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Tingting (Maggie) Tang
Zhaotai Group, Beijing
maggie3746@yahoo.com

 

Introduction

Due to the Covid-19 outbreak and its rapid spread in the United States, many cities imposed travel bans, issued shelter-in-place orders and enforced social distancing to slow its spread, which brought about significant disruption and uncertainty to businesses and economies.

For example, in New York and California, as well as many other states, restaurants were ordered to shut down all dine-in services. The ability of such businesses to continue operations and generate revenue has already been greatly affected. Many commercial and retail tenants alike are facing financial hardships. It is reported that more than ten million new unemployment claims were filed from March to April due to the pandemic and more than 30 per cent of tenants nationwide failed to pay any of their April rent.[1] That figure does not include the tenants whom landlords allowed to abate rents for the month or longer, which is assumed to be 60 to 70 per cent of tenants. As such, breach of leases is readily foreseeable. In addition, the economic fallout from the pandemic has brought great challenges for tenants in meeting contractual obligations and maintaining their relationships with the landlords, especially for commercial and retail tenants.

For the commercial and retail leases, tenants would probably want to invoke force majeure or the doctrine of frustration to excuse their obligations to pay the rent, demand rent abatement or even request to terminate the leases. How are these claims rooted? Will they be upheld by the courts? Commercial and retail tenants need to understand the application of these rarely invoked clauses and doctrines.

Force majeure?

Can force majeure be invoked by the commercial tenants in the pandemic?

As we all know, the pandemic is continuing to spread and many cities have issued lockdown or quarantine. In such a situation, may a commercial tenant invoke a force majeure to avoid certain contractual obligations?

Black’s Law Dictionary explains that force majeure ‘is meant to protect the parties in the event that a contract cannot be performed due to causes which are outside the control of the parties and could not be avoided by exercise of due care’.[2] Generally speaking, the main purpose of force majeure is to discharge a party from certain contractual obligations when its performance of such obligations has been prevented by an unforeseeable and unavoidable event, which is called a force majeure event.

To decide whether force majeure applies, a tenant must first look at its lease and see if a force majeure clause is contained in the contract. If there is a force majeure clause, the main issue is whether this clause can be applied to the present situation. If there is no express force majeure clause contained in a lease, the tenant shall instead turn to the common law cases for invoking the other doctrines.

This part will focus on the scenario that a lease contains a force majeure clause. Most commercial leases contain a force majeure clause, though they could be variously stated. Some force majeure clauses may include a list of specific events (typically including acts of God, such as severe acts of nature or weather events such as floods, fires, earthquakes, hurricanes or explosions; war, acts of terrorism and epidemics; acts of governmental authorities such as expropriation, condemnation and changes in laws and regulations; strikes and labour disputes; and certain accidents[3]) that constitute a force majeure. Some may be more generally described to include anything beyond the parties’ reasonable control or may state that force majeure events ‘include but are not limited to’ several specific events and then contain broad ‘catch-all’ language such as ‘or any other events which are beyond the parties’ control’.

As the World Health Organization declared Covid-19 a pandemic on 11 March 2020, and the US government imposed travel bans and quarantines, Covid-19 can certainly be regarded as a force majeure event as long as any of the words ‘pandemic’, ‘epidemic’ or ‘disease’ is on the list of qualifying events.

However, even absent that specific reference in a force majeure clause, any broad or vague force majeure clause in the lease will cover the present situation because it falls into the definition of a force majeure event and meets the standards of ‘beyond the tenants’ control’ and ‘unpredictable’, ‘unforeseeable’ and ‘unavoidable’, unless it is otherwise expressly excluded in the lease. Be aware that economic hardship alone is typically not enough to qualify as a force majeure event.[4] Even though a commercial tenant is not generating any revenue because of the lockdown and is facing serious financial hardship, the force majeure clause cannot be invoked to justify the tenant’s suspension of contract performance.

Since the pandemic constitutes a force majeure event, may the force majeure clause be triggered? Not exactly. Besides the requirement of the occurrence of a force majeure event, there is a further requirement for the application of the force majeure – proving the causal link between the occurrence of the event and the inability to perform the contractual obligations. Force majeure applies only when an event truly prevents or hinders the tenant from performing the obligations to the landlord. In practice, the causation between a force majeure event and the inability to perform the obligations is required by most courts in the US. The party claiming a force majeure should show that the event was not foreseeable and directly caused the failure to meet its contractual obligations.[5]In some states, the tenant has to prove that the force majeure event must be the proximate cause of the tenant’s inability to perform such obligations. Generally, the effect of the force majeure event on the tenant’s ability to perform will be considered. Here is an example to make it easy to understand. An earthquake occurs in a city and many of the buildings in the north of the city are seriously damaged or destroyed. However, the buildings in the south are not damaged by the earthquake. The earthquake is obviously a force majeure event but such an event cannot be invoked by the tenants of the buildings in the south to excuse their obligations as they have not really been affected by the event.

Thus, a tenant that may want to invoke force majeure in the present situation must show an actual and direct impact of Covid-19 on its ability to perform its contractual obligations. Indirect impacts of Covid-19, such as pricing fluctuations or decline of customers, are less likely to be found to prevent the tenant’s performance. If the impact is caused by the tenant itself or predates the contract, the force majeure clause will not likely assist the tenant to avoid performance.[6]This is especially the case where the impact on the tenant was avoidable or where the only impact was to render an obligation more expensive (but not unreasonably expensive) to perform.

What obligations can be excused under the force majeure clauses?

If the two requirements for applying the force majeure clause are satisfied, the next question is what contractual performance under a commercial lease can be excused. Could the tenant suspend the rent payment, delay the rent payment or even terminate the lease before the lease expires? Broadly speaking, it really depends. Only the obligations that the tenant is hindered from performing or delayed of performing by the force majeure event can be excused. The courts will look for the impact of the force majeure event on the tenant’s ability to perform such contractual obligations and decide if such obligations actually cannot be performed. Each lease and tenant’s situations shall be analysed on a case-by-case basis.

It is important to note that monetary obligations, for example, payment of rent, are often addressed specifically in force majeure clauses as obligations that cannot be suspended during the time of force majeure. This means that a tenant may still be required to pay rent under their lease even during a force majeure event. The tenants,  therefore, should carefully review the specific language in their leases. On the other hand, if a lease is silent on this issue, will the force majeure clause excuse the tenant’s obligation to pay rent? Unfortunately, the answer might be no as there is little precedent to support this notion. It is generally recognised that the rent payment will not be completely prevented by the occurrence of the force majeure event and shall not be excused entirely, but it appears to be a trend that it could be suspended for the duration of the force majeure. In practice, we also see that many commercial landlords are willing to allow the delay of rent payment in light of the pandemic so as to provide some support to their tenants and strengthen their relationship with the tenants.

Some tenants wish to demand rent abatement during this period of time. This completely depends on the landlord’s sole discretion. As mentioned above, many leases will exclude monetary obligations from the excusable obligations during the force majeure period. The tenant should not stop paying rent or unilaterally choose to reduce the amount of rent it is obliged to pay. Even if such exclusionis not explicitly provided in the leases, it is commonly held that the tenant does not have an entitlement to seek a rent reduction. A unilateral decision by the tenant to pay less rent would result in a breach of lease.

Some commercial tenants may want to quit their business and terminate their commercial lease before the lease terms expire because of the effects of the pandemic. However, no statutes or common law give the tenant an implied right to terminate a lease early due to a force majeure event. To put it simply, during the time of force majeure or otherwise, the right for the tenant to terminate a lease early is not supported by the law and the courts in the US, unless there is a clause in the contract entitling the tenant to an express right to break the lease due to the force majeure event or on a specified date. Some well-negotiated commercial leases may have a break clause after a certain period of time passes, for example, the tenant of a ten-year lease may have right to terminate the lease after the end of the fifth year. In that case, the tenant could request a termination. The tenant that does not have any break rights pursuant to the lease should bear in mind that an earlier termination of the lease will constitute a breach of the lease and shall be liable to the landlord for that breach.

Doctrine of frustration?

Besides force majeure, the doctrine of frustration, a common law argument, is also asserted by the tenants very often in order to avoid their contractual obligations, especially when a lease lacks a force majeure clause. Unlike force majeure, the doctrine of frustration is not usually stated in a contract but is implied therein. The doctrine of frustration applies when ‘performance remains possible, but the reason the parties entered the agreement has been frustrated by a supervening circumstance that was not anticipated, such that the value of performance by the party standing on the contract is substantially destroyed’.[7] In other words, the doctrine of frustration excuses performance of contract when the parties’ overall contractual intent and objectives have been completely thwarted by an unforeseen event.

To successfully invoke the frustration defence, the claiming party must establish:

‘1) the basic purpose of the contract, which has been destroyed by the supervening event, must have been recognized by both parties when the contract was entered into; 2) the event must be of a nature not reasonably to have been foreseen; and the frustration must be so severe that it is not fairly to be regarded as within the risks that were assumed under the contract; and 3) the value of counter performance to the claiming party must be substantially or totally destroyed.’[8]

When the court finds that these requirements are all met, this doctrine will come to play. Therefore, the application of this doctrine is highly dependent on fact and decided on the court’s discretion on a case-by-case basis. However, from the precedents, it is observed that the courts construe this doctrine very narrowly and strictly and that an extremely high threshold is usually set in order for the doctrine of frustration to apply.

In practice, the doctrine of frustration is usually applied to a commercial lease when a property was destroyed by fire or earthquakes, or the specific and identified permitted use in the lease or intended use of the leased space becomes incompliant with the local laws or regulations after the lease comes into force. For example, the doctrine of commercial frustration was found to apply where a lessee entered into a lease to operate a cinema and thereafter the applicable zoning was changed to prohibit the operation of a cinema at that location. As a result of the zoning change, the lessee was unable to conduct any of its intended business.[9] Based on the specific situations, the lease may be terminated or payment of the whole or part of the rent will be excused.

Frustration of a contract is a difficult threshold to reach, which can be seen clearly from the following case. The doctrine of frustration was found not to apply to a lessee where the federal government appropriated leased premises for a portion of the lease term for war purposes. The court found that since the subject matter of the lease, that is, the property, had not been destroyed and was still in existence, the federal government’s appropriation merely carved out short-term occupancy and did not destroy the lessee’s lease hold estate.[10]

The doctrine is not likely to apply to commercial leases despite the fact that many businesses have experienced serious commercial disruption and may find it hard to meet their contractual obligations or in turn find that their contracts are not being fulfilled because of the pandemic and the government’s recent restrictions on economic and social activities. First, the threshold to succeed with a frustration claim is notoriously high. A contract is deemed to be frustrated where an unforeseen event makes it impossible for the substantial purpose of the contract to be fulfilled. In the context of a lease, it seems that the Covid-19 outbreak would not destroy its substantial purpose, given that compared with a five or ten-year commercial lease, the pandemic and government restrictions are likely to be temporary. In addition, a court may not decide that the pandemic will frustrate a commercial lease and allow all of the contractual obligations to be excused or such a lease to be terminated. If the court finds that the frustration doctrine applies in some cases, many tenants will bring lawsuits and can successfully get remedies (ie, terminating a lease, stopping rent payment or reducing the rent amount) based on the issue preclusion and such precedents. This will bring significant impacts to the lease market and the real estate industry.

Based on this analysis, the doctrine of frustration can hardly be expected to succeed in the present situation. However, it should be noted that whether the substantial purpose of a commercial lease is destroyed by the pandemic or government-ordered shutdowns depends on the nature of the lease and the actual impact on the lease. It is also important for tenants to note that frustration is not triggered by changes in the economy or markets that would affect the profitability of a contract. The downturn of the economy is not regarded as a frustrating event.

Conclusion

While the Covid-19 pandemic continues to spread, some states are considering reopening the economy. It is anticipated that restrictions and bans would be lifted soon. However, courts will still be faced with unique and novel questions when handling commercial lease disputes, especially the application of force majeure and doctrine of frustration.

The interpretation and application of any contractual force majeure clause is highly dependent on the particular terms of the clause in question and the specific circumstances causing a disruption of normal business activities.[11] Therefore, in the commercial landlord/tenant context, all commercial tenants that wish to rely on force majeure or the doctrine of frustration to relieve their obligations should carefully review their lease provisions and applicable state law to determine: (1) whether a force majeure applies; (2) if it applies, what obligations can be excused or delayed; (3) if it does not apply, whether the common law defence of frustration of purpose can apply based on their specific factual situations; and (4) if the frustration doctrine cannot apply, what the consequences of failure to perform their contractual obligations are. Tenants should also consider whether the situation is truly unforeseeable for them and whether the difficulties they are experiencing involve more than just economic hardship because either force majeure or doctrine of frustration will not be triggered by the economic hardship.