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left to battle out their interests in a legal setting, often relying on inapplicable contractual provisions and outdated legal precedent.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.

Reopening Commercial Buildings: Guidelines and Legal Duties

Landlords and property managers have massive amounts of guidance materials available to them as they prepare to reopen their properties. These materials detail many different things a property owner can do.  In the face of this, the question being asked by many owners is: what are they actually required to do, what is their legal duty?  Unfortunately, the answer is both fact- and circumstance-specific, taking into account the property and its users, as well as federal, state and local requirements. But landlords and property managers should always be cautious about measures they commit to implement because commitments that exceed the minimum required by the circumstances can, if not implemented fully, expose them to liability.

As landlords and property managers prepare to reopen their commercial, retail, and office buildings, they have available to them a wide variety of guides and resources.  There is no shortage of these materials, which are being prepared and provided by commercial real estate trade groups and the large brokerage/property management companies, as well as all manner of law firms and other professional advisors.  As with much of the information that has circulated during the pandemic, available information has been packaged and repackaged, and pushed out in great volume.  Many people have described taking it as “drinking from a firehose.”  This makes sense — advisors want to be helpful to their clients and position themselves as experts to the public and prospective clients.

These materials offer detailed guidance on a wide variety of steps that can be taken to both make buildings safer and to make tenants and other users comfortable in returning to these spaces.  They provide thoughtful advice, recommendations, and practical checklists.  The guides include communications and management advice; social distancing, cleaning and disinfecting protocols; and guidance specific to different areas and elements of each property. Altogether, it is an impressive set of resources.

It is clear from reviewing these materials that there is a lot that landlords and property managers can do.  That there is always one more thing that can be done.    The practical question that these materials beg however is:  what does a landlord and property manager need to do in order to protect themselves from claims and liability?   What is required?  What is my duty as a landlord or property manager, and what is the standard of care? The materials are much more tight-lipped on this issue, in many ways the crucial, practical and bottom-line issue on the minds of landlords and property managers.

At least one of the trade groups has recognized the issue in their materials, declaring that “[t]his Guide or any part thereof does not, and is not intended to, create a standard of care for any real estate professional or property manager” and “is not meant to advocate, promote or suggest any preferred method or methods for dealing with a Pandemic.”  Additional comments beg the question: “Users should seek advice from a qualified professional before applying any information contained in this Guide to their own particular circumstances.  Users should always obtain appropriate professional advice on… legal issues.”  The concern is the liability exposure created if landlords have a duty to do all of these things, and the standard of care is compliance with these exhaustive guidelines.

The answer, unfortunately, is that it depends on the specific circumstances.  Most leases do not have provisions which clearly define or disclaim duties in connection with this pandemic.  This leaves the matter open to argument, and the various guidelines and industry resources can be part of that argument.  Establishing the existence of a legal duty and the applicable standard of care is key to a successful claim. For a tort claim of negligence against a landlord, a plaintiff will need to prove the landlord owed a duty to the plaintiff, the landlord breached the standard of care applicable to that duty, plaintiff suffered an injury, and the landlord’s breach of the standard of care was the proximate cause of that injury.

What is the standard of care?  California Civil Code 1714 (a) states that “everyone is responsible… for an injury occasioned to another by his or her want of ordinary care or skill in the management of his or her property or person…” The courts have held that this duty of care espoused in Section 1714 applies to possessors of land for injuries to people on their premises (see Rowland v. Christian (1968) 69 Cal.2d 108, 119) and that a landlord owes a tenant the same duty of reasonable care in providing and maintaining a leased premises. (Becker v. IRM Corp. (1985) 38 Cal.3d 454, 467.)  Under these cases, any departure from that standard will be analyzed by balancing various factors, including the foreseeability of the harm, the degree of certainty that the plaintiff suffered injury, the closeness of the connection between the defendant’s conduct and the injury suffered, the moral blame attached to the defendant’s conduct, the policy of preventing future harm, the extent of the burden to the defendant and consequences to the community of imposing a duty and liability and the availability of insurance for the risk involved.

The take-away from all of this for landlords and property managers is: be careful in taking on duties. The existence of a duty does not have a single, objective standard, and therefore landlords and property managers should be careful in defining and assuming these duties by, among other things, agreeing to perform certain tasks or assuming responsibility for obligations that they may not otherwise be responsible for.  If a duty is taken on, be sure that it is performed to the standard of care.  In other words, if you’re going to agree to do something, you need to actually do it; failing to complete that which you have agreed to do is prime fodder for a claim of negligence.

Landlords should also be mindful of their resources outside of the lease.  This can include reviewing available insurance coverage and other risk management tools to mitigate liability exposure, as well as revising leases as appropriate to clarify and define landlord’s duties going forward.  The current circumstances were difficult to predict, but a diligent landlord can minimize future issues by targeting the concerns raised and addressing them for future leases.

Opportunity Zone Funds and Investors Get Relief in Light of COVID-19

On June 4, 2020, the Internal Revenue Service published Notice 2020-39 (Notice) which provides relief to qualified opportunity funds (QOFs) and their investors in light of the COVID-19 pandemic.  Here is a summary, and more details follow below:

  • Investors who otherwise would be required to reinvest capital gains into a QOF any time this year on or after April 1 now have until December 31, 2020 to reinvest such gains.
  • A QOF’s failure to hold at least 90% of its assets in “QOZ property” on any semi-annual testing date from April 1, 2020 through December 31, 2020 will not cause the entity to fail to qualify as a QOF.
  • Qualified Opportunity Zone Businesses taking advantage of the working capital safe harbor can add an additional 24 months to their working capital safe harbor period.
  • The period between April 1, 2020 and December 31, 2020 is disregarded for purposes of the 30-month “substantial improvement” period.
  • QOFs that received proceeds from the disposition of QOZ property have up to 12 additional months to reinvest those proceeds in QOZ property.
  1. Overview of Opportunity Zones. Congress created opportunity zones in 2017 to encourage investments in economically distressed communities.

The Opportunity Zone program provides taxpayers the opportunity to defer gain on the sale or exchange of an asset if the gain is reinvested in a Qualified Opportunity Zone Fund (a “QOF”) within 180 days. Note that the entire proceeds from an asset sale need not be invested in a QOF; rather, only the portion of the proceeds that represent gain must be invested in a QOF. The gain is deferred until the sooner of (i) the date the taxpayer sells its investment in the QOF or (ii) December 31, 2026. If the taxpayer invests in the QOF in 2020 or 2021, the amount of gain that will ultimately be recognized is reduced by 10%.

Additionally, if the taxpayer holds its QOF interest for 10 years, the taxpayer will recognize no taxable gain when they sell that investment. In order to be a QOF, an entity must be organized for the purpose of investing in QOZ Property and 90% or more of its total assets must be QOZ Property.  QOZ Property includes both new and substantially improved tangible property, including commercial real estate (e.g., offices buildings, apartment complexes, etc.) and equipment located in qualified opportunity zones. These investments can be direct or through subsidiary corporations or partnerships that operate businesses in qualified opportunity zones. Each U.S. state has its own qualified opportunity zones.

  1. Relief regarding 180-day investment requirement for QOF investors.

Background

If a taxpayer has gain from the sale or exchange of property with an unrelated person, the taxpayer can elect to exclude from gross income the amount of such gain that the taxpayer invests in a QOF during the 180-day period following the date of such sale or exchange (“180-day investment requirement”).

Relief

The Notice states that if a taxpayer’s 180th day to invest in a QOF falls on or after April 1, 2020, and before December 31, 2020, the taxpayer now has until December 31, 2020 to invest the gain in a QOF.

III. Relief regarding 90% investment standard for QOFs.

Background

For an investment vehicle to qualify as a QOF, it must be corporation or a partnership organized for the purpose of investing in QOZ property (other than another QOF).  The QOF must satisfy the 90% investment standard, meaning it must hold at least 90% of its assets in QOZ property, determined by the average of the percentage of QOZ property held by the QOF measured semi-annually on (i) on the last day of the first 6-month period of the QOF’s tax year (June 30 for calendar year taxpayers), and (ii) on the last day of the QOF’s tax year.

If the average of the percentages of the QOZ property held by a QOF on the semi-annual testing dates fails to meet the 90% investment standard, the QOF must pay a penalty for each month that the QOF fails to meet the standard. However, no such penalty is imposed “with respect to any failure if it is shown that such failure is due to reasonable cause.”

Relief

The Notice provides relief by stating that, in the case of a QOF whose (i) last day of the first 6-month period of the tax year or (ii) last day of the tax year falls within the period beginning on April 1, 2020, and ending on December 31, 2020, any failure by that QOF to satisfy the 90% investment standard for that tax year is disregarded for purposes of determining whether the QOF meets the 90% investment standard rules. This prevents QOFs from being held liable for the statutory penalty.

  1. Relief regarding working capital safe harbor for QOZ businesses.

Background

An entity must meet certain requirements to be a “QOZ business,” including the requirement that less than 5% of the average of the aggregate unadjusted bases of the entity’s property be attributable to “nonqualified financial property” (as defined in the Internal Revenue Code — essentially cash and cash equivalents). However, if the QOF satisfies the “working capital safe harbor”, the QOF may hold an unlimited percentage of its assets in cash and short-term instruments.

One of the safe harbor requirements is that the business keep a written schedule consistent with the ordinary start-up of a trade or business for the expenditure of the working capital assets within 31 months of the receipt by the business of the assets. A QOZ business can extend the working capital safe harbor period to a maximum of 62 months. If a QOZ business is located in a QOZ within a presidentially declared disaster area, then the QOZ business may receive an additional 24 months to expend its working capital assets.

Relief

The Notice provides relief by stating that, as a result of the emergency declaration by President Trump on March 13, 2020 regarding COVID-19, all QOZ businesses covered by the working capital safe harbor before December 31, 2020 now will receive up to 24 additional months to expend the working capital assets of the QOZ business (i.e., the QOZ business now has up to 86 months to expend working capital).

  1. Relief regarding 30-month substantial improvement period for QOFs.

Background

QOZ Property includes tangible property acquired after 2017 if (i) the entity puts the property to its original use in the QOZ (“original use requirement”), or (ii) the property is substantially improved (“substantial improvement requirement”).

The substantial improvement requirement is met only if, during any 30-month period beginning after the date of acquisition, there are “additions to basis with respect to such property” that, in the aggregate, exceed the adjusted basis of that property as of the beginning of that 30-month period (“30-month substantial improvement period”).

Relief

The Notice provides relief by stating that, for purposes of the substantial improvement requirement, the period beginning on April 1, 2020 and ending on December 31, 2020 is disregarded in determining any 30-month substantial improvement period.

  1. Relief regarding 12-month reinvestment period for QOFs.

Background

If a QOF sells or disposes of some or all of its QOZ property or if a distribution with respect to the QOF’s QOZ stock is treated as a return of capital, and if the QOF reinvests some or all of the proceeds in QOZ property by the last day of the 12-month period beginning on the date of the distribution, sale, or disposition, then the reinvested proceeds are treated as QOZ property for purposes of the 90% investment standard.

To qualify for such treatment, the QOF needs to hold such proceeds continuously in cash, cash equivalents, or debt instruments with a term of 18 months or less. If the QOF’s plan to reinvest some or all of such proceeds in QOZ property is delayed due to a presidentially declared disaster, then the QOF may receive up to an additional 12 months to reinvest the proceeds, provided that the QOF invests the proceeds in the manner originally intended before the disaster.

Relief

The Notice provides relief by stating that if any QOF’s 12-month reinvestment period includes January 20, 2020, then that QOF receives up to an additional 12 months to reinvest the proceeds in QOZ property.

Post Moratorium Evictions

As the first of the rent moratoriums are expiring, landlords throughout California are eager to file unlawful detainer actions to obtain possession of their properties from tenants who have failed to pay rent or comply with repayment obligations. While it is natural for landlords to want to immediately initiate unlawful-detainer proceedings, they should proceed with caution. Landlords who issued 3-day or 30-day notices to their tenants for failure to pay rent during the moratorium period would be wise not to rely on those notices as the basis of an unlawful detainer action.

Many of the moratoriums specifically prohibit the issuance of those notices during their operative period.  For the overly eager landlord filing a prompt unlawful-detainer action, that action may fail because it is based on a defective notice issued at a time when it was specifically prohibited by a moratorium.

While it is understandable that landlords want to recoup their rents and obtain possession, care must be given to ensure that the unlawful detainers are based on enforceable notices, which do not violate the moratoriums. Only valid notices will permit landlords to obtain possession and judgments for past rent as expeditiously as possible. Proceeding on the basis of an invalid notice will be counterproductive and delay matters further.

The lawyers of Weintraub Tobin are able to discuss any notices a landlord may have provided to confirm their appropriateness for an unlawful-detainer proceeding to avoid newly enacted defenses.

Paycheck Protection Program Flexibility Act of 2020

On June 5, 2020, President Trump signed into law H.R. 7010 – the Paycheck Protection Program Flexibility Act of 2020 (“PPPFA”). The PPPFA makes significant borrower favorable amendments to the Paycheck Protection Program (“PPP”).

Background.

As our readers know, the PPP loan program was enacted pursuant to the CARES Act as a tool to help small businesses keep employees on their payroll. The draw of the program is the ability for borrowers to have the loans forgiven. In other words, the loans can be essentially converted into tax-free grants. One caveat is that borrowers are permitted to spend PPP loan proceeds on very limited types of expenditures. PPP loans may only be spent on payroll, rent, utilities and interest on certain pre-existing obligations.

In order to obtain loan forgiveness additional conditions must be satisfied. The CARES Act permitted loan forgiveness only to the extent the loan proceeds were spent during an eight-week period following loan origination (the “Covered Period”). The Small Business Administration (“SBA”) added a requirement that payroll expenses constitute at least 75% of Covered Period expenditures to achieve full loan forgiveness. Moreover, subject to one large exception, a portion of loan forgiveness will be lost for borrowers who reduce the number of full-time equivalents on their payroll OR reduce the average hourly wage or annual salary of an employee by more than 25%. The aforementioned exception to loan forgiveness reduction applies (in its original form) where (i) reductions in full-time equivalents or average hourly wages and salaries took place between February 15 and April 26, 2020 and (ii) the number of full-time equivalents and compensation are restored by June 30, 2020.

PPP Flexibility Act Changes.

Longer Covered Period, Reduced Payroll Costs Requirement. The most significant changes are an increase in the Covered Period to 24 weeks from 8 weeks; and the replacement of the 75% payroll expenditure requirement with a reduced 60% payroll expenditure requirement. In other words, borrowers now have 24 weeks to spend their PPP loan proceeds and can spend up to 40% of the loan amount on rent, utilities and interest on pre-existing debts without forfeiting any loan forgiveness.

Borrowers with existing PPP loans can choose to stick with the original 8-week Covered Period.  Such borrowers will be obligated to maintain payroll levels only through their original 8-week Covered Period in order to qualify for maximum loan forgiveness (or qualify under the Restoration Rule described below). On the other hand, borrowers using the new expanded 24-week covered period will need to maintain payroll levels for the full 24 weeks in order to avoid reductions in their forgivable loan amounts (or qualify under the Restoration Rule).

Restoration Rule.  As noted above, a reduction in payroll levels during the Covered Period would result in a reduction in the amount of the PPP loan forgiven unless the payroll levels were restored by June 30, 2020.  The PPPFA replaces the June 30, 2020 date with December 31, 2020.  Accordingly, if the borrower cuts the number of full-time equivalents or the salary or wages of its employees between February 15, 2020 and April 26, 2020, those reductions will not result in a loss of loan forgiveness if those cuts are restored by December 31, 2020.

Maturity.  After enactment of the PPPFA, PPP loans with any unforgiven loan amounts will have a minimum maturity of 5 years (previously 2 years).  The PPPFA states that lenders and borrowers will not be prohibited from mutually agreeing to modify the maturity of pre-PPPFA PPP loans to conform to the new 5-year minimum maturity date provided by the PPPFA.

Loan Payment Deferral.  The PPPFA extends the loan payment deferral period.  Originally, borrowers were not required to make any loan payments for six months.  Now PPP loan repayment will be deferred until the date on which the SBA remits the loan forgiveness amount to the lender.  PPP loan recipients who do not apply for forgiveness will not be required to make loan payments until 10 months following the close of the Covered Period.

Rehiring, Employee Availability. Additionally, the borrower will not suffer a reduction of its loan forgiveness amount due to reductions in the number of full-time equivalent employees IF the borrower is able to document EITHER:

(A) The borrower was both unable to rehire individuals who were employees on February 15, 2020 AND unable to hire similarly qualified employees on or before December 31, 2020;

OR

(B) The borrower was unable to return to the same level of business activity as of February 15, 2020 due to compliance with requirements or guidance issued by the Secretary of Health and Human Services, the Director of the Centers for Disease Control and Prevention, or the Occupational Safety and Health Administration related to the maintenance of standards for sanitation, social distancing, or any other worker or customer safety requirement related to COVID–19.

Payroll Tax Deferral. PPP borrowers are now permitted to delay paying the employer’s share of 2020 payroll taxes.  One-half of the employer’s share of payroll taxes are now due December 31, 2021 and remaining half will be due December 31, 2022. PPP borrowers can now enjoy this deferral even if they have their PPP loan forgiven. Previously, PPP borrowers were denied this benefit once their loans were forgiven.

The new PPPFA changes will benefit some PPP borrowers more than others. The SBA and Treasury Department will likely provide additional guidance soon.

Strategies for Granting Rent Relief in the Age of COVID-19

Over the past several months, the COVID-19 health crisis has affected everyday life by a magnitude that is hard to fathom. Routine tasks, such as going to the grocery store or walking the dog, suddenly necessitate precautions like face masks, social distancing, and excessive amounts of sanitizer. Unemployment is near record levels, businesses have shuttered, and most of us are confined to our homes to avoid further spreading the COVID-19 disease.

Yet while most of us have adjusted to the “new normal” and cities and counties begin to reopen, it’s hard not to think we’ve hit just the tip of the iceberg in terms of how this crisis will affect our lives for many years to come. Federal, state and local jurisdictions have adopted aggressive measures to mitigate the potentially disastrous effects, including direct stimulus checks and forgivable loan programs, but these programs will expire soon. When these funds are no longer available and the new post-COVID-19 reality sets in, all of us will need to reassess both our personal and professional circumstances.

Landlords and tenants are no exception. While the Paycheck Protection Program and other federal funding options helped many tenants survive the initial few months of the crisis, these tenants will continue to struggle to pay rent long after their funding has been used. Landlords are left in a difficult situation – evict the tenant (assuming no moratoria apply) and spend months searching for a new tenant, or provide relief to the tenant in an effort to maintain occupancy until the economy recovers.

There are many approaches for providing rent relief, each of which has both advantages and disadvantages for landlords seeking to preserve their rental stream and minimize their losses. These options, of course, are subject to any other landlord commitments such as loan covenants, reporting obligations, and other financial requirements. Below are some of these options:

Rent Abatement
For many landlords, abatement of rent for one or more months represents the quickest and most straightforward option to provide relief for a struggling tenant. Doing so offers a tenant the prospect of removing what is often a primary expense and, for tenants that can continue to operate, hopefully building up sufficient revenues to resume paying rent the following months. Moreover, tenants often perceive rent abatements positively, potentially strengthening the landlord-tenant relationship going forward. Landlords must weigh these benefits against waiving rent that is otherwise properly due and payable under the lease without any prospect of repayment.

Rent Deferral
Often the most practical option, deferring rent allows a landlord to offer immediate relief to a tenant without actually sacrificing the payment of rent. Whether with interest or not, deferred rent can be spread over a period of several months or the remainder of the term in regular monthly, quarterly or annual payments. While many enactments permitting repayment preclude late fees or interest, nothing prevents a landlord and tenant from agreeing to include such additional amounts to offset the benefit of deferred rent. Unlike rent abatement, this option ensures payment of all rent, with landlords simply bearing the cost of the time value of money.

Monetary Concessions
In lieu of abating or deferring rent, a landlord can abate or defer other costs for which a tenant is otherwise responsible under the lease, such as operating expenses, insurance, taxes and the like. For landlords with loan obligations or other reporting requirements which mandate certain rent thresholds, offering other monetary concessions provides tenant relief without jeopardizing important landlord commitments. These concessions represent hard costs incurred by a landlord, however, so their forgiveness is not often a much better alternative absent a specific reason for preferring payment of rent.

Blend and Extend
Landlords and tenants wanting to provide rent abatement without sacrificing the total amount due under a lease can instead elect to extend the term of a lease in exchange for a rent credit. This option, often referred to as “blend and extend,” provides a longer rental stream for the landlord in exchange for immediate rent relief for the tenant. For many landlords, the prospect of a longer tenant commitment may afford additional value justifying the credit to the tenant. Landlords must also consider that this option sacrifices potential rent during this extended period from the existing tenant or a third-party tenant.

Additional Security
A common approach to rent relief immediately following the start of the COVID-19 crisis involved application of a tenant’s security deposit to rent immediately due and requiring replenishment at a later date. While this alternative maintained cash flow for a landlord, it often merely delayed a tenant’s eventual difficulty in paying rent. Rather than seek security through a deposit, sophisticated landlords prefer to seek actual collateral, personal guarantees or letters of credit from their tenants in exchange for immediate rent relief. This right strengthens a landlord’s position if the tenant ultimately fails and breaches its lease. Of course, relying on additional security suggests an eventual tenant default and lease enforcement, a prospect landlords generally like to avoid.

Non-monetary Concessions
When financial concessions are impractical, landlords may prefer to seek other benefits with respect to their leases which confer value for the landlord. This may include removal of early termination rights, rights of first refusal, options to extend or other rights originally granted to a tenant to complete a lease transaction. While these rights may not immediately offset the loss of rent, the concessions otherwise received may ultimately offer greater benefit for the landlord.

In evaluating the above strategies, landlords would be wise to require a tenant requesting relief to adequately demonstrate financial hardship. Many opportunistic tenants have seized upon the current situation to seek rent relief despite consistent or improved revenues. A shrewd landlord can often stymie these tactics by demanding the tenant provide ample financial records and information, including prior year financial statements, tax returns, sales reports, and bank statements, showing that the tenant cannot satisfy its leasehold obligations. If a tenant has received financial assistance from a federal loan relief program, the landlord should require those funds be paid toward rent to the extent permissible.

Regardless of which approach(es) a landlord may pursue, landlords must be careful to condition such relief on a tenant’s full performance of all remaining obligations under its lease. A landlord offering relief is not in a better position after doing so if, a few short months later, the tenant defaults, leaving the landlord without a tenant and with less rental income to collect via enforcement. It is critical for landlords to preserve all of their rights and claims under a lease while acting in good faith to assist their tenants during this difficult time.

Like their tenants, landlords must adjust to the new reality presented by the current COVID-19 health crisis. With a practical, reasoned approach, however, landlords can minimize the unwanted effects attendant with a pandemic and assist their tenants survive without unnecessarily forgiving a substantial portion of their rental income. If you would like assistance preparing lease amendments addressing these issues, the attorneys at Weintraub Tobin are here to help.

SBA Releases PPP Loan Forgiveness Application (UPDATED*)

On Friday May 15, 2020, the Small Business Administration (“SBA”) released the application borrowers will use to request forgiveness of their Paycheck Protection Program (“PPP”) loans.  On Friday May 22, 2020, the SBA and Treasury jointly issued an Interim Final Rule clarifying some portions of the forgiveness application.  PPP borrowers have been awaiting additional guidance regarding the forgiveness portion of the program for well over a month.  While the application and interim final provides some additional guidance, many questions remain.

BACKGROUND

As our readers already know, the PPP loan program was enacted pursuant to the CARES Act as a tool to help small businesses keep employees on their payroll.  The draw of the program is the ability for borrowers to have the loans forgiven.  In other words, the loans can be essentially converted into tax-free grants.  One caveat is that borrowers are permitted to spend PPP loan proceeds on very limited types of expenditures.  PPP loans must be spent only on payroll, rent, utilities and interest on certain pre-existing obligations during an eight-week period following loan origination.

SBA had previously required that borrowers certify that 75% of their PPP loans would be expended on payroll.  Moreover, subject to one large exception, a portion of loan forgiveness will be lost for borrowers who reduce the number of full-time equivalents on their payroll OR reduce the average hourly wage or annual salary of an employee by more than 25%.  The aforementioned exception to loan forgiveness applies where (i) reductions in full-time equivalents or average hourly wages and salaries took place between February 15 and April 26, 2020 and (ii) the number of full-time equivalents and compensation are restored by June 30, 2020 (the “June 30 Restoration Exception”)

THE APPLICATION

As noted above, many questions remain unanswered but the application does provide clarification of certain issues, including the following.

Eight Week Testing Period / Covered Period

In order to qualify for forgiveness, amounts must be spent during the eight-week period commencing upon the date the loan proceeds are disbursed to the borrower (the “Covered Period”).  For administrative convenience, borrowers who pay employees at least as often as biweekly may elect to calculate eligible payroll costs using the eight-week period that begins on the first day of their first pay period following the loan disbursement date (the “Alternative Payroll Covered Period”).  Note that this alternative eight-week period only applies to payroll costs and not to other qualifying expenditures.

Expenses Paid or Incurred

One question that tormented borrowers was whether eligible costs had to be paid and incurred during the Covered Period or whether they could be incurred and/or paid during the period.  With respect to payroll costs, the application provides:

Borrowers are generally eligible for forgiveness for the payroll costs paid and payroll costs incurred during the eight-week (56-day) Covered Period (or Alternative Payroll Covered Period) (“payroll costs”). Payroll costs are considered paid on the day that paychecks are distributed or the Borrower originates an ACH credit transaction. Payroll costs are considered incurred on the day that the employee’s pay is earned. Payroll costs incurred but not paid during the Borrower’s last pay period of the Covered Period (or Alternative Payroll Covered Period) are eligible for forgiveness if paid on or before the next regular payroll date. Otherwise, payroll costs must be paid during the Covered Period (or Alternative Payroll Covered Period).

Similarly, with respect to eligible non-payroll costs, the application provides:

An eligible nonpayroll cost must be paid during the Covered Period or incurred during the Covered Period and paid on or before the next regular billing date, even if the billing date is after the Covered Period.

However, the May 22 Interim Final Rule clarifies that pre-payments of interest are not eligible for forgiveness.  Accordingly, it appears that any eligible payroll or non-payroll costs (other than prepayments of interest) paid during the Covered Period count towards loan forgiveness despite when the cost was incurred.  Additionally, costs incurred during the Covered Period and paid in accordance with the usual schedule for payment can also be forgiven even if the payment date falls after the conclusion of the Covered Period.

Calculating Full-Time Equivalents

Recall that a reduction in full-time equivalents (“FTEs”) during the Covered Period will result in a proportionate reduction in loan forgiveness.  The application permits borrowers to calculate the number of FTEs in one of two manners.  The first way to calculate FTEs is to determine the average number of hours worked by each employee per week during the Covered Period and divide that number by 40.  The resulting quotient is rounded to the nearest 1/10th and capped at 1.0.  Alternatively, borrowers can count all employees who average 40 or more hours per week as 1.0 and each employee working less than 40 hours as 0.5.  Once the borrower has calculated each employee’s FTE status, the results are aggregated.

The average number of FTEs during the Covered Period is then compared against the number of FTEs during one of the following periods (at the Borrower’s election): (i) February 15, 2019 to June 30, 2019; (ii) January 1, 2020 to February 29, 2020; or (iii) in the case of seasonal employers, a consecutive twelve-week period between May 1, 2019 and September 15, 2019.  The number of FTEs for the Covered Period and the number of FTEs during the reference period chosen by the borrower must be calculated using the same methodology.

Additionally, any FTE reductions resulting from one of the following reasons will not impact loan forgiveness: (i) employees who were terminated prior to April 26, 2020 and who rejected a good-faith, written offer of rehire during the Covered Period (the employee’s rejection of the offer to rehire must be reported to state unemployment insurance offices); and (ii) any employees who (a) were fired for cause, (b) voluntarily resigned, or (c) voluntarily requested and received a reduction of their hours.

Calculating Salary and Wage Reductions

As noted above, borrowers who reduce their employees’ salaries by more than 25% will suffer a loss in the amount of loan forgiveness.  This calculation is made on a per employee basis.  Meaning, each employee’s compensation during the Covered Period is measured against that employee’s compensation from January 1, 2020 to March 31, 2020.

It is unclear how this rule would apply if the borrower terminated a number of employees and rehired lower wage workers.

June 30 Restoration Exception

Any reductions in FTEs or compensation that are restored on or before June 30, 2020 will not result in a reduction of loan forgiveness.  The application does not specify how this rule operates.  For example, for how long do employees need to be rehired?  How does one test FTEs on June 30, 2020?  Is it a one-day test or do we test based upon a payroll period ending or starting on June 30, 2020?

Owner Compensation

Pursuant to prior SBA guidance, compensation payable to owners is limited to 8/52 weeks of 2019 net profits.  Additionally, healthcare expenses and retirement contributions attributable to self-employed individuals, general partners and other Schedule C filers are not eligible for forgiveness.  It appears that health and retirement contributions made on behalf of shareholder-employees are eligible for forgiveness.

The application requires a certification that the amount for which forgiveness is requested “does not exceed eight weeks’ worth of 2019 compensation for any owner-employee or self-employed individual/general partner, capped at $15,384 per individual.”  Accordingly, it appears that borrowers cannot receive full loan forgiveness if they use PPP funds to increase compensation to owner-employees, including corporate shareholder-employees.

Loan Forgiveness Process

In order to receive loan forgiveness, borrowers must submit the PPP loan forgiveness application linked in the introductory paragraph above to its lender.  Within 60 days of receiving the application, the lender must issue a decision to SBA regarding loan forgiveness.  Within 90 days of receiving the lender’s decision and subject to the SBA’s additional review of the original loan and/or forgiveness application, the SBA will remit payment of the appropriate forgiveness amount to the lender together with accrued interest on such amount.  Accordingly, it can take up to 150 days to receive final notification of loan forgiveness.

CONCLUSION

While these new rules do provide some additional guidance, the answers to many important questions (particularly with regard to the June 30 Restoration Exception) still remain unclear.

Some practitioners expect that SBA will promulgate further guidance concerning PPP loan forgiveness.  However, it is unlikely that such guidance will be issued soon enough to be helpful for borrowers who have already received loans.  Additionally, there are many proposals being discussed in Congress to amend the Paycheck Protection Program.  We will be sure to provide additional updates in the event additional guidance is issued or amendments are enacted.

*This alert was initially published on May 18, 2020 following the release of the PPP loan forgiveness application and has been updated to include certain clarifications provided by the May 22, 2020 Interim Final Rule.

NOTE: This article has been updated from the original publication on May 18, 2020 to reflect new information provided by the SBA on May 22, 2020.

Further SBA Guidance on Necessity Certification for PPP Loans

Small Business Administration (SBA) guidance published on May 13, 2020 adds clarity to the “necessity” certification that borrowers were required to make when applying for Paycheck Protection Program (PPP) loans.  According to this guidance, borrowers that received PPP loans of less than $2 million will be deemed to have made the necessity certification in good faith.  As to borrowers with loans greater than $2 million, if the SBA notifies the borrower that the SBA has determined that the borrower lacked an adequate basis for the necessity certification, the borrower will be able to avoid enforcement action by repaying the loan.

Background

Every PPP loan application requires that the borrower certify that current “economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant.”  In April 2020, Treasury Secretary Steven Mnuchin and the SBA announced that the SBA would audit select PPP loans, including all loans in excess of $2 million.  These audits will include an examination of whether the aforementioned necessity certification was made in good faith.  Our previous post on this topic is available here.

SBA Guidance

Borrowers are likely to find the following two portions of the May 13 guidance especially significant:

Safe harbor for <$2 million borrowers: “Any borrower that, together with its affiliates, received PPP loans with an original principal amount of less than $2 million will be deemed to have made the required certification concerning the necessity of the loan request in good faith.”

Notice-and-cure opportunity for other borrowers: “SBA has previously stated that all PPP loans in excess of $2 million, and other PPP loans as appropriate, will be subject to review by SBA for compliance with program requirements set forth in the PPP Interim Final Rules and in the Borrower Application Form. If SBA determines in the course of its review that a borrower lacked an adequate basis for the required certification concerning the necessity of the loan request, SBA will seek repayment of the outstanding PPP loan balance and will inform the lender that the borrower is not eligible for loan forgiveness. If the borrower repays the loan after receiving notification from SBA, SBA will not pursue administrative enforcement or referrals to other agencies based on its determination with respect to the certification concerning necessity of the loan request.”

Our Observations

As the necessity certification is rather subjective, many PPP borrowers were rightfully concerned over potential second-guessing by the SBA.  Borrowers with loans of less than $2 million should take comfort in this new guidance.  PPP borrowers with loans of $2 million or more can avoid enforcement actions by repaying loans in the event of an audit.  However, because the funds will likely be spent prior to an audit, larger borrowers must still consider the prospect of a review of whether the loans were “necessary” and factor that into their spending plans.  These borrowers would also be well advised to document their company’s need for liquidity and the impact of Covid-19 on their industries in general.  As a final note, borrowers should be advised that the May 13 SBA guidance does not bind other federal agencies.

Guess What? The Laws HAVE Changed – Avoiding a Conduit Trust Catastrophe after the SECURE Act

Like most estate planners, we always remind clients that tax and estate planning laws are subject to change and frequently do. As busy practitioners, it is impossible for us to reach out to every client when a change might affect him or her, so we remind all clients to come back to see us if they have questions or are concerned about how recent developments affect their plans (and in any event, at least every three to five years).

January 1, 2020 saw one such key change in the law—the implementation of the SECURE Act. The “Setting Every Community Up for Retirement Enhancement” Act made a number of changes to federal retirement program regulations, such as repealing the maximum age at which one can contribute to a traditional IRA and raising the required minimum distribution age from 70 ½ to 72. From an estate planning perspective, however, the biggest change was the partial elimination of what is often called “stretch” treatment for IRAs.

Before the SECURE Act, a person who inherited an IRA could base his or her annual distributions on his or her life expectancy. This allowed for continued tax-free growth and smaller annual distributions, reducing the likelihood of an IRA distribution raising one’s income tax bracket or a person outliving his or her inherited IRA. The SECURE Act eliminated this “stretch” treatment for all but four categories of beneficiaries. Spouses, individuals not more than 10 years younger than the plan owner, chronically ill or disabled individuals, and minor children of the plan participant are now the only beneficiaries allowed to use their life expectancies to determine their annual distributions.

In general, everyone else must distribute their entire inherited IRA over a period of 10 years, although they have complete flexibility to choose when to take distributions within the 10-year period. This change does not allow the IRA to function as an income stream for life, as many IRA owners would want for their successor beneficiaries; and if the IRA is large, this could move a beneficiary into a higher income tax bracket.

So, that’s the law, like it or not (and many do not like the new options). Many people have named their trusts as beneficiaries of their IRAs so that the trustee can elect lifetime treatment on behalf of beneficiaries. Before the SECURE Act, if the trust was drafted accordingly, it would function as what is commonly referred to as a “conduit” trust payable over the beneficiary’s life expectancy. Distributions would be immediately passed out to the beneficiary and taxed as income to the beneficiary (not the trust). This allowed trustors to know that a certain beneficiary would receive a certain benefit for life and avoided the IRA distribution being taxed as income to the trust (trusts often pay the highest rate of federal income tax). Relying on a conduit trust was preferable to naming the beneficiary directly on the IRA because in the latter case the beneficiary could choose to take a lump sum distribution, possibly contravening the decedent’s intent. Now, except for the four categories named above, relying on a conduit trust approach for a beneficiary’s lifetime stretch of an IRA is no longer an option.

For some, this will not be a catastrophe. It eliminates some attractive options, to be sure, but utilizing the conduit trust still allows a stretch of the retirement assets to the beneficiary over ten years (as opposed to the beneficiary taking a lump sum distribution, for example). However, some estate plans are specifically designed to hold retirement assets in trust because an individual beneficiary has serious health or addiction issues that would be significantly worsened if the person received a large sum of money. Other people know a beneficiary of theirs will never be able to support himself or herself or manage his or her own accounts, so they’ve set up what they believe is a lifelong trust to accomplish this on the beneficiary’s behalf. In these situations, having a conduit trust in one’s plan might result in what previously was expected to be a lifetime gift being paid over ten years instead. This really could be a catastrophe.

Fortunately, there are options. A different type of retirement trust called an “accumulation” trust can still hold IRA benefits for the life of a beneficiary, although there are generally less desirable tax consequences. What is right for your plan will depend on your unique situation, so if you have any concerns at all, you should reach out to your attorney for specific advice. The ramifications of the SECURE Act are complicated, and this post has merely highlighted one potential issue. An estate planning attorney, working in tandem with your CPA and/or financial advisor, will be able to help you maximize your retirement plan assets given the current law.