Legal Overview and Rent Relief Negotiation Tips for Commercial Tenants During COVID-19

Updated as of April 4, 2020

Commercial tenants who have lost the use of their spaces as a result of impacts from the 2019 novel coronavirus disease (“COVID-19”) need to understand their legal exposure, and how to strategize for post-pandemic recovery. This article provides a legal overview of issues office tenants in California and New York are facing due to COVID-19, and some practical pointers on approaching workout negotiations. Of course, each case is unique and tenants should review their lease documents and consult with counsel to see how these considerations apply to them.

Force Majeure Clauses.

Closures due to a global pandemic or governmental orders related thereto, such as the Shelter in Place Order in effect in San Francisco or the NY State on Pause order in New York, may fall within the definition of a “force majeure event” in a lease. However, in most cases, a force majeure clause does not excuse or toll a tenant’s obligation to pay rent. Historically, tenants accepted this position based on the assumption there were recovery rights via business interruption insurance, or rent abatement under a lease casualty clause, but unfortunately those assumptions do not hold true in the current situation.

Note that while force majeure clauses likely won’t excuse tenants’ performance of monetary obligations, they may be utilized to excuse tenants’ performance of non-monetary obligations in contexts where COVID-19 impacts prevent fulfillment, such as:

·      preventing a claim of “holdover” if a tenant is unable to vacate due to a shelter in place order;

·      arguing against alleged “tenant delay” that can accelerate commencement dates if a tenant is unable to complete tenant improvements as a result of civil authority orders;

·      avoiding claims for delay in delivery of possession to a subtenant;

·      arguing against alleged defaults due to violation of open and operating covenants; or

·      preventing the trigger of a good guy guaranty based on failure to perform a non-monetary obligation such as repairs or maintenance.

Moratorium on Evictions.

California and New York have taken aggressive steps to provide temporary protections for commercial tenants against enforcement of eviction proceedings. Pursuant to Executive Order N-28-20, Governor Newsom enabled California municipalities to institute moratoriums on commercial and residential evictions attributable to COVID-19. San Francisco Mayor London Breed then issued a supplementary proclamation mandating a 30-day moratorium on evictions of commercial tenants with 2019 global gross receipts equal to or less than $25 Million (the tenant-friendly mechanics are summarized in detail in this article published by law firm Buchalter). In New York, Governor Cuomo issued Executive Order No. 202.8 prohibiting enforcement of commercial evictions of commercial tenants for a period of 90 days.

Tenants must understand that these protections defer evictions, but do not provide for rent abatement, forbearance, or waiver of defaults - failure to pay rent still constitutes a default. More, even if an eviction action is delayed, tenants could lose other rights (reduction of deposit, extension/expansion/renewal rights) if they miss a payment. Further, as these orders do not toll the timelines for bringing unlawful detainer actions, Landlords in both California and New York have already started preparing eviction actions in order to reserve their place in line for enforcement action once the moratorium is lifted. 

Insurance Coverage.

The information provided in this update is simply an overview of the mechanics of business interruption insurance as applied to commonly issued policies for office tenants. Tenants should consult with insurance experts to understand their particular coverage terms and consider the best strategy for their individual situation.

Most insurers are taking the position that business interruption policies will not cover losses arising from COVID-19, and insurers are resisting equitable arguments or legislative actions challenging their denial of coverage.

Business interruption insurance is intended to compensate a tenant for disruption caused by property loss. To successfully exercise a claim, most policies provide that the insured party must present evidence of physical property damage that is included on the policy’s list of covered perils.

While physical contamination of tangible property may satisfy the physical threshold requirement, infection between individuals and precautionary measures taken to prevent the spread of infection from a pandemic may not. This is likely to become a hotly contested issue, and an uphill battle for tenant-insured parties. In anticipation of insurance company claim rejections due to COVID-19, a restaurant in New Orleans has already filed a lawsuit seeking a declaratory judgment that damage from COVID-19 fulfills the physical damage threshold.

Even if the physical damage threshold is met, business interruption policies commonly exclude spread of a viral pandemic from the list of covered perils (an action taken following the SARS outbreak). In addition, some insurers may try and resist coverage by arguing that COVID-19 constitutes a “pollutant” that is subject to pollutant exclusions.

In response to COVID-19, bipartisan members of the U.S. House of Representatives wrote to the insurance industry requesting they participate in coverage, but to no avail yet. Also, the Insurance Services Office has issued endorsement forms offering limited coverage for income loss and expenses resulting from government-ordered closures or quarantining of a premises or even suspension of certain forms of public transportation. But these would only be prospective solutions for future occurrence. The forms have not yet been filed with any states and what such coverage will cost remains to be seen.

Despite the insurance industry’s collective firm stance on COVID-19 claims, some insurance litigators like Miller Friel PLLC point to precedent casting doubt on what the insurance companies are saying. Accordingly, each tenant should engage its insurer to review their policies, and even if the likelihood of coverage seems low under current law, file a claim so if the law changes, they will have their place in line for relief.

Limited Government Relief

The U.S. Small Business Administration, as well as New York and California governments have been rolling out relief programs that aim to put capital in the hands of business owners injured by COVID-19. The SBA’s Paycheck Protection Program seemed the most promising way for small businesses to secure rent relief, in that it offers partial loan forgiveness if funds are used for payroll costs, interest on mortgages, rent, and utilities between February and June 2020. But following extremely high subscription and lack of guidance, the SBA issued an interim rule on April 3 clarifying that despite earlier statements, only up to 25% of the forgiven loan amount can be used for non-payroll expenses. For companies renting space in high rent markets like New York and San Francisco, this is of limited value.

Further, tenants with venture-backed funding or private equity investment may not be eligible for PPP loans due to affiliate restrictions. Note that the NVCA has been lobbying for exceptions to the affiliate rules for startups, but as of an interim rule issued by SBA on April 3, only non-profit and faith-based organizations have been granted an exception from such rules.

Common Law Contract Defenses and Novel Claims.

Given the current lack of relief available under lease agreements and insurance policies , common law defenses to contract enforceability may become bases for lawsuits. Most notably, tenants may bring forth defenses based on “frustration of purpose,” “impracticality,” and “impossibility”  Be aware these concepts are narrowly interpreted in California and New York, but may gain traction the longer shelter in place orders and economic shutdown continues. For more information on common law defenses, see this article published by Baker McKenzie.

In addition, tenants may argue that current government-ordered closures constitute a public taking, entitling them to abatement as per the lease terms; however, while a creative approach, it is novel and without legal precedent.

Seeking Relief Now – A Practical Approach.

In the aftermath of an unprecedented, total shutdown of office occupancy due to COVID-19, recovery will require the cooperation of tenants and landlords, regardless of the lease terms. Moreover, landlords’ lenders will need to be reasonable in adjusting loan covenants that enable landlords to agree to rent abatements or deferrals, and in refinancing commercial mortgage debt. However, until the end of the COVID-19 crisis, or until responsive legislation is passed at the federal and state levels, it may be premature for parties to meaningfully engage in lease workouts. In the meantime, tenants should negotiate for short term abatements and deferrals. Here are some tips:

·      Know Your Landlord. Tenants must consider a landlord’s organizational structure and financial position in strategizing relief requests. Is the building encumbered and/or part of a larger portfolio (possibly securitized and subject to stringent loan covenants)? Is the landlord a mom and pop or a global REIT? Levels of autonomy and pain threshold will vary greatly and negotiating strategies should be tailored accordingly. The Federal Reserve issued a press release encouraging mortgage lenders to work out loan restructuring with borrowers (landlords), noting that COVID-19 related workouts will not automatically be characterized as “troubled debt restructurings.” Hopefully, that will provide larger landlords with more freedom to negotiate with tenants.

·      Respect Your Rank. To date, Landlords have been far more responsive to relief requests from retailers who have lost nearly all revenues than office tenants. In approaching landlords, office tenants should be armed with data indicating financial damage suffered, and a narrative explaining how their particular business has been harmed by the office closure due to COVID-19. If business is largely functional on a remote basis, tenants should expect less movement – but while keeping in mind that few losses means business is good!

·      Be Realistic. To date, tenants have no legal right to relief, and office landlords have been far more receptive to requests for short-term deferrals rather than abatement. Aggressive negotiations may be counterproductive or backfire, particularly if a tenant cannot substantiate material losses.

·      Think Now and Later. For the moment, temporary requests - 2-3 months of deferred rent, draw down upon a deposit with deferral of replenishment - are more achievable than a comprehensive lease restructuring. You can re-approach for more when the market has stabilized.

·      Get Creative.  Negotiate repayment of deferred rent via (1) an extension at the end of the term (so the tenant at least gets the benefit of a longer tenancy) or (2) amortized in monthly payments over the remaining term, so rent will only increase slightly. If appropriate, offer the landlord a lien on furniture or offer to transfer title to the landlord upon expiration so the landlord can market the space plug & play.

·      Communicate Strategically. Tenants should leverage personal landlord contacts and relationships in delivering requests and to the extent possible, communicate via business principals rather than attorneys or even brokers. While shadow counseling is very helpful in preparing a narrative for landlord discussions, the message will be best received from a stakeholder.

Feel free to share this work with anyone who may need help dealing with these issues.

Laura Drossman advises clients in California and New York on commercial real estate and business law matters.

Direct: 212-674-4747

Email: laura@drossmanlaw.com

Website: www.drossmanlaw.com