Does "Frustration of Purpose" Terminate Tenant's Lease?

Q: A tenant at my shopping center is unable to get the proper insurance that’s required for it to do business. It already signed a lease with me, but now it’s trying to get out of it, relying on “frustration of purpose” as a justification. What is “frustration of purpose” and can it terminate a tenant’s lease?

A: The doctrine of frustration of purpose discharges a party’s duties to perform under a contract where “an unforeseen event has occurred, which, in the context of the entire transaction, destroys the underlying reasons for performing the contract, even though performance is possible,” explained a New York trial court in a recent case on the issue. “Frustration of purpose excuses performance when a ‘virtually cataclysmic, wholly unforeseeable event renders the contract valueless to one party,” the court emphasized. So, in your case, the tenant’s inability to get insurance may not be enough for it to claim that the entire agreement is void.

In that case, a tenant leased space at a shopping center for its sporting goods store. The center was in a flood zone and had been flooded several times, ruining the inventory of the center’s tenants each time. Under the lease, the tenant was required to have an “all-risk” insurance policy that would cover flood-related damage, including improvements, furniture, and lost inventory. As a result of a tropical storm, a nearby river flooded the center and the area was evacuated and declared a major disaster area.

After the flood damage had been fixed, the tenant was unable to get an insurance policy due to the previous history of flooding at the center. The tenant discontinued operations. It sought a declaratory judgment against the center’s owner finding that, due to the flood event and its inability to procure insurance to conduct its ongoing business operations on the premises, the lease was terminated.

The owner sued the tenant, arguing that the inability to obtain an all-risk insurance policy can’t frustrate the lease or “render the tenant’s performance impossible.” It asked the trial court for a judgment in its favor without a trial.

A New York trial court ruled in favor of the owner. The court pointed out that “where, after a contract is made, a party’s principal purpose is substantially frustrated without his fault by the occurrence of an event the non-occurrence of which was a basic assumption on which the contract was made, his remaining duties to render performance are discharged, unless the language or the circumstances indicate the contrary.”

The court pointed out that three criteria must be met before courts will find frustration of purpose: (1) the purpose that is frustrated must have been a principal purpose of that party in making the contract—that is, the object must be so completely the basis of the contract that, as both parties understand, without it the transaction would make little sense; (2) the frustration must be substantial; it’s not enough that the transaction has become less profitable for the affected party or even that he’ll sustain a loss—the frustration must be so severe that it’s not fairly to be regarded as within the risks that he assumed under the contract; and (3) the non-occurrence of the frustrating event must have been a basic assumption on which the contract was made.

Commercial frustration applies only where the parties could not have provided for the frustrating event through contractual safeguards. “If a party could reasonably foresee an event that would destroy the purpose of the contract, and did not provide for the event’s occurrence, then that party will be deemed to have assumed the risk,” said the court. It said that the issue in this case was “whether the party seeking to avoid liability could have anticipated the frustrating event and guarded against it.”

The court compared this case to a similar Florida case where the court held that the future availability of contractually required insurance at a reasonable price, or at all, is clearly a business risk, but could reasonably have been foreseen by the tenant at the creation of the lease.

The tenant argued that the unforeseeable event was the insurers’ refusal to issue an all-risk policy for the site. But actually, the event was the flooding that had the potential to make it difficult to get insurance. And, here, the flooding was clearly foreseeable. Because the tenant was aware of the possibility of flood, it couldn’t have assumed that all-risk insurance would be available, said the court. While it may be financially difficult or unprofitable for the tenant to continue to operate its retail store, that doesn’t excuse the tenant’s obligation to perform under the terms of the lease, concluded the court [Gander Mt. Co. v. Islip U-Slip LLC, January 2013].

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