Impact of COVID-19 on Real Estate Contracts - Force Majeure, MAC Clauses, Impossibility of Performance and other Considerations
As countries around the globe begin to aggressively respond to the COVID-19 virus, governments have called for social distancing, closing of certain retail, dining and other businesses, and eviction moratoriums. The capital markets have been in turmoil for weeks. For real estate and other clients who have entered agreements for the purchase and sale of property and commitments to fund such transactions, as well as leases, construction contracts and property management agreements, the uncertainty caused by this COVID-19 response has raised critical questions about if, and how, to proceed with planned transactions. Clients are reviewing agreements to determine whether there are conditions to closing, material adverse event (MAE) provisions, or force majeure provisions that might justify a decision to not proceed with a transaction. These types of provisions can be found in all types of real estate related documents, including loan commitments, leases, property management agreements, construction contracts, development agreements and in some cases purchase and sale agreements. Absent such provisions, clients have asked whether common law contract standards—such as frustration of purpose, intervening government conduct, or impracticability—might excuse their performance under their contracts. Anxious lenders, landlords, tenants, developers, contractors, sellers and buyers are evaluating similar arguments, trying to evaluate how to ensure that a long-planned transaction proceeds to closing. This alert outlines the broad contours of such contractual arguments, and the practical considerations that parties should bear in mind as they consider their options.
I. Contractual Provisions Justifying Conduct
The first step for parties’ evaluating their rights to cancel, or enforce, a transaction is to review the terms of the contract itself. Both leases and real estate purchase and sale agreements commonly include provisions excusing certain performance obligations if the asset is destroyed or suffers material physical damage or condemnation. Although unusual, some real estate purchase and sale agreements may also include clauses that condition closing on the non-existence of a non-physical material adverse event with respect to the property. Many leases that require the build-out of a tenant’s space, construction contracts, development agreements, property management agreements as well as a few real estate purchase and sale agreements structured as forward purchase contracts for buildings under construction, may also contain a force majeure provision, permitting at least temporary (and sometimes permanent) voidance of certain obligations in the event of an “act of god” or other event beyond the parties’ control. It is common in real estate purchase and sale agreements to include a “time is of the essence clause”, meaning that the dates for performance in the contract are material to the agreement and that failure to perform by the specified time will be a material breach. However, real estate purchase and sale agreements also include various conditions to performance which can override this time of essence requirement. In addition, many loan commitments and real estate purchase and sale agreements may include conditions to closing such as financing contingencies, rent roll contingencies, or lease review requirements that may also be affected by COVID-19 related events. While these conditions are often negotiated based on the facts of the specific transaction they should be reviewed to determine whether they could be triggered by COVID-19 related events. Finally, it is common in real estate contracts to include a provision which extends performance to the next “business day” when performance would otherwise fall on a day which is not a “business day”. These provisions may also be impacted by COVID-19 related events.
A. Material Adverse Event Provision
Real estate purchase and sale agreements, as well as leases, commonly include provisions conditioning performance if there is material physical damage or destruction to the asset or a condemnation. Some parties may argue that a government required shutdown of a building is a temporary taking. If this taking argument is successful, and a temporary taking impacts an entire building, a buyer may be able to terminate the purchase and sale agreement, depending on the applicable language of the agreement. However it is common in leases to limit tenant termination rights for condemnation to permanent takings. Therefore each agreement should be reviewed individually to determine the possible impact of a temporary taking.
Many loan commitments and a few purchase and sale agreements may also contain a provision conditioning performance on the non-existence of other non-physical, material adverse events. The extent to which such a condition to funding or closing may be met will depend upon the definition of MAE included in the agreement. For example, loan commitments may provide lenders the right to terminate loan commitments in the event of any material adverse change in the financial condition of the Property, borrower or owner. Property purchase and sale agreements may define an MAE as an event or development that individually or in the aggregate is materially adverse to the business, results of operation, or financial condition of the property. Some provisions may then also have carve out provisions that exclude general changes in the economy, financial markets, or political environment from the scope of an MAE.
Whether an event falls within the definition of an MAE will depend upon (i) the definition used of the MAE and the scope of any carve-outs; and (ii) whether the adverse event is “material” to the agreement as a whole. In addition, 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.” See Akorn, Inc. v. Fresenius Kabi AG, 2018 WL 4719347, at *53 (Del. Ch. Oct. 1, 2018). Short term hiccups typically are not sufficient; rather, the adverse event “must be expected to persist significantly into the future.” See Hexion Specialty Chemicals, Inc. v. Huntsman Corp., 965 A.2d 715, 738 (Del. Ch. 2008); see also In re IBP, Inc. Shareholders Litig., 789 A.2d 14, 67 (Del. Ch. 2001) (the adverse event must be “consequential . . . over a commercially reasonable period, which one would think would be measured in years rather than months”). Further, although there is no quantitative threshold to determine materiality as a matter of law, many courts will look to the securities law definition of materiality, and may require at least a 10% impact on relevant financial performance metrics.
Even if not expressly included in the language of an MAE definition, some courts will imply a requirement that the MAE could not have been reasonably foreseen by either of the parties. Although there is no exact definition for when an event is reasonably foreseeable, parties and courts will look for evidence (in emails, deal documents or industry publications) that the party exercising the right anticipated that the event might occur and that it may have an effect on the transaction. For example, in Capitol Justice LLC v. Wachovia Bank, N.A., Wachovia had asserted its rights under a MAE clause to terminate a loan commitment for a loan intended to be secured through CMBS financing when the CMBS market ceased to function in 2007.1 706 F. Supp.2d 23, 26-27 (D.D.C. 20009). In a determination on summary judgment regarding whether a MAC had occurred, the court focused on whether significant changes in the CMBS market were reasonably foreseeable at the time the contract was drafted. Id. The court agreed that “parties often include MAC clauses to protect against unknown, not known, events,” see id. at 30 (emphasis added) (citing Hexion, 965 A.2d at 738). See also, In re. JC’s East, Inc., 1995 WL 555765, at *3 (holding that a MAC had not occurred because the adverse change in question was “foreseeable at the time of the transaction.”).
The events related to COVID-19 may have substantial impacts on the financial performance of some commercial or multi-family properties, potentially including closures of retail businesses, defaults by tenants, or imposition of eviction moratoriums that substantially impact net operating income. Whether that conduct is sufficient to fall within an MAE, however, will depend on the definition of the MAE and the overall context of the financial performance of a property. In a multi-tenant property, defaults on a single lease, or with respect to a small percentage of the square feet of a property may not be material to the financial performance of the property in total. On the other hand, if a property goes from being substantially leased up to substantially uncommitted, or in a single-tenant building where the tenant invokes a rent suspension or reduction, lenders would likely consider such a change material from the perspective of a loan commitment. In the context of a purchase and sale agreement, however, if the building is valued based on 10- or 20-year cash flow projections, a seller may argue that the short term loss of rent (even for a significant portion of the property) is merely a “hiccup” that does not constitute an MAE. Moreover, if the contract or loan commitment was entered after COVID-19 was first identified in China, the parties are likely to disagree as to whether the events supporting the MAE were reasonably foreseeable. An argument can be made that even though China had its issues, nobody saw the events that are now taking place globally. With information changing by the hour, many of those events, while perhaps feared, might not have been reasonably foreseeable based on the information available at the time the agreement was entered.
As can be seen, even where the COVID-19 has led to dramatic governmental actions and shut downs, it cannot always be assumed that such conduct would justify triggering an MAE. Having litigated such disputes, the authors would note that each case should be evaluated based on the specific factual circumstances, the language in the agreement, and the context of the transaction. For parties considering invoking such MAE provisions, or for those responding to such invocation, there are many practical steps that should be taken both to avoid the risk of potential litigation, and to best position the party in the event of such litigation. Particularly in the context of the COVID-19 issues, it will be important for parties both to be, and to be perceived as, reasonable actors under the circumstances.
B. Force Majeure Provision
If a real estate related contract specifies that a condition for performance is the absence of a force majeure event, parties may also consider whether the effects of the COVID-19 pandemic (or the government response thereto) constitutes force majeure. Whether certain events triggered by the COVID-19 pandemic would constitute force majeure will depend in significant part on the definition of force majeure (if any) included in such contract.
For instance, formulaic force majeure provisions may define a force majeure only as an “act of god” or an “event outside the contracting parties’ control”. Such provision will leave substantial room for disagreement between the parties as to whether the COVID-19, or the business responses thereto, constitute an “act of god,” or otherwise as a force majeure event. On the other hand, some provisions provide very specific definitions of what qualifies as a force majeure, which may be defined to include fire, flood, war or insurrection. Unless the term “epidemic” or similar terms are included, it may be difficult to fit the COVID-19 events into the force majeure provision, unless the governmental responses lead to events that fall into other enumerated force majeure events, such as material shortages, labor shortages or hopefully not an issue, civil disobedience.
Courts interpret force majeure provisions narrowly, and will frequently insist that the events giving rise to the suspension or termination of the agreement fall squarely within one of the defined events. In situations where a force majeure provision contains a catch-all phrase in addition to specifically defined events, such as “other events beyond the [applicable party’s] control”, courts apply the canon of ejusdem generis, which holds that “words constituting general language of excuse are not to be given the most expansive meaning possible, but are held to apply only to the same general kind or class as those specifically mentioned.” Team Mktg. USA Corp. v. Power Pact, LLC, 41 A.D.3d 939, 943 (N.Y. App. Div. 2007); see also Circuit City Stores, Inc. v. Adams, 532 U.S. 105, 114-15 (2001) (“[E]jusdem generis [is] the statutory canon that where general words follow specific words in a statutory enumeration, the general words are construed to embrace only objects similar in nature to those objects enumerated by the preceding specific words.” (internal quotation marks and citation omitted)).
Further, as with MAEs, “the event must not only be one included in the force majeure clause, but must be unforeseeable as well.” Phibro Energy, Inc. v. Empresa De Polimeros De Sines Sarl, 720 F. Supp. 312, 318 (S.D.N.Y. 1989) Thus, where a purchase and sale or loan commitment was entered after the emergence of COVID-19 in China, a party receiving notice of a force majeure event may argue that the events currently playing out were foreseeable at the time of contracting. As noted above, however, where events and information are changing daily and even hourly, the result may depend on whether subsequent events were reasonably foreseeable based on the information available at the time the agreement was entered.2
Like MAE provisions, a party considering the termination of a contract 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 significant dispute about whether the event was beyond the terminating parties’ control, whether it was reasonably foreseeable, or whether it falls into the definition of a force majeure or alternatively amounts to a change of economic circumstance the risk of which the terminating party took on. In any subsequent dispute, there will be an acute focus on the justifications provided, and the reasonableness of each party’s conduct.
Also some force majeure provisions require notification to the other party of the force majeure event within a specified number of days of its occurrence. It may be difficult for a party to provide such notice when the consequences of events such as COVID-19 are not immediately known. In such case, a party should nonetheless 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. For example, it may be prudent for a lessee to inform a building owner that the lessee is being compelled to close its business, and while it hopes to be able to continue its performance, it may in the future be forced to exercise its rights under the force majeure provision. Doing so reduces the risk of unnecessary dispute about the timeliness of any notice.
C. Other Conditions to Closing
In addition to the non-existence of MAEs or force majeure events, the COVID-19 pandemic and governmental response pose hurdles to other conditions required for closing. For example, if a loan commitment is conditioned on further underwriting, appraisals, debt coverage ratios, or occupancy, changes created by COVID-19 may hinder the satisfaction of those conditions. Similarly, if a purchase and sale is conditioned on receipt of financing, on a minimum leasing threshold or on the execution of a pending lease transaction, again the COVID-19 pandemic and related response may pose a hurdle to meeting those conditions. Further, both buyer and seller may be acutely focused on the terms of tenant leases, and whether those leases may give tenants the right to terminate the leases based on pending events. The existence of such clauses may not be sufficient reason for a buyer to terminate a transaction, but depending on other conditions to closing, buyers may consider whether such lease language would trigger some other condition.
In some instances, the respective rights of a contract party may be sufficiently unclear that the parties would decide to renegotiate the terms of the transaction to address the change in circumstance, rather than insist upon proceeding under the parties’ perceived interpretation of the agreement. In other instances, buyers may determine that the potential risk exceeds the value of any deposit amount, and simply terminate the arrangement. In those instances where a party does seek to terminate an agreement due to the non-occurrence of a condition necessary to closing, again the party should give careful consideration to the relevant governing law, the strength of the contractual language, and the contextual circumstances.
D. Definition of Business Day
Many contracts include a provision which extends performance to the next “business day” when performance would otherwise fall on a day which is not a “business day”. However there is no universal definition of “business day”: some contracts refer to days that are not weekends or holidays; some to days when banks are open in specific jurisdictions, and some contracts do not include a definition, and instead rely on common usage. If the contract contains a definition of “business day” it should be reviewed to determine whether title company or bank closures due to COVID-19 may be grounds for delay. If the contract relies on common usage rather than expressly defining “business day” then it is possible that a court would consider difficulty or inability in closing or meeting another deadline due to business or government closures as grounds for extending performance under a next “business day” clause.
II. Non-Contractual Common Law Principles that Excuse Performance
Even in the absence of contractual MAE or force majeure provisions, parties may turn to common law defenses of impracticability, frustration of purpose, or prevention by government regulation as potential options to discharge their obligations under real estate related contracts. Each of these defenses are typically recognized at common law and are incorporated into the Restatement (2d) of Contracts, which is followed in most jurisdictions.3 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 (i) that is outside of a party’s control; and (ii) the non-occurrence of which was a basic assumption on which the contract was made. Restatement (2d) Contracts § 261. Similarly, under the doctrine of Frustration, a party’s contractual obligations may be discharged if, after the contract is made, the party’s principal purpose is substantially frustrated (i) without the party’s fault; and (ii) where the occurrence or non-occurrence of an event was a basic assumption on which the contract was made. Restatement (2d) Contracts § 265.
The application of each of these defenses depends upon 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. Ferguson v. Ferguson, 54 So.3d 553, 556 (Fla. Dist. Ct. App. 3d 2011). Parties will not be excused from their contractual obligations due to the occurrence of an event that the parties had clearly contemplated. See The Currituck Assocs. v. Hollowell, 601 S.E.2d 256, 264 (N.C. Ct. App. 2004) (water supply issues did not constitute frustration where the parties’ prior contracts included provisions pertaining to those issues). In addition, economic conditions generally do not constitute an unanticipated circumstance. See Ferguson, 54 So.3d at 555 (“[e]conomic downturns and other market shifts do not truly constitute unanticipated circumstances in a market-based economy.”); Dorn v. Stanhope Steel, Inc., 534 A.2d 798, 812-13 (Pa. Super. Ct. 1987) (observing that “commercial impracticability and frustration of purpose” should be applied only in cases where performance of the contractual obligations would cause an “especially severe and unreasonable” loss). However, one court has suggested that a municipality’s imposition of impact fees could constitute commercial impracticability. See City of Key West v. R.L.J.S. Corp., 537 So.2d 641, 648 n.10 (Fla. Dist. Ct. App. 3d 1989).
Similar to those defenses, parties may also be discharged from their obligations if the performance of a duty is made impracticable by having to comply with a governmental regulation or order, the non-occurrence of which was a basic assumption on which the contract was made. Restatement (2d) Contracts § 264. See RECP IV WG Land Invests. LLC v. Capital One Bank (USA), N.A., 811 S.E.2d 817, 829 (Va. 2018) (excusing performance where the contract incorporated rules, which the county subsequently amended and left “unworkable and therefore unenforceable”); UNCC Props., Inc. v. Greene, 432 S.E.2d 699, 702-03 (N.C. Ct. App. 1993) (finding impossibility of performance where the county had condemned the real property to be sold). This defence applies even where the government is the party seeking relief from performance of its contractual obligations, “provided that the law or governmental action frustrating performance was not adopted or enacted with the intent of relieving the governmental agency of its contractual obligation.” Leon County v. Gluesenkamp, 873 So.2d 460, 463 (Fla. Dist. Ct. App. 1st 2004).
In the context of the substantial COVID-19 outbreak, contract parties may consider invoking such common law principles to excuse their performance under their agreements. It should be recognized, however, that in most courts “the doctrines of commercial impracticability and frustration of purpose are to be applied sparingly,” and that for a change in economic circumstances to justify non-performance, a party must demonstrate that the change was beyond the normal range of anticipated circumstances. See Dorn v. Stanhope Steel, Inc., 534 A.2d 798, 586 (Pa. Super. Ct. 1987). That said, a dramatic change in building revenues as a result of COVID-19 related shut downs or government-mandated closures, may in some circumstances be sufficient justification under these common law rules. As noted above, however, even where the argument seems clear, parties are well advised to provide substantial notice, and to take all available steps to mitigate the impact of their decisions on their counterparties. Experience has shown that such steps can reduce the likelihood of litigation, and can also improve the party’s chances of success if they have to defend their decision to a judge or jury.
1. The MAC clause in Capitol Justice provided that Wachovia could terminate the agreement if there was “any material adverse change in the capital, banking and financial market conditions that could impair the sale of the loan by Lender as contemplated in the term sheet.” 706 F.Supp.2d at 29.
2. Courts have not decided, as a matter of law, that a force majeure event must not have been reasonably foreseeable to the parties at the time of contracting. See VICI Racing, LLC v. T-Mobile USA, Inc., 763 F.3d 273, 289 (3d Cir. 2014) (examining the controlling case law and observing that “[a]t no point did the Court in Stroud suggest that all force majeure clauses must be read to incorporate the concept of foreseeability. Rather, the Chancery Court engaged in standard contractual analysis to determine the intent of the contracting parties, and found that, given the nature of the real estate industry, the parties expected the clause to include such a concept”).
3. Even jurisdictions that do not follow the Restatement, such as Georgia, may recognize similar defenses under somewhat different doctrines. See, e.g., Ga. Code Ann. § 13-4-21 (“If performance of the terms of a contract becomes impossible as a result of an act of God, such impossibility shall excuse non-performance, except where, by proper prudence, such impossibility might have been avoided by the promisor.”).
