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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.

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.

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.

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[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.

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.

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.