COVID-19: Every Commercial Lease Is Under Review
The spread of COVID-19 is having a significant impact on many businesses as they feel the effects of stay-at-home orders, non-essential business closures, market instability, labor issues, and supply chain disruptions caused by the pandemic. While the full legal, regulatory and commercial implications of COVID-19 will continue to develop, the following information may prove valuable in assisting commercial landlords and tenants with a host of difficult questions related to existing lease obligations in the face of the unprecedented (at least in modern times) impact of COVID-19.
COMMERCIAL LEASE OBLIGATIONS
For many businesses, real estate carrying costs are among the largest line items in their expense budget. Until the recent pandemic, most companies presumed that they would not have a business without a place for their employees to gather together and work.
The employees of most businesses, absent an exemption from the applicable governmental authorities, have been ordered to remain away from their places of business for at least two months, following which there will be a structured phase-in period before occupancy can go back to “normal” levels. As a result, many commercial tenants are requesting rent relief, and landlords are attempting to respond to these requests in a strategic manner, taking into account the ongoing commercial viability of their tenants.
START WITH THE PROVISIONS OF THE LEASE
A lease is a contract, and the first place to start is to review its provisions, in particular, the following:
- Force majeure;
- Interruption of access or services; and
- Business interruption insurance.
Most force majeure clauses make reference to national emergencies, and many specifically reference epidemics or pandemics. However, in most cases, a force majeure may postpone performance of required actions, but usually state that the existence of a force majeure event does not forgive the payment of rent.
Interruption of Access or Services
Leases often expressly cover circumstances where access, services, utilities, etc., are interrupted. These clauses often provide that after the passage of a certain number of days, rent is abated. However, these provisions often limit any such abatements to circumstances due to the control, negligence or fault of the landlord, and sometimes expressly exclude force majeure events.
Business Interruption Insurance
Many leases make specific reference to business interruption insurance and may require the tenant to maintain such coverage. Occasionally, leases require a landlord to maintain the same.
If a landlord maintains business interruption insurance, the premiums of such insurance are likely to be included in maintenance charges, all or a portion of which may be passed through to the tenant. In such circumstances, the tenants will certainly argue that they are entitled to the benefit of such coverage.
Such lease provisions typically require insurance to cover interruptions for a period of 12 months, but generally have not contained many other details as to such coverage. The current COVID-19 pandemic has brought attention to the virus exclusions contained within many commercial property and business interruption policies. It is expected that new leases will require tenants to obtain coverage on forms that do not contain a virus exclusion. Landlords may also require tenants to purchase a policy containing a coverage extension for communicable disease. These policies may cover lost business income and expenses if a space is ordered to be closed or decontaminated by a public health or governmental agency as a result of the discovery or suspicion of an outbreak of a communicable disease. Such coverage extensions may come with their own separate sub-limits of liability. Insurance premiums for such coverages are likely to increase in the wake of COVID-19.
Depending on the tenant’s industry and the nature of the property, tenants may also want to procure event cancellation insurance or environmental liability insurance, and the landlords may want to be named as an additional insured.
Most leases include an express covenant of quiet enjoyment, and the same is provided as a matter of law. In the coming months, it is likely that the scope of such a covenant will be tested in the courts. In addition to the foregoing, other clauses such as provisions imposing a duty of continuous operation and co-tenancy requirements, which are often found in the retail leases, should be reviewed carefully.
NEXT, EXAMINE THE FACTS
Many would argue that the COVID-19 pandemic caused by the novel coronavirus is a force majeure event. It is clearly a national emergency, and many businesses have been ordered to close by governmental authorities. However, essential businesses have been allowed to continue to operate, although supply chain and other COVID-19 disruptions may be impacting their ability to do so.
As to whether there has a been an interruption of access, landlords will likely point out that access to premises has not been prevented, that their buildings are open, and that while the current governmental orders bar employees from going to work, tenants have generally not been denied access. Tenants will argue that as a practical matter, they simply cannot use their rented space.
Having reviewed the terms of the leases, where do businesses go from there? Depending on lease terms and circumstances, tenants are requesting benefits ranging from outright forgiveness to deferral of rent. The first question is, how much? It is too soon to tell, but it appears that the stay-at-home orders will have a duration of approximately two months followed by a return-to-normal phase-in period of uncertain duration. In making requests for relief, tenants need to consider the period of time it will take their businesses to return to some level of normal operations. For example, educational institutions think in terms of semesters. Other businesses have to consider the availability of supplies, materials and the other items necessary to operate.
One of the most problematic scenarios is when the leased space is currently under construction. It is too soon to tell how quickly permits, materials, supplies and manpower will become available.
Landlords will, as stated above, be quick to point out that their buildings continue to remain in service. However, landlords are generally mindful of the impacts of the current crisis and are generally willing to work with tenants – although, so far, rent deferrals appear more common than rent abatements. A landlord will typically ask for current financial statements and information with regard to the structure and ownership of the tenant. They will also want to know whether the tenant has pursued all other avenues for financial relief, including applying for Payroll Protection Program (PPP) funds, a portion of which can be used to cover rent.
Many businesses have been frustrated by the difficulty and sometimes impossibility of obtaining PPP funds. However, it will certainly help in negotiations to be able to tell the landlord that the tenant properly applied for PPP funds and advise the landlord as to the status of the same.
Keep in mind that this discussion is primarily with respect to the payment of rent and additional rent. It is unlikely that parties will insist on enforcement of specific deadlines and/or performance of various obligations, such as construction, continuous operations, etc., during the current crisis.
The variables therefore are the amount of rent that will be the subject of the proposed restructure, the timeframe of the restructure, and whether the same is to be forgiven or deferred.
The parties should enter into a confidentiality and nondisclosure agreement when any such negotiations commence.
Phillips Lytle has already engaged in a number of transactions where rent for the lockout period is deferred and payable over a number of months. The amount, the commencement date of the repayment, and the duration of the repayment are negotiable variables. Some of these agreements may contain a partial forgiveness of rent, which is generally subject to certain conditions.
It is also possible that a tenant may want to apply an existing security deposit to cover the rent during the lockout period. The question then becomes when and if the security deposit will be replenished.
Negotiations are made easier if either party can offer incentives to the other. For example, a willingness on the part of a tenant to extend the term of their lease can go a long way to securing rent relief from landlords. On the flip side, a tenant may need an adjustment to the amount of space they are leasing. A landlord will usually want a tenant to take on more space, whereas under the current circumstances, many tenants are having to consider downsizing. Of course, many tenants that had been on a growth trajectory cautiously hope that such trajectory resumes when the COVID-19 crisis winds down.
Before such discussions commence, it is in the best interests of all parties to enter into an agreement, providing that all discussions are confidential and that the same are non-binding until finalized.
Landlords may need the approval of their lenders to grant any rent concessions.
The COVID-19 pandemic will likely lead to many modifications of lease agreements. Any lease modification presents a good opportunity to update the lease for this new era. For example:
- If not already stated, a lease should be amended to provide that it can be signed in counterparts, and that a transmission of a signed lease via PDF or other electronic data transmission constitutes an original agreement; and
- Notice provisions should be updated to include electronic notices. It may also make sense to expressly provide that notices of any type, including default notices, may be given by the attorneys for the respective parties. The updated provisions should expressly provide that each party waives any defenses to enforcement based on electronic signature or the delivery method of the notice.
- Operating expenses for commercial properties are going to increase with respect to items such as increased cleaning and upgraded air handling. Existing expense pass-through clauses should be reviewed carefully, and future leases should take such increases into account.
For further assistance with the specific business impacts of COVID-19, please contact a member of the Commercial Leasing Practice Team; the Insurance Coverage Practice Team; the Coronavirus (COVID-19) Response Team; or the Phillips Lytle attorney with whom you have a relationship.