Include Three Key Points in Lease Audit Provisions

Operating costs are one of the main cost concerns for both retail and office building tenants. So they’re one of the first things on a tenant’s radar when it’s looking to cut costs. A tenant trying to trim operating costs can spell trouble for you, however, if believing that it has overpaid for its share of the building’s operating expenses it decides to perform a lease audit—but you forgot to negotiate owner-favorable lease audit provisions before the lease was signed.

Don’t make the same mistake twice. Remember when negotiating your leases that an owner’s first step in preparing for audits should be at the lease negotiations stage. While you don’t want to fight your tenant’s right to a lease audit—because you could be accused of cheating or sued for an accounting—you still have to protect yourself if errors are found. You can do this by insisting on three key points in your lease provisions that limit your tenant’s right to inspect your books and records so that the tenant doesn’t have free reign over the process. For an example of this type of provision that you can adapt, see our Model Lease Clause: Limit Tenant’s Right to Lease Audit.

Key Point #1: Prohibit Contingency Fee-Based Auditors

One of the biggest points in a lease negotiation for the owner is prohibiting the tenant’s use of a lease auditor who works on contingency to perform the audit [Clause, par. 1]. These lease auditors get paid based on the amount of money they save for the tenant with the errors they find. Insist on a certified public accountant that’s being paid on an hourly basis to do the audit. This is a major point that gets negotiated into lease audit provisions, so don’t be afraid to make it a sticking point.

Key Point #2: Set Threshold Requirement

Another controversial issue is the threshold requirement for how much the owner should pay for the tenant’s audit. For example, if the owner agrees to be responsible for reimbursing the tenant for the cost of the audit if its errors reach a certain amount, what will that amount be? How erroneous do the charges have to be to trigger the owner’s obligation to pay? This is a critical number and one worth fighting for in the lease [Clause, par. 5].

Usually, the owner and tenant agree on a percentage of the money, if any, that’s owed to the tenant as a result of errors. Your best option is to negotiate provisions that make the tenant perform any audits at its “sole cost and expense” [Clause, par. 5].

And remember that imposing a limitation on how often the tenant can perform a lease audit and whether the tenant can exercise its right to audit if it’s in default are two provisions that limit your exposure to unnecessary delving through your books and records [Clause, par. 1].

Practical Pointer: The most important thing you can do not just for lease audit rights, but every other aspect of a commercial lease is to negotiate from your form lease. To start with, an audit right won’t be in your form. Some tenants are unaware of how lease audits may help their bottom line. It’s up to the tenant to bring up the lease audit point, and offer language that it’s comfortable with. But remember to include an operating expense provision with terms on how these expenses are paid monthly and how they’re reconciled at the end of the year.

Key Point #3: Include Crucial Resolution Provision

When negotiating lease audit provisions, it’s important to have a final and binding resolution provision to handle disputes. Without this provision, a disagreement about the audit could spark a lawsuit. A provision should dictate what happens if there’s a dispute--for example, if you disagree with the audit results, you and the tenant refer the dispute to a mutually acceptable independent certified public accountant who will work with you both to resolve the discrepancy, and render a final and binding decision [Clause, par. 3]. This achieves finality without a lawsuit.

Regardless of the length of the provision, it should include what happens as a result of an audit’s findings:

• If there’s an overpayment, the owner pays the tenant back;
• If there’s an underpayment, the tenant pays the owner; and
• If there’s a discrepancy and the owner disagrees with the audit, it’s handled in an agreed-upon way [Clause, par. 2].

But just to say “once a year the tenant may look at the owner’s books and records” isn’t enough. This leaves open the issue of what happens if the tenant initiates an audit and finds errors.