Who Knew Purchase Options Could Be So Complicated?

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We don’t know if there are more ways to write a purchase option in a lease “wrong” than right,” but we do know opportunities abound. Here are a couple of examples. The first is based on a statement of California law within a court opinion from March of 2018. [See it by clicking: HERE.] Basically, that court lifted text from earlier cases, each of which is pretty stark. Here they are:

Where an option to purchase exists within a lease agreement, the exercise of the option to purchase causes the lease and its incorporated option agreement to cease to exist, and, instead, “a binding contract o[f] purchase and sale c[omes] into existence between the parties.”

[W]hen defendant exercised the option granted her to purchase the property by making the first payment of $500 thereunder, the lease and option agreement no longer existed and a binding contract of purchase and sale came into existence between the parties.

Further, a consequence of the termination of the lease agreement is that the former lessee’s obligation to pay rent under the lease also terminates, unless there is an express stipulation that requires continued rent payments after the exercise of the purchase option.

Where the relation of landlord and tenant exists under the terms of a written lease, containing an option to purchase which the lessee exercises, [and it is exercised,] he is no longer in possession as a tenant, but his possession is that of a vendee.

These concepts have a number of consequences beyond the end of an obligation to pay rent. One of them is financial. If the tenant, in fact, continues to pay rent after the date of exercise, without having been obligated to do so, it is entitled to a credit against the purchase price. On the other hand, if the closing is delayed beyond the date when it “normally” would have taken place, the landlord-seller is entitled to compensation for the loss of use of the money it would have received. Yes, that number is difficult to calculate but difficult isn’t the same as not reasonably estimated, starting with mortgage interest. With those “rent” issues in mind, it makes sense for a lease to cover this issue because there is no bar on the parties agreeing that rent will be paid during the “holding” period or specifying if or how it will be applied to the purchase price.

Then, there is the question of what to make of post-exercise rent payments. Do they act as a revocation of the option exercise? Leave that out of your leases and invite expensive litigation if the landlord wants to invalidate the exercise.

Another implication is that a “default” under the lease after the valid exercise of a purchase option will not invalidate an otherwise proper exercise. That’s because there can’t be a lease default under a lease that no longer exists. This presents an opportunity for careful drafting to describe the rights and obligations of the parties during the pendency of the “vendor-vendee” relationship (i.e., when the “purchase contract” is in effect prior to the closing). On the flip side, if a tenant exercises a purchase option and no closing takes place, the implication of all of this would be that the tenant has to “get out” because it no longer has a lease. There might be some equitable remedies a court would grant in such a circumstance (especially when the tenant was not a fault for the unconsummated closing), but why leave that to chance?

Case law is replete with court decisions over disputed purchase options. [When we “speak” of purchase options, we include straightforward ones and well as rights of first refusal, rights of first offer, etc. For those who want to read a little about these devices, some prior blog postings about these can be seen by clicking: HERE and HERE and HERE and HERE.]

Too often, in fact, far too often, landlords and tenants think that saying the purchase price will be at “fair market” is definitive itself. [This “fact” pertains, as well, to setting a renewal or extension rent at “fair market.”] Simply speaking, while taking this simplistic approach will not make the option unenforceable, it sure can make for expensive problems if the parties can’t agree on the price (in a purchase option) or on rent (in a rent reset). For example, in the case we relied on above for the stark quotations, the parties took such a simplistic approach. Then, each obtained an appraisal, one of which was five times the other – now what? The lease didn’t say. So, the parties elected to litigate the issue for more expense and more delay.

That takes us to a more recent California court decision, one from the beginning of this year [and one that can be seen by clicking: HERE.] In the lease discussed in that case, a right of first refusal was fully described in two related leases. Here is what we mean by “fully.” On the face of the earlier lease was an uninitialed, handwritten provision reading, in its entirety, “First option to purchase.”  In the later executed lease, there was a provision saying only: “Right of 1st refusal to purchase.” Unlike in the first lease, this was initialed by both parties.

In the reported case, it appears that the landlord did not contend that the lack of initialing on the first lease was a fatal defect to the tenant’s exercise of the option. Further, it doesn’t seem that it argued that the tenant’s purported exercise was flawed because the options, in each case, were too indefinite to be enforced. The first would have been a factual dispute, one that we couldn’t illuminate. The second is a tough issue because a court might need to go outside of the four corners of the lease to ascertain the parties’ intentions and might have looked at the local custom and trade when it came to what a right of first refusal meant. The absence of time limits is not fatal; the understanding is always that, absent specified limits, “reasonable” applies.

What happened is that the landlord received an acceptable purchase offer from a third party. It was for a small amount of cash with the landlord-seller “taking back” a mortgage that barred prepayment. The tenant responded with a higher purchase price. It proposed to pay with proceeds from the same size loan, but its loan would come from an outside lender. The landlord, who would be deprived of mortgage loan interest, (correctly) determined that the tenant’s offer, though with a higher price, would be financially less desirable. So it rejected the offer as non-conforming.

It goes without saying that this dispute would not have been resolvable by reference to any language in the leases’ handwritten right of first refusal “provisions.” Even if a written purchase option might be “so complicated,” it would be an understatement to say that simplicity could invite disputes, delays, and unneeded costs.

There was an overriding issue in this dispute over the purchase rights. The leases had expired, and by the terms of each lease, the tenant was a permitted holdover tenant. So, did the rights of first refusal, if they were otherwise valid, carry over into the holdover period? Here, Ruminations is off the hook when it comes to supplying an answer. We can simply report that the majority view in the United States is that such an option is not an “essential” term of a lease and doesn’t carry over. The minority view is to the contrary; they do carry over. Think of how much easier it would be if the lease itself declared the result.

The take-away from today’s blog posting is pretty obvious. Purchase options of every variety should be detailed. At a minimum, they need to cover common situations. They need a method to set the “price” in a way that an outside party can look at the method and say, “This is how it works.” Yes, these provisions, well-written, can occupy a lot of “real estate,” in terms of paper, and principals often say: “That’s too long and complicated, can’t you just write it up in a few sentences.” We who craft these documents need to resist. Incorporating poorly written purchase option provisions in a lease may be a way to increase litigation revenue for law firms, but doing so is a great disservice to landlords and tenants.

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Comments

  1. The proposition that exercise of a purchase option terminates the lease, converting it into a PSA, has always seemed nutty to me, but this is not the first time I’ve heard of it. In essence it forces anyone writing an option of any kind (or ROFO or ROFR) to remember to add language negating the nuttiness. Such language is hardly intuitively obvious. But maybe that’s just an example of why one shouldn’t rely on intuition in writing legal documents. One should instead start from a knowledge of the governing law, even if nutty. As a final thought, if the lease goes away (absurdly) as soon as the tenant exercises the option, doesn’t that also mean the tenant should move out immediately?

  2. Tim Scott says:

    Joshua Stein is correct that this rule is nutty. In no circumstance has any landlord or tenant ever intended that the lease terminates on exercise instead of it surviving until the sale closing. This existence of this rule reflects the longstanding problem of litigating in front of judges that come out of non-business litigation areas and have no idea what business deals are about. They often don’t even have any idea how to follow the money. Nevertheless, we must write for the unsophisticated and hope they don’t find some new and creative way to ignore the parties obvious intent.

    • Maybe the answer is to keep our documents dumb and simple, so they cannot possibly be misinterpreted. We tend to make them very complicated, in the belief that a judge might actually read and understand them. Unlikely.

  3. I am with Joshua Stein on the lease termination issue. A purchase option that has not closed escrow in no way in hell negates an existing leasehold interest. The tenant who might exercise the purchase option, is buying the property subject to “all” lease hold interests. Example, the property could be a multi-tenant property. But neither here or there whether there is one tenant or multiple tenants.

    A purchase contract has various provisions to conduct due diligence, obtain a loan in most cases, which in turn means the purchase price subject to an appropriate appraisal acceptable to the lender, and various other items of a purchase agreement conditions.

    Meanwhile time moves onward, and the tenant is still a tenant. Said tenant does not become an owner until the purchase agreement contract closes escrow. Then, the new owner can cancel their existing lease contract if they so choose to do so.

    What idiotic judicial entity that came up with the idea that the lease automatically terminates with a purchase option is exercise needs to be replaced on the bench.

    I never heard of such BS in my life. BTW … are judges required to obtain annual continuing education of subject matter relevant to their jobs, like the rest of us in the real estate world are required to do?

    Taking it another step further in absurdity, what is the difference is a tenant exercising a purchase option, or a 3rd party submitting a offer to purchase? Nothing!!

    Therefore, taking the idiot judges opinion to the nth degree, any time “any” purchase offer is submitted, all existing leases are automatically negated.

    What a can of worms that would open.

    Best wishes,

    /s/
    James T Saint, CCIM
    COO

  4. The fundamental flaw here is the assumption that the buyer will close, i.e., that signing a contract (or merely agreeing to close, as the result of exercising an option) is equivalent to closing. Reporters make the same mistake when covering real estate transactions. Signing a contract is very much not the same as closing. In many cases, it’s just the beginning of a long and overly interesting adventure for the seller. But I disagree with some comments in the above reply. If a contract arises from an option (or a ROFO or ROFR) it will tend to be very simple. It won’t have a due diligence period, contingencies, or other complexities. It will have very limited reps and warranties. We like to attach the very simple form of contract to the lease, or even eliminate the contract entirely and just say the buyer will bring some money and the seller will convey some real property subject only to certain title exceptions. (That’s 99% of any purchase and sale. We just make them more complicated than they need to be.)

    • Randall L Gunn says:

      To give the court’s a limited amount of forgiveness, termination of the lease and having all future payments going toward the purchase price gives motivation for the Seller to proceed to closing and NOT shop the deal.

  5. Jeremy Deeken says:

    It appears that the court is applying some merger of estates principle to find that the rights and obligations of the party as a lessor, having no title, were replaced with their rights as a contract vendee having equitable title. This is similar to a lender who accepts a deed in lieu of foreclosure only to find they are not able to foreclose out intervening liens because their mortgage interest (along with its power of foreclosure) was replaced with their “greater” interest as the fee owner. Many of the default rules applicable to these sort of transactions are based upon English common law, are counter-intuitive and not reflective of the intentions of the modern commercial parties.

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