What do you do when the deal sheet, agreed-upon by the parties, says: “Tenant will have a right of first refusal to lease adjacent space at a rent to be agreed-upon by Landlord and Tenant”? And, if you’ve been in this business more than three weeks, you’ve seen that.
Is it possible that those who make such a deal have a very different understanding of what constitutes a right of first refusal than does the “market”? Is it possible that they also think if parties decide that they will agree on something later, they are obligated to agree? Unless you have a better explanation, it sure looks that way. Where do we start?
While contracting parties, as contrasted to parties negotiating a contract, have a “duty of good faith and fair dealing,” a contract term implied by law into every agreement (with such limited exceptions as not to warrant listing them), they do not have a duty to reach an agreement (under our scenario); only to negotiate in good faith. While it is true that we’ve seen some courts interpret “at a price to be agreed-upon” to mean that if the parties can’t agree on, say, rent, they must have meant “reasonable” rent, that’s just not an outcome you can expect. Basically, an “agreement to agree” is unenforceable. Legal gurus will be able to find a judicial opinion or two that holds otherwise, but that’s a very slim reed to rely upon, and certainly not wise in the business sense.
So, our advice, mostly for the benefit of those who have not come this this understanding on their own, is – don’t do it. If one party or the other has a right to expand or extend a lease term or anything like that, make sure the essential terms are agreed-upon. If you can’t or don’t agree on “fixed” numbers, make sure the terms can be established, at the time in question, by reference to some objective standard. What does “objective standard” mean? To Ruminations, it means that an outsider, by following an agreed-upon procedure, can, formula-like, solve the “equation.” That procedure could call for one or more people to express their opinion as to what the price should be. It means having a set of rules to combine or otherwise get an answer out of the competing opinions. Most of us would call that an “appraisal process.” Or, by example, a rent could be set with reference to a formula based on the last three or five rental rates at the same project. Or, by reference to an index, such as the cost of living index. [And, we’d strongly advise that you actually name “which” cost of living index, but that’s a gripe for another day.] The price could be based on a “most favored nation” concept, at 100% of that number or at 95% or at 107% – you pick. What it shouldn’t be based upon is: “at a price based on our differing needs and desires five years from now.”
Here are two observations from practice. First, don’t forget that the parties aren’t bound to any formula set out in an agreement if they decide to change the formula later. All agreement terms are subject to change if the parties agree to do so. A pretty simplistic example is the common lease extension (renewal) option where a tenant has the right to extend its lease’s term for five years at the fixed rent printed right there in the lease. In such a case, the tenant has the right, but not the obligation to exercise the extension option. In this “one way” example, if the previously agreed-upon “renewal” rent turns out to be above market at the time it would go into effect, a tenant would simply say: “I’ll extend the lease term, but not at the above-market rent printed in our lease. The rent has to be market rent, the same rent you’ll be getting (eventually) if I leave and you find a new tenant. So, avoid empty space with a gap in rent revenue, and avoid the hassle by agreeing to the lower rent.” Not all “deals” like that are one-way. Sometimes, it makes sense for parties to agree to change previously agreed-upon business terms because doing so works for both sides. For example, landlords and their tenants usually agree on extension rent rates even though a lease might spell out a pretty good appraisal process. Leases don’t have to say that the parties will first try to negotiate a renewal rent before going to appraisers; they can always choose to agree on a rent.
What’s the take on this “practice tip”? Basically, if the parties intend to have an extension (or other option right) in a lease or contract, and intend that it be a real right, they need to agree on how the right will be given effect if they don’t set the price in advance.
We promised a second observation. Here it is. If the price (or other business term) is for an event that’s going to happen in the near term, fix that price or business term now. Where does that thought come from? Have you ever seen a deal for a one year term (and it could be a lease) with a one year renewal option for a non-volatile item (i.e., not crude oil or soy beans) and the deal says that the option price (think rent) is “as to be agreed upon.” If you haven’t, then you’ve probably been out there only ten weeks. While we’ve never had a crystal ball that worked, we feel pretty comfortable that a rent number for a year from now can be set today. In fact, it isn’t a big stretch to say the same thing about the rent that would go into effect in five years or even ten years. Even if there is a situation that makes it difficult to agree on what the rent would be in the “second” year, why not use a formula?
Now, as to a right of first refusal, which we and others abbreviate as a ROFR. What does the marketplace think it is? Fundamentally, it means that when a tenant (in the most common examples) has a ROFR, its landlord needs to show it any bona fide offer (one that the landlord would accept) from a third party and the tenant then has the right to step into the shoes of that third party. If the tenant does so, the landlord must make that very same deal with its tenant. Later postings will discuss the various “techniques,” “procedures,” “limitations,” and “protections” that can be used to cabinet a ROFR. Today, we’re ranting about how often deal sheets call for a ROFR without knowing what one is.
Before Ruminations drifts off to describe some siblings to a ROFR, we’ll tell you how, when representing a tenant, we “interpret” our opening puzzle: “Tenant will have a right of first refusal to lease adjacent space at a rent to be agreed-upon by Landlord and Tenant.” To us, to give respect to both concepts, a ROFR and “based on an agreement,” the parties “must have meant” that if adjacent space becomes available, it can’t be offered to anyone other than the tenant until a good faith negotiation fails to result in a mutually agreeable rent. If an agreement was reached, the space would then be added to the existing lease, with the only difference being that its “rent” would be at the agreed-upon rate. That’s the “at a rent to be agreed-upon” part. But, if the contracting parties (landlord and tenant) abide by their contractual obligation to negotiate in good faith and deal fairly with each other, but can’t settle on a price, the “ROFR” gets its life. The landlord can take third party offers. If the landlord then gets a bona fide offer it is willing to take, it has to go back to its tenant and let that tenant step into the shoes of the offeror. How else would you interpret the deal sheet and get a ROFR and a “to be agreed-upon” into the lease?
If the parties really meant only that the tenant would get first crack at expansion space, but that if no agreement on lease terms could be reached, the tenant’s rights would be over, they should have said so. They could have used the shorthand: “right of first negotiation” or ROFN, where either the tenant or landlord could make the first suggestion as to the price.
A ROFN is a close first cousin to the “right of first offer” or ROFO, wherein the landlord tells the tenant that the adjacent space will shortly become available and the tenant could then make an offer. In the “fairest” approach to a ROFO, the landlord can reject its tenant’s last offer, but if it then negotiates with third parties for the space, it can’t take any better (from a tenant’s point of view) offer without letting its existing tenant step into the offeror’s shoes.
In scribbling today’s posting, our vantage point is the proverbial 30,000 feet above ground level, flying fast and loose. For simplicity, we’ve written about a lease, not a purchase or other contract. Our flying has been “loose” and glib in describing a ROFR, a ROFN, and a ROFO. We didn’t mention a ROLO (and we’re leaving its meaning as a puzzle to be solved by those who haven’t seen ROLO before). We haven’t explained why anyone would ever grant any such rights in the first place. Part of the reason for all of that is because we’re at 1,607 words (just before “words”). Part of the reason is Ruminations has a lot of later opportunities to develop those thoughts. So, for today – “good bye.”
N.B. This is the 125th posting for Ruminations. If you haven’t been with us from the start, why not browse today?