Many small businesses have asked the Clinic whether they are still bound by their commercial leases when the COVID pandemic has made it almost or totally impossible for them to operate their businesses.  These are similar to the questions raised by many students in college towns throughout the United States regarding the apartment leases that they signed in March 2020 or earlier for the next fall semester.  There is no easy answer to these questions under contract law, and the best course is probably to initiate a discussion with the landlord or other counterparty.

We will use for example the small-restaurant hypothetical that we have used in previous posts.  Two recent college graduates, Mary and Marty, own and operate a small restaurant, M & M’s Pasta Delites, in downtown State College, Pennsylvania.

There are several defenses that commentators have been discussing with respect to COVID-related breaches.  Contracts, including leases, often have a force majeure clause that, depending on its language, may excuse a party from performance.  The typical clause excuses a party’s failure to perform due to an unforeseen extreme event that is beyond the control of the non-performing party. These events often include weather-related emergencies, fires, government actions, riots, wars, strikes, and other work stoppages.

 

 

Invoking a force majeure defense may sound like a good course of action for a tenant or other party when a governmental authority has imposed shutdown, percentage-occupancy or other COVID-related restrictions on its business.  However, the defense is only available if the applicable contract contains this defense, and many leases and other contracts exclude payment obligations (e.g., rent) from the defense.  Moreover, leases often provide this defense to only the landlord.  Even if a party may want to invoke the defense, the terms of the applicable clause may expose the invoking party to an unintended termination of the contract.

We have on occasion used other common law defenses (developed in case law) to assist clients with renegotiating their contracts during the COVID crisis.  A party may have an excuse to performance when performance has become commercially impractical. Many states, including Pennsylvania, have followed the Restatement (2d) of Contracts position in Section 261 that a party’s duty to perform under a contract is excused where “performance is made impracticable without his fault by the occurrence of an event the non-occurrence of which was a basic assumption on which the contract was made.”  The unforeseen event must be something more than dire economic conditions.

Another defense recognized in the case law is frustration of purpose, which is similar to the commercial impracticability defense.  The frustration of purpose defense requires the non-performing party to show that there has been a change in circumstances that makes the other party’s performance virtually worthless to the non-performing party. In other words, the principal purpose for the contract is substantially frustrated by the intervening event.

In Mary and Marty’s situation with M & M’s Pasta Delites, let’s assume that the Commonwealth of Pennsylvania has issued an order shutting all restaurants for indoor dining due to the COVID pandemic.  It is unlikely that their lease has a force majeure clause that gives them the right as a tenant to stop paying rent.  The defense of “commercial impracticability” is likely not useful to a tenant to excuse its obligation to pay rent.  The government shutdown order affects the tenant’s ability to use the leased premises as a restaurant and generate revenue but does not directly affect its ability to pay the rent.  The better argument for a tenant is known as “frustration of purpose.”  If the lease requires that the premises are to be used for a restaurant, as is often the case with a restaurant lease, the tenant may be able to argue that its purpose in making the lease – to obtain use of the premises for operation of a restaurant– was frustrated by the shutdown order.

 

A number of state and local governments have enacted short-term orders that freeze rent or outlaw evictions during the pandemic, but these orders typically do not to protect commercial tenants.  Most professionals have recommended that a tenant with a desire to continue its business should discuss the situation with its landlord in an effort to get some relief while revenue has disappeared or slowed to a trickle.  A landlord may be willing to reduce or forego rent during a shutdown, or perhaps defer the rent for later payment over a number of months.  When the landlord foresees difficulty replacing the tenant quickly, a landlord may be willing to forebear from its remedies against a defaulting tenant if the tenant is able to continue to pay taxes as they come due and cover the cost of maintaining the premises during the shutdown.

A typical lease provides that a landlord may declare a default, evict the tenant and collect all of the remaining rent (through the end of the lease) along with costs and penalties.  A lease may also have a confession-of-judgment clause under which the landlord may obtain from a court a judgment against the tenant without the notice and hearing requirements normally required for a judicial proceeding.  However, in an environment when there are far more businesses that are closing than opening, the landlord would be faced with a difficult question: “then what?”  The landlord may be better off betting on the revival of the tenant at some point in the future vs. evicting the tenant, obtaining a judgment that it cannot collect and having a property that will certainly be vacant for a substantial period of time.

It is worth reminding individuals that they have a weaker bargaining position if they have personally guaranteed a lease for their business.  It is common for landlords and banks to insist that the founders of a new business, as with Mary and Marty in our example, guarantee the performance of their business.  If a landlord or bank presses for full performance by a company and any guarantors, there is always the possibility that the all or some of the debtors may choose to file for protection in bankruptcy in order to stop the rent collection and eviction process and ideally negotiate concessions under the lease to preserve the going concern value of the business.

Tenants cannot simply assume that landlords are greedy and heartless if they refuse to renegotiate non-performing leases during the COVID pandemic.  Commercial real property landlords feel the cash squeeze from COVID business conditions too.  The lease between a tenant and a landlord is the last link in a chain of connected contracts.  Landlords typically have financed their ownership of the property by borrowing from investors and using the property and the stream of rent as collateral. When the rent payments stop flowing in from tenants, landlords are strapped for cash to pay their own debts.  A landlord might want to compromise with a tenant on rent while the tenant’s business is struggling with COVID conditions.  But, its ability to compromise may be hampered by covenants in its debt obligations that prohibit the landlord from making any rent concessions to its tenants.

The Clinic is available to help small businesses with their contractual issues during the pandemic.  Our clients include not only tech-based startups in college towns across Pennsylvania, but also many fitness studios, hair salons, restaurants, and other retail establishments that often operate in rental properties.

 

This post was written by Tom Sharbaugh, Director of Penn State Law’s Entrepreneur Assistance Clinic. It was edited by Riya Anchi, a third-year student at Penn State Law and a member of the Clinic.