By Adrienne Beatty, Stephan Cutler and Matthew Werthman

Law360 (June 11, 2020, 6:05 PM EDT) --

Adrienne Beatty

Stephan Cutler

Matthew Werthman

Social distancing requirements imposed in response to the COVID-19 pandemic have caused countless businesses across the country to operate at a significantly reduced capacity, if not shut down entirely.

Among the hardest hit are business in the hospitality, restaurant and entertainment industries, and even though some of the restrictions on business operations are being relaxed or lifted, restaurants and entertainment businesses will continue to face challenges due to increased costs of operations and reduced customer volume and/or demand.

In response to these concerns, the California Senate Judiciary Committee recently advanced S.B. 939, which, if enacted, would place a temporary ban on certain commercial evictions, provide certain commercial tenants a year to repay the rent that was not paid during the state of emergency and, perhaps most strikingly, allow certain commercial tenants to terminate their leases without penalty.

Thus far, the bill has elicited strong reactions from both its supporters and detractors. In the words of one of the bill's co-authors, Sen. Scott Wiener, D-San Francisco, speaking at a Judiciary Committee hearing on May 22, California faces "a mass extinction event of small businesses and nonprofits in every neighborhood," and the very real prospect of permanent closure due to reduced capacity mandates.

Meanwhile, the bill's opponents argue that it disproportionally favors tenants while rendering commercial landlords unable to pay operational costs and debt service on their properties due to significantly decreased rental revenues.

Key Provisions of the Bill

In its current form, the bill would add new two new sections to the California Civil Code. Section 1951.9 (or Section 1 of the bill) would impose a ban on the eviction of a so-called "eligible COVID-19 impacted commercial tenant" during the state of emergency instituted by Gov. Gavin Newsom on March 4 and for 90 days after the end of such state of emergency.

Section 1951.9 would also afford an eligible commercial tenant the right to defer rent payments that accrue during the state of emergency for approximately 12 months following its conclusion. Section 1951.10 (or Section 2 of the Bill) would create procedures for an eligible commercial tenant to renegotiate or terminate its lease. Although both new sections use the phrase "eligible COVID-19 impacted commercial tenant," the definition is more restrictive in Section 1951.10.

Eviction Suspensions and Rent Deferral

The bill would prohibit commercial landlords from initiating unlawful detainer proceedings against eligible COVID-19 impacted commercial tenants that fail to pay rent or fulfill some other lease covenant that comes due during California's state of emergency. The eviction moratorium would remain in effect for 90 days after the state of emergency is lifted and would only apply to overdue rent that accrued during that period.

Moreover, the bill would: (1) allow eligible commercial tenants to defer payment of rent that accrues during the state of emergency until the last day of the month in which the one year anniversary of the date the state of emergency is lifted; and (2) prohibit late fees with respect to such deferred rent.

To be eligible for the bill's protections, a commercial tenant would need to send notice to its landlord affirming that it meets one of the following three criteria:

• It must have experienced a decline in average monthly revenue of at least 20% over the two most recent calendar months as compared to its average monthly revenues for the two calendar months preceding the date state or local shelter-in-place orders took effect or its average monthly revenue for the same calendar months in 2019;

• It must have been prevented from or delayed in opening its business because of the state of emergency; or

• It must have suffered a decline in capacity of at least 15% due to compliance with COVID-19 motivated official public health orders or occupational health and safety guidelines.

Lease Modification and Termination

Eligibility requirements for the bill's lease renegotiation and termination provisions are more stringent than those for the eviction and rent deferral protections.

In this case, an eligible COVID-19 impacted commercial tenant is a small business (meaning a business with 500 or fewer employees not dominant in its field of operation, the principal office of which is located in California, the officers of which are domiciled in California) that:

• Operates primarily in California;

• Occupies commercial real property pursuant to a lease;

• Is an eating or drinking establishment, place of entertainment or performance venue; and

• Meets one of the three above-listed criteria, except that instead of suffering a 20% decline in average monthly revenue, it would need to show a 40% decline, and instead of a 15% decline in capacity, it would need to show a 25% capacity decline.

Moreover, the lease modification and termination provisions cannot be invoked by any publicly traded company or a company owned by or affiliated with a publicly traded company.

For an eligible commercial tenant to invoke the lease termination provisions, it would need to first send notice to the landlord affirming the above eligibility requirements and expressing its desired lease modifications. If the landlord and tenant fail to agree, after engaging in good faith negotiations, to modified lease terms within 30 days of the landlord receipt of such notice, then the tenant would have the option to terminate the lease during the next 10 days.

If the lease is terminated, the tenant must vacate the premises within 14 days from service of the termination notice, and the tenant would no longer be liable for any future rent or fees under the lease, though it would be responsible for not more than three months' worth of past due rent incurred during the state of emergency plus any unpaid rent that accrued outside of the state of emergency, and the tenant would have 12 months after vacating repay it. Furthermore, any third-party guaranties associated with the lease would also terminate and become unenforceable.

Constitutional Challenges

Passage of the bill would inevitably lead to legal challenges, perhaps most notably on grounds that it violates the contracts clause. A foundational tenet of constitutional law, the contracts clause provides that "[n]o State shall … pass any … Law impairing the Obligation of Contracts."[1] California's constitution contains an analogous provision,[2] as do most states' constitutions.

While on its face the contracts clause "restricts the power of States to disrupt contractual arrangements,"[3] the U.S. Supreme Court has held that "[s]tates must possess broad power to adopt general regulatory measures without being concerned that private contracts will be impaired, or even destroyed, as a result."[4] Were that not the case, contracting parties "would be able to obtain immunity from the state regulation by making private contractual arrangements."[5]

The Supreme Court has set forth the following two-part test for purposes of analyzing contracts clause arguments (hereinafter referred to as the Sveen test, based on its latest application in the 2018 case Sveen v. Melin). As a threshold issue, a contracting party must demonstrate that the challenged state law has created a substantial impairment of a contractual relationship.[6]

A court then conducts a means-end analysis — a balancing test — wherein it considers "whether the state law is drawn in an appropriate and reasonable way to advance a significant and legitimate public purpose."[7]

Substantial Impairment of Lease Contracts

A reviewing court applying the Sveen test to the bill would first consider whether it creates a substantial impairment of a contractual relationship. Here courts assess whether the contract in question contains ambiguous language, as well as the extent to which the industry in question is regulated.

In most cases, the language in a commercial lease is unlikely to qualify as ambiguous, at least on the topic of rent payment and lease termination. Moreover, the commercial real estate industry — unlike, for example, the residential real estate industry, or the insurance industry — is not subject to a particularly heavy-handed regulatory regime, which makes sense given the bargaining parity of the parties involved.

Considering that it is unusual for a tenant to a commercial lease to be able to breach the lease without risking the full legal consequences of that action, there is little doubt that the bill would qualify as a substantial impairment of the contractual relationship because it would substantially shift the balance of power towards the tenant and away from the landlord.

Reasonable Drafting to Facilitate a Legitimate Public Policy

Moving to the second prong of the Sveen test, one must next consider whether (1) the statute in question advances a legitimate public policy and (2) whether it is drafted in an appropriate and reasonable way to advance such purpose.

The public policy behind the bill — protecting certain small business owners, albeit at the expense of commercial landlords (many of whom may also be small businesses) — presents the first point of contention, particularly for Section 2 of the bill. Section 2 would require an "eligible COVID-19 impacted commercial tenant" to be "an eating or drinking establishment, a place of entertainment, or a performance venue" in order to make use of the rent deferral and termination provisions.[8]

Yet it is unclear why protecting this category of small business from liability under a commercial lease constitutes a significant state interest. What is special about protected tenants as compared to other small businesses that were not deemed essential or life sustaining yet were also significantly impacted by COVID-19?

Moreover, why is there only a significant state interest in shielding protected tenants from liability under their leases, as compared to liability that protected tenants may also have towards other creditors that supplied them with the furniture, fixtures, equipment and materials needed to conduct their businesses? Why is there not a significant state interest in protecting small landlords that lease space to protected tenants from loss of rental income under a commercial lease that they and their mortgage lender relied on in extending credit to the landlord?

This point holds true even if Section 2 of the bill were to apply uniformly to all commercial tenants. The contention that "the interest advanced by the [Bill] is not to give tenants an advantage over landlords but rather stave off what might otherwise be a wave of business closures and evictions"[9] is immaterial when in fact the bill does give tenants an advantage over landlords.

Moreover, it is worth noting that the state statutes that have passed muster under the contracts clause, based on a survey of major contracts clause jurisprudence, have been aimed at protecting the public at large, rather than a certain category of small business.

For instance, the Supreme Court has upheld state statutes which purported to accomplish the following: protecting homeowners from loss of their homes via foreclosure;[10] providing for the general welfare of citizens by the reclamation of overflowed infertile lands and the erection of dams, levees and dikes for that purpose;[11] preserving fresh water[12] and game lands for hunting;[13] and protecting employee pensioners[14] and insurance policyholders.[15]

Even assuming the purpose behind the bill were found unobjectionable by a reviewing court, it is not a foregone conclusion that the bill presents an appropriate or reasonable mechanism to achieve such purpose. The Judiciary Committee noted that "there is a logical relationship between the interest advanced—preventing eviction and closure of a large number of small businesses and restaurants—and the mechanism employed."[16]

But how will granting a termination right to a tenant advance the goal of preventing the closure of protected tenants? If a protected tenant terminates its lease, the business that was once located in the leased premises will surely close — at least until it is able to gather the resources to reopen in a new location. So it seems as though the idea that a logical relationship is the standard is likely to be fertile ground for debate.

The case Home Building & Loan Association v. Blaisdell[17] provides further analysis as to the question of whether a statute is properly drafted to advance the public policy at issue. In Blaisdell, the Supreme Court held that a Minnesota statute extending the time during which borrowers could occupy and repurchase property following foreclosure did not violate the contracts clause.

Under the contested statute, mortgage principal remained, interest accumulated and the borrower was required to pay rent during the extension period. The statute was deemed a temporary and legitimate response to an emergency that imposed reasonable conditions on borrowers and lenders.

Commercial landlords challenging the bill are likely to argue that a statute permanently depriving them of all or part of their lease payments — in addition to undermining the lease contracts and interfering with their reasonable expectations thereunder — exceeds a reasonable response to the COVID-19 pandemic and inappropriately shifts the financial burdens of the economic disruption to landlords.

Current Status of the Bill

The Judiciary Committee approved the bill, subject to certain amendments, on May 22, with five senators in favor, three abstaining and one against, and it was read a second time in the California Senate and amended on May 29. The bill was referred to the California Senate Appropriations Committee for a hearing on June 9, during which the committee voted to send the bill to the Senate Suspense file for further evaluation.

At the hearing, co-author Wiener advised that he is implementing amendments to the bill to address the concerns of all stakeholders, which he indicated would be available in the coming days.

Among other things, Weiner, perhaps in response to challenges and concerns raised similar to those identified in this article, indicated that the bill would be amended to replace the lease termination option with softer language that will, nevertheless, incentivize landlords to renegotiate their leases with those commercial tenants impacted by COVID-19, as contemplated in the original bill; however, as of the publication of this article, the revised bill was not yet available for review.

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Adrienne Beatty is an associate, and Stephan Cutler and Matthew Werthman are partners, at Klehr Harrison Harvey Branzburg LLP.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] See U.S. const. art. I, §10, cl. 1.

[2] See Cal. Const. art. I, § 9 ("[a] law impairing the obligation of contracts may not be passed.").

[3] Sveen v. Melin , 138 S. Ct. 1815, 1821 (2018).

[4] U.S. Tr. Co. of N.Y. v. New Jersey, 431 U.S. 1, 22 (1977).

[5] Id.

[6] Sveen at 1821-22.

[7] Sveen at 1822 (citations omitted).

[8] Proposed Civ. Code, § 1951.10, subd. (a)(2).

[9] Senate Judiciary Committee Analysis, May 22, 2020, https://sjud.senate.ca.gov/sites/sjud.senate.ca.gov/files/sb_939_wiener_senate_judiciary_committee_analysis.pdf (last visited June 8, 2020).

[10] Home Building & Loan Assn. v. Blaisdell, 290 U.S. 398 (1934).

[11] Manigault v. Springs , 199 US 473 (1905).

[12] Hudson Valley Water Company v. McCarter , 209 US 349 (1908).

[13] Geer V. Connecticut , 161 US 519 (1896).

[14] Allied Structural Steel v. Spannaus , 438 US 234 (1978).

[15] Sveen v. Melin , 138 S. Ct. 1815 (2018).

[16] Senate Judiciary Committee Analysis, May 22, 2020, https://sjud.senate.ca.gov/sites/sjud.senate.ca.gov/files/sb_939_wiener_senate_judiciary_committee_analysis.pdf (last visited June 8, 2020).

[17] 290 U.S. 398 (1934).

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