07/02/2008
California Court Clarifies Tenant’s Rights Under Commercial Lease to Measure Premises and to An Accounting of Charges Supporting Operating Expense Pass-Throughs
In an important decision for owners and tenants of commercial property, a court of appeal panel in Southern California has held that language in a lease that purports to make binding on the tenant the square footage of premises for purposes of determining rent can be challenged by the tenant based on negligent misrepresentation. In addition, the decision held that, with certain exceptions, upon request by the tenant, a landlord must provide reasonable documentation in support of operating expense additional rent so as to enable the tenant to verify that the expenses were actually incurred by the landlord. This second holding appears to go further than any previously published California decision on this topic.
McClain v. Octagon Plaza, LLC1 involved a shopping center lease of a small teaching supply business operated by a husband and wife in an unnamed shopping center in Valencia, California. The parties documented the lease on a standard AIREA Industrial/Commercial Multi-Tenant Lease-Net form, which provided that the premises contained 2,624 square feet. The lease contained standard language that disclosed that the square footage noted in the lease was “an approximation,” and that the parties agreed that “any payments based thereon are not subject to revision whether or not the actual size [of the premises] is more or less.”2 The lease also provided for the tenant to pay its pro rata share of operating expenses. As is customary, the lease required the landlord to provide the tenant with a “reasonably detailed statement” showing the tenant’s share of actual common expenses within a stated period following the end of each calendar year.
Important to the outcome of the case was the fact that prior to entering into the lease, the tenant had attempted to confirm the size of its premises with the landlord. However, the landlord declined to re-measure the premises and informed the tenant that re-measuring the premises was an unreasonably costly expense and that the landlord “had intimate knowledge of every detail of the shopping center” and that the tenant could “rely on their representations regarding the sizes of the unit and the shopping center.”
After a dispute arose between the parties concerning the tenant’s share of common area expenses, the tenant filed a complaint alleging (i) fraud in the inducement (a misrepresentation involving the square footage of the premises), and (ii) for an accounting of the tenant’s share of common area expenses.3
A statement in a lease concerning the square footage of the premises does not insulate a landlord from liability for fraud.
The court rejected the landlord’s argument that the language of the AIREA lease form providing that the square footage amount for the premises was an “approximation” and stating that both parties agreed to the number as “reasonable” shielded the landlord from liability for fraud or misrepresentation. The court of appeal found that all of the elements of negligent misrepresentation (a form of fraud) were present.4 The sole question was whether any of the contract provisions that sought to disclaim liability, such as provisions stating that the square footage was an “approximation” which the parties expressly agreed was “reasonable,” and a stipulation that the tenant “assumes all responsibility for [its investigations] as it relates to the occupancy of the premises,” were sufficient to defeat the tenant’s claim for negligent misrepresentation.
The court of appeal rejected this argument and held that contract provisions that seek to waive a party’s claims for, or absolve a party from, fraud are not enforceable and do not bar a fraud claim. Analogizing the AIREA lease provisions to an “as is” clause in a contract, the court of appeal cited numerous cases to the effect that such a clause is ineffective in insulating a contracting party from fraud claims regarding non-obvious defects. The court was not swayed by the landlord’s argument that use of the words “approximate” and “reasonable,” along with the statement that the tenant’s rent was not subject to change, regardless of actual size of the premises, made reliance by the tenant on the terms of the lease unreasonable. The court held that whether the tenant’s reliance was reasonable was a question of fact to be decided at trial, and not a question of law, and therefore summary judgment was inappropriate.5
It is also interesting to note that, in this case, the square footage discrepancy of the premises was 186 square feet (a 7.6% discrepancy), and yielded in a 4% reduction in tenant’s percentage share of operating expenses (from 23% of common area expenses to 19% of such expenses). The court found these figures to be material.
A landlord must provide a tenant, following request, with an account of operating expenses.
Of equal importance was the court’s second holding that, in a commercial lease, where the tenant pays a pro rata share of operating expenses of the building or shopping center as additional rent—even if the lease is silent as to a tenant’s right to “audit” or “inspect” the landlord’s books and records, a tenant is entitled to the disclosure of documents supporting the landlord’s statement of operating expenses in order that the tenant can verify that the listed expenses were incurred and that the listed amounts are accurate. While the court of appeal rejected the tenant’s claim that it was entitled to “audit” the landlord’s books and records relating to operating expenses, the court of appeal came down in favor of a tenant’s right to “an accounting” of expenses.
The facts relevant to the tenant’s accounting claim were that, in response to the tenant’s request for a “reasonably detailed statement” regarding operating expenses, the landlord did provide a “more elaborate description of common expenses.” The tenant was not satisfied with the landlord’s response, even though it appeared that the landlord was willing to provide the tenant with copies of cancelled checks verifying expenditures set forth in the landlord’s statement. The tenant went further and questioned various expenses, disputed the need for other expenses and demanded documentation beyond that needed to verify actual expenses.
Relying on a series of California cases applying the covenant of good faith and fair dealing, the court of appeal came down in favor of according tenants the right to an accounting of common area expenses. The court noted that a landlord may discharge this obligation “in any reasonable manner it selects, including providing [the tenant] with copies of pertinent documents or giving [it] an opportunity to view the original documents.” This is likely to be cited often by tenants in future instances where they seek to obtain an accounting of operating expense pass-throughs.6
It is important to note that the court did not address the issue of the enforceability of a contract provision to the effect that the landlord’s statement is deemed final and binding on a tenant after a period of time. The court cited with approval cases holding that the implied covenant of good faith cannot impose substantive duties on the contracting parties beyond those incorporated into the specific terms of their contract. This would suggest that a reasonable time bar on challenging operating expense statements would be upheld.
Why is this case important and what can landlords learn from the case?
The court in Octagon Plaza sent a clear message that landlords cannot shield themselves from fraud and misrepresentation lawsuits by using contractual language that attempts to shift responsibility for the truth and accuracy of factual statements in a lease to the tenant.
With respect to annual statement for operating expenses, landlords should keep accurate records of such expenses. While a landlord does not have to submit his or her books to a tenant for a full audit, landlords should be able to provide copies of documents, such as invoices and cancelled checks, to a tenant (upon request) that substantiate that the amounts listed on its statement have been incurred and are accurate. Lease forms should be reviewed to confirm that reasonable sunset clauses are included.
This Cooley Alert was written by Manuel Fishman, a real estate partner in the firm’s San Francisco office with the help of Whitney Peterson, a second year law student at Northwestern University and a 2008 summer associate of the firm. If you would like to discuss the Octagon Plaza case, please feel free to contact Mr. Fishman or any other attorney in the firm’s national real estate leasing practice group.
Notes
1 McClain v. Octagon Plaza, LLC, 159 Cal. App. 4th 784 (2008). Although decided on January 31, 2008, the case only became final on April 30, 2008.
2 While the language in the lease did not specifically say that the square footage was “final and binding” on the parties, that language would probably not have made a difference to the court’s holding. See discussion in text.
3 The case arose in the context of a demurrer by the landlord to the tenant’s complaint. The trial court found for the landlord and dismissed the tenant’s complaint. Upon appeal, the court of appeal reversed. Because of this, all of the allegations in the tenant’s complaint were assumed to be true. Of course, at trial, the truth and veracity of the allegations would have been tested—but that was not the posture of the facts of the case before the court of appeal.
4 Those elements are: (1) the assertion as a fact of something that is not true, (ii) by a person who has no reasonable basis for believing the statement to be true, (iii) made with the intent to induce reliance thereon by the injured party, (iv) the justifiable reliance on the statement by the injured party, (v) resulting in damage.
5 It is important to note that courts in other jurisdictions may reach a different conclusion as to whether statements in a lease that put the tenant on notice of its responsibility to verify information undercut a tenant’s ability to rely on lease terms. For example, In Wohl v. Owen, 153 Misc. 2d. 282 (1992), a New York court held that the square footage of office space was a matter that was “readily ascertainable by reasonable inquiry” by a tenant and that the tenant was alerted to this inquiry by the language in the lease that provided that the square footage was “deemed to be” a stated figure. This case may be distinguishable from Octagon Plaza, however, because the court found the tenant in Wohl to be “knowledgeable in real estate matters.”
6 The Octagon Plaza court did not cite what many believe to be a seminal case in this area, P.V. Properties, Inc. v Rock Creek Village Associates Limited Partnership, 549 A.2d 403 (Md. Ct. Spec. App. 1988). While one can read tea leaves, the omission appears to relate to the fact that the Rock Creek Village decision based its holding, in part, on the finding that the landlord has a fiduciary relationship with its tenants. The Octagon Plaza court expressly avoided addressing this legal theory. However, in other respects, the Octagon Plaza court breathed life into the Rock Creek Village decision in California (and the case was cited by both parties in their appellate briefs).