IT SEEMED LIKE A REALLY GOOD IDEA AT THE TIME:

RIGHTS OF FIRST OFFER AND FIRST REFUSAL

Joshua Stein[footnoteRef:1] [1: Joshua Stein practices commercial real estate law at Joshua Stein PLLC in New York City. For information on the author, visit www.joshuastein.com. The author appreciates helpful comments from Carl Gaines, editor of the Mortgage Observer, NY; Alfredo R. Lagamon, Jr., of Ernst & Young LLP, NY; Donald H. Oppenheim of Berkeley, CA; Robert M. Safron of Patterson Belknap Webb & Tyler LLP, NY; Michael B. Vincenti of Wyatt, Tarrant & Combs, LLP, Louisville, KY; and Elizabeth T. Power, of the authors staff. Blame only the author for any errors or missed insights. An abbreviated and preliminary version of this article appeared as an installment of the authors monthly column in the Mortgage Observer, www.commercialobserver.com. Readers are encouraged to comment on and respond to this article by sending email to joshua@joshuastein.com. Copyright (c) 2014 Joshua Stein. All rights reserved.]

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 some provisions 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 interest in the property (the Sellers Interest).[footnoteRef:2] In a ground lease, the Sellers Interest would consist of the ground lessors leased fee estate or the ground lessees 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. [2: If a Seller never decides to sell, then the First Right never arises. In contrast, a purchase option lets a Holder buy on certain terms at certain time(s) whether or not the Seller wants to sell. Ground leases have fewer purchase options than First Rights, because a landlord assumes the tenant will exercise any option at the first opportunity, defeating the landlords goal of preserving long-term ownership and an annuity. An individual landlords death often activates a purchase option, because the resulting basis step-up finally makes a sale feasible as a tax matter.]

Ground lessors often agree to grant First Rights to ground lessees. They do that because the whole ground lease transaction was premised, at least in part, on the ground lessors 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 lessors Interest. This also allows the ground lessee to protect itself from an undesirable or at least unknown new ground lessor.[footnoteRef:3] [3: Of course, the ground lease should have been written so that the ground lessee does not care who the ground lessor is. It just should not matter. Because ground leases rarely restrict conveyances of the fee estate in any meaningful way, except sometimes through First Rights, the ground lessee must assume that the worst possible counterparty in the world will acquire the fee estate, and the ground lease still needs to work for the ground lessee and its present and future lenders.]

Less often, ground lessees give First Rights to their ground lessors, so that if the ground lessee ever decides to sell, then the 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[footnoteRef:4]; or a simple exercise of negotiating leverage to give the ground lessor a future opportunity down the road. [4: Just as the ground lessee should not care who the ground lessor is, the ground lessor should not care who the ground lessee is either. The ground lease should make sense to the ground lessor and its lender regardless.]

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.[footnoteRef:5] [5: First Rights in joint venture agreements raise even more issues than those addressed in this article, primarily because in a joint venture the non-exercise of a First Right often allows the Seller to force a sale of the entire property, not just the Sellers interest. This raises the stakes. As just one example, the First Rights language in a joint venture agreement will often allow a sale of the entire property at a price equal to 95% or more of the property valuation that the Seller proposed. If the Seller forces through a sale of the entire property at the 95% floor price, can the Seller require that the joint venture sell the entire property to an affiliate of the Seller? Can the Holder stop such a sale? Other footnotes in this article mention some, not all, other issues specific to First Rights in joint venture agreements. Buy-sell (shotgun) clauses in joint ventures raise similar issues, plus many others.]

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 Holders 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. Whats a ROFO? Whats 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 Sellers Purchaser).

My informal research indicates that the commercial real estate industry believes a ROFO requires a Seller to offer (the first offer) the Sellers Interest to the Holder, at a price the Seller specifies in 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 Sellers Interest to a Sellers Purchaser.[footnoteRef:6] If the Holder does not meet the Sellers proposed price in the First Right Notice, then the Seller can sell to a Sellers Purchaser, as long as the price exceeds 95% (typically) of the price named in the First Right Notice.[footnoteRef:7] [6: As an alternative, if and when the Seller has told the Holder that the Seller wants to sell, a ROFO could entitle the Holder to give the Seller the first offer for the Sellers Interest. In my experience, though, the first offer in any ROFO comes from the Seller, not the Holder.] [7: If the Seller wants to sell for less, then the Seller must give the Holder another First Right Notice at the lower price. The Holder then has a shorter time to respond. The same applies if the Seller plans to offer a Sellers Purchaser other terms materially more favorable, whatever that means, than those in the First Right Notice a whole new avenue for discussion and dispute.]

In contrast, a ROFR requires the Seller to go into the market, find a Sellers Purchaser, then give the Holder a First Right Notice offering the Holder the right to match the purchase price the Seller was willing to accept from the Sellers Purchaser.[footnoteRef:8] One should really call it a right to ma