Daily Development for
Tuesday, January 5, 1999

By: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

LANDLORD/TENANT; FRUSTRATION OF PURPOSE: Where post lease changes in local regulations prohibit tenant from conducting its business profitably, but it can still operate within the use provisions in the lease, albeit at a loss, the tenant has no right to claim frustration of purpose unless the tenant can otherwise demonstrate that the parties understood the continuation of the prohibited use to be a "basic assumption" underlying the lease relationship.

Mel Frank Tool & Supply, Inc. v. DiChem Co., 580 N.W.2d 802 (Iowa 1998).

Tenant leased property for three years with a use clause that identified the purpose of the lease as "storage and distribution." The lease prohibited the tenant from making any unlawful use of the premises. Tenant was in the chemical distribution business, and on the day before the lease, in the first direct contact between landlord and tenants, a tenant representative told landlord that tenant intended to sell chemicals.

Soon after the lease commenced, the city passed an ordinance heavily regulating the storage of hazardous chemicals and a building inspector visited the site and issued an order compelling major changes in the premises if the tenant were to continue to store the chemicals that it had there.

The tenant elected to relocate its business outside the city limits, and sent the landlord a letter indicating that the city action compelled it to vacate the premises and terminate the lease.

The landlord sued for breach of lease and the tenant argued frustration of purpose. The trial court ruled for landlord. On appeal: held: Affirmed.

The court noted that the Restatement 2nd of Contracts identified the frustration of purpose defense as available in limited circumstances, even where the obligor has not protected itself by contract from the danger of a failed purpose:

"An extraordinary circumstance may make performance so vitally different from what was reasonably to be expected as to alter the essential nature of that performance." In these circumstances, "the court must determine whether justice requires a departure from the general rule that the obligor bear the risk that the contract may become more burdensome or less desirable." Whether extraordinary circumstances exist justifying discharge is a question of law for the court.

The Restatement recognizes three distinct grounds for the discharge of the obligor's contractual duty: First, the obligor may claim that some circumstance has made his own performance impracticable.... Second, the obligor may claim that some circumstance has so destroyed the value to him of the other party's performance as to frustrate his own purpose in making the contract.... Third, the obligor may claim that he will not receive the agreed exchange for the obligee's duty to render that agreed exchange, on the ground of either impracticability or frustration."

But the court ruled that the idea of this doctrine was to address the circumstance of some "basic assumption" underlying the parties' original agreement no longer existing. This "basic assumption," the court notes, need not be express, but it must be shared by both parties.

The articulation of this doctrine in the case of changes in the regulatory environment for a tenant under a lease, the court notes, usually is covered by another part of the Restatement, section 265, dealing with "supervening frustration."

"In the absence of . . . a provision for termination, however, there is some uncertainty as to the effect of subsequent legal prohibition or restriction on the use of the premises. It may generally be said that in the absence of any such stipulation, a valid police regulation which forbids the use of rented property for certain purposes, but leaves the tenant free to devote the property to other legal uses not forbidden or restricted by the terms of the lease, does not invalidate the lease or affect the rights and liabilities of the parties to the lease. And, even though the lease by its terms restricts the tenant's use of the premises to certain specified purposes, but not to a single purpose, the prevailing view is that the subsequent enactment of the legislation prohibiting the use of the premises for one, or less than all, of the several purposes specified does not invalidate the lease or justify the tenant in abandoning the property, even though the legislation may render its use less valuable. If there is a serviceable use for which the property is still available consistent with the limitations of the demise, the tenant is not in a position to assert that it is totally deprived of the benefit of the tenancy. "

The court cites thorough but basically useless language from the Restatement to establish general principles to recognize an event of frustration of purpose. Three circumstances must exist: First, the use in question must have been so fundamentally a part of the contract that without it, in the understanding of both parties, the contract would have made little sense. Second, the frustration of the use must be substantial not just an interference with profitability [although the Restatement hedges here and uses circular reasoning the interference must be such that the parties would not have been viewed as allocating it to the tenant]; and third, the frustration must be outside the basic assumptions that the parties made when entering into the contract [again a circular test.]

As is often the case the examples cited by the Restatement prove more helpful in interpreting the message than the complex but circular and duplicative general principles. The Restatement section alludes to gas station leases in which, due to post lease government regulation, the tenant cannot operate profitably, but is not prohibited from operating at all. In such circumstances, the tenant remains bound on the lease and cannot plead frustration of purpose. The examples of government regulation stated include a regulation reducing traffic flow or a rationing of gasoline. The Restatement also cites the example of a lost franchise with a gasoline distributor also not an event that would justify a frustration of purpose defense.

The court then reduces all of the above to the Iowa statement of the rule:

"A subsequent governmental regulation like a statute or ordinance may prohibit a tenant from legally using the premises for its originally intended purpose. In these circumstances, the tenant's purpose is substantially frustrated thereby relieving the tenant from any further obligation to pay rent. The tenant is not relieved from the obligation to pay rent if there is a serviceable use still available consistent with the use provision in the lease. The fact that the use is less valuable or less profitable or even unprofitable does not mean the tenant's use has been substantially frustrated."

That made this case easy. The lease did not even allude to the storage and distribution of chemicals alone. The tenant had lots of other potential uses of the premises. But it should be noted that the court (perhaps because it had the facts) accepts the notion that the tenant had the right to expect to be permitted to be in the chemical distribution business. The City ordinance restricted only the sale of certain hazardous chemicals, and not the tenant's entire line of products. Consequently, it was not barred from conducting business, even though it might not be able to do so profitably.

Comment 1: The editor has no quarrel with the result, and in fact would go still farther. The facts cited by the court do not indicate that the landlord actually acknowledged or was even aware that the purpose of the lease (as opposed to the tenant's business plan) was the storage and distribution of chemicals. One conversation on the eve of execution should not overcome the specific language of the use clause. Certainly the tenant would argue otherwise if it later chose to enter a different type of "storage and distribution" not involving chemicals.

Why can't we just say that the tenant has obtained a business asset and the risk of making a profit from it?

Comment 2: The court does not make clear whether the lease provides for assigning or subletting. If it does, then the editor is even more inclined to opt for a construction that puts the risk of frustration on the tenant.

Comment 3: Where premises have a limited business use and the use contracted for becomes completely impossible, then it does seem unfair for the tenant to continue to be bound unless the landlord has clearly transferred the risk. For instance, the late lamented Ontario Motor Speedway was useful for nothing but auto races not even suitable for band performances or soccer games. Any contract regarding that structure obviously contemplated its continued use for the dedicated purpose, and if the state banned auto racing as immoral or unsafe, then it would seem that the landlord should take the risk.

Comment 4: What is the impact of this case (and this theory) on the various gasoline service stations that have just become subject to very expensive refitting requirements for their underground storage tanks. In the editor's neighborhood, a number of stations have closed their doors rather than comply. Frustration of purpose? See the Restatement quote above.

Items in the Daily Development section generally are extracted from the Quarterly Report on Developments in Real Estate Law, published by the ABA Section on Real Property, Probate & Trust Law. Subscriptions to the Quarterly Report are available to Section members only. The cost is nominal. For the last six years, these Reports have been collated, updated, indexed and bound into an Annual Survey of Developments in Real Estate Law, volumes 1 - 6, published by the ABA Press. The Annual Survey volumes are available for sale to the public. For the Report or the Survey, contact Maria Tabor at the ABA. (312) 988 5590 or mtabor@staff.abanet.org

Items reported here and in the ABA publications are for general information purposes only and should not be relied upon in the course of representation or in the forming of decisions in legal matters. The same is true of all commentary provided by contributors to the DIRT list. Accuracy of data and opinions expressed are the sole responsibility of the DIRT editor and are in no sense the publication of the ABA.