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Operating Expenses (Part 3) – Audit Rights

Operating Expenses (Part 3) – Audit Rights

This is the final blog post in a 3 part series on the negotiation of operating expense provisions in commercial leases. Part 1 provided an introduction and examples of landlords attempting to capture questionable costs, which has become more prevalent due to the down leasing market. Part 2 provided key negotiation points for the exclusion of certain costs and caps on controllable costs. This Part 3 discusses tenant audit rights, which allow the tenant to audit the landlord’s records to determine if costs were passed through appropriately.

It is important to understand that a tenant needs both the operating expense exclusions (as discussed in Part 2) and audit rights. If a tenant has properly negotiated the operating expense exclusions but has no right to audit the landlord’s determination of costs, the tenant likely has to sue the landlord in order to make the landlord produce its records. This is very costly and a deterrent for challenges from the tenant. On the other hand, if a tenant has audit rights but has not properly negotiated the operating expense exclusions, then the landlord can pass through excessive charges and the audit rights essentially are worthless.

Audit Rights

Below is a sample “tenant friendly” provision that provides for tenant audit rights. The key negotiation points for the tenant are: (1) the ability to audit the landlord’s records, (2) the landlord must honor the results of the audit, and (3) if the audit discloses an overstatement of 5% or more, the landlord must reimburse the tenant for the cost of the audit.

Landlord shall maintain books and records of all Operating Costs and shall permit Tenant to audit Landlord’s statements for any annual period. If Tenant elects to audit such books and records, Landlord shall reasonably cooperate with Tenant, and any deficiency or overpayment disclosed by such audit shall be promptly paid or refunded the case may be. If any such audit discloses that the Operating Costs reflected on Landlord’s statement were overstated by more than five percent (5%) of the actual Operating Costs for the subject year, Landlord shall reimburse Tenant for the reasonable costs of such audit.

The typical landlord’s concerns with this provision are as follows: (1) the audit should be performed by a certified public accountant, (2) the accountant should be paid on an hourly basis and not on a contingency basis, (3) the audit should take place at landlord’s business offices, (4) tenant’s right to audit should be contained within a time window, such as 90 days following receipt of the final statement for a lease year, (5) the results of the audit must be held confidential from other tenants, and (6) the landlord should have the right to challenge the results of the audit, with the determination of a neutral CPA controlling.  Since tenants frequently request audit rights, most large landlords have pre-approved audit rights language to address these concerns. In addition, such pre-approved language allows landlords to consistently apply audit rights to all leases and even consolidate all tenant audit requests into one audit.

Following is sample language that addresses the landlord concerns from above:

Tenant, at its expense, shall have the right upon 10 days prior written notice to Landlord (an “Audit Notice”) to be given only within 90 days after Tenant receives the annual statement of the actual Operating Costs to audit Landlord’s books and records relating to such statement with respect to any specific charge or charges disputed in writing by Tenant, subject to the further terms and provisions of this Section: (a) no audit shall be conducted at any time that Tenant is in breach or default of any of the terms, covenants or provisions of this Lease (any required notice having been given and any applicable cure period having expired); (b) any audit shall be conducted only by reputable independent certified public accountants employed by Tenant on an hourly or fixed fee basis, and not on a contingency fee basis; and (c) Tenant shall not audit Landlord’s books and records more than one (1) time for any calendar year. Tenant acknowledges that Tenant’s right to inspect Landlord’s books and records with respect to actual Operating Costs for the preceding calendar year is for the exclusive purpose of determining whether Tenant has paid the correct amount for Operating Costs and if it is determined in accordance with the provisions of this Section that Tenant has paid estimated Operating Costs an amount in excess of the actual Operating Costs properly due and payable, Landlord shall not be deemed to be in breach or default of this Lease, but rather, Landlord shall provide a credit to Tenant as set forth herein. Tenant shall have 90 days after delivery of the Audit Notice to complete Tenant’s inspection of Landlord’s books and records concerning actual Operating Costs at Landlord’s accounting office located in Maricopa County, Arizona. Prior to its inspection and as part of the Audit Notice, Tenant agrees to request, in writing, all pertinent documents relating to the inspection. If in Landlord’s possession or reasonable control, Landlord will provide such documents to Tenant and Tenant shall not remove such records from Landlord’s accounting office, but Tenant shall have the right to make copies of the relevant documents at Tenant’s sole cost and expense. Tenant shall deliver to Landlord a copy of the results of such audit within 10 days after receipt by Tenant. The nature and content of any audit are strictly confidential. Tenant, for itself and on behalf of its representatives, shall not disclose the information obtained from the audit to any other Tenant in the Building. A breach of this confidentiality agreement shall constitute an Event of Default under this Lease. If as a result of its audit, Tenant determines that the actual Operating Costs for the period covered by any statement are less than the amount shown on such statement, Tenant shall promptly notify Landlord of such determination, which notice shall be accompanied by a copy of the results of Tenant’s audit. Upon receipt of such notice and accompanying information, Landlord may object to Tenant’s determination by providing Tenant with written notice of such objection within 30 days following receipt by Landlord of Tenant’s notice and accompanying information. Unless Landlord so objects, Landlord shall credit to Tenant the excess as determined by the results of Tenant’s audit within 30 days following receipt of Tenant’s notice and accompanying information. If, however, Landlord timely objects, Landlord and Tenant shall appoint, by mutual agreement, a neutral independent certified public accountant who shall promptly make a written determination of the Operating Costs for the period in question and shall provide such determination to Landlord and Tenant. The neutral independent certified public accountant’s determination shall be binding upon Landlord and Tenant for all purposes. If the neutral independent certified public accountant determines (or if Landlord does not timely object to the results of Tenant’s audit) that Landlord has overstated Tenant’s pro rata share of Operating Costs by 10% or more during any one accounting year, then Landlord shall pay (i) for the reasonable costs of the audit, not to exceed, however, Three Thousand Dollars and No Cents ($3,000.00), as well as (ii) the fees and costs owed to the neutral independent certified public accountant for its services. If the neutral independent certified public accountant determines that Landlord did not overstate Operating Costs as asserted in Tenant’s audit, Tenant shall pay the fees and costs owed to the neutral independent certified public accountant for its services. Any refund due Tenant shall be payable in any event.

In addition to exclusions and audit rights, there are other key concepts in negotiating operating expense provisions, including base years and gross ups. I will cover these concepts in a future blog post.

Prior to using any language or concepts from this blog entry, consult with an attorney.

Ryan Rosensteel is a real estate and construction attorney licensed in Arizona. You can contact him at ryan.rosensteel@azbar.org.

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