Practical Commercial and Industrial Lease Considerations in the COVID-19 Era

As we continue to navigate the rapidly changing landscape created by the COVID-19 pandemic, we have put together some practical advice that commercial and industrial landlords and tenants should consider as this event continues. Many states have enacted requirements for non-essential businesses or businesses not classified as life-saving or part of core infrastructures to close their physical operations, or in some cases have issued blanket “shelter-in-place” or similar directives. These actions will undoubtedly lead to disagreements between landlords and tenants regarding several typical lease provisions.

Commercial and industrial landlords and tenants should be proactively considering how best to resolve the following issues before they become full-blown disputes:

Force Majeure Provisions

Many leases include language excusing performance of certain obligations by one or both parties if there is a Force Majeure event that qualifies as an “Act of God”, or other event outside the control of the parties. The exact scope and extent of these provisions is dependent on the specific language at issue. However, certain principles are generally applicable; including that the language usually limits the qualifying events, that the event must be beyond the party’s control and not due to its fault or negligence, and that the party asserting the defense has the burden of proving that the event qualifies as a force majeure. Additionally, such provisions typically do not excuse performance of monetary obligations. Notably, courts generally construe these provisions narrowly within the contract’s plain language.

Parties would be wise to take proactive steps to best position themselves to invoke or react to a force majeure claim or defense. These include reviewing their specific lease provisions to evaluate the potential applicability of any force majeure rights/remedies and whether there are certain notice and response requirements. While it remains to be seen whether efforts to assert claims or defenses based on force majeure will be successful, these provisions will be invoked by tenants and/or landlords in the coming weeks and months, at least in an effort to negotiate deferrals or extensions of obligations.

Non-Contractual Common Law Principles Excusing Performance

In addition to contractual defenses, lease parties may turn to common law defenses of impracticability, frustration of purpose, or prevention by governmental regulation as potential grounds to excuse performance under a lease. These defenses are common law defenses recognized in most jurisdictions. For example, the doctrine of impracticability allows for the discharge of a party’s obligation if performance becomes impractical due to an event outside of party’s control, the non-occurrence of which was a basic assumption on which the contract was made. A frustration of purpose occurs when the party’s principal purpose is substantially frustrated, at no fault of the party, where the occurrence or non-occurrence of an event was a basic assumption on which the contract was entered. Similarly, where performance of a duty is made impracticable due to the imposition of a government regulation or order, the non-occurrence of which was a basic lease assumption, a party may be excused from performance.

Whether these defenses would be successful depends on whether the circumstance has made performance of the agreement materially different from what the parties could reasonably have contemplated when they entered into the Lease. It remains to be seen whether the dramatic changes in the business world caused by the COVID-19 government mandated shutdowns and closures are sufficient justification under these common law rules. Although these are well-recognized common law defenses, the successful use of these defenses would in most cases completely change or negate the contract obligations negotiated by the parties, and accordingly courts are hesitant to support these defenses unless the circumstances clearly warrant it. Regardless of the strength of the argument, lease parties should all take reasonable steps to notify the other party of their intentions and take actions to mitigate the impacts of any decisions on the other party.

Liquidated Damages for Late Delivery

If a Lease provides for payment of liquidated damages for failure of a Landlord to deliver the premises by a date certain, the current work stoppages directed by many states could trigger these provisions. Parties should be prepared to discuss a reasonable delay in delivery schedules due to any mandatory directives or supply shortages.

Payment Delays and Rent Abatement or Deferral

Likewise, government mandated business closures will undoubtedly result in cash flow and other liquidity issues for tenants. Tenants will likely be seeking delays in rental payments or abatements from landlords, who will in turn, need similar concessions from lenders. At the very least, lease provisions calling for payment of late fees, penalties or interest payments on late rental payments, or even triggering a default will need to be addressed. Parties to leases should be actively engaged in discussions to resolve this very likely and imminent issue, including negotiating rental abatements or deferrals and corresponding loan payment abatements or deferrals, as well as waiving or deferring late fees and discretionary charges. As an initial response to government-mandated shutdowns, some lenders and landlords are agreeing to 90-day deferrals on debt service and rent obligations, with the deferred payments made up through increased or additional payments later in the term.

Material Adverse Event (MAE) Provisions

Leases and other real estate agreements, including purchase and sale agreements, commonly include provisions addressing what happens when there is material physical damage or destruction of the asset. Some parties may argue that a government required shutdown of a building or use of a space is a temporary taking, which in some cases may allow for termination of the agreement. While leases typically limit tenant’s right to terminate only to permanent takings, depending on the specific lease language this may be an issue.

For landlords with leveraged assets, many commercial loan commitments include provisions that condition performance on the non-existence of other non-physical, material adverse events. For example, loan commitments may provide lenders the right to terminate loan commitments in the event of any material adverse change in the financial condition of the property, borrower or its tenants. The events related to COVID-19 may have substantial impacts on the financial performance of some commercial properties, potentially including closures of retail businesses, defaults by tenants, or imposition of eviction moratoriums that substantially impact net operating income. Whether that conduct is sufficient to fall within an MAE, however, will depend on the definition of the MAE and the overall context of the financial performance of a property.

Continuous Operations and Security

Many leases require businesses to continuously operate a premises and consider any prolonged closure to be an event of default. In the case of government mandated closures, the absence of physical presence of the tenant may create security issues that need to be addressed by the parties.

Restoration and Holdover

Leases that are at or near the end of the term during this COVID-19 period, present a unique set of issues. Among these are how a Tenant can fulfill its end of term restoration obligations (if any) and meet the turnover deadlines. Correspondingly, commercial leases often provide for increases in rental payments during any period of holdover, which could be triggered if the tenant is unable to meet its restoration obligations before the end of term. Again, the parties should attempt to proactively address these issues in an effort to allow for reasonable accommodations to be made.

Delay in Performance of Non-Monetary Obligations

Both landlord and tenant may be delayed in meeting any non-monetary obligations during this period. Depending on the Lease language, such a delay could result in a default, a self-help right with a charge-back of expenses, or rental abatement. Landlords and tenants should consider whether a suspension of such provisions is appropriate.

Business Interruption and Rental Income Insurance

To the extent a lease requires one or both parties to carry business interruption or rental income insurance, a careful review of those policies is warranted. Under many policies, coverage is only implicated when there is direct physical damage to or destruction of the insured property. Moreover, courts generally interpret coverage in accordance with the policy’s plain and ordinary language. What constitutes a “business interruption” also varies as some policies may require the total cessation of business in order to trigger coverage, whereas others may only require a slowdown or a reduction of business capacity. A policy may also specifically exclude certain occurrences such as civil disturbances and power service failures or may only cover certain business locations. All these considerations are heavily dependent upon the jurisdiction and the policy language at issue. So far in this pandemic, insurance companies appear to be denying coverage under these policies based on the lack of physical damage to the insured property. Some State legislatures are reviewing these issues and considering legislation to broaden the scope of coverage, although changing the agreed-upon policy terms by statute would have obvious constitutional implications and would be subject to challenge from the insurance industry.

Bottom Line

Landlords and tenants are already dealing with many of the issues outlined above and we expect a number of additional issues to arise as we continue through this uncertain time.

Our combined team of Stevens & Lee lawyers, Griffin Financial Group investment bankers and other professionals in our multidisciplinary platform is ready to help you with any of the foregoing steps. We are working together to stay current on new developments and to assist clients with issues affecting them during this unprecedented global health challenge.

If you have any questions concerning the above guidance, please contact Steve Buck, Ambrose Heinz or the Stevens & Lee attorney with whom you regularly work.

This News Alert has been prepared for informational purposes only and should not be construed as, and does not constitute, legal advice on any specific matter. For more information, please see the disclaimer.