16 Apr Commercial Leases Examined–Audit Rights
This is the fourth in an occasional series of posts examine Commercial Lease Agreements. Previous posts examined percentage rent provisions, term length and stuffed definitions, and relocation clauses. This post will examine audit rights for the tenant.
Many, if not most, commercial leases are “triple net” leases which require the tenant to pay for or contribute to real estate taxes, insurance costs, and a pro-rated share operating costs for the entire facility. In particular, operating costs can vary from year to year since such costs might include electricity for commons spaces, heating and cooling for shopping malls, and similar variable costs that are outside the complete control of the landlord. As a result, a common feature of commercial leases will be an reconciliation and adjustment procedure, whereby the Landlord reconciles their accounts and charges the Tenant a share of those operating expenses. To protect Tenants from arbitrary charges of operating expenses or other additional rent, a commercial lease agreements often contain a provision allowing the Tenant to audit the Landlord’s operating expenses records.
The audit procedure need not be complicated, but the following provision is a lesson in how not to draft an Audit Rights provisions.
3.08 Audit Rights. Within sixty (60) days of the reconciliation and adjustment as set forth in Section 3.02 regarding Operating Expenses (but not more than once per year), if Tenant disputes the amount of Additional Rent set forth in the reconciliation statement, an independent certified public accountant (which accountant is a member of a nationally recognized accounting firm), designated and paid for by Tenant, may, upon at least twenty (20) business days prior written notice to Landlord, and at reasonable times, inspect Landlord’s records at Landlord’s offices, provided that Tenant is not then in default under this Lease and Tenant has paid all amounts required to be paid under the applicable reconciliation statement, as the case may be. No such audit may be conducted on a contingency basis by the accountant (and therefore no portion of the fee or other compensation payable to the accountant may in any way be tied to the results of such audit), and any such audit conducted on such basis shall be deemed void for the purposes hereof, and Tenant hereby waives and further rights under this Section 3.08 following the performance of an audit on such basis. Tenant’s failure to dispute the amount of Additional Rent set forth in any statement within sixty (60) days of Tenant’s receipt of such statement shall be deemed to be Tenant’s approval of such statement and Tenant, thereafter, waives the right or ability to dispute the amounts set forth in such statement. If after such inspection, Tenant still disputes such Additional Rent, a determination as to the proper amount shall be made, at Tenant’s expense, by an independent certified public accountant (the “Accountant”) selected by Landlord, subject to Tenant’s reasonable approval. The results of any audit conducted pursuant to this Section 3.08 shall be kept confidential by Tenant and its accountant, and at Landlord’s request, such accountant must agree in writing (in a commercially reasonable form) to keep the results of such audit confidential and not to reveal the same to any parties other than Landlord and Tenant. In the event of any breach of the foregoing confidentiality/non disclosure covenant by the accountant, Tenant or Tenant’s agents, then: (i) the same shall constitute a default under the Lease without further notice from Landlord; (ii) the audit with respect to which such breach occurred shall be deemed void for the purposes hereof; (iii) Tenant hereby waives and further rights under this Section 3.08 following such breach; and (iv) Tenant hereby indemnifies and will hold Landlord harmless from and against any and all costs, claims, actions, causes of action, liabilities, losses or damages (including reasonable attorneys fees) suffered or incurred by Landlord as a result of such breach.
This 448 word behemoth cries out for subsections. The use of subsections would also help make some of the redundancies and inconsistencies apparent. Discussed below are the major provisions examined and presented in an order in which I would draft the provision.
Exercise & Loss of Audit Right
The general purpose of this section is to state that following a reconciliation and adjustment the Tenant has a right to dispute the reconciliation. In this case, the Tenant has sixty days, as stated very early in the section. However, buried later in the section is a poorly written if/then conditional stating:
Tenant’s failure to dispute the amount of Additional Rent set forth in any statement within sixty (60) days of Tenant’s receipt of such statement shall be deemed to be Tenant’s approval of such statement and Tenant, thereafter, waives the right or ability to dispute the amounts set forth in such statement.
So, if the Tenant fails to dispute the reconciliation within sixty days, the reconciliation is deemed approved and the Tenant can no longer dispute the reconciliation. Clearly, timeliness is an issue, but by separating the two time provisions by more than 150 words, the consequences of failure to meet the 60 day deadline might get lost or missed.
A far better presentation of the exercise time and time limit of the audit right would be to simply state:
After receiving the results of a reconciliation and adjustment conducted according to Section 3.02, Tenant may dispute the results within 60 days by providing written notice to the Landlord of Tenant’s intent to exercise its audit rights. If Tenant fails to dispute the reconciliation and adjustment results within 60 days, the results are deemed accurate and Tenant waives the right to dispute the results.
This statement establishes a discretionary right for the Tenant, groups all timing issues in one subsection, clearly identifies time frames, sets the obligations necessary to dispute the reconciliation and adjustment, and specifies the penalty for failing to provide timely notice.
Inspection & Audit
The provision in this example Audit Rights clause provides a two step “inspection-audit” procedure. Such a procedure is constructed to cost the Tenant a lot of money and thus creates a strong incentive to simply accept the reconciliation.
The first step is called an inspection. The Tenant would have to give 20 business days notice of intent to conduct an “inspection.” The time frame itself is acceptable, but redundant. If notice of dispute and intent to exercise is given to the Landlord, why is another notice necessary. Additionally, the sixty days notice is presumed to be calendar days but this twenty day notice is business days. The disparate counting standards creates an unnecessary ambiguity.
The inspection then has to be carried out by ” an independent certified public accountant (which accountant is a member of a nationally recognized accounting firm).” An independent CPA is wise and prudent. However, I remain puzzled why such accountant must come from a “nationally recognized firm.” Certified public accountants are a regulated profession and licenses are issued to CPAs by a state board and those CPAs are held to fairly rigorous professional standards. The only discernible difference between a CPA with their own firm and a CPA from a nationally recognized firm is the latter likely charges a much higher hourly rate thus creating a cost disincentive for the Tenant to pursue an “inspection.”
However, such matters are trivial to the larger point; what precisely is the point of the inspection? If a Tenant is paying for an “inspection” the CPA might as well conduct a full audit of the operating expenses. But this example states that first a CPA conducts an inspection and if the Tenats still disputes the operating expenses, the Tenant has to pay for a Landlord-appointed CPA to conduct an audit. Thus, the Tenant still has to pay for another accountant to conduct an audit.
All of these provisions result in a very significant cost to the Tenant. But assuming the Tenant is willing to pay those CPA costs, completely left unstated in this provision is what happens if the inspection and audit result in findings that state the Tenant over paid?
The answer is nothing. There is no provision that states the Tenant will get a refund or get a credit against their rent of any kind.
This subsection would be a procedural subsection. A far more equitable section would allow for a Tenant paid audit if there is a dispute. If the Landlord disputes the first audit, the Landlord can commission a second audit paid by the Landlord and if there is a discrepancy between the two audits, teh results are averaged. If the Tenant underpaid, the Tenant pays the average. If the Tenant overpaid, the Tenant receives a credit in the averaged amount.
(b) Procedure. (1) If Tenant exercises its Audit Right, Tenant shall commission, at Tenant’s expense, an audit to be performed by an independent certified public accountant (“Tenant’s Audit’). The Tenant’s Audit shall be conducted with at least ten days prior notice to Landlord and shall take place no later than 90 days after Tenant receives notice of the results of the reconciliation and adjustment. (2) If Landlord disputes the results of the Tenant’s Audit, the Landlord may commission, at Landlord’s expense, an audit to be performed by an independent certified public accountant (“Landlord’s Audit’). The Landlord’s Audit shall take place no later than 60 days after the report of the Tenant’s Audit. (3) If the results of the Tenant’s Audit and the Landlord’s Audit are not identical, the results shall be averaged together to create the audited result. If the audited result is an overpayment by the Tenant, Landlord shall credit Tenant for the overpayment or refund the audited result to the Tenant within 30 days of the Landlord’s Audit report. If the audited result finds an underpayment by the Tenant, Tenant shall pay the Additional Rent owed within 30 days of the Landlord’s Audit report.
This revised provision, while lengthy, adequately balances the rights of the Tenant and the Landlord, while at the same time equitably distributes the costs of the audits. To be frank, there would need to be a significant charge to the Tenant from the reconciliation process to justify the cost of an audit. But if an audit is necessary, the idea would be to resolve the matter quickly.
Non-Disclosure of Audit
The sample provision requires the result of any audit be kept confidential (presumably so tenants don’t talk to each other about being scammed by the Landlord). While requiring a non-disclosure and confidentiality agreement is a reasonable term, some of the consequences of a breach of the NDA contained in the sample provision are unduly harsh given the potential damages from a breach of the NDA. The consequences include:
1. Automatic breach of the lease, which in this case would grant the Landlord the right to evict the Tenant. Thus, through no fault of its own, the Tenant can be evicted without further notice and be responsible for the attendant costs of eviction. Given that the likely damages to the Landlord might be some additional payments or credits to other Tenants for overcharging, the eviction is a pretty harsh move.
2. The audit is deemed void for its purpose. The result of voiding the audit is that the Tenant then has to pay the original results of the reconciliation–which is in dispute because the Tenant thought it unfair. Such a consequences is likely to lead to further dispute.
3. Tenant waives any further audit rights. The way this provision is written it is unclear whether the loss of audit rights is for the current reconciliation or for the duration of the lease. I presume the Landlord intends it to be for the duration of the lease. Again, the chances for mischief are higher if there is not audit right present.
4. Indemnification for Landlord Losses. Of all the consequences, this is the most reasonable. I would recommend, however, that the indemnification applies only if it is found that the Tenant is responsible for the breach of the NDA. Any NDA should be worded to protect the Landlord through a third party claim procedure. If the CPA breaches the NDA, then the action should be against the CPA by the Landlord and not the Tenant.
A suggested rewrite of the provision would be much simpler.
(c) Any CPA engaged by the Tenant to perform Tenant’s Audit must agree in writing to keep the results of the Tenant’s Audit confidential. The Tenant and the Tenant’s Audit CPA shall agree to specifically include Landlord as a third party beneficiary of the confidentiality agreement between Tenant and Tenant’s Audit CPA. In the event a Landlord’s Audit is conducted, Tenant agrees to keep confidential the results the Landlord’s Audit. If requested by Landlord, Tenant shall sign a reasonable confidentiality agreement with the Landlord. If Tenant breaches its confidentiality agreement with either the Tenant’s Audit CPA or the Landlord, Tenant shall indemnify Landlord for any damages (including reasonable attorneys fees) suffered or incurred by Landlord as a result of such breach.
This rewritten provision ensures that the results of any audit are kept confidential but without the unduly harsh consequences that are meant to be punitive on a over-sized manner.
Conclusion
The sample Audit Rights provision provided above is a complex, nearly unreadable, and overly punitive provision. The length of the provision detracts from the ability of the reader (and potential tenant) from understanding the rights and responsibilities of the parties.
Based on my suggestions from above, here is a version of the Audit Rights re-written in a format that is clearer.
3.08 Audit Rights. (a) After receiving the results of a reconciliation and adjustment conducted according to Section 3.02, Tenant may dispute the results within 60 days by providing written notice to the Landlord of Tenant’s intent to exercise its audit rights. If Tenant fails to dispute the reconciliation and adjustment results within 60 days, the results are deemed accurate and Tenant waives the right to dispute the results.
(b) Procedure. (1) If Tenant exercises its Audit Right, Tenant shall commission, at Tenant’s expense, an audit to be performed by an independent certified public accountant (“Tenant’s Audit’). The Tenant’s Audit shall be conducted with at least ten days prior notice to Landlord and shall take place no later than 90 days after Tenant receives notice of the results of the reconciliation and adjustment.
(2) If Landlord disputes the results of the Tenant’s Audit, the Landlord may commission, at Landlord’s expense, an audit to be performed by an independent certified public accountant (“Landlord’s Audit’). The Landlord’s Audit shall take place no later than 60 days after the report of the Tenant’s Audit.
(3) If the results of the Tenant’s Audit and the Landlord’s Audit are not identical, the results shall be averaged together to create the audited result. If the audited result is an overpayment by the Tenant, Landlord shall credit Tenant for the overpayment or refund the audited result to the Tenant within 30 days of the Landlord’s Audit report. If the audited result finds an underpayment by the Tenant, Tenant shall pay the Additional Rent owed within 30 days of the Landlord’s Audit report.
(c) Any CPA engaged by the Tenant to perform Tenant’s Audit must agree in writing to keep the results of the Tenant’s Audit confidential. The Tenant and the Tenant’s Audit CPA shall agree to specifically include Landlord as a third party beneficiary of the confidentiality agreement between Tenant and Tenant’s Audit CPA. In the event a Landlord’s Audit is conducted, Tenant agrees to keep confidential the results the Landlord’s Audit. If requested by Landlord, Tenant shall sign a reasonable confidentiality agreement with the Landlord. If Tenant breaches its confidentiality agreement with either the Tenant’s Audit CPA or the Landlord, Tenant shall indemnify Landlord for any damages (including reasonable attorneys fees) suffered or incurred by Landlord as a result of such breach.