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Being Gun-Shy:  Difficulties Surrounding the Trigger of Right of First Refusal and First Offer

Sheldon A. Halpern
Commercial Leasing Law & Strategy
July 2, 2005

The right of first refusal (ROFR) and its close cousin, the right of first offer (ROFO), collectively sometimes called preemptive rights, are devices used to afford the grantee a degree of flexibility in potentially buying or leasing the subject property at a future time. These rights can be considerably more troublesome, especially to grantors, than may be immediately apparent to many real estate deal makers. Many who have been "burned" recognize that the problems include: 1) financial loss and delay in completing a transaction that arise from dampened interest in the subject property on the part of third party potential bidders, and 2) disputes (sometimes resulting in litigation) that arise from issues surrounding the triggering, execution, and preservation of the right. This article focuses on the second problem, with special emphasis on disputes that revolve around the triggering of the preemptive rights. It also suggests certain drafting implications that follow from the analysis.

The ROFR assures the grantee that if a third party offer is made to buy (or lease, in a landlord-tenant scenario) the subject property and if the grantor is willing to accept such offer, the grantee may choose either to buy (or lease) on the same terms or to allow the grantor to accept the offer. The ROFO operates similarly, except that the ROFO, in its most common form, requires the grantor to make its offer to the grantee before conveying the property to a third party. A ROFO mitigates the financial loss/delay problem described in the paragraph above because there is no requirement that the grantor make a third party deal before offering the property to the grantee. However, it is less helpful in mitigating the dispute/litigation problem.

The benefits of preemptive rights to the grantee include the following:

1) Right to purchase:

  • The right may allow an owner of real property to expand its holdings to include adjacent property in the future.
  • It may also be used to benefit a tenant who may wish to purchase its leased property in the future.

2) Right to lease:

  • The right may allow a tenant to expand its leased space.

3) Right to buy out joint venture partner:

  • The right, traditionally granted to all venturers reciprocally, is intended to be activated upon the exit of one member. It allows the remaining venturers the opportunity to purchase the departing venturer’s interest before it can be conveyed to a third party.

When is the Right Triggered?

The preemptive right is triggered when the grantor is prepared to sell or lease the subject property (having first received an acceptable offer in the case of the ROFR) to an outside party, or in fact takes action to do so. From the grantor's perspective, some transfers should not trigger the right. However, the grantor may be primarily motivated at the time of the transfer by an attempt to extricate itself from the limitations of the preemptive right. Disputes have frequently arisen as to which transactions (undertaken for which reasons) appropriately avoid triggering the right.

The following are examples of scenarios in which it may be unclear whether the right is triggered if the document does not expressly so provide:

1) Grantor sells a portion of the property to, a third party:

If the subject property consists of two lots, and the grantor sells one of those lots, is the grantee’s right triggered? From the grantee’s perspective, allowing one lot to be sold free of the preemptive right would completely vitiate the right because it would imply that the second lot could be also be sold unencumbered by the right. From the grantor's perspective, a preemptive right was granted only as to both lots; if the grantee needed a right to buy either lot, it could have attempted to negotiate for such right. Careful drafting can avoid the issue when there is more than one distinct lot. Dealing with other partial sale possibilities can create more difficult drafting challenges--for example, if the grantor subdivides the subject property after granting the right and attempts to sell one of the subdivided lots.

2) Grantor receives an offer for the purchase (or lease) of more than the subject property:

Suppose the grantor receives an offer on more parcels than are covered by the right, or attempts to sell the larger group of parcels in a “package deal.” The judicial response to such a situation varies widely. In many cases courts have refrained from activating the grantee’s right to meet or beat the outsider’s bid, while in others, the courts determined that the right was triggered. Among those judicial decisions that did not activate the preemptive right, the remedy for the grantee has ranged from the harsh measure of allowing no relief, to providing the grantee with injunctive relief against the grantor’s actions. In essence, this latter solution protects the grantee by blocking the package deal, but does not provide the grantee the full enjoyment of the right by enabling it to buy (or lease) the subject property.

In those cases in which the right is determined to be triggered, sometimes the grantee is allowed to acquire the subject property, but not the entire package included in the package deal. Such an approach may present valuation problems, as the grantor and third-party would have incentive to overvalue the subject property. In other scenarios, the grantee is granted monetary relief, and in others, the grantee is given the choice to purchase the entire package, rather than only the one protected by the preemptive right. The wide disparity in the judicial holdings is a clarion call for careful negotiation and drafting.

3) Grantor corporation conveys the subject property to an outsider via a stock sale:

Is the preemptive right triggered when a corporate owner of the subject property makes a stock sale of the company? Courts have held that the right is not triggered. The same issue applies to property held by other forms of entities, eg, partnerships and limited liability companies. These problems (from the grantee's perspective) can be overcome by careful drafting, but a more difficult negotiation and drafting problem relates to the potential sale of some, but not all, of the stock (or partnership or membership interests). This issue also arises frequently in negotiations as to lease assignment rights and can be dealt with similarly (setting a threshold percentage and carving out sales of stock of public companies and mergers and consolidations).

4) Grantor transfers the subject property to an affiliate:

This often occurs with no intent to defeat the grantee’s preemptive right. For example, if the grantor, a developer, transfers the subject property to a joint venture between the grantor and a financial partner, the grantee may not be affected in a way that would warrant triggering of the right. If the grantor is an individual, such “affiliate” should be defined to include family members. (Perhaps the preemptive right should "run" with the property and limit sales by the affiliate owner.)

5) Grantor transfers the subject property pursuant to a separate agreement or for tax reasons:

Suppose the grantor conveys the subject property to another entity pursuant to an agreement external to the grantor-grantee relationship? For example, a partnership or corporation holding the property as its sole asset may dissolve or a trustee may convey the property to the beneficiary, in each case pursuant to governing documents. Cases have held that the resulting transfer does not trigger the preemptive right because the transfer was mandated by an agreement that is independent of the agreement documenting the preemptive right. Foreclosure of a mortgage is another example. In each case it is important to specify whether the right "runs" with the property. In the case of the mortgage, allowing it to do so may inhibit financing.

It could also be argued by grantors that conveyances made primarily for tax reasons should not trigger the grantee’s preemptive right, eg, to take advantage of Section 1031 tax-deferred exchange benefits or the conveyance of the grantor’s property to an operating partnership affiliated with a REIT in exchange for partnership units. A grantee might be loathe to accept absolute carve outs for fear that the primary motivation of the grantor might be to evade the preemptive right. How can the motivation issue be resolved at the drafting stage? Should the preemptive right be enforceable when the replacement property or the partnership units are sold?

6) The third party offer is withdrawn or never fully consummated:

Sometimes a third party may modify or withdraw its offer after the initial extension of it. Case law tends to follow the sensible approach that if the outsider’s offer is withdrawn before the grantee acts upon its right, the right is not triggered. The issue of offer consummation presents a more complex question of what action by the third party actually constitutes the offer – for example whether a nonbinding letter of intent triggers a ROFR, or whether a fully articulated and executed offer is required to act as a trigger. In a comprehensively drafted provision, the exact format of the offer that would trigger the ROFR should be defined, and it should be made clear that only an offer that the grantor is prepared to accept should trigger the ROFR. This issue also points to a benefit of the ROFO over the ROFR: with the former, the right is triggered by the grantor’s decision to sell (or lease), not by some instrument being delivered by an outsider. (Even in a ROFO, however, the comprehensiveness of the offer made by the grantor to the grantee should be agreed upon.)

7) Unique or unmatchable provisions are included in the third party offer:

Suppose the offer submitted by the third party features provisions that are difficult to match by the grantee? The introduction of such complications could either be a deliberate attempt to preclude the grantee from being able to execute the ROFR, or simply a result of the business dynamics behind the third party’s interest. The courts tend to rule that if the distinctive feature of the third party offer was introduced in good faith and motivated by sound business reasons, the grantee would be required to match the offer on equivalent terms in order to capitalize on the ROFR. In one case, for example, the third party’s offer to purchase the grantor’s property included a provision that the third party would share profits from the property with the grantor. The court ruled that the grantee did not have to match the new term, concluding that the grantor and third party intended to preclude the grantee from exercising its ROFR. Another case featured a third party offer that provided for a Section 1031 exchange of the offeror’s residential properties for the grantor’s subject property. The court ruled that the grantee must identify a suitable replacement property in order to exercise its ROFR. The ROFO would avoid issues such as those presented in the above cases because that provision is not contingent upon a third party offer.

Conclusion

The problems surrounding triggering events discussed in this article are examples of the myriad problems that can arise in connection with ROFRs and ROFOs. Often these problems arise from unanticipated facts and events. It is difficult to anticipate all contingencies. This challenge in forecasting how the preemptive right will play out, in combination with the fact that preemptive rights are often not central to the underlying business deal (so that the deal person may not be anxious to spend substantial legal fees to achieve a well-crafted provision), too frequently results in a failure to draft these rights comprehensively. This failure can create substantial confusion as to whether a triggering event occurs. From the grantor's perspective, it is usually best to avoid granting preferential rights altogether, and especially to avoid granting them as a "throw away" concession.

Sheldon A. Halpern is a partner in Pircher, Nichols & Meeks, a law firm that represents real estate clients nationwide through its offices in Los Angeles and Chicago. Peter Massumi, a third year student at Harvard Law School, assisted in the preparation of this article.