A recent decision of the Ontario Superior Court of Justice highlights the importance of carefully negotiating and drafting additional rent provisions in a commercial lease. Ayerswood Development Corporation v. Western Proresp Inc. (2011 ONCS 1399 released March 11, 2011) (“Ayerswood”) involves a claim by a landlord for a large adjustment in respect of operating expenses and taxes which were paid by the tenant based on estimates.
Most commercial net lease forms will require tenants to pay certain items of additional rent (in particular, operating costs and taxes) based on estimates determined by the landlord. This can be beneficial to both parties, as it means the landlord has funds available to pay expenses when they come due and it means the tenant generally knows what its monthly lease expenses will be for the year (which will usually be the same amount each month even if the landlord had to pay more in a particular month). If a landlord has not properly estimated an item and requires the tenant to pay an adjustment, it can be difficult for the tenant if it has limited cash flow as it is not likely to budget for this (which means it can be difficult for landlords to recover these amounts).
In the Ayerswood case, the tenant leased premises for 5 years starting on May 1, 2001. The tenant paid all rent due through the term including an estimated amount for operating costs and realty taxes. When the term expired on April 30, 2006, the parties were trying to negotiate a further renewal and when they could not agree on a renewal, the landlord evicted the tenant. On December 10, 2007, the landlord completed its first and only reconciliation and claimed that $42,778.00 was owing by the tenant as an adjustment for operating costs and realty taxes.
Section 3.04 of the lease in Ayerswood provided that operating costs could be estimated by the landlord for a "period" and then went to provide (emphasis added): “As soon as practicable after the end of such period, the Landlord shall advise the Tenant of the actual amounts for such period and, if necessary, an adjustment shall be made between the parties" (paragraph 24). The general practice in the commercial leasing industry is for landlords to deliver annual adjustment or reconciliation statements in respect of amounts paid based on estimates. The language in this lease is not unusual and even though it does not specifically provide that annual statements will be delivered, the reasonable expectation of the tenant was likely that there would be annual adjustments. The landlord in this case did not actually adjust for any periods during the term until after the expiry of the term. The tenant argued that it was not liable for the adjustment since the landlord did not bring its claim "as soon as practicable" as provided in the lease. The landlord argued that the term "period" was not defined and that it could use May 1, 2001 to December 10, 2007 as the "period" and therefore it complied with the lease. The Court agreed with the landlord and noted that the adjustment was made at the end of a "period" and that “[i]f the parties had wished to define the period, presumably they would have included such a definition in the lease" (paragraph 28).
The Court rejected the tenant's argument that a portion of the landlord’s claim was barred because of the Real Property Limitations Act (R.S.O. 1990 c. L.15) since the adjustment payable by the tenant was not due until it was billed on December 10, 2007 (so the landlord's six (6) year limitation period started running that day) (paragraph 31). In addition, the Court rejected the tenant's argument that the landlord should be estopped from bringing the adjustment claim because it had waited seven (7) years , reasoning that the tenant knew there would be an adjustment and there was no evidence that the tenant detrimentally relied on the landlord's delay (paragraph 32).
Although the landlord argued that the delay was due in part to a tax appeal, six (6) years is still quite a lengthy period to have not done any reconciliations (on cross‐examination the landlord's representative had himself said that the delay due to the appeal could have been three (3) years) (paragraph 12). This result could have been avoided if the lease had defined "period". For example, many commercial leases use the term "rental year" rather than “period” and then define it to be a twelve (12) month period either based on the calendar year, a twelve (12) month period starting on the commencement date or another twelve month period chosen by the landlord. Prudent tenants should insist on this type of language. This decision also raises concerns with using the language "as soon as possible" and the preference would be to specify a time period by which annual reconciliations must be completed (standard periods range anywhere from 90 to 180 days after the expiry of the rental year). By defining the period and having a fixed date by which the reconciliation must be completed, it will enable the tenant to clearly identify when the landlord would be in breach of its obligations and, if necessary, to bring a claim against the landlord.
Annual reconciliations are also important to tenants because there may have been an overcharge of additional rent. Landlords recognize that it can be difficult for a tenant to bear the expense of a large adjustment so they will try to ensure that their estimates are close to actual costs and may adjust the estimate upward in order to ensure that there is a bit of a buffer if any expenses end up being higher than expected. If a tenant has overpaid, it will want annual reconciliations to be completed so that it can be credited with any overpayment (as landlords will not generally agree to pay interest on such amounts, it is not unreasonable for a tenant to expect annual reconciliations and a refund or credit for an overpayment).
Tenants should review their leases for any language which limits their ability to dispute additional rent statements and which would bind the tenant to a statement even if the tenant can show the statement is in error. Often tenants will be required to raise any concerns with a reconciliation statement within a very short period of time from receiving the statement (and there will often be language which provides that the landlord can deliver amended or corrected adjustment statements at any time). A fair and balanced approach may be to agree on a fixed period for both parties (i.e. the tenant must raise disputes within two (2) years and the landlord only has two (2) years to deliver amended statements). This would allow both parties to have the ability to close their books for a prior period after the expiry of this agreed upon time frame. With respect to being bound by a statement that is delivered, the landlord’s concern is that there has to be a mechanism for resolving any disputes. Tenants are often reluctant to agree that the landlord should be the party determining any such dispute, but it may agree that a statement is binding if provided by a third party auditor that provides an opinion that the charges are in accordance with the tenant’s lease form (tenants that have negotiated any additional exclusions or deductions from the landlord’s standard definitions of operating costs and taxes should ensure that the adjustment is to be done in accordance with their lease and not just the landlord’s standard lease form). Another approach may be to provide that if the parties cannot agree, the tenant can have the matter arbitrated.
When drafting additional rent provisions, a tenant may also want to consider whether it should have any audit or review rights. For example, the tenant may want a right to review the landlord's books and records in order to confirm that amounts being charged to it are in accordance with the lease. Landlords are generally reluctant to grant this type of right and when it does, these rights will likely be subject to strict conditions. For example, the landlord may insist that the right be personal to the original tenant, that it can only be undertaken no more than once per year, and that the tenant can only review a specified period (i.e. it can review records for that year or the two (2) prior years but it cannot go on a “fishing expedition” for all prior years). Landlords may also want to provide that the audit be undertaken by the tenant and not by a third party or someone being paid based on a percentage of any recovery from the audit. Other concerns will be the amount of notice the tenant has to provide, the location and time of the audit, whether the landlord can supervise the audit, whether the results of the audit must be provided to the landlord (including any discovery of underpayments) and confidentiality. For tenants that do not have the resources to perform audits (or are unable to negotiate such a right), language should be requested which provides that the landlord will, upon request, provide the tenant with back‐up information, documentation and invoices in order to substantiate particular items of additional rent.
Another remedy some tenants will insist upon is the right which provides that they will not be required to pay any increase in additional rent estimates until the reconciliation for the prior year is completed. From the landlord’s perspective, the concern with this is that the landlord will likely want to increase the estimate at the beginning of a rental year before the reconciliation for the prior year is completed. In this situation, landlords may want to limit the right to the period following the date on which the statement is due (for example, if the landlord is required to reconcile within 90 days of the expiry of the prior rental year, the tenant should be required to pay based on the landlord's estimate until the date the statement is due and if the statement is not delivered, then the tenant can pay based on the estimate for the previous year until the statement is delivered and then any necessary adjustments are completed).
It is important for both landlords and tenants to carefully consider the additional rent adjustment provisions in their commercial leases. It is in interest of both parties that the lease provisions be clear and specific regarding the obligations, rights and remedies of both parties.