November 19, 2020
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. See In re CEC Entertainment, Inc., ch. 11 case No. 20-33163 (MI) (Bankr. S.D. Tex.). This is a significant change from prior chapter 11 practice where debtor tenants must either pay the full contract rent under their commercial leases 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 to do so.
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. 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. 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.
Court decisions regarding force majeure and COVID-19 still remain uncommon as of this writing. In re CEC Entertainment, Inc., however, is the exception.
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. 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.
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. 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. CEC has numerous leases in other states, including California, New York, Michigan, North Carolina, New Mexico, Colorado, Massachusetts, Connecticut, Delaware, and Oregon.
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 bankruptcy court’s 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.
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. See NY City Council Local Law 1932-A. (exempting individuals from commercial lease guaranty obligations in New York City during the COVID-19 pandemic). 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.