Case Illustrates Twists and Turns in Dealing with Rights of First Refusal Martin Doyle Facts of the Case

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1 Case Illustrates Twists and Turns in Dealing with Rights of First Refusal By: Martin Doyle As originally published as a Special to the Legal Intelligencer, PLW, October 19, 2009 Martin Doyle is a member of Saul Ewing's real estate department in the firm's Philadelphia office. He has worked on a number of major real estate transactions and has been involved in all aspects of real estate development, sales, finance and leasing. Doyle received a law degree, cum laude, from the University of Pennsylvania Law School. The New Jersey Superior Court case of St. George's Dragons L.P. v. Newport Real Estate Group illustrates a number of interesting and important points about the drafting and interpretation of right-of-first-refusal provisions. At the highest level, the most important of these is that the grantor of such rights needs to be quite clear about its expectations with regard to their exercise. St. George's also highlights the need for drafters to consider all possible future scenarios and is interesting in part because it challenges the reader to think, "What might I have done to avoid this result?" This is emphasized by the vigorous response launched by the plaintiff landlord, who, having made his bed in one deal, fought in this litigation to undermine that deal when a better opportunity appeared within reach. Facts of the Case In 2000, St. George's Dragons L.P. (the landlord) and Nazmiyal Inc. (the tenant) entered into a lease that contained a fairly typical right of first refusal provision: "If the Landlord at any time receives one or more bona fide offers from third parties to purchase the demised premises and if such offer is acceptable to the Landlord, then Landlord agrees to notify Tenant in writing, giving the name and address of the Offeror, and the price, terms and conditions of such offer, and Tenant shall have thirty (30) days in which to elect to purchase the property for the consideration contained in the bona fide offer," as noted in the Superior Court opinion. In October 2005, the landlord and Newport Real Estate Group LLC (the buyer) entered into an agreement of sale for the property at a purchase price of $4.5 million, subject to the tenant's right of first refusal, according to the opinion. Notice was sent to the tenant stating the purchase price, and the tenant timely sent a letter exercising its right to buy the property. Immediately following this, the landlord sent the tenant a fax indicating that the landlord expected to net $4.38 million from the deal, the Superior Court opinion noted. This was followed by a draft agreement prepared by the landlord that differed in certain material respects from the

2 document executed by the landlord and the buyer. The most important difference was that tenant, under the new contract, was expressly required to pay "any brokerage commissions over $125,000." The tenant was unclear as to the import of this change and asked the landlord to clarify, which the landlord refused to do. The tenant thereupon refused to sign the new contract. Subsequently, the tenant learned that, before the tenant's lease was put into place, the landlord had entered into an agreement with a real estate broker (Brothers), which entitled Brothers to a 5 percent commission in the event that any tenant bought the property, the Superior Court opinion noted. A second broker (Pivnick) had brought the tenant to the building, and Brothers had, at the time, agreed to split its commission with Pivnick if the tenant bought the building, according to letters sent to St. George's attorney by Brothers in Brothers subsequently agreed with the landlord that if any other non-tenant party purchased the property, Brothers would accept a 2.5 percent commission, the net effect being that Brothers would receive the same percentage commission regardless of who bought the property. The Landlord's Conundrum With a sale to someone now looming, the landlord found itself in a funny position. If the tenant bought the property, the brokerage commission would be $250,000. If, on the other hand, the buyer bought the property, the commission would only be $125,000. The landlord therefore began to look for a way to shift to the tenant the cost of the additional commission that would be incurred upon a sale to the tenant. The tenant predictably refused to agree to this increase in its purchase cost. Interestingly, the issue of brokerage costs had been dealt with previously by the landlord and the tenant at the time of their initial lease negotiations. Pivnick, the broker who introduced the tenant to the landlord, had helped the parties negotiate their lease. In initial drafts, the lease included a provision that required the tenant to pay all brokerage commissions in the event that the tenant bought the property. This provision was subsequently deleted during the lease negotiations and not contained in the document signed by the parties, as noted in the opinion. The Trial Court's Findings The trial court found that the facts made it clear that Brothers was the landlord's broker and that the landlord had agreed to pay Brothers a 5 percent commission in the event that any tenant bought the property. The trial court also found that Pivnick, though having relationships with all parties in the transaction, was acting as the landlord's agent when it acted as scribe for the lease negotiations. The court found that the parties had expressly negotiated the deletion of the provision calling for the tenant to pay any commissions. Consequently, the trial court held that if the landlord sold to the tenant, the landlord was obligated by its agreement with Brothers to pay the full 5 percent commission. The trial court further found that the landlord had provided notice to the tenant that it had received an offer it intended to accept, and that the tenant then unequivocally exercised its right to purchase at the price and upon the terms offered by the buyer, whereupon a binding agreement was created between the landlord and the tenant. -2-

3 Most importantly, the trial court held that the tenant's payment obligation was "governed by the right of first refusal" and not by reference to the amount that the landlord expected to net from a sale to the buyer. The landlord's expectation as to net recovery was not referenced in the agreement with the buyer, and the lease explicitly gave the tenant the right to pay the "same consideration" as the buyer, not an obligation to pay more. In sum, the trial court held, the lease did not require the tenant to guarantee the landlord the same net proceeds, and any reduction suffered by the landlord was because of "the self imposed obligations" negotiated by the landlord with third parties. The trial court ruled that the tenant had a right of specific performance and that the full 5 percent commission was to be paid by the landlord to Brothers and Pivnick. Could the Landlord Have Avoided This Situation? To ask if the landlord could have avoided this problem is really to turn the situation on its head. The landlord's problem was not that it was getting hurt by its deal with the tenant in fact, it had agreed to this structure and its brokerage obligations years ago. What must have been driving the landlord crazy now was that it had, in the meantime, gotten an offer from Brothers that would save it $125,000, but only if the tenant did not buy the property. The landlord wanted to figure out a way to get that better result even if it were required to sell to the tenant. The problem was that the only way the landlord could achieve this would be to take skin off the back of either the tenant or the brokers, and there just were not enough volunteers to make this happen. (In point of fact, one of the brokers, Pivnick apparently did offer to cut its commission by one-half in the event of a sale to the tenant, leaving only a difference of $62,500 between reality and the landlord's ideal. The trial court rightfully expressed astonishment that the landlord and Brothers could not figure out a way to compromise on the remaining $62,500 gap in order to save a multimillion-dollar sale and avoid huge litigation costs for everybody.) Appeals Court Affirms and Analyzes RFRs The Superior Court affirmed the trial court's decision and in so doing reviewed a number of important principles regarding rights of first refusal. Such a right, the court held, "limits the right of the owner to dispose freely of his property by compelling him to offer it first to the party who has the first right to buy." Such rights may be structured in any manner chosen by the parties, but, as the court noted, most often contemplate a bona fide third-party offer as the triggering event. In such cases, the purchase price is not set out in the right of first offer provision, but is rather calculated by reference to the third-party offer, which the owner has expressed a willingness to accept. The court took the position that, since the tenant was not involved in negotiating the agreement between the landlord and the buyer, ambiguities in that agreement, if any, would be interpreted in the favor of the tenant as right holder, particularly where the landlord and the buyer appear to be working to structure their deal to the detriment of the tenant. The court confirmed the trial court's determination that the lease only required the tenant to pay the same amount as the buyer had agreed to pay, and that the tenant had not agreed to guarantee the landlord's net proceeds. The trial court cited the Rhode Island case of Kenyon v. Andersen, in -3-

4 which that court rejected a right holder's attempt to argue that it could pay a discounted price to seller since its purchase would not trigger a commission obligation; that court held that the seller was entitled to the same consideration regardless of his third-party obligations, and to rule otherwise would render such rights ambiguous and contradict the intent of the parties. The Superior Court noted that it might have been possible for the landlord to structure its agreement with the buyer in such a manner so as to achieve its goal of pushing additional costs on to the tenant. However, such a structure would only be effective "so long as the right of first refusal was also worded with sufficient clarity to put the right-holder on notice that it could be obligated to meet a price term other than solely a gross purchase price." Such drafting is unlikely to occur unless the grantor of the right is aware of the potential disconnect between various scenarios at the time the right is granted. Moreover, the court noted, if the landlord and the buyer had intentionally drafted their agreement with a sort of "poison pill" (e.g., purchase price is $4.5 million, but if another buyer purchases, that purchaser must pay the buyer an additional $1 million), such an agreement would likely be inconsistent with the landlord's obligation of good faith and fair dealing under its agreement with the tenant. Events Prior to Litigation During the course of events prior to the litigation, the landlord took certain actions that certainly did not help its standing with the court. First, the agreement with the buyer was for cash and provided for an extremely short closing deadline, which the court interpreted as an attempt to create a transaction the tenant could not meet. Second, as noted, the landlord delivered to the tenant a contract that did not mirror the landlord/buyer agreement, but failed to note that there were differences. Finally, the trial court noted that the landlord made minimal efforts to work issues out with the tenant, instead resorting to litigation once the dispute became apparent. Other Drafting Tips for Rights of First Refusal It is worth noting that the landlord's relatively simple right of first refusal provision omitted several other grantor protections that are typical in many such provisions. First, what if the landlord had wanted to transfer the property to a relative or related company? There should be a carve-out for such situations. Also, although perhaps not applicable here, what if the landlord wanted to sell a portfolio of properties, including the tenant's property? Such transactions are often carved out of rights of first refusal or are at least treated more specifically, so the rights of the tenant and landlord are more clear. (Must the tenant acquire the entire portfolio? Must the landlord pull one site out of a portfolio deal to offer to tenant, when this might harm his current deal?) Finally, and most importantly, it is arguable that if the tenant had declined to exercise its right of first refusal, the buyer would have been bound to offer the property to the tenant again if it ever wanted to re-sell; considering the burden of such a right, it is reasonable for the parties to agree that this is a one-shot deal, and that if a tenant declines to exercise its purchase right, the right will be terminated and not binding upon a subsequent owner. -4-

5 Conclusion The trial court and Superior Court clearly got this one right, and while, given chronology, it would have been difficult for the landlord to foresee this situation in time to draft to get its desired result, the case highlights the need to always consider the specific facts and circumstances of each situation. Real estate attorneys always say that each property is different and that relationships are varied and often highly idiosyncratic; these should be carefully considered before drafting a provision of such import. -5-

6 This article is reprinted with permission from the October 19, 2009 issue of The Legal Intelligencer. (c) 2009 ALM Properties Inc. Further duplication without permission is prohibited. All rights reserved. -6-