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The Importance of Lease Drafting: Lease Language Takes Center Stage in “Cinemex”

When in the throes of protracted lease negotiations, frustrated clients often ask me whether a proposed term is truly necessary to the contemplated transaction.  Most clients start these discussions with the goal of achieving a fair form of lease, but as consideration of the minutiae of lease provisions continues, clients typically hit a point where they no longer wish to spend any more money on legal fees and simply want to “get the deal done.”  This sentiment is both understandable and reasonable, especially where the risks associated with a provision may not outweigh the cost in legal fees required to resolve it in a favorable manner.  This sentiment can also cause mistakes, however, if either side is so committed to consummating a transaction quickly that it is willing to sacrifice clarity or accuracy in its lease.

A recent decision out of a Florida bankruptcy court highlights the importance of the language of a lease, as something as simple as a misplaced phrase can have disastrous results. The case, In re Cinemex[1], involved a movie theater operator who filed for Chapter 11 bankruptcy protection and sought to avoid its obligation to pay rent under one of its leases pursuant to a force majeure provision. That provision excused either party’s obligation to perform its obligations under the lease for certain enumerated conditions as follows:

If either party to this Lease, as the result of any … (iv) acts of God, governmental action, condemnation, civil commotion, fire or other casualty, or (v) other conditions similar to those enumerated in this Section beyond the reasonable control of the party obligated to perform (other than failure to timely pay monies required to be paid under this Lease), fails punctually to perform any obligation on its part to be performed under this Lease, then such failure shall be excused and not be a breach of this Lease by the party in question, but only to the extent occasioned by such event.

Cinemex, the tenant, relied on the fourth subsection to circumvent its rental obligations, claiming that the Florida Governor’s orders closing movie theaters fell squarely within the “governmental action” exemption.  The Landlord argued that the subsequent parenthetical (emphasized in bold above) carved out Tenant’s obligation to timely pay rent from this exception.  The carve-out on which the Landlord relied is very common in commercial leases, where landlords insist on the continued payment of rent regardless of the circumstances.

The court found that, because of its placement immediately following the fifth subsection (for matters beyond the reasonable control of a party) rather than before or after the entire five-subsection list, the Landlord’s carve-out only applied to the fifth subsection and did not apply to the fourth subsection.  As a result, the Tenant was permitted to claim application of the force majeure provision and was excused from its obligation to pay rent during the period in which the governmental action prevented its operations at the premises. This was undoubtedly not the Landlord’s intent, and resulted in lost rent to the Landlord.

This case is a good reminder that the specific language of a lease, and its placement within the document, can be critical to determining its application.  When lease negotiations bog down, it can be difficult for clients to appreciate how a provision can be applied or why it is so important, especially when the negotiations have been ongoing for weeks or months.  But part of the reason clients hire attorneys is to ensure that this language is drafted precisely to have its desired effect. As the Cinemex decision illustrates, inartful drafting can lead to disastrous results for parties to a lease (the court in Cinemex conclude the lease was not a “well drafted document”).  While they can be stressful and expensive, protracted lease negotiations are sometimes necessary to ensure that the lease matches the parties’ intent and will be interpreted exactly as the parties desire.

[1] In re Cinemex U.S. Real Estate Holdings , CASE NO. 20-14695-BKC-LMI (Bankr. S.D. Fla. Jan. 26, 2021).

Litigation Update: North Carolina Court Finds Insurers Liable Under Business Interruption Policies for COVID Losses Resulting from Shutdown Orders

In our last update, we highlighted a recent case out of the US District Court of Missouri (Studio 417) in which the court issued a preliminary ruling that allowed a group of policyholders to proceed with claims against their insurers based on allegations that the insurers wrongfully denied claims due to losses sustained as a result of the COVID-19 health crisis under business interruption insurance policies.  Prior to that ruling, insurers had largely stonewalled policyholders who submitted COVID-related claims under business interruption policies.  That case confirmed that these individuals could state facially valid claims for recovery and seek damages from the insurers based on the allegation that the presence of the virus on workplace surfaces constituted loss of or damage to property.

In what is further welcome news to policyholders, a North Carolina court went a meaningful step further, finding the insurers liable for wrongful denial of policyholders’ COVID-related business interruption claims in that case (North State)—claims based on the effect of COVID-prompted government shutdown orders as opposed to the virus’s physical presence at a particular policyholder’s business.  The North State case involved a similar set of circumstances as the Studio 417 dispute: a collection of restaurant owners and other retailers filed a lawsuit against their common insurer, alleging a right to recover insurance proceeds to offset losses incurred due to government-mandated shutdowns that affected their respective businesses.  The insurer denied coverage, finding that no physical loss or damage had occurred such that coverage would have been triggered as required by the insurance policy.

In finding the insurers liable for breach of the insurance policies, the North State court held that the ordinary meaning of the phrase “direct physical loss” includes the loss of ability to utilize or possess the insured property.  According to that court, the “loss” requirement “describes the scenario where businessowners and their employees, customers, vendors, suppliers and others lose the full range of rights and advantages of using or accessing their business property.  This is precisely the loss caused by the [g]overnment [o]rders.”  Moreover, because nothing in the insurance policies precluded recovery for virus-related causes of losses (which is not always the case in business interruption policies), the court concluded that the ordinary meaning of direct physical loss was either clearly applicable to government shutdowns or, at worst, the proper interpretation of an ambiguous phrase in the policy.  This decision represents a major win for policyholders, who now have a final court ruling supporting their claim for coverage despite the “direct physical loss” requirement.

On the whole, insurers remain relatively successful in thwarting policyholder efforts to obtain coverage under their business interruption policies for COVID-related losses.  Whether through hardline stances at the claims stage, aggressive litigation tactics, and/or major funding advantages, insurers can often overpower their insureds and cut off these claims before reaching the courts.  These recent decisions, however, highlight the potential for recovery for policyholders who maintain their resolve in pursuing insurance coverage during these unprecedented times. While odds of success remain long, desperate and/or persistent individuals may be able to obtain recovery for their COVID-related claims if they have business interruption policies.  Only time will tell whether cases like Studio 417 and North State coalesce into a widely adopted judicial perspective on the interpretation of business interruption policies.

California Proposition 19 Limits Parent-Child & Grandparent-Grandchild Exclusion

Since 1986, when Proposition 58 passed, certain transfers of real property between parents and their children have been excluded from reassessment for purposes of determining property taxes. Proposition 58 provided an exclusion from reassessment for (1) a principal residence of the transferring parent, and (2) the first $1 million of full cash value of all “other real property” transferred from a parent to a child. Proposition 193, passed in 1996, added a similar reassessment exclusion for transfers between grandparents and their grandchildren (when the grandchildren’s parents are deceased).

In November 2020, California voters approved Proposition 19. Proposition 19 limits the tax benefits described above. Beginning on February 16, 2021, the transferee must continue to use the property as a principal residence in order to qualify for the exclusion. Family farms are also eligible, but the transferee must continue to use the property as a family farm.  Also, the property tax bill will increase if the value of the property at the time of transfer equals or exceeds the parent’s assessed value plus $1 million. If that happens, the transferee’s new combined base year value equals (1) the existing factored base year value, plus (2) the amount by which the fair market value exceeds the sum of the existing factored base year value and $1 million. For an example, see page 4 of Letter to Assessors No. 2020/061. The $1 million amount will be adjusted for inflation beginning February 16, 2023, and every February 16 after that.

Before and After Proposition 19:

Before Proposition 19Proposition 19
Principal Residence
  • Principal residence of transferor
  • No limit on value excluded from reassessment
  • Principal residence (land, in excess of area of reasonable size used as site for residence, may be excluded as “other real property”)
  • Principal residence (or family farm) of transferor and transferee
  • Limit on value that can be excluded from reassessment: current taxable value plus $1,000,000 (adjusted for inflation)
  • Principal residences and family farms
Other Real Property
  • Transferor lifetime limit of $1,000,000 of factored base year value
  • Eliminates exclusion for “other real property” other than the principal residence
Grandparent-Grandchild Middle Generation Limit
  • Parents of grandchild must be deceased on date of transfer
  • No change: Parents of grandchild must be deceased on date of transfer
Filing Period
  • File claim within 3 years after transfer, or before transfer to third party (whichever is earlier)
  • File for homeowners’ exemption within 1 year after transfer
Effective Dates
  • Through February 15, 2021
  • On and after February 16, 2021

The above chart is based on a summary published by the California Board of Equalization.

*This post was updated on January 7, 2021, to correct an error, by changing “current fair market value” to “current taxable value” in the first row of the chart above.

PPP Second Draw Loans

In December 2020, President Trump signed into law the Consolidated Appropriations Act, 2021 (the CAA).

In total, the CAA provides $900 billion in COVID relief, including $284 billion for additional Paycheck Protection Program (PPP) loans for new borrowers and “second draw” loans for existing borrowers.

The eligibility requirements for a “second draw” PPP loan (PPP2 Loan) are as follows:

1) The borrower must spend the full amount of the first PPP loan before receiving the PPP2 Loan.

2) The borrower must employ no more than 300 employees per physical location.

3) The borrower must demonstrate a 25% or more reduction in gross receipts in a quarter during calendar year 2020 compared to the same 2019 quarter.

The size of a PPP2 Loan can be up to 2.5 times the average monthly payroll costs during the 1-year period before the loan or during the 2019 calendar year. A borrower in the hospitality or food services industry (with an NAICS code beginning with 72) is eligible for a loan of up to 3.5 times average monthly payroll costs. The amount of each PPP2 Loan is subject to an overall cap of $2 million.

The Small Business Administration has not provided guidance as to how to calculate whether the business suffered a 25% or more reduction in gross receipts.

The SBA is expected to publish a new application form and guidance for PPP2 Loans.

Because the PPP2 Loan program should use much of the existing PPP framework, financial professionals believe the rollout of this new round of loans should go more smoothly compared to the initial PPP rollout last year.

COVID Relief Bill: PPP-Paid Expenses Are Deductible (Updated 12/28/2020)

This past Monday, December 21, a $900 billion pandemic relief bill came out of the U.S. House and Senate. It is called the Consolidated Appropriations Act, 2021. If President Trump signs it, it will become law. Weighing in at 5,593 pages in length, it addresses many areas, including vaccines, education, childcare, jobless benefits, energy, and national security.

Part of the bill is the COVID-Related Tax Relief Act of 2020 (COVIDTRA). One reason why COVIDTRA is getting attention is that it provides direct payments to individual taxpayers, “recovery rebates” – similar to the direct payments that went out to individuals earlier this year.

Another thing COVIDTRA does is clarify that taxpayers whose Paycheck Protection Program (PPP) loans are forgiven ARE allowed deductions for otherwise deductible expenses that were paid with PPP loan proceeds. See COVIDTRA Section 276(a)(1). This overrides the IRS’s earlier position that businesses could not claim deductions for expenses paid with PPP loan proceeds when the loan is forgiven or expected to be forgiven. COVIDTRA also clarifies the tax basis and other attributes of the PPP borrower’s assets will not be reduced as a result of PPP loan forgiveness.

When a PPP loan is forgiven, the borrower does not need to include the amount of the forgiven PPP loan in taxable income. That is a great benefit for the borrower. Now, under COVIDTRA, the ability for taxpayers to deduct expenses paid with forgiven PPP loan money further amplifies the benefits of the PPP loan.

For example, think about a partnership that gets a $100 PPP loan. The partnership spends the $100 on PPP-specific expenses (payroll, rent, etc.), and then has the PPP loan forgiven. The partnership does not pay any federal income tax on the $100. Also, according to COVIDTRA, the partnership can reduce its taxable income by $100 by deducting the $100 that it spent on the PPP-specific expenses. If the owners of the partnership are all taxed at a rate of 37% on ordinary income passed through from the partnership, $100 of PPP money (received tax free) also saves them $37 in taxes.

If it becomes law, this will be a significant tax benefit for many businesses.

On Tuesday, December 22, President Trump threatened not to sign the bill, pressing for higher direct payments and changes to various provisions.  However, on Sunday, December 27, he signed the bill as passed by Congress.

If you have further questions, please contact:

Jim Clarke – 916.558.6084

COVID-19’s Impact on Leasing and Other Transactions

By Louis Gonzalez, Jr., Josh Escovedo, and Mark Ellinghouse

California Real Property Journal

This article was first published in Volume 38, No. 4, 2020 of the California Real Property Journal, reprinted by permission.

The COVID-19 pandemic has strongly affected contractual relationships in the real estate industry. This article discusses the most important legal defenses for practitioners to be aware of, summarizes and evaluates the few recent cases considering how these defenses apply in the pandemic, and provides recommendations for limiting exposure during future pandemics.

I.      INTRODUCTION

COVID-19 has disrupted commerce and life as we know it. It has resulted in the passing of various ordinances and issuance of executive orders that have shut down businesses, disrupted the labor force, and kept the population at home. This has severely impacted countless businesses, resulting in a massive decrease in revenue and causing numerous businesses to reduce their workforce, if they are even able to stay open. As a consequence, parties have been forced to evaluate the enforceability of their lease agreements, looking for ways to either enforce or excuse performance.

Recent Federal Decision Regarding Business Interruption Insurance Could Mark a Turning Point for COVID-Affected Businesses (Updated 9/29/2020)

Many businesses affected by COVID-19 and the related shelter-in-place orders are turning to their business interruption insurance policies in hope of finding relief. In general terms, a business interruption insurance policy replaces some or all of a business’s income when the business is forced to curtail or cease its operations as the result of a disaster. In the vast majority of cases, insurance companies have turned away COVID-related business interruption claims, claiming that these policies do not provide coverage for COVID-related claims. Rather than fight with insurance companies, many business owners elect to focus their efforts on other forms of relief, including PPP loans and other forms of public assistance. But some, like the owner of the world-renowned Napa Valley restaurant The French Laundry, have sued to enforce their business interruption insurance policies.

Policy holders contend that their business interruption policies were written as part of “all-risk” property insurance coverages, which are designed to comprehensively protect against all risks except those expressly excluded under the policy terms. The insurance companies’ argument is based on a common policy term referring to “physical damage or loss” as the trigger for business interruption coverage. Insurance companies argue that this term means that coverage exists only where the business has suffered physical damage or physical loss, such as in the case of a fire or a storm—actual, tangible, physical alteration of the business’s property. Under the insurers’ interpretation, no coverage exists because COVID-19 and its effects did not cause physical damage or alteration to the policy holder’s property.

In what policy holders hope marks the start of a growing trend, one federal court in Missouri preliminarily ruled in favor of the insured businesses and against the insurance companies. The case, Studio 417, Inc. v. The Cincinnati Ins. Co. (“Studio 417”),[1] involved a collection of salon and restaurant owners whose business interruption claims were rejected by their insurer based on the physical damage or loss argument. After the businesses filed suit, the insurer brought a motion to dismiss their claims on the grounds that the business interruption policies in place did not afford protection under the express policy terms and applicable law.

The court ruled in favor of the policy holders, finding that they had adequately alleged facts that established coverage and that, based on those allegations, the insurance company wrongfully denied coverage. The court’s reasoning focused on the policies’ “physical damage or loss” triggering language. The court found that the word “or” was meaningful, that it differentiates between the concept of “physical damage” and “physical loss,” and that the business owners need only allege that they had incurred either physical damage or loss to qualify for coverage. The court reasoned that the insurance company’s reading of the policy terms would effectively merge the concepts of “physical damage” and “physical loss,” making the “physical loss” policy term superfluous and meaningless.

Noting that the policy did not specifically define the terms “physical damage” and “physical loss,” the court relied on the plain meaning of those terms, finding that physical loss exists when property is taken from one’s possession or when a business is prevented from using the property. Based on this reading of the policies, the court found that the businesses alleged facts establishing coverage because the COVID-19 virus is a physical substance that rendered the business locations unsafe and, coupled with the government orders, rendered their locations unusable. The alleged presence of the COVID-19 virus onsite was key to the Studio 417 decision.

It is important to note that the Studio 417 decision is not a final determination on the merits of the claims—it merely resolved a motion to dismiss, which is a preliminary motion where the court accepts the plaintiffs’ factual allegations as true and deals only with matters of law. The plaintiffs will still need to prove their claims at trial, which the insurer will undoubtedly defend vigorously. The Studio 417 decision is meaningful, however, because it preliminarily establishes as a matter of law what the business interruption policy terms mean. The burden will be on the plaintiffs to prove the facts establishing “physical loss.”

It is also important to recognize that the Studio 417 decision may not necessarily have far-reaching impact. Although it is a federal court decision, Studio 417 was decided based on Missouri state law; the decision is not binding nationwide. In fact, federal court determinations of state law are not even binding on the Missouri state courts. Studio 417 was, however, recently cited with apparent approval by a federal court in California confronted with similar issues. In that case, Mudpie Inc. v. Travelers Cas. Ins. Co. (“Mudpie”),[2] a similar set of plaintiffs brought a claim for coverage under their business interruption insurance policies. Unlike in Studio 417, the court in California found that the plaintiffs did not allege sufficient facts to establish a claim in Mudpie. But the court gave the plaintiffs an opportunity to amend their claims—to add factual allegations—which indicates the court’s implicit recognition that a COVID-related claim, if based on the right facts, could trigger coverage under a business interruption policy in California.[3]

For business owners who had largely written off the availability of business interruption coverage for relief, Studio 417 presents a ray of hope and potential lifeline for their struggling businesses. The Studio 417 decision might also provide a roadmap for policy holders considering litigation to enforce their policy rights. As federal and local assistance programs wind down and the true effects of the COVID-19 health crisis begin to have more widespread, potentially catastrophic effect, Studio 417 could signal an inclination for courts to find coverage for insured businesses. If such a trend develops, insurance companies will undoubtedly be more inclined to provide or, at least negotiate, some level of relief for their insureds.

It goes without saying that a trend toward enforcing coverage could mean the difference between the success or failure of many businesses. But the implications of coverage are far-reaching, impacting vendors who work with those businesses, landlords whose properties house those businesses, and the development of policy terms going forward. Policyholders are encouraged to resubmit their claims for coverage and monitor the progress of cases in their state to determine whether Studio 417 represents a positive bellwether or merely a mirage. Policyholders should also be on the lookout for changes in policy terms, such as new defined terms, as their policies come up for renewal.

For assistance with reviewing your business interruption policies and other available forms of relief, and/or the effect on your existing obligations, please contact the attorneys at Weintraub Tobin.

[1] Studio 417, Inc. v. The Cincinnati Ins. Co., No. 20-cv-03127-SRB, Order Denying Mot. to Dism., issued Aug. 12, 2020 (W.D. Mo.)

[2] Mudpie Inc. v. Travelers Cas. Ins. Co., No. 20-cv-03213-JST, Order Granting Mot. To Dism., issued Sept. 14, 2020 (N.D. Ca.)

[3] See also, Optical Services USA/JCI v. Franklin Mutual Insurance Co., No. BER-L-3681-20, a recent New Jersey decision reaching a similar conclusion in a matter involving an insurer challenging coverage under a business interruption insurance policy.

Recent Case Confirms Need for Landlords and Tenants to Address Force Majeure and COVID-19 in All Current and Future Agreements

While the effects of the COVID-19 health crisis have impacted daily life for months, the legal implications of this pandemic are just starting to develop. Unforeseen conditions often wreak havoc on existing contractual relationships, which are typically based on factual assumptions that, due to unexpected conditions like COVID-19, may no longer be appropriate. Many parties work through these circumstances through negotiation, reconciling their previous expectations and current conditions with their desired outcome, but these negotiations aren’t always successful. When these discussions fail, the parties are typically left to battle out their interests in a legal setting, often relying on inapplicable contractual provisions and outdated legal precedent. Few participants leave these litigated disputes happy.

A recent case shows how disputes resulting from the COVID-19 health crisis may play out in the near future. In In re Hitz Restaurant Group,1 the court considered whether a force majeure provision in a lease excused a restaurant operator’s obligation to pay rent. The case arose in the context of the tenant’s bankruptcy, with the court deciding whether the tenant was required to pay rent under the lease pending resolution of the bankruptcy proceeding.2 The lease in dispute included a force majeure clause which excused performance by a party of “any of its obligations [that] are prevented or delayed, retarded or hindered by . . . laws, governmental action or inaction, orders of government.” The tenant, relying on its governor’s order requiring “all businesses . . . that offer food or beverages for on-premises consumption to suspend service,” argued that this order qualified as an order of the government which triggered application of the force majeure clause in the lease and therefore excused the tenant’s obligation to pay rent.

The court agreed, finding that the governor’s order fell squarely within the force majeure provision’s scope. The court was unpersuaded by the landlord’s argument that the tenant’s payment obligation should remain enforceable because the government order did not technically prevent the tenant from paying rent (such as by paying rent electronically). In addition, the availability of public resources, such as forgivable SBA loan assistance, did not change the conclusion that force majeure applied. Finally, even though the force majeure provision expressly carved out the excuse of “lack of money,” the court determined that the executive order was the proximate cause of its inability to generate revenue and pay rent and prevailed over the “lack of money” exception.

Interestingly, after the tenant admitted that it could still operate through take-away service during the shutdown, the court engaged in an analysis of the percentage of rent that should be excused. Apparently, neither party provided the court with much information to determine the appropriate amount of rent reduction. The landlord didn’t address the issue and the tenant only stated that approximately 25% of the restaurant’s square footage could have been used for permitted services. Accordingly, the court interpreted the tenant’s estimation as an admission that it owed at least 25% of the rent and ordered that amount to be paid within two weeks of its ruling.

Though we have not interviewed the litigants, this outcome appears unsatisfactory for both landlord and tenant. For the tenant, the fact that its statement regarding use of the square footage of its leased premises was used as the basis for determining rent could be perceived as unfair, as usable square footage doesn’t necessarily indicate whether tenant has full use of such space (such as for in-house dining) or correlate to the impact of the force majeure event. For the landlord, the court’s conclusion supporting application of the force majeure provision despite the tenant’s ability to operate and an express provision carving out lack of money as a justifiable excuse was undoubtedly a bad conclusion. In addition, though, the landlord did not anticipate that the court would consider a percentage reduction in rent and therefore did not introduce evidence supporting a greater percentage of rent to be paid by the tenant, missing the opportunity to argue for a higher monthly rent requirement.

Perhaps the most meaningful conclusion from this case does not arise from its outcome, but rather from the fact that it confirms the unpredictability of court interpretations of lease disputes. Both commercial landlords and tenants enter into lease agreements for the purpose of providing certainty and predictability in their relationship, setting forth the likely (and sometimes unlikely) situations that may occur during the term and pre-negotiating their outcomes. In circumstances like the current pandemic, the unpredictability of judicial interpretations reinforces the need for provisions that comprehensively address unpredictable outcomes like outbreaks, epidemics, and other “acts of god” with reasonable, comprehensive solutions. It also reaffirms the danger of refusing to negotiate a resolution when unforeseen events transpire, as each party risks a negative outcome when relying on a judicial forum to reach a conclusion. In any event, both landlords and tenants risk such unpredictable results when they fail to address acts of force majeure in all of their future agreements given the current circumstances.

For sample force majeure provisions or to further discuss how COVID-19 may affect legal agreements going forward, please contact the attorneys at Weintraub Tobin.

Frustration of Purpose: How Two WWII-era Cases Provide Guidance Regarding Lease Enforcement During the COVID-19 Health Crisis

Unlike the Great Recession in 2008, landlords and tenants responding to the negative economic impact of the COVID-19 health crisis appear to be focusing more on rent relief as opposed to strict interpretation and enforcement.  Both sides seem to acknowledge that this downturn is driven by external, uncontrollable influences, and therefore each side should cooperate to weather the storm. It is the approach we most strongly encourage our clients to take, as it strengthens the relationship between landlord and tenant and avoids unnecessary expenditures on costly lease enforcement.

Not all parties have taken this approach, however.  Some, whether out of opportunity or desperation, have instead taken a more aggressive position, claiming that the uncontrollable nature of this pandemic justifies suspension of contractual duties and/or entitles a party to terminate its lease.  Many legal arguments have been proffered to support this position, including force majeure, impossibility, casualty, eminent domain and frustration of purpose.  This article will discuss the latter, clarifying the nature of the doctrine and explaining how two precedential decisions may affect how it may apply to current lease disputes.

What is Frustration of Purpose?

Frustration of purpose applies when performance of a contract or lease remains possible, but the fundamental reason of one of the parties for entering into the contract has been frustrated by an unanticipated supervening circumstance, destroying substantially the value of performance by the party standing on the contract.[1] If the doctrine applies, the party to the contract is discharged from its obligations under the contract, including the remainder of the term. This doctrine has been considered by many California courts, including those addressing the impact of government-imposed regulations on the obligations of tenants and landlords under a lease.

Can Frustration of Purpose be Used by a Tenant to Justify Immediate Termination of a Lease?

In a case which dates back to World War II[2], a landlord leased commercial space to a tenant who intended to display neon signs to illuminate and advertise for his business. After the lease commenced, the United States government ordered, as an emergency war measure, that all outside lighting, including neon signs, be shut off between sunset and sunrise. The tenant claimed that he was prevented, due to the order and without fault on his part, from using the neon signs he used to illuminate his business during the nighttime, and that both parties contemplated such use as the primary purpose of the lease at the time of the execution of the contract. The lease between the parties clearly contemplated the use of the neon signs, but did not state what hours the signs could be lit. The tenant first offered to surrender the lease, terminate it, and allow the landlord to remove the signs. However, after the landlord refused, the tenant stopped paying rent, and the landlord sued to collect.

The court agreed with the tenant.  Relying on the doctrine of frustration of purpose, the court held that the tenant was entitled to terminate the lease because the parties clearly contemplated, prior to entering into the contract, that the use of the signs at night “was the essential, primary and principal basis for which the signs were rented.” Therefore, as the governmental order prevented the tenant from using the signs, the entire purpose of the lease was frustrated and the tenant was discharged from its obligations under the lease, including future rent.

Does Frustration of Purpose Automatically Apply and Permit Termination of a Lease?

Not all tenants are entitled to rely on frustration of purpose to terminate their leases simply because an intervening event has occurred. In another WWII case[3], the California Supreme Court considered the effect of a wartime order on a lease for an auto dealership. In 1941, the tenant rented property in Beverly Hills for the purpose of displaying and selling new cars “and for no other purpose whatsoever.” On January 1, 1942, the federal government ordered that the sale of all new automobiles be discontinued to support the war effort. Recognizing the effect that the order would likely have on the tenant’s business, the landlord lifted all restrictions in the lease regarding the tenant’s use of the premises. The landlord also permitted tenant to sublease and offered to reduce the rent if the tenant was unable to operate profitably. Despite these concessions, the tenant sought to repudiate and terminate the lease, claiming frustration of purpose. The landlord then sued for unpaid rent.

In this case the landlord prevailed, as the court found that the tenant was not entitled to terminate the lease based on frustration of purpose. At trial, the tenant admitted that he continued to sell new automobiles and gasoline at the location, confirming that the tenant was able to operate consistent with its original purpose to some extent. The court also found that the landlord made considerable concessions which, in this particular instance, were significant given that the property was located on a main artery in Los Angeles County and the location was adaptable to many commercial purposes if the tenant chose to utilize the premises in a different way. In fact, after the tenant vacated the premises, the landlord immediately found a willing tenant to step in and rent the property. The court held that even though the government regulation made business more difficult and less profitable, a tenant could not invoke the doctrine of frustration of purpose unless the regulation completely destroyed the value of the lease.

Lessons for Landlords and Tenants Considering the Impact of Frustration of Purpose

These two cases offer up a couple takeaways regarding the obligations of landlords and tenants following an unanticipated supervening circumstance, such as the COVID-19 health crisis and related governmental orders requiring individuals to shelter in place.

First, landlords should be mindful that providing flexibility to a tenant in occupying their leased premises may help avoid a claim of frustration of purpose and termination of the lease. For the auto dealership landlord, the court strongly considered the flexibility, fairness, and cooperation of the landlord, who did everything it could to ensure that the leased premises retained some value for the tenant. By removing use restrictions, allowing transfers and subletting, and/or reducing rent, the landlord was able to overcome the argument that the purpose of the lease was frustrated. Unlike the neon signs case, in which the entire and sole purpose of the tenant’s lease was deprived as a result of the governmental order, the auto dealership landlord took affirmative acts to preserve such value and thereby protect its lease. In sum, it behooves a landlord – where economically feasible – to cooperate with a tenant and/or offer concessions in order to prevent a tenant from claiming the purpose of the lease was entirely frustrated. Even if those measures prove to be unsuccessful, it may later benefit the landlord in court.

Second, landlords and tenants should consider the impact of restrictive use provisions in their leases.  Landlords, especially in multi-tenant shopping centers, generally want to narrowly define a tenant’s permissible use so as to avoid overlapping and/or violation of exclusivity restrictions.  The most recent health crisis reminds landlords of the dangers of taking this approach, as doing so may coerce a tenant into the unwanted conclusion that its purpose was entirely frustrated.  Landlords may also want to grant a tenant the ability to pursue alternative uses with their landlord’s consent, which might provide a secondary manner of broadening the purpose. In either case, the language of the lease should be clear as to the purpose of the lease so as to avoid unwanted interpretation by a court. In the neon signs case, the court was left to determine what the primary purpose of the lease was because the parties failed to define its purpose with specificity. Careful drafting may have given the landlord more options or remedies.

While global pandemics and the related government-mandated use restrictions are rare, they can have a significant effect on businesses of all sizes and across industries. These two cases remind landlords and tenants that special attention should be paid both to the language of a lease and each party’s response to these crises. Not only will such consideration and cooperation benefit a landlord should the matter proceed to litigation, it will also engender goodwill with the tenant or future tenants. If you would like assistance with interpreting lease provisions and/or responses to the COVID-19 health crisis, whether in connection with a claim of frustration of purpose or not, please contact the attorneys at Weintraub Tobin.


[1] Cutter Laboratories, Inc. v. Twining (1963) 221 Cal. App. 2d 302, 314–315.

[2] 20th Century Lites, Inc. v. Goodman (1944) 64 Cal. App. 2d Supp. 938.

[3] Lloyd v. Murphy (1944) 25 Cal. 2d 48.