Operating Costs Audits and the Role of the New Consultants-A Landlord's Perspective

WeirFoulds LLP - Leasing Update June 2004 | JUNE 1, 2004
Lisa Borsook

What is the role of the new consultants? That one is easy. To make landlord's lives miserable. Any comparison to a Revenue Canada audit isn't entirely appropriate, Revenue Canada audits are by and large preferable. As far as I understand it, Revenue Canada auditors are not compensated in relation to how much grief they can cause. Second, they generally have read the Income Tax Act and are trying to apply some of its principles to the facts with which they are dealing. Suffice to say, I would be more comfortable dealing with operating cost consultants if they worked on a flat rate or hourly basis like the rest of us.

But let me try and give you a practical response to landlord's questions of how to deal with an op cost consultant when they come calling. The first issue is pretty easy-confirm that its treatment of op costs has been fair and in accordance with the provisions of the lease. You can test the answer later, but it sure doesn't hurt to know at the outset whether you can withstand this sort of inquiry with head held high or not. The legal analysis is also actually relatively straightforward. First, and I know that you have heard this before, look at the lease. What does it say about the Tenant's right to audit the landlord's books and records? What are the pre-requisites to the tenant exercising such a right? What are the limitations? Anticipating a fairly standard landlord's form of lease, the tenant may have no audit rights. That pretty much can shut down the problem, subject to more practical considerations which I will canvas shortly. If it has a right, that right may limit the extent of its investigation in a variety of ways. For instance, the tenant may only be able to look at certain types of records, and only at certain times. The tenant's right to do so may be limited, or may be limited to certain categories of persons, like the tenant's accountants. Recent landlord's leases have specifically provided that % based audits by commission hungry agents are not permitted-I don't think that is the exact wording, but that would be gist of it. Don't hesitate to look at the person's qualifications before you let them in. Is there a confidentiality requirement? Does the landlord have the right to impose requirements-like the obligation to sign a confidentiality agreement, or to use their information solely for the purpose of their client, the named tenant? Timing may be a factor-the time within which the tenant can exercise the right may have passed The number of years of investigation may be specifically limited by the terms of the lease. All of that information may limit the terms of their investigations and set the parameters within which the investigation can proceed.

The second analysis is what happens after the investigation has occurred, and the consultant has commenced to question the propriety of various items in the operating cost statements. The first point I want to make here, is that the consultants' analysis may be wrong. They may have asked for adjustments without reference to the terms of the lease-carving out exclusions that the tenant may want to get, but for which it did not bargain. The most common request is to delete any management or administration fees, structural costs, capital costs, depreciation, or by their analysis of what the tenant's proportionate share should be, reduce the amount payable altogether. In my experience, they are just not necessarily right. Understanding how proportionate share is calculated is often a big problem.

The third point-the fact that they are dead wrong on their request for a particular adjustment- doesn't mean that the consultant will cede the point. In my experience, and taking into consideration that their compensation may be a percentage of the amount they are able to recoup for the tenant, they may press the point nonetheless, and there is something to say for the nuisance factor, although making concessions may have long term implications, or even significantly greater implications than the landlord originally imagined. For instance, a concession made in one year, without justification, will invariably come back to haunt the landlord. And the consultant may also assume that if the landlord made a concession for this tenant, it will make it for other tenants in the development. So-they will then go to other tenants and describe their success in dealing with the landlord, and before you know it, the landlord has a tenant revolt on its hands. Suffice to say, concessions without justification are not a good idea, and are to be avoided. Short term gain; long term pain.

Now some landlords will tell you that this analysis doesn't get them anywhere-the tenant is too big and significant in the grand scheme of the centre for the landlord not to be somewhat conciliatory-for the sake of preserving the relationship with the tenant in the future. And there may be other factors which affect how the landlord, for the sake of expediency, has to deal with the consultants' requests. For example, the failure to resolve the issue with the consultant may impact on the landlord's ability to dispose of the centre to a purchaser. The tenant is going to allege that there is an outstanding dispute, and depending on the size of the adjustment, the period of time for which it is claimed, and the future implications, the impact of that allegations can be disastrous in terms of the sale, and the sale price. The landlord may be in the process of obtaining financing, and the mortgagee is looking for a clean estoppel certificate. Same problem. What are some of the other legal principles that a landlord might want to consider in analyzing a tenant's request for an adjustment-and this analysis is relevant regardless of whether or not a consultant is involved?

First of all, there are cases which make it quite clear what a landlord can and cannot charge. For instance, the case law is relatively clear that when the lease is silent, or not specific, a landlord can't pass through capital taxes or management and administration fees. But a landlord shouldn't just dismiss the right to charge certain amounts, because of the case law. It may be distinguishable. The issue may not be whether or not the amount is chargeable at all, but what the charge should be-that is its quantum. That is a lot easier to deal with, from a landlord's point of view, than having the charge eliminated altogether. Second, a landlord should consider what exactly is the tenant's right to compel the landlord to make the readjustment-does the lease permit any kind of right of set-off, and if so, in this particular circumstance? If the tenant has a right of set-off that is a big hammer-right or wrong on the issue as to whether or not the adjustment claimed is a correct one.

Keep in mind the obligation to perform contractual obligations in good faith. That works both ways-the tenant shouldn't assume that the landlord is trying to fleece it-there are plenty of perfectly good consultants and auditors who don't know how to read a lease. Tenant's have obligations of good faith too-like to pay rent without setoff, and if they don't perform their obligation, they may find themselves on the wrong side of a locksmith. In any event, the notion of a party's obligation of fulfill its contractual obligations in good faith is an evolving one, and I for one can't say with certainty how a court would interpret the parties' respective obligations in any given situation.

Then there is the notion of proprietary estoppel,-the notion that a party cannot insist on its strict legal rights if to enforce those rights would be inequitable having regard to the dealings between the parties. In other cases, a slightly different variation of the principle is argued as detrimental reliance-where one party acts to his detriment on the reasonable reliance of the representations of the other, thereby disentitling the other from going back on those representations. The legal argument may also be framed as waiver –which is a voluntary concession granted by one party, upon the faith of which another shapes their conduct and which waiver will remain effective until it is made clear by notice or otherwise that the waiver is to be withdrawn and the strict position under the contract restored. Which of those arguments will apply in the circumstances depends on intention, and a clear review of the facts of the case. And of course, let's not ignore real estoppel-like the tenant signing an estoppel certificate in which it stated that the lease was in good standing, and it had no claims against the landlord. If a landlord finds one of those in its file, it can go a long way toward shutting the tenant down.

Finally, and this is very complicated, there is the question of limitations. Generally speaking, the tenant has to commence its action within six years, based on the Real Property Limitations Act, which probably applies. Ten years if the lease is a specialty, which is another big thorny issue, depending on whether or not the document is under seal. So, the tenant shouldn't be able to go back farther than that in its investigation. But I for one always find limitations confusing, so my warning here is that in the particular circumstances, you have to consider the issue and have someone work their way through it to see whether or not the tenant's claim is statute barred.

My most important point in all of this-I know that in one context or another I repeat the same thing over and over-what is the landlord's bargaining position? Who needs each other more, the landlord or the tenant? Who has the bigger hammer? What are the prevailing circumstances? Are the landlord's op costs competitive with op costs in the vicinity?. Because lease terms or no lease terms, rights of set-off or no rights of set-off, proprietary estoppel or no reliance issue, none of it matters if the landlord wants to close a sale, finish the financing, or this is the landlord's biggest tenant, or the landlord is facing a combined tenant revolt and the landlord still has to pay its mortgage. The advice you receive has to be informed, but realistic in the circumstances. And finally think about time. How much time does the landlord want to devote to this problem? Consultants have all the time in the world. Landlords are notoriously short of it. And lawyers are billing based on time-which can make the costs of dealing with the problem, large or small, seem disproportionate to the problem. Time-that is a factor which you have to think about in dealing with these issues.