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self-study / Real Estate

Can a commercial tenant terminate its lease because it cannot operate due to a stay-at-home order?

Borger joshua web

Joshua J. Borger

Partner, Berliner Cohen LLP

Email: Joshua.Borger@berliner.com

Boston College Law School; Newton MA

Josh practices commercial and civil litigation in a variety of areas, including unfair business practices, breach of contract, trademarks, trade secrets, fraud, employment, insurance coverage and litigation, Proposition 65, and general business litigation. In addition to his litigation work, Josh represents companies in nonlitigation matters, including employment matters and licensing agreements.

Businesses will lose billions of dollars because they cannot operate due to the coronavirus. People either will not enter retail establishments or cannot do so due to stay-at-home orders. Restaurants are existing on takeout orders and those who do not have takeout windows are not operating at all. This will lead to a dispute between commercial tenants who cannot pay rent and their landlords.

The dispute will raise a host of issues, not the least of which is whether the tenant may terminate the commercial lease because the purpose of the lease has been frustrated. This article addresses these issues.

The doctrine of commercial frustration

Whether or not the commercial lease can be terminated under these circumstances falls under the doctrine of commercial frustration. That is, the tenant cannot operate the business he expected due to a circumstance beyond his control. Therefore, as argued, it should be terminated. The doctrine's application is limited to circumstances when the risk of the frustrating event was not reasonably foreseeable and the value of performance is totally or nearly totally destroyed.

The World Health Organization declared the frustrating event here (the coronavirus) to be a pandemic. The United States has declared a public health emergency and announced restrictions on travel. Governor Newson, as with many other governors, issued a stay-at-home order except for essential needs. The government-imposed restrictions have closed or limited most retail establishments.

The government-imposed closures are analogous to government-imposed restrictions during a war. In fact, as shown below, the majority of cases dealing with commercial frustration come from wartime conditions during World War I and World War II.

Can a lease that identified the purpose be terminated if it cannot operate now?

Tenants will argue that their lease allows them to operate, for example, a dine-in restaurant. And, they do not have take-out. Since they cannot operate the restaurant, the lease terminates because it serves no purpose. Is it that simple? Never.

Most leases will contain a statement of the purpose. Continuing with the example, the purpose of the lease is to operate a restaurant. This alone is not sufficient to require the tenant to operate a restaurant. Unless there is an express requirement to operate a restaurant in the lease or it can be implied for the circumstances, the tenant may use the leased property for any reasonable purpose that is not prohibited by the terms of the lease. If the tenant is not required to operate a restaurant, then the tenant cannot terminate the lease because he was unable to operate the restaurant. It was a failed hope, not a requirement. In essence, the mutual expectation of the parties was not "frustrated."

The fundamental reason for entering into the contract must be recognized by both parties. Continuing with our wartime theme, in Brown v. Oshiro, 68 Cal. App. 2d 393 (1945), the defendant leased a hotel in 'Little Tokio' in Los Angeles, which he claimed that he intended to operate as a Japanese hotel only. But, he was prevented from doing so because of the evacuation of the Japanese during the war. In holding that the doctrine did not apply, the Court of Appeal reasoned, "In order that the defense of frustration be applicable it is not sufficient that the purpose or 'desired object' of one of the parties to the contract has been frustrated. The purpose or desired object of both parties must have been frustrated." Id. at 397. The Court of Appeal cited the lack of evidence that both parties understood that the lease was intended as a hotel for Japanese people. Rather, per the lease, the lessee simply leased a hotel which still had value despite the evacuation because he was able to sublease it. Thus, the purpose of both parties (to lease the premises) was not frustrated.

On the other hand, some leases (either expressly or impliedly) restrict the use of the lease property to a specific purpose. A commercial tenant who cannot operate a business specifically required under the lease due to the coronavirus may be able to terminate the lease. Under this circumstance, the mutual expectation of the parties was "frustrated."

As applied here, tenants will need to review their leases to determine whether they are required to operate a business that, in fact, cannot operate due to a government-imposed restriction. As in Oshiro, the doctrine will not apply simply because of a tenant's desire to operate a business that cannot operate under the present circumstances.

What if the government restrictions make the lease less profitable or entirely unprofitable?

The general rule is that commercial frustration does not apply where laws or governmental acts merely make performance more difficult or unprofitable. See Lloyd v. Murphy, 25 Cal. 2d 48, 55-57 (1944). Instead, the governmental action must render the lease meaningless or destroy its value. See Glendale Fed. Sav. & Loan Assn. v. Marina View Heights Dev. Co., 66 Cal. App. 3d 101, 154 (1977).

20th Century Lites, Inc. v. Goodman, 64 Cal. App. 2d Supp. 938 (1944), involved a lease of an electrical advertising sign which the lessee was required to use at his business, not elsewhere. In April 1942, following the commencement of the lease, the federal government issued an order prohibiting the illumination of all outside neon or lighting equipment between the hours of sunset and sunrise due to the war. When the lessor sued the lessee for failure to make lease payments, the lessee defended on the basis of commercial frustration.

The Court of Appeal held that the governmental proclamation, through no fault of the parties, frustrated the purpose of the contract, which was to lease an illuminated sign at night. The Court rejected the lessor's argument that the contract still had value because the sign could be used during the day. The Court determined, based on evidence, that the purpose of an "electrical" sign versus an ordinary sign was to advertise at night, not during the day.

Conversely, in Lloyd v. Murphy, 25 Cal. 2d 48 (1944), the California Supreme Court held that the lessee of property for the purpose of selling new cars failed to show that the value of the lease had been destroyed by federal regulations placed on the sale of new cars due to the war because the sale was not made impossible but merely restricted. The California Supreme Court reasoned that a lease is not terminated if the governmental regulation limits the business, thereby making it less profitable, but does not entirely prohibit it: "The landlord has not covenanted that the tenant shall have the right to carry on the contemplated business or that the business to which the premises are by their nature or by the terms of the lease restricted shall be profitable enough to enable the tenant to pay the rent..." Id. at 56-57.

Using the restaurant analogy, a tenant that is required to operate a restaurant without take-out now has a lease with no value. That tenant likely could assert commercial frustration. A restaurant with take-out has a lease of less value than before the government orders, but commercial frustration likely would not apply because it still has some value even though the profit may not cover the rent. Oddly enough, the tenant with no profit may be better off than the tenant with little profit.

Is the lease stayed or terminated?

Some local governments have halted evictions of commercial tenants. Those restrictions will eventually be lifted. Of course, that does not mean that the commercial tenants will be able to start their business up again. The temporary restriction may result in the complete collapse of some businesses. Do the tenants remain liable for the rent?

A temporary period where the lease cannot be fulfilled does not justify terminating the contract unless time is of the essence or the temporary impossibility defeats the purpose of the contract. G.W. Andersen Construction Co. v. Mars Sales, 164 Cal. App. 3d 326, 334-37 (1985). The obligations under the lease are suspended during this period unless the performance after the impossibility ceases would impose a substantially greater burden than terminating the contract or the temporary impossibility becomes permanent. Autry v. Republic Productions, Inc., 30 Cal. 2d 144, 149 (1947); Maudlin v. Pacific Decision Sciences Corp., 137 Cal. App. 4th 1001, 1017 (2006).

In 20th Century Lites, Inc. v. Goodman, the Court of Appeal also rejected the lessor's argument that the proclamation merely suspended but did not terminate the contract. As held therein, once the doctrine is invoked, the contract is terminated. The Court relied upon a United States Supreme Court case (Allanwilde Transport Corp. v. Vacuum Oil Co., 248 U.S. 377 (1918)), where a party argued that the government's embargo on ships leaving American ports during a part of World War I, because of the enemy submarine menace, constituted but a temporary impediment, and therefore did not terminate the contract. The Supreme Court disagreed, finding that the embargo could continue as long as the submarine menace continued, which could have been until the end of the war. As such, the condition was deemed "permanent" to justify terminating the contract. See Johnson v. Atkins, 53 Cal. App. 2d 430 (1942) (holding that the buyer's obligations under a contract for goods to be shipped to Colombia were excused and the contract was terminated when the Colombian government cancelled permission for entry).

No one knows how long the stay-at-home restrictions will last. President Trump was hoping that we could be back at work by Easter. Yet, the restrictions have been continued until the end of April at least. Applying 20th Century Lites, the temporary stay could be deemed "permanent" at some point. When that point occurs is not clear, but 20th Century Lites implies that a "temporary" condition is "permanent" if, as here, there is no set ending date. If so, this justifies terminating a lease.

If it is not deemed a "permanent" condition, then the parties will have to argue whether continuing the lease would impose a greater burden than terminating it (an admittedly vague standard). The burden on the tenant is that he cannot afford the lease and it serves no purpose (the business is gone). The burden on the landlord is that he has an existing tenant (albeit one who cannot pay) and likely cannot find another. Two courts weighing these equities could come to polar opposite conclusions.

Conclusion

As with all legal issues, the inevitable dispute between commercial landlords and tenants does not have a clear resolution. Both parties should consult legal counsel to determine whether the coronavirus "frustrates" the lease such that it can be terminated. 

#640

Ben Armistead


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