How to Deal with Retail Tenant's Demand to Exclude Bad Debts from Gross Sales

When negotiating a percentage rent lease, don’t be surprised if a retail tenant demands that you exclude bad debts from the formula for calculating gross sales. This is hardly an unreasonable demand. After all, why should the tenant have to pay percentage rent on customer receivables that it can’t collect? But if you’re not careful, giving in to this demand can cost you more than you bargain for. Here’s a negotiating strategy you can use to protect your interests and maximize the percentage rent you receive, depending on the overall situation and bargaining leverage you have.

First Choice: Flatly Reject the Demand

Every exclusion from gross sales that you accept means money out of your pocket. So, the optimal response to demands for exclusions is to simply say no. Just be prepared to provide reasons for your rejection in case the tenant presses you. Possible explanations that you may want to use to justify refusing to exclude bad debts from a tenant’s gross sales:

• The tenant is in a better position than you to avoid bad debts since it deals directly with the customers and thus can not only make informed judgments about whether customers will pay but also implement measures to reduce risk of nonpayment, such as running credit checks, requiring a cash or credit card up-front payment, or demanding a certified check;
• Bad customer debt is part of the retail tenant’s risks of doing business—not yours—and can be factored into the prices tenants charge; and
• As the landlord, you don’t pass through your own “bad debts” to tenants—for example, by raising the rents of or reducing the services provided to other shopping center tenants to make up for the rent you can’t collect from another tenant.

Second Choice: Compromise on Bad Debt Exclusions

If you don’t have the negotiating leverage to flatly reject the demand, you may have to compromise with the tenant. This is where the lease language becomes crucial. Like our Model Lease Clause: Set Limits on Retail Tenant’s Right to Exclude Bad Debt from Gross Sales, your lease provision allowing for exclusion of bad debts from tenants’ gross sales should include three types of limitations:

1. Exclusion applies only to bad debt tenant reports to IRS. First, limit the exclusion to legitimate bad debts. One way to define legitimate is as “bad debt” the tenant actually reports on its federal and state tax returns. There should also be language in the lease—typically contained in the tenant records or audit provisions—that requires the tenant to give you access to its tax returns [Clause, section a].

2. Tenant must make reasonable effort to collect bad debt. Don’t let the tenant classify an unpaid debt as “bad debt” unless and until it makes what in your judgment are reasonable efforts to collect the debt [Clause, section a]. For example, you may want to go beyond the Model Clause and require the tenant or a collection agency to first send a notice to the deadbeat customer, or even begin legal proceedings, before chalking it up as bad debt.

3. Cap on total bad debt that tenant can exclude. Don’t let tenants exclude more than a specific percentage of its gross sales in any particular year as bad debt. Attorneys advise trying to keep the cap at 1 percent and counting bad debt above that percentage as gross sales [Clause, section b].

4. Tenant must include debt in gross sales when paid. Last but not least, specify that all or any percentage of excluded bad debt that the tenant eventually does collect must be included in gross sales immediately after the money is collected [Clause, section c].