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Commercial Lease Default Rates Expected to Rise as COVID-19 Continues to Impact Businesses – April 1st, 2020 Update

By Alan Sorem, Real Estate & Land Use Attorney

The recent quarantine orders have had significant impacts on individuals, businesses, and the economy. Commercial lease default rates will spike as retail and office users are forced to close or dramatically change their businesses. Effective April 1, 2020, Oregon Governor’s Executive Order 20-13 ordered a moratorium for evictions of commercial leases for 90 days, subject to extension or termination by the Governor, for defaults caused by the failure of a tenant to pay rent, late charges or utility charges. Tenants must provide a landlord notice, within 30 days of unpaid rent being due, with documentation or other evidence that the nonpayment is caused by, in whole or in part, the COVID-19 pandemic. Acceptable evidence includes proof of lost revenue caused by any governmental order. Executive Order 20-13 is in addition to prior state orders in Oregon and Washington that already limit access to court proceedings.

None of these executive orders directly change the terms of the parties’ lease obligations with the exception of the recent order prohibiting late charges or other penalties arising from nonpayment defaults tolled by this order. Therefore, the parties must rely on the express lease terms and common law to determine what relief is available from their respective duties and what new obligations may apply.

If a tenant intends to continue to accept exclusive possession of the property notwithstanding the moratorium on evictions and notwithstanding a payment default, the tenant should attempt to reach a prior understanding with the landlord in addition to providing notice. Otherwise, the tenant could be sued for all rent due and owing under the lease, which often includes the right to seek all future rents owed and other costs and fees. 

Considering these significant risks to both parties, early communication is advisable to all. Such negotiations should consider three items: 1) does the lease include an applicable force majeure provision; 2) the parties’ mutual obligations of good faith; and 3) the potential defense to performance available under common law.

 

Force Majeure 

The lease may include an express force majeure provision as to what might happen if a party cannot meet its obligations due to a pandemic or government action. Most leases address historical impacts from “acts of god” through obligations to obtain insurance. Insurance policies should be reviewed; however, it is unlikely such policies cover pandemics or related government restrictions. If the lease includes an obligation for construction services, it is more likely that a force majeure provision is provided and applies. However, most commercial leases do not contain such clauses. Therefore, many lease disputes will be governed by common law obligations of good faith and the potential defense provided by the doctrine of frustration of purpose.

 

Good Faith

All contracts have an obligation for good faith, which means parties must act in an honest manner consistent with commercially reasonable practices. In a commercial lease situation during, the obligation for commercially reasonable practice might require a landlord to assume more stringent cleaning policies for common areas and any other areas typically cleaned by the landlord or landlord’s agent. Cases for landlord supplied tenant improvements and other services may require the landlord to ensure that such agents are implementing social distancing and cleaning recommendations.  

 

Doctrine of Frustration

Notwithstanding a tenant’s attempts to maintain its business, the tenant’s ability to continue to use the property and/or pay rent may be limited or prohibited. In such cases, a tenant might be able to discharge their obligations under the lease due to the doctrine of frustration. 

In leases, the party may be relieved of an obligation if the party proves all of the following: the lease was entered into with a particular primary purpose; both parties mutually understood the primary purpose of the lease – even if it was not expressly stated; something substantially frustrated that purpose; the cause of the frustration was something that the parties mutually assumed would not occur, and the risk of the frustrating circumstance was not impliedly allocated to the party who later seeks rescission. The party seeking relief must show that the frustration is substantial. It is not enough that the transaction has become less profitable for the affected party. If it is was possible to reasonably foresee the event, there will be no relief.

Modern commercial leases almost always provide for an express statement of a purpose. Where a tenant was forced to close their business, a defaulting tenant may show that their purpose was frustrated. However, we do not yet know how long such closures will last. A closure for a period for many businesses will not be a complete frustration as oppose to single-event-based transactions. The foreseeability of a pandemic and the related government responses together with the duration and scope of the closures (compare a bar that is completely closed, versus a restaurant that serves take-out meals, versus a professional office use) will vary greatly limiting the ability to predict legal outcomes. 

 

Recommendations for Negotiations

Below are a few practical recommendations that may help parties with their understanding of their new obligations and potential defenses.

1.        Judicial relief will likely be delayed, so parties should be motivated to resolve issues outside of a court order.

2.       The courts will open again, so parties should not act as if there will never be legal recourse.

3.        Express terms of a lease should still be expected to apply, but reasonable accommodations should be considered as part of an overall obligation of good faith. 

4.      Parties should communicate with one another how recent events are affecting their ability to perform and create a record of such communications.

5.       Anticipate that the obligation for commercially reasonable dealings will impute the application of local, state, and federal orders about cleaning and social distancing standards.

6.       Understand that proving to a court that complete discharge of the duty to pay rent will be difficult to meet for many tenants.

7.       Parties have a duty to mitigate their losses before seeking recovery of their damages.

8.      Remember that issues affecting leasing obligations often affect the borrowing obligations of the landlord and/or tenant, and such borrowing relationships should be considered in any lease dispute.

 

If you have any questions regarding how to handle a potential lease dispute related to the Covoid-19 pandemic, please contact Alan Sorem or the other attorneys in the Real Estate and Land Use group.

 

Alan Sorem is a partner in the Real Estate & Land Use practice group and the Financial Services and Construction industry groups. The information in this article is not intended to provide legal advice. For professional consultation, please contact Alan Sorem at Saalfeld Griggs PC.  503.399.1070.  asorem@sglaw.com © 2020 Saalfeld Griggs PC