Getting a Lease Termination Right for Tenant with Incorrect Gross Sales Report

Q: I’ve negotiated percentage rent provisions in my leases with several of my retail tenants at the shopping center I own. I’m relying on these tenants to give me correct gross sales figures so that I can get the percentage rent that I’m owed, and can gauge how well the tenants’ businesses are doing. I’ve heard of scenarios where a dishonest tenant may try to undercut the owner’s percentage rent by lowering its gross sales figures. Can I get the right to end a lease with a tenant that understates its gross sales? How would I do this?

A: Yes, you can negotiate the right to end your lease with a tenant that’s sneaky with its gross sales reporting. If you catch the tenant in an audit, it may be able to correct the understatement without any serious repercussions—if you have a typical lease. 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.

But there’s a good way to cut the tenant’s incentive to understate its gross sales figures. 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.

Three Issues to Negotiate

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. You shouldn’t have much trouble getting the tenant to accept your termination right. But there are some points that you may have to negotiate.

Issue #1: 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. 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. The lower the percentage, the higher the tenant’s incentive to check the accuracy of its numbers, since it will know that a small deviation could mean the end of its lease.

Issue #2: How much time will you give the 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. Fifteen days’ written notice that the lease will terminate is common.

Issue #3: Will the tenant get the 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. 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.

Carve Out Right to Audit

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 percent, e.g., 3 percent] 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 number, e.g., 15] days’ written notice to Tenant.