IT SEEMED LIKE A REALLY GOOD IDEA AT THE TIME:
RIGHTS OF FIRST OFFER AND FIRST REFUSAL
Joshua Stein[1]
In most places where I have lived, my bathroom sink had a lever apparatus that was supposed to control the drain stopper.If you moved the lever up or down, this was supposed to open or close the drain.It was a great idea.It sometimes worked, at least for a while.
Before very long, though, every drain stopper stopped holding the water in the sink, or it got stuck, or it got tangled up with a congealed mass of hair and old soap, or the lever handle disconnected itself from the stopper.If I ever had the drain stopper apparatus fixed, it never stayed fixed.
Eventually I learned I should not rely on the drain stopper as a way to keep the water in the sink. Even though the drain stopper lever apparatus seemed like a great idea, it just did not work in the real world. And I needed to learn to accept that. I needed to figure out some other way to keep the water in the sink when necessary.
The drain stoppers that work badly, if at all, remind me of someprovisions we often see in ground leases – provisions that sound like really good ideas but, in my experience at least, do not work very well and can produce unsatisfactory outcomes and uncertainties for all concerned.
I am referring to rights of first offer (each, a “ROFO”) and rights of first refusal (each, a “ROFR”).These rights(each, generically, a “First Right”) arise if one party (a “Seller”) decides it wants to sell its interestin the property (the Seller’s “Interest”).[2] In a ground lease, the Seller’s Interest would consist of the ground lessor’sleased fee estate or the ground lessee’s leasehold. The Seller cannot sell its Interest unless the Seller first gives the other party (the “Holder” of the First Right) an opportunity to buy it – the ROFO or ROFR.That concept has a ring of fairness and logic to it.The idea is even sort of creative.
Ground lessors often agree to grantFirst Rights to ground lessees.They do that because the whole ground lease transaction was premised, at least in part, on the ground lessor’s stated strong desire to continue to own the fee estate.If the ground lessor ever changes its mind, it seems reasonable to give the ground lessee “another shot” at buying the ground lessor’s Interest.This also allows the ground lessee to protect itself from an undesirable or at least unknown new ground lessor.[3]
Less often, ground lessees give First Rights to their ground lessors, so that if the ground lessee ever decides to sell, thenthe ground lessor can prevent and pre-empt the transaction by exercising its First Right. These clauses may reflect a desire for symmetry; a desire to protect the ground lessor from an undesirable or at least unknown new lessee[4]; or a simple exercise of negotiating leverage to give the ground lessor a future opportunity down the road.
Joint venture agreements often establish similar rights between the venturers.Most comments in this article also apply to First Rights in joint venture agreements, but this article focuses on ground leases.[5]
Regardless of the deal context, however, if you ever actually try to exercise a First Right– or have one exercised against you – they are like the drain stoppers in every bathroom sink I have known.They turn out to work in a very unsatisfactory way, or not at all.But you can never predict exactly when, why, or how they will not work.Sometimes they will not work in multiple ways.
I have recently lived through three major adventures with three clients involving First Right clauses, none written by me.Over the years before that, I encountered other First Rights.Every time, the contractual language on the First Right failed to answer some basic questions.And to the extent the contractual language did define the rights and obligations of the parties, those rights and obligations in some ways made little or no sense. They just did not work, at least from the Holder’s perspective.
Almost all the problems with First Rights described in this article arose, or were at least identified, in the three completed matters I worked on in the last year; a fourth First Rights matter that led the parties to negotiate some other resolution; and a fifth, involving a ground lease more than 50 years old, that has not started yet but could soon. Each of the three completed matters involved a $100-million plus building in Manhattan. In no case did the Holder actually exercise its First Right. In no case was the Holder happy with the process, the contract documents, or the outcome. But in no case did the matter go into litigation. And in each completed matter the Seller was able to achieve its ultimate business goal of a graceful exit.
The problems with First Rights start at the very beginning, with the definitions of terms.What’s a ROFO?What’s a ROFR?Clients throw these acronyms around rather loosely, to refer to any concept of giving the other party a pre-emptive chance to purchase before a Seller sells to just anyone the Seller finds in the marketplace (a “Seller’s Purchaser”).
My informal research indicates that the commercial real estate industry believes a “ROFO” requires a Seller to offer (the “first offer”)the Seller’s Interest to the Holder, at a price the Seller specifiesin a notice to the Holder (a “First Right Notice”), before the Seller goes into the marketplace to try to make a deal and sell the Seller’sInterest to a Seller’s Purchaser.[6]If the Holder does not meet the Seller’s proposed price in the First Right Notice, then the Seller can sell to a Seller’s Purchaser, as long as the price exceeds 95% (typically) of the price named in the First Right Notice.[7]
In contrast, a ROFR requires the Seller to go into the market, find a Seller’s Purchaser, then give the Holder a First Right Notice offering the Holderthe right to match the purchase price the Seller was willing to accept from the Seller’s Purchaser.[8]One should really call it a “right to match.”For some reason,people call it a “right of first refusal” instead – perhaps because the ROFR holder has the right to “refuse” to match the Seller’s Purchaser.This is not a very persuasive explanation.[9]But clients often say ROFO when they mean ROFR, and vice versa.[10]And they sometimes talk about a “right to match” when they mean a ROFR or even a ROFO. And they rarely give much thought to how any of these First Rights actually work.[11]
A ROFO has the advantage of letting the Seller “clear the decks” before going out into the market to try to sell itsInterest.Once the Seller has given a valid First Right Notice and the Holder does not respond in time, the Seller can proceed freely with itsmarketing, bidding and negotiation process, without having to explain[12] to prospective Seller’s Purchasers that the Holder might match the Seller’s Purchaser’s bid.In contrast, with a ROFR, the Seller will worry, with good reason, that prospective Seller’s Purchasers will not work too hard to analyze and possibly buy the Seller’s Interest – they will not take the Seller’s offering seriously – if the Holder can pre-empt whatever transaction the Seller and the Seller’s Purchaser negotiate.[13]A ROFR will drive away Seller’s Purchasers, hence drive down the Seller’s selling price.
On the other hand, a ROFO forces a Seller to figure out satisfactory pricing when it gives a First Right Notice, long before it has fully exposed its Interestto the marketplace.The Seller may guess too high or too low in setting the price in the First Right Notice.The Seller can, of course, reduce that risk by doing some marketplace homework before naming its ROFO price.Sellers often do that.[14]The sequencing still lacks the discipline and reliability that might have resulted from full market exposure and real bids from realpotential Seller’s Purchasers.
In my experience, if any party to a real estate transaction cannot avoid granting a First Right, it will typically prefer to grant a ROFO rather than a ROFR, though plenty of smart people feel otherwise.In my experience, the desire to simplify the third-party marketing process usually outweighs the burden of having to come up with a number for the ROFO before going to market.[15]
For any First Right, if a Seller ever wants to sell,[16] the Seller will have to give the Holder a First Right Notice, triggering the Holder’s First Right and allowing the Seller to proceed only if the Holder does not exercise that First Right.[17]The Holder will then need to respond to the First Right Notice within a period that is so short that the First Right is useless or at best highly problematic.
Typically, the deadline for a Holder to respond to any First Right Notice(the “Deadline”) seems to be 30 days. But if a Holder receives a First Right Notice, even the most diligent Holder will need a few days to figure out what the First Right Notice is, what to do about it, which lawyer to call,[18]and what the Holder’s rights and options are.And a First Right Noticeoften seems to arrive on a Friday before a holiday weekend or when the decisionmaker is out of town or in the month of September (the Jewish holidays) in New York.For these and other reasons, the typical 30-day Deadline often quickly becomes 20 days or less.
Within that unrealistically quickDeadline, the Holder must decide whether it wants to buy the Seller’s Interest – typically a major capital investment that may or may not match the Holder’s current investment agenda, liquidity, time horizon, and funding position. That decision, in turn, requires significant underwriting and due diligence, somewhat mitigated by the Holder’s existing familiarity with the Seller’s Interest.It also requires the Holder to figure out how to finance the purchase, because most real estate investors will not have piles of cash sitting around waiting to fund the entire purchase price for the next deal.[19]
A conservative Holder will not want to commit to purchase unless the Holder knows a lender is willing to provide financing for most of the purchase price.[20]But 20 days is barely enough time to engage a mortgage loan broker (if desired) and open conversations with potential lenders, let alone identify a single best lender and achieve a relatively high comfort level that the lender will in fact make a large enough loan to support a purchase pursuant to a First Right.
Even though the Holder will not actually have to close within 30 days after they receive a First Right Notice, they will have only that time in which to decide and commit to close – with potentially serious consequences if they default.The Holder cannot safely decide to exercise and then ignore the consequences of a possible change of heart.
The short time limit will become particularly burdensome if, in that time, the Holder not only tries to decide whether and how to exercise its First Right, but also tries to negotiate some other resolution with the Seller. If the Holder chooses to go down those two paths at once, each exercise will significantly distract the other, and the 30 (really 20 or fewer) days will pass very quickly.
To mitigate these problems, a Holder may want a contractual right to extend the Deadline for potentially a significant time, in exchange for paying an extension fee, perhaps calculated on a daily basis. The Seller will, of course, worry that any delay increases uncertainty and particularly the risk of losing Seller’s Purchaser, or further deterring Seller’s Purchaser from the outset.
The next problem that often arises with First Rights involves the garden-variety issue of making sure that if a Holder does decide to exercise its First Right, it does so in a valid and effective way.That is not always as easy as it sounds.Anyone who needs to give a formal legal notice can fail to do so in a wide range of ways.[21]In the world of First Rights, the courts have been known to cut Holders some slack if they do not exercise in strict compliance with the First Right, much as the courts sometimes excuse imperfections in the exercise of an option. A Seller can try to protect itself from sympathetic courts by building appropriate protective language into the First Right. And, to avoid any need to throw itself upon the mercy of the courts (sympathetic or otherwise), as soon as the Holder considers exercising its First Right, the Holder should re-read the ground lease and the First Right Notice to prevent any future issues.
Even if a Holder intends to exercise its First Right strictly in accordance with its terms, uncertainty may still surround the exact requirements for valid exercise of a First Right, as more fully described later in this article.And the Seller may have taken certain positions about what would constitute a valid exercise.If the parties do not see eye to eye on these matters, it may be hard for the Holder to figure out exactly what it must do in order to give a valid exercise notice.
In these cases, the Holder may want to give two notices. The first would say as little as possible, merely referring to the ground lease and the First Right Notice, and stating that the Holder exercises its First Right.This first notice would comply with the literal requirements of the ground lease, but otherwise take no position about what constitutes a valid notice, to avoid creating issues or grounds for the Seller to claim the exercise notice was invalid.
The Holder could also give a second notice, addressing those issues and offering to resolve them quickly, but making clear that the first notice is unconditional and effective regardless of those issues or their resolution.The Holder will probably not want uncertainty or issues to cloud the effectiveness of the exercise notice.
Conversely, the Holder may receive a First Right Notice and may assert that it is not a valid notice, or may not respond at all before the Deadline.In that case, can the Seller safely go ahead with a Seller’s Purchaser?Only if the Seller is absolutely sure that the First Right Notice was valid and – if the Holder has claimed the notice is invalid -- that the Holder is completely wrong.
Few Sellers and even fewer Seller’s Purchasers (and even fewer lenders to those Seller’s Purchasers) would be willing to go ahead in the face of such a dispute.Instead, whether or not a court would ultimately agree with the Holder, the existence of a dispute of this type could in practice derail the Seller’s ability to proceed with a Seller’s Purchaser. If the Seller ultimately prevails in that dispute, does the Holder potentially face substantial liability for having derailed the Seller’s transaction with the Seller’s Purchaser? Might the Holder face liability even for merely failing to respond before the Deadline?[22]
Ordinary language on First Rights rarely addresses these issues, just as it rarely addresses many other issues that First Rights can create.For example, a Seller may want the right to require the Holder to issue a formal confirmation that the Holder acknowledges receipt of a valid First Right Notice, and chose not to exercise its First Right.And if the Holder thinks a First Right Notice is invalid, then perhaps the Holder should have an obligation to notify the Seller quickly, rather than wait until the day before the Deadline or say nothing at all.
Of course, if the First Right language requires the Holder to provide any formal notice or confirmation in response to a First Right Notice, then any Seller’s Purchaser will insist that the Seller obtain it – thus guaranteeing that the Seller will be at the mercy of the Holder if the Holder has any basis to refuse to issue the confirmation.
Conversely, unless the First Right language exculpates the Holder from liability if the Holder incorrectly withholds a confirmation, the Holder may hesitate to raise genuine objections to the First Right Notice for fear of incurring substantial liability to the Seller. The Holder would much prefer to see language expressly saying that any disagreement about these matters can be resolved only by issuance of an injunction or a declaratory judgment – perhaps by an arbitrator – much like language in a lease that exculpates a landlord from liability for unreasonably withholding a consent.
These hypothetical situations may sound overly intricate and far-fetched, but issues like these can readily arise if any Seller ever actually decides to activate a First Right and give a First Right Notice.Language on First Rights rarely addresses most of these issues about the First Right Notice process. Though all these issues seem very “technical,” they can become very substantive and even expensive if a First Right ever actually plays out in real life.