Why Do You Think Your Lease’s Audit Clause Provides Any Benefit Or Protection?

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Audit clauses in leases are not throw-away provisions. They are not something to be copied from the last document and the one before that and so on. While intended by landlords to “make” pass-through cost billings “final,” as often written, they won’t satisfy that purpose. Similarly, a tenant or other kind of occupant who wants to “contain” its landlord’s right to audit sales records for percentage rent purposes also may want to read what follows. For simplicity (and because the overwhelming number of such situations involve tenancies), we’ll speak of tenants and leases, but the same concepts apply to Covenants, Conditions and Restrictions (CC&Rs) and similar, but differently named, documents.

Almost certainly, a tenant can challenge the billings it receives from its landlord for operating expenses, taxes, insurance premiums, utilities, and stuff like that. The lease doesn’t have to say so. While it might be risky for a tenant to refuse to pay such billed charges within the lease’s allotted time period just because the bill doesn’t seem “right,” there doesn’t appear to be any general principle of law that precludes a tenant from suing its landlord and getting “audit-like” information as part of that law suit. Yes, there will be a statute of limitations and, yes, the jurisdiction will have some form of “you can’t file a frivolous law suit” rule. But, if the tenant has a good faith, reasonable belief that the billings are wrong, it can sue and get its money back (if correct). In addition, there is limited case law support for the proposition that a tenant has an implied right to see detailed information supporting pass-through charges, at least in an action for an accounting.

None of that means that a well-drafted lease shouldn’t have a provision regarding each party’s right to audit certain financial information belonging to the other. It should. A clearly defined right to audit pass-through charges beats the right to sue for that information, hands down.

We were reviewing the May 5, 2010 Missouri Circuit Court decision in the following case: American Multi-Cinema, Inc. v. Developers Diversified Realty Corporation. It can be found HERE. A movie theater chain leased three locations from a property owner. Though each landlord was a single location owner, they shared the same parent owner. That owner’s property manager ran all three locations. Admittedly, the theater chain was overcharged for common area charges (CAM). The three landlords adjusted billing statements for certain later years, but refused to do so for earlier years despite the admitted overcharging. Their refusal was based on defenses they claimed were available to it under the leases. Here they are: (1) the theater chain was seeking relief from overcharges outside the “audit periods” in the leases; (2) the theater chain was estopped from seeking relief because it was making a claim inconsistent with the chain’s prior conduct; and (3) the chain had already waived its right to reimbursement of the overcharges.

The court rejected all of those defenses based on the facts presented (which facts, as reported, seemed pretty convincing in the theater chain’s favor). Here, we’ll focus on the “beyond the audit period” defense raised by the landlords. Though we’ll mention “waiver” and non-waiver” today, we’ll discuss the concept of waiver and the effectiveness of “no-waiver” clauses in a future posting (if we remember).

Though the three properties had a common owner, the “right to audit” provision in the documents for the three locations, though similar one to another, differed slightly. Here are excerpts of the salient provisions from the two leases and one set of CC&Rs:

LOCATION 1

Tenant shall, at Landlord’s regular accounting office …, be entitled to audit (…) Landlord’s books and records of the Common Facilities Expense … for any Lease Year within 24 months of Tenant’s receipt of the statement therefor. … Any amount found by such audit to be due Tenant shall be immediately paid to Tenant by Landlord.

LOCATION 2

… [W]ithin (2) years after receipt of any such certified statement [Theater Chain] shall have the right to audit Developer’s books and records pertaining to the operation and maintenance of the Common Area for the calendar year covered by such certified statement, provided that in no event shall [Theater Chain] exercise such audit right more than once per calendar year; [Theater Chain] shall notify Developer of its intent at least fifteen (15) days prior to the designated audit date.

LOCATION 3

Tenant shall, at Landlord’s regular accounting office …, be entitled to audit (…) Landlord’s books and records of the Common Facilities Expense … for any Lease Year within 12 months of Tenant’s receipt of the statement therefor. … Any amount found by such audit to be due Tenant shall be immediately paid to Tenant by Landlord.

If anyone thinks the quoted text or any of the myriad of similar formulations we customarily see constitute a private statute of limitations for the making of overcharge claims, think again. We argue over whether the “open” audit period should be 90 days or four years. We argue about whether the auditing party has to go to “who knows where” to exercise the right. We argue as to what records can be reviewed. We argue about a lot of collateral matters. Most of all, we argue about these things, Ruminations would venture, because most negotiators mistakenly belief that all of these “restrictions” constitute a limitation on how long a party has to make an overcharge claim or what might be the scope of that claim.

Not only does the case cited above tell us otherwise, but our good sense does as well. Yet, the common (mis)belief persists.

Readers, listen up to these things said by the court:

[Developer] breached its agreements under the three leases to only bill [Theater Chain] for items properly categorized as CAM by charging [Theater Chain] for items outside the definition of CAM contained in the leases.

[Our interpretation: what’s the audit right got to do with anything, Developer, you breached the lease and your tenant can get damages.]

In so doing, the Court rejects the primary defense raised by [the Developer] – that [the Theater Chain] improperly seeks reimbursement of overcharges for time periods outside the “audit periods” contained in the leases. [Developer] argue[s] that [Theater Chain] is barred by the lease language from recouping overcharges beyond two years, in the case of the Missouri and Arizona leases, and one year in the case of the Ohio lease.

[Our interpretation: the court has the same understanding of the inapplicability of the audit provisions as do we.]

It is undisputed that agreements which purport to effectively establish a shorter period of time in which to bring a claim than would otherwise exist are not favored in the law. Accordingly, their language is construed strictly against the party invoking their provisions. Here, the Court cannot find from the language of the leases any language from which it can determine that the parties intended that the claims brought by [the Theater Chain] here would be barred as argued by [the Developer]. Indeed, the Court concludes that the “cumulative rights” language and “non-waiver” provisions in the agreements and, notably, the absence of any language indicating that [Developer’s] CAM calculations would be “final and conclusive” after a certain period of time indicates a contrary intention.

[Our interpretation: if you want set a time limit for overcharge claims, say so clearly and directly. Limiting an otherwise available legal remedy isn’t something the courts like to see, but they’ll abide by an agreement to do so, if reasonable. That’s what “disfavored” means.]

The Court also concludes that the audit provisions in the agreements were intended only to apply to the time period within which [the Theater Chain] was to request an audit of the landlord’s records at the landlord’s business offices. In this case, it is undisputed that [the Theater Chain] never requested an opportunity to audit, or review, the landlord’s records at the landlord’s business offices. [The Theater Chain’s] review was conducted at [the Theater Chain’s] offices by its own personnel and/or agents.

[Our interpretation is the same as yours.]

The Court concludes similarly that [the Developer] failed to prove [the Theater Chain] waived its right to reimbursement of overcharges. Waiver is the intentional relinquishment of a known right. …. Waiver may be inferred from the actions of the parties, but the acts upon which the person asserting waiver relies must clearly and unequivocally establish the intent to waive known rights.

[Our interpretation: don’t go yelling “waiver, waiver” (pants on fire) just because the other party didn’t complain sooner.]

There is no evidence that [the Theater Chain] knew when it paid the CAM charges that it was being overcharged. [The Theater Chain] received a statement and bill from [the Developer]. [The Developer] assumed and accepted the contractual duty to bill CAM charges correctly. [The Developer] did not provide [the Theater Chain] with sufficient detail by which [the Theater Chain] could know whether it was being overcharged. Indeed, [the Developer] had a duty to certify each CAM billing statement as true and to provide reasonable detail of the CAM charges for each year and how such amount was arrived at. The Court finds [the Developer] never certified any CAM statements as required by the Leases. Also, [the Developer] never provided [the Theater Chain] reasonable detail of the charges and how they were calculated. This fact, combined with the “non-waiver” provisions in the agreements, causes the Court to conclude that [the Theater Chain] has not waived its claims here.

[Our interpretation: a tenant doesn’t need to base its claim on an audit anyway, so what’s the big deal?]

We have no intention of providing a particular “audit” provision. That’s mostly because every serious landlord (or landlord’s negotiator) and every serious tenant (or tenant’s negotiator] has her, his or its “hang-ups” about what such a provision should say. That goes beyond “how long do you have to begin your audit.” It goes beyond the date or event from which that limiting period begins. It could be a limit as to what can be reviewed. It could go to where the records can be reviewed. Or, who can review the records – only a CPA? It could go to who can’t conduct the audit – a non-employee? Often it goes to whether an auditor who is paid on a contingency basis can do the audit.

Everyone has her or his favorite formulation as what the triggering billing or statement has to look like and what documents have to accompany that billing or statement. We think some level of detail should be provided. We also think a lease should include, as an exhibit, a formatted billing statement listing the categories and subcategories that should be on future bills. It would be best if, for established properties, the exhibit showed the actual figures for the completed period closest in time to lease execution.

Basically, it goes on and on.

It you ask for our opinion, we would vote in favor of free and open disclosure, but not a procedure that invites harassment. After all, the business deal is to “pass through” a (hopefully well) defined set of expenses and we think there is no justification for anything other than fully transparent billing. If the billing was deliberately overstated, the color of the auditor’s pencil shouldn’t be the determining factor as to whether a landlord can keep “ill gotten gains” or whether a tenant can “short change” its landlord on percentage rent payments. If there was an innocent error, by far the usual case, then what landlord would want to keep a mistaken, unearned payment and what tenant would want to negligently cheat its landlord out of rent?

As to the topic at hand, if there is any justification for a consensual shorting of the normal six year statute of limitations on filing a lawsuit for breach of contract, then the parties should agree on “how long.” Ruminations doesn’t think six years is sacrosanct; after all, the Uniform Commercial Code (UCC) shortened the period to four years for transactions in the sale of goods.

We don’t think record retainage considerations justify going below the default of six years. After all, tax law requires that records be kept longer than that. On the other hand, the concepts of “old and cold,” “let us sleep in comfort,” and “we’ve got to close the books” all work for us. What doesn’t work for us are form leases that say you have 30, 60 or 90 days to make your claim or not at all. In fact, we would charge any proponent of such a proposition – if you don’t catch us in 30 days, we get to keep what we weren’t entitled to receive – with disingenuousness or “the form is the form -itis.”

On a constructive note, if we were King (and, believe us, we know we aren’t even a pawn), we’d pick three years. That allows a tenant to look at the bills at least once every three years and, if an error is suspected, to look at the prior two years for the same or similar alleged errors.

So, conceptually, we would lobby for leases saying that:

the amounts shown on each “statement” will be deemed final and conclusive for all purposes on the third (3rd) anniversary of the recipient’s receipt of that statement with no exceptions for errors or discrepancies of any kind and regardless of the magnitude of any actual error. Each party voluntarily and knowingly waives any and all claims against the other and against any other person or entity based upon any error or discrepancy in any bill or statement unless the complaining party sends notice of the claim or commences a legal action based on its claim within three (3) years after it first received the statement on which the claim is asserted. Any such claim, to be valid, must be accompanied by a reasonably detailed explanation of the basis for the claim; otherwise the claim will be treated as not having been made. No blanket or naked claims will be treated as valid claims.

That’s the concept. It isn’t a lease provision. Whatever you choose to say, it has to be integrated into the “text” of your lease, not ours.

Here’s one final thought – a “cliff hanger” for dessert. If you want to know why the property manager was jointly and severally liable, together with each landlord, respectively, for an aggregate amount of $462,978.16, you’ll want to read the court’s decision.

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Comments

  1. As a professional lease auditor for more than 20 years (ouch!), I think that your article is on-target. Thank you. Respectfully, Bob Wiesner

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