Businesses have been hard hit by the COVID-19 pandemic and resulting “shelter in place” orders issued by state officials. Bankruptcy courts have been flooded with large retailer bankruptcy filings. Since January 2020, approximately 27 retailers have filed for bankruptcy, including Century 21, Stein Mart, Tailored Brands, Inc., Lord & Taylor, Ascena Retail Group, Inc., Modell’s Sporting Goods, Pier 1 Imports, Inc., J. Crew, Neiman Marcus, JCPenney, Tuesday Morning, GNC, Sur La Table and Brooks Brothers, just to name a few. Large gyms and fitness centers are also joining the mix, including Gold’s Gym, Town Sports International, Flywheel Sports and 24 Hour Fitness. The restaurant industry is suffering too, as we see companies like TooJay’s, FoodFirst Global Restaurants, CEC Entertainment Inc. and Garden Fresh Restaurants filing for bankruptcy. The foregoing is certainly not exhaustive and does not even consider small business filings. And, guess what? We have approximately three months left in 2020, leaving plenty of time for this list to grow.
Yes, commercial landlords are worrying, as they should, about whether or not their tenants will file for bankruptcy. However, that should not be their only concern. They need to worry about whether their tenants will look to void their commercial leases outside of bankruptcy. In New York, due in part to the ongoing moratorium imposed by Governor Andrew Cuomo on the commencement of proceedings relating to the nonpayment of rent and eviction of commercial tenants [the freeze has most recently been extended to October 20, 2020, by Executive Order 202.64], few courts have been able to test the enforcement of commercial leases and potential defenses tenants may raise as a result of the COVID-19 pandemic.
However, an August 2020 decision and order issued by New York County Supreme Court Judge Kathryn E. Freed in Backal Hospitality Group LLC, et al. v. 627 West 42nd Retail LLC, Index No. 154141/2020, may give practitioners and commercial landlords a sneak peek at what is to come. For now, it is too early to tell whether other courts will find commercial leases unenforceable due to the COVID-19 pandemic and related government-mandated shutdowns in New York.
In Backal, a private event company/caterer entered into a ten-year lease for property located in New York City for the purpose of hosting and organizing large-scale private parties and events in June 2018. A $500,000 security deposit and “good guy guarantee” [a type of personal guarantee putting the business owner or principal on the hook for any rent due up to the time the tenant vacates the space and returns it to the landlord, typically found in commercial lease agreements] were required under the lease and later, a $500,000 letter of credit was established to replace the cash initially provided as security. Pursuant to the lease, landlord 627 West 42nd Retail LLC (“627 West”) was authorized to draw upon the letter of credit in the event the lease was breached. Fast forward to March 2020 – – when Governor Cuomo’s March 22, 2020 Executive Order prevented the event company/caterer from operating the leased space for events and thus, left it unable to pay future rent and looking to vacate the space and terminate the lease.
As the tenant failed to pay rent, 627 West drew down the letter of credit to satisfy outstanding rental arrears through June 2020. The tenant and guarantors on the lease quickly commenced an action seeking (1) a declaratory judgment that the lease had been terminated, and (2) an order permanently enjoining 627 West from preventing the tenant and guarantors from canceling the letter of credit that secured the lease. They then brought an emergency application seeking an order directing 627 West to refund the amount of the letter of credit or, alternatively, directing 627 West to post a bond in the amount of the letter of credit pending the final resolution of the case.
On June 23, 2020, the court granted a temporary restraining order (“TRO”) preventing 627 West from further drawing on the letter of credit and enjoining the landlord from using or transferring any of the funds it had already drawn down. However, after oral argument, the court issued its decision and order on August 3, 2020, which vacated the June 25, 2020 TRO and denied the plaintiffs’ application (the “decision and order”).
According to the decision and order, the tenant and guarantors argued that they were “likely to succeed on the merits since their surrender of the premises, combined with 627’s acceptance of the keys, establish[ed] that 627 allowed plaintiffs to terminate the lease without penalty.” Further, they argued that they would suffer “irreparable harm  if they [were not] granted the relief they [sought] since they [would] be unable to return the deposits their clients made in connection with parties planned at the premises.” They also argued the doctrine of “impossibility of performance” under the lease in light of the March 22, 2020 executive order prohibiting large gatherings.
In opposition, 627 West argued that (1) 627 West delivered a notice of default to the caterer after it failed to pay March and April 2020 rent obligations, (2) after the tenant and guarantors requested a lease modification as a result of the COVID-19 pandemic, the parties entered into negotiations regarding a possible lease modification, and (3) notwithstanding such discussions about a possible lease modification, 627 West never agreed to allow the caterer to vacate the premises without penalty. 627 West noted that the tenant and guarantors had no evidence that the parties agreed to an early termination of the lease or waiver of all rent due. It further argued that the lease prohibited the caterer from surrendering the premises without written approval from 627 West and required the caterer to pay any rent after it vacated the premises due to a default.
The court found that the tenant and guarantors failed to establish the likelihood of success on the merits and focused on the language of the lease itself. The lease contained provisions stating that surrender of all or part of the premises would be valid only if in writing and signed by 627 West [plaintiffs failed to produce any such writing] and that the delivery of keys would not operate as termination of the lease or surrender of the premises.
Further, the court was not persuaded by the plaintiffs’ argument that the March 22, 2020 executive order banning large gatherings made it impossible for them to perform under the terms of the lease. In so holding, the court referred to a provision in the lease which suggested that the parties “contemplated a scenario…in which performance by plaintiffs might become prohibited by a governmental order, and agreed that, if such a situation arose, they would reach an agreement regarding the collection of rent at the conclusion of the governmental restriction.” The court reasoned that, “[a]lthough the parties attempted in vain to negotiate a lease modification, plaintiffs nevertheless attempted to unilaterally terminate the lease in a manner violative of the terms thereof.”
It is important to note that the court’s decision in Backal is only a finding that the tenants and guarantors were not likely to succeed on the merits of their claim. It is not a final determination as to whether the tenant and guarantors can obtain the relief they are seeking. Nonetheless, Backal offers a glimmer of hope for landlords that New York courts will look specifically at the terms of the negotiated lease obligations in instances where the COVID-19 pandemic and governmental restrictions prevent a tenant’s business from operating, and will not be persuaded by common law doctrines like impossibility of performance or frustration of purpose.
Backal Hospitality Group LLC, et al. v. 627 West 42nd Retail LLC is a case to watch as it develops. The plaintiffs filed their complaint earlier this month, including causes of action for rescission of the lease based on frustration for purpose and impossibility of performance, reformation of the lease [i.e. asking the court to find the parties’ “true intent” of the tenant’s obligations should it be deprived of the use of the premises], breach of contract, money had and received, and unjust enrichment.
Practitioners and commercial landlords alike should also look out for other judicial decisions that address whether tenants can avoid commercial leases based on impossibility of performance or frustration of purpose in the COVID-19 era. A finding by a court that a lease is void and unenforceable by law based on the impact of COVID-19 and impossibility of performance or frustration of purpose will chill the commercial real estate market.
In addition to the arguments raised by the plaintiffs in Backal, practitioners and commercial landlords should be on the lookout for tenants to raise the applicability of a lease’s force majeure provision [a provision that excuses non-performance due to certain enumerated circumstances beyond the parties’ control, such as war, strikes, riots, “Acts of God” and governmental orders] or the doctrine of impracticability of performance [in general, the doctrine excuses nonperformance based on the occurrence of an event “the non-occurrence of which was a basic assumption on which the contract was made.” See Restatement 2d of Contracts, § 261.]