third person outside of the leased property that is performed on property in which the landlord has an interest, which conduct could be legally controlled by him, is attributable to the landlord for the purposes of applying the rule of this section” Id. The covenant of quiet enjoyment is generally an implied covenant in commercial leases, although some commercial leases explicitly define and grant the covenant. see e.g. Atlantic Richfield Co. v. Beasley, 215 Va. 348, 350 (1974) (no dispute as to existence of covenant in landlord-tenant relationship).

It is hard to imagine a scenario when one could legitimately attribute the governmental shut-down order for all “non-essential businesses” to any landlord. Nor could it be argued that the shut-down order in the midst of a pandemic is a matter that the landlord can reasonably control. Thus, we see no application of this covenant, unless your specific lease states anything to the contrary.

F. Does the Government Shut-down Order Affecting All “Non-Essential Businesses” Constitute A Regulatory Taking Under the 5th Amendment to the United States Constitution and the Virginia Constitution Article I, Section 11?

We have received several queries about whether the government shut-down order constitutes a regulatory taking under both the US and Virginia Constitutions. While these circumstances to not concern a physical taking, is there an argument to be made for a regulatory taking in light of the government mandated shut-down due to COVID-19?

While this memorandum is not a discussion of the constitutional nuances of the U.S. Supreme Court’s jurisprudence on the taking’s clause, the answer depends on the specific language used in the “condemnation” section of your lease.

As you may know, both the fifth amendment to the US Constitution and Article I § 11 prevent the taking of private property except for “public use” and only if “just compensation” is provided to the owner. On the other hand, “A ‘regulatory taking’ occurs when a regulation or limitation on land use interferes with a landowner’s rights but does not deprive the land of all economically viable use” (see Sunrise Corp. of Myrtle Beach v. City of Myrtle Beach, 420 F.3d 322 (4th Cir. 2005). Determining whether a regulation is a taking is “essentially [an] ad hoc, factual inquiry” Penn Central Transportation Co. v. New York City, 438 U.S. 104, 124 (1978).

Our opinion is that it appears unlikely that courts would classify government regulations enacted to prevent the spread of COVID-19 as a regulatory taking, and not as a legitimate exercise of traditional state police powers. If one were to adopt that premise, then the question of just compensation, i.e. damages, becomes moot.

• Stickley v. Givens, 11 S.E.2d 631, 635 (Va. 1940) (noting that the validity of statutes authorizing the destruction of animals and plants have been sustained as an exercise of the police power);
• Kroplin v. Traux, 165 N.E. 498, 501 (Ohio 1929) (observing that “the elimination of disease, whether in human beings, crops, stock, or cattle, are in general authorized under the police power.”);
• Wallace v. Feehan, 206 N.E.2d 438, 442 (Ind. 1934) (noting that the validity of statutory provisions to address a pest attacking plants was not questioned as being proper under the state’s police power);
• Miller v. Schoene, 276 U.S. 272 (1928) (upheld state statute that authorized the destruction of cedar trees without compensation to prevent the spread of a disease that harmed apple production).

CONCLUSION

We at Fox & Moghul will continue to monitor the developments with the courts and keep our clients updated as to all material developments on these issues. We hope that you all are staying safe during this time. If you would like to discuss your specific case situation, please do not hesitate to contact us at admin@moghullaw.com or 703-686-5406. This brochure constitutes attorney advertising and is not to be construed as legal advice. Prior results do not guarantee future outcomes because each case is different.

PLEASE VISIT OUR BLOG FOR MORE UPDATES ON THESE AND OTHER RELATED ISSUES.

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¹ According to the Small Business Administration (“SBA”), there are nearly 30.7 million small businesses in the U.S., employing around 47.3% of the private workforce, available at https://advocacy.sba.gov/2019/04/24/small-businesses-drive-job-growth-in-united-states-they-account-for-1-8-million-net-new-jobs-latest-data-show/

² See National Restaurant Association Coronavirus Information and Resources available at https://restaurant.org/covid19

³ Lustig, Hanna The Cheesecake Factory Announced It Wasn’t Paying April Rent, Eliciting Calls of Solidarity Online Amid A Growing Strike Movement available at https://www.insider.com/the-cheesecake-factory-2020-rent-strike-2020-3 (March 26, 2020); see also Paynter, Sarah Cheesecake Factory, Subway, other major retailers tell landlords they can’t pay April rent due to coronavirus available at https://finance.yahoo.com/news/cheesecake-factory-subway-other-major-retailers-tell-landlords-they-cant-pay-april-rent-due-to-coronavirus-141920106.html

⁴ A standard force majeure clause reads as follows:

FORCE MAJEUR: In the event that either party hereto shall be delayed or hindered in or prevented from the performance of any act required hereunder by reason of strikes, lock-outs, labor trouble, inability to procure materials, failure of power, restrictive governmental laws or regulations, riots, insurrection, war or other reason of a like nature not the fault of the party delayed in performing work or doing acts required under the terms of this Lease, then performance of such act shall be excused for a period equivalent to the period of such delay. See Reston Recreation Ctr. Assocs. v. Reston Prop. Inv’rs Ltd. P’ship, 238 Va. 419, 426-27, 384 S.E.2d 607, 611 (1989).

⁵ Restatement (Second) of Contracts, § 261 (illustrations 1 and 11).

A contracts to construct and lease to B a gasoline service station. A valid zoning ordinance is subsequently enacted forbidding the construction of such a station but permitting variances in appropriate cases. A, in breach of his duty of good faith and fair dealing (§ 205), makes no effort to obtain a variance, although variances have been granted in similar cases, and fails to construct the station. A’s performance has not been made impracticable. A’s duty to construct is not discharged, and A is liable to B for breach of contract.

On June 1, A agrees to sell and B to buy goods to be delivered in October at a designated port. The port is subsequently closed by quarantine regulations during the entire month of October, no commercially reasonable substitute performance is available (see Uniform Commercial Code § 2-614(1)), and A fails to deliver the goods. A’s duty to deliver the goods is discharged, and A is not liable to B for breach of contract.

⁶ Id. at 1095 (Contract for “fully staged orchestrally accompanied [operatic] performances” could not be performed by the plaintiff opera company because of severe thunderstorm that caused an electrical power outage. The performance was cancelled and defendant Wolf Trap did not make final payment, arguing excusal under the doctrine of impossibility of performance for “An act of God.” The district court rejected the defense and ruled in favor of the plaintiff. On appeal, the precise issue confronted by the Fourth Circuit was whether Wolf Trap’s defense of impossibility of performance was proper. The 4th Circuit reversed district court’s judgment and remanded the case to the lower court to determine “whether the possible foreseeability of the power failure in this case was of that degree of reasonable likelihood as to make improper the assertion by Wolf Trap of the defense of impossibility of performance”).