Applying Frustration Of Purpose to NY Commercial Leases

June 18, 2020Articles Law360

One of the many areas affected by the COVID-19 pandemic is landlord-tenant relations — particularly as it relates to commercial leases. Gov. Andrew Cuomo's declaration of emergency on March 7, and subsequent executive orders mandating the closure of nonessential businesses, has radically altered the commercial landscape in New York.

Even as some nonessential businesses begin to reopen in certain counties, many businesses are not yet permitted to do so, either because of the nature of their business, their geographic location or both. For example, most nonessential businesses in New York City still cannot fully operate in their leased premises. If you are reading this article while working, there is a good chance that you are working from home.

These extraordinary conditions have caused commercial landlords and tenants to closely analyze their rights and obligations. Some commercial tenants have questioned whether to pay rent during the shutdown order. In turn, landlords have faced difficult decisions regarding the future of their tenant relationships.

Although there is currently a moratorium on evictions in New York through Aug. 20, the New York Unified Court System recently lifted the suspension on the electronic filing of nonessential cases. Therefore, we likely will see a raft of litigation in New York Supreme Court concerning rental obligations for commercial tenants who have been unable to fully operate.

The Doctrine of Frustration of Purpose

Generally, commercial leases provide that rent is not subject to offset or abatement unless the lease expressly provides otherwise. However, under certain circumstances, tenants may seek to rely on common law defenses to landlord claims for rent.

One such defense is the doctrine of frustration of purpose. This doctrine "discharges a party's duties to perform under a contract where an unforeseen event has occurred, which, in the context of the entire transaction, destroys the underlying reasons for performing the contract, even though performance is possible."[1]

The Elements of the Doctrine

New York courts have adopted the elements of the doctrine set forth in the Restatement (Second) of Contracts, which requires that: (1) the purpose that is frustrated must have been a principal purpose of that party in making the contract; (2) the frustration must be substantial, or so severe that it is not fairly to be regarded as within the risks that he assumed under the contract; and (3) the nonoccurrence of the frustrating event was a basic assumption on which the contract was made.[2]

Based on this last factor, it follows that if a lease contains a force majeure provision allocating the risk of the frustrating event, a party cannot rely on the defense of frustration of purpose.

Unlike the common law doctrine of impossibility, the defense of frustration of purpose is less focused on a specific obligation that cannot be performed but rather on the purpose of the contract in general. Arguably, the principal purpose of a commercial lease is to allow the tenant to conduct its business in the leased premises.

Yet the purpose of the lease must be considered in connection with the second element, how much this purpose is frustrated. This is a relatively high bar; some courts have required that the contract be rendered valueless for the defense to apply.[3] Based on this standard, courts have held that if a tenant can operate in the leased premises, albeit in a limited manner, the frustration is not severe enough.[4]

Thus, commercial tenants who are permitted to operate in their leased premises to facilitate takeout service or curbside pickup may struggle to benefit from the doctrine. The analysis will be different for those tenants who are not permitted to use their leased premises at all.[5]

The third element of the frustration of purpose analysis relates to the foreseeability of the frustrating event. Some courts have required that the event be virtually cataclysmic and wholly unforeseeable.[6] Given this standard, it is unsurprising that the doctrine has been invoked relatively infrequently in New York. Examples of situations in which it has been invoked include natural disasters[7] and executive orders during wartime.[8]

Remedies for Frustration of Purpose

For tenants who succeed in establishing the defense of frustration of purpose, the remedy is not certain. Some courts have suggested that a tenant who successfully invokes the doctrine may terminate its lease.[9] Others courts have suggested that a tenant may be excused from payment of rent.[10] It is unclear whether the tenant may elect either remedy.

Of course, the remedy may be connected to when a tenant seeks relief. If a tenant's business closed due to the shutdown orders, and then reopened, courts may not be inclined to allow that tenant to terminate its lease. If a tenant terminated its lease while it was unable to operate, with no clear answer on when it could reopen, courts may be more inclined to permit a termination.

Conclusion

With the crisis posed by the pandemic, New York courts will likely have the opportunity to clarify, and expand on, the doctrine of frustration of purpose. Absent legislation, if commercial tenants are excused from rent payments during a certain period, landlords will have to bear this reduction in income without any concomitant reduction in mortgage payments or property taxes.

If commercial tenants are not excused from rent payments for the period during which they were unable to operate, many will struggle to stay in business. Thus, the jurisprudence generated from any upcoming litigation will have major implications for commercial landlords and tenants.

[1] Sage Realty Corp. v. Jugobanka, D.D. , 1997 WL 370786, at *2 (S.D.N.Y. 1997) (quoting Bank of America Nat'l Trust and Sav. Ass'n v. Envases Venezolanos, S.A. , 40 F.Supp. 260, 266 (S.D.N.Y. 1990) (internal quotation marks omitted)).

[2] Gander Mountain Co. v. Islip U-Slip LLC , 923 F.Supp. 2d 351, 359 (N.D.N.Y. 2013); Sage Realty Corp., 1997 WL 370786, at *2.

[3] U.S. v. Gen. Douglas MacArthur Senior Vill. , 508 F.2d 377, 381 (2d Cir. 1974).

[4] Colonial Operating Corp. v Hannan Sales & Serv., Inc. , 265 A.D. 411 (2d Dep't 1943) (wartime orders that prohibited sale of new cars, but permitted the sale of used cars, did not completely frustrate purpose of car showroom's lease); Fisher v. Lohse , 181 Misc. 149, 150 (Sup. Ct. Queens Cty. May 13, 1943) (roadside restaurant's purpose was not frustrated by government acts to conserve food for the war effort even though the volume of its business was "substantially reduced.").

[5] Sage Realty Corp., 1997 WL 370786, at *2 (S.D.N.Y. 1997) (Treasury Department's revocation of tenant's license frustrated purpose of the lease, although the defense was rejected based on the foreseeability prong).

[6] Gen. Douglas MacArthur, 508 F.2d at 381.

[7] Gander Mountain Co., 923 F.Supp. 2d at 351 (tenant's inability to obtain insurance after flood); Axginc Corp. v. Plaza Automall, Ltd. , 759 Fed. Appx. 26 (2d Cir. 2018) (tenant's inability to obtain flood insurance after Hurricane Sandy).

[8] Colonial Operating, 265 A.D. at 411; Fisher, 181 Misc. at 150; Port Chester Central Corp. v. Leibert , 179 Misc. 839 (Sup. Ct. Westchester Cty. Jan. 19, 1943)

[9] See Jack Kelly Partners LLC v. Zegelstein , 140 A.D.3d 79, 85 (1st Dep't 2016) ("Here, without the ability to use the premises as an office, the transaction would have made no sense, and the inability to lawfully use the premises in that manner combined with defendants' alleged failure and refusal to correct the CO constitutes a frustration of purpose entitling plaintiff to terminate the lease."); Colonial Operating Corp. v Hannan Sales & Serv., Inc. , 178 Misc. 885 (App. Term 2d Dep't 1942), reversed 265 A.D. 411.

[10] Fisher, 181 Misc. at 150 ("Unquestionably, had the governmental acts referred to completely frustrated the performance by the defendant of the lease in question, payment of rent would be excused as a matter of law.").

Reprinted with permission from Law360 (c) 2020 Portfolio Media. Further duplication without permission is prohibited. All rights reserved.

This article was also featured among the "Hottest Firms And Stories On Law360."