A recipe for disaster? Court finds commercial lease was not frustrated

When a contract is legally frustrated, the contract automatically comes to an end and the parties’ obligations cease. In the recent decision of Cao v ISPT Pty Ltd [2024] NSWCA 188, the New South Wales Court of Appeal provides judicial guidance on the application of the doctrine of frustration in commercial leases in light of the COVID-19 imposed shutdowns.

The retail lease and the pandemic

Beijing Roast Duck Sydney Pty Ltd leased restaurant premises in Sydney's World Square Shopping Centre from ISPT Pty Ltd with Cao and Zhao (the appellants) acting as guarantors for the tenant. The tenant temporarily closed the restaurant in March 2020 in order to comply with public health orders issued in response to the COVID-19 pandemic. The tenant later went into liquidation, and ISPT Pty Ltd (the lessor) sought to recover unpaid rent from the guarantors.

The appellants argued that government-mandated restrictions forcing the closure of dine-in services and the subsequent limitations on business operations in response to COVID-19 frustrated the lease.

The Court of Appeal considered two key issues:

• Special Condition 4: Whether a special condition in the lease requiring the tenant to open the restaurant for business was rendered incapable of performance due to the public health orders, such that the contract was frustrated.
• Frustration of the lease generally: Whether the lease as a whole was frustrated, specifically because the public health restrictions made the business unviable.

The doctrine of frustration

Drawing on the principles established by Codelfa Construction Pty Ltd v State Rail Authority of New South Wales, the NSW Court of Appeal laid out the test for frustration:

For a contract to be frustrated by an unforeseen circumstance, it must be shown that:

• the “circumstance renders the context of performance so different from what the parties had assumed as to render the contract a fundamentally or radically different thing from what had been contracted for”; and
• “[a]ny relevant assumption of the parties is to be found from what is contemplated in the contract as understood in the surrounding circumstances in which it was made. The change in the assumed context must be such as to take it outside those risks for which either party had assumed responsibility.”

Essentially, the unforeseen circumstance must make the performance of the contract radically different to initial contemplation and the risk of such unforeseen circumstance arising must not have been assumed by either party under the contract.

Special Condition 4 and the impact of public health orders

Special Condition 4 imposed liquidated damages of $250 per hour if the tenant failed to open the restaurant during specified hours. The appellants argued that compliance of this Special Condition 4 was rendered incapable of performance by the public health orders, such that the contract was frustrated.

The Court found that:

• the public health orders did not prevent the tenant from offering takeaway services. Takeaway services were within the scope of the permitted use in the lease, being “Franchise and licenced a la carte/take away offering ...” The tenant could still "open the premises for business" through takeaway operations which was held to be within contemplation of the parties when entering into the lease and not so radically different to what was contracted for;
• Special Condition 4 was stated as being “subject to the law” and the lease imposed an obligation on the tenant to “obey the law” (clause 22) and not open the premises if it is “prohibited by law” (clause 29); and
• a reasonable business person would not interpret Special Condition 4 as applying during periods when government orders legally prohibited full operations. Applying liquidated damages in such circumstances would be “surprising, uncommercial and potentially contrary to public policy.”

Was the lease generally frustrated?

The appellants argued that the public health orders fundamentally and radically changed the nature of the lease, as they made it impossible to operate the restaurant as originally intended, rendering it commercially unviable.

The Court rejected this argument, noting the following factors in making its decision:

• the COVID-19 restrictions only affected the restaurant’s operations temporarily. By July 2020, the restaurant could operate at 80% capacity, and the restricted period represented only 6.4% of the lease term. These limitations were not sufficient to frustrate the lease;
• the fact that takeaway services could still be offered meant that the tenant could continue operating within the framework of the lease; and
• government relief measures, including the JobKeeper scheme and rental relief programs, were available to mitigate the financial impact of the pandemic on businesses.

The Court also determined that the risk of business disruption due to external events was explicitly allocated to the tenant under the lease. Clauses 47 and 49 contemplated various scenarios where the tenant might be affected by external events, including public health restrictions. Clause 49 specifically placed the risk of business interruption on the tenant. This allocation of risk meant that the lease could not be considered frustrated when such disruptions occurred, as these risks were assumed by the tenant when entering the contract.