§ 19.03 Escalations

Escalations are a form of “additional rent.”1 Tenants are required to pay this additional rent to the landlord over and above base rent in order to reimburse the landlord for increases in operating expenses and taxes beyond the level established in the base year calculation. Escalations may also include other increases resulting from an inflation index.

Escalation clauses are generally written in such a way that the costs to the tenant can never go down. In fact, the typical escalation clause covers only increases in costs and in the case of some leases, “escalations” are charged whether or not increases actually occur.

Despite their importance, escalation provisions traditionally have not received the full attention they deserve in commercial lease negotiations. These provisions are often filled with vague and confusing language and complex mathematical formulas, making it very difficult to determine the monthly costs and the year-end reconciliation amounts. Generally the accountants are left to handle the calculations and the various problems which arise, long after the lease is signed. That is where the tenant makes his mistake. Once the lease term begins, the escalation provisions probably see as much or more activity than any other lease clause. Unlike renewals, expansions and terminations, which may take place only once during the entire lease term, the escalation billings take place as many as three or four times every year. Escalation provisions can substantially increase the tenant’s expenses. The amounts are often compounded, resulting in rent obligations which increase quickly and in rather large increments. The escalation clause increases will vary depending on which formula is used. Some lease escalation clauses are tied to increases in real estate taxes, others to operating costs and still others are based on the Consumer Price Index, Porters’ Wage, or other formulas.

Many billing disputes in commercial real estate leases arise because of vague lease language. To avoid unexpected liability, prevent unnecessary confusion and resultant disputes, the parties should be certain to have an attorney who specializes in commercial real estate leasing review any verbiage that has ongoing economic implications.2

[1]—Net and “Not So Net” Leases

Some parts of the country have net leases, and some parts have “not so net” leases. Essentially, a net lease is one where the tenant pays a smaller base rent per square foot (presumably net of all base components), plus a percentage of operating costs and taxes for the building or complex, plus shared common area charges, such as maintenance, repairs, paving and lighting.3 The percentage of these charges to be paid by the tenant is based on the percentage of the building that the tenant occupies in relation to all of the leasable areas in the building.4

Under a “not so net” lease, there is generally a larger base rent figure, which includes the landlord’s profit figure and other costs base components associated with the building’s overall cost to run. Base rent should not include the expense of tenant operations within individual premises, however, there may be exceptions, such as rent inclusion electricity, of which the tenant should be very aware.5 At any rate, when all these components are bundled into the base rent figure, it is easy to lose sight of what is there and how these calculations should work.

1 As previously discussed, additional rent is anything that the landlord wants it to be. Escalations are the best known and probably the most expensive form of additional rent in office leases.

2 See: § 19.03[5] infra for a discussion of tenant audit rights, § 19.03[6] infra for a discussion of monitoring landlord escalation calculations and § 19.03[7] infra for an escalations checklist.

3 These are pass through charges since they are to be paid net of any base amount.4 These charges are not escalations or increases over base factors. They are based upon a percentage of actual

increases. See § 7.09 supra discussing the issues inherent with the sum of the demised and demisable premises in a building.

During the base year, the landlord is expected to cover all its base costs, including debt service, under its base rent figure. After that, the tenant is expected to pick up its proportionate share of subsequent increases over the base amount (whether it be a base year, stop or stipulated base amount) figure for the remainder of its lease term. The challenge to the tenant is to determine whether or not the correct numbers are working into the escalation calculations.

[2]—Cost Comparisons Between Buildings

Cost comparisons must be made between spaces available for lease in different buildings when a prospective tenant is shopping for new premises. Just as certain buildings have different usable to rentable square foot ratios, they also have different competitive advantages or disadvantages in the costs to operate them. For instance, there are many buildings in New York City that have real estate taxes in the $6.00 to $8.00 per rentable square foot range. There are also some buildings with real estate taxes of $12.00 per rentable square foot.

Likewise, some buildings are incredibly disadvantaged when it comes to utility and electrical efficiency. Their costs per rentable square foot are much higher than those buildings that are new, high tech and energy efficient. Similar discrepancies occur with respect to operating and cleaning costs for buildings that are old, versus ones that are new; or with buildings that have very sharply negotiated positions in their cleaning contracts, versus ones that have brand new maintenance and operating contracts that are advantageous to unions. These numbers have to be examined and broken down.

In addition, buildings may use different concepts of base years for calculating escalations. Some use the last year as a base year, while some buildings split years or half years. Some have fiscal years covering portions of two calendar years. Some have the current year of occupancy or the current year of the term, which can be considerably different. Some buildings pick “next year,” which could turn out to be a year and some months of actual possession by the tenant. Or some buildings may use a particular base year for a given escalation and another base year for another!

In any event, care and attention should be given to these differences in order to have the definitions fully understood. The base year may be triggered by the contract portion of the lease term or it may commence upon the substantial completion of the premises when delivered by landlord to tenant. This can translate into an extremely large monetary difference and should be carefully considered and understood.

In addition, there are some very subtle, but expensive differences, between office space in buildings in which different types of uses are present. Retail space, regional malls and mixed use buildings may contain some major costly landlord “grabs.” When examining a potential space to lease, these issues should be analyzed.

[3]—Taxes

[a]—Definition

In order to determine what a tenant will be paying in the way of tax escalations, the tenant must understand the definition of taxes, as well as the amount over which it will pay the increases. It is not difficult to figure out what the base year or the base amount or factor for taxes will be. These figures can be obtained from a tax assessor’s office or they can be required to be verified within the lease. It is also a good idea to take the extra time to compare that figure to its component in the base rent just to see if the two figures agree. The more difficult concept, however, is calculating what taxes actually are.

5 See § 17.02[1] supra discussing rent inclusion electric factors. Under rent inclusion electric, a price per square foot is added to base rent or included in base rent (if so defined) as a charge for the landlord to supply electricity to the tenant’s premises.

Simply, taxes are a payment made by a landlord, in most regions to a governmental or quasi-governmental agency, reflecting tax rates or mill levies applied to the assessed valuation of the property as determined by the government, plus any special or benefit assessments imposed on the property. Special assessments are generally imposed either in dollar amounts, rates or dollars times square foot area or numbers of people. Special assessments are generally levied to pay for land or improvements, such as sidewalk, traffic or sewer and water service, but may also arise to benefit transportation, landmark displacement or other special governmental or human services. They are usually paid in installments by the benefited district over the useful life of the benefit.

[b]—Method of Calculation

The tenant must make sure that the base tax includes only that portion of the special assessments that falls within the base year period. All special assessments should be calculated upon the installment method to smooth out the impact over the term of the lease, whether or not the landlord pays them in installments. Note that landlords generally fail to include installments of special assessments in the base year. This seems to be a common practice. The affect is to shift more of the burden to the tenant by reflecting these installments as increases paid after the base year.

The other prevailing method of calculating taxes is to multiply the valuation times the rate. Here the taxing authority determines the assessed valuation of the land and the assessed valuation of the improvements upon which a mill or a tax rate levy will be imposed. Land and improvements are generally treated differently. Land may be assessed at a full value and the improvements may be phased in or partially abated. Again the tenant should examine these figures with care.

Some areas have different rates for taxes and special assessments. When calculating the taxes, especially for the base year, the tenant must make sure to understand thoroughly any reduction or limitation on the full amount of the assessed valuation of the land or the improvements by way of incentive abatements and the timing of when the land and the improvements become part of the assessment rolls when fully completed. In addition, the impact on base taxes should be adjusted, if appropriate, to avoid an artificially low base tax amount. Remember that the tenant will pay future escalations based upon the increases above this base.

In some jurisdictions due to technicalities with the assessment rolls, an otherwise completed building with tenants in it may not be on the tax rolls at full value, irrespective of incentive abatements, for up to two years after it is actually physically completed. Even if the building is fully assessed, the assessed valuation may reflect additional abatements or deductions. Such an artificially low assessed valuation may occur through an incentive abatement program that erodes or becomes smaller with each year of the program allowing the assessed valuation of the land or the improvements to increase from year to year without regard to the actual increase in the value of the project due to market conditions. As has been pointed out repeatedly, the assessed value of a project can increase in several different ways simultaneously.

Just as many buildings have different taxes, they also may have different base years, base factors, abatements and special assessments. Buildings also increase on the tax rolls at different times, for instance, when they are sold or refinanced. To try to calculate the impact of the base amount of taxes that will be paid by the landlord and the amount of increases each year, the tenant must dig into the existing taxable components of real estate and fully understand them all.

The components of assessable real property rights include the actual land, any improvements on the land, easements benefiting the land, encumbrances on the land (such as space leases or ground leases), air rights and unutilized development rights, income from the property, and types of use restrictions. Also to be considered are special assessments, free trade zones and payments in lieu of taxes. Only when all these factors are considered can the tenant arrive at the appropriate comparable number to weigh one prospective property against another.

Once the tenant has determined the property’s characterization and assessed valuation, 6 it can calculate what the taxes should be for the base year and estimate future escalations. In making these calculations, care should be taken to include only so much of the land as is necessary to support the building. Be cautious of the tendency of landlords in some of the larger cities to include the building containing the premises with other combined tax lots. When this occurs, the tenant will be paying taxes on excess improvable land and improvements that may be of no benefit to the tenant or may not be related at all to its use and enjoyment of the building. Remember that a garage, for instance, may be part of the building, but it may serve the public rather than the tenants. Similarly, there may be other buildings on the property that may or may not be assessed and may or may not be paying their freight on the combined tax lot. The tenant should sort out all these considerations and calculate which ones are relevant and fair.

[c]—Fluctuations

Once it is understood how real estate taxes are computed and what will be the base amount of the taxes that the landlord will be funding, it is still not smooth sailing. A facilities manager or corporate real estate manager worth his or her salt will not allow taxes to increase because of additional improvements to the building other than those in the demised premises, nor will he or she allow the base taxes for the base year to be subsequently reduced and have all the subsequent years recalculated.

Consider the following example. The tenant is paying $40.00 a rentable square foot, with taxes comprising $7.00 per square foot for the base year. But there is a little extra word or two inserted in the lease after the base year definition: “as finally determined.” In this instance, these three little words mean that in the second, third or fourth years or more, depending upon the appeal process for taxes in the particular region, the base year assessments may be redetermined and reduced. The tenant is still paying $40.00 per square foot of base rent. However, the landlord, after the adjustment, is only paying $6.00 per square foot as base escalation for taxes. Since the tenant is paying $7.00 per square foot in its base rent and the landlord is now paying $6.00, the landlord has a $1.00 per square foot savings in payments per year for the rest of the lease term. Moreover, since the lease clause allows the landlord to adjust the base year in the lease downward in subsequent years, the escalations payable by the tenant per square foot can increase. For instance, if in the second year after the assessed valuation adjustment, the taxes per square foot have increased back up to $7.00, the tenant will pay an additional $1.00 of escalation per square foot to reflect that increase, even though the tenant’s base rent includes $7.00 per square foot for taxes. This is because the base year $7.00 figure had been adjusted downward to $6.00 for escalation purposes for all future years. The $40.00 base rent figure was not reduced to $39.00, however. This is a windfall to the ownership.7

In this example, as strange as it may seem, the landlord has saved $1.00 per square foot and the tenant is paying an additional $1.00 per square foot. This will remain so for the remainder of the lease term . It is no small amount of money. Tenants should defend against this type of occurrence in the negotiation process and in the language of the lease.

[d]—Timing of Payments

6 This is done after deducting any incentives and abatements, adding any installments or special assessments and determining what exactly the taxable lot consists of that the tenant should be paying for. This latter inquiry should include the building where the premises will be located, plus only so much of the land or improvements on the tax lot as benefits the tenant under the particular lease.

7 Side stepping the windfall for the moment, there are certain ownership costs associated with having new or empty buildings. Taxes are one of those ownership costs. Unlike operating expenses, which increase by usage of tenants and which may correlate to the usage by one singular tenant in the building, real estate taxes do not.

Only taxes paid by landlords should be paid by tenants and only as, if and when the landlords pay them. This is usually quarterly or semiannually and, provided that the tenant’s check reaches the landlord in time to clear the bank before the landlord must pay the taxes, there is no compelling reason for taxes to be paid monthly or earlier by a tenant.

Escalations should be based on taxes actually paid as opposed to the time they are assessed. If the taxes are subsequently forgiven before payment, there should be no payment required for that portion by the tenant. If forgiven after the payment, there should be a refund to the tenant of its share of that excess payment. The lease should allow for subsequent years tax review and reduction proceedings after the base year, recovery by the landlord of the portion of the cost of performing such review procedures and tenant recoupment of its fair share of the refund amount that was paid through escalations.

[e]—Tenant’s Proportionate Share

Some landlords think that if a building is not completely occupied, they should increase the occupying tenants’ proportionate shares of taxes so that the tenants are paying as if the building is fully occupied even though they may be the only tenants! Under this scenario, if a tenant is occupying half the building and its proportionate share of taxes is 50%, if it is the sole occupant of the building it will pay 100% of the increases in taxes. That will be a different result than having a tenant pay its proportionate share of 50% times the landlord’s hypothetically assessed valuations based on a fully tenanted and occupied building with all tenant improvements and installations in place. Although there is some argument in favor of this theory with respect to operating expenses, there is no justification with respect to real estate taxes.

Determining tax contributions can be a tricky business. There are so many variables. It is imperative that tax responsibility be stated clearly in the lease. In a New York case, the state Supreme Court upheld a lease clause requiring the commercial tenant to pay a disproportionate share of tax increases.7.1 The court found that the lease set forth a “simply unambiguous formula for determining the tax increase,” to which the tenant agreed.7.2 Even though the actual space occupied was significantly less than the “deemed 6%” of the building’s area, the court noted that the tenant’s space was deemed to be 6% and the “lease specifically disclaimed ‘that the figure bore “any relationship [to the] precise amount of space in the demised premises and the space containing the building.’”7.3 The court further noted that the impact of the future tax charges could be figured out simply “by multiplying the hypothetical increase by 6 percent.”7.4 The plaintiff/tenant also tried to argue that the parties had unequal bargaining power. The court rejected that argument stating that the lease had been negotiated at arm’s length by experienced parties and the tenant had been represented by counsel who was experienced in real estate.”7.5

The decision in this case is significant because it demonstrates that courts will not simply rewrite a lease to alleviate a hard or oppressive bargain, that “deemed measurements” can be quite different from actual measurements. Tenants can and should be aware of their loss factor—landlord’s measurement versus the tenant’s actual, usable space. Tenants and their counsel should also be sure to focus on the escalation formula to be used, not simply on a base rent. The tax payments for the tenant in this case “increased from about $7,000 to about $53,000 over a

7.1 609 Corporation v. Park Towers South Co., reported in New York Law Journal, p.18, col. 1 (N.Y. Sup. Dec. 8, 2005).

7.2 Mollen, Realty Law Digest, New York Law Journal, p.5-6 (Feb. 9, 2005).7.3 Id., citing 609 Corporation v. Park Towers South Co., reported in New York Law Journal, p.18, col. 1 (N.Y.

Sup. Dec. 8, 2005).7.4 Id.7.5 Id. at 6.

period of only three years.”7.6 Clearly the tax amount would have gone up substantially anyway, to approximately $39,750, but the increase suffered by the tenant was even worse and not based on actual space measurements.

[f]—Payment in Lieu of Taxes

The astute tenant or facilities manager should watch out for what is currently in vogue: payment in lieu of taxes. On any taxing lot there may be tax exempt improvements, which are assessed but on which no taxes are collected. These include improvements on land owned or operated by governmental, charitable and religious entities.

Care should be given to analyze the escalations and the definitions clauses. These clauses may be written to define taxes as the assessed valuation of all improvements times the tax rate even though the landlord may only be paying the amount resulting from a calculation involving some, but not all of the improvements. This also is true in the event of any incentive or other abatement program.

This generates a problem for the base year that can easily be overcome by multiplying the assessed valuation times the tax rate for the base year, but in subsequent years basing it on taxes actually paid or payable. This means that the tenant will have an appropriate base year, but will never pay more taxes in its proportionate share than landlord pays for that same share.

[g]—Tax Increase Clause

The following clause illustrates an additional rent element of an office lease providing for tax increases.

Example 1:

Section I: Increase in Taxes:

A. For the purpose of this Lease, the following definitions shall apply:

1. “Taxes” shall mean the taxes and assessments and special assessments levied, assessed or imposed upon the Building and/or the land under, including any land(s) dedicated to the use of, the Building, by any governmental bodies or authorities. If at any time after the date hereof the methods of taxation prevailing on the date hereof shall be altered so that in lieu of, or as an addition to or as a substitute for the whole or any part of the taxes, assessments, levies, impositions or charges now levied, assessed or imposed on real estate and the improvements thereof, there shall be levied, assessed or imposed (a) a tax, assessment, levy, imposition or charge on the rents received therefrom, or (b) a license fee measured by the rent payable by Tenant to Landlord, or (c) any other additional or substitute tax, assessment, levy, imposition or charge, then all such taxes, assessments, levies, impositions or charges or the part thereof so measured or based shall be deemed to be included within the term “Taxes” for the purposes hereof. Taxes shall be calculated by aggregating all assessments, levies, and impositions and multiplying the sum obtained thereby by the applicable “tax rate(s)” of the taxing authorities and adding to the product obtained thereby, the aggregate of the products of the special assessments as multiplied by the applicable “tax rates.” In the event more than one measurement of assessed valuation is utilized by an applicable taxing authority, the measurement upon which the applicable tax rate is applied by the taxing authority as a basis to calculate and collect taxes shall be deemed to be the measurement of assessments, charges or impositions in determining Taxes for the purposes of this Article.

7.6 Id.

2. “Base Tax” shall mean Taxes, as finally determined, for the Tax Year commencing July 1, 2001.

3. “Tax Year” shall mean the fiscal year for which Taxes are levied by the governmental authority.

4. “Tenant’s Proportionate Share” shall be calculated to be _______ percent.

B. 1. If the Taxes for any Tax Year shall be more than the Base Tax, Tenant shall pay as additional rent for such Tax Year an amount equal to Tenant’s Proportionate Share of the amount by which the Taxes for such Tax Year are greater than the Base Tax. (The amount payable by Tenant is hereinafter called the “Tax Payment.”) The Tax Payment shall be prorated, if necessary, to correspond with that portion of a Tax Year occurring within the term (“Term”) for which the Demised Premises are demised pursuant to this Lease. The Tax Payment shall be payable by Tenant within ten (10) days after receipt of a demand from Landlord therefor, which demand shall be accompanied by Landlord’s computations of the Tax Payment.

2. In the event the Base Tax is reduced as a result of an appropriate proceeding, Landlord shall have the right to adjust the amount of Tax Payment due from Tenant for any Tax Year during the Term, and Tenant agrees to pay the amount of said adjustment on the next rental installment day immediately following receipt of a rent statement from Landlord setting forth the amount of said adjustment.

C. If Landlord shall receive a refund for any Tax Year in respect of which a Tax Payment shall have been made by Tenant, Landlord shall repay to Tenant, Tenant’s Proportionate Share of such refund after deducting therein the actual costs and expenses of obtaining such refund incurred by Landlord. If Landlord should effect a reduction in assessed valuation, thus reducing the amount of Taxes which would otherwise be payable by Tenant hereunder, Tenant shall pay, upon demand, to Landlord, Tenant’s Proportionate Share of the actual costs and expenses of obtaining such reduction of assessed valuation incurred by Landlord.

D. With respect to any period at the commencement or expiration of the Term, which shall constitute a partial Tax Year, Landlord’s statement shall apportion the amount of the additional rent due hereunder. The obligation of Tenant in respect of such additional rent applicable to (1) the last year of the Term or part thereof or (2) the last year of this Lease, if this Lease shall terminate prior to its Term, shall survive the expiration of the Term of this Lease or the earlier termination of this Lease, as the case may be.This second example is a more detailed provision than Example

1. It provides the tenant with additional rights and the landlord with further obligations. Whereas Example 1 merely states the tenant’s obligations, Example 2 provides the tenant with the right to dispute the amount claimed as due and states that the tenant will not be obligated to pay penalties or interest resulting from delinquent real estate tax payments of the landlord. This latter example also states that the tenant can request that the landlord institute tax certiorari proceedings to challenge particular real estate tax disputes.

Example 2:

(a) During the term of this Lease, Tenant agrees to reimburse Landlord for Tenant's Proportionate Share (as hereinafter defined) of Real Estate Taxes (as hereinafter defined) attributable to the Building which are in excess of the "Base Year Taxes." "Base Year Taxes" for computing tax increases shall be the Real Estate Taxes for the Building payable in the fiscal year commencing in the latter of the first full lease year or the year in which the Building is Ninety-Five (95%) percent occupied and fully assessed for tax purposes. Landlord represents and warrants that, as of the date this Lease is executed, Base Year Taxes are not subject to any abatements, phase-ins for assessments, reductions in rates, credits, exemptions or any other benefits or discounts that may effectively reduce the Base Year Taxes from what they should be in a fully assessed Building at the then prevailing tax rate for similar commercial real estate in _________________________.

(b) For purposes of this Lease, "Tenant's Proportionate Share" shall be deemed to be a fraction, the numerator of which shall be the number of rentable square feet contained in the Premises and the denominator of which shall be the total number of rentable square feet contained in the Building. Landlord represents and warrants that the total number of rentable square feet contained in the Building is _______ square feet. Landlord represents that the sum of the tenants' proportionate shares does not exceed One Hundred (100%) percent of the rentable area of the Building. In the event that the rentable area of the Premises or Building is increased, Tenant's Proportionate Share for all purposes under this Lease shall be adjusted accordingly.

(c) Landlord shall, with the submission of the comparative Operating Costs statement, furnish to Tenant a computation showing Tenant's Proportionate Share of the increase in Real Estate Taxes above Base Year Taxes for said year. Any amount due under the provisions of this Section shall be paid to Landlord by Tenant within Thirty (30) days of Landlord’s submission.

(d) Tenant shall have the right to notify Landlord that it disputes the correctness of Landlord's statement, specifying in what respect Landlord's statement is claimed to be incorrect. Tenant shall pay additional rent in accordance with the disputed Landlord's statement pending the resolution of such dispute by agreement or otherwise. If the resolution of the dispute results in a credit to Tenant, such credit shall be applied to the next rent(s) owing.

(e) Tenant's obligations under this Section shall be prorated as of the date of expiration or termination of this Lease.

(f) In no event shall Tenant be obligated to pay any penalty or interest that may result from the delinquent payment of Real Estate Taxes by Landlord, nor shall Tenant have any obligation for the payment of any increased Real Estate Taxes attributable to the addition of any rentable area to the Building or any improvements made to any other tenant's space that are not part of the Building on the Commencement Date. In addition, Tenant shall have no obligation to pay for any increases in Real Estate Taxes that are attributable to pre-assessment of the Building as a result of the sale, or other transfer, of the Building.

(g) The term "Real Estate Taxes" shall be deemed to be only the real estate taxes assessed against the land and Building. In no event shall it be deemed to include franchise, estate, inheritance, succession, capital levy, transfer, general income and excess profit taxes of Landlord, nor shall it include any license, permit or inspection fees imposed on Landlord or any tax on the rent or rents received by Landlord from the Building or assessments against the Building for local improvements or otherwise. In no event shall Real Estate Taxes include any amount included in Section 10 as Operating Costs.

(h) If, as a result of any application or proceedings brought on behalf of Landlord for reduction of the assessed value of the Building for any tax year subsequent to the base year, there shall be a decrease in Real Estate Taxes for such tax year, Landlord's statement next following such decrease shall include an adjustment for such tax year reflecting such decrease in Real Estate Taxes, and Landlord shall promptly refund to Tenant (or permit Tenant to offset against the next payments of rental due under this Lease) the amount previously overpaid by Tenant for such tax year. In no event shall Base Year Taxes be decreased even if such Base Year Taxes are reduced as a result of an application or proceedings brought by or on behalf of Landlord.

(i) Landlord represents that it will not collect more than One Hundred (100%) percent of the total Real Estate Tax increase for a given tax year from the tenants in the Building. In no event will Tenant's Proportionate Share exceed, on a percentage basis, the portion of the Building it leases.

(j) Provided that there exists reasonable grounds for contesting the validity or amount of any Real Estate Taxes, Tenant may request that Landlord institute a tax certiorari proceeding to challenge the particular Real Estate Taxes in dispute. Upon the final determination of any contest, Tenant shall immediately pay and satisfy its Proportionate Share of the amount found to be due (to the extent such amount exceeds Base Year Taxes), together with any costs, penalties and interest attributable to the tax contest, as described in a detailed statement thereof which Landlord shall give to Tenant.

[4]—Operating Expenses

[a]—Porter’s Wage or Penny Wage Formula

In the old days, the hourly wage rate of a standard building employee would increase from year to year. The number of cents that it increased would then be multiplied by the square footage area of the demised premises. The result would be the escalation for that year. That formula involved a relatively small hourly wage and a small cents increase. It was called a penny for penny escalator.

Early on, landlords discovered that they could increase the tenant’s escalation by one and a half, two or even three pennies for every one penny increase in the wage rate. Over time, it became obvious that this was quite a profit center for landlords. Then the hourly wage rates increased. A 100% increase in the hourly wage rate became 300 pennies instead of ten pennies. That, multiplied by more than “a penny for a penny,” resulted in an incredible increase per square foot for escalations. There was no relationship between the increase in hourly salaries and the cost to operate or clean the building

Not being one to be outdone by a “small” city like Chicago where the penny formula began, certain New York City landlords decided to add the value of the fringe benefits that were negotiated on behalf of the union employees to the hourly rate increase. This formula took the place of hard hour cost increases.

In order to avoid disputes and arguments over what constituted a necessary and appropriate operating expense, landlords designed a new way to calculate escalations. It was based on a formula that purported to have a relationship to the cost of running a building: the relative increases from year to year of the cost per square foot of a porter or other comparable union employees as set forth in the union contract. Thus, the porter’s wage formula was born.

Increasingly, more benefits come to union building employees in the form of fringe benefits than in the form of hourly wage rate increases. To price fringes based on their hourly impact, divide the cost of the fringes or the benefits by the number of hours worked in the fringe period. This generates a great many variables and has been a veritable storehouse of creativity for landlords. Not only do many of the landlords use a different denominator for the hours worked for the benefit period, they do not always price the benefit or even the hours in the denominator consistently from year to year or in accordance with any generally accepted standards.8

It is extremely important for the tenant to fully understand exactly how the porter’s wage provision in its lease works. Unfortunately, many tenants agree to escalations tied to the porter’s wage, but do not really understand how the provision will operate. By accepting that the typical porter’s wage provision calculates additional rent pursuant to an index and not by measuring the actual increase in a landlord’s building operating costs, the unwary tenant has set itself up to pay escalation regardless of whether the landlord even hires a porter.9 Furthermore, unless the language of the lease controls the landlord’s method of calculating the porter’s wage rate, the landlord will have a free reign to choose how these computations are done; the calculated cost of a porter can be forced up and the hours worked forced down, therefore increasing the porter’s wage rate.10 The impact on the amount of the tenant’s additional rent can be startling.11

One commentator calculated a porter’s wage escalation under a typical provision using two different methodologies: the Standard Hours Method and the Hours Worked Method.12

“The Standard Hours Method assumes that there are 2,080 hours in a working year (52 weeks times 40 hours per week), and that this is the number utilized in the denominator. The Hours Worked Method assumes the porter works fewer than 2,080 hours, because he gets 272 hours off a year for various holidays, vacation and the like. The porter, therefore, only works 1,808 hours. If this lower hours number is used, the Landlord has raised the Porter’s Wage, some would argue, artificially. As you can see, it can get much worse. When a tenant agrees to an escalation based on Porter’s Wage with fringes, the question is ‘is the dollar of hours for vacations and other times the porter does not work included or excluded from the cost of the porter [the numerator]?’ The Hours Worked Method assumes the hours (the denominator) are already reduced by the number of those hours not worked. If you allow the landlord to reduce

8 The standards in this field are so sketchy, that few, if any, landlords price the fringes the same way nor have an hourly wage increase that is even close to the same number from year to year. This inconsistency and non-standardized approach to price in the application of the porter’s wage formula to escalations can make comparison of proposed premises for leasing very difficult.

9 Sollis, “Does a Landlord in New York City Owe a Fiduciary Duty to His Tenant to Compute Fairly ‘Additional Rent’ Owing Under a Typical Porter’s Wage Escalation Clause?,” The Real Estate Corner, Wood and Di Sciullo, eds., 4 The Metropolitan Corporate Counsel No. 8/9 (Aug./Sept. 1996). Mr. Sollis is a member of Sussman Sollis Evin Tweedy & Wood, LLP in New York City and is a partner of Mr. Wood’s, the coauthor of this treatise.

10 Id.11 Id.12 Id.

vacation hours and the like from the denominator but include the cost of those hours in the cost of the porter (the numerator), the effect is to permit the landlord to ‘double-up’ and increase the Porter’s Wage rate even more dramatically.”13

The methodology and components used to calculate the porter’s wage rate should be carefully stated in the lease and all terms defined. All of the ramifications of this provision should be completely understood before the lease is signed or the tenant may be in for an expensive surprise.14 Do not count on the courts for relief from an overreaching porter’s wage provision in a commercial lease. Traditional law, in New York, for example, still considers these to be arm’s length transactions, although there are signs that the hard line may be softening somewhat.15

The following is a sample operating cost escalations provision:15.1

In the event that "Operating Costs" (as hereinafter defined) for any calendar year during the term of this Lease subsequent to the "Base Year for Operating Costs," (as hereinafter defined), shall be greater than the "Base Operating Costs" (as hereinafter defined), then Tenant shall pay to Landlord, as additional rent, an amount equal to such increase for such year multiplied by Tenant's Proportionate Share.

For purposes of this Paragraph:

(1) The term "Base Year for Operating Costs" shall mean the first calendar year during the term hereof in which Ninety-Five (95%) percent of the gross rentable area of the Building is occupied for the entire calendar year. The Base Year for Operating Costs shall not be earlier than the first full calendar year after the Commencement Date. The term "Base Operating Costs" shall be those actual Operating Costs that are incurred by Landlord during the Base Year for Operating Costs and a reserve for the costs that would have been incurred by Landlord for warranty repairs and servicing during the Base Year for Operating Costs.

(2) The term "Operating Costs" shall mean, for a particular year in question, the aggregate expenses incurred by Landlord in that year in connection with the operation, maintenance and repair of the Building in accordance with sound management and accounting principles and practices generally accepted with respect to the operation, maintenance and repair of office buildings of similar size and quality in ______________________.

13 Id., citing Morgan Guaranty Trust Co. of New York v. Solow, 68 N.Y.2d 779, 506 N.Y.S.2d 674, 498 N.E.2d 147 (1986) (under a long term leases, a change in the method of calculating porter’s wage rates might increase additional rent by millions of dollars). Obviously, there are many factors that can further complicate these calculations.

14 Id. Mr. Sollis suggests that the tenant should insist “that an actual calculation utilizing the escalator be provided and incorporated into your lease as an example of how the rate will be calculated in the future.”

Using a hypothetical 1992 comparison year for a class A office building, a minimum wage of $28,156.96, and assuming $15.00 per square foot, Mr. Sollis found that under the Standard Hours Method (wage only rate), the base rent escalation would be 8%. However, if the Hours Worked Method (doubled up with fringes) were used, the escalation would be 15.58%. He noted that the market inflation was running approximately 3.59% at the time. Id. The windfall for the landlord is clear.

Grateful appreciation is extended to Arthur R. Klampert of Goldstein Golub Kessler & Associates of New York City for contributing the calculations.

15 Id.15.1 See § 19.03[4][b][i] infra for the Building Operating Cost Addendum (BOMA), which provides a sample

clause excluding certain costly expenses that might otherwise be passed on to the tenant as building operating costs.

(3) Operating Costs shall specifically exclude all expenses for: (i) any capital improvements and repairs made to the land or Building, (ii) painting, redecorating or other work which Landlord performs for any other tenant or prospective tenant in the Building; (iii) expenses for repairs and other work due to fire, windstorm or other insured casualty or due to construction defects or defective equipment in the Building; (iv) leasing commissions and advertising expenses in leasing and procuring new tenants for the Building; (v) accounting fees and legal expenses incurred in enforcing the terms of any lease of space in the Building; (vi) interest or amortization payments on any mortgage or mortgages that are liens on the Building or on any ground lease; (vii) rental payable by Landlord with respect to the land and/or the Building; (viii) Real Estate Taxes; (ix) any expenses for which Landlord receives reimbursement from any source; (x) any expenses incurred by Landlord as a result of the presence of asbestos in the Building, (xi) depreciation of the Building; (xii) the cost of performing any services for other tenants in excess of the services required to be provided to Tenant by Landlord under the Lease; (xiii) the cost of providing After Hours HVAC to any tenant; (xiv) the cost of providing electricity to portions of the Building other than the common areas; (xv) costs incurred by Landlord as a result of the negligence or willful acts or omissions of Landlord, its agents, employees or contractors; (xvi) salaries, expenses, fringe benefits and other compensation for executives or other personnel above the grade of building manager; (xvii) costs of contracts with related companies of Landlord if such contracts are not at rates competitive with the rates of other local contractors providing such services; (xviii) leasehold amortization and other noncash items, or costs associated with any lease or sublease assumed by Landlord; (xix) costs or payments associated with Landlord's obtaining or retaining air rights or developments rights; (xx) auditing fees, except for those incurred in connection with escalation statements or maintenance and operation of the Building; (xxi) cost of repairs, replacements or improvements incurred by reason of fire or other casualty or arising from the exercise of the right of eminent domain whether or not insurance proceeds or condemnation awards are recovered or adequate for such purposes; (xxii) costs related to any employee if such employee performs work or services for other than the Building, except for any bookkeeper or accountant of Landlord to the extent of the pay relating to time spent serving the Building; (xxiii) cost of tools and operating equipment purchases for use in the Building prior to one year after it is initially opened for occupancy by tenants, and cost for services that are reimbursed under any warranty or guarantee of any equipment; (xxiv) all costs incurred in connection with the initial construction of the Building, including the removal or correction of any violations therefrom and the cost of repairing any defects in the initial construction thereof; (xxv) any costs or expenses incurred in connection with any other building or improvement other than the Building; and (xxvi) any fringe benefits that are not mandatory pursuant to the applicable union contract.

(4) Only those expenses that will benefit all of the tenants in the Building will be included in the term "Operating Costs."

(5) On or about the Ninetieth (90th) day of each calendar year during the term of this Lease, Landlord shall furnish Tenant with a comparative statement of Operating Costs for the preceding calendar year and the Base Operating Costs, showing in detail on a line item basis the total Operating Costs for the preceding calendar year, and setting forth Tenant's Proportionate Share of the increase in Operating Costs for such year above the Base Operating Costs. Tenant shall pay any amount due within Thirty (30) days of the submission of the comparative statement. If Tenant shall dispute any such statement, it shall have the right during business hours and at Landlord's place of business to examine Landlord's books and

records with respect to such statement and dispute on not less than Three (3) days’ prior written notice to Landlord. If Tenant's audit discloses an overstatement of Operating Costs, an overpayment or an improper billing, then Tenant's Proportionate Share of the increase in Operating Costs above Base Operating Costs shall be reduced in accordance with the findings of the audit. Any overpayments made by Tenant shall be refunded to Tenant within Thirty (30) days of Tenant's invoice to Landlord.

(6) Tenant, however, shall still have the right during business hours and at Landlord's place of business to examine Landlord's books and records on not less than Three (3) days' prior written notice to Landlord, even though Tenant may not have initially disputed Landlord's statement and made payment. If Tenant's audit discloses an overstatement of operating expenses or taxes, then Tenant's pro rata share of the operating expenses or taxes shall be reduced in accordance with the findings of the audit and any subsequent resolution of a dispute.

(7) If the Operating Costs shall be less than the Base Operating Costs in any year during the term hereof for which Tenant may be liable to pay additional rent pursuant to this Section, Landlord shall pay to Tenant an amount equal to such decrease multiplied by Tenant's Proportionate Share.

If Landlord fails to render a statement for Operating Expenses or Real Estate Taxes within three years of the due date as defined above, then Landlord waives its rights to collect any overage for Operating Costs or Real Estate Taxes for said years. Such failure shall not relieve Landlord of its responsibility to reimburse Tenant for any excess paid by Tenant during subsequent years.

[b]—Pass Throughs

Because of the profit potential, most landlords with significant tenants have moved from the porter’s wage formula back to actual net operating expense “pass throughs.” Under this system, the tenant picks up its pro rata share of all increases in the costs to operate a building.15.1 The following issues should be examined: (1) are the operating expenses appropriate and reasonable; and (2) are such expenses reasonably necessary to operate the building?

[i]—Definition of “Operating”

The term “operating” under a complex office lease is often a pyramid definition16 that can include management, repair, maintenance, partial replacement, cleaning, decorating, landscaping and possibly alteration costs. Operating cost escalations are the share of building operating expenses passed on or charged to a tenant. They tend to be the single most unpredictable cost element in a lease, adversely affecting a tenant’s bottom line in ways never contemplated at the time the lease is signed. Understanding how these charges are determined, the factors that are considered and carefully reviewing and negotiating the escalation provision can significantly help improve cost controls.

15.1 The term pass-through implies actually charging the tenant to reimburse the landlord for its out-of-pocket costs. A pass-through applies only to actual costs and should not be used otherwise. Frequently the landlord will set up a formula, allocation or other spreading or sharing of costs, charging tenants based on a proportionate share calculation. That is not a pass-though and may result in revenue for the landlord not simply a reimbursement of actual out-of-pocket costs.

16 See § 1.05[1] supra for a discussion of pyramiding definitions.

In any event, it is important for the tenant to understand what costs are involved so he can determine whether or not he can afford the lease. When examining the language, all avenues flowing in and out of the definition must be explored to fully understand what exactly will be covered.

Leases take one of two typical approaches in their definition of “operating.” The long way enumerates everything that can be included in an operating expense. The short way speaks in general terms of all costs associated with operating, managing, repairing or replacing portions of the building. The short clause allows practically anything that is reasonably appropriate for operating a building to be included. The longer, more specific clause only allows those things specifically enumerated to be included unless the clause also contains all-inclusive language, such as “or any other such cost or expense of operating or maintaining the property.”

Whatever drafting technique is employed, the language must be carefully analyzed and the definition modified, if necessary, to fairly express the parties’ intentions. Only those costs and expenses that are “fair game” should be included in an operating expense escalation cost. But how is fair game determined? The parties have to define fair game and set parameters. Attention should be given to properly drafting any exclusions from operating expenses to fit the nature of the deal. Exclusions will vary with a variety of factors, including the size of the space being leased and the duration of the lease.

The following is a sample clause defining operating expenses. It is a very detailed, broadly drafted and very pro-landlord operating expense clause.

“Operating Expenses” shall be defined as all direct and indirect costs incurred by the Landlord in the operation, maintenance, repair, overhaul, and any owner’s overhead in connection with the Project. Such cost shall include by way of illustration, but not limitation: utilities; janitorial services; security; landscaping; any and all assessments Landlord must pay for the Project pursuant to any covenants, conditions or restrictions, reciprocal easement agreements, tenancy-in-common agreements or similar restrictions and agreements affecting the Project; gross receipt tax (whether assessed against the Landlord or assessed against Tenant and paid by Landlord, or both); water and sewer charges; accounting, legal and other consulting fees; repair or replacement of all surfaces, wall coverings, decorative items, carpets, drapes and other window covering; any insurance that Landlord is responsible hereunder or which Landlord or any first mortgagee with a lien affecting the Premises deems necessary in connection with the operation of the Project; utility surcharges, or any other costs levied, assessed or imposed by or at the direction of, or resulting from statutes or regulations or interpretations thereof, promulgated by any federal, state, regional, municipal or local government authority in connection with the use or occupancy of the Project; costs incurred in the management of the Project including supplies, wages and salaries of employees to include benefits, payroll taxes and similar governmental charges; ground rent; management office rental; a management fee and, in the event Landlord is directly participating in the administration of the Project, and administrative fee in the amount of Landlord’s actual expenses, such administrative fee not to exceed fifteen percent (15%) of the annual Operating Expenses; heating, ventilation and air conditioning repairs and maintenance; elevator maintenance and upgrades; equipment; tools; supplies; repair and maintenance of the structural portions of the Building including plumbing, HVAC, electrical systems and the roof; rental or leasing charges used in the operation and maintenance of Project; maintenance and repair or replacement of all signs (other than Tenant’s signs); audit or verification fees; the cost of any capital improvements made to Project for the purpose of reducing costs or increasing safety or is government mandated; costs of repairs, resurfacing, repairing, maintenance, painting, striping, lighting , and operations of the garage; and appropriate reserves. Operating Expenses shall not include taxes, depreciation on the Building or

equipment therein, broker commissions, roof structure and services not uniformly available to all tenants of the Project.

The tenant should use a list of exclusions to narrow down those costs to those that actually involve “operation and maintenance’ of the building. The following is a sample clause excluding certain costs being escalated to the tenant. Though there are lengthy exclusion lists, this particular list is limited to the top twenty to twenty-five exclusions that have been found to be most costly.

BUILDING OPERATING COST ADDENDUM (BOCA)

1. “Building Operating Costs” is defined as those expenses which are escalated to Tenant. Notwithstanding anything to the contrary, the following items shall be excluded from the calculation of Building Operating Costs:

(a) any expenses, which under generally accepted accounting principles, consistently applied, and sound management practices would not be considered a normal maintenance or operating expense;

(b) all costs associated with the operation of the business of the entity which constitutes "Landlord" (as distinguished from the costs of Building operations) including, but not limited to, Landlord's or Landlord's Managing Agent's general corporate overhead and general administrative expenses or such costs that normally would be included in a management fee (e.g., placement/recruiting fees for employees, risk management costs, corporate accounting, employee training programs, health/sports club dues, employee parking and transportation charges, tickets to special events, bank charges, etc.);

(c) costs incurred by Landlord in connection with the correction of defects in design and construction of the Building or Project;

(d) costs of a capital nature, including, but not limited to, capital improvements, capital repairs, capital equipment, and capital tools, all as determined in accordance with generally accepted accounting principles, consistently applied, and sound management practices, except costs of 1) any capital improvement made to the Building which improvement actually reduces Building Operating Costs, limited to the amount of actual savings realized or 2) which is required by government regulation enacted following Tenant's occupancy, the amount of all such costs to be amortized on a straight-line basis over the asset’s useful life or 3) any cost incurred that is considered recurring, routine maintenance (e.g., painting of the common area and replacement of common area carpet, the aggregate cost of which does not exceed $20,000 in any Lease Year for any particular project), the amount of all such costs to be amortized on a straight-line basis over the useful life of the asset. In no event shall the costs of replacing or retrofitting the HVAC system to comply with any of Sections 604-606 and/or 608 of the Clean Air Act be included in Building Operating Costs;

(e) any costs of any services sold or provided to tenants or other occupants for which Landlord or Managing Agent is entitled to be reimbursed by such tenants or other occupants as an additional charge or rental over and above the basic rent (and escalations thereof);

(f) expenses in connection with services or other benefits which are provided to another tenant or occupant and do not benefit Tenant;

(g) overhead or profits paid to subsidiaries or affiliates of Landlord, or to any party as a result of a non-competitive selection process, for management or other services to the Building, or for supplies or other materials, to the extent that the costs of such services, supplies, or materials exceed the costs that would have been paid had the services, supplies or materials been provided by parties unaffiliated with the Landlord on a competitive basis and are consistent with those incurred by similar buildings in the same metropolitan area in which the Building is located;

(h) wages, salaries and other compensation paid to any executive employee of Landlord and/or Landlord's Managing Agent above the grade of Building Manager;

(i) any cost or expense related to removal, cleaning, abatement or remediation of "hazardous material" in or about the Building/Common Area or real property, including without limitation, hazardous substances in the ground water or soil;

(j) advertising and promotional costs including tenant relation programs and events;

(k) all costs incurred in owning, operating, maintaining and repairing any underground or above-ground parking garage and/or any other parking facilities associated with the Building and Common Areas, including but not limited to, any expenses for parking equipment, tickets, supplies, signs, claims insurance, cleaning, resurfacing, restriping, business taxes, management fees and costs, structural maintenance, utilities, insurance of any form, real estate taxes, and the wages, salaries, employee benefits and taxes for personnel working in connection with any such parking facilities if the parking garage/facility revenues exceed parking garage/facility expenses. If garage revenues do not exceed garage expenses, then such costs may be included in Building Operating Costs to the extent total garage expenses exceed total garage revenues; provided, however, if any tenants receive free or abated parking, the full value of such free or abated parking shall be deemed revenue of the garage for purposes hereunder.

(l) Landlord's gross receipts taxes, personal and corporate income taxes, inheritance and estate taxes, other business taxes and assessments, franchise, gift and transfer taxes, and all other real estate taxes relating to a period or payable outside the term of the Lease;

(m) any increase of real estate taxes and assessments due to any change in ownership including, but not limited to, the sale or any other form of transfer of title of the Building and/or Common Area or any part thereof, or due to the transfer of title of any leases in the Building, or due to any renovation or new construction in the Building or Common Area or related facilities;

(n) any fines, costs, penalties or interest resulting from the negligence, misconduct or omission of the Landlord or its agents, contractors, or employees;

(o) any rental payments and related costs pursuant to any ground lease of land underlying all or any portion of the Building and Common Areas or any costs related to any reciprocal agreement;

(p) any costs, fees, dues, contributions or similar expenses for political, charitable, industry association or similar organizations;

(q) any rental and any associated costs, either actual or not, for the Landlord's and/or Landlord's Managing Agent's management and/or leasing office;

(r) acquisition costs for sculptures, paintings, or other objects of art or the display of such items;

(s) costs incurred in connection with the original design and construction of the Building or Project or any major changes to same, including but not limited to, additions or deletions of floors, renovations of the common areas (except as expressly permitted under Paragraph 1 (d) above), replacement of major components that have reached their useful life irrespective of whether the replacement may result in reducing the Building Operating Costs, and the repair of damage to the Building or Project in connection with any type of casualty, event of damage or destruction or condemnation;

(t) costs incurred in connection with upgrading the Building to comply with disability or life insurance requirements, or life safety codes, ordinances, statutes, or other laws in effect prior to the Commencement Date, including without limitation the Americans With Disabilities Act, including penalties or damages incurred as a result of non-compliance;

(u) costs for reserves of any kind;

(v) costs incurred in connection with modifying, upgrading, replacing, repairing or maintaining the Building’s telecommunication system.

Building operating costs that cover a period of time not entirely within the Term of the Lease shall be prorated. In the event Tenant ceases to occupy (but still leases) the Premises, Tenant shall receive a credit against Building Operating Costs equal to the cost of electricity and janitorial services and any other expense not incurred as a result of such vacancy. It is agreed that Landlord shall not profit from the collection of operating expenses.

A more thorough discussion of exclusions is contained later in this chapter.17

[ii]—Capital Improvements

A tenant looking for a large block of space for many years is generally making the election to lease in order to avoid the periodic, but usually unplanned for, capital expenditures associated with ownership. One of the first arguments that arises in this type of situation is what capital improvements or other major expenses, if any, are allowed to be passed through to the tenant through operating expense escalations?

Capital improvements or expenses of this sort are usually associated with the curing of construction or latent defects or with completing construction or original fit-up for operation. In addition, capital expenditures of this sort may be associated with curing violations of laws or curing conditions that, if discovered, would be violations. Capital expenses can also arise prior to leasing when the premises, other leasable space in the building, as well as the public portions of the building, are brought into compliance and made free of hazardous substances. Clearly, anything that occurs prior to the time the tenant is in, operating, all its installations are done, the

17 See § 19.03[4][c] infra.

building is done and everything is in compliance should not be passed through in an operating expense clause.18

Capital expenses that are ongoing should be the subject of negotiation. Generally large tenants do not allow any capital expenditures benefiting more than one period of time (usually one year) to be charged as operating expenses.19 Many tenants will agree, however, that capital improvement costs can be included for improvements related to the saving of operating expenses, but only to the extent of the actual savings or in some instances, the estimated potential savings, amortized on an annual basis over the useful life of the improvement.

[iii]—Types of Leases

To understand basic operating costs concepts, a number of terms must be defined first. The three main types of operating cost lease provisions are “industrial triple net,” “full service gross,” and “modified gross.” These terms are commonly misused and misunderstood. In order to understand basic operating cost concepts, these terms must be clearly defined. Each is discussed in turn.

[A]—Industrial Triple Net19.1

The industrial triple net lease is where the tenant contracts directly with vendors for building services, and pays the vendors directly. In a true industrial triple net lease there are no operating costs escalations passed on by the landlord to the tenant since the tenant pays everything directly to the vendors.

[B]—Full Service GrossA full service gross lease is where the landlord contracts directly with and pays vendors for

building services without separate charge (i.e., operating cost escalations) passed on to the tenant. The tenant's base rent covers its share of building operating costs. Similar to an industrial triple net, under a true full service gross lease no operating cost escalations are passed on by the landlord to the tenant since such costs are included in base rent. These types of leases are now rare because the landlord assumes all of the risk of rising costs to operate and maintain the building.

[C]—Modified GrossIn a modified gross lease, the landlord contracts directly with and pays vendors for building

services and then passes through those costs to the tenant for reimbursement. Under this type of lease, a tenant is usually billed separately for its share of building operating costs apart from base rent. The calculation of the tenant's share depends on which type of modified gross lease has been entered into: base year, expense stop, stipulated base amount, or office triple net.20

[c]—Exclusions

Operating expenses can increase significantly over time. A tenant may not be prepared for such increases. Generally, the lease will limit operating expenses by the use of certain

18 These issues can be bifurcated and dealt with as they arise in a pre-leasing and postleasing context.19 Those that allow it require that the capital expenditure be amortized, included year-to-year in the amount

representing a straight line basis depreciation, but not included in the last two years of the lease. 19.1 The three nets are generally equated with (1) operating and maintenance expenses, (2) taxes and (3)

insurance.20 Each of these terms is defined and discussed in § 19.03[4][i] infra.

exclusions. Typical exclusions include any reimbursable costs from insurance or condemnation awards, from other tenants for direct services, from overtime and additional services, as well as charges for levels of service that are greater than the level of service of that particular tenant under the lease. The lease may also try to exclude the cost of electricity furnished to non-public areas in the building and limit duplicative costs in the areas of taxes and electricity payments.

Other exclusions include: any debt service on mortgages or rental under ground leases; the cost of any work in leasable or leased premises, as opposed to work done for the common benefit of building residents; costs associated with professional fees for disputes or litigation with tenants; landlord advertising or promotional expenses; costs for casualty that would have been reimbursable by insurance had landlord carried full value insurance; salaries and fringe benefits that are above comparable salaries and benefits for comparable employees; salaries of personnel that are shared among buildings or those above the grade of a building manager; fees or costs in excess of the comparable market value thereof for services rendered by vendors affiliated with landlord; and any type or line item service that the landlord is generally providing to the building, but not to the tenant under the lease.

In addition to having specific exclusions, there should also be a general limitation provision requiring all services to be delivered at the landlord’s actual net cost, such as after-hours HVAC. “Actual” at the time of disbursement is an easy concept. “Net” at any time means that if there are any discounts, volume, credit banks or other payments or benefits received by the landlord related to any service provided to the building, those should find their way back to the benefit of the tenants.

A prospective tenant can also protect itself by attempting to address increases in advance. This can be done in a letter of intent.20.1 A tenant with leverage should try to get the landlord to agree to “an annual cap on the tenant’s liability for increases in operating expenses.”20.2 Landlords generally want to limit the cap to items that are “not controllable.”20.3 However, what constitutes “noncontrollable” is open to debate. The lawyers or the landlord and tenant themselves will need to clearly define that term. “At a minimum, controllable costs should expressly exclude “real estate taxes, insurance, seasonal maintenance such as snow removal, sanding, etc. and utility costs.”20.4 Landlords may also try to impose exclusions to the expense cap for “wages and benefits pursuant to collective bargaining agreements, non-insured casualties, and legal compliance.”20.5 Tenants should try to limit these exclusions. In any event, the parties should make every attempt to deal with these issues early on when they first strike a deal. 20.6 This will avoid misunderstandings and disagreements during the negotiating process.

[d]—Costs of Landlord Negligence

An operating expense resulting from the negligence of the landlord is another area that is quite controversial. Take, for example, a landlord who allows a non-union, non-licensed plumber to inspect and work with some of the risers and feeder pipes in the building. The plumber affixes his wrench to a high pressure water column without turning off the pressure in the pipe in order to tighten a slightly dripping shut-off valve. The pipe breaks and severe water damage results.

20.1 Crowe, “Address Exclusions from Operating Expenses Prior to Lease Negotiations,” 16 Commercial Leasing Law & Strategy 1 (Law Journal Newsletters Apr. 2004).

20.2 Id. Note that not all tenants will be successful in obtaining the kind of cap they would like, larger tenants or those with other forms of leverage will have a better chance of getting a landlord to agree to a reasonable cap on increases in operating expenses.

20.3 Id.20.4 Id. at 1-2.20.5 Id. at 2.20.6 Id.

The landlord may be deemed liable for negligently hiring the plumber as well as for the plumber’s negligence. The costs associated with repairing the tenant’s and building’s damages from the flood, as well as to the damage to the plumbing should not find their way into an operating expense escalation clause.

Landlords who operate first class buildings, as well as other respectable buildings, are expected to have a certain level of management and operating ability. These buildings are generally under a building manager who receives a management fee. If there is negligence, the costs should come out of the management fee or the ownership’s pocket and should not be passed through to tenants.

[e]—Other Operating Expense Issues

[i]—Capping Expenses

Tenants should always seek a cap on expenses—without one, costs can truly spiral. The cap must bear some relevance to the actual expenses that a tenant will pay in the space. It should offer a real discount from these expected actual costs. A cap of 10-15% per year is basically worthless. Instead, a reasonable cap should be 3-5% increase in annual expenses over prior years’ expenses. The tenant should also be mindful of expense exclusions from the cap. Some landlords have excluded janitorial costs, utility costs, management fees, repairs and maintenance and taxes from the cap, leaving the tenant without anything to cap.

[ii]—Cumulative vs. Compound Formula

The tenant should also be aware of how the expense caps are being calculated. Are they calculated on a cumulative or a compound basis? The following example demonstrates that there can be a significant difference in cost to the tenant.

Assumptions: Base Amount = $10.00 Allowable Increase = 5% per year

Cumulative Calculation = base amount x [1. (adjustment year x allowable increase)]

Adjustment Year 1 = $10.00 x [1 + (1 x .05)] = $10.50Adjustment Year 2 = $10.00 x [1 + (2 x .05)] = $11.00 and so on . . .

Compound Calculation = amount at year end x (1 x allowable increase)

Adjustment Year 1 = $10.00 x [1 + (1 x .05)] = $10.50Adjustment Year 2 = $10.50 x [1 + (1 x .05)] = $11.03 and so on . . .

OVER A FIVE YEAR ADJUSTMENT PERIOD, THE DIFFERENCE IS $.26/ RSF!

[iii]—Definition of Capital

Another important consideration is how capital is being defined. According to basic accounting and the GAAP definitions, capital (1) provides benefit for more than one accounting period, (2) is extraordinary and nonrecurring or (3) increases the use life or capacity of the system. Once capital expenses are defined, the lease should state whether or not the capital item can be passed on or escalated to the tenant.

[iv]—Management Fee vs. Corporate Overhead

The following services should be covered under the management fee. Landlords will seek to pass on these costs to tenants as operating expenses:

(1) Accounting costs (2) Regional manager and staff salaries(3) Risk management(4) Training and human resources(5) Express mailing charges(6) Employee fringe benefits (such as health club dues, country club dues, etc.)

These costs and any others with comprise the management fee should be disclosed either in the lease or in a side letter.

[v]—Passing on Garage Expenses as Operating Expenses

Prior to the 1970s, when parking was often free, it was appropriate to charge the expenses to operate and maintain the garage. However, when landlords started charging a parking fee, things needed to be changed. From a tenant’s perspective, if a separate parking fee is assessed, then the costs of operating and maintaining the garage or lot should be covered by the fee and not billed to the tenants again through operating expenses. This failure to offset the parking expenses with the parking revenue is not in accordance with GAAP (Generally Accepted Accounting Principles) that requires matching revenues to expenses. A landlord may say there is really not a difference between a tenant paying rent and its share of operating expenses (which are not offset by rent) and when a tenant pays for a parking fee and also pays its share of garage operating expenses. However, there are differences. First, the square footage of the garage is not included in the calculation of the pro rata share of the building. Second, other people use the space in the garage to park (visitors, retail, public parking, etc.) whereas there is not outsider nontenant use of the building. Because the added outsider use of the garage is over and above the normal use, income associated with it should be used to offset the expenses. Besides, most lease documentation gives the landlord the ability to adjust parking fees to reflect market rates and/or the increased cost of operations.

A landlord seeking to charge the tenant for operating and maintaining the garage without offsetting the expense with income should include the following language in the lease:

“Landlord may escalate as part of common area expenses all costs associated with the upkeep, maintenance, taxes and ongoing operation of the garage without any offset from any revenue generated from such activity.”

When such language is not present, it is difficult, if not impossible, for a landlord to justify escalating such costs to the tenants.

[vi]—Costs Associated with Maintaining Good Tenant Relations

Many costs are associated with keeping tenants happy or maintaining good tenant relations. These include holiday gifts and parties, flower arrangements, socials, lunch time concerts, and seasonal decorating. In the great majority of cases, these costs are incurred purely for marketing reasons. That is, they are intended to increase tenant retention and lease renewals. As a function of leasing, these costs should never be escalated and are the sole responsibility of the landlord. Additionally, a gift, by definition, is “free of charge.”

[vii]—Management Office Rent

The tenant should seek to exclude from operating expenses any specific reference to rent for a building office or management office since this is often a fictitious expense. After all, if the management company is actually paying rent to the landlord for the management office space, then the landlord has received a revenue, not incurred an escalatable expense. Any further recovery of the same amount by means of the tenant’s operating expense payments constitutes a double reimbursement. It is more likely that no rent is actually charged or paid for the management office. So long as the building is less than fully occupied, it can be argued that the landlord has incurred no expense in providing the management office space. It has not lost the opportunity to lease the space to a new tenant on account of the presence of the management office since adequate rentable space is still available.

If the building is fully occupied, the landlord can argue more effectively that it has lost potential revenue due to the presence of the management office. In this case, it is not unfair to include the reasonable cost of the management office rent in operating expenses, provided, however, that the cost is based on a reasonably-sized office (not including square footage attributable to leasing agents’ regional or corporate functions) and a rental rate consistent with the rate charged to other tenants in the building. In a base year lease, the inclusion of management office rent in operating expenses is not critical as long as the rent is also included in the base year.

[f]—Tenant’s Proportionate or Pro Rata Share

Pro rata share is defined as the Premises’ rentable square feet (RSF) divided by the Building’s RSF. Some landlord are tricky and will define pro rata share as Premises RSF divided by Building RSF times 95%. When asked what the 95% is, they say it is the gross-up. In fact, however, it represents a double gross-up. The landlord not only is allowed to gross-up the variable expenses, but he has also grossed-up the tenant’s pro rata share. The following is an example of how this works:

Premises = 50,000 RSFBuilding = 300,000 RSFBuilding occupied = 200,000 RSFBuilding operating costs (grossed-up for occupancy) = $3,000,000

Type of lease = Net lease, there is no offset to expenses.

Normally this would be calculated as follows:

50,000 RSF/300,000 RSF = 16.67% times $3,000,000 = $500,100 owed by the tenant to the landlord.

Under the trick, double gross-up method, the calculation is as follows:

50,000 RSF/(300,000 RSF x 95%) = 17.54% times $3,000,000 = $526,200 owed by the tenant to the landlord.

Decreasing the denominator inversely increases the pro rata share and, in this case, costs the tenant an additional $26,100. Some landlords play tricks with words. Instead of using Building rentable they use Building rented. They define pro rata share as Premises RSF divided by Building rented (notice, not lrentable21) square feet. In the example above, the calculation would be:

21 Rentable and leaseable are interchangeable.

50,000 RSF/200,000 RSF = 25% times $3,000,000 = $750,000 owed by the tenant to the landlord or an additional $249,900 over and above the normal calculation.

To save money on escalations, the definition of pro rata share should be “Premises rentable square feet divided by Building rentable square feet.”

[g]—“Grossing Up”21.1

The “grossing up” practice is not limited to taxes. It applies as well to operating expense escalations. In the latter instance, however, the practice is more defensible. For instance, if a tenant is the only tenant in the building, that tenant is conceivably using 100% of the tenant cleaning services if the landlord is not cleaning vacant space. If the cleaning cost goes up the next year, that tenant should pay for the entire increase of that operating expense if it is still the only tenant in the building. If that sole tenant occupies 50% of the building, the landlord can either double its tenant proportionate share so that the tenant would pay 100% of the increase for the operating expense attributable to the cleaning over the base year, or it could increase the operating expense to a number that would result in approximately a payment as if the building were 100% occupied.

It is easier to adjust the tenant’s proportionate share taking into consideration the common area component (or load factor) with accuracy (if not too complicated with tenants moving in and out of the building) than it is to adjust with accuracy the operating expense that would occur if the building were 100% occupied. In the cleaning scenario, if the building were fully occupied, the expense of the cleaning would be more than double what it was in the base year when the hypothetical tenant was the building’s sole occupant, occupying 50% of the building’s space. This may not hold true of other operating expenses, however. For example, the expense of heating in the winter is significantly less than double the cost if the building is 100% occupied instead of 50% occupied. Body warmth of human beings in the building in the morning and throughout the day causes the heat requirement from the heating equipment to be considerably less.

There are several methods of calculating the gross-up. Whichever method is used, it should be applied consistently to the same categories of expense throughout the lease term. 22 It is also important to determine if the methodology has a sound basis. Tenants should pay careful attention to the relationship of occupancy and resulting operating expense for each type of service. The type of service and the relationship to full occupancy may be different depending on the type of activity.

[h]—Building Occupancy

What is a fully occupied building? The terms “occupancy level” and “leased level” are two different things. Most people consider a fully occupied building to be one that at any time has achieved a 90% leased level. Some buildings may never in their lifetime reach a 90% occupancy level. On the other hand, the building can be 100% leased and not occupied.

Fundamental to the fair application of the base year method is the gross-up concept, also known as extrapolation. A gross-up is an artificial increase of an expense. Landlords should gross-up23

only the variable component of a variable expense. Variable expenses are defined as those costs which vary directly due to tenants’ occupancy. Janitorial, electricity and management fee are examples of variable costs, while landscaping, services relating to the lobby, administration and

21.1 See Example 5 in § 7.09 supra for a typical clause for “grossing up” the tenant’s proportionate share of increases in costs.

22 See § 19.03[4][i] infra for a discussion of calculating the gross-up.23 The terms gross-up, extrapolate and adjust are interchangeable.

security are examples of fixed costs. In the context of operating expenses, under a gross-up provision, if building occupancy is less than 95% (or "fully occupied"), then all categories of operating expenses which are affected by occupancy changes are adjusted to reflect these costs as if building occupancy were 95% or greater. This gives the tenant the cost base of a fully occupied building and protects it from large increases in operating expenses due to increases in building occupancy.

When applied to both the base year and all future years, and correctly calculated, grossing up ensures that the only increases in operating expenses chargeable to the tenant are those attributable to increases in wage rates, utility rates, contract rates and the like, but not occupancy. Expense categories that are typically grossed up include cleaning (tenant-occupied areas only), electrical supplies, utilities, management fees, and possibly such other costs as trash removal, interior window cleaning, building personnel costs and elevator maintenance, depending on the circumstances. In addition, taxes should be based on a fully assessed building.

When limitations on grossing-up or other operating expense concepts are based on either an occupancy or a leasing level, careful attention has to be paid to the particular concept to see that it is such a level can be attained. For example, the authors are aware of a rather large space lease where the landlord is not allowed to increase operating expense escalations over a flat rate per square foot with a small increase per annum not to exceed a certain percentage throughout the term of the lease until such time as the building is 90% or greater occupied by tenants. This limitation has significantly hampered the landlord, since the landlord in that instance expected to be about 90% leased within the first two years, but the odds are that it may not be 90% occupied for quite some time, if ever.

[i]—Calculating the “Gross-Up”

As previously noted, there are different ways to calculate the gross up. The landlord may offer a base year lease, an expense stop lease, a stipulated base year or an office triple net lease. Each one uses its own method of calculation, resulting in different figures for the tenant’s operating expense obligation. There are different reasons to gross-up under the various types of leases. In a base year situation, a gross-up is used to make an equivalent comparison. Whereas, a gross-up of an expense stop, stipulated base amount or office triple net is used to enable the landlord to recover most of its variable component costs.

The important considerations when applying a gross up in a base year lease is consistency and if the correct methodology was implemented. It should be determined if: (1) the correct methodology of grossing-up was used, and (2) it was on a consistent basis from year to year. In an expense stop, stipulated base amount or office triple net, only janitorial, electricity and management fee should be grossed up.

[i]—Base Year Lease

A base year lease is intended to confine the tenant's operating expense obligation to the type of increases experienced by a fully occupied building over a base level of expenses established at the beginning of the lease term consisting of the same type of cost items. Under the base year lease, the total amount of actual expense (grossed-up as applicable) experienced by a building during the initial year (or immediately preceding or following year as designated in the lease) of the tenant's occupancy offsets future years' operating costs (grossed-up as applicable).24 When the base year lease is coupled with a gross-up provision, the tenant only pays for the increase in costs resulting from wage increases, contract increases, etc., and not due to occupancy changes or the addition of extra services. After the base year, the tenant is billed its pro rata share of the

24 “Gross-up” means that the figures are adjusted to reflect a tenant cost based on full occupancy of the building. Full occupancy should be defined in the lease as, for example, 95% or 100% occupancy.

difference between the actual operating costs for that year and the base year operating costs. For example, if base year operating costs totaled $1 million and, in the following year, expenses rose to $1.25 million, a base year tenant would be responsible for its pro rata share of the excess $250,000.

From the tenant's perspective, this is the fairest method of calculating its operating cost obligation.25 The base year methodology is not broken down to dollars-per-rentable square foot, a calculation method which creates rounding errors frequently in the landlord's favor.

Most importantly, the base year expenses may be adjusted in later years to accommodate the cost of new services which were not provided and thus not included during the base year. For instance, if interior landscaping costs arise after the base year due to the addition of a lush, green atrium, those costs can be adjusted to approximate what would have been charged during the base year. Then the result can be added to the base year to provide an offset against interior landscaping costs in future years. This ability to adjust the base year figure means that an equivalent (“apples-to-apples”) comparison of costs can be maintained throughout the lease term. This “apples-to-apples” comparison of every cost element from the base year forward is the heart of the base year concept.

In most cases, tenants want only a 95% gross-up provision instead of a 100% one. The only time a tenant would want a 100% gross-up provision in a base year lease is when the building is more than 95% occupied in the tenant’s base year. The following is a sample gross-up clause that should be used in a base year lease.

If the Building is not at least 95% occupied during all or a portion of any Lease Year, including the Base Year, then Landlord shall make an appropriate adjustment in accordance with industry standards of the Building Operating Costs for each such Lease Year and Base Year to determine what the Building Operating Costs would have been for such year as if the Building had been 95% occupied, and the amount so determined shall be deemed to be the amount of Building Operating Costs for the year. Such adjustment shall be made by Landlord by increasing those costs included in the Building Operating Costs which according to industry practice vary based on the level of occupancy of the Building. Any cost incurred in subsequent years and not included in the Base Year shall be added to and included in the Base Year, grossed up as applicable, as if the cost was incurred and/or paid in the Base Year. In the event any portion of the Building is covered by a warranty at any time during the Base Year, Building Operating Expenses for the Base Year shall be deemed increased by such amount as Landlord would have incurred during the Base Year with respect to the items or matters covered by the subject warranty had such warranty not been in effect at the time during the Base Year.

[ii]—Expense Stop Lease

Under the expense stop lease, the tenant receives an offset against actual operating expenses calculated on a dollars-per-rentable square foot basis. According to this method of calculation, actual expenses are figured on a per rentable square foot (RSF) basis and are reduced or offset by the assigned expense stop amount. The excess is then multiplied by the number of rentable square feet within the tenant's premises to arrive at the tenant's operating expense obligation.

For example, if actual expenses of a 420,000 rentable square foot building totaled $5 million, then the per rentable square foot equivalent would be $11.9047 rounded to $11.91 ($5 million divided by 420,000). If a 100,000 rentable square foot tenant had a $10 expense stop, then its operating expense obligation would total $191,000 (based on the $1.91 difference between the

25 The base year method utilizes actual cost information. In contrast, the expense stop method, which calculates on a dollar-per-rentable square foot basis, may not correlate with actual expenses. See § 19.03[4][i][ii] infra for a discussion of the expense stop method of calculation.

actual expense amount of $11.91 and the assigned expense stop of $10 multiplied by the 100,000 square foot size of the tenant's premises).

This method is much less attractive from the tenant's perspective because the assigned expense stop is often an arbitrary amount which may not be tied to actual expense levels. Since it is expressed in terms of dollars-per-rentable square foot, it necessarily can cause rounding errors which too often accrue to the benefit of the landlord. Unlike the base year lease, once the expense stop has been designated, it is unlikely that it can be changed or adjusted to accommodate the addition of new services in later years. In order to increase a potential tenant's interest in a rental offer, many landlords will propose a lower base rental rate along with an expense stop, and then make up the difference in base rent by keeping the expense stop low. Many unsophisticated tenants have accepted such an offer and are later stunned when the first operating expense bill arrived.

The following is a sample gross-up clause that should be used in an expense stop, stipulated base or office net lease. Again, the tenant should negotiate only a 95% gross-up instead of 100%.

If the Building is not at least 95% occupied during all or a portion of any Lease Year, then Landlord shall make an appropriate adjustment for each Lease Year to determine what the Building Operating Costs would have been for such year as if the Building had been 95% occupied, and the amount so determined shall be deemed to be the amount of Building Operating Costs for the year. Such adjustment shall be made by Landlord by increasing those variable components of such variable costs included in the Building Operating Costs which vary based on the level of occupancy of the Building (i.e., janitorial contract, electricity and management fees).

[iii]—Stipulated Base Amount Lease

A stipulated base amount lease is a hybrid of the base year and expense stop methods of calculating operating expenses. Like an expense stop, it is usually an arbitrary amount which may not be tied to actual conditions. Further, once agreed upon in the lease, it is usually not subject to change or adjustment. However, like a base year, it is expressed as a whole dollar amount and is not broken down into dollars-per-rentable square foot.

For instance, the stipulated base amount assigned to a new lease may be an arbitrary $750,000, although actual expenses for the year totaled $1.2 million. The tenant's operating cost obligation is based on its pro rata share of the difference between actual expenses and the stipulated base amount. If new services are added to the building in later years, no adjustment of the stipulated base amount can be made; it remains fixed, regardless of changes in services, over the entire term of the lease. However, since the stipulated base amount is not susceptible to rounding errors, it is preferred over an expense stop.

[iv]—Office Triple Net Lease

An office triple net lease offers the tenant no offset against operating expenses. Increasingly it is being used by landlords in the office leasing market. Unlike an industrial triple net, services are contracted and expenses are incurred by the landlord, rather than the tenant, and passed through to the tenant for reimbursement. Since there is no expense offset, tenants pay their share of expenses on a dollar-for-dollar basis.

Many tenants can be misled into believing they are receiving a "good deal" because the landlord offers a lower base rental rate in an office triple net lease. If a tenant is not fully aware of the actual cost history (as opposed to projected cost) of the building, tenants are often shocked when the first operating cost statement arrives.

An example illustrates this:

Projected Expenses: Year 1 = $7.00, Year 2 = $8.00 and Year 3 = $9.00

YEAR 1 YEAR 2 YEAR 3 BASE YEAR

Base Rent $20.00 $20.00 $20.00Op Costs $ 0.00 $ 1.00 $ 2.00 Total Rent $20.00 $21.00 $22.00

OFFICE TRIPLE NET

Base Rent $13.00 $13.00 $13.00Op Costs $ 7.00 $ 8.00 $ 9.00 Total Rent $20.00 $21.00 $22.00

But what if the landlord underestimated, and actual costs were $10, $11 and $12 respectively.

YEAR 1 YEAR 2 YEAR 3 BASE YEAR

Base Rent $20.00 $20.00 $20.00Op Costs $ 0.00 $ 1.00 $ 2.00 Total Rent $20.00 $21.00 $22.00

OFFICE TRIPLE NET

Base Rent $13.00 $13.00 $13.00Op Costs $10.00 $11.00 $12.00 Total Rent $23.00 $24.00 $25.00

Under this scenario, the tenant would be paying an extra $3.00/RSF a year!

[j]—Operating Expense Statements

The vehicle for issuing operating expense escalation statements and how to challenge and review them is subject to wide disagreement among practitioners. A fair approach is that operating expenses should be reflected consistently from year to year and should be based upon generally accepted accounting practices as applied by certified public accountants practicing generally in the first class building market in a particular locale. The expense statements should be in sufficient line item detail so as to provide a tenant with relevant information. They should be in that same detail and prepared the same way from year to year.

There should be no time limit on the right of a tenant to review the expenses or to correct errors, nor should there be a limitation on the landlord’s right to correct previously issued statements or to issue statements when it has failed to so do. The landlord should have the right to collect operating expense escalations and reasonable estimated installments monthly in arrears and be able to adjust for unanticipated significant increases, but not by more than three percent over the previous year’s line item amount. Landlords and tenants should reconcile estimated payments within thirty days after the end of any lease year. Any underpayments or overpayments should be recouped with interest carried until paid.

It is recommended that disputes evolving out of operating expense or tax escalations be decided by arbitrators with at least fifteen years experience in the management of commercial real property. Litigation should be avoided. A judge typically has no background on the custom, practice and sophisticated standards of the commercial real estate field, leaving a lot of room for imprecision in determining the intention of the parties in litigation. Arbitrators, on the other hand, work with these types of situations all the time and are better able to interpret the intent of the contract and apply it to what is the custom and practice in the area based on the terms of art used in the lease. It also saves a lot of time and a lot of money.

[5]—Tenant's Right to Audit

One of the rights seen with greater frequency in an office lease is the right of a tenant to audit or review the landlord's records to determine accurately the actual operating expenses the landlord has legitimately incurred during the lease term.26 It is a good idea for a tenant with a right to audit the landlord’s books and records relating to operating expenses to audit the first full year of operating expenses. It is assure that the landlord maintains the records and enables the tenant to determine which items were included and excluded in the landlord’s calculations.26.1

This will establish up front that the calculations were done properly. Additionally, the tenant will

26 Impediments to auditing escalation statements are currently under review by the Office Leasing Subcommittee of the Commercial Leasing Committee of the ABA, Alan M. DiSciullo, Chairman.

show the landlord that he means business and intends to assert his rights diligently. Thus, the landlord “will be that much more careful in making sure that the operating expenses are carefully and correctly computed and compiled.”26.2

Note that the expense that the landlord is permitted to pass through to a tenant may be spelled out in the lease very broadly. For example, the lease may simply state that “the Tenant shall reimburse the Landlord for its proportionate share of operating expenses” with these expenses spelled out in greater detail elsewhere in the contract. Operating expenses are broadly construed to mean an Owner’s actual out-of-pocket expenses related to its operation, repair and replacement of component parts, and management of the building. They specifically cover wages and salaries (including fringe benefits) to employees below the executive level; independent contractors hired for security, repairs, maintenance, cleaning and other building related services; electricity supplied to the common areas of the building, fuel, steam, water and other utilities used at the building; insurance expenses, including “All Risk” coverage, if available and public and general liability insurance; costs of tools, supplies and services; real estate taxes; alterations expenses and improvements necessary to comply with governmental regulations; general accounting and legal fees; and other costs and expenses related to the owner’s operation of the building. The battle over operating expenses is often the second most contested negotiation after rent.27 Generally, the criteria for including a cost as an operating expense is that it is related to the tenants’ use and occupancy of the building. By contrast, the owner’s organizational expenses, for example, executive compensation, marketing and general administration expenses should be excluded.

The right to audit should not be abused. The entitlement to do an audit and the remedies if an error is found should be clearly spelled out in the lease. Some tenants will only claim that they believe an error exists and seek to conduct an audit when they are in default under their lease. 27.2

A savvy landlord will insist that an audit may only be conducted if the tenant is in compliance with the lease—not in default of any of its provisions. The landlord should insist that “any defaults be cured and that all payments that have been billed for under the Base Rent provision or the operating expense provision have been paid. The landlord should be willing to agree that any contested payments may be made under protest pending the outcome of arbitration, but they do not want a tenant to be able to withhold the payment of rent or operating expenses pending the completion of an audit”27.3 or resolution of a dispute. Some tenants will also claim a right to terminate if an error is found in the landlord’s calculations. Landlords should limit the tenant’s remedy to reimbursement of the overpayment plus interest. It would also be reasonable for the tenant to insist that the landlord pay for the cost of the audit and any attorney’s fees. In such a case, the landlord should insist that those fees only be payable if the audit discovers an error exceeding a certain amount or percentage of operating expenses. That is fair since the calculations are complex and it is reasonable for there to be discrepancies or small errors. To avoid controversy, all of these conditions should be spelled out in the lease. Timing is important

26.1 Meyer, “Operating Expenses and CAM/Hidden Agendas and Corporate Guerrilla Warfare Tactics,” in Meyer, Rusche, Sarasek & Wood, 1 Negotiating Commercial Leases: How Owners & Corporate Occupants Can Avoid Costly Errors No. 2941, p.505 (PLI/Real Estate Fall 2004).

26.2 Id.27 A New York State decision has taken concealment of operating expenses to a different level by imposing the

requirements and penalties of N.Y. Gen. Bus. Law § 349, the State's Consumer Protection Law, upon a landlord who overcharged a tenant in operating expense during a lease term. 99 Realty Co. v. Wall Street Transport Corp., The New York Law Journal, April 20, 1994 (Cir. Ct. N.Y. Co. 1994).

27.2 Id. See also, Henning, “Comments on Operating Expenses and Tenant Audit Rights,” in Meyer, Rusche, Sarasek & Wood, 1 Negotiating Commercial Leases: How Owners & Corporate Occupants Can Avoid Costly Errors No. 2941, p.485 (PLI/Real Estate Fall 2004).

27.3 Henning, “Comments on Operating Expenses and Tenant Audit Rights,” in Meyer, Rusche, Sarasek & Wood, 1 Negotiating Commercial Leases: How Owners & Corporate Occupants Can Avoid Costly Errors No. 2941, p.503 (PLI/Real Estate Fall 2004).

too. The tenant’s audit right should be limited to a set time period. At some point, the landlord should be able to close his books and know that the calculations are accepted as final.

What if the lease does not address whether the tenant has the right to audit? Contract law recognizes the implied covenant of good faith and fair dealings. It is this covenant that allows a tenant to audit its landlord even in the absence of an expressly stated audit provision. What entity would pay a bill not understanding what it was being billed? When the lease is silent as to how many years a tenant can audit, the tenant’s audit right would normally be limited to the statute of limitations for that state.

Although the failure of a lease to address a tenant's right to audit the landlord's operating expense records is not necessarily grounds for denial of such a right, it is certainly helpful and advisable to establish the right, as well as the ground rules for such an audit, in the lease document.

Due to the difficulty and complexity in conducting these audits, a lease auditing industry has developed with several highly qualified auditing firms governing the market with their expertise in this limited field.

When drafting a provision addressing lease audit rights, it is important to cover the basic grounds.28 For example, who will conduct the audit, when and where will it be performed, and what may be audited. Consider whether someone who was not a party to the lease negotiation will be able to administer the lease such that the intent of the parties is adhered to throughout the duration of the lease term.

Who Will Conduct the Audit? The lease clause should address whom the tenant might choose to conduct the audit. Tenants or their representatives should have the right to conduct an audit. Although some rules must be set (i.e., reasonable notice, during normal business hours, etc.), the right itself should not be restricted. Some landlords will attempt to restrict the tenant to use a certified public accountant only, often insisting that the CPA be employed by a national accounting firm. This restriction denies the tenant the right to use one of its own personnel (such as a facility manager or accountant). It also requires the tenant to commit to spending unexpected and usually unbudgeted funds to employ the CPA without any certainty that overcharges exist which will pay for the cost of the audit. The tenant should insist on the right to verify operating expense charges via an audit, as well as the right to decide who will conduct the audit on its behalf. In some states the laws are changing and CPA firms may now work on a contingency basis as long as they are “non- attesting.” This defeats most landlords’ unspoken objection in attempting to insist on a CPA as the auditor.

When Shall the Audit Be Performed? The lease clause should address timing, frequency and duration. It should describe the time frames and mechanisms to request an examination, perform the review, dispute the charges and settle any claims.

Some landlords get tenants to agree that if the tenant does not notify the landlord that it intends to audit within thirty days of receipt of the reconciliation statement, then the reconciliation is considered final and binding on both parties. This type of notification is very burdensome on the tenant and should never be agreed to. Instead, a tenant should have the right to notify the landlord of its intent to audit prior to the delivery of the following year’s reconciliation. The tenant should establish its right to audit prior years’ operating expense records and base year records, if applicable. It may be more efficient to audit once every three years for the entire three year period rather than once annually. Although the landlord wants

28 Silver, CPA, “Avoiding Unnecessary Billing Disputes” (Deloitte & Touche, LLP Aug. 11, 1998).

closure, it is ultimately more convenient for the landlord to deal with the tenant’s auditor once every three years instead of every year. The tenant should resist any effort to limit the duration of its access to the landlord’s books and records (e.g., one eight hour day for a two year audit) because the time required to conduct the audit depends on the condition of the books and records as well as the level of the landlord’s cooperation. The tenant should establish in the lease document its right to photocopy operating expense records examined during the course of an audit.

What May Be Audited? The lease should be clear as to what will be provided for review. The landlord will not want to have all its papers subject to review. Only the documents necessary to the audit should be available. A lease audit should not be an opportunity to conduct a fishing expedition. Nor should it be conducted in a way that unnecessarily interferes with the business of the party being audited.

Where Shall the Audit Take Place? The lease should specify where the audit will be conducted (i.e., at the building or at the landlord’s home offices). Timing and location are important. Again, the audit should not be unnecessarily disruptive to the business of the party being audited.29

The tenant should seek reimbursement from the landlord of the costs of the audit if the landlord’s errors exceed 2-5% of the amount of operating expenses paid by the tenant during the period of time covered by the audit. To protect the landlord, additional language should state the amount paid will not exceed the amount overbilled. The tenant should also consider adding language that will allow disputes with the landlord to be resolve through arbitration instead of litigation, the more costly and lengthy process. Since the financial determinations involved are quite complex, arbitration, using an arbitrator experienced in real estate leasing issues and, especially knowledgeable about operating expenses and audit procedures, would be the best person to decide the case.29.1 Having such an experienced arbitrator will reduce the need for calling experts to testify and the arbitrator’s knowledge of the industry practices and customs should result in a fair determination. Allowing the case to go to court could be costly and the judge usually will not be as astute or experienced as the arbitrator when it comes to considering the issues and resolving the case.

Other provisions that will be utilized and scrutinized repeatedly throughout the lease term include: gross-up requirements, inclusions and exclusions, caps on increases, special definitions, and so on.30 Untangling and calculating the operating expense passthroughs can be a monumental challenge, particularly when it normally falls squarely on the shoulders of someone who was not a party to the negotiations. For this reason, it is most critical that the escalation clauses are clearly drafted, with examples and estimates wherever possible.

Landlords also may want to insist on a confidentiality agreement with respect to discrepancies discovered in an audit.30.1 Tenants have been known to reveal errors discovered through an audit

29 Id.29.1 Henning, “Comments on Operating Expenses and Tenant Audit Rights,” in Meyer, Rusche, Sarasek &

Wood, 1 Negotiating Commercial Leases: How Owners & Corporate Occupants Can Avoid Costly Errors No. 2941, p.506 (PLI/Real Estate Fall 2004).

30 Id. For further treatment of the subject matter discussed in this paragraph, see Silver, N.15 supra.30.1 See also, Henning, “Comments on Operating Expenses and Tenant Audit Rights,” in Meyer, Rusche, Sarasek

& Wood, 1 Negotiating Commercial Leases: How Owners & Corporate Occupants Can Avoid Costly Errors No. 2941, p.502 (PLI/Real Estate Fall 2004).

to other tenants in the building resulting in a flood of audit requests and other problems for the landlord. Tenants have used the threat of revealing this information to other tenants as a means of leverage to force landlords to settle the audit dispute for even higher amounts than they would otherwise be entitled to recover.30.2

The following are sample audit provisions which should be incorporated into a lease. The first one takes a pro-tenant perspective. The second audit provision is represents a negotiated perspective, fairer to both parties.

AUDIT BY TENANT

(Pro-Tenant Perspective)

(a) Landlord shall provide to Tenant in substantial detail each year the calculations performed to determine the Building Operating Costs in accordance with the applicable provisions of the Lease. Landlord shall show by account the total operating costs for the Building and all adjustments corresponding to the requirements as set forth herein. Landlord shall provide in reasonable detail its calculation of Tenant's pro rata share of Building Operating Costs by setting forth the ratio of Premises rentable square feet to Building rentable square feet. Landlord shall also provide the average Building occupancy for such year.

(b) Tenant shall have the right, at its own cost and expense (without requirement that Tenant pay Landlord’s costs of complying with this provision), to audit or inspect Landlord's detailed records each year with respect to Building Operating Costs, as well as all other additional rent payable by Tenant pursuant to the Lease for any Lease Year (not to exceed one time per year). Landlord shall utilize, and cause to be utilized, accounting records and procedures for each Lease Year conforming to generally accepted accounting principles, consistently applied, with respect to all of the Building Operating Costs for such Lease Year, including without limitation, all payments for Building Operating Costs, to facilitate Tenant’s audit or inspection. Pursuant to the foregoing, Landlord shall be obligated to keep such records for all Lease Years associated with this Lease until two (2) years following the termination of the Lease, including any Lease Year prior to Landlord’s ownership of the Building. Within fifteen (15) business days of Tenant’s written notice to Landlord of its desire to review Landlord’s books and records, Landlord shall forward to Tenant or Tenant’s authorized representative, full and complete copies of the Building’s general ledger, all escalation worksheets and their supporting documentation for each Lease Year being reviewed. General ledgers shall be the type printed from Landlord’s particular computerized accounting system reflecting: (1) the full year’s listing of expenses with such expenses of course listed under its applicable account (which account has its name and number clearly specified) and with each account’s expenses summarized via account balances, (2) for each expense, the date of the expense, the payee/vendor, the amount (including debits and credits), and the transaction description (reflecting an explanation of what the expense was for), and (3) the various income accounts indicating the income items which were received and applied during the year. If after the review of such documentation, Tenant desires to perform a complete audit of Landlord’s books and records, Tenant shall give Landlord not less than ten (10) business days prior written notice of its intention to conduct any such audit. Landlord shall cooperate with Tenant during the course of such audit, making all pertinent records available to Tenant, Tenant’s employees and agents for inspection during normal business hours in Landlord's Building management office. Landlord agrees to make such personnel available to Tenant as is reasonably necessary for Tenant, Tenant's employees and agents, to conduct such audit. Tenant, Tenant's employees and agents, shall be entitled to make photostatic copies of such records,

30.2 Id.

provided Tenant bears the expense of such copying, and further provided that Tenant keeps such copies in a confidential manner and does not show or distribute such copies to any other third party.

(c) The results of such audit, as reasonably determined by both parties, shall be binding upon Landlord and Tenant. If such audit discloses that the amount paid by Tenant as Tenant's Share of Building Operating Costs, or of other additional rental payable pursuant to the Lease, has been overstated by more than three percent (3%), then, in addition to immediately repaying such overpayment and associated interest to Tenant, Landlord shall also pay the costs incurred by Tenant in connection with such audit (which costs shall not exceed the amount repaid or credited to Tenant).

AUDIT BY TENANT

(Fairer, Negotiated Perspective)

(a) Landlord shall provide to Tenant in substantial detail each year the calculations performed to determine the Building Operating Costs in accordance with the applicable provisions of the Lease. Landlord shall show by account the total operating costs for the Building and all adjustments corresponding to the requirements as set forth herein. Landlord shall provide in reasonable detail its calculation of Tenant's pro rata share of Building Operating Costs by setting forth the ratio of Premises rentable square feet to Building rentable square feet. Landlord shall also provide the average Building occupancy for such year.

(b) Tenant shall have the right, at its own cost and expense (without requirement that Tenant pay Landlord’s costs of complying with this provision), to audit or inspect Landlord's detailed records each year with respect to Building Operating Costs, as well as all other additional rent payable by Tenant pursuant to the Lease for any Lease Year (not to exceed one time per year). Landlord shall utilize, and cause to be utilized, accounting records and procedures for each Lease Year conforming to generally accepted accounting principles, consistently applied, with respect to all of the Building Operating Costs for such Lease Year, including without limitation, all payments for Building Operating Costs, to facilitate Tenant’s audit or inspection. Pursuant to the foregoing, Landlord shall be obligated to keep such records for all Lease Years associated with this Lease until two (2) years following the termination of the Lease. Tenant shall give Landlord not less than ten (10) business days prior written notice of its intention to conduct any such audit. Landlord shall cooperate with Tenant during the course of such audit, making all pertinent records available to Tenant, Tenant’s employees and agents for inspection during normal business hours in Landlord's Building management office. Landlord agrees to make such personnel available to Tenant as is reasonably necessary for Tenant, Tenant's employees and agents, to conduct such audit. Tenant, Tenant's employees and agents, shall be entitled to make photostatic copies of such records, provided Tenant bears the expense of such copying, and further provided that Tenant keeps such copies in a confidential manner and does not show or distribute such copies to any other third party.

(c) The results of such audit, as reasonably determined by both parties, shall be binding upon Landlord and Tenant. If such audit discloses that the amount paid by Tenant as Tenant's Share of Building Operating Costs, or of other additional rental payable pursuant to the Lease, has been overstated by more than three percent (3%), then, in addition to immediately repaying such overpayment and associated interest to Tenant, Landlord shall also pay the costs incurred by Tenant in connection with such audit (which costs shall not exceed the amount repaid or credited to Tenant).

[a]—Audit Procedures

A tenant's rights to audit the landlord's records (commonly referred to as a lease audit) are usually granted by contract. Office building operating expenses typically range between $5 and $13 per square foot per year in most United States markets. In many cities, these expenses are higher. The leases where audit rights may be necessary are usually the modified gross or net leases of varying degrees. The truly full-service gross or industrial triple net leases without any CAM (common area maintenance) charges fall outside of the auditing ambit since the base rent is the only charge to the tenant. In full-service gross leases, the base rent includes all additional charges, utilities and other expenses associated with a commercial lease. Alternatively, in the industrial triple net lease, all these expenses are assumed directly by the tenant. The usual lease ripe for audit is the one in which the landlord passes through increases in taxes or operating expenses over a stop or stipulated base amount or base year. The expense the landlord is permitted to pass through must be spelled out in the lease. It may merely state “the Tenant shall reimburse the Landlord for its proportionate share of operating expenses” with these expenses explained in greater detail elsewhere in the contract.

The carefully crafted provision should grant the tenant the right to conduct an audit as well as clarify the implementation of the audit process. The clause should address the time period for the initial notice, the phase and time of the audit, the parties permitted to conduct the audit (e.g., the tenant or its agents), which party will bear the costs of the audit and the manner of reinforcement if an overcharge is found.

A legal issue found in any audit is the extent that the applicable statute of limitations may permit a tenant to go back in time in its examination. In particular, the statutes differ in their handling of the treatment of the effect of an executory contract,31 causing considerable lack of continuity in the parties' approach to the audit and the entire auditing process. For instance, when a portion of the lease may still be executory during part of the limitations period, it may result in the entire lease being subject to the auditing process.32

Thus, without limiting language in a lease, a landlord may not know when actions occurring during an earlier part of the lease (even if it is twenty or thirty years ago) may be subject to an audit because the last part of the lease falls within the statute of limitations period. At the same time, a tenant may still be subject to receiving billings from periods long ago, simply because the latter part of the lease (again, only a short period) falls within the limitations period.

Overall, more lease auditing issues are developing as a greater number of expenses are more closely scrutinized and challenged. However, having the right to audit in the lease is just the beginning. Gathering all the data necessary to check the escalation figures is the real challenge.

[b]—The Standstill Agreement

The following Standstill Agreement is intended to stay or suspend the proceedings for a lease audit action while the parties attempt to resolve their differences without either party losing its legal rights, particularly the rights to bring an action within a specific statute of limitations. Statutory limits differ from state to state. Whereas, in a state like New York, the statute acts as an absolute cut off after the six year period, states like California have “springing” statutes, that is, they allow a party to go back through the entire contract, even decades if any part of the contract falls within the statutory period. Thus, even if only a year or less of the contract is within the applicable statutory period, the complainants can go back to the beginning of the contract with their claim.

31 An executory contract is one in which there are still remaining obligations, such as rent payments, term, repairs.

32 For an excellent treatment of this entire topic, see Hellmuth, Lease Audits: The Essential Guide, (Statelaw Guides, Inc. 1994).

STANDSTILL AGREEMENT

THIS AGREEMENT made on this 15th day of October, 2001 by and between ABC CORPORATION, (“Tenant”), a New York corporation having its headquarters at ____________________, New York, NY and BIG BANKING CORPORATION (“Landlord”), a New York banking company having its headquarters at ___________________, New York, NY _____________.

RECITALS

WHEREAS, the parties have entered into a Lease dated as of June 7, 2000 that has been amended from time to time thereafter (collectively the “Lease”) for property more specifically described in the Lease located at _____________________, New York, NY; and

WHEREAS, Tenant has occupied the Premises from the inception of the original Term in March, 2001 and continues to occupy the Premises under the Lease, as renewed, for a Term through March 31, 2015; and

WHEREAS, there presently is a dispute as to the accuracy of the billings for Rent and Additional Rent under the Lease; and

WHEREAS, Tenant and Landlord agree that it is in their mutual best interests to resolve any disputes arising under the Lease privately and without any litigation or other formal dispute resolution proceedings.

NOW THEREFORE, in consideration of the mutual promises and the terms and conditions of this Agreement, which the parties agree constitute full and valuable consideration for this Agreement, the parties agree as follows:

1. In anticipation of entering into negotiations regarding such disputes, Tenant and Landlord agree that neither will commence any action or proceeding respecting the Lease prior to the earlier of: (a) December 15, 2001 or (b) ten (10) days after delivering written notice to the opposing party that the notifying party has determined that further negotiations would not be productive and that the notifying party intends to resolve such disputes by some other means (the “Expiration Date”). Tenant's agreement to forebear instituting litigation prior to the Expiration Date is predicated upon the assumption that a meeting can be arranged with Landlord's representatives to occur on or before October 25t, 2001.

2. Tenant and Landlord further agree that any applicable statute of limitations respecting any claim under the Lease which either party might assert against the other as of the date hereof is tolled until the later of: (a) the Expiration Date; or (b) such other specific date as the parties may hereafter agree in writing. This agreement to toll the statute of limitations does not apply to any such claim barred by an applicable limitations period which has expired prior to the date of this letter, and shall preclude the assertion to any future tribunal that by reason of conduct of either Tenant or Landlord is inequitable to permit a party to impose the defense of the statute of limitations with respect to any such claim other than such assertion based on breach of fiduciary duty when such assertion does not require a showing of bad faith.

ENTERED INTO on the date first stated above by the authorized representatives of the parties to this Agreement.

BIG BANKING CORPORATION ABC CORPORATION(“Landlord”) (“Tenant”)By: ___________________ By:___________________

A standstill agreement allows the parties to analyze the merits of their claim and their defenses without having to go to the next step, litigation. It gives the parties time to resolve disputes before matters become more complex. Once litigation begins, it is difficult to negotiate a settlement until after the early stages of litigation, such as filing the complaint, answer and early discovery or legal investigation. The standstill agreement allows the parties to keep their legal rights “frozen at a point in time,” while discussing the merits of the audit claim without the statutory limitations period running. This breathing period from litigation enables parties to discuss the issues raised by the audit and possibly resolve them without resorting to formal dispute resolution mechanisms.

In this example, the parties have agreed to give each other a four month breathing or Standstill period before instituting litigation. This period presumes that the parties will meet regularly during the standstill period with a set meeting date of October 25th. There is a short fuse added to the agreement which gives either party a right to cancel the agreement upon ten days notice to the other that further negotiations will not, in their opinion, be fruitful in bringing about a negotiated settlement.

[c]—Interpreting the Agreement

A number of issues arise when conducting a lease audit. In analyzing these issues, the first place to look for guidance is the lease. The lease clauses should be examined and interpreted. If the clauses are clear, it should not be necessary to bring in the persons who drafted and negotiated the lease to provide interpretation and explanation of the clause and the parties’ intentions. However, when the lease terms are ambiguous or difficult to interpret, the parol evidence rule comes into play. The individuals who participated in the construction of the provisions will be needed to testify as to their meaning. This can be problematic in the case of an older lease, since the original participants may not be available, may not have accurate recollection, or may not even be alive.

In the late 1990s, the authors were involved in an audit of a lease that was drafted in the early 1970s. Of the four original negotiators and lawyers involved with the lease, only one party was still alive and, after so many years, he did not remember the particulars of the deal or the complicated clauses.

Various causes of action may exist if a problem is discovered, for example, for: breach of contract, fraud, negligent misrepresentation, negligence, conversion, or restitution and unjust enrichment. One or the other party may seek declaratory judgment that the lease should be interpreted as he or she feels is just or request a reformation of the contract. Other issues involve the running or tolling of the statute of limitations, applicability of the estoppel doctrine, existence of a waiver, choice of the forum for dispute resolution, whether the matter will be resolved in court, by arbitration, mediation or some other alternative dispute resolution methods, such as judicial alternative mediation services.

[i]—Escalations

Escalation clauses are interpreted in accordance with the intentions of the parties to a commercial lease. The meaning is “gleaned” from a consistent period of action by the parties with respect to the particular clause or clauses.33 In one case, the court found that “[a] mutual

33 Kenilworth Realty Trust v. Bankers Trust Company, 112 Misc.2d 523,447 N.Y.S.2d 210 (1982)

understanding rooted in 25 years of conduct is truly convincing evidence of what the original lessor and the defendant intended.”34

Lease clauses may give sophisticated parties who have negotiated an agreement at arm's length the “benefit of the bargain” regardless of the economic consequences. For example, in one case, the court addressed a complaint that an escalation clause was “unconscionable” since rent escalations were measured by a common industry-wide criterion, the RAB labor rate, instead of the actual labor costs of the building.35 First the court considered the claim of ambiguity and stated that “a lease is subject to the rules of construction applicable to any other agreement.”36

The lease had been entered into at arm's length and, ultimately, on terms which resulted from “suggestions and counter suggestions” and negotiations by two sophisticated parties, each attempting to persuade the other. The language of the clause was “largely a mathematical formula to be applied on stated contingencies.” Moreover, the court noted that it was not a novel provision, but one commonly found in New York City commercial leases.37

The court further noted that there was no requirement in the lease that rent escalations be measured by actual costs as opposed to common industry-wide standards chosen by the parties—either knowingly or by adoption of an extraneous schedule. Simple language, as the court noted, in the agreement served that purpose and actual wages, in this instance, paid to building employees were not to be considered unless a collective bargaining agreement was not in effect.

The court dealt with the issue of unconscionability by stating that the parties freely assumed the risk that occurred in this case and the possibility of a large increase in the RAB labor rate. The parties understood or should have understood the risks involved when they entered into the contract.

In a more recent case, a New York court found “no ambiguity in the escalation clauses in the parties' original lease.”38 Moreover, the court looked to the course of conduct of the parties for over a decade and observed that the “plaintiff's consistent payment for close to a decade of commercial rent charges on a 'compounded' basis with the inclusion of calculations under an escalation clause derived from the Porter's Wage Index under the original lease, the parties' renegotiation of the same escalation clauses for a renewal period and the plaintiff's failure to challenge a subsequent compounding of rents under the clause for such a long period of time” made it clear to the court that the plaintiff was estopped—or legally prevented—from raising the issue of the unfairness or inequity of the clause. The court dismissed the plaintiff's claim since the parties' practical construction comported with the plain meaning of the escalation clause and the plaintiff's long term acquiescence to defendant’s interpretation of the clauses. The court further noted that “although the result of this construction clause is economically harsh, parties are free to make their own contracts, and courts do not serve as business arbiters between parties in approximately equal stances.”39

". . . for 25 years, everyone involved with the lease—i.e., every successive owner as well as the defendant tenant—operated on the predicate that paragraph 46 provided an aggregate cumulative Cap over rent paid in the first year. Such an unbroken history of practical construction provides its own telling definition of what paragraph 46 means."

34 Id. See also, Reltron Corp. v. Voxakis Enterprises, Inc., 57 A.D.2d 134, 395 N.Y.S.2d 276 (1977); Refrigeration for Science, Inc. v. Deacon Realty Corp., 70 Misc.2d 500, 334 N.Y.S.2d 418 (1972); 3 Warren's

Weed, New York Real Property, Leases and Lettings § 10.02 (19__); 4 Williston, Contracts § 623 (3d ed. 19_).35 George Backer Management Corp. v. Acme Quilting Co., 46 N.Y.2d 211, 413 N.Y.S.2d 135 (1978).36 Id. Farrell Lines, Inc. v. New York, 30 N.Y.2d 76, 82, 330 N.Y.S.2d 358, 377 (1972).37 Id., citing Romance Bridals v. Broadway Co., New York Law Journal, p.6, col. 3 (Jan 27, 1976).38 CBS, Inc. v. P.A. Building Co., 200 A.D.2d, 606 N.Y.S.2d 718 (1994).39 Id. See George Backer Management Corp. v. Acme Quilting Co., 46 NY 2d 211, 219, 413 N.Y.S.2d 135, 385

N.E.2d 1062 (1978). See discussion of estoppel in § 19.03[5][c][ii] infra.

Courts have consistently held that they will not rewrite part of an agreement that is clear and unambiguous simply because a party's expectation of the bargain did not materialize due to a change in economic circumstances.40 The courts will, however, examine the clause in question, look to see if it can be read clearly on its terms and then in context with the other lease terms. Then the courts will look to see if the intent or subsequent conduct of the parties was contrary to the lease terms, if there was any ambiguity indicated by the parties conduct, or, conversely, whether subsequent conduct did, indeed, affirm the initial interpretation of the clause. Courts have consistently upheld clauses despite the harshness of their terms or results on the premise that the parties are (ostensibly) on an equal commercial footing and have a clear and complete understanding of the contractual terms even if the terms make reference to seemingly oblique stand alone agreement, standards (such as RAB or Porter's Wage Index) or side agreements. What the parties have negotiated and agreed to, even if such an understanding is not readily discovered on the first or even second or third glances, is what the courts will uphold regardless of the economic ramifications for either party.

On the other hand, once the courts are comfortable that an escalation clause was intended only to pass through a proportionate share of a landlord's actual increased expenses, they will strike aggressively at a landlord's attempt to turn an escalation clause into a windfall profit center.41

[ii]—Estoppel and Conclusivity Clauses

Tenants may be prevented from bringing a claim, even if it is within the applicable statute of limitations, if the parties have engaged in a course of conduct over the years in handling the disputed rent escalation that affirms or supports the defendant's interpretation of the clause. A theory related to the estoppel argument is the tenant's failure to object soon enough after receiving an erroneous escalation notice and the lease has a short “conclusivity” clause. Such a clause, for example, would give the tenant thirty or sixty days after receiving a bill to object, otherwise it “deems” the bill to be accurate and the tenant is prevented from later disputing its accuracy, barring outright fraud or intentional misrepresentation.42

40 Wallace v. 600 Partners Co., 205 A.D.2d 202, 618 N.Y.S.2d 298 (1994), aff'd 86 N.Y.2d 543 (1995); North Fork Bank & Trust Co. v. Romet Corp., 192 A.D.2d 591, 596 N.Y.S.2d 449, 450 (1993); Slamow v. Delcol, 174 A.D.2d 725, 726, 571 N.Y.S.2d 335, 336 (1991), aff'd 79 N.Y.2d 1016, 584 N.Y.S.2d 424 (1992); Morlee Sales Corp. v. Manufacturers Trust Co. N.Y.2d 16, 19, 210 N.Y.S.2d 516, 519 (1961).

41 See, e.g., 1100 Avenue of the Americas Associates v. Bryant Imports, 161 Misc.2d 582, 616 N.Y.S.2d 848 (N.Y. App. Term 1994), which involved the interpretation of a tax escalation clause agreed to by the respondent tenant which passed through the tenant's proportionate share of taxes attributable to the tenant's share of the property. The tenant's refusal to pay stemmed from its discovery that the landlord had subsequently entered into a net lease with another tenant in which that tenant was obligated to pay the landlord for all of the real estate taxes on the property, so that the landlord would receive as additional rent from its tenants more than the taxes it was obligated to pay on the property. The court struck hard against the landlord since the primary intention of the additional rent clause was to keep the landlord from having to pay any real estate taxes on the property, not to give him a windfall. See also, Fairfax Co. v. Whelan Drug Co., 105 A.D.2d 667, 481 N.Y.S.2d 366 (1984), cited favorably in 1100 Avenue of the Americas Associates v. Bryant Imports, 161 Misc.2d 582, 616 N.Y.S.2d 848 (N.Y. App. Term 1994) (landlord attempted to impose additional rent under a tax escalation clause despite the fact that he was receiving a tax abatement under Section J51-2.5 of the Administrative Code of the City of New York; court found that it would be inequitable to allow an owner to collect a tax escalation pass through without having actually paid the taxes in the first instance).

42 See Silverstein Properties v. Paine Webber Jackson & Curtis Inc., 65 N.Y.2d 785, 493 N.Y.S.2d 110 (1985). There the court was faced with a situation where the tenant, a major national investment banking and stock brokerage company, was disputing the correctness of escalation statements it had received for one of its New York City administrative and headquarters sites. The agreement contained a conclusivity clause limiting the tenant's time to dispute a bill. According to that clause, failure to object to the bill within the designated time meant that the tenant could not later dispute the amount. The court found against the tenant, holding that such conclusivity clauses will be upheld and become the "final determination between Landlord and Tenant of the real estate taxes and Expenses for the periods represented . . ." with the tenant being obligated under the lease "[to]give a written notice

The danger with a conclusivity clause is that it will most likely be upheld under the same contractual rules of construction already discussed and yet it will act as a severe curtailment of a tenant's statutory rights in states where the statute of limitations may run for four, six or even more years from the date of incident or rendering of the erroneous bill and the tenant would otherwise have had the advantage of a “springing” statute. As previously explained, the “springing” statute allows the tenant to reach back beyond the strict statutory period in the lease as long as any part of the lease is still “executory” or viable during the stated statutory period.43

Tenants usually will agree to a one or two year conclusivity period as a way of closing a negotiation point and often obtain a concession from the landlord that the landlord will not rebill back beyond a mutual conclusivity point if it discovers unbilled expenses that reach beyond the agreed upon stop period.

The courts have frequently estopped plaintiff-tenants from disputing the accuracy of statements when they have failed to give such timely notice to the latter. Estoppel may apply in the case of tenant's inaction or silence in the case of tenant's positive words or deeds. The prima facie estoppel case arises from: (1) a duty to speak; (2) a failure to speak; and (3) damages to another party directly due to this silence.44

A landlord may raise, as an affirmative defense, that despite the clearly unauthorized calculation of additional rent, a tenant is deemed to have ratified the additional rent calculations by failing to object to them. It has been held that a tenant is deemed to have ratified the calculations by failing to object to them upon receipt of the statements on which the miscalculated additional rent was reflected.45 Nevertheless, the Second Circuit has indicated that even though it found ratification through untimely objection on the record before it, its decision “did not foreclose the possibility that [the party asserting ratification] may be estopped from raising a defense based on the written notice clause if [that party's] own assurances or deceptive acts forestall a customer's filing of the required written notice.”46 According to that court, an estoppel would be appropriately invoked where a landlord wrongfully, but unintentionally, calculated additional rent owing to its economic advantage, but never disclosed to a tenant that it was calculating such additional rent other than pursuant to the Lease.

For silence to result in estoppel, it must amount to bad faith, be of such a terrible nature to induce the other party to alter its position, and it would be unconscionable to permit the person remaining silent to enforce its rights.47 The person asserting estoppel must show it: (1) lacked knowledge of the true facts; (2) relied on the conduct of the party to be estopped; and (3) prejudicially changed its position in reliance on that party's conduct.48

[d]—Various Causes of Action

[i]—Breach of Contract

A tenant may bring a cause of action against a landlord for breach of contract.49 In a number of states, for example, New York, contracts contain an implied duty of good faith dealing among

to Landlord that it disputes their accuracy or their appropriateness . . ." "within Thirty (30) days" after such bills are furnished.

43 "Springing" statutes are discussed in § 19.03[5][b] supra.44 La Porto v. Philmont, 39 N.Y.2d 7, 382 N.Y.S.2d 703 (1976).45 See, e.g., The DBL Liquidating Trust v. Clarkson Construction Co., 157 B.R. 539 (S.D.N.Y. 1993).46 Modern Settings, Inc. v. Prudential-Bache Securities, Inc., 936 F.2d 640, 646 (2d Cir. 1991).47 Rainbow Commercial Alliance, Inc. v. Licciardi, 89 Misc.2d 841, 393 N.Y.S.2d 140 (1976).48 Airco Alloys v. Niagara Mohawk Power, 76 A.D.2d 68, N.Y.S.2d 179 (1980).49 See, e.g., BWA Corp. v. Alltrans Express U.S.A., Inc., No. 23883, slip op (N.Y. App. Div. Aug. 15, 1985).

the parties so as to effect their intentions in entering the contractual relationship.50 Specifically, a landlord may have breached a implied condition of its contract with a tenant in miscalculating amounts owing under the lease and in overcharging the tenant for additional rent. The landlord incorrectly calculated amounts due because he charged the labor costs, as opposed to utilizing the mandated RAB labor rate, and this reasonably and foreseeably led to the tenant's damages.

It should be noted that a tenant's breach of contract damages would theoretically be subject to set off by an affirmative defense successfully establishing a tenant's failure to mitigate damages. A person who suffers from a breach of contract must not, by inattention, lack of care, or inexcusable neglect, allow his or her damages to grow and then charge the entire amount to the other party.51 Under this duty to mitigate, the recovery amount which a tenant may obtain against a landlord for miscalculating the additional rent at issue, in clear breach of contract, might nevertheless be diminished by culpable conduct attributable to a tenant, for example, in failing to audit such statements fully or regularly.

[ii]—Fraud

To state a claim for fraud, under New York law, a plaintiff must allege and prove: (1) a material misrepresentation of fact, (2) that the representation was made knowingly with the intent to deceive, (3) that the misrepresentation did in fact deceive plaintiff, and (4) that plaintiff's injury was caused by the misrepresentation.52

Depending upon further development of the facts, claims for fraud and deceit may lie against a landlord for miscalculation of additional rent demanded from, and paid by, a tenant.53

New York's statute of limitations for actions based on fraud has two parts: an action must be commenced within six years of the actual commission of the fraud, or within two years of when plaintiff discovered, or with reasonable diligence should have discovered, that he has been defrauded, whichever period is longer.54 It might be argued that under such a limitations period, all of a tenant's claims against a landlord should be allowed, because a tenant could not have discovered the fraud until the audit revealing the fraud was completed, and any such claim thereafter commenced would be timely.

The Second Circuit has considered this “when discovered” issue frequently in securities fraud cases. In one such case, the court explained that the “discovery” of the existence of such securities fraud claims includes the concepts of “constructive” and “inquiry” notice as well as

50 In re People by Phillips, 250 N.Y. 410, 165 N.E. 829 (1929).51 Saboundjian v. Bank Audi, 157 A.D.2d 278, 556 N.Y.S.2d 258 (1990).52 Zaro Licensing, Inc. v. Cinmar, Inc., 779 F. Supp. 276 (S.D.N.Y. 1991).53 Compare: Newmark & Company Real Estate, Inc. v. C&A Trimming Corp., 134 Misc.2d 371; 511 N.Y.S.2d

205 (N.Y. Civ. 1987) (sustaining a cause of action sounding in fraud: "Notwithstanding the fact that the defendant read and understood, the lease, it was entitled to expect that the computation of rent escalation, in futuro, would be made in good faith. It should be noted that the facts set forth in the CPA statement are not matters within the [tenant's] own knowledge nor does the defendant have the means available to it of knowing the truth by the exercise of ordinary intelligence.") and Worldwide Adjustment Bureau v. Edward S. Gordon Co., Inc., 111 A.D.2d 98, 489 N.Y.S.2d 231 (1985) (sustaining a claim of fraud on allegations that the escalation clause in issue established a formula for determining rent escalations which was not contingent upon actual increases in real estate taxes and labor rates, thus leading to the realization of profits by defendants. This receipt of profits by the landlord created a situation contrary to that represented by the landlord, who advised the tenant that the landlord would only be made whole for actual increases in operating charges. This statement was untrue when made and was known to be false by the person making it and that the tenant relied on statement when entering the lease), with S.R. Leon Co. v. The Towers. 194 A.D.2d 600, 599 N.Y.S.2d 53 (1993) (dismissing the complaint: "with regard to the alleged fraud regarding escalations, Article 38A constitutes an agreement by the plaintiff that a discrepancy in the actual size of the premises does not overrule a tenant's obligation to pay escalations when it had ample opportunity to inspect. See Wohl v. Owen, 153 Misc.2d 282, 580 N.Y.S.2d 854 (1992). (Emphasis added.).

54 N.Y. Civ. Prac. L. & R. §§ 203(f), 213(8).

actual notice.55 A plaintiff in a federal securities case, and by extension a plaintiff seeking to recover for fraud under New York law, will be deemed to have discovered fraud for purpose of triggering the statute of limitations when a reasonable man with ordinary intelligence would have discovered the existence of the fraud.56 When the circumstances would suggest to a man of ordinary intelligence the probability that he has been defrauded, a duty of inquiry arises, and knowledge will be imputed to the individual who does not make such an inquiry. These circumstances are often analogized to “storm warnings.”57

The doctrine of “equitable tolling” is similarly limited.58 Equitable tolling will stay the running of the statute of limitations for so long as a potential cause of action is concealed from plaintiff, through inducements or otherwise by defendant, but only so long as the plaintiff has “exercised reasonable care and diligence in seeking to learn the facts which would disclose fraud.”59 Applying such standards, the Second Circuit dismissed a plaintiff's security fraud claims as time-barred, despite the fact that: (1) plaintiff was a forty-five year old widow of admittedly no financial sophistication; (2) while plaintiff acknowledged that the limited partnership prospectuses through which she purchased speculative limited partnership interests contained myriad warnings concerning the high degree of risk involving such investments, she had not bothered to read the prospectuses, as she informed her broker, and was relying exclusively on his recommendation of such investments as consistent with her disclosed conservative investment strategy; (3) each investment involved a disclosure form that plaintiff signed, admittedly without reading, which explicitly acknowledged the high degree of risk she was assuming knowingly. The court emphasized, despite apparent misleading advise from her broker, plaintiff complained of matters which were “clearly disclosed in a manner sufficient to put a reasonable investor on constructive notice that she had not been sold investments of the type she sought.”

The Second Circuit also ruled against plaintiff on her fraudulent concealment claim. Plaintiff's arguments are worth considering in some detail, insofar as they help illustrate the often harsh results reached when a defrauded party waits too long to commence an action, once the plaintiff is “constructively”, as opposed to actually, on notice that it has been defrauded. The plaintiff emphasized that: (1) her broker induced her to sign documents without reviewing them with her or giving her an opportunity to read them, (2) her broker had, in fact, destroyed copies of purchase orders she had signed, informing her that she should not need them for her records, and (3) her broker had delivered to her a fifteen-page report glowingly discussing his recommended investments which allegedly induced her into not reading the prospectuses.60 The Second Circuit rejected the tolling argument, stating that receipt of the prospectuses alone put her on constructive notice of her claims, and there was no indication that her broker had suggested she read the report in lieu of the prospectuses.

55 Dodds v. Cigna Securities, 12 F.3d 346 (2d Cir. 1993), cert. denied 114 S.Ct. 1401 (1994).56 Armstrong v. McAlpin, 699 F.2d 79, 88 (2d Cir. 1983) ("The test as to when fraud should with reasonable

diligence have been discovered is an objective one. '[T]he means of knowledge are the same thing in effect as knowledge are the same thing in effect as knowledge itself.'" Accord: Watts v. Exxon Corporation, 188 A.D.2d 74, 594 N.Y.S.2d 443 (1993); Smith v. Sarkisian, 63 A.D.2d 780, 404 N.Y.S.2d 911 (1978), aff'd 47 N.Y.2d 878, 419 N.Y.S.2d 74 (1979).

57 Bogart v. Shearson Lehman Brothers, 1993 U.S. Dist LEXIS 1182 (S.D.N.Y. 1993), quoting Cook v. Avien, Inc., 573 F.2d 685, 697 (1st Cir. 1978). See also, Grandour v. Shearson Lehman Brothers, 213 A.D.2d 304, 624 N.Y.S.2d 390 (1995).

58 Dodds v. Cigna Securities, N. 55 supra.59 Arneil v. Ramsey, 550 F.2d 774, 780 (2d Cir. 1977).60 Id., relying on McCoy v. Goldberg, 748 F. Supp. 146, 158 (S.D.N.Y. 1990), in which the statute of limitations

was tolled where an investment advisor "deterred plaintiff from examining extensive offering documents."

With respect to the two-year “on notice”/discovery portion of the statute, the analysis becomes more complex. If for a long time period, a landlord's calculations of additional rent were concealed and it was not disclosed to a tenant that the landlord had used components other than those the parties agreed to use in a lease, discovery may not occur without an audit. A landlord, no doubt, would argue that a tenant has a duty to inquire into the propriety of calculations as soon as the first statement evidencing a miscalculation is delivered to it. However, such miscalculations may not be evident, in which case, landlords may argue that an audit of the landlord's records should be requested when calculations are complex and that it is the industry practice to have certified public accountants audit such statements forwarded by a commercial landlord. A tenant should not be able to sit back for ten to fifteen years and do nothing to assure itself of the propriety of the determinations other than “checking the math.” Plainly this is a difficult issue hinging on the facts involved. Note, however, that the decisions of New York courts, on the one hand, exhibit a particular distaste for security fraud actions, and, on the other hand, have exhibited a reluctance to impute discovery to a plaintiff, such as a tenant, maintaining a claim of fraud in nonsecurities fraud contexts, who had no reason to suspect he has been defrauded.61

It should also be noted that well-accepted New York law provides that a cause of action for fraud will not be sustained when it relates to a breach of contract.62 Nevertheless, it has also been held that “a breach of contract may be so intended and planned; so purposely fitted to time, and circumstances and conditions; . . . as to cease to be a mere breach of contract.”63 The court stated that “such misconduct would give rise to an action in tort.”64 In essence, such a breach is deemed to have fraudulently induced the injured party to engage in the undertaking that is the subject of the litigation. Where such a breach of contract arose arguable within the context of, if not a fiduciary, certainly a special relationship, the acts might be sustainable as a separate cause of action for fraud and deceit.65

The benefits of asserting a fraud claim also include the possibility of recovering punitive damages, which are not recoverable in the case of breach of contract.66 While the propriety of seeking recovery of this species of damages must await further developments, in order to recover punitive damages for tortious conduct, a tenant must allege facts indicating that the landlord acted in a “wanton, willful or malicious manner,”67 and that it seeks to “vindicate a public right to deter morally culpable conduct.”68 Acts such as these involving public rights are to be distinguished from mere “private wrongs for which punitive damages may not be recovered.”69

61 Second Circuit: Rosen v. Spanierman, 894 F.2d 28 (2d Cir 1990).State Courts:New York: Trepuk v. Frank, 44 N.Y.2d 723, 405 N.Y.S.2d 452 (1978); Azoy v. Fowler, 57 A.D.2d 541, 393

N.Y.S.2d 173 (1977).62 Crabtree v. Tristar Automotive Group, Inc., 776 F. Supp. 155 (S.D.N.Y. 1991).63 Rich v. New York Central and Hudson River Railroad Co., 87 N.Y. 382, 393, 34 N.Y.S. 1146 (1895).64 Albemarle Theatre, Inc. v. Baybery Realty Corp., 27 A.D.2d 172, 277 N.Y.S.2d 505, 510-511 (1967).65 Hargrave v. Oki Nursery, Inc., 636 F.2d 897, 899 (2d Cir. 1980); Market Street Limited Partners v. Englander

Capital Corp. 1993 U.S. Dist. LEXIS 10002 (S.D.N.Y. 1993).66 Westinghouse Electric Supply Co. v. Pyramid Champlain Co., 193 A.D.2d 928, 597 N.Y.S.2d 811 (1993).67 RKB Enterprises, Inc. v. Ernst & Young, 182 A.D.2d 971, 582 N.Y.S.2d 814 (1992).68 Quail Ridge Associates v Chemical Bank, 162 A.D.2d 917, 921, 558 N.Y.S.2d 655, 658 (1990), appeal

dismissed 76 N.Y.2d 936, 563 N.Y.S.2d 64 (1990), quoting Halpin v. Prudential Ins. Co., 48 N.Y.2d 906, 907, 425 N.Y.S.2d 48, 49 (1979).

69 RKB Enterprises v. Ernst & Young, N. 67 supra, 182 A.D.2d at 973.

Finally, it must be remembered that in New York State, all culpably negligent behavior is subject to New York's “pure” comparative negligence system.70 This includes all actions based on intentionally culpable conduct, including fraud, as well as the traditional negligence actions hereinafter discussed.71 Under this comparative negligence system, the amount of recovery a tenant might obtain against a landlord for fraudulently calculating the additional rent at issue would be diminished in the proportion that the culpable conduct attributable to a tenant (for example, in failing to audit fully or regularly such statement upon delivery) bears to the culpable conduct that caused the damages.72 Furthermore, the statute, in using the term culpable conduct as opposed to negligent conduct, requires not just comparison of negligence, but rather comparison of conduct which, for whatever reason, the law deems blameworthy.73 As is the case with respect to the duty to mitigate damages flowing from a breach contract discussed above, while it is impossible reasonably to anticipate even a ballpark figure by means of which a tenant's hypothetically culpable conduct might offset any recovery otherwise coming its way, the possible existence of such a set off must be considered when analyzing a tenant's rights.

[iii]—Negligent Misrepresentation

Since it may be difficult to prove, as opposed to sufficiently allege, in proving, as oppose to alleging sufficiently, the facts of a landlord's knowing misrepresentation of the additional rent owing under a lease, some thought must also be given to a possible claim sounding in negligent misrepresentation. A key distinction between recovery for injuries arising out of intentional misrepresentation and recovery for negligent misrepresentation within a contractual setting is that in order to establish a claim for negligent misrepresentation, the injured party must establish that: (1) a “special relationship” existed between it and the breaching/misrepresenting party; (2) that based upon such special relationship, the accused party covenanted to provide the injured party with correct information; (3) that the information provided was false or incorrect; and (4) that the injured party reasonable relied on that information and was damaged thereby.74 In this regard the traditional landlord-tenant relationship is perceived to be one of equals, established through arm's length negotiation, and not typically of the “special” character giving rise to the duties at issue in a negligent misrepresentation claim.75

By way of example, in a 1993 case, a contractor was able to satisfy the pleading of a “special relationship” with owner, who was alleged to have negligently misrepresented the nature and extent of the work to be done by the contractor.76 The contractor alleged that an agency relationship existed between it and the owner and claimed that when the owner “prepared the electrical specifications and the timetable for completing the electrical work” it “knew or should have known that the specifications were incomplete and that the electrical work could not have been completed within the timetable.” Even in the absence of privity of contract, such a “special relationship” has been found where the tortious party knew or should have known that the injured

70 N.Y. Civ. Prac. L. & R. §1411.71 Laboy v. Walkill Central School District, 201 A.D.2d 780, 607 N.Y.S.2d 746 (____). See §§ 19.03[5][d][iii]

and [iv] infra.72 N.Y. Civ. Prac. L. & R. §1411.73 McCabe v. Easter, 128 A.D.2d 257, 516 N.Y.S.2d 515 (1987).74 Andres v. LeRoy Adventures, 201 A.D.2d 262; 607 N.Y.S.2d 261 (1994); Westinghouse Electric Supply Co.

v. Pyramid Champlain Co., 193 A.D.2d 928, 597 N.Y.S.2d 811 (1993).75 Cf., Texaco Inc. v. A.A. Gold Inc., 78 Misc.2d 1050, 357 N.Y.S.2d 951 (1974), aff'd 45 A.D.2d 1054, 358

N.Y.S.2d 973 (1974). See also, CBS, Inc. v. P.A. Building Co., 200 A.D.2d 606, 606 N.Y.S.2d 718 (1994).76 Westinghouse Electric Supply Co. v. Pyramid Champlain Co., 193 A.D.2d 928, 597 N.Y.S.2d 811 (1993).

party would be relying specifically on the accuracy of the information disclosed in making a particular business decision.77

[iv]—Negligence

A claim for common negligence against a landlord may also exist. A tenant need only show that (1) the landlord owed the tenant a cognizable duty of care, for example, to compute additional rent pursuant to the applicable RAB labor rate; (2) the landlord failed to exercise that duty; and (3) the tenant suffered injury as a proximate result of that failure. 78 A person who contracts to do certain work is charged with a common-law duty of exercising reasonable care and skill in the performance of the work required to be done by the contract.79 While such a duty may arise out of contract it is separate and distinct undertaking from the contractual duty.80

Punitive damages are theoretically recoverable for negligently inflicted injuries. An action for failure to exercise due care in the performance of a contract is governed by the six-year contract statute of limitations if the claimant is seeking recovery for damage to property or pecuniary interests.81

[v]—Conversion

“[D]enial or violation of the plaintiff's dominion, rights, or possession [of plaintiff's property], is the basis of an action for conversion.”82 “[I]f the action is one for conversation, the time period will run from . . . when the conversion occurred.”83 The facts of the case will dictate whether a cause of action for conversion/embezzlement lies against a landlord. In this regard, a tenant need

77 See, e.g., Prudential Insurance Co. v. Dewey, Ballantine, Bushby, Palmer & Wood, 80 N.Y.2d 377, 590 N.Y.S.2d 831 (1992). See Ossining Union Free School limitations, found in N.Y. Civ. Prac. L. & R. § 213(1), which does not include the optional "or from the time with reasonable diligence it should have been discovered," N.Y. Civ. Prac. L. & R. § 203(f), applicable to claims of actual fraud. See also:

Second Circuit: Asbeka Industries v. Travelers Indemnity Co., 831 F. Supp. 74(S.D.N.Y. 1993).State Courts:New York: Milin Pharmacy, Inc. v. Cash Register Systems, Inc., 173 A.D.2d 686, 570 N.Y.S.2d 341 (1991)

(applying N.Y. Civ. Prac. L. & R. § 213(1) and applying cases.But see, Country World, Inc. v. Imperial Frozen Foods Co., 186 A.D.2d 781, 589 N.Y.S.2d 81 (1992)(applying

three year limitations period (N.Y. Civ. Prac. L. & R. § 214(4) and N.Y. Civ. Prac. L. & R. § 214(5).See also, In re Argo Communications Corp., 134 Bankr. 776, 794-796 (Bankr. S.D.N.Y. 1991), noting the

inconsistent positions of New York courts, but holding that where the negligent misrepresentation claim is closely aligned with an intentional misrepresentation claim, then the six-year limitations period of N.Y. Civ. Prac. L. & R. § 213(8) applies. Section 213(8) provides that such an action must be commenced from the time that the misrepresentation was made, or the injured party, with reasonable diligence, could have discovered the making of the misrepresentation). See Elghanayan v. Amir Victory, 192 A.D.2d 355, 596 N.Y.S.2d 35 (1993)(holding squarely that "The Statute of Limitations with respect to the cause of action sounding in constructive fraud and seeking an accounting by reason of defendants' alleged conversion and breach of fiduciary duty has not expired as it did not begin to run on the date of the alleged wrongdoing, but rather on the date of discovery." See also, Walsh v. Walsh, 91 A.D.2d 1198, 459 N.Y.S.2d 187 (1983).

78 Akins v. Glens Falls City School District, 53 N.Y.2d 325, 441 N.Y.S.2d 644 (1981).79 Palka v. Servicemaster Management Services Corp., 83 N.Y.2d 579, 611 N.Y.S.2d 817 (1994); Columbia

University v. Gwathmey Siegel & Associates Architects, 192 A.D.2d 151, 601 N.Y.S.2d 116 (1993).80 Rosenbaum v. Branster Realty Corp. 276 A.D. 167, 93 N.Y.S.2d 209 (1949).81 Video Corporation of America v. Frederick Flatto Associates, Inc., 58 N.Y.2d 1026, 462 N.Y.S.2d 439 (1983).82 Sporn v. MCA Records, Inc., 58 N.Y.2d 482, 488, 462 N.Y.S.2d 413, 415 (1983).83 Id. Cf., Solomon R. Guggenheim Foundation v. Lubell, 153 A.D.2d 143, 146, 550 N.Y.S.2d 618, 620 (1990)

(for theft, "limitations period . . . begins to run (immediately upon the occurrence of the theft . . . and this is so even if the owner does not know that a theft has occurred."). Accord, Chan v. Mui, 1993 U.S. Dist. LEXIS 14793 (S.D.N.Y. 1993).

not establish that the landlord is guilty of a tortious taking of the tenant's property or that it acted in bad faith in order to establish a claim in conversion against him.84

The New York statute of limitations for claims sounding in conversion is three years.85

[vi]—Unconscionability

In one instance, a court found a landord’s actions in requiring a tenant to pay an additional rent of 15% for increases in property taxes and insurance premiums over a base amount to be unconscionable. The court reasoned that the tenant only occupied 2.4% of the leasable area and the record showed that the tenant had been assessed 6.25 times its share of the increases based upon its proportionate share of its rentable to total building rentable space.86

[vii]—Restitution and Unjust Enrichment

A cause of action claiming unjust enrichment is based in equity on the principle that a landlord who has received the gratuitous benefit of overpayments of additional rent would be unjustly enriched in the eyes of the law if it were able to hold on to such overpayments.87 Such a claim requires the court to determine “whether it is against equity and good conscience to permit the defendant to retain what is sought to be recovered.”88

In New York, the cause of action is covered by the six-year limitations period found in N.Y. Civ. Prac. L. & R. § 213(1), and starts to run from the occurrence of the wrongful act giving rise to a duty of restitution and “not from the time when the facts constituting the fraud were discovered.”89

[viii]—Actions for Declaratory Judgment and Reformation of Contract

It is worth considering and discussing the causes of action seeking a declaratory judgment to determine the true intention of the parties when drafting these sections and considering an action to reform the contract. It is well settled that an action to reform a contract must be commenced within six years from when the parties entered into the agreement.90 A claim for declaratory relief with respect to a provision of the agreement is subject to the same six year period.91

84 Pokoik v. Gittens, 171 A.D.2d 470, 567 N.Y.S.2d 49 (1991).85 N.Y. Civ. Prac. L. & R. § 214; Chan v. Mui, 1993 U.S. Dist LEXIS 14693 (S.D.N.Y. 1993).86 Brandt v. Dade Dental Center, Inc. 680 So.2d 1063 (Fla. Dist. App. 1996). See also, Steinhardt v. Rudolph,

422 So.2d 884 (Fla. Dist. App. 1982), review denied 434 So.2d 889 (Fla. 1983). Cf., Foursquare Properties Joint Venture I v. Johnny’s Loaf & Stein, Ltd., 116 Wis.2d 126 (1983), where a lease provision was found to be unconscionable where a tenant’s payment of a disproportionate share of property taxes resulted in the landlord obtaining a windfall.

87 Markwica v. Davis, 64 N.Y.2d 38, 484 N.Y.S.2d 522 (1984); Restatement, Restitution 2d §1 (Tent Draft No. 1 1983).

88 Merrill Lynch, Pierce, Fenner & Smith, Inc., v. Chipetine, 1995 N.Y. App. Div. LEXIS 12294 (1995), quoting Paramount Film Distributors v. State of New York, 30 N.Y.2d 415, 334 N.Y.S.2d 388 (1953).

89 Sakow v. Sakow, ____ A.D.2d ____, 631 N.Y.S.2d 637 (1995); Congregation Yetev Lev D'Satmar, Inc. v. 26 Adar N.B. Corp., 192 A.D.2d 501, 596 N.Y.S.2d 435 (1993).

90 S.C.M. Corp. v. Fisher Park Lane Co., 40 N.Y.2d 788, 390 N.Y.S.2d 398 (1976); Frasca v. Frasca, 129 A.D.2d 766, 514 N.Y.S.2d 757 (1987); Schmitt v. Schmitt, 123 A.D.2d 617, 506 N.Y.S.2d 892 (1986), appeal dismissed 69 N.Y.2d 1038, 517 N.Y.S.2d 1031 (1987).

91 Northerly Corp. v. Hermett Realty Corp., 15 A.D.2d 888, 225 N.Y.S.2d 327 (1962) (applying ten-year period under New York Civil Practice Act § 53).

[e]—Must Potential Claims Against a Landlord Be Submitted to Arbitration?

Parties to a commercial dispute will not be held to have chosen arbitration as the form for resolution of their disputes in the absence of an express, unequivocal agreement to that effect. 92 It is routinely held that an agreement to arbitrate must be express, direct and unequivocal as to issues or disputes to be submitted to arbitration, particularly in instances where there is a limited arbitration clause.93 Where, for example, a provision in a commercial lease stated that any controversy arising over the manner of computation of additional rent was arbitrable, such arbitration was held not to be applicable to tenant's challenge to the meaning of the formula for adjusting rent.94

Nonetheless, the parties might wish to submit voluntarily their dispute to arbitration, which typically is thought of as a less formal, less costly means of dispute resolution. The advantages of doing so also include the opportunity for a tenant to choose one or more of the arbitrators before which such dispute would be determined. This is often considered a significant advantage when unique, industry-specific matters are in dispute.

[f]—Guidance on Conducting a Successful Audit

Following the rules discussed below makes lease interpretation easier and improves the likelihood of having a successful audit examination.

[i]—Draft Carefully and Clearly

It is essential that clauses involving operating expenses and other additional charges be drafted precisely and clearly. While this caveat applies to the lease generally, it is especially important in this area due to the amount of money involved, the potential for costly error and the difficulties attendant with interpreting these causes in the heat of an audit or dispute. The general definition of what is included in Operating expenses and other additional expenses should be stated at the onset. The clause should then itemize what is included in pass through and then what is specifically excluded. Operating expenses have some generally defined meaning and generally exclude capital expenses, organizational costs and structural costs.

Since additional expense clauses are complex, it helps to provide examples which clarify how the provision works. Using examples of a consumer price index or operating escalation allows the parties and later readers of the clause to better understand the intent of the original parties with respect to how the escalation would work. The examples also may make the clauses self-explanatory, thus reducing the need to rely on witnesses who may be unavailable, deceased or who simply do not remember the particulars of the transaction. It is also best to state any rights that a tenant may have in the lease in the form of a landlord representation, warranty or covenant since these terms have enhanced weight when it comes to enforcing these rights against an owner.

[ii]—Bring the Audit Team in Early

The audit team should consist of a corporate representative, an attorney and two (or more) CPAs, one who conducts the audit and the other who may be called as an expert witness in subsequent negotiations or litigation. The key to negotiating an audit refund is often early intervention and negotiation so that any problem areas can be addressed in the expense clause.

92 Calvin Klein Co. v. Minnetonka, Inc. 88 A.D.2d 503, 449 N.Y.S.2d 729 (1982).93 Robert Stigwood Organization, Ltd. v. Atlantic Recording Corp., 83 A.D.2d 123, 443 N.Y.S.2d 726 (1981).94 100 William Co. v. Aetna Insurance Co., 163 A.D.2d 170, 558 N.Y.S.2d 34 (1990), appeal denied 76 N.Y.2d

712, 563 N.Y.S.2d 767 (1990).

[iii]—Use the Best Team Possible

In such a potentially lucrative field, there certainly are a number of charlatans. Due to the complexity of the issues and the need for skilled negotiators, it is best to use knowledgeable and reputable professionals to handle an audit. Experience is essential in establishing issues and credibility in handling an audit successfully.

[iv]—Beware of Dangers and Hidden Pitfalls in Lease Drafting

Leases, especially the operating expense provisions, are fraught with hidden landlord profit centers. These centers include early commencement dates, unfavorable work allowance provisions, passing on of electricity costs or use of formulas which result in a high electricity charge to the tenant, and measurement formulas which indicate a far greater square footage than the tenant actual uses. Tenants must also watch the indexed rent clauses, tax and expense bases and stops, and operating expense clauses generally. All of these are pitfall for the tenant and hidden profit centers for the landlord. Using clear, concise and understandable language is necessary to reduce the tenant’s exposure to these potential pitfalls.

[v]—Conduct Audits Early and Frequently

Apart from the practicality of discovering errors early during the term, a tenant may run into difficulties when trying to recover from a landlord if the audit or recovery period extends beyond any applicable statute of limitations. Such statutes bar a tenant’s right to recover beyond a certain date so that a tenant’s claim will be limited to a set time period as set forth in the applicable statute of limitations. Recovery for damages outside that time period will be barred and thus recovery may be reduced substantially. These statutes and their applicable time periods vary from jurisdiction to jurisdiction. They also differ based on the cause of action asserted. Tenant claims may also be barred because the tenant failed to pursue its cause of action early enough or it established a course of conduct that results in its actions being estopped from further prosecution. Finally, contract provisions known as conclusivity clauses may limit a tenant’s right to question, audit or otherwise challenge the lease to some short period of time, for example, thirty or sixty days from the issuance of an invoice stating that expenses are due. The courts usually uphold these provisions.

[vi]—Avail Yourself of the Benefits of Technology

Many corporate users are hampered with numerous locations and leases, which make it difficult to track or audit any particular lease for excessive pass through expenses. Using and negotiating standardized agreements or common operating expense clauses helps a tenant identify potential issues. Computer tracking software can help in identifying potential lease audit areas.

[vii]—Be Aware that Most Lease Errors Are the Result of One or Both Parties Not Understanding the Clause

Most of the issues that arise from a lease audit are not the result of fraud or misrepresentation, but rather result from common calculation or interpretation errors. emphasizing the need for early audit and tracking of potential errors and miscalculations in these clauses.

[viii]—Be Prepared to Explain and Persuade the Trier of Fact or Persons Resolving Disputes

Often when a tenant enters into mediation, arbitration or other settlement negotiations, the person(s) resolving the dispute will not be as well versed in real estate, leases, or issues that arise in a lease audit. Thus, the tenant should not assume any such knowledge, but rather be prepared to educate the mediator, arbitrator or other trier of fact about these issues. It is up to the tenant, its counsel and other experts to explain and persuade the other side and those addressing the problem and working to resolve disputes.

[ix]—Generally Lease Audit Issues Are Best Resolved Through Negotiation and Settlement

Lease audits involve complex monetary issues arising in commercial transactions. They are usually neither interesting to or readily understandable for the average layperson sitting on a jury selected to resolve a lease audit dispute. Usually, the parties are an institutional landlord and institutional or corporate tenant, with little emotional appeal to the average juror. Among other reasons, these matters lend themselves to be settled, or negotiated outside of a courtroom.

[x]—The Lease Audit Process Is Still Evolving

Due to the relative newness of this field, anyone venturing into a lease audit is a pioneer. There is much to be discovered as these audits proceed and become more common.

[6]—Monitoring Landlord's Escalation Calculations

In order to determine whether the landlord's escalation calculations are accurate, the tenant must have access to all relevant information. Particularly in a complex commercial office lease, not only is it imperative to check the landlord's operating expense records, but the tenant may also need to know the landlord's income account figures. In certain situations, these numbers all play a vital part in the determination of the landlord's net expenses. Without all the pertinent information, it may be impossible for a tenant to monitor a landlord's escalation calculations for accuracy.

The complicated escalation provisions of a sophisticated office lease are completely understood by the legal practitioners designing them on behalf of landlords, but they are rarely intimately understood or understandable by tenants or, for that matter, by accountants, managing agents or the individuals preparing escalation statements95 for the landlord. Example 3 illustrates a complex operating expense escalation clause.96 Note that the escalation provisions contain certain exclusions from the term “Operating Expenses.” The difficulty in calculating a tenant's proportionate share of operating expenses under such a clause is immense.

Example 3:

ARTICLE 5

Adjustments of Rent

[Sections 5.01 through 5.06 omitted].

5.07. For all purposes of this Lease:

95 Landlords for large buildings generally use a form escalation statement. Major line items in the statement are reflected in accordance with standard escalation provisions in a standard form lease.

96 The sections pertaining to tax escalations have been omitted from the example.

(a) “Operating Expenses” for any lease year shall mean the aggregate of all costs, expenses and disbursements incurred and paid by Landlord (directly or by way of reimbursement by Landlord to its agents or contractors) which in accordance with generally accepted cash basis accounting standards and principles in the real estate industry and with Landlord’s federal income tax reporting basis consistently applied from year to year with respect to the operation, repair, safety, cleaning, maintenance, management and security of the Building (excluding ground floor retail space or garage areas and their core, shell or facade), Building equipment and the Land, including any plazas, sidewalks and curbs immediately adjacent thereto (collectively, “Landlord’s Property”) and shall include (without limitation) the following:

(i) salaries, wages, fringe benefits of every kind and nature, bonuses and the cost of any hospitalization, medical, surgical, Worker’s Compensation, union and general welfare, pension, retirement or life insurance plans, disability or other benefits imposed by law or otherwise with respect to employees, and social security, unemployment and other payroll taxes (including only the foregoing and other benefits or expenses that are customary for workers in office buildings of this stature and are in fact given to the workers in the Building) (collectively, “Labor Costs”) paid or incurred by Landlord (directly or by way of reimbursement by Landlord to its agents) relating to employees of Landlord or its agents engaged in the operation, repair, cleaning, maintenance, management and security of Landlord’s Property; provided that if any such employees of Landlord or its agents provide services for more than one building, then a prorated portion of the Labor Costs shall be included in Operating Expenses, based on the portion of their working time devoted to Landlord’s Property;

(ii) the costs of electricity, gas, steam or other fuel for common areas and other non-leasable portions of the Building; operation of elevators and security systems; heating, cooling, air conditioning and ventilating; chilled water, hot and cold water, sewer and other utilities; utility taxes, water and sewer rates and charges;

(iii) the cost of cleaning (including windows), janitorial, trash removal, concierge, security and other services and systems (excluding purchase and installation thereof);

(iv) the cost of all appropriate insurance, including Worker’s Compensation, property, casualty, liability, excess liability, plate glass, multiperil, and fidelity insurance without limitation and the fees and charges of insurance consultants and including the full replacement cost insurance required to be maintained by Landlord as elsewhere required by this Lease;

(v) the cost of repair to, and maintenance of, Landlord’s Property, including the Building systems;

(vi) the cost of Building cleaning goods and supplies;(vii) the cost of machinery, equipment, materials and tools used in the operation, repair,

cleaning, maintenance, management and security of the Landlord’s Property and any sales and use taxes thereon;

(viii) the cost of uniforms, work clothes and dry cleaning;(ix) management fees for managing the Landlord’s Property, or if no management fee is

being incurred, an imputed management fee which in either case shall not exceed the amount that would be paid to an independent third party manager for a property equal in size and class to the Building;

(x) fees and charges payable under service agreements and other payments made to Landlord’s agents or independent contractors for maintenance, cleaning and/or operation less any payments to such agents or contractors made pursuant to Section 5.05(a)(i) above. If there is any affiliation with such agent or independent contractor, the costs shall be comparable and competitive;

(xi) owner’s and agents’ administrative costs and expenses, including bookkeeping, stationery, telephone, telegraph, telecopy (or other telecommunication) costs paid by Landlord

with respect to the operation, repair, cleaning, maintenance, management or security of the Landlord’s Property, except if a management fee is being paid by Landlord under (a)(ix) hereof such items shall be excluded to the extent there is duplication of charges;

(xii) legal, accounting and professional fees and disbursements paid in connection with the operation, repair, cleaning, maintenance, management and security of Landlord’s Property;

(xiii) fees for and costs of licenses, permits and inspections required in connection with the operation, repair, cleaning, maintenance, management and security of the Building;

(xiv) costs of successfully contesting the validity or applicability of any Legal Requirement (as defined in Exhibit D) for the Landlord’s Property; provided, however, that the costs of any such contest included in Operating Expenses for any Lease Year shall not exceed the amount by which Operating Expenses for such Lease Year were actually reduced as a result of such contest;

(xv) those taxes, duties, charges, levies and assessments that are payable in respect of amounts that are otherwise includable within Operating Expenses;

(xvi) all expenses and costs (excluding extraordinary repairs or Capital Expenses) paid by Landlord as a result of or in order to comply with applicable laws, including laws pertaining to energy or natural resource conservation or environmental protection (such as the costs of securing alternative sources of utilities, energy or other products or services and the costs of making the Building compatible with the use of such alternative sources); and codes or regulations of any governmental authority having or asserting jurisdiction or any order, rule, requirement of any utility company, insurer of Landlord or the Board of Fire Underwriters (or successor organization), but excluding the cost of curing any existing violations of New York City Local Law #5;

(xvii) rent for personal property leased to Landlord the purchase price of which, if purchased, would be fully includable in Operating Expenses in the year of purchase;

(xviii) Capital Expenses (as defined in § 5.07(f));(xix) painting, wallpapering, decorations, displays and exhibits in public or other non-

leasable areas, excluding areas (if any) being used by Landlord for purposes not connected with the operation, maintenance, management or security of the Landlord’s Property;

(xx) costs of compliance with Legal Requirements (defined below) to the extent not elsewhere included, but excluding any non-compliance existing as of the date of execution of the Lease;

(xxi) any and all other expenses paid by Landlord for operation and maintenance of Landlord’s Property which are customary for similar buildings in New York City.

(b) “Operating Expenses-Exclusions”. The following shall be excluded from Operating Expenses:

(i) expenses relating to leasing space in the Building or preparing space for lease or for occupancy (including Landlord’s work, other tenant work or tenant improvements, leasing commissions and advertising expenses);

(ii) legal fees and disbursements paid for collection of tenant accounts, or negotiations of leases, or relating to negotiation and disputes between Landlord and other lessees and occupants of the Building;

(iii) the cost of electricity furnished to any leasable space in the Building and the cost of electricity otherwise furnished to any tenant or occupant of the Building or to equipment owned, installed or exclusively serving such tenant or occupant;

(iv) the cost of repairs or replacements or restorations incurred by reason of fire or other casualty or condemnation for which Landlord should have coverage under agreed value replacement cost insurance policies or should receive pursuant to condemnation awards and in

any event, any Operating Expenses shall be net of insurance reimbursements or what would have been reimbursed had Landlord maintained the insurance levels required under this Lease;

(v) expenditures for refinancing and debt service;(vi) taxes on any inheritance, estate, succession, transfer, gift, franchise, corporation,

income, gains or profit tax or capital levy;(vii) depreciation;(viii) telephone, telegraph, telecopy or other telecommunications costs reimbursed by

lessees and occupants of the Building and telecommunications related services provided to any tenants or to others including tenant’s shared services, except such as are provided without separate charge to all office tenants of the Building;

(ix) capital expenditures, including lobby and elevator renovation costs, except to the extent permitted in Section 5.05(a)(xix) and not excluded by any other provision of this Section 5.05(b);

(x) rent payable by Landlord under any ground lease;(xi) Labor Costs of any person above the grade of Building manager;(xii) costs and expenses otherwise includable in Operating Expenses, to the extent that

Landlord is reimbursed from other sources (including other tenants) for such costs and expenses;

(xiii) expenditures (capital or otherwise) paid in connection with the removal, replacement, enclosure, encapsulation or other treatment of asbestos containing material (“ACM”);

(xiv) expenditures (capital or otherwise) paid in connection with the removal, replacement, enclosure, encapsulation or other treatment of any hazardous material undertaken by reason of the same being hazardous material;

(xv) any amount paid by Landlord to a company or other entity affiliated with Landlord in excess of the amount which would have been incurred on an arms-length basis;

(xvi) the costs of HVAC services provided to any leasable space in the Building (other than such HVAC services as a prudent owner would customarily furnish for the proper maintenance of the Building, the costs of which shall be included in Operating Expenses) during any time when Tenant is not entitled hereunder to the same or does not receive same without separate or additional charge therefor, including labor, electricity, steam, fuel and maintenance costs allocable thereto;

(xvii) the costs of any other service or facility, or level or amount thereof, provided to Tenant or any other tenant or occupant in the Building which either (i) is not generally offered, supplied or furnished to tenants, (ii) is at a greater level than provided to Tenant at no additional cost or (iii) is supplied or furnished to Tenant pursuant to the terms of this Lease with separate or additional charge (other than the Labor Costs relating to those employees of Landlord, or any of their agents who man any messenger receiving area in the Building, which Labor Costs shall be included in Operating Expenses);

(xviii) costs and damages resulting from the negligent or tortious acts of Landlord, its employees and agents;

(xix) any costs or expenses paid in connection with any other building or improvement other than Landlord’s Property;

(xx) any costs or expenses paid for maintenance or repair of ground floor retail stores, garage or parking areas, including windows, storefronts, or heating, ventilating or air conditioning not part of a building wide system, utilities or other services;

(xxi) any doubling up of payments causing two (2) years expenses to be paid in one calendar year.

(c) “Operational Year” shall mean the calendar year 1992 and each subsequent calendar year during the Term of the Lease and any renewal or extension term;

(d) “Operational Year Operating Expenses” shall mean the Operating Expenses incurred during the applicable Operational Year;

(e) “Base Operating Expenses” shall mean Operating Expenses incurred during the 1992 Operational Year;

(f) The term “Capital Expenses” shall mean the annual amortization (reasonably determined by Landlord on a straight-line basis over an appropriate period, determined in accordance with generally accepted accounting principles, but not to exceed ten (10) years) of expenditures for capital improvements or capital equipment which either (i) under generally accepted real estate accounting standards and principles are expended or regarded as deferred expenses or (ii) are made by reason of Legal Requirements (excluding requirements, obligations or conditions, compliance with which is necessary to obtain a permanent Certificate of Occupancy for the Building or pre-existing this Lease) or Insurance Requirements as defined in Exhibit D, provided, however, that in the event Landlord receives a reduction, an exemption or abatement of Taxes or insurance premiums by reason of any such capital improvement or capital equipment, for purposes of calculating Capital Expenses, shall be reduced by the amount of such exemption or abatement. There shall be included in the annual amortization of such costs interest payable by Landlord during such year on money borrowed by Landlord in order to make such capital improvement or purchase any item of capital equipment or interest on money borrowed by Landlord in connection with the operation of the Building and which Landlord certifies to Tenant was allocated to such capital improvement or the purchase of capital equipment. Notwithstanding the foregoing, “Capital Expenses” shall not include the (a) construction of the Building or any expenditures for any alteration, renovation, subdivision, layout or finish of any space in the Building performed in connection with occupancy of such space by a tenant or in connection with renewal of a lease for such space with any tenant thereof, and (b) any item which does not result in a reduction of Operating Expenses greater than the annual amortization of the cost of such item. Before undertaking any work that Landlord intends to be a Capital Expense, Landlord shall forward a lifecycle cost statement for such work to Tenant.

5.08. In determining the amount of the Base Operating Expenses or the Operating Expenses for any Operational Year, if less than ninety-five (95%) percent of the rentable area of the Building shall have been occupied by tenants at any time during any such year, Operating Expenses for such Operational Year shall be determined for such year to be an amount equal to the like expenses which would normally be expected to be incurred had the occupancy of the Building been ninety-five (95%) percent throughout the applicable year.

5.09. If Landlord is not furnishing any particular work or service (the cost of which if performed by Landlord would constitute an Operating Expense i.e., such service at such level is available to or being given to Tenant without charge) to a tenant who has undertaken to perform such work or service in lieu of the performance thereof by Landlord, the Operational Year Operating Expenses for each Operational Year during which such situation shall occur shall be increased by an amount equal to the actual consideration paid by Landlord therefor (including any rent reduction) and if not ascertainable then by an amount equal to the additional Operating Expense which reasonably would have been incurred during such period by Landlord if it had at its own expense furnished such service or services to such tenant.

5.10. In any Operational Year in which Operational Year Operating Expenses exceed Base Operating Expenses, Tenant shall pay to Landlord Tenant’s Proportionate Share of such excess.

5.11. During or after the first Operational Year, and each year thereafter Landlord shall forward Tenant an itemized statement prepared by Landlord’s certified public accountants in accordance with generally accepted cash basis accounting standards and principles, consistently applied, (“Statement”) and certified by Landlord as correct, of the Base Operating Expenses and the occupancy adjustment pursuant to Section 5.08. Thereafter, each Operational Year during the Term Landlord shall forward to Tenant a Statement of the Operational Year Operating Expenses for that prior Operational Year and a computation of the amount payable by Tenant pursuant to this Article for such Operational Year.

5.12. With each installment of Fixed Rent payable during the Term during and after the 1994 Operational Year, Tenant shall pay to Landlord on account of the amount payable pursuant to this Article for the then Operational Year:

(i) until the earlier of (a) nine (9) months after the end of the preceding Operational Year or (b) the date Landlord forwards the applicable Statement for the preceding Operational Year, the amount of the monthly payment due during December of such Operational Year; and

(ii) Landlord shall use all reasonable efforts to forward the applicable Statement for the preceding Operational Year within six (6) months after the end of such Operational Year, but if Landlord does not forward the applicable Statement for the preceding Operational Year, within nine (9) months after the end of the Operational Year, payments by Tenant shall be suspended until the applicable Statement is forwarded; and

(iii) after Landlord forwards the applicable Statement for the preceding Operational Year, one-twelfth (1/12th) of Landlord’s estimate of the amount payable to Tenant for the current Operational Year, not to exceed one hundred five (105%) percent of the amount payable pursuant to this Article for such preceding Operational Year.

5.13. Once Landlord forwards the applicable Statement for the preceding Operational Year, Landlord and/or Tenant, as the case may be, promptly shall make appropriate payment to the other within thirty (30) days (without interest) of any amount overpaid by Tenant or owing to Landlord for such Operational Year based on the amount due pursuant to such Statement and amounts theretofore paid by Tenant for such preceding Operational Year. Such payments shall not be deemed a waiver of Tenant’s rights to dispute any Statement.

5.14. Landlord’s and Tenant’s obligations to make any payment pursuant to this Article shall survive the Expiration Date or any sooner termination of this Lease and shall be appropriately prorated for any Operational Year which is only partially within the Term.

5.15. Each Statement given by Landlord pursuant to Section 5.11 shall be binding upon Tenant unless, within six (6) months after its receipt of such Statement, Tenant notifies Landlord of its disagreement therewith, specifying the portion thereof with which Tenant disagrees. Pending resolution of such dispute, Tenant shall, without prejudice to its rights, pay all amounts determined by Landlord to be due, subject to prompt refund by Landlord (without interest) upon contrary determination.

Provided that Tenant complies with the provisions of this Section 5.15 and Section 5.16, Tenant shall have the right to reasonably review books and records relevant to Operating Expenses for each Operational Year and for the Base Operating Year. The right of the Tenant

under this paragraph to dispute Operating Expenses may only be exercised once for any Statement. Tenant agrees that any review of records under this paragraph shall occur at Landlord’s office. Except as provided in Section 5.14, any review to be conducted under this paragraph shall be at the sole expense of Tenant and shall be conducted by public accountants.

5.16. Landlord’s failure to render Statements with respect to any Operational Year shall not prejudice Landlord’s right to thereafter render a Statement with respect thereto or with respect to any subsequent Operational Year, nor shall the rendering of a Statement prejudice Landlord’s right to thereafter render a corrected Statement for that Year. If such dispute shall not be resolved within ninety (90) days after the giving of such Landlord’s Statement or estimate, as the case may be, Tenant shall, within sixty (60) days after written notice from Landlord of the expiration of such ninety (90) day period, submit the dispute to arbitration pursuant to Article 34, failing which Tenant shall be deemed to have waived its objections. Tenant agrees to use reasonable efforts to see that any information obtained by Tenant pursuant to this section shall be treated as confidential (but such information may be disclosed in the arbitration proceeding on a confidential basis).

Any agreed on or arbitrated errors disclosed by the review of records under this Article shall be promptly corrected. In the event that the results of the review of records (taking into account, if applicable, the results of any arbitration) reveal that Tenant has overpaid its obligations for a preceding period, the amount of such overpayment shall be credited against Tenant’s next subsequent installment payments of rent or if after the Expiration Date, refunded to Tenant. In the event that such results show that Tenant has underpaid its obligations for a preceding period, the amount of such underpayment shall be paid by Tenant to Landlord with the next succeeding installment obligation of rent.

5.17. Landlord’s and Tenant’s obligation to make the adjustments or payments referred to in this Article 5 shall survive any expiration or termination of this Lease. Any delay or failure of Landlord in billing any amounts due under this Article 5 shall not constitute a waiver of or in any way impair the continuing obligation of Tenant to make any such payments hereunder; provided however if Landlord fails to render a Statement within two (2) years after the expiration of any Operational Year, then Landlord waives the right to collect any additional Operating Expenses based on such Statement for that Operational Year and Landlord’s future Statements (for increases, if any, of subsequent Operational Years over the Base Year) shall not thereby be affected if timely sent.

As can be seen by a careful review of this clause, the various items of cost or expense to a landlord are technically and precisely defined. What is includable and excludable as an expense is defined. The exclusions from what is excludable as an expense are also carefully defined. Certain expenses are grossed up or increased to reflect less than 100% occupancy of the building.97 Certain expenses are reduced to reflect above-market costs or shared benefits. Certain expenses are amortized over a period of time. Certain expenses have other limitations, for example, capital items for energy conserving equipment. Care must be taken that these “exclusions from inclusions” or “exclusions from exclusions” do not creep back into the picture when the landlord calculates the tenant’s proportionate share for Operating Expenses.98

Assuming that the landlord and the tenant or their agents or accountants can agree on the formula for inclusions, exclusions, deductions and adjustments of the operating expense or other

97 See § 19.03([4][g] supra discussing the concept of “grossing up.”98 Not only will this be subject to the precision of the mathematical calculations, but it may also be affected by

the interpretations of the definitions and language in the lease.

escalation language,99 how the tenant confirms and when the tenant confirms the landlord’s compliance with the escalation roadmap is equally important. These escalation calculations and bills are not “self-monitoring.” A tenant who does not carefully check the landlord’s escalation calculations is essentially rubber-stamping the landlord’s figures, an unwise business practice, to say the least.

A well-drafted escalation clause will provide a right for the tenant or its accountant to review the landlord’s books and records relevant to operating expenses. Section 5.12(ii) of Example 2 requires the landlord to provide a Statement100 for the “Operational Year” within six months after the end of such “Operational Year.” Section 5.15 provides that the tenant has “the right to reasonably review books and records relevant to Operating Expenses.” While these provisions appear to give the tenant the right to examine all the information it needs to check the accuracy of the escalation figures, the landlord and the tenant may be at odds as to what books and records are relevant to operating expenses. The lease should go as far as it can to avoid such ambiguities.

Given the complex and detailed nature of the escalation provisions and the exclusions from the term “Operating Expenses” in Section 5.07(b), it is just as important for the tenant to examine the landlord’s income accounts as it is to examine the landlord’s expense accounts in order to make an accurate determination of reimbursements and exclusions, as well as categories of income and expenses. The exclusions in this clause are lengthy and sophisticated. They carefully deal with reimbursables from other tenants or other sources as well as the netting of discounts, rebates or recapturing of such expenses from rent inclusion electric, overtime charges, etc. The only viable way to determine the amount to be deducted from operating expenses attributable to exclusions set forth in the lease is to ascertain whether or not the landlord received income pertaining to those exclusions.

The tenant can expect the landlord to vigorously oppose the tenant’s request to examine its income accounts. If tenant comes up against a landlord’s opposition to open its records for examination, it may be necessary for the tenant to bring an action for an accounting 101 or for a judgment asking the court to declare that landlord is required to provide tenant with sufficient information to allow tenant to verify its escalation charges.102 All this becomes very tricky, however, because the tenant is generally staring down the barrel of the language in the lease requiring it to respond or object to its escalation bill within a certain amount of time.

The bottom line is that the tenant should be responsible only for paying its proportionate share of the actual increases in the operating costs of maintaining the building. Unless the tenant has access to all relevant data, including the landlord’s income accounts, there will be no way for the tenant under a sophisticated lease to know whether or not the landlord has helped itself to a windfall profit by charging the tenant for a portion of operating expenses that have already been paid by another tenant or from another source.

99 A very large assumption!100 Section 5.11 of Example 2 defines “Statement” for the first Operational Year as “the Base Operating

Expenses and the occupancy adjustment pursuant to Section 5.08” and for subsequent years, as a “Statement of the Operational Year Operating Expenses for the prior Operational Year and a computation of the amount payable by Tenant pursuant to this Article for such Operational Year.”

101 See P.V. Properties, Inc. v. Rock Creek Village Assocs. Ltd. Partnership, 77 Md. App. 77, 549 A.2d 403, 409-410 (Md. App. 1988) (court stated where landlord maintains exclusive control of all records relating to those charges and tenant is forced to rely on landlord’s good faith in calculating tenant’s proportionate share of common area expenses, a fiduciary relationship exists and the tenant is entitled to an accounting).

102 Id., 549 A.2d 403, 406-408 (plaintiff filed declaratory judgment, asking court to declare that defendant landlord “is required to provide an itemization of the actual costs comprising the annual common area maintenance in sufficient detail so as to permit verification”; although not explicitly provided under the lease, court found an implied obligation of “landlord to disclose its cost data and the basis upon which tenant’s common area maintenance liability was computed”).

[7]—Escalations Checklist

• With respect to escalations, there are many issues to be checked and re-checked by the tenant before entering into the lease. The lease language should be clear on these issues. Here are a few important ones:

• Only pay for your proportionate share of actual taxes paid by the building on the building. Make sure, for example, that you will not being paying on two football fields attached to some church, or on a city-leased or owned property, or on a combined tax lot, or on a garage that is built in the building, but is used by the general public.

• If taxes go down on the building, make sure your escalations do not go up by the same amount of the tax saving that the landlord is receiving in the base year.

• Make sure that you are only paying for appropriate operations of the building. Do not pay for operating expenses of other buildings on the same tax lot or on the garage or public parking area, whether or not in the building. Do not pay to manicure and landscape other parcels that will be built on later. Do not pay for capital improvements that benefit others, for example, the three floor cafeteria installed by the landlord in the building to service another tenant, or retail space to serve the public. Do not pay for capital or other expenditures paid by the landlord to cure defects, violations or hazardous situations. Do not pay more than 100% of the overall building escalations.

• Pay only for your own electricity, heat and moving costs, such as take down, relocation and setup. Do not pay these costs more than once.

• Make sure that the deflator index formulation does not allow creeping or galloping profit increase. This can happen if it is applied to all of the components of base rent, including the electricity factor. Many of the components are growing independently from year to year and are reimbursed through escalations, i.e., increases to taxes and operating expenses.

• Check to be sure that you are not paying escalations for other tenants or that you are not paying for a period of time prior to occupying the premises or perhaps even before signing the lease.

• If there is a miscalculation in your taxes or operating expense, make sure you have the right to cause it to be adjusted.

• Do not pay tax expenses if the landlord is not paying them.• Fully understand the nature of porter’s wage charges if your building operates under that

formula.