Old And Cold – Audit Rights And Claim Cut-Offs

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Is there a time to let old things die? We are qualified to answer that question when it comes to matters emotional, but when it comes to “business,” Ruminations only has some thoughts. Today, we’ll discuss chasing people who owe money but, because money isn’t everything, we’ll start with a little digression intended to make a point.

How long should the government (that’s us, by the way) be permitted to chase a criminal? Many (but not all) states have laws that answer that question. Here’s New York’s answer:

6 years for felonies punishable by 8 or more years in prison

3 years for felonies punishable by less than 8 years in prison

No limit for murder or other capital offenses.

Three years for misdemeanors committed against children 13 and younger.

One year for other misdemeanors.

Though the time limit to file civil claims also varies by state and by the type of claim being made, they also butt up against time limits. Typically, general contract claims must be made within 6 years after the claim can first be made. Claims arising out of the sale of goods have a 4 year limit. Tort claims (and automobile accidents fall in that category) typically have a two or three year limit. Some defamation claims have an even shorter limit – only one year. Unsurprisingly, claims against government entities often have shorter time limits. After all, “Whoever has the gold makes the rules.”

Federal tax law also imposes time limits on how long the Internal Revenue Service (IRS) can “chase” a taxpayer (or non-payer). Normally, audits of filed returns cannot be started more than three years after the later of the date a return is filed or the date by which it was due to be filed. The IRS doesn’t pursue collection more than 10 years after a tax assessment is made. But, there is no time limit within which to pursue a taxpayer (or non-payer) that fails to file a return, files a substantially incomplete return or files a fraudulent return.

We can learn some principles from those (very limited) examples. First, and most relevant to today’s posting, is that that there are limits. The grudge may continue, but the claim is barred. Another point is that not every claim is serious. We need to “let go” of lesser “hurts” sooner than “greater” ones. Lastly, even powerful people – e.g., the government – agree to let things go.

Where does this bring us today in the world of retail real estate? Well, under all leases, the tenant has an obligation to pay money to its landlord – rent, percentage rent, common area expenses, taxes, etc. When a tenant overpays its landlord, the obligation is reversed – its landlord owes it money. And, then, there are other situations where money may be owed one to the other, generally in the category of reimbursements.

We doubt anyone would assert that any of those obligations are voluntary or that they are only payable if and when the one who owes the money “gets around to it.” But, what about money that might be not be owed until a bill is calculated and delivered (i.e., a statement is rendered)? In a lease, there are two common examples: pass-through expenses to be paid by the tenant (common area expenses, taxes, etc.) and percentage rent to be paid by the tenant. Though both are tenant obligations, the amount to be paid is determined in opposite ways. As to pass-through expenses, the landlord does the calculations. As to percentage rent payments, the tenant does. What they have in common is that each calculation may be wrong.

That’s the set-up for today. Even when wrong, when should or does a claim of over- or under- payment become “old and cold” – when has too much time passed for a claim to be made? After all, who will argue that a tenant shouldn’t be able to get an overcharge refunded or that a landlord shouldn’t be paid the agreed-upon percentage rent?

Why should there be a limit in the first place? For one, proofs disappear. For a variety of reasons, it is permissible to dispose of records and paperwork after some period of time. Typically, for financial records, that period is 6 or 7 years. With digital files, there may be no good reason for such a “small” time limit, but those are the numbers. Even with such files, a time limit still makes sense because reasonably economical storage media degrades and retrieval software “disappears.” Human witnesses come and go. Memories fade. And, perhaps most importantly, finality itself has a value.

So, is there a blanket time limit for a claim of underpayment or overpayments? Yes, there are for contract claims, and each state has a general “statute of limitations,” typically 6 years. BUT, contracting parties can agree to “private” limitation periods, most often shorter ones but sometimes longer ones. And, bowing to business realities, they often do. When done properly, it’s easy to do so. And, it’s just as easy to think you’ve done so, but haven’t.

Here’s an example of a time limitation taken from a tenant-form lease:

Landlord agrees that any rental payments or other payments becoming due to Landlord pursuant to the provisions of this Lease or any extensions thereof, which remain unpaid and for which no claim has been made in writing by Landlord to Tenant within 2 years after the date when such payment is due, will be deemed to be and is waived by Landlord.

Here is an example from a landlord-form lease:

Tenant waives any and all rights Tenant may have to bring any claim, suit or action with respect to any Tax Statement unless such claim, suit or action is filed with a court of competent jurisdiction within fourteen (14) months after the applicable Tax Statement Date, TIME BEING OF THE ESSENCE.

However written, the gist of such provisions is that if a claim is not made (or a lawsuit is not filed) within a stated period, the claim itself is lost. Those are the smart and effective ways to establish an outer time limit for making a claim.

We would end today’s posting here if we only wanted to cover the underlined part of what we wrote above: “When done properly, it’s easy to do so. And, it’s just as easy to think you’ve done so, but haven’t.” But, what we really wanted to do today is to write about the “but haven’t” part.

Many, many lease writers confuse “audit rights,” those given to one party or the other to “verify” that it is being asked to pay the “proper” amount or to receive the “proper” amount with a time limit for claims. After all, when it comes to common area costs and other pass-through charges, the landlord holds all of the underlying information and “writes” the bill. When it comes to percentage rent, the shoe is on the other foot – the tenant controls the information. No one expects either, tenant or landlord, to blindly accept the other’s calculations. That’s why it is fair and appropriate to require the statement-preparing party to furnish backup information with a statement and to allow the “bill-payer” to dig in a little deeper behind a statement. Broadly, the ability to look “deeper” is called an “audit right.” Certainly, if a lawsuit is filed to claim an overcharge or an underpayment, the claimant will have the right to review the supporting records (bills, sales records, etc.) and these claims can be made for 6 years. That’s the right to “discovery” that parties have in lawsuits. But, why should a landlord and tenant have to be in court before those records can be reviewed? They shouldn’t. [A separate question, raised last week, is “Why form leases ‘forget’ to give audit rights?”]

When an audit right is included in a lease, for some reason, it seems that those who write these provisions think there should be a time limit within which the audit can be conducted. The law typically would allow investigation of those records for 6 years, yet these “audit right” clauses usually set a one to three-year limit. Why? Well, it turns out that the number one [Family Feud] answer is: “because of a mistaken thought.” They really aren’t focusing on whether the books and records can be examined. Experience and case law show that those who put these time limits into “audit right” provisions think they are cutting off claims at the end of that time period. That is common and that is wrong.

Here are examples from two leases and one Easements, Covenants and Restrictions Agreement, all of which were involved in a single litigation:

Tenant shall, at Landlord’s regular accounting office during normal business hours, be entitled to audit (or authorize an accountant designated by Tenant to audit) Landlord’s books and records of the Common Facilities Expense, Landlord’s Insurance Charge and/or Taxes Applicable to the Leased Premises for any Lease Year within 24 months of Tenant’s receipt of the statement therefor.

…[W]ithin (2) years after receipt of any such certified statement, [tenant] 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 [tenant] exercise such audit right more than once per calendar year.

Tenant shall, at Landlord’s regular accounting office during normal business hours, be entitled to audit (or authorize and accountant designated by Tenant 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.

Take note, that none of those provisions, in documents each prepared by sophisticated parties, say anything about making claims. They only address doing audits. Nonetheless, the respective (related) landlords under the three leases argued that claims were barred after 12 or 24 months (depending on what each particular clause specified for the particular lease). The court knew better. Here’s what it “taught” the landlord:

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 tenants] here would be barred as argued by [the landlords]. 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 [the landlords’] CAM calculations would be “final and conclusive” after a certain period of time indicates a contrary intention.

So, if you want to make a percentage rent payment or a pass-through charge bill “final and conclusive,” i.e., no longer disputable, you need to say so CLEARLY.

For those interested in Ruminations’ opinion as to having such limits (on audits or claims) in the first place, here it is. Our preference is that the jurisdiction’s statute of limitations (e.g., 6 years) apply to claims and that there are liberal audit rights until then. Audit rights should be reasonable and practical, conditioned only by administrative considerations. Would a shorter claims cut-off period be offensive? No, not really – we think 3 years would be commercially reasonable, but we also think that if a “classification error” is discovered during an audit of the prior 3 years’ information, the auditing party should be entitled to review and make claims for older, similar errors. An example would be finding an “excluded” cost included in common area expenses or the failure of a tenant to include a particular revenue source in its percentage rent reports. That’s our own view. The view of any particular employer or client overrides our view in every case, as it should be for yours.

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Comments

  1. Dan Kopp says:

    The problem with a six year limit is that properties often change hands during such a time period and the buyer of the property (and now landlord) probably has no recourse against its seller if it has to refund money for prior years to the tenant. I’m sure you will say that is not the tenant’s fault–but it is a fact, and is part of the reason why shorter limits are often imposed. (I don’t think the estoppel certificate helps the buyer here because a smart tenant qualifies the relevant provision “to its knowledge.”)

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