Rights Of First Refusal Transmogrify Into Purchase Options

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Rights of first refusal create difficult situations. For that reason, knowing landlords resist granting them. Unknowing ones don’t know not to resist. Then again, “resist” doesn’t mean never. So, like it or not, there are plenty of leases with such a provision.

We’ve written about rights of first refusal and alternatives to such provisions. If you’d like to get on the same page as those who have seen what we’ve written in prior blog postings, click: HERE and HERE.

A few weeks ago, we came across a case that gives a pretty good explanation about what a first of right refusal is and what it becomes. But, we’re getting ahead of ourselves. First, here’s the story.

A landlord owned two adjacent parcels. One was tenanted by a quick service restaurant, the other by a discount store. The quick service restaurant had the earlier lease and that lease gave it a right of first refusal to purchase both parcels. The later (in time) discount store lease had a purchase option (not a right of refusal). The option was exercisable during the last two years of the lease term, but was expressly subject to the right of first refusal in the quick service restaurant’s lease. Got it so far?

Here’s where it gets interesting, possibly tricky as well. Five years before the discount store’s purchase option was first exercisable, the landlord accepted a third-party offer to buy both parcels. The quick service restaurant responded by exercising its right of first refusal.

Now, we’ll speculate beyond the words of a March 2, 2017 reported decision by a Massachusetts court. If the quick service restaurant took title to the property, its lease would have been extinguished under a legal doctrine called “merger by deed.” Simply speaking, the same party can’t be both the landlord and tenant on the same lease. So, if a tenant “becomes” its own landlord, the lease becomes a nullity. We’re pretty sure the quick service restaurant knew that. That’s because if it could “save” its lease in place, then if the discount store tenant exercised its purchase option, the restaurant tenant still would have its right of first refusal. That would let the restaurant tenant make the discount store’s purchase option a useless exercise because if the option were exercised, the restaurant tenant would go ahead and trigger its right of first refusal.

So, with that in mind, here’s the way the restaurant’s purchase closing went down. Instead of taking title to the property in its own name, its owners formed a new entity to take title to the property. That left the lease in place with the restaurant remaining the tenant and its affiliate becoming the landlord.

So, here’s the question. With the lease in place, never having been interrupted, did the right of first refusal survive the transaction? The restaurant tenant thought so. The discount store tenant disagreed. The court decided. Here’s how it framed the question: “The question, therefore, is whether a right of first refusal in a lease is extinguished once it is exercised, or whether it may continue in existence if the holder of the right does not take title to the property itself, but creates a separate legal entity that takes title after the exercise and is assigned the lease that contains the right of first refusal.” What did it decide? Readers will need to wait.

First, some law about rights of first refusal, purchase options, and how they differ. We’re using this very court’s words:

A right of first refusal is not an option to purchase property at a certain price, but a limitation on the owner’s ability to dispose of property without first offering the property to the holder of the right at the third party’s offering price

The owner’s obligation under a right of first refusal is to provide the holder of the right seasonable disclosure of the terms of any bona fide third-party offer.

On notice of receipt of a bona fide offer from a third party, a right of first refusal ripens into an option to purchase according to its terms.

[An] option to purchase is an irrevocable offer by the [property title holder] to the [ultimate purchaser] to sell to him on the terms stated.

The exercise of an option to purchase constitutes an acceptance of the irrevocable offer that the option represents.

We think the court was on a roll, so we’ll hang on the best we can. Here’s the court’s practical explanation of a right of first refusal:

Underlying the principles of rights of first refusal and options is the assumption that an option is only exercised once. The standard chain of events in the life of a right of first refusal in a lease is (a) a bona fide, third-party offer is received by the landlord that triggers the tenant’s right of first refusal; (b) the landlord reports the offer to the tenant; (c) the tenant now has an option to accept the offer without changing its terms, within the time period set under the right of first refusal; (d) the tenant accepts the offer, which is now binding; (e) the tenant and the landlord execute a purchase and sale agreement; (f) the transaction closes and the tenant takes title to the property and is no longer a tenant.

Pay close attention to clause (c) in the cited paragraph. When a tenant exercises its right of first refusal, the right of first refusal is extinguished because it has been converted into a purchase option. Read that again. The right of first refusal becomes an option. The right no longer exists. Contrast that with the following. If a lease or other agreement doesn’t say otherwise, an unexercised right of first refusal will survive over and over and be available through successive sales of a property. However, once exercised, it is extinguished. Once extinguished, it can’t be exercised again.

So, the discount store tenant prevailed. Wise as the restaurant tenant may have been to preserve its lease by taking title in a different entity, the plan didn’t work. It was still a tenant. Its lease continued in effect. The words of that lease still said “right of first refusal.” But, it had already been used. It was no longer effective because it had been used, and when it was used, it became an option, an option that had been previously “used.”

What could the restaurant tenant have done? It could have negotiated for a lease that barred any grant of a purchase option by the landlord after the date of its lease or that would make that purchase option ineffective if it, the restaurant tenant, ever exercised its right of first refusal. Then, it could have recorded a notice of lease and included such a restriction in the notice of lease.

The landlord could have negotiated with the discount store tenant for a provision that would extinguish the purchase option if the property was sold to the restaurant tenant.

As an old Yiddish idiom goes, “Oyb di bobe volt gehat reder, volt zi geven a vogn.” That translates as: “If my grandmother had wheels, she’d be a wagon.” Basically, would-haves and could-haves don’t matter much once the deal is done.

So, as a business matter, a right of first refusal seems like a pretty simple thing. In fact, the concept is pretty simple. What isn’t simple, however, is expressing the terms of that right in a way that doesn’t trigger problems that aren’t simple. For Ruminations’ thoughts about that, readers may want to go back and look at those old blog postings (by clicking: HERE and HERE).

Readers interested in reading the court’s full decision can do so by clicking: HERE.

For those readers who are curious if the restaurant tenant would take a financial hit, it seems that it would not. The discount store’s purchase option provided that the purchase price was the greater of $10,000,000 or the appraised value of the (one) parcel. That protected the restaurant tenant for the value of its interest. It may, however, have interfered with any development plans the restaurant tenant’s owners may have had for the pair of contiguous parcels.

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Comments

  1. Wise ruling. Once the restaurant exercised its ROFR, it was likely provided a copy of the discount store lease along with title and other due diligence docs. The restaurant then had the OPTION of moving forward to close, thereby assuming the risk of the discount store’s future exercise of its lease option, or terminating the escrow based on disapproval of the discount store lease. It wouldn’t have been fair for the ROFR to renew (and the “innocent” discount store to suffer the effective loss of their option) simply because the restaurant tenant attempted a merger avoidance structure.

    The interesting question now is “If the discount store exercises its option at a price lower than the restaurant paid, would the restaurant have a claim against the landlord? I think not because, again, the restaurant assumed the risk that their ROFR would not survive after its exercise and purchasing the property subject to the discount store’s option.

  2. Ben McIntosh says:

    Love the site; first time commenter. I’m sure I’m making a fool of myself, but can it really be said that the purchase option was “expressly subject” to the ROFR if, at the end of the day, the holder of the exercised purchase option ended up with greater rights than the holder of the exercised ROFR?

  3. Howard Burns says:

    Court ruling actually wise and understandable, that alone is amazing. ROFR’s are fair for tenants in particular where taxes will increase dramatically with a sale. Worded properly, they work.

  4. Tim Scott says:

    Yes but … good analysis on ROFO non-survival , but the Court, QuickServe and its lawyers missed the more important issue. (And the buyer entity wasn’t created to keep the ROFR in place. Undoubtedly, for planning and finance reasons they didn’t want the property asset to be part of the restaurant assets – I sure wouldn’t.)
    The option provided “This option is subject to the prior right of first refusal to purchase the entire parcel of land owned by the Landlord (including the subject Premises) and which prior right of first refusal is held by the Tenant of the Burger King restaurant located adjacent to the Premises.”
    So the Option was clearly subject to the ROFR. Since the Option in the Lease would presumably follow a normal sale of the property and the new owner/landlord would be subject to that Option, the “Option is subject to ROFR” language would be utterly meaningless surplusage if the option were still exercisable after a ROFR sale. So being “subject to” must mean the optioned property is subject to prior sale to 1 specific buyer, which would nullify the option.
    This is bolstered in that the earlier granted ROFR was seemingly for the entire fee estate. And yet with the Court’s decision, the earlier ROFR for the entire estate is rendered a ROFR to purchase a conditional estate for a few years by the later grant of the Option to a person that knows of the ROFR – so the innocent party got the shaft.
    The Court and QuickServe got it wrong, but maybe Quickserve has an action against the owner for breach of the ROFR in granting this Option.
    The reality is this is yet another drafting lesson where the Option itself was terribly drafted by never saying what “subject to” meant. Further QuickServe should have insisted on an estoppel from Discount acknowledging the option was extinguished prior to their closing. Finally, the litigator that represented QuickServe probably doesn’t really understand business deals and didn’t have good counsel from a transactions oriented strategy advisor that should have seen this. In this case, bad pleadings made for bad law of the case.

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