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Certain Tenant Disclaimers In Leases May Be Of Limited Effect

By: Kenneth S. Kramer, Danielle Sveska Gensch
04/02/08

A recent California Court of Appeal decision held that a landlord could be liable for misrepresenting the square footage of premises and confirmed that the tenant had certain rights to review common area expense information, notwithstanding provisions in the lease stating that the parties agreed to accept the specified square footage as accurate and the lack of any audit provisions in the lease.  McClain v. Octagon Plaza, LLC, (2008) 159 Cal.App.4th 784.  The trial court had found that the lease prohibited the tenant from pursuing an action against landlord for misrepresentation as to the square footage issue, and held after trial that she was not entitled to an accounting as to expenses.  The Court of Appeal reversed such holdings in certain respects, permitting the tenant to proceed with its action in the trial court for misrepresentation on the square footage issue and concluding that she was entitled to accounting information but not an audit.  The landlord has filed a petition for review with the California Supreme Court, which has neither been accepted nor denied by the Court as of the end of March, 2008.  The case provides guidance to landlords as to the extent to which California courts will enforce certain disclaimer provisions in leases, and as to the manner in which property managers should respond to tenant concerns.

 

In McClain, a retail tenant with a teaching supply store in a small shopping center in Valencia claimed that her landlord had misrepresented the square footage of her space as specified in the lease, as well as the total square footage of the shopping center on which her share of common expenses was based.  The tenant also asserted that she had the right to review the landlord’s records of operating expenses even though the lease provided only that she was entitled to receive "a reasonably detailed statement" of such expenses and did not provide any audit right.  The lease form utilized was an American Industrial Real Estate Association (AIR) form Standard Industrial/Commercial Multi-Tenant Lease – Net.  The Court found that the landlord may have misrepresented the square footage of the premises and the center, and that the tenant was entitled to review the documents used by the landlord in preparing its statement of common expenses.  The Court remanded the case back to the trial court for further proceedings consistent with such holdings.

 

Expense Review and Audit Rights

 

Under her lease, Kelly McClain was expressly entitled to "a reasonably detailed statement" of common expenses.  The lease included this language only and did not provide for an audit of common expenses.  The tenant contended that it was entitled to a full accounting under the theory that a landlord (i) owes a fiduciary duty to a tenant, and (ii) is required to do so under the covenant of good faith and fair dealing.  While the court rejected these claims, the rights it did grant to the tenant were more than what many landlords would have expected to be required under the lease provisions at issue. 

 

The landlord originally sent the tenant a letter that simply set forth the tenant’s share of the common expenses, without providing any further detail as to specific expenses.  The tenant objected, and the landlord provided a detailed break down.  The tenant then objected to some of the expenses and requested an audit, which the landlord rejected.

 

While the Court did not grant an audit right, it did state that the landlord must meet the terms of the lease by providing "a reasonably detailed statement" of expenses, and that the tenant is entitled to verify that expenses were in fact incurred and that the listed amounts are accurate.  Such verification, the Court concluded, requires the landlord to provide access to the documents it used in preparing such statement.  The Court relied on cases in which California courts have recognized that "when two parties enter into an agreement for the sharing of profits that accords one party exclusive access and control over financial records bearing on the profits, the implied covenant accords the other party the right to an accounting of the profits."

 

The landlord’s duty to provide access to the documents it used in preparing a statement of expenses may be discharged in any reasonable manner, including providing the tenant copies of the pertinent documents or an opportunity to view the original documents.  The Court made clear that such rights did not entitle the tenant to demand explanations of the reason for incurring specific expenses, to challenge the decisions of a landlord to incur specific expenses, or to question whether expense items were necessary.

 

While the McClain case involved a small tenant in a small center, for which a landlord could conceivably and without inordinate difficulty provide copies of all invoices or payments, the standards set forth in the case are not limited to smaller properties.  By comparison, consider the difficulty to the owner of an urban multi-building business complex of providing each tenant access to copies of service contracts, payroll records and invoices.  While the burden stops short of giving audit rights to all tenants, the impact of the McClain case may still be significant to an unprepared landlord.  Absent a subsequent contrary finding or acceptance of the appeal of the McClain case by the California Supreme Court, commercial landlords may wish to assemble an annual package of supporting documents regarding incurred operating expenses and to be prepared to provide such a package to tenants upon request in order to meet the requirements of McClain.  Landlords will also need to consider whether there are more stringent lease provisions that can overcome the holding of the McClain court, and whether to limit the review period for expense statements whether or not an audit provision is in the lease.  

 

Misrepresenting the Square Footage of the Premises

 

McClain also claimed that the principals of Octagon Plaza, LLC misrepresented the size of her premises as well as of the building.  The lease recited the size of the premises as 2,624 square feet, and contained a somewhat typical disclaimer that,

 

"…Unless otherwise provided herein, any statement of size set forth in this Lease, or that may have been used in calculating Rent, is an approximation which the Parties agree is reasonable and any payments based thereon are not subject to revision whether or not the actual size is more or less."

 

The lease also stated that the tenant had been advised by the landlord to satisfy itself regarding the condition of the premises and had made such investigations as it deemed necessary.

 

Prior to entering into the Lease, the tenant expressed a desire to the landlord to measure the premises, but the landlord dissuaded the tenant from doing so, expressing offense at such inquiries and claiming that measuring would be costly and time-consuming due to the unique shape of the premises.  The court called this a "pretense," finding that the landlord intentionally and knowingly misrepresented the size of the premises and that the tenant justifiably relied on the landlord’s misrepresentations.

 

The landlord billed tenant its share of common area expenses based on the shopping center as a whole, which consisted of 11,835 square feet, making the tenant’s share of common expenses 23%.  An application for earthquake insurance filed prior to the date of the McClain lease stated the square footage of the center to be 12,800 square feet.  Such application was in Octagon’s files.  The Court found that the effort to persuade the tenant not to verify the actual square footage of the premises and the existence of the insurance application showing a different square footage than that used by landlord for determining the tenant’s proportionate share in and of themselves were adequate to meet the elements of a claim for misrepresentation, contrary to the trial court’s determination that no action for misrepresentation had been or could be adequately stated.

 

The court also discussed the magnitude of the variances, including that the landlord’s claimed size of the premises at 2,624 square feet was 7.6% greater than the actual 2,438 square feet (a significant difference to the court), that the resulting overstatement of the tenant’s share of common expenses was 23% instead of 19%, and that such variances caused the tenant to be responsible for excess common expense payments of $90,000.  The Court of Appeal did not find these variances to meet a standard of approximation contemplated by the lease provisions quoted above.

 

With respect to the waiver language of the lease, which stated that the tenant had undertaken an independent investigation of the premises, the Court (citing California Civil Code Section 1668, which makes contractual exemption from fraudulent conduct void as against public policy) found that the landlord could not use the waiver language to avoid its misrepresentation.

 

Landlords should not dissuade tenants from verifying factual matters related to premises, even where the lease purports to disclaim any later challenge to such factual matters.  Landlords should also take care to assure that any factual matter stated in a lease is not contradicted by the landlord’s own file information.  Landlords may need to recognize that if a variance from the stated footage of premises is too great, the Courts may not honor provisions purporting to prohibit a tenant from gaining the benefit of a later re-measurement or later discovery of facts at variance with the lease.  The practice of having demised spaces measured by a third party may provide some protection from these circumstances.

 

Ken Kramer is a partner, and Danielle Gensch is a senior associate, with the Real Estate Practice Group at Nossaman.  Ken has practiced real estate law for over twenty years and has extensive experience in acquisitions and sales, leasing, entity formation, financing, telecommunications licensing and environmental issues.  Danielle has practiced law for nine years, and her practice focuses on real estate acquisitions, development, land use, leasing, financing and public agency representation.  Ken may be reached at (949) 833-7800 or kkramer@nossaman.com.  Danielle may be reached at (415) 398-3600 or dgensch@nossaman.com.

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