On March 19, 2020, in response to the growing Covid-19 pandemic impacting California and the U.S., Governor Gavin Newsom issued the nation’s first stay-at-home order closing all “nonessential” businesses and ordering residents to “shelter-at-home.” As many businesses across the country have lost customers and income during the pandemic, and others have been closed by government mandate, many commercial tenants are struggling to determine if they can remain financially viable and whether their businesses will be able to regain enough consumer activity and revenue to be sustainable once the government restrictions are lifted and thereafter.
This article will propose a general framework within which landlords and tenants can productively conduct discussions to address and attempt to resolve new issues between them as a result of the pandemic. This is not a comprehensive list, but rather illustrates the important discussions landlords and tenants need to begin to have with one another.
- Landlord’s Due Diligence When A Commercial Tenant Requests Financial Relief Under its Commercial Lease
When a landlord receives a request for financial relief from a tenant, the landlord should analyze each request on a case-by-case basis. The following are some steps that a landlord should consider in undertaking that due diligence.
- Request Information from Tenant. A landlord should request information from the tenant including the following:
- i) Tenant’s financial statements and most recent tax returns; ii) A summary of any governmental assistance the tenant has applied for and the status of all applications, plus copies of those applications;
iii) Whether the tenant has applied for, or obtained, business interruption insurance and the status of that insurance or application;
- iv) A detailed description of why the tenant is seeking financial relief from the landlord; v) The tenant’s short term and long term business plans for improving operations and increasing net revenue at the lease premises after the lifting of emergency stay-at-home orders; and
- vi) The tenant’s rent relief proposal to the landlord. 2. Careful Lease Review. The landlord should carefully review its lease agreement with the tenant to determine if there are any applicable provisions, including rent abatement and whether base rent is a flat fee or percentage of the rent component.
- Lender Considerations. It is common for commercial property in California to be encumbered by one or more deeds of trust. The landlord’s flexibility in negotiating with a tenant will be driven, in part, by lender considerations. It is critical that the landlord/borrower review its loan documents to determine whether any disclosure requirements to its lender may arise from the tenant’s request for financial relief. Often, the landlord/borrower will not be able to agree to lease modification terms with a tenant outside of the parameters of any lender preapproved lease modifications as set forth in the loan documents. In other words, loan agreements require the landlord/borrower to obtain lender consent to any material lease amendment.
Where the lease premises is encumbered by financing, the landlord should have the tenant sign a pre-negotiation agreement before commencing a lease restructuring discussion with the tenant. This is important to protect the landlord against a claim by the lender that any agreed upon terms between landlord and tenant are not legally binding absent any required lender approvals. In this pre-negotiation agreement, the tenant would acknowledge that its negotiations with the lender are not legally binding until a formal written agreement is entered into and any required lender consent has been obtained
- Analyze Application of Emergency California Legislation. The landlord shall review all applicable governmental orders (i.e. Governor’s Executive Orders, Judicial Council Emergency Rules, county and city ordinances) relating to rent relief or eviction moratoriums in the jurisdiction of
the lease premises. California State Governor Gavin Newsom has enacted a series of Executive Orders that suspend the ability of landlords to evict commercial tenants and lift the restrictions previously imposed by local governments’ legislative policies on unlawful detainers. Several counties and cities across California have enacted tenant-friendly measures which provide for a variety of relief remedies to individuals and businesses during this Covid-19 crisis. In most cases, a tenant qualifies for relief only if it has suffered adverse financial hardship due to the pandemic; however, some jurisdictions do not even require a tenant to prove financial hardship. In fact, under the Judicial Council Emergency Rules, courts will not even issue a summons or permit an unlawful detainer action, which means an unlawful detainer complaint cannot currently be served on a tenant by the landlord. Furthermore, the rules prohibit entering a default and default judgment, which means that a tenant who does not respond to an unlawful detainer complaint cannot be evicted. Once these governmental orders are reversed, unlawful detainer actions will again be allowed to proceed.
Even if a landlord wants to take an aggressive approach, claiming a default under the lease and exercising all of its remedies, the landlord should consult legal counsel to understand how the California Governor’s Executive Orders, the Judicial Council Emergency Rules, and the county and city ordinances may impact a landlord’s ability to exercise its remedies.
- Reputation Issues. Regardless of merit, the landlord should consider the potential impact on its reputation of taking an aggressive stance in the community and among renters in the market. A reputation gained from aggressive posturing during a pandemic may have long standing consequences after the emergency measures are lifted.
- Tenant’s Due Diligence Before Requesting Financial Relief Under its Commercial Lease
Below are some of the steps that a tenant should consider in undertaking its due diligence before approaching a landlord for financial relief. 1. Careful Review of the Lease.
- a) Lease Provisions. In the case of a retail lease, all or, more likely, a portion of rent may be tied to income produced at that location (e.g. percentage rent).
- b) Abatement. The lease may very well address situations where rent is abated but it is likely that these provisions relate to a casualty, condemnation or disruption in essential services necessary to operating business from the premises. This will likely not apply to the circumstances caused by the Covid-19 pandemic.
- c) Force Majeure. Much has been made about examination of force majeure clauses in the context of lease related issues between landlords and tenants. While it is possible that the provision covers a pandemic by including “acts beyond the reasonable control of the parties,” it more likely covers events such as terrorism or “Acts of God.” A force majeure provision generally suspends performance and/or limits liability but does not generally exclude or relieve a tenant from the
obligations to pay rent. A detailed analysis of the application of force majeure is beyond the scope of this article but note that many courts have tended to interpret the provision in a narrow fashion. It will be important to examine the specific language in the lease and any relevant case law to interpret these types of provisions.
- Business Interruption Insurance. The tenant should examine its business interruption insurance policy to determine if it provides coverage. Many insurers are taking the position that Covid-19 is excluded from the policy. Nevertheless, it may be advisable to file a claim because case law will likely develop out of the numerous cases triggered by the Covid-19 pandemic. (Business interruption insurance could also be accessible to the landlord, but will likely face the same challenges as mentioned above).
- Government Programs. The tenant should apply for and exhaust all government programs (such as the PPP) for which they may qualify.
III. A Path Forward Assuming that most tenants are looking for ways to afford to stay in their lease until the emergency stay-at-home orders are lifted, there are various tools that tenants and landlords can use in a negotiation to hopefully reach a settlement that works best for all parties. Although not a comprehensive list, below are a few strategies the parties can consider.
- The Parties Should Initiate Communication With Each Other. The biggest mistake landlords and tenants can make is to cut off communication with each other. A tenant having financial difficulty is best served by approaching its landlord directly about any disruptions in the tenant’s business. Likewise, landlords should reach out to their tenants and see how each of them is specifically faring in the pandemic, which provides for open and continued communication.
- Negotiation Options. A path forward in negotiations can take a number of structures. Below are some negotiation alternatives for consideration.
- a) Rent Abatement. A tenant may ask for a rent abatement until it is able to reopen for business. Rent abatement may include the following: monthly base rent, percentage rent, common area charges, property tax reimbursement, insurance reimbursement, and potentially other expenses typically passed through by a landlord to its tenants. The tenant will want to tie the abatement period to a discretionary time period (such as when the tenant may reopen for business or when the tenant’s business hits certain financial milestones). The landlord, on the other hand, will want to tie the rent abatement to a fixed period of time or set an outside deadline. A landlord may very well resist rent abatement altogether because this suggestion does not address the landlord’s ongoing requirements to pay real property taxes, debt service, utilities, insurance, operating and repair and maintenance obligations as well various other landlord related fees.
- b) Rent Deferral. While most landlords may not be inclined to abate rent, they may be amenable to a temporary rent deferral. A preferred form of rent deferral among landlords is a rent deferral with a repayment plan at regular intervals or a lump sum at the end of the deferment period. Under this approach, however, there may be unexpected tax consequences for both
parties. If the parties contemplate such a structure, any potential tax consequences should be properly addressed with their accountants.
- c) Blend and Extend. In response to a request for a rent deferral, a landlord may ask for an extension of the lease term. In turn, a tenant may request a free rent period at the beginning of that extended lease term or a lower rent structure which steps up at specific points during the term of the lease.
However, given that landlords in this type of situation are generally concerned with their ability to charge and collect rent from tenants as soon as possible, they may be reluctant to extend a lease and provide the tenant a free rent period unless the tenant has good credit and a business plan demonstrating the viability of their business.
- d) Credit Enhancement. A landlord may only agree to offer a rent abatement, rent deferral, or tenant improvement allowance in the case of a “blend and extend” lease modification if the extension of the lease term is for a significant period of time and if the tenant can provide the landlord with credit enhancement. Where the landlord includes a tenant improvement allowance in connection with an extension of the lease, credit enhancement will give comfort to the landlord that it will not be offering money up front to a tenant who may soon default under the lease. Credit enhancements may be (a) in the form of a lease guaranty, (b) an increased security deposit, (c) a letter of credit or (d) in the case of a retail store or restaurant, the addition of percentage rent as an additional component to the tenant’s overall monthly rental obligation.
- e) Tap the Security Deposit. Depending on the provisions of the lease, the parties may agree that the landlord can apply some or all of the security deposit to any amount of unpaid rent for a short, defined period of time. This has the advantage of providing the landlord with short term liquidity, but does not address the problem of the tenant replenishing the security deposit.
- f) Sublease. A tenant who wants to get out of its lease obligation altogether or significantly reduce its footprint may seek to sublease all or a portion of its lease premises to another tenant. Most leases provide that the landlord must consent to any sublease. In California, absent another standard, the landlord must grant or withhold its consent to the proposed sublease using a reasonability standard. It may not be practical in the current pandemic environment to find a subtenant. However, if a tenant does find a qualified subtenant, it will be important for the tenant to review its lease and comply with all of the requirements when submitting the sublease request to its landlord
- g) Lease Buyout. Under a buy-out scenario, the parties will need to calculate the remaining lease term and apply a percentage discount to the amount of rent remaining. This alternative is only viable if the landlord has use for the space itself or with a new or existing tenant. Under this scenario, it is also critical that the tenant seeking the buyout has access to capital to pay for the lease buyout.
- The Bottom Line Landlords and tenants should set realistic expectations. If the parties cannot resolve their dispute by
negotiation, the parties should be prepared for a lengthy and expensive dispute resolution process. As discussed above, California has placed a stay on eviction proceedings until a period of time after the emergency order is lifted. The specific time periods and requirements vary from jurisdiction to jurisdiction in California. Therefore, the parties will need to examine the applicable Executive Orders, Judicial Counsel Emergency Rules, and ordinances at the time the tenant asks for financial relief. Given the backlog of civil cases in the courtrooms before the pandemic, it will be a significant period of time before such disputes get anywhere near courtrooms.