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Considerations for Commercial Tenants for Negotiating Lease Modifications or Contemplating Lease Terminations

November 12, 2020
By: Ethan C. Geis

As the COVID-19 pandemic continues its grip on the country and appears to be entering a surge phase this winter, many commercial tenants are dealing with the uncertainty of the prolonged effect of both restrictive public health measures employed by local and state governments to combat the virus’ spread and also a general reduction in economic activity. While there may be additional federal and state relief bills to come, there is no immediate help on the horizon, and tenants have or will be exhausting the remaining relief afforded under prior bills enacted earlier during the pandemic.

Tenants that had previously made timely and full rent payments and continued business operations to the extent allowed under COVID-19 restrictions may now be in the position of reevaluating their lease obligations aiming either towards negotiating certain portions of their lease, including rent obligations, that are no longer feasible or exploring potential justifications for unilaterally limiting lease obligations or terminating their leases. This article outlines items that tenants may consider in negotiating lease modifications as well as a giving a brief overview of the legal doctrines that may justify excusing a tenant’s performance under its lease.

Items to Consider When Attempting to Renegotiate Lease Provisions.

One of the outcomes of the early phases of the pandemic with regard to commercial leasing was that landlords were, in general, willing to negotiate with tenants and to make lease modifications, including deferring rent obligations, in order to retain tenants and relieve some of the economic pressure governmental regulation had placed on their tenants. It remains to be seen whether that same goodwill will continue during the next phase of the pandemic, especially if no direct relief is extended to landlords. Additionally, regardless of the question of their willingness, landlords that may be inclined to work with the tenants on renegotiating lease provisions could be hamstrung by covenants owed to their lenders to not modify leases without that lender’s consent.

Tenants may be able to improve the likelihood of successful lease renegotiations if they come to the table prepared to make reasonable and creative concessions. As the tenant will likely be negotiating for a temporary reduction in base rent, the tenant will need to generally give long-term value in exchange for short-term survival.

The simplest form of lease modification, and one of the most common adjustments made in the beginning of the pandemic, is for the parties to agree to defer rent for a defined period of time—whether defined at the outset with a definite resumption date or set according to a contingent date that is tied to the rollback of various governmental restrictions affecting the premises or the business. The initial items for the parties to negotiate are: (i) over what length of period which the deferred rent will be amortized when paid back—unless a free rent period is established and (ii) whether and what rate will interest accrue on the amounts deferred. The parties will need to determine whether the deferred rental amount will be partial or full. Tenants, especially those whose businesses are based on providing services on site, may want to seek a deferral rate that varies and tied to governmental restrictions on occupancy at the premises.

To induce the landlord’s agreement to rent deferrals, tenants may need to consider offering non-monetary modifications of the lease agreement:

Term Modifications. Term modifications are a frequently used bargaining chip. While typically the tenant would offer a term extension to the landlord, there may be circumstances in which limiting the term may appeal to the landlord if the landlord is attempting to change the tenant profiles at a particular property complex or if the current tenant is paying below-market rent for the area.

Elimination of Tenant Option Rights. The parties may consider eliminating certain option rights held by the tenant: options to purchase, extend the term, or expand the premises.

Guarantees. If one is not already in place, the landlord may seek a guarantee from one or more of the tenant’s principals. If the landlord’s agreement to deferring or abating rent is contingent on execution of a guarantee, tenants should focus on limiting the effective term of the guarantee, place a cap on liability, or limit the scope of the guarantee to cover only deferred rental amounts.

Landlord Lien. If the lease does not already create such a lien, a tenant could incentivize the landlord to extend rent relief by giving the landlord a secured interest in the personal property on the premises. Very likely this will be secondary to any of tenant’s current lenders, but such a lien would give the landlord some additional assurance of being made whole.

Security Deposits. In addition to agreeing to paying back deferred rent, if a tenant has sufficient funds presently, but anticipates cash flow problems going forward, it may be appropriate to increase (or create if there is none) a security deposit on file with the landlord, which would be reduceable or reimbursable upon the extinguishment of pandemic-related restrictions.

Covenants Requiring Payment of Government Relief Monies. Even though many COVID-19 state and federal relief programs, as of the writing of this article, have drained their funding and many tenants have exhausted the availability of such resources, a tenant could agree, to the extent allowable under future program terms, to agree to attempt to make lawful claim for funds under future relief packages and apply any receipts against its account with landlord.

Percentage Rent. The parties could incorporate a temporary percentage rent structure in addition to a reduced or deferred base rent. This concept can align the parties’ interests and ensure not only that if the worst effects of the pandemic are avoided, total rental payments remain high, but it can also be a way for a tenant to receive relief when needed while allowing a landlord to profit from upside revenue increase.

Subletting. Depending on the nature of the tenant’s business and the set-up of the physical premises, a landlord may be more inclined during the pandemic to allow subletting of a portion of the premises to ensure steady income. The tenant would likely still be responsible ultimately for all rental payments if the sub-tenant fails to make payment, but such a strategy could alleviate temporary financial stress.

Future Tenant Improvement Allowances. If the lease is relatively new or if there are funds tabbed for future tenant improvements, the parties could reduce the amount will landlord contribute or eliminate classes of expenses like furniture, fixtures, and equipment that are reimbursable under a landlord-funded allowance.

Legal Justifications for Not Performing Lease Obligations.

If circumstances are drastic enough and a landlord is not willing to negotiate a modification to the lease that will allow a tenant’s business to survive, a tenant may be in the position of examining whether the tenant has legal cause to avoid its lease obligations or terminate the lease. While the law does not favor parties avoiding contractual obligations, there are several related legal doctrines that may allow a tenant to make a credible case to unilaterally limit rental payments, or in certain circumstances, terminate the lease: frustration of purpose, impracticability, and impossibility. Below are brief overviews of what must be satisfied in most jurisdictions to raise these doctrines.

Before examining these legal doctrines, tenants need to examine their leases for two items.

First, tenants should not overlook the obvious. Is there a contractual right to terminate early that is held by the tenant? While such a provision will be rare unless the tenant had considerable leverage at the time of the initial lease negotiations, in some cases, the parties may have structured their lease with a percentage rent concepts that includes an early termination right if gross revenue levels fall below a certain level. Or, if the premises are located on a multi-tenant property, there may be clauses in the lease relieving the tenant of performance if a certain percentage of rentable square footage is vacant or not open for business or an anchor tenant has shuttered operations.

Second, does the lease contain a force majeure clause that reasonably addressed the effect of the pandemic and governmental regulation in response to the outbreak? In many jurisdictions, if an applicable force majeure provision is in place within the parties’ lease, it might be determined that the parties voluntarily contracted around the default legal rules pertaining to the effect of unforeseen circumstances on lease obligations (like a worldwide pandemic) by allocating who bears the risk in such an event.

If there is no specific termination right, there are several related legal doctrines that may allow the avoidance of lease obligations: frustration of purpose, impracticability of contract, and anticipatory breach of contract.

Frustration of Purpose. The frustration of purpose doctrine allows a party to be excused from performance under a contract if an essential or the principal purpose of the contract is frustrated due to circumstances that were wholly unforeseen and which were not caused by the party looking to be relieved of performance. This defense will not apply when the event frustrating the purpose of the contract was reasonably foreseeable (even if unlikely) and the parties reasonably could have addressed the issue in the contract.

Impossibility or Impracticability of Contract. impracticability or impossibility of contract doctrine (sometimes these are separated into two distinct legal defenses) are doctrines related to the frustration of purpose doctrine. Outside circumstances may render excusable a party’s performance (or a delay in performance) if, after the parties enters the contract, an intervening force or event makes one party’s performance under the contract substantially more costly or difficult, or actually impossible. Raising such a defense could relate either to the pandemic itself and its economic effects or the secondary forces of governmental restrictions being placed on certain businesses, including the costs of compliance.

Anticipatory Breach by Landlord. In addition to the doctrines above, it is also possible due to the pandemic’s reach that actions taken or not taken by the landlord could give an excuse to a tenant to not fully perform under the lease or abate rent. If the landlord closes common areas or reduces services to a retail center, a tenant may be able to reduce rent because the tenant is not receiving the full benefit of the bargain struck with the landlord. In order to claim an anticipatory breach there must clear evidence or intention by the landlord, in advance, not to perform the bargained-for performance. Depending on the severity of the anticipated breach, it may allow the tenant to terminate the lease, though such a circumstance is likely to be rare, and may only give cause to the tenant to reduce or abate rent.

Ethan C. Geis is an attorney with the law firm of Davis|Kuelthau in Milwaukee. He has experience representing businesses, investors, and management in a wide range of capacities, including development, financing, leasing, and acquisition and disposition of properties. Additionally, Ethan counsels both well-established businesses and start-ups with regard to entity selection and formation, governance, regulatory compliance, crisis and succession planning, and commercial contract drafting. He can be reached at egeis@dkattorneys.com or 414.225.1415.