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California closed your business to stop coronavirus, but that may help you terminate your commercial lease early

Commentary

Phil Diamond (philipdiamond@comcast.net) is a real estate attorney, of counsel to Lerman Law Partners LLP, where he handles a wide range of real estate-related litigation and transactions, including commercial lease disputes. He is also a mediator and arbitrator through his independent practice, Diamond Dispute Resolution. Diamond is also a licensed real estate broker, commercial landlord and developer.

Jeff Lerman (jeff@lermanlaw.com), co-founder of Lerman Law Partners LLP, has a national reputation as “The Real Estate Investor’s Lawyer” and is also such an investor. He focuses on helping investors with their transactions and litigation. He is past president of Marin County Bar Association and included in the list of Super Lawyers.

This has been a terrible year if you own the kind of business governments have made unlawful for you to operate, yet your lease still obligates you to pay rent.

For many businesses, Black Friday and the period through Dec. 31 have been when the business can go from a losing year (in the “red”) to a profitable year (in the “black”). But that period will not save your business if coronavirus public policy makes it completely unable to operate (see “The List”). And with the current COVID-19 surge and the uncertainty of further government assistance, the situation may not get any better anytime soon.

However, there is a strategy that could enable you to stop the bleeding and restructure or terminate your commercial lease now.

‘Commercial frustration’ and lease performance

The List: Closed businesses with strong cases for lease termination

As of Nov. 30, these are businesses not allowed to operate and likely have the strongest commercial-frustration argument:

• Bars, breweries and distilleries that don’t serve food

• Bowling alleys

• Concert venues

• Indoor family entertainment centers, playgrounds, dance studios, and yoga studios

• Live theaters

• Nightclubs

• Saunas and steam rooms

As for amusement parks, convention centers, festivals and theme parks, we don’t have enough information to know whether those facilities are typically leased such that the commercial-frustration issue might be relevant.

The strategy is based on the concept that is referred to by California courts as “commercial frustration.” Simply put, it means that when the purpose of a contract becomes nearly or totally impossible to achieve due to an event that was neither contemplated nor foreseeable by the parties, the injured party’s performance under the contract will be excused and that party’s obligations under the contract will be considered “discharged” (i.e., no longer required). (Dorn v. Goetz (1948) 85 Cal.App.2d 407, 412)

The argument is strongest when no indoor use can be made, as opposed to indoor use at limited capacity or potential outdoor uses.

The doctrine is not new, and it has been applied by California courts to commercial leases on many occasions — including occasions when the unforeseen event was a new law or governmental order that made unlawful the operation of a business that had been lawful at the time the lease was entered into. When the unforeseen event occurred, the lessee/tenant’s obligations under the lease, including the obligation to pay rent, were discharged. Here are some examples:

  • In 1922, a lease for commercial space that was to be used for a wine and liquor business was held by the court to have been discharged when the passage of Prohibition made the object of the lease impossible to perform (Industrial Development & Land Co. v. Goldschmidt (1922) 56 Cal.App. 507, 509).
  • In 1944, a lease for neon advertising lights to be placed upon the tenant’s business was permanently discharged due to a wartime government order banning nighttime illumination, even though the order was only temporary (20th Century Lites, Inc. v. Goodman (1944) 64 Cal.App.2d Supp. 938, 945).
  • In 1978, a lease for an electric burglar alarm system was discharged when it became unlawful to use the radio waves required for the system because they interfered with secret government radio frequencies (Federal Leasing Consultants, Inc. v. Mitchell Lipsett Co. (1978) 85 Cal.App.3d Supp. 44, 47).

The common thread in all of the above cases is that, whereas the lessee was still able to lease commercial space, the advertising lights, and the burglar alarm system, the value of the lease was destroyed because the lessee could not use those things for the intended purpose. Commercial tenants therefore have a strong argument that, where a lease is for a business that was lawful to operate when entering into the lease but which thereafter became unlawful by operation of a COVID-19 governmental order, all obligations under the lease (including the obligation to pay rent) are terminated as of the time it became unlawful to operate the business, and even if the prohibition is only temporary.

The argument is strongest when the tenant’s business has been and remains completely unlawful to perform by COVID-19 orders, and where the lease expressly makes that the only purpose for which the premises may be used. In other words, it’s when no indoor use can be made, as opposed to indoor use at limited capacity or potential outdoor uses.

Force majeure clauses and rent carve-outs

Finally, there is a related strategy that commercial tenants should know about as well. Many commercial leases contain a clause titled “force majeure.” That’s French for “superior force,” and it is sometimes colloquially referred to as “act of God.” These clauses essentially restate the legal principle that when an unforeseeable and unpreventable event occurs that makes performance under a contract virtually or completely impossible, whether by “act of God” or otherwise (e.g., a hurricane or the outbreak of war), the obligations of the impacted party will be terminated.

Commentary

Phil Diamond (philipdiamond@comcast.net) is a real estate attorney, of counsel to Lerman Law Partners LLP, where he handles a wide range of real estate-related litigation and transactions, including commercial lease disputes. He is also a mediator and arbitrator through his independent practice, Diamond Dispute Resolution. Diamond is also a licensed real estate broker, commercial landlord and developer.

Jeff Lerman (jeff@lermanlaw.com), co-founder of Lerman Law Partners LLP, has a national reputation as “The Real Estate Investor’s Lawyer” and is also such an investor. He focuses on helping investors with their transactions and litigation. He is past president of Marin County Bar Association and included in the list of Super Lawyers.

In the 1946 decision in Pacific Vegetable Oil Corporation v. C.S.T., Ltd. (29 Cal.2d 228, 238), the seller of goods was discharged from contractual obligation to buyer when outbreak of war prevented seller from shipping the goods.

The principal difference between force majeure and commercial frustration is that under the former, performance becomes virtually or totally impossible (e.g., the seller is prevented from shipping the goods), whereas under the latter, performance may still be possible but becomes valueless (e.g., the leased commercial space can still be used but not for the primary purpose of the lease).

For purposes of COVID-19 relief from a commercial lease that cannot be used for the primary purpose of the lease, a problem that many tenants face is that many force majeure clauses also provide that, even if an unforeseeable event occurs that prevents the tenant from operating its business, the tenant is still obligated to pay rent (sometimes referred to as a rent carve-out).

Landlords may take the position that the terms of the lease, which is a contract, must be enforced as with any other contract, in accordance with the unambiguous written terms of the contract, including the force majeure clause. (Civil Code Section 1636; Mathes v. City of Long Beach (1953) 121 Cal.App.2d 473)

In that case, the court decided that the municipality and the general contractor may contractually provide, in a force majeure clause, for what happens in the event the federal government stops the work.

Frustrating the rent carve-out

If your lease contains a force majeure clause with a rent carve-out, we have a work-around. The common law doctrine of commercial frustration is codified in California Civil Code Section 1511. (Northrop Corp. v. Triad Intern. Marketing S.A. (9th Cir. 1987) 811 F.2d 1265, 1270)

Section 1511(1) provides that a party’s obligations under a contract are discharged when performance under the contract “is prevented … by the operation of law, even though there may have been a stipulation that this shall not be an excuse…” (emphasis added).

The argument is that the tenant’s performance under the contract — the operation of its business — has been prevented by the COVID-19 pandemic orders preventing the business from operating. Also, the rent carve-out is a “stipulation that” prevention by operation of law “shall not be an excuse,” and the rent carve-out is therefore unenforceable under Section 1511(1).

Further, California law also provides that parties may not contract around this Civil Code section, and in the event of a conflict between contract language and the law, the Civil Code prevails. (Peter Kiewit Sons’ Co. v. Pasadena City Jr. College Dist. (1963) 59 Cal.2d 241, 243-244)

While there is not yet any published California case applying Section 1511(1) specifically to a lease or anything else in the context of COVID-19 governmental orders, we believe the statute and supporting case law provide a strong argument that commercial landlords may not enforce a contractual requirement for the payment of rent even if the tenant is prevented by operation of law from obtaining the benefits of the lease.

So, the doctrine of commercial frustration can be used to restructure or terminate a commercial lease in the right circumstances. Of course, a tenant should work with a lawyer who knows how to handle this negotiation to maximize the commercial tenant’s chance of achieving its desired outcome.

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