3 April 2023
Tenants of commercial real estate are increasingly facing bankruptcy due to general price increases as a result of inflation that has already risen significantly due to the COVID-19 pandemic and then the war in Ukraine - as recently seen in a senior citizens' home operator in Bad Soden-Salmünster, Germany.
The reason for this is the commonly agreed indexation clause in commercial leases in which the parties agree to a rent adjustment mechanism determined by a price index calculated by the Federal Statistical Office in Germany, usually the consumer price index (CPI), which reflects inflation. An indexation clause based on the CPI leads to an increase in rent as soon as the cost of living rises. With barely perceptible inflation rates of sometimes less than 0.5 per cent p.a., the indexation clause has been in the shadows for decades. This has changed abruptly with an inflation rate that has now settled at just below 10 per cent p.a.
During the COVID-19 pandemic tenants were able to partially enforce rent reductions by invoking the pandemic-related special situation. This was made possible by the now famous Section 313 German Civil Code, the so-called “regulation on the disturbance of the basis of contract”. And once again, tenants raise their voices to restrict the applicability of indexation clauses on the grounds of Sec. 313 German Civil Code.
For concluded contracts, the noble principle of private law "pacta sunt servanda" applies, which means that contracts must be fulfilled as they were concluded.
This principle may only be breached unilaterally in explicitly regulated exceptional cases. This also applies to the application of Sec. 313 German Civil Code, which requires numerous conditions to be in place for the provision to apply at all.
The regulation of “disturbance of the basis of the contract” (Sec. 313 German Civil Code) allows for exceptions to the above-mentioned principle in only a few cases, so that the adjustment of a contract can be demanded unilaterally and in extreme cases a contractual correction may be achieved. However, the provision does not specify how/in what manner the adjustment of a contract must take place. Ultimately, in the event of a dispute between the parties, this is up to the discretion of a judge. In relation to indexation clauses such an adjustment could be a temporary suspension of the indexation clause and/or a cap on the adjustment rate.
The purpose of the regulation concerning the “disturbance of the basis of contract” is to resolve the tension between adherence to a contract on the one hand and the need to adjust the contract due to significant changes on the other hand. This always requires a comprehensive weighing of all circumstances of the individual case.
The applicability of Sec. 313 German Civil Code requires that
The "significant change" could currently be seen in the exceptionally high inflation resulting from the Russian attack on Ukraine, the extent of which was not foreseeable for the parties. The war in Ukraine is a challenging situation for world politics, which has led to massive economic changes, in particular to an artificial shortage of primary energy sources. In order for Sec. 313 German Civil Code to apply, the parties would have had to agree that the circumstance constituting the significant change is the basis of the transaction. This means, the parties must have assumed a permanently low inflation as the basis of the lease and must have assumed this circumstance when concluding the contract.
However, the agreement of an indexation clause already indicates that the parties have taken the risk of a high inflation into account at the time of conclusion of the contract. They wanted to prevent a possible devaluation of the rent by agreeing upon the indexation clause and consciously provided for an indexation of the rent for this reason.
The purpose of an indexation clause is to maintain the original balance between performance and consideration and to compensate for changes caused by inflation (as well as deflation, if applicable), i.e. to secure the value of the rent during the lease period by adjusting the rent to the economic development. In this context, it is a typical risk in long-term contracts that an indexation clause may temporarily work in favour of one or the other party during the entire lease period. The fact that the inflation is currently higher than was foreseeable at the time of conlusion of the contract does not fundamentally change the allocation of risk made by the parties, namely that the tenant bears the risk of (even high) inflation and the landlord bears the risk of deflation.
Even if one would argue that Sec. 313 German Civil Code is applicable - from a legal point of view, difficult to justify - the tenant would still have to prove that the balance between performance and consideration is disturbed by the current situation to such an extent that the typical risk assumed by tenant has been exceeded and is no longer reasonable for the tenant to take. However, since it is often possible for tenants of commercial leases to increase their own prices towards their customers due to the high inflation (e.g., by raising prices in retail or by raising accommodation prices in hotels, etc.), the argument that the current situation is unreasonable for the tenant is likely to apply only in extreme exceptional cases.
From the mere agreement on an indexation clause it can be soundly deduced that the parties to a lease agreement have anticipated and contractually regulated the risk of inflation or deflation - unlike the outbreak of the COVID-19 pandemic - which should exclude the application of Sec. 313 German Civil Code. The indexation clause has been agreed precisely for the circumstance that has now occurred. From a legal point of view, it is therefore likely to be extremely difficult to restrict the application of the indexation clause by invoking Sec. 313 German Civil Code. Even though the legal situation for landlords is likely to be much better this time than during the COVID-19 pandemic, they will still have to consider whether they can fully enforce their claim for rent adjustment by applying the relevant indexation clause. Reality shows that the enforcement of the indexation clause can have existential consequences for many tenants. The economic consequences resulting from a tenant's bancrupty - writing-off of rental arrears, costs of subsequent letting, reduced rents when concluding new leases - can be much more serious than suspending or deferring an adjustment of rent according to the indexation clause.
Therefore, many economically reasonable landlords will feel compelled to agree upon creative solutions with their tenants. These may include suspensions of indexation, caps on adjustments, deferrals of rent increases and similar solutions. And since lawyers are known to find a solution to every problem, this situation will also be resolved satisfactorily for both parties.
Judgment of the Federal Administrative Court (4 C 1/20) of 9 November 2021
by multiple authors
by multiple authors