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Force Majuere & Frustration of Contract In Commercial Leases

Force majeure is a French term – it means “major or superior force.”  It is an unforeseeable event that is outside of the control of the parties. It is a type of contractual provision that you will find across contracts, including in many commercial lease agreements. The clause is included to let a party off-the-hook when something extraordinary happens. Something that makes it impossible to do the thing they thought they could do when they entered into the contract. The common thread is that of the unexpected. Something beyond regular human foresight and skill.

When reviewing your commercial lease agreement, you must look at the Force Majeure (“FM”) clause in the context of COVID-19 as it relates to your [in]ability to continue operating your business.  Thousands of commercial tenants are now confronted by huge cash flows issues with revenue ground to a halt and ongoing liabilities (including lease payments) that they are unable to fund. As a result, one of the options for these tenants may be to invoke the FM clause in their commercial lease agreement. 

It important to review the specific language of the FM clause in your commercial lease agreement. Some FM clauses say that such a scenario only applies if “performance of obligations under the contract becomes impossible.”  That means it is not physically possible for the party to do the thing that was set out to do when the contract was entered.   The impact of COVID-19 on your specific business is a key consideration to determine whether it makes continued operation impossible (i.e., schools, restaurants, and other non-essential business that are subject to mandatory government closure) or more difficult to perform but still possible to operate. Can the tenant and its employees still gain access to their premises to retrieve files and/or laptops in the event access to the building is restricted?

You must consider what types of events will trigger a FM based on the wording of the lease. Some contracts may be silent on this.  Others will be specific – naming specific events that constitute FM (e.g. flood, strike, fire, or ‘Act of G-d,’ etc.).  The unifying thread of an ‘Act of G-d’ is an uncontrollable event that was not foreseen at the time the contract was entered into.  When the contract was negotiated may be critical. For instance, some contracts may expressly stipulate “pandemics” in FM clauses. Especially those that were negotiated around the time of the SARS virus. 

The determination as to whether COVID-19 is considered an FM event is based on how that term is defined in your contract. 

In many cases, parties to a contract could reasonably argue that they could not foresee the pandemic at this scale occurring at the time the contract was entered into.   On the other hand, just because it is more economically difficult for the party to perform the agreement, the simple fact that the event has caused a constraint on profitability, it may not be enough to trigger the FM clause.

If it is Physically Possible To Continue To Operate My Business But It Will Be Extremely Costly – What Are My Choices?

Do I have to pay my contractual obligations or just pay damages for breach of contract?  There is a well-recognized ability in the case law that it may be more economical for a party to an agreement to cease performing an agreement and breach the contract, rather than continue performing and lose money – this is often referred to as an ‘efficient breach.’   The counter-party in the breach of contract can be made whole, whereas the breaching party will minimize its losses by ending the contract at that time.

A key consideration is if a party breaches a contract with another party – that may impact the counter-parties ability to perform its other contractual relationships, which could lead to a cascade of breached contracts with third-parties.  Those other parties could potentially bring a claim against the initial breaching party based on tort law principles.  

Whatever industry you operate in, your company must consider how they will continue their business in the face of COVID-19.  Parties should take into account commercial leasing considerations and review their leases to determine what rights and obligations they have in light of COVID-19.

What Happens If You Do Not Have an FM Clause in Your Contract? Frustration of Contract

You may be able to rely on the doctrine of frustration of contract. Frustration is the occurrence of an unforeseen event that causes a radical change in performance of contract. This radical change makes performance under existing circumstances impossible, impractical or frustrates the original purpose of the agreement. The onus would be on the party alleging frustration of the contract to prove these elements.

According to the Supreme Court case Naylor Group Inc. v Ellis-Don Construction Ltd., the doctrine is applied where, “a situation has arisen for which the parties made no provision in the contract and the performance of the contract becomes ‘a thing radically different from that which was undertaken by the contract.’ The result of a successful frustration claim is that the contract is deemed frustrated and all obligations are extinguished as of the date of the supervening event.

If you have any questions with respect to your commercial lease and your rights and obligations in the face of COVID-19, it is important that you speak with qualified legal counsel to discuss the same. 

Triple Net Leases – Q & A

As a real estate lawyer handling commercial leasing disputes and a commercial property manager, I am commonly involved with payment disputes between Landlords and Tenants, often resulting from ambiguity in the terms of a Lease Agreement.  In this article, I will provide some initial definitions to differentiate between a Gross Lease and Net Lease and thereafter I will discuss some specific challenges, and means to remedying such challenges, pertaining to the most common lease in the commercial property context – the Triple Net Lease.

Gross Lease: A gross lease is where the tenant pays the landlord a flat monthly rental amount, which is determined upon signing of the Lease Agreement, and the landlord pays all expenses related to property ownership (i.e., property taxes, maintenance, utilities, and insurance).  Gross leases are more common in residential leasing (i.e., apartment) transactions. The monthly rental payment in a gross lease is typically higher than in a net lease scenario.

Net Lease: In a net lease, a tenant is required to pay, in addition to the monthly fixed rental payments, a contribution towards the landlord’s property taxes, insurance, maintenance, repairs, utilities, etc. In such cases, the Lease Agreement stipulates that the tenant is to pay the landlord a Base Rent and an Additional Rent (amounts which are typically based on a dollar value per square foot of rentable space). Where property taxes, maintenance, and insurance are all paid by the tenant, the lease is typically referred to as a “triple net lease,” in which case the Landlord receives the funds “net,” after the expenses passed through to the tenant are paid.  Net leases are most common in a commercial property context.

Net Leases – What is Additional Rent?

As mentioned, in a triple net lease the tenant is required to pay Base Rent (i.e., the cost of renting the premises) plus an Additional Rent (i.e. to defray the landlord’s property-related expenses). In commercial properties where multiple tenants lease divisible units of a larger building, a triple net lease will include a provision allowing the landlord to charge its tenants for their respective contributions (usually on a proportionate share basis of the ratio that the rentable area of the particular tenant’s premises bears to the total rentable area of the commercial property).

The operating costs (i.e., the expenses incurred by the Landlord in owning, operating, insuring, repairing, and managing the property) are shared between the tenants based on their proportionate share of the property.

Calculating Additional Rent

Triple net leases typically provide the landlord with the right to estimate, in advance, the amount a commercial tenant will pay in respect of operating costs on an annual basis. At year-end, the total amount paid by the tenant to the landlord on account of operating expenses is compared to the actual amount of operating expenses incurred by the landlord during that period.  At this point, these amounts are to reconciled between the landlord and tenant within a period of time (typically 30- 60- or 90 days following year-end) to ensure that the tenant is credited for any overpayment of Additional Rent or the tenant pays the landlord for any underpayment.

In the multi-tenant scenario, the Landlord is required to determine the proportionate share of operating expenses applicable to each tenant, and reconcile their Additional Rent payments accordingly.

Operating Cost Statements

Operating cost statements are financial disclosures provided by landlords’ to tenants to support their claim for Additional Rent. Such statements will itemize total maintenance and repair bills paid during the relevant time period, property tax installments, insurance premiums, and variable utility payments. Landlords have a common law obligation to produce an operating cost statement to its tenants, irrespective of the terms of the Lease Agreement. As such, tenants have the right to inspect the landlord’s claims for Additional Rent and can request books and records, and supporting invoices, to substantiate such claims.

In 1877352 Ontario Inc. v. 699147 Ontario Inc.the Court indicated: “the duty of the Landlord to perform its obligations under the Lease is served by requesting it to deliver all documents that are the basis for the annual adjustment.  It is commercially reasonable to imply a term into the Lease that requires the Landlord to deliver with its annual adjustment for Additional Rent a copy of all the documents such as tax bills, insurance premiums, property management invoices, which support the amounts claimed.” 

In 2373322 Ontario Inc. v. Nolisthe tenant was obligated under the lease to make Additional Rent payments in monthly installments with the landlord at least once a year to provide an operating statement as required to accurately calculate the amounts payable in respect of Additional Rent. The Landlord provided one operating statement in 2016 to substantiate the expenses incurred from 2013 to 2016. The Court concluded that the failure of the landlord to deliver the operating statement does not relieve the tenant from the obligation to pay Additional Rent once the statement is provided. In this case, the Court permitted the Landlord to recover its proportionate share of expenses notwithstanding its late deliver of the statements.

Avoiding Disputes in a Commercial Lease

In order to avoid Additional Rent disputes, it is imperative that the Landlord provide the Tenant with an operating statement shortly after year-end. If the Tenant requests supporting documentation, the Landlord should deliver the same in order to substantiate its Additional Rent reconciliations. In the subsequent years, the Additional Rent estimate is based on the actual amount of expenses incurred by the Landlord in the previous years. If you are a Landlord, it is imperative that you comply with these obligations in order to properly administer a Triple Net Lease; otherwise, a tenant may have the right to hold-back Additional Rent Payments claimed.  As such, a professional accountant and lawyer with experience handling these matters can save both parties from substantial costs in the event of a dispute.

In a legal and property management capacity, we have been involved in a number of disputes between commercial landlords and tenants related to cost allocations. In many cases, disputes arise around repair and maintenance obligations and the parties respective payment obligations under the lease (a topic we will delve into further in a later blog post).  For the purposes of this discussion, it is imperative that the reader understands the characteristics of a gross vs. net lease, and the obligations of landlords and tenants in both scenarios.  For further questions about commercial lease disputes or other real estate-related matters, feel free to contact Goldstein Law at 647-838-6740.

Commercial Lease Renewals

Negotiating Commercial Lease Renewals

In a typical commercial lease, the landlord and tenant will agree to renew the lease on the same terms and conditions of the original lease; however, the base rent is typically subject to negotiation upon renewal.  Case law in Ontario suggests that a Court will enforce a renewal clause if it is sufficiently clear and unambiguous.

Ambiguous Renewal Clauses

Where the rent is simply to “be agreed” where there is no formula for determining the rent upon the renewal or extension period, the clause would be considered void due to uncertainty. Courts have found phrases such as “current market rents” or “fair market rent” to be enforceable, rather than those terms that indicate “rent is to be determined based on a mutually agreed upon” amount.

Use of the Premises

The type of ‘use’ of the premises ought to be considered as well in the formula for determining the rental rate at renewal.  The fair market rent based on the tenants existing limited use may be different than the fair market rent of the premises with a broader use, or at the highest and best use; as such, the type of use that will be applied to determine the market value of the rent should be stipulated in the renewal clause.

Tenant Improvements

Landlords should not assume that the value of tenants improvement are to be included in the “fair market rent” that is negotiated upon renewal or extension.  If the clause indicates that the renewal rent will be based on the “as is” condition of the property at the date of the original lease, then the current market rent will be based on the unimproved condition of the property (and as such, the tenant will not have to pay twice for its capital investment into the property).  With specific wording in the renewal clause, such as the “rental rate will be based on the current and finished condition of the property as of the date of renewal, and with reference to similar properties for a similar term,” the value of tenant improvement would be included in determining the fair market rate.

A number of issues are considered in determining the fair market rental value of a commercial lease renewal and extension and the language of the commercial lease agreement will guide the analysis. For a consultation with a commercial leasing lawyer, contact Goldstein Law and we will advise you to maximize the value of your commercial property.