My good friend Gregg Pasternak tells us why we need audit rights in our leases, how they work, and how they should be structured. I particularly like his opening line:
“Operating Expense Audit Rights are Like Nuclear Weapons”
You don’t want to use them, but it’s nice to know you have them, just in case. OK, that may be a tad bit hyperbolic, but much like renewal options, HAVING the right is the key, since audits are time-consuming and expensive, and rarely conducted.
Why Audit Rights Exist -Typical operating expense provisions provide a list of what will and will not be passed through to the tenants, and the timing for landlord’s delivery of annual estimate statements and reconciliations. For the most part, tenants can (and do) rely on the integrity and accuracy of landlord’s statements, but landlords make mistakes like everybody else. Fortunately, most landlords are unwilling to commit fraud and do not willfully pass-through impermissible costs or otherwise “cook the books” to the detriment of the tenants, but it DOES happen, and tenants do need the ability to keep landlords honest.
The Process – Audit provisions are usually similar in terms of process. Tenants are given a specific window following receipt of an expense statement to elect to commence an audit (anywhere from 30 days to 2 years), and provisions usually restrict the types of auditors that can be used to nationally or regionally recognized firms operating on a non-contingency fee basis. Tenants are often required to sign a confidentiality agreement and landlords are usually given the right to contest the initial results of the audit. However, as with most provisions, the devil is in the details. Here are the issues to make sure are addressed (and ultimately resolved) in your client’s favor.
1) Make sure the window to inspect Landlord’s books and records is long enough. Landlords want the deadline for Tenant’s election to audit to be as short as possible, in order to get closure on expense statements and generally just to discourage audits. Understandable, but tenants need to make sure their rights have teeth, and that means having enough time to review Landlord’s statements in depth and make a well-reasoned decision. There is no reason why tenants should have less than 90 days to do so, and on deals of 10,000 rentable square feet or more, the standard in most markets is at least 6 months.
2) Make sure Tenant doesn’t have to specify dispute until it has reviewed Landlord’s books. Some provisions provide that if Tenant wants to dispute an expense statement, they must state with particularity the dispute following receipt of the statement. This implies that the audit right is only a vehicle to resolve an existing dispute, which is a far too narrow interpretation of the right. It CAN be such a vehicle, but its larger purpose is to review the totality of Landlord’s expense statements to confirm their accuracy. Tenants should not need to have a particular dispute in order to exercise the right to review Landlord’s books and records.
3) Tenant needs a dispute mechanism if Landlord disagrees with Tenant’s accountant. Once Tenant’s audit is complete, the results are forwarded to the Landlord, and most provisions state that Landlord will make appropriate reconciliations if Landlord does not dispute Tenant’s findings. Landlord should have the right to dispute Tenant’s results, but many provisions do not provide a mechanism for resolving such a dispute. Without a dispute mechanism, Tenant’s only recourse is an expensive lawsuit, which renders the entire provision mostly worthless. Leases should ideally provide that a dispute will be resolved by a neutral third-party auditor, or as an alternative, an expedited arbitration process.
4) Contingency fee auditors (See Resources for a few recommendations of lease audit specialists). Most provisions prohibit Tenant from using an auditing firm which charges on a contingency basis, meaning they receive a portion of every dollar saved. Landlords will argue that this over-incentivizes auditors to go crazy with their reviews, and that if one digs hard enough, one can always find SOMETHING to dispute. Tenants will argue that this is hardly a bad thing since it makes sense for someone looking for errors to be fully incentivized to find them. Regardless, there is a real difference of opinion in the industry as to whether using contingency auditors actually favors tenants or not. The best approach is to ask your client whether the right to use a contingency-fee auditor is important to them, and fight the issue only when so instructed.
Most states recognize the covenant of good faith and fair dealings which would allow for an audit of their expenses. One could go back a number of years to audit, based upon the statute of limitations for contract law in that state. In most states, that is 4 years. Why would a tenant restrict its right to audit within 180 days or less after receipt of the statement if they don’t get something in return? That is a big concession for landlords to ask. Tenants must not restrict their right to audit.
Thanks for your comment Terry. Interesting take regarding the Statute of Limitations governing the timeframe in which to review.
The problem with relying on a non-contractual right to audit is that without the express right in your lease, you would have to file a lawsuit to enforce it, and it could be prohibitively expensive.
Thanks Gregg. I have seen many boiler plate leases that provide only 90 days for the tenant to review and getting 180 days is better than that. I find it difficult to get more than 180 days mainly due to the fact that buildings often sell. A buyer would have a hard time purchasing a building knowing they could be subject to audits from a time prior to their ownership.