Hold Your Horses Before You Close That Deal: Rights of First Offer, Rights of First Refusal and Options. Beat U. Steiner

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1 Hold Your Horses Before You Close That Deal: Rights of First Offer, Rights of First Refusal and Options PROGRAM OVERVIEW: Beat U. Steiner This program is an advanced look at Rights of First Offer ( ROFO s ), Rights of First Refusal (ROFR s) and options (sometimes referred to collectively in this paper as preferential rights and by some practitioners as preemptive rights ). The topics in this program are intentionally narrow and specially selected. The program looks at preferential rights in depth from four vantage points: as a drafter of such a right, as a litigator, as a title insurer and as a law professor. For this reason, this and the other papers will not cover the basics of preferential rights, except in a summary way. Preferential rights are commonly used by real estate lawyers in a number of contexts, such as office and retail leases, ground leases, residential condominiums and cooperatives, planned communities, franchise agreements and joint ventures (whether as partnerships, LLC s or in some other form). They are also used in all kinds of more obscure circumstances, such as renewable energy financings and by church denominations in relation to the real estate of local churches, to mention two I recently encountered. This program is limited to ROFR s, ROFO s and options in the context of commercial real estate transactions. It does not deal with the many additional issues that arise in other contexts, particularly in franchise agreements and joint ventures. ROFR s, ROFO s AND OPTIONS DISTINGUISHED ROFR s, ROFO s and options are usually granted as part of a larger transaction, such as a lease, a sale contract, or a joint venture agreement. Each of them imposes a burden on the Grantor, and there are good reasons for a Grantor to resist granting any of them if it can. Generally, the burden is perceived to be least for a ROFO, greater for a ROFR and greatest for an option. A common complaint about preferential rights is that people brokers, lawyers and especially judges confuse terms, especially calling ROFO s as ROFR s and vice versa. A simple explanation of each follows: ROFO Right of First Offer Sometimes called a right of first opportunity. It gives the Holder the opportunity to respond to an offer the Grantor is willing to make to (or accept from) the Holder, and to take to the open market if the Holder does not accept it. Its chief advantage to the Holder is the ability to accept what the Grantor is willing to take to the market before the Subject Property goes to the market. Its chief disadvantages to the Holder are that (1) the offer may not come at a propitious time for the Holder and (2) the Holder has to respond without knowing what the market is, although it can protect itself by setting limits on what better offer the Grantor can accept without giving the Holder another chance to accept the better offer. ROFO s are used in approximately 32% of commercial leases. 1 1 The percentages here and in the next two paragraphs are based on a poll responded to by members of the ACREL Leasing Committee.

2 ROFR Right of First Refusal Sometimes called a right of last opportunity. It gives the Holder the right to accept an offer made by a third party to the Grantor. Its chief advantage for the Holder is the ability to accept an offer that has been tested by the market that is, at least one other party is willing to accept those terms. Its chief disadvantages to the Holder are that (1) the offer may not come at a propitious time for the Holder and (2) the Holder has to accept what a third party has offered, rather than what the Holder might find optimal. Its chief disadvantage to Grantor is the requirement that it must negotiate another deal to present to the Holder an exercise that, because it may result in futility, is not only difficult but, generally, depresses the market for the Subject Property. ROFR s are used in approximately 13% of commercial leases. Option A unilateral power granted to the Holder to exercise a right, usually to purchase property, or, with respect to a lease, to extend or shorten the term or to expand or contract the leased premises. An option benefits only the Holder, never the Grantor, but a Grantor gives an option usually as part of a larger deal, to get the deal done. Its chief advantage to the Holder is that it may, but does not have to, be exercised. Its chief disadvantage to Grantor is that the property subject to an option is limited in use to what is practical given the possibility that the option may be exercised at the discretion of the Holder. The Grantor protects itself by setting limits on when and how the option may be exercised. An option of one kind or another is used in approximately 75% of commercial leases. STATUTORY ROFR S One of the questions our panel was asked to address relates to statutory preferential rights. There are a few, and it is worth checking your state or provincial laws as these statutes are generally obscure and, thus, can come as a surprise. A few examples are: Uniform Partition of Heirs Property Act with respect to heirs property, the Act grants a right to the co-tenants who do not request partition to purchase the interest of the co-tenant(s) who request partition for a price based upon the fair market value of the property as determined by a court ordered appraisal procedure. Enacted in Alabama, Arkansas, Connecticut, Georgia, Montana, and Nevada. Introduced to the 2016 legislature in Hawaii, South Carolina and West Virginia. Partition by sale - ROFR or buy-out right granted to tenants in common if a cotenant seeks partition and the court orders a partition by sale See e.g., South Carolina Code of Laws, Section Also granted by courts in some states by common law. See Mitchell article cited in the Resources Section below. Petroleum Marketing Protection Act (PMPA), 15 USC Sec See Patel v. Sun Company, Inc., 141 F.3d 447 (3rd Cir. 1998). In the context of a petroleum franchisor s decision to terminate the franchise (e.g., because it is leaving the market), the franchisor must have made either a bona fide offer to sell the property to the franchisee or, if applicable, have provided the franchisee a 2

3 DRAFTING CHECKLIST right of first refusal of at least 45 days duration on an offer made by a third party. PMPA Section 2802(b)(3)(D)(i)(III). State counterparts to the PMPA: e.g., California Business and Professions Code Sec ; CT Gen Stat Sec mm (2012); N.J. Rev. Stat. Sec 56: (2013). Bankruptcy Code 11 U.S.C. 363(i): Before the consummation of a sale of property to which subsection (g) or (h) of this section applies [sale of property in a Chapter 11that is owned by a debtor and one or more non-debtors], or of property of the estate that was community property of the debtor and the debtor s spouse immediately before the commencement of the case, the debtor s spouse, or a co-owner of such property, as the case may be, may purchase such property at the price at which such sale is to be consummated. Attached is a checklist indicating many of the issues that might be considered in drafting the terms of a preferential right. The length of the checklist is indicative of how complex preferential rights are. What it highlights are all the issues that may not be addressed in a simple clause that grants a preferential right A caveat: the checklist has a subliminal bias towards preferential rights in leasing transactions. 3

4 RIGHTS OF FIRST OFFER, RIGHTS OF FIRST REFUSAL AND OPTIONS 1 DRAFTING CHECKLIST 2 o Granting issues o Purpose of the Preferential Right o Ability to expand o Ability to acquire the Subject Property if ever sold o Ability to control ownership of the Subject Property o Protection of a co-tenant s interest o Other o Which Preferential Right is best o Right of First Negotiation (as an alternative to a ROFO) o Right of First Offer ( ROFO ) o Right of First Refusal ( ROFR ) o Option o Auction process (as an alternative to a ROFR) o Grantor should consider negative economic and practical consequences of granting the Preferential Right o Reduction in value of the Subject Property o Delay in consummating a deal o Finding a willing buyer or tenant if a ROFR or option exists o Time to clear the preferential right o Possibility of a dispute and litigation o If relevant under state law for an option, state in the grant whether the option is a true option or a contract of sale o Grant made by the proper party or parties (e.g., all owners of the Subject Property) o Grant complies with Statute of Frauds, if applicable o Consideration o Adequate is given for the grant o If part of lease or other agreement, that may be sufficient o If a naked grant, separate consideration may be required o The need to recite the consideration and what recitals are legally acceptable o Consider the interplay of the Preferential Rights if more than one right is granted (e.g., ROFR and option) o Duration o Consider effect on enforceability (unreasonable restraint on alienation) o Consider Rule Against Perpetuities o Consider statutory limits on duration or enforceability, if any 1 Referred to in this checklist as Preferential Rights and sometimes elsewhere referred to as Preemptive Rights 2 This checklist covers real estate transactions commonly using preferential rights (with particular emphasis on leases). It does not cover many additional issues relevant to preferential rights in a franchise agreement or in a partnership, limited liability company or other joint venture agreement. i

5 o Is the Preferential Right an interest in real property or not? o Effect under state law o Availability of specific performance o Rights in casualty loss and condemnation proceeds o Ability to obtain title insurance o Inurement and binding on successors and assigns or not (e.g., survives transfer of the Subject Property by the Grantor) o Covenant running with the land or not o Is it a personal or a real covenant? o Privity issues o Does it touch and concern the land? o If a real covenant, consider the Rule Against Perpetuities o Right to record the Preferential Right or evidence of it o Enforceability if not recorded o Form of recorded document o The entire document granting the Preferential Right o Memorandum of the Preferential Right o Short form granting the Preferential Right - required in some states (e.g., Colorado) o How to remove the encumbrance on title o Form of release consider whether a re-conveyance is required o Quitclaim deed o Release instrument o It is hard to effect a release without Holder s cooperation at the time of release consider o Quitclaim deed or release instrument held in escrow o Liquidated damages for failure to release o Is it a covenant running with the land, even if recorded? o Ability to obtain title insurance to insure the Preferential Right o Effect of grant on any existing mortgage o Due-on sale clause o Restrictions on encumbrances o Effect of the bankruptcy of the Grantor or the Holder on the Preferential Right o Application of the covenant of good faith and fair dealing o Applies if the grant is merely a right to negotiate o Applies to the terms of an offer in a ROFR and the terms of the third-party in a ROFR o Applies to any discretionary matter either the Grantor or Holder may exercise as to the Preferential Right or its exercise o Brokerage obligations o On the grant of the Preferential Right o On the exercise of the Preferential Right o Should Holder get the benefit if the Grantor pays no commission? o Governing law o Effect on the granting agreement if the Preferential Right is not exercised (e.g., does lease continue of purchase option is not exercised?) ii

6 o Who can exercise besides Holder? o Assignee of the right to exercise the Preferential Right o Assignee of the rights after the Preferential Right is exercised o Affiliate(s) of the Holder define affiliate o Assignee of the lease in which the right is granted o Acquirer of stock or membership or partnership interest of Holder o Surviving entity in a merger o Foreclosing lender of the Holder s interest o Trustee in bankruptcy of Holder o Subject Property define carefully o Specified space or parcel of real property define accurately o As to leased space o Any space in the Building o Any space on the same floor or specified floors of the Building o Adjacent or contiguous space - define adjacent or contiguous o At least one common wall? o Ignore separations created by bathrooms, staircases, elevators? o Is across the hall adjacent or contiguous? o For a ROFR, the right is not applicable if the third party offer incudes more space or property than the Subject Property o Grantor will want exercise only as to all or none o Holder will want to exercise the ROFR as to the Subject Space without taking the additional space o Holder will want to exercise a ROFO or option as to part, but not all, of the Subject Property o Grantor will resist o Grantor may allow partial exercise, so long as the remaining space can just as easily be rented to a third party o In a lease, Grantor or Holder may want the Subject Property to be measured o Grantor will want current measurement standards (e.g., BOMA) o Holder will want same measure standard as applies to its existing lease o In a lease, consider signage, parking, storage and other ancillary space o Appurtenances (especially for rights to purchase) o If the Subject Property is a portion of a larger tract, consider all issues related to the subdivision o Legality of the subdivision o Effect on zoning and other land use rights o Availability of access and utilities o Conditions to exercise of the Preferential Right o No Event of Default o At the time of exercise o At the time the Holder takes occupancy of or acquires title to the Subject Property iii

7 o No event which with the passing of time of or giving of notice would result in an Event of Default o At the time of exercise o At the time Holder takes occupancy of the Subject Property o For a ROFO o What triggers the Offer? o Grantor s intention to sell or lease how manifested? o Grantor s giving notice to Holder (regardless of what else Grantor has done to start the sale or lease process) o Possibly a notice from the Holder that it wants the ROFO to begin o Who makes the first offer, the Grantor or the Holder? o Any limitations on the offer? o Grantor s or Holder s estimate of fair market (fair rental) value o Reasonable o Good faith o Factors taken into consideration o Creditworthiness of the Holder o No or reduced brokerage commission o Length of the lease term, if applicable o Quick close o For a ROFR, what triggers the offer? o Offer from a third-party Grantor will want to consider excluding: o Transfer to an affiliate define affiliate o Transfer by operation of law o Mergers, consolidations, share exchanges and the like o Stock or membership interest transfers o Transfer in exchange for stock or partnership or membership interests held by Grantor o Transfer of all or substantially all of Grantor s assets o Distribution of assets following dissolution of the Grantor o Like-kind exchange o Mortgage, deed of trust or other lien o Transfer in foreclosure or deed in lieu of foreclosure o Condemnation or deed in lieu of condemnation o Transfer to a governmental entity o Transfer among co-tenants o Co-tenant partition o Estate planning transfer, including transfers to a trust, family limited partnership or family limited liability company o Gift or charitable donation o Ground or other lease (with or without a purchase option) o Sale, lease-back transaction o Easement, license or other nonpossessory interest o Transfer of more than the Subject Property or of the Subject Property with specified conditions, limitations, restrictions or the like (i.e., a package deal ) iv

8 o Package deal does not trigger the Preferential Right o Holder has right to accept package deal or not o Holder may exercise the Preferential Right without regard to the additional property, conditions, limitations, restrictions or other elements How to allocate or determine purchase price o Holder may provide economic equivalent to additional property, conditions, limitations, restrictions or other elements How economic equivalent is determined o How Holder may respond to a package deal to avoid losing its Preferential Right Additional time Right to conduct due diligence o Grant of a Preferential Right to a third party o Bona fide offer o Market price o Market standard terms of sale o No unique or impossible-to-match terms to thwart the ROFR o No poison pills o For an option, what triggers the right to exercise? o At any time chosen by Holder o Passage of time or time window o Occurrence of a specified event o Expiration of the lease o Failure to commence construction or other condition subsequent o Desire to sell or exit o Other event applicable in the circumstances o Lease or other agreement containing the grant is in full force and effect o Lease has not been assigned by Holder o Holder wants right to assign, at least to affiliates define affiliates o Holder has not subleased any of the Premises o Holder wants right to sublease, at least as to some portion of the Premises o No change of control of Holder o Holder will resist o Holder will want exclusion if it is a public company o Holder will want at least a defined universe of other parties who can control Holder o Exercise period (if Preferential Right has a limited duration) o Required time from the commencement of lease has run o Preferential Right has not expired o Preferential Right is not subject to rights of third parties o Third party rights existing when Holder s lease is entered into o Holder will want the details of the existing rights o Holder will want Grantor to allow the exercise of those rights only strictly in accordance with their terms v

9 o Grantor will want the right to extend leases of existing tenants o Third-party rights granted by Grantor to third parties after lease is entered into Grantor wants to maximize flexibility for future deals with third parties o Holder will resist as to grants of future rights o Holder will want this limited o Customary (or specified) renewal rights o Any ROFO s. ROFR s and options, subject to the rights of the Holder o Right of Grantor or its affiliates to use the Subject Space o Right of Grantor to leave the Subject Property vacant or off the market o Accepted within the specified number of days from when Grantor gives Holder notice of the offer ( Offer Notice ) o Acceptance of exact terms stated in the Offer Notice o Holder wants acceptance of substantially (materially) the same terms or commercially similar terms o Courts will often ignore immaterial terms the Holder cannot match o Holder s creditworthiness at the time of exercise (for lease of the Subject Property) o Holder will want creditworthiness equal or better than at the time of the original lease o Agreement as to brokerage obligations o Consent of Holder s guarantor(s), if any o Offer Notice (for ROFO and ROFR) o Form of third-party offer for ROFR o From a third-party not an affiliate define affiliate o Bona fide offer o Not a shell third-party o Not made up to defeat the Preferential Right o What is required from third party o Term sheet o Letter of intent o Fully negotiated lease or purchase contract o Contents of Offer Notice (for ROFO and ROFR) o For a lease o Description of the Subject Property o Rentable area of the Subject Property o The approximate date the Subject Property will become available in a ROFO or the commencement date in a ROFR o The rental rate o Additional Rent terms o The term of the lease applicable to the Subject Property, including options, if any o Holder usually wants the same term and same options as in its existing lease vi

10 o Grantor may want to hold to the term stated in the thirdparty offer if Holder has a ROFR o Grantor will want a minimum lease term applicable to the Subject Property (e.g., the usual term in the market for the type of space) o Grantor may not want to include options to renew o If Holder s existing has a longer term than that in the offer Grantor may be willing to match the term Need to determine rental rate during the extended period o Condition of the Subject Property when delivered by Grantor o Amount of tenant finish allowance, if applicable o Any other concessions (e.g., rent abatement, moving allowance) o Holder will want, in addition: o Any improvements to the Subject Property Grantor will make o Any allowances for improvements or other items Grantor will grant o Any other material terms of the offer Operating expenses that are passed through, if applicable Grantor will want to use its standard passthrough Base year for operating expenses, if applicable Expense stop, if applicable o For a purchase (see also other terms below) o Description of the Subject Property be as complete and clear as possible o Purchase Price o Amount o How paid o Date of closing o Condition of the Subject Property o Contingencies to closing, if any o Any other material terms o Rights of Grantor and Holder if Preferential Right not exercised o Right is waived if not timely accepted Grantor may want Holder to acknowledge waiver in writing o Right may be exercised only once o Holder will want a continuous right o Every time the Subject Property becomes available o Grantor will want to limit duration of ROFO s and ROFR s, especially towards the end of the term o Grantor may deal with the Subject Property without regard to the Preferential Right vii

11 o The Holder with a ROFO or ROFR, will want the Grantor to re-offer the Subject Property to the Holder if o Grantor leases or sells it: o For less than the rental rate or purchase price offered to the Holder The Grantor will want some percentage of that rate or price (e.g., 90 95%) o On terms (substantially or materially) more favorable to the third party o The third party defaults under its contract o After a specified date o Holder wants a short time (e.g., 90 days) o Grantor wants a long time (e.g., 180 days one year) o Removing the Preferential Right from real estate record if it has been recorded o Agreement by Holder to remove of record when Preferential Right has expired or been waived o Quitclaim deed from Holder to Grantor held in escrow o Automatic expiration stated in the recorded document if the Preferential Right expires by its terms o Method of exercising the Preferential Right o Notice of exercise of the Preferential Right o Exercised on time o Time is of the essence o Grantor s right to waive timely compliance or not o Exercised in the manner required (e.g., addressee, type of notice) o Exact matching (strict compliance) or o Substantial compliance o Grantor s right to waive failure to comply or not o No deviation from the grant o Same legal description of the Subject Property o No additional terms o No variation of terms o No conditions to exercise or closing not included in the grant o Payment in the amount and form required by the grant, if any o Grantor may want Holder to state that Holder received the offer (and when) and that Holder acknowledges the offer complies with the terms of the Preferential Right grant o For a ROFO or ROFR, notice of acceptance of the offer from Holder to Grantor within a specified number of days after offer notice from Grantor o No changes to the offer o No conditions to the offer o Time is of the essence o Delivery of security or earnest money deposit, if any o Delivery of advance rent, if any viii

12 o Entering into a new lease or amendment to the existing lease within a specified number of days o Entering into a purchase contract within a specified number of days o Holder will want days counted from when it receives the lease documentation or purchase contract from Grantor not from date of exercise of the Preferential Right (see Implementation section below) o Terms that are accepted by Holder o In a ROFO, the terms stated in the Offer Notice o In a ROFR, the terms offered by the third-party o Exact terms o Substantially the same terms o For a lease, Holder will want adjustments for o The term of the lease (see above) o Terms and conditions the same as in its existing lease: o Limits on expense pass throughs (e.g., operating expenses, taxes, insurance common area maintenance charges) and other additional rent o Assignment and subletting rights o Notices and grace periods o Rights as to alterations o Other special accommodations to Holder o Parking rights at the same rate (spaces per square foot) as its existing lease, if applicable o Storage rights at the rate as its existing lease, if applicable o No security deposit if it does not have a security deposit under its existing lease o Right to substitute a letter of credit for a security deposit, if that is allowed under its existing lease o Condition of the Subject Property o Grantor will want them as is o Holder will want at least what is offered by Grantor to the market in a ROFO and at least what is offered by the third party in a ROFR o In an option to purchase, Holder will want Grantor to maintain the Subject Property in its existing condition, ordinary wear and tear excepted (if Holder is not in possession of it) o Implementation after exercise of the Preferential Right o For a lease o New lease or amendment to existing lease o Time period to complete o Terms other than those stated in the offer need to be addressed o Brokerage obligations need to paid o Grantor will want to delay commencement if the Subject Space is occupied and occupants do not surrender the Subject Property on time o For a purchase ix

13 o How determined o Include a purchase and sale agreement in the grant o Describe general terms in the grant o Provide in the grant for agreement to agree to all terms (and the Preferential Right lapses if not agreed upon) or terms not stated in the grant o Terms to be addressed if not stated in the grant o Purchase price or manner for determining the purchase price o Earnest money, if any o Date of closing o Manner of closing o Closing costs o Closing documents o FIRPTA, Nonforeign affidavit o Seller title affidavit and agreement o Seller s closing certificate to purchaser o Closing or settlement statements o Documents required by the title insurance company to issue the title insurance policy o Other customary closing documents o Conditions to closing rights to terminate and not complete purchase for any reason o Grantor conditions o Holder conditions Financing Condition of title Results of a survey Results of an appraisal Condition of the Subject Property Environmental condition of the Subject Property (e.g., a clean Phase I Environmental Assessment) No legal violations Estoppels o Mutual conditions No litigation (affecting right to sell or otherwise) Casualty losses Holder may want right to terminate or to close with an abatement of the purchase price or rights to all insurance proceeds and a credit for the amount of the deductible Consider if Uniform Vendor and Purchaser Risk Act or other similar statue is applicable Right of Holder to participate in settlement Condemnation Right to participate in action and settlement Rights to any proceeds x

14 o Grantor wants option to expire the day before the taking so Holder has no right o Holder wants condemnation proceeds in excess of the option purchase price Consider if Uniform Vendor and Purchaser Risk Act or other similar statue is applicable o Right to a survey of the Subject Property o Surveyor o Type of survey o Matters to be included (e.g., Schedule A items in an ALTA/NSPS survey) o Type of deed o Condition of title o Existing title exceptions agreed to o Additional title matters authorized by Holder in advance (in grant or after exercise) o Obligation of Grantor to cure title defects o Title insurance to be provided o Issuer o Type of Policy o Cost o Endorsements o Prorations o Condition of the Subject Property o As is o Condition existing when right is granted to Holder, subject to normal wear and tear o Condition existing at closing if Holder is in possession o Environmental condition o Warranties and representations o Survival how long o Basket and cap o Brokerage obligations o Remedies for default o Buyer default o retains earnest money as liquidated damages o Actual damages o Specific performance o Effect on lease or other agreement in which the Preferential Right was granted o Seller default o Actual damages o Specific performance xi

15 o Effect on lease or other agreement in which the Preferential Right was granted o Resolution mechanism for terms not stated in the grant - To be determined after exercise o Negotiation o Appraisal mechanism for price o Arbitration for all terms o Mediation o Litigation Jurisdiction Venue o Effect on lease, if applicable o Common law terminates lease upon exercise and makes Holder a contract purchaser with no obligation to pay rent o Grantor will want lease to continue until closing of the purchase o Grantor will not want capital expense obligations to apply after exercise of the option o Effect on existing mortgage, if applicable o Lender issues with Preferential Rights o Consent requirements o Upon grant (e.g., restriction on grants of rights in the Subject Property) o Upon exercise (e.g., due-on sale clauses) o Effect on value of the collateral o Treatment in foreclosure o Ability to foreclose out o Nondisturbance o Separate agreement o Included in SNDA o expressly (best) o By implication o Limitations on the mortgagee s obligations to honor the Preferential Right o No representations or warranties o Deed without warranties of title for conveyance (option to purchase) o No offsets on option purchase price for Grantor s defaulted obligations o Priority of the Preferential Right vis-a-vis the mortgage o Mortgage exists at time of the grant and is prior in right o Subordinated in the lease or in the grant o Effect of relation-back o Effect of the doctrine of merger on the mortgage o Payment of mortgage upon exercise of an option to purchase o Sufficiency of option price o Prepayment penalty o Prior notice requirements xii

16 o Continuance of lease if Grantor breaches the Preferential Right or following its exercise o No obligation of mortgage holder to cure a default if Grantor breaches the Preferential Right or following its exercise _6.docx xiii