REAL ESTATE LAW
BY ROBIN L. NOLAN AND ADAM F. ALDRICH
This article discusses issues that commercial landlords and tenants, and real estate loan borrowers and lenders, are facing in connection with their contractual obligations during the C0VID-19 pandemic.
As the spread of C0VID-19 causes the closures or severe cutbacks of businesses, many in the commercial arena are left to consider their options as landlords and tenants in commercial leases, and lenders and borrowers in real estate loans. Concepts such as force majeure, material adverse effect, and frustration of purpose are becoming part of the current lexicon for these commercial actors. The next step is to understand how such concepts operate in lease provisions and loan documents to determine how they can work for the parties in these unsettling times.
This article provides the legal groundwork to understand commercial lease and real estate loan terms and noncontractual common law defenses that are particularly relevant in the C0VID-19 environment. It reviews how commercial landlords and tenants, and real estate loan borrowers and lenders, are tackling pandemic issues with these terms in mind.
Legal Concepts in Commercial Leases and Real Estate Loans
Parties typically contract to provide who bears the burden of risk for events that commonly affect performance. Such events include acts of God, and financial, business, and property conditions. Parties also rely on noncontractual common law principles that excuse performance.
Force majeure clauses are contract provisions that excuse a party's nonperformance when acts of God or other extraordinary events prevent a party from fulfilling its contractual obligations.1 Whether certain events triggered by the C0VID-19 pandemic constitute force majeure depends on whether and how force majeure is defined in a particular contract.2
When considering the applicability of a force majeure clause, courts analyze (1) whether the event qualifies as force majeure under the contract,3 (2) whether the risk of nonperformance was foreseeable and able to be mitigated,4 and (3) whether performance is truly impossible.5 The primary focus is on whether the clause encompasses the type of event a contractual party claims is causing its nonperformance.6
Force majeure clauses are generally interpreted narrowly; therefore, for an event to qualify as force majeure, the clause at issue must use precise terms such as "war" and "pandemic" to state the event.7Even when a clause encompasses a potential force majeure event, a party cannot invoke force majeure where the potential nonperformance was foreseeable and could have been prevented or otherwise mitigated.8 Further, nonperformance will not be excused if it is merely financially or economically more difficult to satisfy contractual obligations. Some jurisdictions, however, may only require that performance be impracticable.10
A party that considers terminating a contract or delaying its performance based on the existence of a force majeure event should carefully consider the specific events upon which it relies in asserting that right. There will likely be disagreement about whether the event was beyond the terminating party's control; was reasonably foreseeable and could have been prevented; or fits the contractual definition of a force majeure as opposed to a change of economic circumstances, the risk of which the terminating party assumed.
If a party is contemplating termination based on a force majeure event, it should provide notice of the event as soon as practicable, even if it does not know whether the event will result in its inability to perform. Doing so reduces the risk of an unnecessary dispute about the timeliness of any notice.
Material Adverse Effect
Commercial real estate loans typically allocate significant financial, business feasibility, and property condition risks to the borrower. Borrowers often seek to mitigate these risks by negotiating for "material adverse effect" (MAE) clauses, which provide an option to terminate the contract where certain circumstances occur that result in a material or adverse change to the property's condition before closing. Sometimes the term "material adverse change" (MAC) is used interchangeably to refer to an MAE clause.
Whether an event falls within the definition of an MAE depends on (1) how MAE is defined, (2) the scope of any carve-outs to the MAE definition, and (3) whether the adverse event is material to the agreement as a whole. The applicability of the provision may also depend on the extent to which the parties could foresee the event in question and/or negotiated specifically regarding the risk of the event. An adverse event is generally considered material if it "substantially threaten[s]" the fundamental agreement "in a durationally-significant manner."11 To qualify as an MAE, the adverse event "must be expected to persist significantly into the future."12
Whether an MAE has taken place usually presents a factual inquiry, and expert testimony and detailed financial information are almost always necessary.13 A party seeking to terminate a contract based on an alleged MAE bears the burden of proving that the risk was unforeseeable at the time the party executed the contract and that the event in question will significantly impact the property in the long term.14 Similar to force majeure clauses, courts evaluate whether the party's decision to terminate the contract based on an MAE was due to a circumstance that was reasonably foreseeable and has a long and lasting impact.
For example, in Capitol Justice LLC v. Wachovia Bank, N.A., Wachovia Bank asserted its rights under an MAE clause to terminate a loan commitment for a loan intended to be secured through commercial mortgage-backed securities (CMBS) financing when the CMBS market ceased to function in 2007.15 In its analysis of whether a material change had occurred, the court focused on whether significant changes in the CMBS market were reasonably foreseeable when the contract was drafted. The court held that "parties often include MAC clauses to protect against unknown, not known, events[,]"17 but that the MAC clause at issue was ambiguous "because there is more than one interpretation that a reasonable person could give to the MAC clause... "18
Even where CO\TD-19 has led to dramatic governmental actions and shutdowns, it cannot be assumed that such conduct would justify triggering an MAE clause. Each case must be evaluated based on its specific factual circumstances, the language in the agreement, and the context of the transaction. If negotiations are ongoing for a prospective transaction, careful consideration should be given to crafting the MAE clause in light of the COVID-19 pandemic. A review of recently filed complaints illustrates that contractual provisions other than MAC/MAE have been relied upon by parties seeking to avoid contractual obligations in the COVID-19 era, including failing to comply with obligations to continue operations in the normal course of business due to compliance with government-mandated shutdowns; specific performance, for failing to comply with the scheduled closing; breach of contract, for refusing to close on a merger because financial information the seller provided the buyer did not take into account the effects of coronavirus; and declaratory judgment seeking a declaration that a buyer validly terminated a Transaction Agreement under which it would acquire a majority interest in the seller's retail business because the seller breached covenants, representations, and warranties by substantially altering its business operations.19
Noncontractual Common Law Principles that Excuse Performance
Even in the absence of contractual MAC or force majeure clauses, parties may turn to common law defenses of impracticability or frustration of purpose as potential options to discharge their obligations under real estate contracts. Each of these defenses is incorporated into the Restatement (Second) of Contracts,20 which is followed in Colorado.21
Under the doctrine of impracticability, a party's contractual obligations may be discharged if, after the contract is made, the party's performance becomes impracticable by the occurrence of an event that is outside of a party's control and the nonoccurrence of which was a basic assumption on which the contract was made.22
Similarly, under the doctrine of frustration of purpose, a party's contractual obligations may be discharged if, after the contract is made, the party's principal purpose is substantially frustrated without the party's fault and where the occurrence or nonoccurrence of an event was a basic assumption on which the contract was made.
The application of each of these defenses depends on whether an unanticipated circumstance has made the performance of the contract materially different from what reasonably should have been within the contemplation of both parties when they entered into the contract.24 Economic conditions generally do not constitute an unanticipated circumstance.25 A governmental regulation or order, the nonoccurrence of which w as a basic assumption of the contract, may constitute commercial impracticability,26 but a party must overcome a high bar to succeed on a commercial impracticability argument.27
Potential COVID-19 Issues with Commercial Leases
Governmentally imposed stay-at-home orders implicate numerous issues in commercial leases involving nonessential businesses. With an understanding of those potential issues, landlords and tenants can work to craft...