Option or Right of First Refusal: Which Is It?
by John C. Murray
© 2005
Introduction
If they are not careful, the parties to legal documents creating or transferring real property interests (including leases and purchase agreements) who wish to incorporate options to purchase, rights of first refusal or similar rights, can create unwanted and unanticipated problems when negotiating and drafting such provisions. Options and related rights should never be taken lightly, and should be clearly and comprehensively negotiated and drafted to reflect the intention and expectations of the parties.
Clear Expression of Intention - The Stuart v. D'Ascenz Decision
A recent Colorado appellate court decision illustrates the dangers of not being careful to ascertain that the option language in a lease expresses the intentions of both of the parties. In Stuart v. D’Ascenz, 22 P.3d 540 (Colo. Ct. App. 2000), reh’g denied, 2000 Colo. App. LEXIS 1945 (Colo. Ct. App., November 9, 2000), cert. denied, 2001 Colo. LEXIS 384 (Colo., May 14, 2001), the court ruled that a lease provision providing that the tenant had the right of first refusal with respect to a sale of the property, with a specified purchase price, granted only a right of first refusal and not an option to purchase.
The facts in this case were straightforward. The plaintiff, who owned and operated a bar in Denver, Colorado, agreed to sell the bar to the defendant for $125,000. The parties entered into two agreements in connection with the transaction: (1) a purchase agreement for the sale of the bar, and (2) a lease for the property (executed five weeks after the purchase agreement), whereby the plaintiff would continue to operate the bar.
The lease contained the following clause (which was certainly not a model of drafting precision or clarity):
Leasee [sic] has the 1st right of refusal on the property for a period of (2) calendar [sic ] year term from the start of this lease. The purchase price shall be $160,000.
Approximately one year after the execution of the lease, the plaintiff offered to purchase the property for $160,000. The defendant refused this offer. The plaintiff then sued for specific performance, claiming that the lease clause quoted above granted her an option to purchase. The trial court agreed with the plaintiff, holding that the language in the lease clause evidenced the intention of the parties to grant the defendant an option to purchase the property. The trial court stated that even when it considered extrinsic evidence offered by the defendant, it had arrived at the same conclusion.
The appellate court reversed the holding of trial court, finding that the lease unambiguously provided the defendant with only a right of first refusal. The appellate court first stated the “distinction in law” between an option and a right of first refusal. According to the court, “an option to purchase gives the holder the power to compel the owner to sell the property regardless of the owner’s desire to do so; in contrast, a right of first refusal does not give the holder the power to compel the owner to sell but merely requires the owner, when and if he or she decides to sell, to offer the property to first to the holder.” (citations omitted)). Id. at 542. The appellate court then cited case law in both Colorado and other jurisdictions that held that the mere fact that a purchase price was contained within an otherwise unequivocal right of first refusal did not create an option. Therefore, the court ruled, the lease clause did not create an option because nothing in the clause indicated that the plaintiff had any right to demand conveyance of the property before the defendant indicated his intention to sell it, and if the defendant subsequently decided to sell the property his only obligation would be to first offer it to the plaintiff for the stipulated purchase price of $160,000.
Finally, the appellate court rejected the plaintiff’s argument that certain provisions in the purchase agreement executed by the parties independently created an option right in the plaintiff. The court stated that because the lease clause was unambiguous, its meaning could not be altered by extrinsic evidence. The court further held that even when extrinsic evidence as to the terms of the purchase agreement was considered, such evidence showed that although the plaintiff had attempted to negotiate a provision providing both an option right and a first right of refusal, the counterproposal submitted by the defendant -- and accepted and signed by the plaintiff -- provided only a right of first refusal to the plaintiff. Moreover, the court held, because the lease was executed later in time than the purchase agreement, “the purchase agreement provisions merged into the unambiguous clause in the lease dealing with the same subject matter.” Id.
Discussion of Stuart v. D’Ascenz Decision
1. The Colorado appellate court’s decision – finding that the language in the lease created a right of first refusal and not an option – is not surprising. The language clearly referred to a first right of first refusal, and the statement of the “purchase price” – although certainly not a model of clarity (or intelligence) - did not alter this fact. This is, of course, no excuse for the sloppily drafted and worded option provision in the lease. It is always dangerous to combine a right of first refusal and a separate option right in the same agreement (whether deliberately or inadvertently). If such alternative rights must be inserted in the agreement, the parties’ counsel should be careful to clearly and conspicuously spell out in detail the terms of each of such rights and the circumstances under which one or the other will prevail (to avoid an ambiguity that must be decided by a court).
2. The Colorado court cited law from other jurisdictions in support of its holding, stating that:
Although options are often linked to stipulated prices, and rights of first refusals (or pre-emptive rights) to third party offers, see Kroehnke v. Zimmerman, 171 Colo. 365, 467 P.2d 265 (1970), Peters v. Smuggler-Durant Mining Corp., 910 P.2d 34 (Colo. App. 1995), aff'd, 930 P.2d 575 (Colo. 1997), neither stipulated prices nor third party considerations determine whether a particular clause is an option or a right of first refusal. See Producers Oil Co. v. Gore, 610 P.2d 772, 774 (Okla. 1980) (recognizing that a right of first refusal can be premised on "a stipulated price, or . . . a price the [owner] is willing to sell to a third party"); Jankowski v. Zafrullah, 155 A.D.2d 793, 548 N.Y.S.2d 70, 71 (App. Div. 1989) ("the contract's recitation of a purchase price was not incompatible with" a right of first refusal); Long v. Wayble, 48 Ore. App. 851, 618 P.2d 22 (1980)(language -- "Lessor agrees to give lessee first right of refusal on purchase of this property at an asking price of $ 35,000." -- created not an option but a right of first refusal).
Id.
3. See also Ferrero Constr. Co. v. Dennis Rourke Corp., 311 Md. 560, 584-85 (Md. 1988) (“a right of first refusal is impotent to put property outside the stream of commerce. The holder of a right of first refusal cannot force the owner to sell the property. Nor can the holder prevent a sale once the owner has decided to sell. The holder of the right is limited to either accepting or rejecting the offer when the owner desires to sell. Moreover, because the right of first refusal in this case is not to be exercised at a fixed price, but is instead based on a price the owner is willing to accept from a third party, the right does not discourage the owner from placing improvements on the property, and the owner is assured of getting the fair market value for his land and added improvements”); Bloomer v. Phillips, 164 A.D.2d 52, 54-55 (N.Y. App. Div. 1990) (“Unlike an option, which creates a power to compel a sale, a first refusal right ‘contemplates a willing seller who desires to part with the property.’ Should the seller decide not to sell before the right of first refusal is exercised, ‘the selling party has fully complied with its obligations under the first refusal clause by not selling without first making the required offer.’ Thus, the selling party is not required to do more than was promised by keeping the offer open even after deciding against the sale. Accordingly, we find that the first refusal offer herein did not become an irrevocable option by operation of law. . . . Nor, in our view, did the parties intend so under the specific terms of the agreement. We recognize that contracting parties, if they so choose, may specifically provide that a first refusal offer must remain open, ‘making it an option.’ However, that is not the case here. Although the contract provided plaintiffs with an ‘irrevocable’ right of first refusal, the term ‘irrevocable’ specifically applied only to the right of first refusal and not to defendants' offer to sell. In our view, the term is unambiguous and to interpret it otherwise in this instance would transform the right of first refusal into an option, a result which was not the intention of the parties and cannot be gleaned from the contract itself (citation omitted). Therefore, plaintiffs were not entitled to relief under the circumstances”); Riley v. Campeau Homes (Texas), Inc., 808 S.W.2d 184, 187 (Tex. App. 1991) ("A right of first refusal, as a preemptive right, requires the property owner to first offer the property to the person holding the right of first refusal at the stipulated price and terms in the event the owner decides to sell the property" (emphasis in text); Polemi v. Wells, 759 P.2d 796, 798 (Colo. Ct. App. 1988) ("[A] preemptive right does not give the lessee the power to require an unwilling owner to sell. It merely requires the owner, if he should decide to sell, to offer the property first to the lessee for the price at which the owner is willing to sell to a third party.").
4. But see Tachdjian v. Phillips, 256 Ga. App. 166, 170-171 (2002). In this case, the court ruled that the language in the real-estate purchase agreement executed by the parties was ambiguous as to whether it granted solely a right of first refusal or, in addition, created an enforceable option to purchase certain real property. The court remanded the case for a jury trial as to what the parties actually intended. The “right of first refusal” in the purchase agreement stated an initial fixed price for a period of years, and thereafter a price “to be negotiated between the parties.” There was testimony by the holder of the right of first refusal that the alleged right to an option to purchase was orally stated and agreed to by the parties and was part of the consideration for the transaction. The court was also concerned that there was no “triggering event” stated in the agreement, i.e., an offer by a third party; the property owner’s decision to sell; or any other triggering event. Furthermore, the court stated that existing Georgia case law “makes clear that if a right of first refusal is to be complete, the parties must supply the triggering term by agreement that informs the parties when such right is operative” (citation omitted). Id. at 170. But the court did not find that the disputed provision constituted an option instead of a right of first refusal; it stated that “the question as to what was intended here is an issue of fact for the jury to resolve” and remanded the case to the trial court for a jury trial on this issue. Id. at 171. The court also stated that, “If the jury finds that the parties intended a right of first refusal (to be triggered by [defendant] offering the party for sale), then [defendant] must prevail.” Id.
Difference Between Options and Related Rights
The following briefly summarizes the differences between options, rights of first refusal, right of first negotiation, and rights of first offer:
1) Option – The clearest and strongest right that can be granted to give a party flexibility in the future; the option grantee (“grantee”) is given the right, but not the obligation, to lease, buy or otherwise control a specified asset in the future. To be enforceable, the option should set forth exactly what asset is subject to the option, the price and terms on which the optionee can exercise the option, the date or dates on or between which the option is exercisable, and the corresponding dates for closing or delivery of the optioned asset. See BLACK’S LAW DICTIONARY (7th ed. 1999), at 1121 (defining “option to purchase real property” as “[a] contract by which an owner of realty enters an agreement with another allowing the latter to buy the property at a specified price within a specified time, or within a reasonable time in the future, but without imposing an obligation to purchase upon the person to whom it is given”).
2) Right of First Refusal – An alternative to an option. Unlike an option, a right of first refusal does not entitle the holder of the right to force the other party to sell of lease the asset. Instead, if and when the other party decides to sell or lease the asset to any third party, the holder of the right of first refusal can require the asset to be sold or leased to him or her for the same price and terms that the owner is willing to accept from the third party. Obviously, a right of first refusal is much weaker from the standpoint of the holder that an option: it does not set the price for the asset in advance, and it allows the owner of the asset to decide whether and when to sell or lease. The property owner generally will resist granting a right of first refusal because of its chilling effect on the marketability of the property. Brokers may be reluctant to list a property that is subject to a right of first refusal unless they are also promised a commission if and when the holder of the right exercises it and purchases the property. See BLACK’S LAW DICTIONARY (7th ed. 1999), at 1325 (defining “right of first refusal” as “[a] potential buyer’s contractual right to meet the terms of a third party’s offer if the seller intends to accept that offer”). The scope of the “price and terms” of a third-party offer that the holder of a right of first refusal must meet should be carefully set forth in the right of first refusal. See, e.g., Hahalyak v. A. Frost, Inc., 444 Pa. Super. 494, 502-503 (1995) (holding that language of right of first refusal was “clear and unambiguous” and that “terms and conditions of any proposed lease” included only economic terms of proposed lease and not agreement of proposed lessee to vacate existing space in the building or agreement of another party to pay “inducement fee” for such vacated space).
3) Right of First Negotiation – In order to avoid the chilling effect of a right of first refusal, the parties may instead use a right of first negotiation. This provision provides that the owner must notify the holder of such a right that the owner intends to sell or lease his or her property. The parties then have a specified period of time in which to negotiate, on an exclusive basis, a mutually acceptable deal. The obvious advantage of right of first negotiation over a first-refusal right (from the owner’s perspective) is that the right of first negotiation period ends before the owner or any third party or broker invests time and money in negotiating a deal. There is therefore no “chill” on the marketability of the asset. A right of first negotiation does not give the holder of the right any assurance that the parties will reach final agreement on the price and terms for the transaction. If the exclusive negotiation period lapses without an agreement on price and terms, the owner generally is free to sell or lease the property to a third party free and clear of the rights of the holder of the first-negotiation right.
4) Right of First Offer – In some transactions, particularly involving the sale of real estate, the parties will provide for a right of first offer (“RFO”) in favor of the buyer. The holder of a RFO has the first right to make an offer for the purchase of the property before the owner can sell the property to a third party. The owner is give a specific period to accept or reject the offer, and if the owner rejects the offer, he or she is free to sell the asset to one or more third parties, with the only restriction being that he or she cannot accept a price that is less (or in some cases less than a percentage of) the price offered by the holder of the RFO. This puts the holder of the RFO in the position of naming its price without knowing the owner’s estimate of the value and without the opportunity to require the owner to negotiate to an agreed price (unless that right is included in the agreement). The RFO is used, for example, where a purchaser of a parcel wants a right to buy the adjacent parcels when they become available for sale, but the owner is unwilling to give an option or right of first refusal. With respect an RFO (which is preferable to a right of first refusal because it minimizes the “chilling” effect on the marketability of the property), the holder of the right can be afforded additional protection by requiring the owner to make an offer to the holder of the right, containing the terms (including price) that the owner will accept, before the owner can offer the property to a third party. This “smokes out” the price that the owner will accept. However, the owner still controls the timing of any potential sale and is not obligated to reduce the price it asks for the property even if it is “unreasonable.” (However, the owner may be obligated, if negotiated for by the holder of the right, to sell the property for at least that price if the holder elects not to accept the owner’s offer).
See generally Paul S. Rutter and Duane M. Montgomery, Options, Rights of First Refusal, Rights of First Negotiation and Rights of First Offer, Corporate Real Estate and the Law (International Association of Attorneys and Executives in Real Estate (AECRE) Newsletter, Vol. 7, No.1, Summer 2000), pp. 5-7; Joseph B. Conn and Karyn E.Corlett, Rights of First Refusal and Rights of First Offer, 2003 ICSC U.S. Shopping Center Law Conference (Palm Desert, CA Oct. 23, 2003), at Tab 26.
Carevouts for Packaged Sales and Other Items
The parties in each of the foregoing cases should be careful to carve out from any of these rights any transactions intended to be excluded, such as a transfer of property between a parent and a subsidiary corporation or other affiliated entities, foreclosure or deed in lieu of foreclosure, gifts and donations --and especially portfolio or bulk sales of multiple properties in a single transaction.
1. The majority of courts holds that where an owner sells or attempts to sell property burdened by a right of first refusal as part of a larger package of properties, the right of first refusal is not activated in its traditional sense. See, e.g., Boyd & Mahoney v. Chevron, USA, 419 Pa. Super. 24, 29-30 (1992) (“[A] right of first refusal as to the conveyance of a property cannot be defeated by including that property in a multi-property or multi-asset transaction . . . The appellant’s argument that the right can be nullified simply by packaging the property for sale with another asset not so encumbered has no merit. Appellants’ logic would deprive the holder of the right the benefit of his or her bargain”); Stuart v. Stammen, 590 N.W.2d 224, 228 (1999) (ruling that holder of right of first refusal could not be forced to purchase property in addition to that which was subject to such right); Landa v. Century 21 Simmons & Co., Inc., 237 Va. 374 (1989) (holding that holder of right of first refusal cannot be compelled to purchase more than is subject to right of first refusal or else forfeit first refusal right); Raymond v. Steen, 882 P.2d 852, 857 (Sup. Ct. Wyo., 1994) (“a right of first refusal is not triggered by an offer on a larger tract which includes the burdened property. Neither is a right of first refusal satisfied by an offer to the holder of the right to sell him a larger tract”); Gyurkey v. Babler, 103 Idaho 663, 668 (1982) (holding that even though vendor separately valued, as a part of total transaction, lot as to which plaintiff had right of first refusal, such lot could not be sold as part of larger parcel as long as lot was subject to such right of first refusal, because “the door would be opened to a myriad of unscrupulous endeavors designed to defeat preemptive rights of purchase by manipulation of lot prices within the terms of a larger sale”); Tarallo v. Norstar Bank, 534 N.Y.S.2d 485, 487 (N.Y. App. Div. 1988) (lessees could not compel conveyance of entire parcel, as right of first refusal did not extend to entire parcel); Whyopen v. Via, 404 So.2d 851, 853 (Fla. Dist. Ct. App. 1981) (landlord could not refuse to honor tenants' first refusal right on theory that tenants had not agreed to purchase entire parcel described in contract for sale); Thomas & Son Transfer Line, Inc. v. Kenyon, Inc., 40 Colo. App. 150, 155 (1977), aff’d 586 P.2d 39 (Colo. 1978) (holding that owner of property cannot defeat right of refusal simply by selling optioned property with other properties which he may own (citations omitted); and stating that “To deny specific performance here would be to defeat the entire purpose of the right of refusal, the protection of the lessee”); Guaclides v. Kruse, 67 N.J. Super. 348, 359 (1961) (“We concur in the generally accepted view as to the optionee's right to an injunction to restrain a vitiating of its option by the inclusion, in the owner's prospective sale, of property in excess of that covered by the option. To allow the owner of the whole to by-pass the optionee merely by attaching additional land to the part under option would render nugatory a substantial right which the optionee had bargained for and obtained”); Brito v. Belvedere Developers, LLC, 2004 WL 877565 (R.I. Super., March 29, 2004) (unpublished opinion) (“Owners should not be permitted to attempt to sell their encumbered parcels to third parties by joining with other landowners, and then be able to deny the rightholder an opportunity to exercise his right by arguing that the encumbered parcel was part of a larger package”); Sawyer v. Firestone, 513 A.2d 36, 40 (R.I. 1986) (“a seller may not defeat a right of first refusal by selling the property subject to the right as part of a larger tract”); Aden v. Estate of Hathaway, 162 Colo. 311, 314 (1967) (ruling that holder of right of first refusal is entitled to injunctive relief, enjoining sale of burdened parcel, when owner decides to sell encumbered parcel as part of larger tract); Chapman v. Mut. Life Ins. Co. of New York, 800 P.2d 1147, 1151 (Wyo. 1990) (holding that while package deal does not trigger right of first refusal in its traditional sense, such that the holder can purchase the property, rightholder is entitled to injunctive relief, enjoining sale of burdened property). Cf. Rottier v. Walsh, 230 Wis.2d 748 (1999) (unpublished opinion) at *3 (holding that unambiguous language of right of first refusal did not permit respondent to require rightholder to either purchase a portion of the parcel or abandon her right of first refusal on that portion, and remanded with instructions to issue declaratory relief and injunction; court stated that “The only reasonable meaning attributable to the document is that Walsh and Rottier intended the ROFR to apply to a sale of the entire property”);
2. A minority of courts holds that the holder of the right of first refusal is entitled to specific performance on the burdened property alone (as opposed to injunctive relief), and that if the rightholder chooses not to exercise the right then the owner can proceed with the sale of the larger package. See, e.g., Berry-Iverson Co. of N.D., Inc. v. Johnson, 242 N.W.2d 126, 134 (N.D. 1976) (holding that attempted package sale activates right of first refusal, entitling rightholder to specific performance on burdened property alone); Brenner v. Duncan, 318 Mich. 1, 6 (1947) (ruling that with respect to attempted package sale including burdened property, “it is competent for the court to fix the option price, afford the optionee an opportunity to accept and thereupon specifically enforce the resulting contract”). In Pantry Pride Enter., Inc. v. Stop & Shop Cos., Inc., 806 F.2d 1227, 1231-32, the court concluded that specific performance was the more appropriate remedy where the parties to the sale assigned separate valuations to the personalty and leasehold interests and, therefore, the problems commonly associated with awarding specific performance in such cases were not present. The court stated that:
In the typical case, a landowner leases a portion of his property to a lessee, who secures a right of first refusal. The landowner subsequently agrees to sell the leased portion and some adjacent property to a third party for a single price. When the lessee tries to purchase only the leased portion of the package, the lessor tries to force the lessee into accepting the package deal or allowing the sale. Most courts resolve this conflict by enjoining the sale of any property subject to the lessee's option. [Citations omitted.] Several practical problems arise in granting specific performance in these contiguous property cases. The first problem is one of valuation. If a court allows the lessee to buy only the leasehold portion, the court must allocate the single purchase price between the leased portion and the remainder of the lessor's property. Some courts are reluctant to undertake this process, which may require the court to determine the value of each acre offered for sale. [Citations omitted.] The second problem is that specific performance may be inequitable for three reasons. First, if the lessor sold the leased and nonleased portions together, he would probably receive a greater price than if he sold the properties separately. By forcing the lessor to sell only the leased portion, the court may be depriving the lessor of this premium. Second, the remaining property may be difficult to sell without the attached leased portion. Third, specific performance forces the lessor to separate his contiguous property merely because he leased a portion of it to the lessee. Because of these equitable considerations, most courts do not grant specific performance, but simply protect the lessee's option by enjoining the sale of the leased portion.
Id. at 1229-30.
3. Only one case appears to take the position that the rightholder’s failure to enter into an agreement addressing the possibility of a package deal leaves the rightholder without a remedy. See Cross-Spieker #23 v. Robert L. Helms Const. & Devel. Co., 731 P.2d 348, 350 (Nev. 1987) (“It is apparent from the terms of the right of first refusal, that the right applied only to offers to purchase Tract B. In this case, there was no such offer. Of course, we would not condone an attempt to evade [the holder of the right of first refusal’s] contractual rights by engineering the sale of a larger parcel (citations omitted), but in this case there was no evidence of any wrongful intent. Rather, the record reflects a good faith decision by [the optionor] to sell the entire tract. Thus, [the holder of the right of first refusal’s] contractual right was totally inapplicable by its own terms”).
4. At least one court has held that with respect to a package deal including the encumbered property, if the holder of the right of first refusal elects to exercise the right the rightholder is entitled to preemptive specific performance on the entire package. See Capalongo v. Giles, 425 N.Y.S.2d 225, 228 (N.Y. Spec. Term 1980) (“where an owner does have an offer from a third party to purchase a piece on which he has given a first refusal option, but on terms which specify inclusion of the piece in a larger parcel . . . he thereupon has a duty to offer the whole parcel to the option holder on the same terms”).
5. See generally Sara Church Dinkler and Morgan R. Smock, Toss That Form Book: How to Draft an Effective Right of First Refusal, 16 NO. 4 ACCA Docket 50 (July/August 1998), at 59; Harris Ominsky, Real Estate Options: Using Them and Losing Them (Part 1), 15 NO. 6 PRAC. REAL EST. LAW. 55 (November, 1999), at 65; Bernard Daskal, Rights of First Refusal and the Package Deal, 22 FORDHAM URB. L.J. 461 (Winter 1995).
Agreements Containing Both an Option to Purchase and a Right of First Refusal
Tenants (and landlords) can get themselves into trouble when – as occasionally happens – the lease provides the tenant with both a fixed-price option and a right of first refusal.
1. See, e.g., Markert v. Williams, 874 S.W.2d 353 (Tex.App.-Hous.(1 Dist. 1994), where the issue before the court (which was a matter of first impression) was whether the tenant’s fixed-price option was extinguished by his failure to exercise his right of first refusal, where there had been a subsequent sale of the property to a bona-fide purchaser. (The tenant had attempted to exercise his option right two years after the sale by the landlord). The court held that under these circumstances, the tenant’s fixed-price option was extinguished because of his failure to exercise the option before the landlord sold the property to the bona-fide purchaser. A way to avoid the issue raised in this case would be to have the provision state specifically that notice by the owner of its intention to market the property would trigger the tenant’s fixed-price option.
2. Some courts have held that a tenant that when both a right of first refusal and a fixed-price option are contained in the same agreement, the option right becomes ineffective and unenforceable when the tenant fails or refuses to exercise the right of first refusal after being presented with a bona-fide third party offer. For example, in a recent decision, Sheperd v. Davis, 265 Va. 108 (2003), the lessee under a lease agreement had both a fixed-price option to purchase a tract of real estate and a right of first refusal with respect to the property. The court ruled that the lessee forfeited his right to purchase the property under the fixed-price option after being presented with a third-party offer. The court would not permit the lessee to invoke the fixed-price option after failing to exercise the right of first refusal (due to the fact that the terms of the third-party offer were not acceptable to him, including a higher purchase price). The court noted that there was a split of authority as to whether (1) a lessee my exercise a fixed-price option notwithstanding the grant of a right of first refusal in the same agreement, or (2) a lessee forfeits the right to purchase under a fixed-price option after being presented with a third-party offer. The court reasoned that the result depends on the particular language used in the provision, and found that in this case, “the terms of the dual-option provision [are] clear and unambiguous.” Id. at 118. The court interpreted the prefatory language to the grant of the right of first refusal, i.e., “notwithstanding anything contained in this Agreement to the contrary” (which did not appear in the portion of the lease provision referring to the option to purchase) as modifying the fixed-price option and giving precedence to the first right of refusal. The court also noted that a sentence in the lease provided that if the landlord did not sell the leased premises in accordance with a third-party offer to purchase, the tenant’s right of first refusal remained in effect, but there was no similar statement that under such circumstances the fixed-price option to purchase also would remain in effect.
3. See also Smith v. Bertram, 603 N.W.2d 568, 573 (Iowa Sup.Ct. 1999) (finding that, where contract contained both option to purchase and right of first refusal and intent of parties was unclear, extrinsic evidence would be admitted; such evidence indicated that right-of-first-refusal clause was added in response to landlord’s insistence that she be entitled to accept higher third-party offers, and therefore parties intended that third-party offer would terminate fixed-option right); Shell Oil Co. v. Blumberg, 154 F2d 251, 252-53 (5th Cir. 1946); M & M Oil Co. v. Finch, 7 Kan. App.2d 208, 213 (1982); Tantleff v. Truscelli, 493 N.Y.S.2d 979, 984 (1985), aff’d 698 N.Y.S.2d 769 (1987); Moon v. Haeussler, 545 N.Y.S.2d 623, 624 (1989); Northwest Racing Ass’n v. Hunt, 20 Ill. App. 2d 393, 399-400 (1959); Tarrant v. Self, 180 Ind. App. 215, 222 (Ind. Ct. App. 1979).
4. But other cases hold that the two provisions, unless otherwise provided in the agreement, are separate and distinct and the tenant can exercise its fixed-price purchase option notwithstanding its failure to exercise its rights under the right of first refusal. These cases hold that there is no ambiguity or else involve provisions that explicitly state that the tenant’s failure to exercise its first-right-of-refusal right shall not affect its fixed-price option (a good drafting tip). See Shell Oil Co. v. Prescott, 398 F.2d 592, 593-94 (6th Cir. 1968), McDonald’s Corp. v. Lebow Realty Trust, 710 F.Supp. 385, 388 (D. Mass.), aff’d 888 F.2d 912 (1st Cir. 1989); Texaco, Inc. v. Creel, 57 N.C.App. 611, 617 (1982); Crowley v. Texaco, Inc. 306 N.W.2d 871, 873-75 (S.D. 1981); Gulf Oil Co. v. Chiodo, 804 F.2d 284, 286 (4th Cir. 1986); Amoco Oil Co. v. Snyder, 505 Pa. 214, 220 (Pa. 1984); Butler v. Richardson, 74 R.I. 344, 350-51 (R.I. 1948).
Applicability of the Rule Against Perpetuities
Another issue that must be addressed in connection with options to purchase and rights of first refusal is the rule against perpetuities, i.e., if by any possibility the interest which is subject to the rule cannot vest or fail within the 21-year limit after some life in being at the creation of the interest, it is void for remoteness.
1. See Jonathon F. Mitchell, Can A Right of First Refusal Be Assigned? 68 U. CHI. L. REV. 985, 994 (2001) ("In traditional common law jurisdictions, a right of first refusal of indefinite duration violates the common law Rule Against Perpetuities"); Ferrero Constr. Co. v. Dennis Rourke Corp., 311 Md. 560, 572 (Md. 1988) (rule against perpetuities is implicated by right of first refusal to purchase real estate, as rule was designed not only to facilitate the alienability of property but also to prevent restrictions that render title to land uncertain). The rule against perpetuities is a "peremptory command of law and not a Rule of Construction." Emerson v. Campbell, Del. Ch., 84 A.2d 148, 155 (1951). But see Continental Cablevision, Inc. v. United Broad. Co., 873 F.2d 717, 722 (4th Cir. 1989) ("Of all options, a right of first refusal is one of the least obnoxious to the policy concerns of the rule").
2. A majority of jurisdictions recognizes that a right of first refusal is subject to the rule against perpetuities (though there is contrary authority). See, e.g., Stuart Kingston v. Robinson, 596 A.2d 1378, 1383-1384 (Del. 1991) ("Although the rule is most often applied in the construction of testamentary devices, it applies equally to rights of first refusal, also known as preemptive rights, to acquire interests in land. Despite the view of some courts that preemptive rights are merely contract rights and not direct interests in property, a vast majority of courts and commentators view such rights as equitable claims sufficient to support an action for specific performance if the property owner attempts to sell to someone other than the owner of the right of first refusal. Because the holder of the right of first refusal acquires merely an equitable interest, it remains inchoate until the owner decides to sell thus triggering the right of first refusal"). See also Lake of the Woods Assoc. v. McHugh, 380 S.E.2d 872, 874 (Va. 1989) (rejecting a request to treat first-refusal provision as procedural right that could be saved by application of "wait and see" doctrine). But see Murphy Exploration & Prod. Co. v. Sun Operating Ltd. Pshp., 747 So. 2d 260, 265 (Miss. 1999)("Mississippi, like many jurisdictions, has modified the draconian effect of this rule with the wait and see doctrine").
3. Courts adopting the minority view generally reach their conclusion by assuming that the sole policy underlying the rule against perpetuities is the elimination of restraints on alienation. Based on this distinction, the minority view contends that, unlike ordinary options, at least some rights of first refusal do not restrain alienation; consequently, the minority view concludes that such rights of first refusal should not be subject to the rule against perpetuities. See, e.g., Forderhause v. Cherokee Water Co., 623 S.W.2d 435, 438-439 (Tex. App. 1981); Robroy Land Co. v. Prather, 95 Wash.2d 66, 71 (1980); Hartnett v. Jones, 629 P.2d 1357, 1361 (Wyo.1981); Weber v. Texas Co., 83 F.2d 807,808 (5th Cir. 1936). Thus, in effect, the minority view postulates that an interest should not be subject to the Rule unless the interest constitutes a restraint on alienation. The minority view then distinguishes rights of first refusal from ordinary options. As stated in VI AMERICAN LAW OF PROPERTY, § 26.64, at 507:
"An option creates in the optionee a power to compel the owner of property to sell it at a stipulated price whether or not he be willing to part with ownership. A pre-emption does not give to the pre-emptioner the power to compel an unwilling owner to sell; it merely requires the owner, when and if he decides to sell, to offer the property first to the person entitled to the pre-emption, at the stipulated price. Upon receiving such an offer, the pre-emptioner may elect whether he will buy. If he decides not to buy, then the owner of the property may sell to anyone."
4. But this position has been harshly criticized. See Ferrero Constr. Co. v. Dennis Rourke Corp., supra, 311 Md. at 572-73 ("Even assuming the validity of the distinction between rights of first refusal and other options, the minority view errs in assuming that an interest should not be subject to the Rule unless the interest constitutes a restraint on alienation. In making this assumption, courts adopting the minority view confuse the Rule Against Perpetuities with the rule against unreasonable restraints on alienation. Admittedly, both rules belong to 'a family of related rules that regulate the devolution of wealth from generation to generation' (citation omitted). These two rules are nonetheless distinct. The Rule Against Perpetuities prevents property interests from vesting remotely (citations omitted). The rule against restraints on alienation, on grantors from unreasonably depriving grantees of the power to alienate their estates (citations omitted). The policies underlying these two rules are likewise not identical. Obviously, the rule against restraints on alienation serves to facilitate the alienability of property. Similarly, one of the purposes of the Rule Against Perpetuities is to facilitate the alienability of property (citation omitted). Contrary to the minority view, however, the Rule Against Perpetuities is not simply a rule against restraints on alienation (citation omitted). Instead, the Rule Against Perpetuities is concerned with restrictions that render title uncertain (citation omitted). Without the Rule Against Perpetuities, it would be possible at some distant point for a remotely vesting future interest to divest the current owner's estate. Because of this threat of divestment, the owner might be deterred from making the most effective use of the property, even if he never has any desire to alienate his estate. Thus, by voiding certain remotely vesting future interests, the Rule Against Perpetuities eliminates this deterrent both for owners who wish to alienate their estates and for owners who have no intention of ever doing so (citation omitted). Consequently, from the standpoint of the Rule Against Perpetuities, it is irrelevant whether a particular future interest imposes a light burden, a heavy burden, or no burden at all upon the alienability of property" (citations omitted)).
5. With respect to how and when the interests vest, see Fitzpatrick v. Mer.-Safe, Etc. Co., 220 Md. 534, 541,(1959) (the rule against perpetuities does not invalidate "interests which last too long, but interests which vest too remotely; in other words the Rule is not concerned with the duration of estates, but the time of their vesting"). The purposes of the rule include the facilitation of alienation of property and maintaining certainty of title. See Emerson v. Campbell, supra, 84 A.2d at 155. See also Stuart Kingston v. Robinson, 596 A.2d 1378, 1383-1384 (Del. 1991)(If there are two doubtful constructions of the meaning of an instrument, "one consistent and the other repugnant to the law, the former will be adopted, but if the meaning is clear" the rule must be observed "since it is founded upon a sound principle of public policy and must be rigidly enforced." In projecting the prospect of vesting "it is not enough that the future interests may, or even that it will in all probability, vest within the limits; it must necessarily so vest." If there is any possibility that the interest will vest beyond the period of the rule, then it is void ab initio"); Curtis v. Maryland Baptist Union Ass'n, 176 Md. 430, 438, 439 ("The term 'vested' as used in the law of property, signifies that there has been the fixation of a present right to either the immediate or future enjoyment of property"); Bloomer v. Phillips, 164 A.D.2d 52, 55 (N.Y. App. Div. 1990) ("we note our disagreement with defendants' argument that . . . the rule against perpetuities applies in this case and invalidates the rights of plaintiffs. Assuming, without deciding, that the rule does apply, because the agreement was not made binding on plaintiffs' heirs and assigns the right of first refusal would necessarily terminate upon the deaths of plaintiffs. Therefore, the rule is not violated inasmuch as the right could not be exercised 'later than twenty-one years after one or more lives in being'). The term "vested" has also another meaning, which is so frequently given to it that it cannot be said to be improper. This other meaning is "transmissible." As Professor Gray of Harvard has said, "Such double meaning is, however, very unfortunate, as it has led to much confusion." Gray, Rule Against Perpetuities, 4th Ed., § 118. Vesting in that secondary sense is not sufficient to escape the rule against perpetuities. The interest must vest in the sense of becoming a vested remainder.
6. Illinois courts have ruled that an option to purchase real estate is subject to the rule against perpetuities. See, e.g., Warren v. Albrecht, 213 Ill.App.3d 55, 58-59, 571 N.E.2d 1179, 1180 (5th Dist. 1991) (“[i]nterests subject to the rule are contingent remainders, executory interests (or devises), options to purchase land not incident to a lease for years, and powers of appointment”). In Arclar Co. v. Gates, 17 F.Supp.2d 818, 823 (S.D. Ill. 1998), the court stated that “[i]t is true that a bare option to purchase or sell real estate exercisable outside the period of the rule against perpetuities is generally held to be void as an unreasonable restraint upon alienation” (citations omitted). The court noted that the only exceptions to the rule were (i) an option to purchase land that is part of a long-term lease of that land, and (ii) an option to purchase an overlying surface estate provided that the option was granted for the purpose of mining the mineral estate. But see In the Matter of Wauka, Inc., 39 B.R. 734, 737 (Bankr. N.D. Ga. 1984) (since right of first refusal included in a sales contract and warranty deed was personal to the individual holder of the right, it did not violate the rule against perpetuities and the holder would be permitted to exercise that right); Park Station L.P. v. Bosse, 378 Md. 122, 138 (2003) (a contract or other instrument, including a right of first refusal, “should be interpreted if feasible to avoid the conclusion that it violates the Rule Against Perpetuities”). Cf. Selig v. State Highway Admin., 383 Md. 655, 676-78 (2004) (rule against perpetuities does not apply to right-of-first-refusal clause in contract and deed where applicable language is mandated by state statute). See also Jonathon F. Mitchell, Comment: Can a First Right of Refusal be Assigned, 68 U. Chi. L. Rev 985, 994-96 (2001) (discussing rule against perpetuities in connection with rights of first refusal).
7. With respect to generally recognized exceptions to the rule against perpetuities regarding options to purchase real estate, see also Ferrero Constr. Co. v. Dennis Rourke Corp., supra, 311 Md. at 567-68 ("In the area of options, courts in the 300 years since the High Court of Chancery decided the Duke of Norfolk's Case (citation omitted), have developed three exceptions to the Rule Against Perpetuities. The Rule does not apply to a lessee's option to renew a lease (citations omitted). It does not apply to a lessee's option to purchase all or part of the leased premises (citations omitted). And it is inapplicable to a usufructuary's option to extend the scope of an easement or profit (citations omitted). All options may violate the Rule Against Perpetuities. Nevertheless, courts have justified these three narrow exceptions because these three types of options yield social benefits that offset the consequences of that violation"); Cambridge Co. v. East Slope Investment Corp., 700 P.2d 537, 542 (Colo. 1985) (holding that the rule against perpetuities did not apply to rights of first refusal contained in condominium declaration, as condominium ownership was a form of property interest unknown to earlier common law; thus, an exception for rights of first refusal to purchase this specialized type of property interest has little bearing on whether rights of first refusal in general should be exempt from the rule against perpetuities).
Enforceability of Right of First Refusal in Bankruptcy
In bankruptcy proceedings, a question may arise as to whether § 365(f)(1) of the Bankruptcy Code renders a right of first refusal contained in a lease unenforceable. Section 363(f)(1) provides that, “notwithstanding a provision in an executory contract or unexpired lease of the debtor, or in applicable law, that prohibits, restricts, or conditions the assignment of such contract or lease, the trustee may assign such contract or lease” if the trustee assumes the lease and provides adequate assurance of future performance.
1. In In re E-Z Serve Convenience Stores, Inc., 289 B.R. 45, 51-52 (Bankr. M.D. N. Carolina 2003), the bankruptcy court held that, based on the facts and circumstances of the case, the landlord’s right of first refusal to purchase the buildings and permanent improvements constructed on the leased land by the debtor-tenant was enforceable and would not be excised by the court. The bankruptcy trustee sought to obtain the court’s approval of the assumption, assignment and sale of the debtor-lessee’s interest under the lease to a third party free and clear of the right of first refusal, arguing that it was unenforceable under § 365(f) as an impermissible restraint on assignability of the lease. The court noted that, “courts have applied 365(f) to ‘lease provisions that are so restrictive that they constitute de facto anti-assignment provisions” (citation omitted). The court also acknowledged that “[w]hile a trustee is required to assume a contract as a whole, the court may strike provisions that are contrary to the provisions of the Bankruptcy Code such as those that place restrictions on assignment.” Id. at 49.
2. But the court ruled in favor of the lessor based on the following undisputed facts: the landlord had submitted the highest bid for the property; the clause was specifically and heavily negotiated by the parties as consideration for below-market rent; the landlord planned to develop the adjacent land; and the clause was necessary to protect the landlord from violating a non-compete clause in another lease to another party on nearby property. The court stated that “[n]umerous courts have recognized a right of first refusal with no analysis of the application of 365(f)” (citations omitted) . . . A review of these cases reveals that the concern of these courts when presented with a contractual right of first refusal is not whether to enforce such right, but how to incorporate a right of first refusal into the bidding and sale procedures of the bankruptcy auction in a fair and equitable manner that still allows for maximization of the value of the estate.” Id. at 52-53. The court also noted that the majority of courts hold that a right of first refusal is an executory contract, but stated that “[w]hether the right of first refusal is part of a larger executory contract or lease, or stands alone, should not alter the treatment of that right. The Trustee has chosen to assume the lease, which includes [the landlord’s] right of first refusal.” Id. at 53 n.11.
3. This was a fact-specific decision and the court ruled for the landlord, as the holder of the first right of refusal, based on the following specific factual and evidentiary findings: the landlord presented uncontested evidence of economic harm to him if the provision were not enforced; the right of first refusal was a material and bargained-for provision of the lease, with consideration to the debtor-tenant in the form of below-market rent; there was no “chilling effect” on the sale of the property; the right of first refusal did not restrict or burden the assignment of the lease and therefore did not fall within the framework of § 365(f)(1); absent the right of first refusal, the trustee could not give adequate performance of future performance; the landlord’s offer was equal or better than the terms of competing offers; the court had not yet entered a final order approving the sale; and disregard of the landlord’s interest would be unfair and inequitable where there appeared to be no benefit to the estate and a clear detriment to the holder of the interest. The court also noted that it “retains some discretion in determining whether a lease provision that does not explicitly prohibit assignment qualifies as a de facto anti-assignment clause thereby rendering it unenforceable” (citations omitted). Id. at 50. The court stated further that it “disagrees with the conclusion that the statutory language of § 365(f)(1) renders any right of first refusal unenforceable and finds that [the landlord’s] right of first refusal is not within the scope of § 365(f).” Id. at 51. The court, in its analysis, referred to the bankruptcy court decisions in In re Auto Trak Corp., 277 B.R. 655 (Bankr. E.D. Va. 2002) and In re Rickel Home Centers, Inc., 240 B.R. 826, 831 (Bankr. D. Del. 1998), with respect to its analysis of whether § 365(f) should be applied to lease provisions that are so restrictive that they should be deemed to be de facto impermissible anti-assignment provisions.
4. The E-Z Serve case highlights the importance of specifically stating, in the lease provision setting forth an option right or first right of refusal, that the provision was bargained for, was a material part of the lease, and would cause economic detriment to the holder if it were not upheld.
5. Unlike an option, a right of first refusal does not entitle the holder of the right to force the other party to sell or lease the asset. Instead, if and when the other party decides to sell or lease the asset to any third party, the holder of the right of first refusal can require the asset to be sold or leased to him or her for the same price and terms that the owner is willing to accept from the third party. 6. 6.
6. Obviously, a right of first refusal is much weaker from the standpoint of the holder that an option: it does not set the price for the asset in advance, and it allows the owner of the asset to decide whether and when to sell or lease. A property owner generally will resist granting a right of first refusal because of its chilling effect on the marketability of the property. However, in the E-Z Serve case the court specifically found that “there is no evidence that the existence of a right of first refusal had a chilling effect on the sale procedure.” Id. at 51. This was so because the testimony demonstrated that the party that submitted the bid for the property accepted by the trustee did so without knowledge of the landlord’s first right of refusal, and the landlord was not aware of the amount of any competing bids because it had submitted a bid that was $51,000 more than the bid submitted by the trustee for approval by the bankruptcy court.
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