Commercial Leases in the Age of the Novel Coronavirus ― Landlord Duties to Obey the Law, Unforeseeable Government Action and the Unconscionability of it All

From the Desk of Rick Scarola

Three new issues for pandemic-driven commercial lease litigation …

Commercial landlord-tenant relationships have potential to produce a tsunami of litigation over impacts of the novel coronavirus:  conflicts as to whether and how a tenant’s lease obligation to pay rent or even continue a lease are affected by the pandemic and the resulting government-mandated restrictions.  The settings vary widely, from commercial business offices to retail businesses to restaurants, but many articles point out that there is an array of common law principles that may govern in all of these controversies.  Frustration of purpose and impossibility are perhaps most commonly mentioned (along with contractual force majeure clauses found in some leases ― a subject itself fraught with much confusion and to be saved for a different writing).

These contract law principles have a long history, but no history of application in circumstances like these.  The pandemic presents novel facts for analysis of commercial lease rights/duties.  We see some new ways of looking at these issues as they are revisited in the age of COVID-19 as well as some additional legal principles that have not yet entered the dialogue in the commercial lease disputes percolating in the courts.

Here are three issues/arguments that we see being overlooked, each of which may substantially strengthen commercial tenants’ arguments that they should not be required to pay rent when they have not been allowed use of their offices, retail space or restaurant space.

  1. Whose Burden Is It, Anyway? The first issue implicates how specific lease provisions will be construed and also suggests a tenant defense of illegality (another common law principle that may be invoked in these disputes).  Bottom line ― restrictions on the use of leased spaces appear to make it just as illegal for landlords to provide them as it is for tenants to use them.

As background, a premise that has worked into the dialogue is that government-mandated closures of offices and retailers and restaurants are restrictions on the tenant, leaving the tenant to scramble for a way to argue that this burden on the tenant can warrant mandatory relief from rent or a lease as a whole.  In fact, however, the dialogue overlooks that the restrictions of government mandates generally apply to both tenants and landlords equally.  If a tenant may not operate a business under a restriction (a prime example being those restrictions imposed in New York by the Governor’s Executive Orders), a landlord seems by plain language of the mandates to be just as barred from allowing a tenant to use space the landlord leases as the tenant is barred from using its space.  Put differently, if a tenant openly and notoriously violates a restriction in a space where use and access are controlled by the landlord, the landlord would also be in violation of the mandate for allowing this to happen.  The tenant-side dialogue often omits this and accepts the landlord-side view that the burden is upon the tenant only and is just a matter of economic hardship for the tenant (the risk of which the tenant ostensibly assumed under the lease).

Seen as a burden on landlords with at least equal force ― with the restrictions barring landlords from making leased space available to their tenants for their intended use ― lease provisions ranging from those governing quiet enjoyment to general use and occupancy rights to casualty issues (as one New York State court recently held) will be construed more favorably for tenants.

As well, seen in this light, the common law doctrine of illegality may be construed to afford relief for tenants if the landlord’s making the space available for use as well as its use by a tenant are both unlawful under a government mandate.

These considerations change the dialogue from one in which affected tenants are seen as the only affected party, facing an economic hardship, and seeking relief from a landlord-bystander that has no duty, fault or role whatsoever.

Argument that the restrictions affect both landlords and tenants equally and that landlords are not simply above the fray may give tenants a powerful arrow in the legal quiver as courts come to grips with the many cases that will address the effect on commercial leases of the unprecedented shutdowns of New York City office buildings and retail and restaurant spaces.

  1. You saw what coming? The second issue is the “foreseeability” ― or the unforeseeability ― of what has actually happened in terms of the commercial space shutdowns.  Foreseeability (or its absence) is an element of invoking many lease protections and also an element of some of tenant-side legal defenses such as frustration of purpose.  Bottom line ― while viruses and even serious pandemics have been foreseeable, the unprecedented shutdowns of commercial business have not been foreseeable.

The blogosphere writing on this issue has generally focused on whether a virus-like pandemic was, as such, foreseeable.  Minds might differ on that question ― and do.  A landlord might argue that the Hong Kong Flu of the late 1960s was relatively recent and a serious pandemic and that the more recent Swine Flu, while ultimately not so far-reaching in consequences, was not stale news when most current commercial leases were signed.

BUT ― whether one might have seen a virus-like pandemic coming seems not to be the correct question for “foreseeability” analysis.

While it is debatable whether this pandemic was foreseeable at all, even assuming that it was, the correct question is the foreseeability of the consequences of this particular serious pandemic.   More specifically, the correct questions are, for an example, whether a three-plus month complete prohibition on the use of commercial office space throughout New York City could have been foreseen and whether a total disruption (if not closure) of retail and restaurant business could have been foreseen.

What has occurred by reason of these restrictions has left some segments of communities and industries in a dystopian state.  The government response, while needed, is indeed unprecedented and many would say truthfully was unforeseeable when their commercial leases were signed.  Some argue that the government’s lack of preparation for the pandemic, and the consequences making many things worse than they might have been, was also unforeseeable.

Restrictions like those experienced since March 2020 ― never seen before for any reason (in earlier serious pandemics or otherwise) ― put the question of foreseeability in a whole new context not being considered in cases we have seen.  As one insurance company put it in a recent filing, arguing (to avoid a coverage claim) that what has occurred was not foreseeable:  “The idea that the policy could have been intentionally ‘designed’ many years ago to account for an unprecedented and unexpected global pandemic strains credulity.”  It strains credulity just as much that commercial tenants could have foreseen being displaced from their restaurants, stores and offices for business-killing periods of time.

  1. Well, that All Seems Unconscionable. The third issue not being discussed is New York’s statutory prohibition against unconscionable provisions in leases (including commercial leases).  New York’s Real Property Law §235-C provides that a lease, or any part of one, that was unconscionable “at the time it was made” may not be enforced in whole or part.  This statute is often overlooked even by commercial real estate specialists, but it applies with full force to commercial leases.

The nuances of how this statute may be applied are beyond the scope of this short piece.  The statute may not turn out to be a tenant-side panacea in this emerging sphere of litigation.  It is limited, for example, by the phrase unconscionable “at the time it was made” ― a phrase with little discussion in caselaw and leaving enormous room for able lawyers on both sides of the issue to argue its meaning into the ground.  The statute has also been held to have a “procedural” as well as a “substantive” unconscionability requirement, requiring that the tenant invoking can establish that there was some unconscionability in the making of the bargain.  Again, this is an issue that may be argued into the ground by able lawyers.

The caselaw guidance, however, while limited, gives a lot of hope to tenants that judges sympathetic to the tenant-side plight will take to this argument.  For one thing, the issue will be examined on a “sliding scale,” such that with greater substantive unconscionability, less procedural unconscionability is required.  And no doubt all but the largest commercial tenants (those with gorilla-in-the-room bargaining power) have unconscionability tales to tell ― such as facing demands for onerous lease terms when time constraints on a prospective move to a new space approached (a timeframe impossible to manage, complicated by a landlord’s presentation of a lease exceeding 100 pages of dense material).  The unconscionability hurdle is not so much of a stress.

Indeed, initial draft leases typically come from the landlord’s very skilled long-standing counsel, have been long-in-the-creation and are well-honed to be replete with landlord-favoring terms at every paragraph.  In the typical scenario, most terms are not ever subject to meaningful negotiation or even meaningful review.  And unsurprisingly, the terms applicable to remote disasters and possible future dystopian circumstances receive no attention at all as a tenant’s very limited negotiating time and capital is deployed instead to the few most immediate, high visibility and high stakes principal deal terms.

While this unconscionability statute has barely been tested in the courts, lease terms ― perhaps especially those written in more general or even obtuse language, and not specifically describing the current world state ― may, if a landlord argues such terms place all risks of the current world nightmare on the tenant while insulating the landlord completely from all harm (except for the nuisance of having to seize tenant security and chase tenant lease guarantors), become unconscionability’s virtual poster child.

As noted above, there is a fiction that has found its way into the dialogue which many commercial landlords cling to ― all is fine at their end, any problems are tenant problems and all rent must be paid (or else) ― such a limitation or landlord-protection provision may not fare well under the microscope of the unconscionability analysis.

Cracks in the Dam? COVID-19 Business Interruption Insurance Coverage Litigation Update

From the Desk of Cassandra Porsch ―

The dam has begun to show cracks in the insurance industry’s adamant position that general business interruption coverage does not cover losses due to the pandemic.  How much water will seep through the cracks?

One of the biggest legal issues arising out of the COVID-19 pandemic continues to be the ability of businesses to collect on their business interruption insurance policies for lost income due to lockdowns.  According to an Oct. 22 report by the National Association of Insurance Commissioners (NAIC), there have been at least 201,285 claims for business-interruption losses caused by coronavirus orders in the United States.  The NAIC reports that of those 164,178 were closed without payment, 34,106 remained open and 3,001 were paid.

Jilted businesses denied insurance recoveries have taken to the courts with thousands of individual and class actions filed all over the country.  As decisions on motions to dismiss in these cases begin to come down, a hodgepodge of conflicting case law is emerging across jurisdictions.  Two of the pivotal issues upon which conflicting law is arising are whether the policy at issue contains a virus exclusion and whether the existence of the virus constitutes a direct physical loss.  A few recent cases have suggested recovery may be possible even over these obstacles.

Whether the Policy Contained a Virus Exclusion

Many cases filed by insureds whose policy contained a virus exclusion are being dismissed.  For example, in Mac Prop. Grp. LLC v. Selective Fire & Cas. Ins. Co., a New Jersey bakery sued its insurer for denying a business interruption claim when it had to close during a shutdown of nonessential businesses.  The policy excluded coverage for loss caused directly or indirectly by “any virus, bacterium or other micro-organism that induces or is capable of inducing physical distress, illness or disease.”  The New Jersey Superior Court found this language “clear and unambiguous,” and determined in dismissing the case that it did not need to reach any other issue such whether there was direct physical loss to the property in dismissing the complaint.

Likewise, in Chattanooga Professional Baseball LLC et al. v. National Casualty Co. et al., the United States District Court for the District of Arizona dismissed a case by a group of Minor League Baseball teams seeking coverage from their insurer for lost income due to the cancellation of their season.  While the teams argued that their losses stemmed from government shutdown orders, the judge noted that those shutdown orders were as a result of the virus and that because their policies contained a virus exclusion, they were barred from recovery.

However, faced with a similar virus exclusion clause, a federal judge in Florida came to the opposite conclusion.  In Urogynecology Specialist of Florida v. Sentinel Insurance, a medical practice which was forced to cease normal operations during Florida’s state of emergency sought to recover its business losses under an “all-risk” insurance policy.  The insurer sought to dismiss the case based on the virus exclusion clause in the policy, which disclaimed coverage for losses caused by the “[p]resence, growth, proliferation, spread or any activity of ‘fungi,’ wet rot, dry rot, bacteria or virus.”  Here, the court found that the language of the policy did not clearly and unambiguously exclude losses related to COVID-19 because the word “virus” was grouped with pollutants, and thus did not necessarily contemplate for exclusion “the unique circumstances of the effect COVID-19 has had on our society.”

“Physical Loss” Clauses

In many cases, business interruption coverage cases are also being dismissed based on a requirement in policies that there be “physical loss” to the property, which courts have interpreted to mean physical damage, and not just loss of use due to the spread of a virus.  For example, a judge in the United States District Court for the Southern District of New York in Social Life Magazine, Inc. v. Sentinel Insurance Company Limited ruled at oral argument on an order to show cause that a publisher could not show a likelihood of success on the merits of its declaratory judgment claim because its insurance policy contained a physical loss provision and merely having to shut down due to the spread of the virus did not cause physical loss to the premises.  The judge noted that the virus “…damages lungs. It doesn’t damage printing presses.”

Similarly, the U.S. District Court for the Southern District of West Virginia in Uncork & Create LLC v. The Cincinnati Insurance Co. found that a restaurant that had to close in response to a government shutdown order had not shown a “physical loss” as required for coverage under its policy.  While the plaintiff argued that it was not required to show a physical alteration to its property in order to meet the physical loss standard, the court still was not convinced that the potential presence of the virus met the standard.  Specifically, the court noted that even if the virus were attached to surfaces at the property, it would not threaten the physical structures as the virus’ presence could be eliminated with surface disinfectants. The court dismissed the case.

However, based on essentially the same facts and another “physical loss” provision, the United States District Court for the Western District of Missouri found that the general presence of the virus in the area was sufficient to constitute physical loss and meet that requirement in the insureds’ policies.  Studio 417, Inc. et al. v. The Cincinnati Insurance Co. involved a hair salon and several restaurants seeking business interruption coverage for COVID-19 shutdowns.  The court noted that a “loss” included “the act of losing possession” and “deprivation” of property.  In reasoning directly contrary to that used by the West Virginia court, it also found that the virus was a physical substance that attached to surfaces and thus made the property unusable.  This court also focused on the disjunctive phrase “physical loss or damage” in the relevant policies, noting that the use of “or” meant that “loss” could occur without physical alteration, with such loss including an inability to inhabit the property even without any alteration to the state of the property.

With both of the above issues, the viability of a case may hinge heavily on minor differences in the language of the insurance policy at issue.  However, even with similar or identical language, the outcome may depend upon a judge’s willingness to consider alternative definitions of basic terms.  As more conflicting case law arises, we should see the business interruption insurance issue work its way through the appellate courts to determine a more standard approach across jurisdictions.  The issue will likely be with us long after the virus has receded.  The insureds’ door to recovery has been opened by at least some courts despite the virtually blanket insurer denials seen to date.