Dec 05, 2020
Commercial Lease Restructuring Update from the Trenches: The Surprising Tenant Defense You May Be Overlooking
Dec 05, 2020
By Jeffrey H. Lerman, Philip R. Diamond & Daniel E. Dersham
COVID-19’s most urgent and significant impact on commercial tenants and landlords may be the sudden inability of many commercial tenants to pay their rent and the resulting challenges to their commercial landlords. Nine months into the pandemic, the authors have had the opportunity to represent both tenants and landlords in commercial lease restructurings. Based on our experience, you may be overlooking a surprising tenant defense if you represent a commercial tenant attempting to negotiate a restructuring or termination of its lease (and consider forwarding this article to your friends or colleagues who are commercial tenants—they will thank you).
Commercial tenant lawyers often discount the doctrine of commercial frustration as a defense because the general belief is that it is unlikely to succeed. Our advice? Don’t give up on it too readily: If the right facts are present for the tenant, both statutory and case law could lead to an acceptable lease restructuring or termination.
Under the doctrine of commercial frustration, tenants in COVID-19 commercial lease disputes 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 becomes unlawful to operate by operation of law, all obligations under the lease are terminated as of the time it becomes unlawful to operate the business, even if the prohibition is temporary. See, e.g., Lloyd v. Murphy (1944) 25 Cal.2d 48, 50 (“The principles of frustration have been repeatedly applied to leases by the courts of this state.”); Federal Leasing Consultants, Inc. v. Mitchell Lipsett Co. (1978) 85 Cal.App.3d Supp. 44, 47 (lease for electric burglar alarm system was discharged when it became unlawful to use the radio waves required for the system); Industrial Development & Land Co. v. Goldschmidt (1922) 56 Cal.App. 507, 509 (lease for wine and liquor business was discharged upon passage of Prohibition); and 20th Century Lites, Inc. v. Goodman (1944) 64 Cal.App.2d Supp. 938, 945 (lease for neon advertising lights placed upon the lessee’s business was permanently discharged due to temporary wartime government order banning nighttime illumination).
If a lease has a force majeure clause with a carve-out for rent (i.e., rent must still be paid even if a force majeure event occurs), tenants arguing commercial frustration can expect landlords to argue that the contractual provision takes precedence over the above caselaw. [Editor’s Note: For a general discussion of force majeure and COVID-19, see Daniel Schneider’s article in the June issue of the Marin Lawyer.] In response, tenants have a strong statutory argument, as follows: The common law doctrine of commercial frustration is codified in Civil Code section 1511. (Northrop Corp. v. Triad Intern. Marketing S.A. (9th Cir. 1987) 811 F.2d 1265, 1270.) Section 1511(1) provides for discharge of an obligation, “[w]hen such performance…is prevented…by the operation of law, even though there may have been a stipulation that this shall not be an excuse….” (Emphasis added.) Parties may not contract around that subsection: If there is a conflict between that subsection and the contract, section 1511(1) 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 this provision specifically in the case of a lease, the statute provides a strong argument that a carve-out in a contractual force majeure clause for payment of rent is unenforceable where the purpose of the lease has been frustrated.
Factors That Increase the Likelihood of Tenant's Success in Arguing Commercial Frustration
Finally, our experience has also revealed there is a higher likelihood of tenant success in restructuring or terminating an otherwise valid lease using the doctrine of commercial frustration when:
- The tenant is engaged in a business that has been especially affected by jurisdictional COVID-19 restrictions (such as a salon, gym, theatre, family entertainment center, etc.);
- The lease is clearly tailored to the tenant’s unique use as the primary purpose of the lease, and the COVID-19 restrictions directly frustrate that purpose;
- The tenant is not arguing merely that payment of rent has become more difficult due to COVID-19 restrictions, but rather that the actual business operations have been prohibited or substantially restricted;
- The tenant is in good standing under the lease and has flexibility to pay a modest settlement amount to terminate the lease (if termination is what the tenant wants); and
- No end or meaningful loosening is in sight for the COVID-19 restrictions affecting the tenant’s business.
The doctrine of commercial frustration can work to restructure or terminate a lease in the right COVID-19 circumstances and, of course, a tenant should work with a lawyer who knows how to handle this negotiation.
Jeff Lerman, Co-Founder of Lerman Law Partners, LLP, has a national reputation as “The Real Estate Investor’s Lawyer”® and is also a real estate investor. He focuses on helping investors with their transactions and litigation. He is Past President of MCBA and included in the list of Super Lawyers. You can reach him at email@example.com.
Phil Diamond 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. Phil is also a licensed real estate broker, commercial landlord, and developer. You can reach him at firstname.lastname@example.org.
Daniel Dersham is an attorney with Lerman Law Partners, LLP, in San Rafael, regularly representing commercial landlords and tenants, investors, developers, corporate clients, and individuals in the purchase, sale, financing, leasing, and development of residential and commercial real estate. You can reach him at email@example.com.