Imagine the following scenario: You own a retail plaza in Toronto. The Plaza contains a few anchor tenants as well as some “smaller” tenants. You just issued your annual reconciliation statement for additional rent for 2011. Thirty days later, you receive a written request from one of your anchor tenants for all backup invoices supporting the additional rent calculated in accordance with that tenant’s lease and charged for the prior year. The lease with that tenant contains no requirement for your statements to be audited nor does it provide the tenant with an express right to demand the backup invoices for your calculations of the additional rent components. You fail to provide the information requested and the Tenant decides to pay a lesser amount each month based on its calculations of its share of the Plaza’s operating costs. You note the tenant in default for doing this and then terminate the lease when the tenant refuses to pay the amount claimed by you. So, what is a landlord required to do in these circumstances?
According to current Ontario case law (Nguyen v. 792267 Ontario Ltd. 2006 CarswellOnt 7595 Ontario Superior Court of Justice, 2006): “Principle, and indeed precedent (though sparse), clearly demonstrate that a landlord, having ownership and control of the premises and knowledge of the expenses associated therewith, has the obligation to provide the tenant with a proper statement and if required, back-up material to support a claim for “additional rent”. A termination in those circumstances above could result in relief from forfeiture and a damage award.
Now, consider a similar scenario but where the tenant is negotiating to obtain an audit right for the rent. The issues for the landlord in facing such a request include additional costs, both monetary and in extra time spent by its staff to respond to queries, reputational issues (if material discrepancies arise), and confidentiality issues from other tenants requesting a similar right as the ”flood gates” can open. So what should the parties consider in trying to address the request?
1. The Demand – Should be based on specific grounds or details based on an initial review of the back-up materials in support of the Landlord’s calculations or at least a detailed landlord’s statement. It should not just be a general demand for an audit each year.
2. Contingency – This basis should be avoided as it is a “fishing expedition” where the tenant is put to no cost and the auditor has no financial interest in the outcome. Typically, landlords will require the tenant to retain a nationally recognized accounting firm to perform the audit.
3. Confidentiality – The request, the process and the results should be kept strictly confidential. Failure to do so can be costly to the landlord in terms of other tenants coming forward who may be entitled to adjustments. Of course, should a valid error be found that affects other tenants, then their statements should be amended as well.
4. Not When In Default – The right should be suspended when the tenant is in default, even during a previously commenced audit.
5. Cut-Off Date – Landlords need certainty that they will not be challenged on additional rent charges after a fixed period of time so there should be a cut-off date for prior years after receipt of the annual reconciliation statement. I have seen periods from thirty (30) days to two (2) years. As I mentioned in an earlier article, if the lease is silent then the limitation period for a tenant rent claim would be two (2) years.
6. Retroactivity – If the audit reveals an error, it should only affect that year’s charges and not prior years (or perhaps at most, one preceding year) given that the tenant declined to exercise audit rights for those prior years.
7. Payments Pending the Audit – They should continue as required by the landlord until such time as any audit discrepancies have been finally resolved.
8. Reconciliation Payments – If an overpayment is confirmed than the lease can provide that the landlord can pay that amount to the tenant or for it to be credited to rent or additional rent as it next falls due. Overpayments/underpayments can be addressed with an interest component if necessary retroactive to the date paid by the tenant or the date they ought to have been paid by the tenant if not paid.
9. Dispute Resolution – Set parameters for an expert to determine audit disputes if they arise. The landlord’s accounting methodology may or may not be consistent with the accounting principles in the lease (such as GAAP – Generally Accepted Accounting Principles).
10. Who Pays for the Audit – Leases often state that if the audit confirms the landlord’s statement within 3%-5% of the statement amount, then the tenant pays the audit fees, whereas tenants want to limit the threshold to the categories in which errors were found and not the entire statement as that is an easier threshold for them to meet.
The Lessons: Even where a lease is silent, a landlord has an obligation to provide a tenant with sufficiently detailed statements with back-up information following request in order for that tenant to understand how the landlord calculated its share of additional rent and confirm it was done in accordance with the language of the lease (including not being charged for items that were expressly excluded from operating costs or which needed to be deducted from the total prior to calculating any administration or management fee). Where an express audit right is sought, the parties need to consider the factors noted above when providing for the audit clause. When acting for a lender or purchaser, tenant audit rights should be identified in the lease as the exercise of the right could lead to rebates/credits. Well-drafted tenant estoppels can help minimize the risks.
Disclaimer: This article is for general information purposes only and not intended as or to be relied upon for legal advice. Consult with a lawyer for your unique situation.
[*If there is a general real estate or leasing related question you would like to see addressed in a future article in “The Legal Corner”, please contact me directly by e-mail at [email protected] with your suggestion. Not all requests can be accommodated.]