This was originally published on the SGR Blog.
Harsh facts do no automatically lead to an equitable result. In a recent case, a commercial tenant signed a New York City lease that contemplated the tenant would “build-out” the leased “white box” space into a second-floor gymnasium. The day after the signing, construction was stopped, and gyms were closed by Executive Order due to the pandemic.
ITS Soho LLC sought rescission and termination of a long-term lease for second-floor space with 598 Broadway Realty Associates, Inc. The lease term was to start on March 15, 2020. The lease required Realty to provide a “white box” to Soho, and Soho was to do its own build-out as a gym. The lease also provided no obligation to pay rent for the first six months, and the first monthly installment was not due until September. Soho took possession on March 15, 2020, and the very next day, March 16, 2020, gyms were ordered to shut down effective on March 17, 2020, due to the ongoing pandemic. Gyms were not permitted to reopen until September 2020.
Bad luck requires almost perfect timing!!!
The lease and the rider did not contain a force majeure clause or any other similar provision that would permit the parties to terminate the lease. Soho claimed that because of the pandemic and the fact that construction was also prohibited, the parties agreed that the leased space would be considered occupied starting on June 15, 2020, and the first few months would be rent free. Soho was hoping to complete the build-out of the space and open the fitness club. However, Soho claimed it was unable to finish the construction of the space. In June, it alleged that it attempted to terminate the lease given that it appeared opening the gym was unrealistic, but Realty refused and continued to bill Soho.
Soho sued. Realty moved to dismiss on the ground that the ongoing pandemic was known at the time the lease was entered into, and Soho should have known not to enter into the lease. It also claimed that Soho’s cause of action for breach of the implied duty of good faith and fair dealing did not state a cause of action because Realty was under no obligation to negotiate a termination of the lease months after it was signed. Because of the ban on construction for three months, Realty allowed an extra three months of free rent after the lease was signed, even though it had no obligation to do so. Realty insisted that, although Soho’s profits were negatively affected, the alleged frustration of purpose was not substantial. At best, according to Realty, even if Soho had not received the extra three months, free Soho faced hardship for only a few months out of a long-term lease.
Soho asserted that it appeared gyms were likely to be closed again in the near future. And claimed that, although its principal was aware of the Covid-19 virus at the time he entered into the lease, he could not have known it would essentially shut down the fitness industry in New York City.
Soho also sought to amend to add a separate cause of action for Realty’s purported breach of the rider. It alleged that Realty breached the good guy guarantee by compelling Soho to pay for more than it should.
Realty claims that the proposed amendment was meritless because it related to a good guy guarantee, which involved Soho’s principal, who was not a party to the action.
Soho’s first cause of action sought a declaratory judgment that the purpose of the lease had been frustrated, the lease should be terminated and the Realty should refund Soho for its first month of rent and security deposit. The doctrine of frustration of purpose requires that the frustrated purpose must be so completely the basis of the contract that, as both parties understood, without it, the transaction would have made little sense. The doctrine is a narrow one, which does not apply unless the frustration is substantial.
Soho did not state a cognizable cause of action. A gym’s temporary shutdown did not constitute substantial frustration of a lease stretching for nearly a decade. Moreover, the lease and other submissions suggested that Soho intended to build out the space to become a gym. In other words, the lease was for commercial space, and Realty delivered the space. That Soho’s preferred use of the premises might not be profitable for a few months was not a basis for this Court to intervene and rip up the contract.
The Court’s decision turned on the specific facts of this case. The parties clearly contemplated the effects of the crisis, and, according to both parties, after the lease was entered into, they agreed that Soho would receive an extra three months free while it attempted to build out the space. After asking for and getting that from Realty, which would have put Soho in the same position because all construction was halted for three months, Soho decided to change its mind and concluded that it no longer wanted to operate a fitness center. That business decision did not justify the application of the frustration of purpose doctrine. Soho could have built out the space and opened its gym. However, even after getting the extra three months free, which was the functional equivalent of Realty taking the hit for the ban on construction, Soho wanted out of the lease. Of course, Soho was entitled to do that, but it did not state a claim to ignore the contract.1
The Court also dismissed the second cause of action, which was based on a breach of the implied covenant of good faith and fair dealing. Implied in all contracts is a covenant of good faith and fair dealing in the course of contract performance. Indicated is the obligation of each promisor to exercise good faith that a reasonable person in the position of the promisee would be justified in understanding were included. This embraces a pledge that neither party shall do anything which will have the effect of destroying or injuring the right of the other party to receive the fruits of the contract.
Soho claimed that Realty breached the covenant by refusing to negotiate to allow Soho out of the lease and continuing to charge rent while Soho was unable to build out on the premises. The Court was unable to find that Realty’s refusal to accommodate Soho’s desire to rescind a valid contract constituted a valid cause of action. Realty was under no obligation to renegotiate the lease so that Soho could walk away and it would be left with a vacant space. And, according to Soho’s principal, after gyms were shut down, Realty agreed that the first six months would be rent-free, and the landlord gave another three months free when construction was halted. Either way, that demonstrated that Realty did, in fact, negotiate in good faith to factor in the devastating effects of the ongoing pandemic and related closures.
The Court denied the cross-motion because the proposed amended pleading failed to state a cognizable cause of action. The new cause of action alleged that Realty breached the rider to the lease by not returning the security deposit upon termination of the lease despite the good guy guarantee providing that Soho’s principal and Soho would not be liable for any other payments following termination of the lease.
The good guy guarantee was a separate agreement between Realty and Soho’s principal, who was not a party to this lawsuit. Moreover, the terms of the good guy guarantee related to the guarantor’s potential liability; it did not purport to absolve Soho of its obligations should Soho properly surrender the premises.
The Court was cognizant of the fact that the pandemic had caused significant financial harm to many businesses across New York City, particularly among gyms and fitness establishments that were shut down for months due to COVID-related orders. But those temporary shutdowns, though they were devastating, were not a basis to rip up a validly signed lease. While the Court empathized with Soho, it could not ignore the fact that, if it were to rip up the contract, Realty would take the loss. Invalidating the contract would put Realty in the position of having to comply with its obligations, such as paying property taxes and maintaining insurance, while Soho simply walked away. Such a result was simply inequitable.
The Court made clear that the decision was based on the specific facts alleged and the relief Soho requested. Soho signed a lease and then after COVID restrictions were imposed, renegotiated the terms of that lease so that it would get extra months of rent-free while it built out the space. At some point, Soho decided it did not want to continue building out the space and try to run a gym. (Gyms opened with restrictions in September 2020). And Soho brought a case to rescind the entire lease and for its money back. Soho did not seek relief for the time it was unable to operate a fitness center; it wanted to walk away, get its money back and blame Realty for not agreeing to terminate the contract. The Court found that, under these circumstances, Soho had not stated valid requests for that relief.
Bad luck requires almost perfect timing!!!!!