Out-of-Pocket Costs, explained

What is an out-of-pocket expense, and why it matters

In many different types of agreements, the phrase “out-of-pocket” is used to modify the description of costs, expenses or other similar items that must be reimbursed by another party.  This modifier is used to ensure that only costs or expenses that an individual or entity pays from their own cash reserves are covered in a given scenario.  Conversely, items that may have an intrinsic cost or expense, will not be covered by the “out-of-pocket” modifier if an individual or entity does not expend funds to pay for such.  For example, in most loan agreements, a borrower will agree to pay for the “out-of-pocket costs and expenses” incurred by its lender in making the loan.  In this scenario, the borrower will pay for the legal fees of the outside attorney(s) retained by the lender to represent them in the transaction.  However, the borrower will not pay for the work that any of the lender’s in-house lawyers perform on the deal because the lender does not have to come “out-of-pocket” to pay its employees for their specific work on the transaction.  Without the “out-of-pocket” modifier though, the lender could argue that the borrower is responsible to pay for the fair market value of the work performed by the lender’s employees, including its in-house lawyers, on the transaction. Consequently, a borrower, tenant, or any other “subordinate” party should always negotiate to limit reimbursable costs to “out-of-pocket” expenses; otherwise, the potential liability can explode as a claim for “in-house” costs can be exorbitant.

In addition to requiring that only “out-of-pocket” costs are covered, it’s important to negotiate other qualifiers to reduce the risk of excess “out-of-pockets” costs. The reimbursing party should require that “out-of-pocket” costs be: (1) “reasonable,” which can prevent a spending party from incurring a large bill that is out of market; (2) “actual,” which requires that the spending party actually pay such an expense in order to receive reimbursement; and (3) “documented,” which requires that the spending party only receive reimbursement for costs, expenses, and fees that it has documented and can provide evidence of (such as invoices and receipts). Here is an example of a markup of a reimbursement provision from a Loan Agreement (additions are highlighted in blue):

“For all purposes of this Agreement, Lender’s costs and expenses shall include, without limitation, all actual, documented, and reasonable “out-of-pocket” appraisal fees, cost engineering and inspection fees, legal fees and expenses (excluding any in-house legal fees or costs), accounting fees, environmental consultant fees, auditor fees, recording taxes, recording fees, filing fees, UCC filing fees and/or UCC vendor fees, flood certification vendor fees, tax service vendor fees, and the actual, documented, and reasonable “out-of-pocket” cost to Lender of any title insurance premiums, title surveys, mortgage registration taxes (if applicable), release, reconveyance, satisfaction and notary fees.”

Lastly, with respect to “attorney’s fees,” a party may want to negotiate to limit attorney’s fees to one law firm. This may be difficult depending on a party’s relative negotiating power, but limiting reimbursable attorney’s fees to one law firm can avoid a large bill where multiple law firms are duplicating work. This would not prevent the spending party from hiring multiple law firms to double and triple check work product, but it shifts the burden of payment for such extra caution from the reimbursing party to the spending party.