The consequences of the spread of the COVID-19 virus have weighed heavily on all aspects of the economy. Many tenants were forced to suspend business activity during the lockdown and even after reopening saw a sharp decrease in profitability, due to both the general decline in consumption and the effect of ongoing containment measures.
The result has been an increased volume of litigation between landlords and tenants. While the most significant rulings from recent months were addressed in a previous article in this newsletter, some more recent cases and commentators’ indications will be discussed in the following paragraphs.
The main takeaway, as detailed below, is that Italian courts are repeatedly inviting parties to negotiate lease agreements in good faith, taking into consideration the impact of the current outbreak (this point was addressed from a practical standpoint in our previous article, which provided 10 practical tips for dealing with agreements “affected by the outbreak”). In doing so, on the one hand, as a rule courts are recognizing that – depending on the case’s circumstances – a discount should be applied on the tenant’s behalf when a property’s profitability has decreased. On the other hand, Courts are also noting that general principles provide that efforts should be made to maintain the agreements in force in lieu of terminating them. It follows that termination (by means of withdrawal on serious grounds or based on hardship or force majeure) is a viable option for dealing with the impact of COVID-19, but it should be reserved as a remedy of last resort to be applied in particularly serious situations.
Renegotiation as the best tool for dealing with the impact of COVID-19 on lease agreements
The Supreme Court recently issued a report (No. 56/2020) on “emergency contract law,” in which it clearly endorses renegotiation of lease agreements.
According to the Supreme Court, in the absence of specific provisions expressly regulating how to deal with a pandemic, renegotiation is the best tool for rebalancing lease agreements following difficulties brought on by the outbreak. This is valid not only for the lockdown period, when business activities were considerably hindered, but also in other cases where the economic crisis has caused systematic financial or management problems for tenants.
More specifically, the Supreme Court ascertained that, given the particular circumstances of the moment, there exists a real duty to renegotiate contracts affected by the outbreak; this obligation stems from the principle of good faith, which is in turn an expression of the principle of solidarity that citizens are required to meet.
From a practical standpoint, this frequently means a partial reduction in lease payments, or a discount for tenants. As a counterbalance, however, the Court of Cassation stated that contract terms cannot be excessively distorted: parties must negotiate to identify the point where contractual balance reflecting reality will be restored, but the virus cannot be exploited to evade compliance with the crux of executed (and binding) contracts. The only methods for doing so are those expressly provided by the law (see below). In other words, a balance must be struck between landlords’ interests and tenants’ needs.
Lower courts have also acted to evaluate similar renegotiation operations. The Court of Rome, in an order dated May 29, 2020, stressed that the principle of good faith, although aimed at cooperation between the parties, cannot be used to effect significant change in the main obligations, as this would undermine the necessary stability of the effects of the contract. The solution adopted by the judge was, therefore, to identify a “partial impossibility” of the landlord’s performance toward the tenant, since the latter, due to the containment measures imposed by the government, was not able to access the spaces covered by the lease agreement. This judgment is interesting because it provides actual figures: as a consequence of the lockdown, the court granted the tenant a 70% reduction in rent fees, limited to the period of “partial impossibility” (March–May 2020). The court also stated that in any case the lockdown cannot be leveraged to avoid contractual liability resulting from circumstances in place before the virus outbreak. Accordingly, the court ordered that, in the absence of further agreement between the parties, the tenant must make the overdue payments in full.
Even more recently, the Court of Rome ruled again on revaluation of rent (order dated August 27, 2020). In the case of a landlord who had refused to renegotiate contractual conditions during the lockdown, the judge imposed a 40% rent reduction for the months of April and May (i.e., the months of “full lockdown”), plus a reduction of 20% for the following months and an extension of the latter reduction through March 2021, in light of the systematic impact the outbreak caused to the lease agreement at issue.
According to the court, the economic crisis resulting from the pandemic and the forced closure of commercial premises must be considered an unpredictable element with the power to alter the conditions of the contractual relationship: in the case of commercial leases, the contract was stipulated “for the effective performance of the business.” But this effective performance became impossible, and parties’ obligations therefore needed to be amended to reflect the current reality. Also in this case, the court emphasized that the parties have an obligation to renegotiate the agreement. And, in the absence of specific provisions to be applied, this is the only tool available to effectively rebalance the position of the parties.
Withdrawal from a lease on serious grounds
In the event that the tenant, due to the consequences of the pandemic, no longer has an interest in maintaining the contract, Italian civil law provides the possibility to withdraw on serious grounds. Article 27 par. 8 of Law 392 of 1978 gives the tenant in a commercial lease the right to withdraw on serious grounds at any time with six months’ notice. The right to withdrawal provided by article 27 is imposed by law, even in the absence of a specific contractual clause.
Settled case law has clarified that serious grounds that justify a tenant’s withdrawal must be determined by facts that are (i) extraneous to the will of the person who invokes them, (ii) unforeseeable, and (iii) capable of making it extremely burdensome to prolong the relationship.
From this perspective, many commentators clarified that the forced closure of business premises and/or economic difficulties resulting from provisions of government decrees can be considered serious grounds for withdrawal, as they meet the three criteria mentioned above. In particular, it has been stated that “an emergency in progress can certainly be considered a serious grounds […] since it is an unforeseeable event independent of the will of the tenant, with impact over a wide geographic area, and involving marked restriction of business activity of the type capable of causing significant negative economic repercussions for the players.“
Termination due to hardship situations
The tenant may also ask the judge for termination due to hardship, pursuant to article 1467 of the Civil Code, which applies when a contractual obligation becomes more burdensome than was originally assessed at the time the contract was negotiated and signed. As opposed to what happens in some foreign jurisdictions, in Italy termination based on hardship applies even in the absence of a specific clause in the agreement. In fact, the Italian Civil Code entitles the disadvantaged party to terminate the contract and obtain restitution retroactively. However, the party against which resolution is sought may propose renegotiating the contract to reestablish equity among the parties. In the abovementioned report, the Court of Cassation points to termination due to hardship as a more appropriate remedy for lease agreements than termination due to an impediment that occurred during performance of the contractual obligation. Indeed, it is not the landlord’s performance that is hindered by the lockdown, but the tenant’s enjoyment.
It remains to be considered, however, under what terms it is possible to resort to such termination. According to the Court of Pisa (order of June 30, 2020), a tenant who claims hardship due to the COVID-19 emergency has the burden to prove it. In fact, the complainant cannot report a general worsening of financial condition in abstract terms, but instead must provide evidence of lower income.
It is also worth noting that, given the scarcity of previous case law on the subject, it is not clear what the reference period for assessing excessive onerousness should be, i.e., how long after a decrease in revenues can the drop be considered excessive compared to normal fluctuations inherent in entrepreneurial risk.
In addition to hardship, when the consequences of the epidemic affect the performance of a contract, Italian law also provides force majeure as a remedy. Force majeure (ITA: impossibilità sopravvenuta) concerns cases where extraordinary and unforeseeable events, beyond the control of the parties, prevent them from fulfilling their contractual obligations. Nonetheless, there are some prerequisites that must apply in order to avoid contractual liability: the impossibility resulting from force majeure must be objective and absolute. This means that the party that is prevented from fulfilling its obligations should always act with due diligence, for example, by undertaking reasonable efforts to mitigate the effects of the event. In commercial leases, however, it is worth noting that the abovementioned Report of the Court of Cassation also clarifies that a tenant’s failure to pay cannot be justified due to “financial impossibility” of an absolute character, since pecuniary obligations can never be considered completely or definitively impossible. Accordingly, failure to pay or late payment cannot be justified by force majeure, even in an epidemic emergency. However, some of the restrictive measures imposed to contain the spread of the virus, such as early or temporary closure of cafes, theaters, and shops, may be labeled unexpected and extraordinary events. Such events could then justify a “partial impossibility” of fulfilling the landlord’s obligation, as identified by the Court of Rome in its order of May 29, 2020.
The pandemic situation has resulted in new scenarios that raise new questions not directly addressed by Italian law. Business premises everywhere have undergone radical reorganization of space, location, and customer flow to comply with security measures and avoid gatherings. Most companies have found that working from home results in efficiency, productivity, and greater work-life balance. Indeed, many companies are now considering continuing remote work and are beginning to think about how they will deal with their unused workspaces.
These issues raise legal questions that require economic analysis of contract law, with reorganization of economic relations and redistribution of the risks in commercial leases already underway. These measures must take into account landlords’ need to amortize their real estate investments, the actual use of the space by the tenants, and tenants’ ability to bear the costs of the rent, even when they do not intend to terminate their leases. Without a doubt, the first measure that ought to be adopted is one that redefines contracts by renegotiating the existing rent and integrating detailed hardship and force majeure clauses that protect the legal relationship in the face of events, unforeseeable and unrelated to the will of the parties, that could prevent the contracts from being executed.