COVID-19 Commercial Tenant Eviction Update

As March approaches, we are poised to hit the two-year anniversary of California’s March 4, 2020, State of Emergency Proclamation relating to the COVID-19 health crisis. In the months that followed, we watched federal, state, and local governments adopt myriad laws, rules, emergency orders, proclamations, declarations, ordinances, and mandates, creating a patchwork of rules and regulations for commercial real estate that defied generalization or statewide compliance practices. The market may never look exactly like it did before COVID-19 (note our last article: to-go alcoholic drinks are here to stay!). As concern over the virus appears to be waning, we are seeing jurisdictions generally, but not uniformly, remove their COVID-19 commercial tenant eviction protections*. We therefore thought it would be appropriate to highlight a few of the notable policies which are in effect in some of California’s markets. Of course, most of the rules listed below have exceptions, and exceptions to the exceptions, so please consult your local laws (or counsel) before proceeding.

How New Legislative Policy May Affect COVID-Related Lease Disputes

Over the last eighteen months, we have been forced to devote significant resources to interpreting how largely-forgotten legal doctrines apply to real estate contracts in a post-COVID world. These principles, including force majeure, frustration of purpose, and impossibility/impracticability, were generally overlooked in real estate transactions until life-altering global events required their use. Indeed, many of the cases interpreting these doctrines date back to the world wars that dominated the first half of the twentieth century. Modern practitioners often did not even address these concepts in their agreements.

Now, these policies have come front and center, driving the discourse between parties trying to adjust their expectations to an entirely different business environment. As I have previously discussed, the judicial process is slow to provide guidance on these issues, failing to provide many opportunities for expedited resolutions and the judicial policy which flows from them. Legislators have, perhaps unsurprisingly, been happy to step into this role, and we have seen a tremendous amount of new policy designed to address the impact of COVID on existing and future contractual relationships. One such new policy is particularly noteworthy.

As a quick background, the frustration of purpose doctrine generally provides that where the fundamental reason of a party entering into a contract has been frustrated by an unanticipated, supervening circumstance which substantially destroys the value of that contract and purpose, that party can be discharged from its duty to perform its contract and the contract can be extinguished. Historically, the defense is available only when the frustration is substantial. It is not enough that the transaction will be less profitable than originally anticipated, or even that one party will sustain a loss; rather, the frustration must be so severe that it is not fairly regarded as within the risks assumed by that party under the contract.

On August 4, 2021, the San Francisco Board of Supervisors passed Ordinance 122-21, which provides that for certain commercial tenants, COVID-19 is presumed to have frustrated the purpose of the lease, excusing these tenants’ obligation to pay rent. This ordinance has essentially rewritten how the frustration of purpose doctrine applies, allowing temporary interruptions of normal operations, such as during the COVID-19 pandemic, to be deemed sufficient to allow for relief. While the ordinance does not override an agreement to the contrary and sunsets after 2025, it should assist small retailers who might otherwise be left without relief.

I find this ordinance disconcerting for several reasons. First, by altering the application of a fundamental legal doctrine, the Board of Supervisors undermines at least a century of existing case law, potentially creating even more uncertainty regarding how these doctrines apply now and going forward. Second, the ordinance ignores the interests of landlords, who risk losing their income stream due to COVID and may not be any more capable of sustaining their business than the tenants protected by the ordinance. Finally, the approach manipulates a legal doctrine to achieve its purpose rather than attacking the issue head-on by, for example, offering cash, tax, or other incentives to parties affected by COVID.

Of course, San Francisco is one of perhaps the most progressive political communities in the country. We have not seen similar enactments in other jurisdictions and I do not predict they will follow. The ordinance highlights the importance of understanding the political climate in which properties are located, as these sorts of policies may be more or less prevalent depending on such factors. While the overall impact of the Board of Supervisors’ ordinance is unlikely to have mass application or significantly change the market, it is a notable development in the global reaction to the unique circumstances presented by a global pandemic.

NY Court of Appeals Decision Highlights Growing Trend of Higher Courts Ruling Against COVID-Related Lease Defenses

Since the start of the COVID-19 health crisis, we have been approached by both landlord and tenant clients asking how COVID affects their leasehold obligations. While we have generally encouraged our clients to approach these matters in an honest and amicable manner with a focus on resolution, disputes have arisen between owners and occupiers. Legal resolution does not come quickly, as the legal process tends to delay final adjudication for several years. Some decisions have been rendered in interim proceedings (such as bankruptcies), but on the whole, there simply has not been enough time for COVID-related disputes to proceed through both the trial and appellate levels and provide guidance on how these lawsuits will be resolved.

A recent decision by a New York appeals court is perhaps one of the first to provide some clarity regarding how an appellate court will interpret how common COVID-related defenses will apply in a lease enforcement action. In The Gap, Inc., v. 170 Broadway Retail Owner, LLC, the tenant (The Gap) sued its landlord under theories of casualty, frustration of purpose, and impossibility, seeking to avoid its obligation to pay rent and terminate its lease in response to the COVID-19 pandemic. When the landlord filed a motion to dismiss the tenant’s complaint, the trial court denied the motion, finding that the tenant had stated a valid claim and providing implied approval that these arguments could be used by tenants to avoid their leasehold obligations.

On appeal, the appellate court unanimously overturned the trial court’s decision.  The judges first concluded that the casualty provision of the lease was not triggered by COVID-19 because no physical loss or damage had occurred. The court then addressed the tenant’s equitable arguments, finding that frustration of purpose did not apply because the tenant was not completely deprived of the benefits of its premises, and it was not impossible for tenant to perform its obligations under the lease such that the lease could be rescinded. The tenant was ordered to pay all back rent and continue paying rent in accordance with the lease going forward.

Although not binding in California, this decision is emblematic of the trend among courts reviewing the impact of COVID-19 on commercial leases. On the whole, most courts have concluded similarly to the New York appeals court, deciding that tenants must bear the risk of a pandemic absent some unique circumstances or lease terms that would vary this conclusion. This is true even in the business interruption insurance context, leaving tenants without many legal options for relief. Hopefully, the various governmental stimulus packages have supported these tenants’ business operations sufficiently to weather the worst of the pandemic and take advantage of what appears to be a booming economic recovery. For landlords, these decisions are welcome support for opposing any tenants who attempt to opportunistically rely on COVID to justify temporary or permanent relief from their leases.

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

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

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

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

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

COVID-19’s Impact on Leasing and Other Transactions

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

California Real Property Journal

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

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

I.      INTRODUCTION

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

Josh Escovedo in the Sacramento Business Journal: An Attorney’s Take on Enforcing Covid-19 Rules

Real estate litigation attorney Josh Escovedo is quoted in the Sacramento Business Journal on his take on the inconsistencies and difficulties of enforcing Covid-19 restrictions relating to businesses.

Government must find a balance between enforcing its rules and protecting the livelihood of small businesses, which can be a difficult position, Escovedo said. 

Read the full article here.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Josh Escovedo in the Sacramento Business Journal: Holding Back The Flood

Josh Escovedo is quoted in a recent Sacramento Business Journal article titled Holding Back The Flood.  The article explains how commercial evictions and lawsuits are inevitable unless Congress acts soon to help businesses.

I think right now there’s a certain level of forced cooperation.

Read the full article on the Sacramento Business Journal website, here.