Making Operating Expense Headlines

Sometimes a headline tells it all.

When an Eel Climbs a Ramp to Eat Squid from a Clamp, That’s a Moray.”

Need I say more?

And why do some people get to write these headlines for a living when I am stuck here reading leases?!!

That one was from the New York Times, telling how scientists discovered that moray eels can hunt on land and will climb a ramp out of the water to grab a tasty morsel of squid (hey, don’t tell me you have never done the same!).

Eels are actually fish and most fish are “suction feeders” (we all have known a few of those).

Unlike some of my fellow attorneys, eels have apparently evolved beyond that.

The eels grab their prey with the teeth of their outer jaw and then have a second set of jaws in their throat to grab lunch and drag it down to its stomach.

A second set of jaws would certainly help when jostling with my sons around the dinner table.

There have been so many great headlines over the years, but the headline in commercial leasing (you knew I would get there eventually) is how many tenants do not regularly conduct audits of their lease’s operating expense provision.

I have mentioned this concern in past newsletters and it continues to amaze me when I raise the point with sophisticated clients and they sheepishly or otherwise admit that they never conduct such audits.

Most leases charge tenants their proportionate share of increases in the building’s operating expenses over an agreed upon base year, allowing the landlords to protect themselves from rising costs.

That may sound equitable but how the operating expense provisions are written and charged can provide a huge (and often improper) profit center for the landlord.

We have been involved with numerous litigations with nefarious landlords taking advantage, sometimes for multiple seven figure sums!

To add to the concern, even if your landlord is not underhanded, and even if you had the clear thinking and levelheaded wherewithal to hire Mintz & Gold to draft a gold plated operating expense provision (you lucky dog you!), operating expense provisions can still contain unforeseen pitfalls.

That is because one dirty little commercial leasing secret is that landlords do not necessarily read the operating expense provisions in their leases when billing their tenants.

I realize that anybody with good sense would skip that bit of Pulitzer Prize winning prose, but it certainly makes sense that in buildings with multiple tenants who have various different operating expense provisions, landlords and their management companies would attempt to bill all of their tenants in the same manner.

The only way a tenant can protect itself is by conducting regular or semi-regular lease audits. A tenant does not necessarily have to audit every year, but it should audit every two or three years and, before it is too late, audit the base year.

A proper operating expense provision will allow tenants access to landlord’s books to conduct such audits and a dispute resolution process to address overpayments.

Follow these eight suggestions to make your operating expense provision grab all the headlines.

  • Insist on audit rights. Perhaps obvious, but you cannot audit your landlord’s books and records unless allowed to do so under your lease.
  • Timing is everything. Your landlord may have a legitimate interest in closing its books, but grant yourself plenty of time to determine whether to audit (e.g., 180, 270 or more days; not the 30, 60 or 90 days usually offered) and plenty of time to conduct the actual audit. Also, have your audit rights extend past the expiration date with respect to the final lease year.
  • Details to follow. Avoid any requirement that you provide specific details at an unreasonably early stage in the process.
  • Include Base Year. It is important when you audit a particular operating expense year that you have the ability to complete (or have already completed) an audit of the base year. Ideally, you should be entitled to audit the base year together with the first operating year that you audit (no matter when that occurs). At a minimum, try and provide that you can audit the base year together with an audit of any of the first three or four operating years.
  • Allow auditor flexibility.
    • Do not allow your lease to restrict your auditor to a firm of certified public accountants. Accountants do not necessarily have any particular expertise in reviewing lease operating expense provisions so provide for a reputable lease audit firm.
    • If you can, avoid restrictions on contingency fee arrangements. Landlords claim that lease auditors paid on a contingency fee basis go on “fishing expeditions” since they are paid based on a percentage of the actual savings but, with due deference to our moray eel friends, an audit is intended to be a fishing expedition and if the lease is properly administered your landlord should not have any worries. Although landlords cannot justify this limitation, you should realize that landlords will dig in their heels on this issue.
    • If all else fails, employ “auditor Jiu Jitsu” to get around the contingency limitation. These methods include employing your lease auditor as a consultant so that even if the auditor reviewing the landlord’s books is an accounting firm that is not paid on a contingency basis, the lease auditor can be providing background expertise. Another common approach is to work with an accounting firm that has a relationship with a lease audit firm (or is willing to start such a relationship). Some lease audit firms have even developed accounting practices to avoid these restrictions (so do not limit yourself to large or “big four” accounting firms). Finally, you can agree to pay your lease auditor on an hourly basis and make up for large savings with a performance bonus that will get you both to the same place. This may require you to incur fees even if the auditor is unable to find any problems (just as the landlord wishes), but many auditors will not charge or only charge a nominal fee if nothing untoward is uncovered.
  • Address dispute resolution. If you and your landlord are unable to resolve disagreements, your lease must provide for resolution by an independent arbiter. Often this will be a certified public accounting firm agreed to by the parties (or selected by the American Arbitration Association or JAMs if the parties cannot agree) and you may be obligated to pay the disputed amount up front, but without this right it could take you years to resolve in court. Usually, the cost of the arbiter is split evenly, but provide that if the arbiter determines that the amounts due were overstated by more than an agreed upon amount (e.g., 5%), your landlord is obligated to pay all of the costs. In the event of such overstatement, you may also want to provide for interest on the overpaid amount at a default rate and perhaps payment by your landlord of your actual out-of-pocket costs with respect to the audit.
  • Cover prior errors. If you discover during your audit that your landlord has made an egregious error that may have been perpetuated over the years, allow yourself the right to reopen operating expenses from prior operating years even if the time period to do so would have otherwise expired.
  • Require maintenance of books and records. You should require that your landlord maintain its books and records (in a uniform system and at an easily accessible location) for a reasonable period of time that coincides with your lease audit rights.

One unexpected discovery from the moray eel experiments is that moray eels apparently have eel memory (like spidey senses?). One eel named Benjen still lives in the lab where he occasionally climbs the ramp looking to reenact a sweet remembrance of a nice piece of squid. Follow the eight suggestions above and your lease operating expense audit provision will be truly memorable.