In a decision of 12 January 2022 (XII ZR 8/21), the Federal Court of Justice recognised a rent adjustment claim by a lessee of commercial premises on the grounds of frustration of contract (as set forth in section 313(1) German Civil Code (Bürgerliches Gesetzbuch)). The lessee had been forced to close his business owing to government action taken to combat the Covid-19 pandemic. The amount by which rent should be adjusted in such cases, however, cannot be determined mechanically, the Federal Court of Justice held. Instead, the circumstances of the individual case are decisive.
Coronavirus closures do not give rise to defects or impossibility in contracts
Contrary to the view sometimes still taken in case law from lower instances, the Federal Court of Justice’s judgment first made it clear that closures of business resulting from government orders issued to combat the Covid-19 pandemic do not give rise to a defect in the leased premises within the meaning of section 536(1), sentence 1 German Civil Code. The Court argued that such restrictions of use do not derive from the leased premises’ actual characteristics, condition or location, as would be required for a defect to be assumed. Instead, they are tied to the business operation of the lessee in question and the flow of potential customers that such an operation entails.
The Court also pointed out that lessees affected are not exempted from paying rent on the grounds that the respective lessors are no longer able to provide and maintain the leased premises in their due state as contractually stipulated (sections 326(1), 275(1) German Civil Code). Irrespective of government action, lessors were in fact still able to allow the premises to be used for the purpose agreed. The official orders to close businesses did not ban lessors from providing premises for use. Such premises therefore continued to be available for the purpose of lease agreed upon.
Claim to rent adjustment under section 313(1) German Civil Code generally possible
A rent adjustment claim by a lessee affected by government action owing to frustration of contract (section 313(1) German Civil Code) is an option, however, in the Federal Court of Justice’s view. Such claim presumes three things: (i) circumstances on which the agreement was based have undergone a substantial change since the agreement was concluded; (ii) the parties would not have concluded the agreement had they anticipated this change, or the substance of the agreement would have been different; and (iii) the party demanding adjustment cannot be reasonably expected to abide by the unchanged agreement.
In the Federal Court of Justice’s view, Article 240(2) Introductory Act to the German Civil Code (Einführungsgesetz zum Bürgerlichen Gesetzbuche) does not conflict with application of the principles of frustration of contract either. This article temporarily suspended the lessor’s power to terminate an agreement because a lessee is in arrears of payment due to the coronavirus. Legislators’ intention in introducing this rule was not in fact to definitively regulate the consequences government action to combat the Covid-19 pandemic might have, in particular on commercial leases.
With regard to whether the requirements for a rent adjustment claim (under section 313(1) German Civil Code) are met, the Federal Court of Justice then stated the following:
- The business basis of commercial lease agreements concluded before the Covid-19 pandemic has substantially changed as a result of the far-reaching restrictions on social and economic life the pandemic has entailed. This, the Federal Court of Justice held, continues to be a rebuttable assumption under the new rule embodied in Article 240 section 7 Introductory Act to the German Civil Code. The only scenario in which other rules might apply is where expectations and circumstances are affected which are contractually supposed to fall within only one party’s sphere of risk. In the case in question, however, there is no reason to believe that the lessee had assumed the sole risk of use were his retail business to be shut down owing to the pandemic.
- In the absence of evidence to the contrary, moreover, it can be assumed that the parties would have concluded the lease agreement with different content had they anticipated the possibility of a pandemic and the ensuing risk of business closures by the government at the time they concluded the agreement. It could be assumed, the Federal Court of Justice argued, that reasonable contracting parties would not impose the entire economic risks involved on the lessee but would instead have provided for a rent adjustment option.
Individual circumstances must be weighed up when assessing whether it is reasonable to abide by an unchanged agreement
In the Federal Court of Justice’s view, however, the entire circumstances of an individual case need to be considered in determining whether a lessee affected by an order to close their business can be reasonably expected to abide by an unchanged agreement. This applies in particular to the contractual or statutory distribution of risk. One thing the Court pointed out here is that although, fundamentally, the lessee bears the risk of using the leased premises – which also includes the opportunity of generating profit through them – any frustrated expectation of profit deriving from government action such as closure of businesses goes beyond the usual risk of use. What the case embodies, in fact, is the general risk that life entails. Unless contractually provided for accordingly, this risk is not included in the distribution of risk under the lease agreement.
But even if not only the respective lessee’s risks are affected here, this does not mean (yet) that affected lessees can always demand that their rent be adjusted over the period of closure. Such a one-size-fits-all approach is not permissible, the Federal Court of Justice stated. Lessees cannot, therefore, simply halve their rents for the period during which their businesses are closed.
Having set out why individual circumstances must be weighed up, the Court then specified the following aspects as being of particular relevance:
- The first important aspect is what disadvantages lessees have suffered from business closures and the duration of such closures. Loss of sales in the specific leased premises affected need to be considered here, the Federal Court of Justice stated. A further decisive point might be what measures the lessees took or could have taken to reduce imminent losses.
- On the other side of the equation, it is necessary to consider the financial benefits lessees have enjoyed from state compensation payments for disadvantages incurred through the pandemic, or payments from insurers with liability for claims. State support measures such as loans, however, must be excluded, as they do not constitute final and definitive compensation for loss of sales.
- Finally, the lessor’s interests also need to be taken into account when weighing up the various factors.
- As a general principle, a lessee demanding amendment of the agreement bears the burden of presenting and proving that abiding by the unchanged agreement would be unreasonable. Should the respective lessor object that the alleged losses do not derive from the Covid-19 pandemic, however, the lessor will bear the burden of presenting and proving this.
The 12 January 2022 judgment is the first decision by Germany’s supreme court on numerous issues connected with restrictions on business ordered by the state in order to combat the Covid-19 pandemic. The Federal Court of Justice ruled that in these circumstances lessees do not have the right to reduce their rent on account of a defect. The Court also ruled that the lessees concerned are not exempted from paying rent merely because the respective lessors cannot provide the leased premises for the contractually stipulated purpose as owed under the agreement. In so doing, the Court takes a view consistent with that of case law from lower instances to date.
The Federal Court of Justice also made it clear that although a lessee of premises used commercially may in principle have a claim under the principles of frustration of contract, this is only a possibility and need not always be the case. Whether and to what degree the lessee affected by the order to close its business is entitled to demand a rent adjustment must be assessed on an individual basis and taking the entire specificities of the case into account. One-size-fits-all solutions are not permissible. Halving rent over a lockdown has been a frequently encountered solution in lease agreements. In future, it will be one but only one of the conceivable ways in which the conflicting interests of lessors and lessees can be reasonably reconciled and the commercial consequences of the Covid-19 pandemic shared by contracting parties.
In practice, the Federal Court of Justice’s decision will mean that when potential rent adjustments are being negotiated more attention will need to be paid than previously to the consequences of a restriction on business ordered by government and/or requirement to close for the respective party. In addition to the circumstances specified by the Federal Court of Justice, such as loss of sales, state payments to cover ongoing costs, or payments by insurers with liability for claims, it will be necessary to focus on what other sources of revenue the affected lessee generated or failed to generate in breach of duty. Savings from expenses not incurred – such as lower staffing or operating costs – will also need to be considered. The Court also pointed out that the lessor’s interests need to be taken into account when weighing up the various factors as required. This makes it clear that loans, insurance and other property-related costs the lessor continues to bear must be included in the assessment. Here, the Court has repeatedly indicated that reducing the originally agreed rent by more than 50% is not an option, especially as the decision also implies that merely having to tap into financial reserves built up over previous years does not in and of itself mean that abiding by the agreement is unreasonable. A final point to note is that the principles set out above do not apply where contractual arrangements distribute risk in derogation of such principles.
The Federal Court of Justice’s decision strengthens the approach taken by many contracting parties over recent years in the pandemic, namely of arriving at a commercially acceptable change to the agreement taking individual circumstances into account. In many cases, however, lease agreement practice has shown that there are a great many more creative solutions beyond rent adjustment in cushioning the Covid-19 pandemic’s impact. These include granting rent-free periods, loans from the lessor, or other incentives. It will also be worth keeping a critical eye on the importance the Federal Court of Justice attaches in future to the efforts undertaken by lessees to compensate for imminent losses. In any event, this aspect must not lead to a situation in which those who have done good business over the pandemic end up in a worse position than those who consciously accepted a loss of sales. By providing legal certainty, the Federal Court of Justice has nevertheless made a valuable contribution to a due and proper reconciliation of the interests of the contracting parties involved.