Commercial Lease Considerations in Light of the COVID-19 Pandemic
April 16, 2020
It has already been approximately one month since the COVID-19 pandemic thrust the commercial real estate industry in Canada into chaos. Landlords and tenants alike continue to face a litany of issues not previously seen in modern times. Many tenants are fighting for their continued survival, with some jurisdictions in Canada reporting that as many as half of the businesses closed will not re-open once this crisis is over. Landlords are grappling with how to keep their projects viable with so many vacancies looming and cash flow becoming increasingly restricted. How the industry addresses and emerges from the recent events will determine not only the immediate future, but also the long-term evolution of our industry.
So how do commercial landlords and tenants proceed in these uncertain times? Below are some key considerations for both landlords and tenants alike.
By now, everyone in the commercial real estate industry is likely well acquainted with the term force majeure, and both landlords and tenants have undoubtedly blown the dust off their respective leases and closely scoured the contents to review those (previously) oft ignored clauses. In essence, force majeure clauses address excusing the performance of a party’s contractual obligations during events where the full performance of their obligations has become impossible due to circumstances beyond their reasonable control.
It should be noted that not all leases contain force majeure clauses and not all force majeure clauses are the same. Force majeure is a contractual principle and not a common law or equitable principle, meaning that if such a clause does not exist in the contract itself, then it is not a recourse that is available to the contracting parties (the exception being in the province of Quebec). Most clauses will contain wording that is broadly phrased, although some clauses may be quite specific as to whether it relates to a public health crisis or whether the tenant’s obligation to pay rent is excluded. Determining whether such clauses exist in the lease (or whether analogous clauses exist under different headings or slightly different wording) and the scope of their application to a party’s specific obligations will be of paramount importance to both landlords and tenants alike.
One could certainly make the argument that a pandemic such as the COVID-19 pandemic, where various levels of government have mandated restrictions or even outright prohibitions on the operation of certain business operations, would qualify as an event of force majeure. However, even assuming that such an event will be considered force majeure, how far will such clauses extend to excuse the performance of a party’s obligations? For a tenant looking to rely on force majeure to excuse the payment of rent, what if the tenant is able to maintain business operations in a reduced or alternative capacity? If financial institutions are open and the tenant has access to funds or credit, is it really impossible for the tenant to pay their rent? For landlords, will force majeure excuse their obligation to provide quiet enjoyment if the landlord closes the project in the absence of a specific order or direction from a governmental authority? Will landlords have the right to access a tenant’s leased premises without their consent or physical presence to clean and disinfect the leased premises?
Even when a party raises force majeure to suspend the performance of their contractual duties and obligations, they still have an obligation to attempt to mitigate any potential damages. For example, can a tenant stay open on a partial basis (i.e. a restaurant offering delivery or pick up service only; vet clinics and dental clinics offering emergency services only; drug stores and grocery stores adopting social distancing initiatives etc…)? Can and should a landlord keep the common areas of a project open while still maintaining social distancing policies? A party wishing to assert force majeure cannot simply rely on the declaration of such an event to remove all positive obligations on their behalf. They must still do what is reasonably within their control to try and limit the scope and quantum of damages being incurred.
If either party intends to rely on force majeure to suspend their obligations during this pandemic, they should ensure that they clearly communicate in writing to the other party why performance of their obligations are now impossible to perform, what steps they are taking to mitigate any damages and efforts they will be undertaking to resume performance of the suspended obligations under the lease once circumstances permit. Simply suspending the performance of a party’s obligation under the lease, for example the tenant withholding payment of rent, based solely on the implied understanding or verbal communication of force majeure may impair the tenant’s ability to rely on force majeure should the matter be contested in the future.
While many are looking to force majeure to be the “silver bullet” solution to their existing lease issues, unfortunately simply identifying that a force majeure clause exists in the lease agreement does not provide a clear and definitive resolution. Each circumstance will require some careful scrutiny by both landlords and tenants alike. Further complicating matters is the lack of a well-defined body of case law around force majeure covering the unique circumstances we are in today with COVID-19. The absence of clear and reliable guidance from the courts as to the scope and application of force majeure clauses in the current crisis leaves many questions that are, so far, without a definitive answer.
Frustration of Contract
The legal doctrine of frustration of contract arises in circumstances when an event occurs that is (a) unexpected; (b) beyond the reasonable control of the parties involved; and (c) makes the performance of the contract impossible or materially different from what either party initially contemplated. If the three-part test as set forth above has been satisfied, an “event of frustration” is said to occur and the contract terminates. Unlike force majeure, frustration is a legal doctrine, and as such it is implied to exist in a contract, even in the absence of a specific clause or wording respecting the same.
Again, there is no simple “one size fits all” solution for frustration that applies uniformly across all situations. Whether the current circumstances surrounding the COVID-19 pandemic will be deemed to qualify as an event of frustration, and the resulting consequences for proceeding in such a fashion, will need to be determined on a case by case basis, including the review of any applicable provincial legislation which applies to the frustration of contracts.
There are a few additional important considerations when looking to frustration as a potential remedy:
a) Frustration is generally not applicable when a contract already contains a force majeure clause. As a result, because force majeure clauses are quite commonplace in the majority of commercial leases, this will likely eliminate frustration of contract as a potential option in a large percentage of leases; and
b) It should be remembered that the end result of the application of this legal doctrine is the actual termination of the contract (as opposed to force majeure, which only suspends the specific obligation for the duration of the event). This may not be a desired outcome if, for example, the tenant values the particular location and wishes to continue doing business in the leased premises after the pandemic is over.
If a party wishes to assert frustration of contract, they should carefully consider the consequences of relying on this potential remedy and consult with legal counsel to determine its applicability and scope as it relates to the specific lease in question.
Non-Payment of Rent
There have been numerous anecdotal reports over the previous weeks of many tenants that are making the arbitrary decision to not pay rent. For many tenants, they simply have no choice. Their cash reserves are such that their ability to withstand a loss of revenue before they become insolvent is measured in weeks and days, not months. It is literally a life or death decision for many of these businesses. However, there are also many tenants that are attempting to come up with solutions and strategies to mitigate their mounting losses and to emerge from this current crisis as viable operations moving forward. For the latter, the consequences of arbitrarily withholding rent should be very carefully considered. While many tenants are relying on the assumption that landlords will have no choice but to refrain from terminating a particular tenant’s lease for non-payment of rent, many tenants also have critical inducements and rights in their leases, such as exclusive clauses, deposits, renewal options and permitted transfer provisions that are often dependent on a tenant continuing to be compliant with the terms of their lease. Even if the landlord does not terminate the lease, tenants may be potentially foregoing the benefits of these inducements and rights by arbitrarily withholding rent.
Tenants who intend to continue operating their businesses in their leased premises after this crisis abates should carefully review the wording of these clauses in their leases and understand the full implications of their actions before taking the arbitrary step of withholding rent. Both parties should also consider the continued existence of these clauses as part of any formal deferral or abatement agreements. Silence or faulty assumptions by either landlords or tenants may lead to disagreement and litigation in the future.
Another consideration for both landlords and tenants is the potential impact of co-tenancy clauses in the lease. Tenants may have the right to terminate the lease or pay a lesser rent (i.e. percentage rent based on their actual revenues or a set lesser amount) if certain other tenants, or a percentage of the total tenants in the project, are no longer operating. Tenants should consider the existence of these clauses and whether they will provide the potential for any rent relief, both in the present and potentially in the future. Landlords should consider the impact of these clauses when negotiating potential resolutions with the tenants in their project to ensure they have addressed these clauses as part of any negotiated deferral or abatement agreements. For example, a landlord who agrees to a formal rent deferral or abatement with a tenant in the short term may be unpleasantly surprised to have that same tenant exercise their rights under a co-tenancy clause to further reduce the rent (or even terminate the lease) once the crisis has abated. In agreeing to amend or remove co-tenancy clauses as part of a negotiated resolution, tenants will need to consider the value of short-term relief in the face of an uncertain future business climate. Co-tenancy clauses could become very material clauses for both landlords and tenants in the weeks and months following the COVID-19 pandemic.
Business/Rental Interruption Insurance
Both landlords and tenants typically carry some form of business interruption or rental interruption insurance. It should be incumbent on both parties (and likely a key component of either party’s requirement to mitigate their damages and prove impossibility of performance) to ensure they have fully exhausted all avenues of recourse and recovery under their respective insurance policies.
Anecdotally, it would appear that many insurance providers are initially denying coverage under these types of policies as it relates to the COVID-19 pandemic. After the SARS outbreak in the early 2000’s, many insurers started to include specific clauses excluding coverage for claims arising as a result of epidemics and pandemics. Nonetheless, it would be wise to carefully review your policies with your legal counsel to ensure that your insurance provider is objectively interpreting the wording and intent of these policies fairly and correctly. Insurers are like any other business and many will seek to limit their exposure in times of crisis such as this. For example, some insurers appear to be relying on the requirement of “physical” damage to the leased premises as a basis to deny coverage under business interruption insurance policies. However, there are already court rulings that have clarified what the concept of “physical” damage means, with more such rulings and judicial clarification to inevitably follow. As such, it may require some negotiation with your insurer to obtain recovery which you may be entitled to under your policy. Do not simply accept your insurer’s initial refusal to cover your claim as proof that your claim is not covered under your policy.
This remains both the “Great Hope” and the “Great Unknown” for the commercial real estate industry. The federal government recently announced that some form of relief for small businesses to help them with costs such as the payment of rent may be coming soon. Whether and to what extent the respective levels of government will intervene to provide aid or assistance to landlords or tenants in these extraordinary times is still anyone’s guess. The nature and extent of such intervention could immediately and dramatically impact the decision making and course of action for both landlords and tenants moving forward. We will all be watching closely to see how government intervention, if any, will impact the commercial real estate industry during this crisis.
WHAT CAN YOU DO?
The obvious first step for both landlords and tenants is to carefully review their respective leases. As mentioned above, there are many issues that will need to be carefully considered and reviewed to identify each party’s respective strengths and limitations. This analysis may vary greatly from lease to lease and will be essential in determining the appropriate next steps.
Many landlords and tenants have already commenced discussions regarding a variety of potential resolutions. Ultimately, a negotiated outcome that is mutually agreeable to both parties will be optimal. Litigation is costly, lengthy and fraught with uncertainty. While a mutually agreeable resolution may not be possible in every situation, to the extent that this can be achieved, and a continued business relationship is preserved, that is likely to be the best outcome for both parties.
Rent Deferrals and Abatements
The most common form of mutually agreeable resolution will likely be a rent deferral (postponing rent until a later date) or abatement (forgiving rent for a period of time). Prior to requesting a rent abatement or deferral, a tenant should first fully understand what it is that they need and be in a position to clearly communicate that need to the landlord. Will the tenant require an abatement as opposed to a deferral? For some tenants, a deferral is merely delaying the inevitable and an abatement is the only solution. For other tenants, a deferral may be an acceptable, if not a preferred, resolution. In either event, tenants should be prepared to demonstrate why, how much and for how long the relief being requested is required. If there is a “win-win” situation that includes a proposed benefit for the landlord (i.e. an extension of the term on the back end of the lease or the addition of a personal guarantee or security from other parties) ensure that is set out in full detail. Formulating and clearly communicating a well thought out request for accommodation to a landlord may significantly increase the tenant’s chances for a timely and optimal outcome.
It is also important when making a request for accommodation that a tenant does not overstate or fabricate their need for assistance. Many landlords will require some proof or back up documentation to substantiate a tenant’s request for accommodation. If it becomes apparent that a tenant has overstated or fabricated such need, this can quickly erode any goodwill between the parties and may make a mutually acceptable and timely resolution that much more difficult to achieve.
In the event that the parties are able to come to a mutually agreeable resolution, said agreement should be put into writing in a formal agreement as quickly as possible thereafter. The majority of leases will contain clauses that require amendments to the lease to be both in writing and signed by both parties. As such, verbal agreements alone are not recommended. In reducing such arrangements to a written agreement, it will be important that both parties, at minimum, ensure the following are included:
a) a consideration clause;
b) the terms of any such agreements, including;
i. is the agreement a deferral, abatement or some combination of both;
ii. when does it take effect (and is it retroactive to a particular time or date);
iii. when will it end (or upon the occurrence of what events will it end);
iv. will interest be charged on any rent deferred and at what rate;
v. will the tenant be required to provide any additional security;
vi. are any other terms of the lease to be amended; and
vii. how can the agreement be extended or amended by either or both parties;
c) time shall continue to be of the essence;
d) the lease shall continue to remain in full force and effect, subject only to the terms and conditions as stated in the agreement;
e) conditions for the deferral or abatement (for example, tenant is not otherwise in default under the lease and/or agreement; tenant is not bankrupt or insolvent etc…) and consequences for failure to comply with said conditions (for example, termination of deferral or abatement; immediate acceleration of all rent previously deferred or abated, including any interest, if any, on the rent so abated or deferred);
f) a clause stating that any amendments, forbearance or other such concessions granted by either party in the agreement shall not be deemed to constitute any waiver of any other clauses in the lease; and
g) an obligation to maintain the confidentiality of all the terms and conditions agreed to and contained in the agreement.
While these agreements are time sensitive, failure to properly and clearly set out the terms and conditions governing the agreement can lead to material issues (and costs) in the future. Remember, lawyers will not get rich by properly papering these arrangements, they will get rich by litigating improperly or non-documented arrangements in the future!
Operating Costs and Property Taxes
Landlords and tenants should carefully examine both operating costs and property taxes to identify where any savings can be achieved as a means to help provide relief to tenants during the pandemic. For example, administration and/or management fees, marketing and promotion charges and reductions in services during the pandemic are some items that may be reduced or eliminated in the short term. In some municipalities, property taxes have been suspended resulting in potential short-term savings for both the landlord and the tenant. These are just a few examples of some of the items that landlords and tenants should be reviewing to try and find savings as soon as possible. Although the potential cost savings in these areas may not be the only solution, they should not be overlooked. Every penny counts!
In addition to the items already mentioned above, landlords will have some additional items they will need to consider.
a) Timely Responses
Landlords should respond in a timely fashion to all requests for rent deferrals or abatements from tenants. Further, landlords should formally respond to tenants who have arbitrarily elected to not pay their rent. Landlords will want to preserve their rights under the lease and clearly communicate their expectations to their tenants until formal agreements can be reached, if any.
A formal rent deferral and abatement agreement may be too detailed and timely to enter into quickly. Further, landlords may be reluctant to enter into longer term agreements with tenants when the situation is so fluid and circumstances change on a moment’s notice. As such, a simple “stand-still” agreement, whereby the landlord does not forgive the non-payment of rent but does agree to withhold enforcement of its legal rights for a defined period of time, may be advisable in certain circumstances while the parties work out the terms of a more formal and longer-term solution.
c) Third Party Obligations
Additionally, landlords will also want to make sure that they have reviewed their lending and co-ownership agreements (as applicable) to ensure they are fully aware of their obligations and liabilities with respect to outside third parties before they agree to any deferrals or abatements with any tenants. Many such agreements will contain prohibitions on the landlord varying the terms of the lease, including any changes to the rent, without notice and consent of said third parties. Landlords will want to ensure they fully understand and are in compliance with their obligations under such third-party agreements before entering into any arrangements with a tenant.
The challenges currently facing the commercial real estate industry are enormous and of a kind few of us have witnessed before and hopefully never will again. While some parties are choosing to take an aggressive and uncompromising approach to negotiations, many believe that the key for both landlords and tenants in these trying times is to initiate and maintain a line of communication in a spirit of cooperation and good faith throughout this crisis. Landlords may likely hold the upper hand from a legal perspective in many leases. However, their options are likely to be limited in many instances due to an expected material wave of business closures once the dust settles and life slowly starts to return to normal. Landlords and tenants need each other. Both have significant financial pressures that limit and ultimately govern their available options. It is incumbent on both parties to work collaboratively and in good faith to find mutually acceptable resolutions that will allow both arties to survive in the short term and emerge from this crisis. Fortunately, it appears many landlords and tenants are proceeding to undertake such discussions in a mutual spirit of cooperation and good faith. It is imperative that once resolutions have been reached, that these agreements are properly and expeditiously documented with appropriate detail so as to avoid further legal issues and costs at a later date.
GLLS is here to assist you and your business or organization in navigating these challenging times. For any specific questions, please don’t hesitate to contact the author at email@example.com or 403-392-5287.
This is paper is not intended to be construed or received as legal advice. These matters can be very complicated, and the appropriate advice provided is very often fact specific to an individual party or lease. In addition, the laws can vary based on different jurisdictions. For legal advice specific to you or your lease, please contact your legal advisor.
Further, circumstances are changing rapidly as this pandemic develops and as all levels of government intervene. As such, the commentary provided herein may not be applicable in light of changes that are implemented subsequent to the publication of this paper.
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