Published on 3/27/2020
April 1 is on the horizon and with it comes an anticipated wave of rent payment defaults based on the current economic climate resulting from the COVID-19 pandemic. In Washington, Oregon, and California, state and local governments began instituting “stay at home”/ “shelter-in-place” mandates and closed certain businesses after commercial tenants already made their March rent payments. What are commercial landlords’ options when faced with the uncertainty of whether their tenants will pay rent on April 1 or in the following months?
As this article explains, landlords should start with closely scrutinizing their leases and pay particular attention to the following issues:
- Force Majeure: Tenants will likely argue that they should receive rent relief or abatement under “force majeure” clauses, which generally allow for extensions of time to perform under a lease when circumstances are outside the parties’ control. As explained below, landlords should review their leases to see whether rent abatement or payment extensions are expressly excluded from the applicable force majeure clause.
- Default Notice and Cure Provisions: Commercial leases generally have notice and cure provisions providing for a set period of time in which a tenant may elect to “cure” after receiving notice of a default. Landlords seeking to hold their tenants to their rent payment obligations should closely comply with such provisions so as to avoid possible waiver arguments from their tenants.
- Lease Guaranties: When faced with a tenant who cannot pay their rent, landlords should evaluate whether any third parties executed a guaranty in connection with the lease.
- Subchapter V of the Bankruptcy Code: In 2019, Congress passed a new Subchapter V of the Bankruptcy Code, which went into effect in February. Under the new Subchapter V, small business debtors can quickly reorganize in a streamlined Chapter 11-like bankruptcy process. Landlords should be aware of the new Subchapter V as they deal with the fallout of potential rent payment defaults.
Commercial property owners should review lease agreements with tenants for a “force majeure” provision, which may excuse a party’s obligation from preforming under a lease in the event of extraordinary circumstances beyond the party’s control. In general, the application of “force majeure” is a question of contract interpretation. The language in such a provision will dictate: 1) the circumstances in which a tenant may enforce the lease and 2) the scope of relief afforded to the tenant. These provisions will not be implied when they are not expressly included in a lease.
Accordingly, whether force majeure is an option for a tenant will depend on the express terms of the lease. Many force majeure provisions do not excuse or extend the obligation to make rent payments. That being said, landlords should always review their leases to see whether the obligation to make rent payments (or payment extensions) is expressly excluded.
Default Notice and Cure Provisions
Generally, commercial leases contain express provisions that require notice of default to a tenant and an opportunity to cure. Inevitably, the current economic climate will prompt some commercial tenants to request extensions of time to cure their rent payment defaults or offer to make partial rent payments. Landlords should be cautious with such extensions because they could result in a waiver of the notice and cure provisions under the lease. Moreover, accepting partial payment of rent could result in a waiver of the rent payment default. Thus, landlords should consult legal counsel before negotiating a voluntary extension of time to pay rent, curing a rent payment default, or accepting partial rent payments in order to preserve their rights and remedies.
A guaranty is a separate agreement from the lease providing for a third-party guarantor to meet the obligations of the tenant under the lease. When a commercial tenant cannot pay their rent, landlords should analyze whether a guarantor under the lease could make the rent payments.
Not all guaranties are created equal, and it is important that landlords closely scrutinize such agreements to see if they are applicable. Some guaranties are limited in time or dollar amount. So-called “bad boy” guaranties may require the tenant to engage in a bad act, like filing for bankruptcy, before the landlord may go after the guarantor for unpaid rent.
That being said, if the guaranty applies, then landlords should determine whether the guaranty contains any waivers of possible defenses, including the right of the guarantor to assert any defenses that the tenant could have asserted against the landlord. Although such waivers are generally enforceable, the law of waivers in guaranties is complicated, and landlords should consult legal counsel to determine whether such waivers are valid.
Subchapter V of the Bankruptcy Code
Under the Small Business Reorganization Act, which went into effect in February 2020, small businesses may reorganize under Subchapter V of the Bankruptcy Code. While Subchapter V defines a small business as “a person or entity engaged in commercial or business activity with aggregate secured and unsecured debts of $2,725,625,” the new CARES Act raises that amount to $7.5 million, allowing a substantial number of businesses to pursue reorganization under Subchapter V.
Subchapter V streamlines and expedites the process of reorganization for small businesses, making bankruptcy a quick option for commercial tenants. First, Subchapter V shortens standard Chapter 11 deadlines for completing the bankruptcy process. Second, Subchapter V gives a small business debtor greater control over its restructuring plan. For instance, the small business is not required to file a disclosure statement, which provides creditors with initial information about a debtor’s plan of reorganization. It will also be easier for a small business to confirm its plan of reorganization, even if creditors have objections. Landlords should be prepared for distressed commercial tenants to be able to quickly file for bankruptcy and reorganize under Subchapter V of the Bankruptcy Code, as this process will stay the tenant’s obligation to pay rent.
Additional COVID-19 Resources for Businesses
Please visit our COVID-19 Alerts and Resources for Businesses page for an updated list of local and federal resources, along with additional Ryan Swanson COVID-19 practice alerts.
This message has been released by the Bankruptcy, Finance & Restructuring group at Ryan, Swanson & Cleveland, PLLC to advise of recent developments in the law. Because each situation is different, this information is intended for general information purposes only and is not intended to provide legal advice on any specific facts and circumstances. Ryan, Swanson & Cleveland, PLLC is a full-service law firm located in Seattle, Washington.