Landlords don’t like lease audits. They believe they run their buildings properly and bill their tenants correctly. They want their internal information kept confidential and don’t want anyone snooping around their books. They want to protect the cash flow on the building. For these and other reasons, landlords push very hard during lease negotiations to restrict tenants’ ability to audit their leases.
Many tenants succumb to this pressure, figuring that there are more important issues to fight over. However, what tenants don’t realize (and landlords do) is that these restrictions often undermine all of the protections that were negotiated into the operating expense escalation provisions because such restrictions make it practically impossible to verify the charges.
Let’s examine some of the arguments landlords commonly make with respect to restrictions on audit rights.
Short Time Limit to Contest Bill
Landlords argue that time limits are important because they need to “close the books” for the year and that an open right to challenge charges leads to uncertainty and risk. They also argue that it is burdensome to have a tenant look at more than the current year when validating charges.
From the tenant’s viewpoint, however, short audit windows present practical problems that are difficult to avoid. First, inadequate time leads to substandard analyses. When a tenant agrees to a short window within which to contest a pass-through, there generally isn’t enough time to check for anything but very basic issues. Second, short windows mean that the tenant cannot check more than one year at a time. Given that many errors are only visible by studying multiple years of expenses together, a short time restriction makes it impossible to identify these errors until it’s too late to do anything about them.
With respect to the argument that the books need to be “closed,” operating expenses and other costs almost always bleed over from one year to the next (isn’t the operating expense reconciliation done months after the year closes?). Such formality is both unnecessary and unjustifiable. Also, landlords keep books and records for internal accounting and tax purposes for many years, so arguing that the records are unavailable is simply not valid.
No Contingency Fees
Landlords often try to restrict the tenant’s ability to retain a firm where the compensation is based on the outcome of the audit. Landlords contend that such contingency fee structures are inappropriate because they cause audit firms to focus on inconsequential items and become too aggressive.
Actually the reverse is true: contingency audit firms have a built-in incentive to focus on the more material issues and to not pursue issues that are small or unlikely to be recoverable. This makes them inherently more focused, more efficient and less burdensome to both landlord and tenant. Also, a tenant can easily assuage the landlord’s fears during negotiations by agreeing it will supervise its auditors and that they will only act with the tenant’s consent and support.
If a tenant is not permitted to retain an auditor on a contingency fee basis, the tenant must commit hard dollars to the effort. Most tenants will find this difficult unless there is something that they already know is improper. This presents a classic “Catch-22″ because the tenant needs a professional auditor’s help to identify what’s wrong. As a result, the tenant has no practical choice but to blindly rely on the landlord’s trust and good faith. This is quite a dangerous position for the tenant, considering how much is at stake and how carefully it negotiated its operating expense provisions.
From a simple business standpoint, it is also inappropriate for either landlord or tenant to restrict the other in who it retains or how they are compensated in these or any other efforts. Restricting a tenant from retaining a contingency fee auditor is analogous to prohibiting the landlord from retaining a property management firm on a percentage-of-revenue basis because it provides incentives to drive more income from their tenants.
CPAs Only
Landlords will argue that any audit must be done by a CPA firm. They assert that this ensures that the audit will be performed professionally and that the results will be unbiased.
This also presents difficulties for tenants, both with respect to compensation and with respect to expertise. Most CPA firms will not or cannot work on a contingency fee basis, forcing the tenant to retain them on an hourly or fixed fee basis. Furthermore, CPA firms generally focus on accounting issues and do not have the expertise when it comes to lease interpretation, market analyses or property management practices. Thus, such a restriction can significantly hamper the tenant in its ability to validate anything but the accounting aspects of its charges.
Records Must Remain Confidential
Landlords argue that their proprietary information must remain confidential. They want significant restrictions on the tenant’s ability to share information with third parties. In some cases they ask for confidentiality language directly in the leases, and in other cases they ask the tenant to agree to execute a confidentiality agreement at a later time.
Most tenants would agree that such proprietary information should be kept confidential. However, tenants must be careful that the restrictions in the lease do not hamper the tenant’s ability to obtain the advice it needs to enforce its lease. Confidentiality requirements should be reasonable and should be spelled out directly in the lease. They should not be deferred to a later time by language that says that the parties will agree to execute a confidentiality agreement later.
Conclusion
Although landlords do not like having their pass-throughs challenged or their books audited, as long as they require tenants to contribute toward building operating costs, tenants must have a reasonable means to verify that the charges are correct. Given the complexity of lease audit pass-through clauses, it is inappropriate for landlords to request (and for tenants to grant) unreasonable limitations on the tenant’s ability to verify its costs.
The landlord-tenant relationship is a dynamic one that spans multiple years. Any procedural needs of the landlord are trumped by both parties’ need to make corrections along the way to ensure that the business deal stays on track.
Sample Short Audit Clause
The following is a sample short lease audit clause that can be used and/or modified as appropriate:
Landlord shall maintain accurate books and records for the charges set forth in the Operating Statement, the Tax Statement and any other charges imposed on Tenant for Additional Rent (collectively, the “Charges”) in accordance with generally accepted accounting principles consistently applied, subject to adjustment as provided in this Lease, and shall keep copies of such records for each year including the Base Year for the duration of the Lease Term, as extended, and for one (1) year thereafter. In order to verify the accuracy and validity of the Charges, Tenant and/or its representatives shall have the right, upon reasonable written notice to Landlord and at Tenant’s sole expense, to examine or have Tenant’s representatives examine the records as are relevant thereto, including the general ledger, escalation worksheets, invoices, canceled checks, contracts and other supporting records. Tenant shall be entitled to make copies of such records as needed. In connection with any examination by Tenant, Tenant agrees to treat and to instruct its employees, accountants and agents to treat all information not otherwise in the public domain as confidential and not to disclose it to any other person except as may be required by law or in connection with any dispute with Landlord relating thereto. If after its review Tenant disagrees with the Charges, Tenant may send a written notice to Landlord of such disagreement specifying in reasonable detail the basis therefor, the amount it claims was not due and the amount of any refund it is claiming. Landlord and Tenant shall attempt to resolve such disagreement amicably, subject to either party’s right to avail itself of the dispute resolution procedures set forth in this Lease.