Grounds for Getting Past Due Rent Forgiven, Abated or Paid Back Over Time Under the Small Business Reorganization Act and California State Law.

In this building block blog we look at a very specific issue:  what options does a tenant have to handle past-due rent in a reorganization plan?  Breaking this down: what options does the tenant have under the SBRA?  And, second, what options does the tenant have under state law?

Let’s first look at options available under the SBRA.  In another building block  blog we look at how leases and other executory contracts (license agreements, for example) are handled under the SBRA.  In short, the tenant has the right to assume the lease, reject the lease or assume the lease and assign it.  To assume the lease, the tenant must have cured or promises to promptly cure all past-due financial obligations.  The SBRA modifies this in only one possible way: after the case is filed, the tenant can ask the court to defer rent payments for 60 days AND the tenant can ask the court to have the rent that is deferred for 60 days be considered an “administrative expense.”  How are administrative expenses handled in bankruptcy?  They are paid out over five years.  So, if the rent is $10,000 per month and the court defers it for 60 days, the tenant, if the court agrees, can repay the $20,000 over five years.  The payment would be $334 per month for 60 months. 

But what if the tenant, because of COVID, is 7 months behind on the rent?  There is no authority under the SBRA or federal law that would give the tenant the right to have the rent forgiven, abated or paid out over time.  Except for the narrow option pertaining to rent that the court defers for up to 60 days discussed above, our federal law tool box is pretty empty. 

So, before we look at state court options, let’s reboot this analysis.  Three questions:

1. As part of the reorganization, can rent owed during the pandemic when the ability to earn the income to pay the rent was significantly impinged by governmental action, be forgiven?
2. If it can be forgiven, can it be forgiven in part or is this an “all or nothing” proposition?
3. If it can’t be forgiven, in whole or in part, can a landlord be forced to accept arrearage payments over a period of time?

Except for the narrow exception noted above, nothing in the SBRA gives a bankruptcy judge authority to forgive rent owed during the pandemic. Nothing in bankruptcy law generally does or other federal law for that matter. If rent is to be permanently excused, forgiven, in whole or in part that would have to be because a bankruptcy judge holds that California state law requires that result. Let’s pause for a moment to address a procedural matter. You may be thinking, “how does a federal bankruptcy judge hear matters where state law governs? I thought bankruptcy judges just heard matters regarding bankruptcy law.” Short answer, because the decision on reorganization of which how past-due rent is handled would be considered a “core proceeding” under bankruptcy law. Bankruptcy law gives jurisdiction to bankruptcy judges to decide all “core proceedings” even if the signing the issue requires the application of state law.

In the bankruptcy proceeding, before the bankruptcy judge hearing a business reorganization case brought under the SBRA we would argue that California law entitles the client to the following relief:

1. That past due rent should be forgiven in whole or in part;
2.  That future rent be reduced or abated;
3. And if the good judge decides that past-due rent is owed, in whole or in part, we would ask that repayment of the arrearages occur over a defined number of months.

To achieve these goals, we would argue that the relief requested is justified for one or more of the following three reasons:

• It is required under the contract’s force majeure or “acts of God” clause; and/or
• The contract doctrine of impossibility of performance; and/or
• The contract doctrine of frustration of purpose.

Argument 1: force majeure or acts of God clauses.  Most contracts contain Force Majuere clauses that excuse performance if certain “acts of God” occur. Here is an example:

Neither party will be liable for any failure or delay in performing an obligation under this agreement that is due to any of the following causes, to the extent beyond its reasonable control: acts of God, accident, riots, war, terrorist act, epidemic, pandemic, quarantine, civil commotion, breakdown of communication facilities, breakdown of web host, breakdown of Internet service provider, natural catastrophes, governmental acts or omissions …

We would argue that government shutdown orders constitute “governmental acts” triggering the clause and thereby excusing the tenant’s performance of an “obligation ” under the lease, that obligation being the payment of rent. We would  argue that there is no obligation to pay rent because our client was prevented by a governmental act from earning the money with which to pay the rent.

But looking at the provision strictly, the “obligation” is the act of paying the rent.  Landlords interpret this as the act of writing a check or making an electronic transfer of money for the amount of money owed each month. From the landlord’s perspective, in the end, they don’t care if a tenant uses leased space to generate income. It’s their space.  A tenant doesn’t have to use it to generate money. There is no obligation to do so.

What if the force majeure clause doesn’t contain a “triggering event” that specifically relates?  What if there’s no force majeure clause, at all?  Under California law, even if an event is not listed in the force majeure provision it can still be grounds for the permanent excuse of not paying the rent if the event is “unforeseeable at the time of contracting.” California Civil Code section 1511 provides that the performance of an obligation is excused “when it is prevented or delayed by an irresistible, superhuman cause or by the act of public enemies of this state or of the United States, unless the parties have expressly agreed to the contrary.” In California, the test for whether a force majeure situation is present is “whether there was such an insuperable interference as could not have been prevented by the exercise of due diligence.” Here, performance of the contract is excused when an unforeseeable event, outside of the parties control, renders performance impossible or impractical.

Argument 2: Next, we would argue that rent is forgiven under the state law doctrine of “impossibility of performance.”  But under California law, “impossibility” “must consist in the nature of the thing to be done and not in the inability of the obligor to do it.” That begs the question. What is the “nature of the thing to be done”? Is it the physical act of writing a check or is it the ability to earn income from which the rent is paid? Impossibility includes not only strict impossibility but also includes impracticability because of extreme and unreasonable difficulty, expense, injury, or loss involved.

Argument 3: Closely aligned with the concept of impossibility is our third argument, the legal doctrine of frustration of purpose. Here, performance remains possible but is excused whenever a fortuitous event supervenes to cause a failure of the consideration or practically speaking a total destruction of the expected value of the performance.  An example here would be a company’s agreement to pay money for a booth at a tradeshow. The company is still capable of appearing at the tradeshow, but the “principal purpose” of the transaction, people attending, is frustrated, delayed or canceled altogether when a governmental order prohibits people from congregating.

Cases are currently pending in both state and bankruptcy courts on these issues so more clarity should be forthcoming.  One bankruptcy judge has already issued a ruling on the applicability of force majeure clauses, the first argument.  The court did not rule on the applicability of impossibility of performance or frustration of purpose arguments, the second and third that we would make.  The court opted for a three-step analysis:

1. Are governmental shutdown orders actions that trigger force majeure clauses?
2. Did the governmental shutdown order that triggered the clause hinder the tenant from performing?
3. Was the governmental order that triggered the clause the proximate cause of the tenant’s inability to pay rent, in whole or in part?

In his decision, the court held that since the restaurant could still provide carry out service and that since 25% of its restaurant was taken up by the kitchen, tenant only had to pay 25% of the rent.  The ruling applied as to past due rent plus rent going forward until the government shutdowns were lifted or modified.

But the uncertainty that currently exists is not necessarily your enemy.  The uncertainty can be used at the negotiation stage to work out a repayment plan.  The approach here would be as follows: best for the landlord and tenant to settle as opposed to an all or nothing result if the matter is brought before a judge.  From the landlord’s perspective, better for the landlord to grant a repayment plan as opposed to a judge ruling that all past due rent is forgiven.  From the tenant’s perspective, better for a tenant to agree to a repayment plan as opposed to a judge shooting down all three state law arguments. 

To find out more about the payment of back due rent in bankruptcy specifically and the other powerful tools available under the SBRA to protect the business you enjoy and a way of life that you have worked hard to achieve, sign up to attend one of our webinars or call to schedule an appointment to discuss the particulars of your case. The initial consultation, up to one hour, is at no charge. The webinars are free, and include a 20 minute question and answer session at the end.  We would also refer you to the blog and video blog sections of our website for discussions on other topics and points of interest, including case studies where we apply the individual principles covered in these building block videos to real life fact patterns.