Unlike the Great Recession in 2008, landlords and tenants responding to the negative economic impact of the COVID-19 health crisis appear to be focusing more on rent relief as opposed to strict interpretation and enforcement. Both sides seem to acknowledge that this downturn is driven by external, uncontrollable influences, and therefore each side should cooperate to weather the storm. It is the approach we most strongly encourage our clients to take, as it strengthens the relationship between landlord and tenant and avoids unnecessary expenditures on costly lease enforcement.
Not all parties have taken this approach, however. Some, whether out of opportunity or desperation, have instead taken a more aggressive position, claiming that the uncontrollable nature of this pandemic justifies suspension of contractual duties and/or entitles a party to terminate its lease. Many legal arguments have been proffered to support this position, including force majeure, impossibility, casualty, eminent domain and frustration of purpose. This article will discuss the latter, clarifying the nature of the doctrine and explaining how two precedential decisions may affect how it may apply to current lease disputes.
What is Frustration of Purpose?
Frustration of purpose applies when performance of a contract or lease remains possible, but the fundamental reason of one of the parties for entering into the contract has been frustrated by an unanticipated supervening circumstance, destroying substantially the value of performance by the party standing on the contract. Cutter Laboratories, Inc. v. Twining (1963) 221 Cal. App. 2d 302, 314–315. If the doctrine applies, the party to the contract is discharged from its obligations under the contract, including the remainder of the term. This doctrine has been considered by many California courts, including those addressing the impact of government-imposed regulations on the obligations of tenants and landlords under a lease.
Can Frustration of Purpose be Used by a Tenant to Justify Immediate Termination of a Lease?
In a case which dates back to World War II, a landlord leased commercial space to a tenant who intended to display neon signs to illuminate and advertise for his business. 20th Century Lites, Inc. v. Goodman (1944) 64 Cal. App. 2d Supp. 938. After the lease commenced, the United States government ordered, as an emergency war measure, that all outside lighting, including neon signs, be shut off between sunset and sunrise. The tenant claimed that he was prevented, due to the order and without fault on his part, from using the neon signs he used to illuminate his business during the nighttime, and that both parties contemplated such use as the primary purpose of the lease at the time of the execution of the contract. The lease between the parties clearly contemplated the use of the neon signs, but did not state what hours the signs could be lit. The tenant first offered to surrender the lease, terminate it, and allow the landlord to remove the signs. However, after the landlord refused, the tenant stopped paying rent, and the landlord sued to collect.
The court agreed with the tenant. Relying on the doctrine of frustration of purpose, the court held that the tenant was entitled to terminate the lease because the parties clearly contemplated, prior to entering into the contract, that the use of the signs at night “was the essential, primary and principal basis for which the signs were rented.” Therefore, as the governmental order prevented the tenant from using the signs, the entire purpose of the lease was frustrated and the tenant was discharged from its obligations under the lease, including future rent.
Does Frustration of Purpose Automatically Apply and Permit Termination of a Lease?
Not all tenants are entitled to rely on frustration of purpose to terminate their leases simply because an intervening event has occurred. In another WWII case, the California Supreme Court considered the effect of a wartime order on a lease for an auto dealership. Lloyd v. Murphy (1944) 25 Cal. 2d 48. In 1941, the tenant rented property in Beverly Hills for the purpose of displaying and selling new cars “and for no other purpose whatsoever.” On January 1, 1942, the federal government ordered that the sale of all new automobiles be discontinued to support the war effort. Recognizing the effect that the order would likely have on the tenant’s business, the landlord lifted all restrictions in the lease regarding the tenant’s use of the premises. The landlord also permitted tenant to sublease and offered to reduce the rent if the tenant was unable to operate profitably. Despite these concessions, the tenant sought to repudiate and terminate the lease, claiming frustration of purpose. The landlord then sued for unpaid rent.
In this case the landlord prevailed, as the court found that the tenant was not entitled to terminate the lease based on frustration of purpose. At trial, the tenant admitted that he continued to sell new automobiles and gasoline at the location, confirming that the tenant was able to operate consistent with its original purpose to some extent. The court also found that the landlord made considerable concessions which, in this particular instance, were significant given that the property was located on a main artery in Los Angeles County and the location was adaptable to many commercial purposes if the tenant chose to utilize the premises in a different way. In fact, after the tenant vacated the premises, the landlord immediately found a willing tenant to step in and rent the property. The court held that even though the government regulation made business more difficult and less profitable, a tenant could not invoke the doctrine of frustration of purpose unless the regulation completely destroyed the value of the lease.
Lessons for Landlords and Tenants Considering the Impact of Frustration of Purpose
These two cases offer up a couple takeaways regarding the obligations of landlords and tenants following an unanticipated supervening circumstance, such as the COVID-19 health crisis and related governmental orders requiring individuals to shelter in place.
First, landlords should be mindful that providing flexibility to a tenant in occupying their leased premises may help avoid a claim of frustration of purpose and termination of the lease. For the auto dealership landlord, the court strongly considered the flexibility, fairness, and cooperation of the landlord, who did everything it could to ensure that the leased premises retained some value for the tenant. By removing use restrictions, allowing transfers and subletting and/or reducing rent, the landlord was able to overcome the argument that the purpose of the lease was frustrated. Unlike the neon signs case, in which the entire and sole purpose of the tenant’s lease was deprived as a result of the governmental order, the auto dealership landlord took affirmative acts to preserve such value and thereby protect its lease. In sum, it behooves a landlord – where economically feasible – to cooperate with a tenant and/or offer concessions in order to prevent a tenant from claiming the purpose of the lease was entirely frustrated. Even if those measures prove to be unsuccessful, it may later benefit the landlord in court.
Second, landlords and tenants should consider the impact of restrictive use provisions in their leases. Landlords, especially in multi-tenant shopping centers, generally want to narrowly define a tenant’s permissible use so as to avoid overlapping and/or violation of exclusivity restrictions. The most recent health crisis reminds landlords of the dangers of taking this approach, as doing so may coerce a tenant into the unwanted conclusion that its purpose was entirely frustrated. Landlords may also want to grant a tenant the ability to pursue alternative uses with their landlord’s consent, which might provide a secondary manner of broadening the purpose. In either case, the language of the lease should be clear as to the purpose of the lease so as to avoid unwanted interpretation by a court. In the neon signs case, the court was left to determine what the primary purpose of the lease was because the parties failed to define its purpose with specificity. Careful drafting may have given the landlord more options or remedies.
While global pandemics and the related government-mandated use restrictions are rare, they can have a significant effect on businesses of all sizes and across industries. These two cases remind landlords and tenants that special attention should be paid both to the language of a lease and each party’s response to these crises. Not only will such consideration and cooperation benefit a landlord should the matter proceed to litigation, it will also engender goodwill with the tenant or future tenants. If you would like assistance with interpreting lease provisions and/or responses to the COVID-19 health crisis, whether in connection with a claim of frustration of purpose or not, please contact the attorneys at Weintraub Tobin.