Force-Majeure Post COVID-19: Chapter 11 as a Means to Reduce Commercial Rent Obligations
October 30, 2020
By: Alan E. Gamza
A recent ruling in the CEC Entertainment Chapter 11 case may pave the way for debtors to use chapter 11 to reduce their rent obligations under commercial leases on the basis of pandemic-related diminished use, if the lease involved contains robust force-majeure or similar contract provisions.1 This is a significant change from the practice in chapter 11 cases where debtors must either pay the full contract rent under commercial leases where it is a tenant while in bankruptcy or reject such leases and vacate the premises. Although the rent abatement matter remains an open issue, and it appears most recent commercial-lease disputes are being resolved out of court, the CEC Entertainment case shows that bankruptcy courts may be willing to grant debtors extraordinary relief in light of the ongoing pandemic, but only if there is some contractual basis for such relief.
This client update will discuss (i) the origins of force-majeure clauses, (ii) the recent force-majeure ruling in CEC Entertainment, (iii) lessons from prior pandemics including the 1918 Spanish Flu and their relevance to today’s pandemic, and (iv) drafting suggestions for future leases and other contracts.
The Origins of Force-Majeure Clauses
The concept of force-majeure, literally translated from French to mean “superior force,” dates back to Roman Law and became part of French civil law in the Napoleonic Code. It developed alongside the common law doctrine of frustration or impossibility of contract, as set forth by an English court in Taylor v. Caldwell in 1863, and similarly by the U.S. Supreme Court in a maritime case The Tornado in 1883.2 Both cases involved fire-related losses that rendered performance under the respective contracts an impossibility. Neither case involved a written force-majeure clause. Over time, parties to contracts and leases added language to their agreements to address the potential impossibility of performance. Today, force-majeure clauses can take many forms, but in general they provide that certain events outside the parties’ reasonable control will excuse their performance under the contract.
For a force-majeure clause to be relevant, a party’s performance under the contract must be prevented or substantially impeded on account of the force-majeure event, despite the party taking all reasonable steps to avoid the consequences of such event. Examples of force-majeure events often include acts of God, war, terrorist events, fire, labor strikes, or other events that severely affect the parties’ ability to perform under the contract or lease. As we will see below, the precise language of any force-majeure clause will be important in the resolution of any dispute where the clause is invoked.
The CEC Entertainment Case
Court decisions regarding force-majeure and COVID-19 still remain uncommon as of this writing. One bankruptcy case, In re CEC Entertainment, Inc., is the exception.3
In the CEC Entertainment case, better known under its “Chuck E. Cheese” trade name, the debtor filed a motion on August 3, 2020, to permit it to maintain occupancy of certain leased restaurant locations in California while paying its landlords less than the contractual rent.4 Two landlords objected to the debtor’s motion, arguing that the debtor had failed to comply with the lease terms and the Bankruptcy Code, which requires debtors to pay the full amount of commercial rent if they want to remain in the leased property during the chapter 11 case.
Following a hearing in September, the bankruptcy court granted the debtor permission to pay a substantially reduced rent amount on one of the California leases (the Gilroy lease), citing the relevant lease’s force-majeure language. The bankruptcy court later requested supplemental briefs regarding another lease (the Cupertino lease), briefs which were filed as recently as September 29, 2020. Later the debtor asked for similar abatements with respect to commercial leases in other states.5 Accordingly, the rent-abatement issue in the CEC case remains fluid – particularly in terms of leases in states beyond California and what will happen with the remaining rent owed under leases covered by the abatement order (i.e., the difference between what is owed contractually and the reduced, post-pandemic amount paid under the order). Although we cannot say that the bankruptcy court’s ruling is correct, and there remain many unresolved issues related to the decision, there is much to learn from the CEC court’s lease rulings to date, particularly regarding the bankruptcy court’s methodology in analyzing the force-majeure issue.
In CEC, the bankruptcy court decided to treat the two California leases separately. The bankruptcy court started its analysis of the Gilroy lease with the force-majeure language itself, which stated as follows:
“Force Majeure. Subject to the casualty and condemnation provisions of this Lease, if either party shall be prevented or delayed from punctually performing any obligations or satisfying any condition under this Lease by any strike, lockout, labor dispute, inability to obtain labor or materials or reasonable substitutes therefor, act of God, unusual government restriction, regulation or control, enemy or hostile government action, civil commotion, insurrection, sabotage, fire or other casualty, or any other condition beyond the reasonable control of such party . . .”(emphasis added)
Regarding the Gilroy lease, the court held that the force-majeure clause applied as a matter of law and that the debtors were excused from paying contract rent, although the outstanding rent had not been “forgiven,” only “reduced” per the debtor’s motion for relief. A key component of the court’s ruling appears to be that the force-majeure clause covered a “government restriction,” as well as CEC’s assertion that it could not operate its entertainment-themed businesses as intended under mandatory lockdown and social-distancing orders. The court then requested supplemental briefs on the Cupertino lease by September 21 concerning the issue of “frustration of purpose,” likely because its force-majeure language did not support the relief granted in connection with the Gilroy lease.
In late September, CEC sought to apply force-majeure clauses to limit rental payments under its leases in other states, including New Jersey and Washington.6 Among the unresolved issues is how the bankruptcy court will treat rent that was abated if CEC seeks to assume either lease, and similarly whether the court will allow landlord claims for the full rent amounts. One possible outcome is that the bankruptcy court will treat the force-majeure provisions as requiring less than full payment under relevant assumed leases.
Another open question is whether the ongoing pandemic will extend lease terms commensurate with the length of government-mandated lockdowns and restricted occupancy/social distancing rules. CEC acknowledged that its sole purpose in bringing its rent abatement motion was to obtain approval for paying rent that was lower than the contract rate – it said that it would return to the court at a later time for other, related relief.
Whether the rent-abatement ruling will survive further scrutiny remains unclear. What is clear so far is that one prominent bankruptcy court appears sensitive to a debtor’s arguments that it cannot operate its business as intended under current pandemic-related restrictions. For this reason alone, it is likely that other rent reductions are likely in more chapter 11 cases, either under force-majeure provisions or frustration-of-contract arguments. The CEC decision may, we believe, be followed by other bankruptcy courts in other chapter 11 cases, including in popular bankruptcy venues like the Southern District of New York and Delaware.
Lessons from Prior Pandemics
Pandemics and their related contractual issues are rare but not new. During the 1918 Spanish Flu pandemic, a case involving the Citrus Soap Company laid the foundation for future force-majeure cases under similar circumstances to those existing in 2020.7 The facts of the Citrus Soap case – which involved a government-imposed lockdown following a “second wave” of infections – will sound familiar. In that case, the seller entered into a contract with the buyer for the delivery of “soap lye crude glycerine” to the buyer’s factory in Berkeley, California. The seller, operating in San Diego, performed under the contract until the local government imposed a mandatory quarantine that required the closure of all “nonessential” factories and businesses, including the seller’s glycerin production lines. Thereafter, the seller restarted its glycerin production, but its final delivery under the contract was late by a few days. The buyer refused to accept late delivery of the glycerin and the seller sued, seeking damages.
In the litigation that followed, the seller cited the contract’s “contingency delay” provision, a form of force-majeure clause that contained the following language:
“This contract is made subject to suspension in case of fire, flood, explosion, strike or unavoidable accident to the machinery or the works of the producers or receivers of this material, or from any interference in plant by reason of which either buyers or sellers are prevented from producing, delivering or receiving the goods and in such event the delivery thus suspended is to be made after such disabilities have been removed; otherwise to be fulfilled in good faith. Notice, with full particulars and the probable term of the continuance of such disability, shall be given to the other party hereto, within ten days of the date of the occurrence of such disability.” (emphasis added)
The trial and appellate courts both agreed that San Diego’s mandatory quarantine triggered the contract’s force-majeure clause. That, coupled with the seller’s good faith actions (including providing notice of delayed delivery) following the quarantine, led to a ruling in the seller’s favor. Interestingly, the contract at issue did not contain the words “government action,” “pandemic,” or “quarantine.”
Although the 1918 Spanish Flu pandemic is perhaps the closest analogy to today’s COVID-19 outbreak, it is worth noting that other influenza outbreaks have led to invocations of force-majeure clauses. Examples include the SARS epidemic, where, for example, China’s Supreme People’s Court issued a general notification in 2003 that force-majeure clauses would apply to government actions taken to prevent the spread of the disease to the extent relevant in contractual disputes. Similarly, a number of courts around the globe have applied force-majeure clauses to the H1N1 Swine Flu in 2009–10. These include court decisions in India and other developing economies that were disproportionately affected by H1N1.8
Post COVID-19 Drafting Considerations
As in virtually all contractual matters, the precise language in any force-majeure clause will likely be determinative in any future dispute. Although courts have held that impossibility or frustration of performance can excuse performance under a contract even where no force-majeure clause exists, the better course for all parties is to document in detail the specific events that could render contractual performance impossible. These events may include standard provision including floods, fire, labor strikes, acts of God, etc., but in light of the COVID-19 pandemic, careful attention should be given to events like government lockdowns, quarantines, and other mandatory government restrictions, including social-distancing rules that can adversely affect profits and sales.
As of the writing of this article, many parts of the U.S. remain in some form of lockdown with social-distancing rules. Some cities, including New York, have enacted local laws that prevent landlords from enforcing personal guarantees against individuals for the payment of commercial rent while lockdowns are in place.9 Regardless of whether such rules are constitutional, they must be taken into consideration in lease negotiations in relevant jurisdictions. Many businesses remain closed or are operating at diminished capacity, and government health laws in many states limit occupancy of enclosed spaces to 25% to 50% capacity, including restaurants, retail establishments, offices, and museums. With winter approaching, health experts predict additional closures and lockdowns in highly populated areas that may continue through the first half of 2021.
All commercial tenants, not just those operating restaurants and bars, would be well-served to consult with counsel to review their current leases for relevant business contingency and/or force-majeure language. In any future negotiations regarding rent reductions or abatements, lessors and lessees should bargain for appropriate language to address what will likely be a restricted business environment for a long period to come. Parties who delay doing so act at their own peril, particularly in light of potential “second wave” restrictions on business operations.
Lawyers at Moses & Singer are well-versed in representing lessors, lessees, and other parties to contracts in a variety of pandemic-related issues, including force-majeure issues and broader matters regarding frustration or impossibility of contract. Please contact Alan Gamza at (212) email@example.com, if you have any questions.
1. In re CEC Entertainment, Inc., ch. 11 case No. 20-33163 (MI) (Bankr. S.D. Tex.). The purpose of this article is to report the bankruptcy court’s unusual decision in the CEC case. The authors are not opining on whether the issue was correctly decided.
4. Motion for Order Authorizing Debtors to Abate Rent payments at Stores Affected by Government Regulations, Aug. 3, 2020, In re CEC Entertainment, Inc., No. 20-33163 (MI) (Bankr. S.D. Tex.) (ECF No. 487) (arguing that COVID-19 regulations frustrated the purpose of debtor’s leases; citing force-majeure provision in the Gilroy Lease referencing “unusual governmental restriction, regulation or control.”).
5. CEC Entertainment, Inc. has leases in California (56), New York (13), Michigan (14), New Jersey (12), North Carolina (11), Washington (8), New Mexico (6), Colorado (8), Massachusetts (7), Connecticut (3), Delaware (2), and Oregon (1).
6. Debtors’ Supplemental Reply in Support of Motion for Order Authorizing Debtors to Abate Rent Payments at Stores Affected by Governmental Regulations, Sep. 28, 2020, In re CEC Entertainment, Inc., No. 20-33163 (MI) (Bankr. S.D. Tex.) (ECF No. 970) (asserting that New Jersey’s frustration-of-purpose doctrine is similar to law in California, North Carolina, and Washington).
8. There is a general consensus that common law jurisdictions require a higher degree of specificity to excuse contractual performance under force-majeure clauses. Civil law systems, such as those in the EU, are generally viewed as more lenient in terms of applying force-majeure to particular events. International commercial law organizations have also spoken on the topic in an attempt to harmonize force majeure law across many jurisdictions. For example, Article 7.1.7 of the UNIDROIT Principles of International Commercial Contracts provides for a form of force-majeure similar, but not identical, to the common law and civil law concepts of the term: relief from performance is granted "if that party proves that the non-performance was due to an impediment beyond its control and that it could not reasonably be expected to have taken the impediment into account at the time of the conclusion of the contract or to have avoided or overcome it or its consequences."