Get Right to End Lease if Tenant Understates Gross Sales

A percentage rent tenant that understates its gross sales can be a nightmare. You rely on the tenant to give you correct gross sales figures so that you get the percentage rent that you're owed and can gauge how well the tenant's business is doing. But a dishonest tenant may try to undercut your percentage rent by lowering its gross sales figures.

That's bad enough. But if you catch the tenant in an audit, it may be able to correct the understatement without any serious repercussions—if your lease is like many we've seen. Leases typically require the tenant to give you the correct gross sales figures and then pay the percentage rent deficiency plus your audit costs. If the tenant knows that it can understate its gross sales figures without being too severely penalized for doing so, it has no incentive to state its gross sales correctly in the first place.

There's a good way to cut the tenant's incentive to understate its gross sales figures, says Toronto attorney Harvey M. Haber: Say in the lease that if you discover during your audit of the tenant's books that it understated its gross sales you can terminate its lease, at your option.

Benefits of Getting a Termination Right

This termination right puts teeth in the requirement that the tenant give you correct gross sales figures. If the tenant knows that understating gross sales could lead to a lease termination, it will think twice before trying to slip incorrect gross sales figures by you.

Issues to Negotiate

You shouldn't have much trouble getting the tenant to accept your termination right, says Haber. But there are some points that you may have to negotiate, he adds.

How big an understatement will trigger your termination right? Even a well-intentioned tenant might make a mistake when calculating its gross sales. So the tenant will insist on some margin of error. Set a threshold understatement amount that will trigger your termination right. It will usually be expressed as a percentage (for example, the option will be triggered if gross sales are understated by 3 percent).

The threshold you set depends on the strength and importance of the tenant, says Kenneth S. Lamy, president of The Lamy Group, Ltd. The more sophisticated and desirable the tenant, the higher you'll have to set the percentage—that is, only an egregious error will trigger the termination right. Lamy has seen the threshold set anywhere from a 3 percent to a 5 percent understatement. The lower the percentage, the higher the tenant's incentive to check the accuracy of its numbers, Haber says, since it will know that a small deviation could mean the end of its lease.

How much time for tenant to move out? The tenant probably will demand that you give it reasonable notice if you decide to exercise your termination right—so it can prepare to move out of the space. You and the tenant will need to negotiate how long. Haber recommends 15 days’ written notice that the lease will terminate.

Will tenant get right to cure? The tenant may argue that your termination right should go into effect only if the tenant doesn't cure the lease violation, by giving you the correct gross sales figures and paying you the percentage rent deficiency (and, if required in the lease, your audit costs) within a set time period. Try not to give in to the tenant on this point, or you won't solve the problem, says Haber. A dishonest tenant will still have an incentive to take advantage of you by understating its gross sales figures and correcting them only when it gets caught.

If you must compromise on this, agree that you'll have the right to terminate the lease—with no cure period—if the tenant repeatedly understates its gross sales by a certain percentage. For example, you can terminate the lease if the tenant understates gross sales in two consecutive audits, says Lamy.

Add Model Lease Language

Ask your attorney about adding the following language to your lease where you give yourself the right to audit your tenant's gross sales records. The language gives you a termination right, but gives the tenant no cure period.

Model Lease Language

If an audit discloses that Gross Sales for the period in question is understated by [insert %, e.g., 3%] or more, Landlord may, at its option and in addition to any other rights or remedies of Landlord under this Lease or at law or in equity, terminate this Lease upon [insert #, e.g., 15] days’ written notice to Tenant.

CLLI Sources

Harvey M. Haber, Q.C.: Partner, Goldman Sloan Nash & Haber LLP, 250 Dundas St. W., Ste. 700, Toronto, Ontario M5T 2Z5 Canada; (416) 597-3392; fax: (416) 597-3370; http://www.gsnh.com; Haber@gsnh.com.

Kenneth S. Lamy: President, The Lamy Group, Ltd., 650 Poydras St., Ste. 2245, New Orleans, LA 70130; (504) 525-9914.