IT SEEMED LIKE A REALLY GOOD IDEA AT THE TIME:RIGHTS OF FIRST OFFER AND FIRST REFUSAL

Joshua Stein1

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 Seller’s “Interest”).2 In a ground lease, the Seller’s Interest would consist of the ground lessor’s leased 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

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 author’s 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 author’s 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.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 landlord’s goal of preserving long-term ownership and an annuity. An individual landlord’s death often activates a purchase option, because the resulting basis step-up finally makes a sale feasible as a tax matter.

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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 grant First 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, 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 lessee4; 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.

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.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.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 Seller’s 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.

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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 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 Seller’s Interest 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 Holder the 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

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 Seller’s 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 Seller’s Purchaser other terms “materially more favorable,” whatever that means, than those in the First Right Notice – a whole new avenue for discussion and dispute.8 A ROFR typically requires a fully negotiated and signed contract with the Seller’s Purchaser, with the closing conditioned on the Holder’s not exercising its ROFR.

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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 its Interest. Once the Seller has given a valid First Right Notice and the Holder does not respond in time, the Seller can proceed freely with its marketing, bidding and negotiation process, without having to explain12 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.

9 I have also heard references to a “right of last refusal,” which does not seem to be very different from the “right of first refusal” discussed in text.10 As a variation on the theme, one sometimes sees a “right of first negotiation,” where the prospective Seller must merely notify the Holder of the Seller’s intention to try to sell its interest. After that, the parties are supposed to try to negotiate a deal, often “in good faith” and on an exclusive basis. If they fail to do it within a stated time, then the Seller can go out to market. These clauses have their own advantages and disadvantages, starting with the great advantage of simplicity and avoidance of most of the issues discussed in this article. A potential holder of a “right of first negotiation” may, however, regard a ROFO or ROFR as more solid and reliable. Although that proposition is probably right, at least in theory, the questions and issues raised in this article may, in practice, call the proposition into doubt. (“The more people I meet, the more I like my dog.”)11 The New York Court of Appeals stated that a “right of first refusal” requires a property owner, “when and if he decides to sell, to offer the property first to the party holding the preemptive right so that he may meet a third-party offer or buy the property at some other price set by a previously stipulated method.” That definition of “right of first refusal” covers both ROFOs and ROFRs as defined in text. Metropolitan Transp. Auth. v. Bruken Realty Corp., 67 N.Y.2d 156, 163 (1986). Here, the Court of Appeals stated: “the rule against remote vesting [Perpetuities] does not apply to preemptive rights [i.e., First Rights] in commercial and governmental transactions, [and] their validity is to be judged by applying the rule against unreasonable restraints.” Id. at 168. Although this case and other more recent New York cases favor enforceability of “reasonable” First Rights, counsel should consider the Rule Against Perpetuities in structuring any First Right, particularly in transactions involving individuals or property outside New York. See, e.g., Morrison v. Piper, 77 N.Y.2d 165 (1990) (rule does apply to ROFRs involving individuals). The Rule Against Perpetuities has perpetual life.12 Prospective Seller’s Purchasers will figure out the existence of the ROFR soon enough when they start their due diligence, i.e., when they read the ground lease. So the Seller may as well simplify things and prevent surprises and emergencies, by mentioning the ROFR early in the process. As its best strategy, the Seller might try to negotiate a waiver of the ROFR long before going to market. The Holder may or may not like that idea. The Holder may regard it as just another revenue opportunity of the type that usually arises from time to time under any ground lease.

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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 Interest to 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 real potential 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

13 The Seller can mitigate that problem by offering a break-up fee to the Seller’s Purchaser if the Holder exercises its ROFR and “takes the deal” that the Seller’s Purchaser negotiated.14 Before a Seller sticks its toe into the marketplace, though, it must make sure it does not stub its toe by unintentionally triggering the ROFO. For example, some ground leases give a Holder the right to buy if a Seller “decides to sell,” with no objective or bright-line definition of what that means or how to measure the state of the Seller’s mind. Should the Holder engage a psychic to delve into the Seller’s innermost thoughts? The Holder or the Holder’s psychic could say the Seller’s inquiries in the marketplace evidenced a decision to sell, triggering the ROFO. The Seller will, of course, want to avoid any unintentional triggering of a ROFO and will want to stay far away from psychics. But does physical proximity matter in the psychic world? This may be the subject of a future article.15 A ROFO results in a longer time between the First Right Notice and the closing than would occur in the case of a ROFR. That delay can create additional problems for a Seller if the marketplace pricing for the Seller’s Interest is volatile. For example, leased fee estates involving corporate credit ground lessees often trade much like bonds. Pricing can change dramatically in a short time based on small changes in interest rates or changes in the ground lessee’s rating. If a ROFO (or, to a lesser degree, even a ROFR) requires the Seller of the leased fee estate to specify a fixed dollar price in the First Right Notice, this may give the Holder (here, the corporate credit ground lessee) the best of both worlds if interest rates move in the “wrong” (or “right”) direction. Use of a ROFR rather than a ROFO mitigates but does not eliminate the problem. The Seller may want the right to specify in the First Right Notice a pricing formula tied to interest rates and other variables on the closing date, rather than a fixed dollar price. Traditional First Rights language requires the latter.

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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 Notice often

16 Conceptually, the ground lease should prohibit any possible sale except to a closely related party (with the First Right remaining in effect) or through a foreclosure, unless the Seller has given a First Right Notice. That sounds easy but many First Rights clauses get it wrong. For example, often a ROFR arises only if the Seller “receives an offer that it intends to accept.” That is what the words of the ground lease say. If instead the Seller initiates an offer to a Seller’s Purchaser and the Seller’s Purchaser accepts the offer, then this would not seem to trigger the ROFR. Sometimes a ROFR arises only if a proposed sale satisfies certain criteria (such as all cash, no other real property involved, a deposit of at least a certain amount, and no due diligence period), but the ground lease does not otherwise restrict the Seller’s transfers. So a Seller could avoid the ROFR simply by entering into a sale that does not meet the criteria for a sale that triggers the First Right. Finally, in many cases, a Seller could avoid any First Right by structuring the transaction as a sale of the equity interests in the Seller rather than as a sale of real property. In my experience, only a minority of First Rights also apply to equity sales. On the other hand, if a First Right did apply to equity sales, then any equity investor that contemplated a sale of its equity might need to contend with two First Rights – a First Right under the ground lease and perhaps a First Right under the joint venture agreement. Proper analysis and alignment of those two First Rights creates almost endless new opportunities for complexity, mistakes, and practical problems. Of course, we have nothing to worry about because smart lawyers can always figure everything out perfectly. See, e.g., Stein, Joshua, It’s Complicated, But Is It Right?, The Mortgage Observer, at 12 (Feb. 2013) (www.pdf2go.org/100006.html).17 In the case of a ROFO, must the Seller go through the ROFO process before negotiating or signing a contract with a Seller’s Purchaser? Or can the Seller first sign a contract with a Seller’s Purchaser but make it entirely subject to subsequent compliance with the ROFO? Depending on the wording of the ROFO, the Holder might argue that the Seller must go through the process sequentially, so the Holder gets a clean “first bite” before anything else happens. In that case, if the Seller signs a deal with a Seller’s Purchaser, then at a minimum the ROFO Notice could be invalid; at worst the whole exercise might constitute a default under the ground lease. The validity of this argument would depend entirely on the words of the First Right. 18 If a Seller actually triggers a First Right, particularly with no warning, this usually means the relationship has reached a point where the parties cannot amicably negotiate something that makes sense to both of them. A First Right is supposed to encourage the parties to work together to negotiate something; no one should actually exercise any First Right. Thus, an exercise of a First Right is often a prelude to a fight. In that fight, the Holder may want to engage new counsel, to assure the Holder receives objective advice on whether the First Right was negotiated and documented appropriately. In contrast, the Holder may fear that the lawyer who negotiated

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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 quick Deadline, 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.

and documented the First Right may not tell the Holder if the First Right was badly written -- and many of them are very badly written. This is the same dynamic that comes into play whenever any transaction starts to head toward litigation.19 Some real estate investors will, of course, or may have substantial revolving credit lines. Those real estate investors – REITs for example – may be the only ones well positioned to benefit from First Rights.20 Ideally, the existing mortgage already encumbering the Seller’s interest in the property will include the lender’s pre-approval of a conveyance to the Holder if the Holder exercises a First Right. If a Holder has perfect and complete foresight and all the time in the world, the Holder might even think of requiring the Seller to include such a pre-approval in any such mortgage. Those conditions are rarely satisfied, though. And even if the Seller’s loan did include such a pre-approval, how likely will the Holder’s tastes in mortgage financing match the Seller’s? Similar issues arise with First Rights granted between members of a joint venture. There, the joint venture agreement will often try to assure that the joint venture’s lender pre-approves any transfers between the joint venturers – whether they arise from exercise of a First Right or from anything else.

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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

21 For a discussion of many ways a Seller, a Holder, or anyone else giving a notice can do it incorrectly, see Joshua Stein, A Checklist for Giving Legally Effective Notices, 51 THE PRACTICAL LAWYER 11 (August 2005) (www.pdf2go.org/9.html).

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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.

When a Seller negotiates a contract with its Seller’s Purchaser (the “Seller’s Contract”) and knows the Seller’s Contract may be subject to a First Right, the Seller should consider the possibility that, when the Seller gives a First Right Notice, the Holder will raise issues with the Seller. The terms of the Seller’s Contract should give the Seller some breathing room – at least some extra time if needed before losing Seller’s Purchaser – to deal with whatever claims and issues a difficult Holder decides to assert.

The parties may also want to consider the possibility that the Seller will give a First Right Notice, but then later change its mind and want to withdraw the First Right Notice and stop the First Right process. Does the Seller have the right to do that? If the ground lease is silent on that point – and it is usually silent – then New York law would allow the Seller to have its way and restore the status quo.23 That would probably be true even if the Holder had expended substantial

22 The First Right language will usually say that after 30 days silence constitutes a waiver. Does that automatically cure the Holder’s default, if any, by failing to respond? Will the Seller want to rely on a deemed waiver? Will the Seller’s Purchaser? Its lender?23 Lin Broadcasting Corp. v. Metromedia, Inc., 74 N.Y.2d 54 (1989).

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time and trouble to consider whether to exercise its First Right and to arrange financing. If a Holder regards that prospect as unsatisfactory, then the Holder should negotiate language in the ground lease to prohibit withdrawal of any First Right Notice, or providing for a withdrawal fee.

If a Holder does decide before the Deadline to acquire the Seller’s Interest and issues a valid exercise notice, what then? The typical First Right simply gives the Holder an option, a possible purchase price based on the First Right Notice, and perhaps a time in which to close. Sometimes the First Right language contemplates that the parties will negotiate some form of industry-standard purchase and sale agreement. That’s a recipe for delay or disaster. Those negotiations will almost surely fail if one party or the other is not very enthusiastic about the transaction, as will often be the case. And sometimes the timeline for those negotiations contemplates that the parties will agree on a form of contract by the Deadline – a virtual impossibility.24

An industry-standard purchase and sale agreement would ordinarily require the purchaser, here the Holder, to fund a deposit at the time of signing the contract. Particularly if the First Right language is silent on contractual terms, the Holder would probably disclaim any obligation to fund any deposit at all. After all, it is hard to infer an obligation to fund a deposit if no written document identifies its amount. It is a key business point on which reasonable minds will differ.

Whether or not the Holder funds a deposit, what happens if the Holder exercises the First Right, and then defaults? Does that constitute a default under the ground lease? If the ground lessee is the purchaser, the prospect of a lease default arising from a failure to close after exercising a First Right could create serious angst for leasehold mortgagees. Thus, ground lessees and their lenders will want to make it very clear that any purchase transaction triggered by a First Right has nothing to do with the ground lease itself. The two should not be cross-defaulted.25

And what about all those other terms in any purchase and sale agreement that always make negotiation of an ordinary purchase and sale – a really very simple transaction – so complex and protracted?

What representations and warranties should the Seller make? Should they be subject to baskets? Floors? Caps? That particular group of issues may be less troublesome than usual in a contract arising from a First Right, given the Holder’s overall familiarity with the Seller’s Interest, but the Holder will still worry about “bad things” the Seller might do to frustrate the Holder’s expectations under the contract.

24 If the parties do not agree to attach a form of contract to the ground lease, then the First Right should perhaps provide for negotiation of the contract only if and when the Holder has exercised its First Right, perhaps with a “baseball arbitration” mechanism to resolve any possible deadlock. That approach carries its own risks and problems.25 If a tenant’s default under a First Right also constitutes a ground lease default, then the tenant’s leasehold mortgagee will worry about the possible need to cure a hypothetical future default whose magnitude or cost cannot be predicted. Although techniques exist to give the leasehold mortgagee comfort, it is better not to go there.

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As another issue, more specific to a First Right, if a Seller sold to a Seller’s Purchaser the Seller would probably need to pay a brokerage commission out of the selling price. If the Seller sells to the Holder, the Seller might avoid that expense. Who should benefit from those savings? How does one quantify them?

That’s not the end of the potential contractual issues that a First Right will often fail to address. When must the Holder close? Can the Holder adjourn the closing? What about condemnation? Adjustments? Real estate tax protests? Pending litigation? Uncertainty about ground rent calculations or payments? Payment of transfer taxes? Environmental risks? Unpaid brokerage commissions? Future free rent periods? Permitted title exceptions?26 Obligations to clear unexpected title issues? Responsibility for prepayment premiums?

If a Holder exercises a First Right, how will all those contractual provisions and many others work? Often the First Right language does not say. That may not be tragic, because 99% of a purchase and sale transaction consists of the purchase and sale itself. It is the other 1% of issues that often seem to incur legal fees that often exceed the practical value of these issues to the parties. In many cases, the ground lease does not consider how most of those issues would be handled if the Holder decides to exercise its First Right.

For a First Right to work well, though, the parties should at least give some thought to the multitude of issues that arise even in a simple purchase and sale contract, and either define in the First Right how those issues will be handled or establish a simple and quick mechanism to fill those gaps. Or the First Right language could require the Seller to specify all “material terms” of any proposed sale in the First Right Notice, and perhaps define what the “material terms” would be.

In the case of a ROFR, as opposed to a ROFO, a mechanism does exist to determine all the terms under which the Holder would need to buy if it exercised its ROFR. Specifically, the Holder may simply need to “match” the Seller’s Contract. That sounds simple and logical, but as with so much else in the world of ROFOs and ROFRs, appearances of being simple and logical may deceive.

The Seller’s Contract could conceivably contain terms that the Holder has no ability to match, such as an obligation for the Seller’s Purchaser to deliver certain real property in exchange for the Seller’s Interest. To respond to that concern, any First Rights language will

26 In a ground lease of the Roosevelt Hotel in Manhattan, Schedule B listed matters of record against the landlord’s title. The ground lease also gave the tenant an option, not just a First Right, to acquire the landlord’s fee estate, at a fixed price, subject to “only the matters set forth in Schedule B.” That schedule listed some fee mortgages, all prior to the lease. The tenant claimed credit against the purchase price for the amounts due under those mortgages. The landlord claimed the tenant owed the full cash purchase price, and also had to take subject to all the mortgages. The trial court held: “the lease purchase option establishes a fixed, all-inclusive purchase price . . . free from any additional mortgage obligations.” Roosevelt Hotel Corp. v. Letoh Assoc., Index No. 600379/99 (May 22, 2000) (Gammerman, J.), aff’d, 282 A.D.2d 380 (App. Div. 2001). The parties could have avoided several years of fascinating litigation by defining more carefully the scope of permitted title exceptions.

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often say that the Seller’s Contract must require payment of the purchase price in cash – with no purchase-money financing and no other consideration beyond the purchase price for the sale.

That sounds reasonable, but often a Seller will have bona fide reasons for a Seller’s Contract to require consideration beyond the stated purchase price, such as a possible future payment to reflect the outcome of some pending issue such as a construction dispute. Does that future payment – even though reasonable, bona fide, and agreed to in good faith -- invalidate the First Right Notice? And if it does not, the Holder will need to have the ability to understand and quantify the likely payment, to help it decide whether to exercise its ROFR. The First Right language should give the Holder the ability to obtain all the information it needs for that purpose, and time to process it. If the Seller provides missing information the day before the Deadline, the Holder will want the right to extend the Deadline.

Any Holder will also worry about the closing date in the Seller’s Contract. The Seller’s Purchaser probably will not sign the Seller’s Contract until after the Seller’s Purchaser has completed its due diligence, found a lender, and achieved a pretty high comfort level about its ability to close. Thus, the closing could take place relatively soon after the Seller and the Seller’s Purchaser sign their Seller’s Contract.

In contrast, if the Seller blindsides the Holder by giving a First Right Notice, the Holder will have had no lead time at all. The Holder will probably need more time than a Seller’s Purchaser to close.

Thus, ROFRs do often give the Holder some minimum time in which to close, even if the Seller’s Purchaser was ready to close more quickly. As a practical matter, though, the closing timeline will still often be too tight for a Holder that starts from a position of complete unpreparedness – one more example of the practical problems of First Rights.

A Holder might also worry about other provisions in the Seller’s Contract, such as extreme or unusual remedies for default; an extraordinarily high deposit; requirements for credit support that the Holder simply cannot satisfy; restrictions on assignment; or provisions that otherwise just do not match the Holder’s business agenda. Those and similar concerns may lead a Holder to insist on limitations on the terms of any Seller’s Contract. A Holder might go a step further and insist on attaching to the ground lease a template for any Seller’s Contract, though that does not seem to be market standard.

A careful Holder may, however, worry not only about the terms of the Seller’s Contract but also about what’s not in the Seller’s Contract. For example, a devious Seller could “get around” the Holder’s ROFR by calling for an above-market price in the Seller’s Contract but simultaneously entering into some other agreement with Seller’s Purchaser. It could be as simple as an agreement for the Seller to provide below-market services after the closing or as sophisticated as a simultaneous sale of another property at a below-market price, but conditioned on the closing of the above-market transaction under the Seller’s Contract.

In assessing the likelihood of any such scheme, the Holder might take comfort from the quality and business ethics of the Seller, but also might not. In the latter case, the Holder might at a minimum insist on receiving some certification from the Seller’s Purchaser’s about the absence

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of other agreements. Similarly, the Holder may worry about future amendments of the Seller’s Contract, particularly amendments that might make the economics more favorable to the Seller’s Purchaser. Should any such amendment require the Holder’s consent or entitle the Holder to a second bite at the apple?

If a Holder receives a First Right Notice and the idea of the Holder’s buying out the Seller’s Interest at the proposed price has no appeal to it at the moment, does that mean the Holder should do nothing and let the Seller proceed with a Seller’s Purchaser? Not necessarily. The Holder may think the Seller is selling too cheap, so the Holder could purchase the Seller’s Interest and resell it to someone else for a profit. The Holder might even decide it makes sense to throw in the Holder’s own Interest, offering both fee and leasehold on a combined basis and making a larger profit as a result.27

Even if the Seller’s offering price in the First Right Notice seems about right, the Holder may prefer to bring in a known third party to acquire the Seller’s Interest (a “Holder’s Purchaser”), as opposed to whatever Seller’s Purchaser the Seller ultimately finds. For these and other reasons, the Holder may want to figure out a way to exercise a First Right, for the benefit of a Holder’s Purchaser, even if the Holder does not itself want to acquire the Seller’s Interest.

The time constraints of a typical First Right make it almost impossible, though, for a Holder to do any of this. If, as noted earlier, the typical 30-day Deadline does not give a Holder enough time to find a lender, it surely does not give the Holder enough time to find a Holder’s Purchaser and for that Holder’s Purchaser to then find its own lender. It just will not happen. Thus the Holder will not be able to squeeze out of the First Right an opportunity to bring in a Holder’s Purchaser or make a profit or both. If those opportunities represented one reason the Holder wanted a First Right, then the Holder will probably not achieve its goal.

Let’s suppose, though, that a prescient Holder negotiated a First Right with a Deadline generous enough so that both (a) the Holder could find a new Holder’s Purchaser, to buy either the Seller’s Interest or conceivably both the Seller’s and the Holder’s Interests; and (b) that Holder’s Purchaser could find a lender and close a loan. Even then, the “flip” transaction might not work, because the typical language of First Rights would trip up the Holder in any number of ways.

27 A Holder seems more likely to convert the Seller’s transaction into an outright sale of the property in the case of a First Right within a joint venture agreement, as opposed to a First Right within a ground lease. In the context of a ground lease, leasehold and leased fee estates trade regularly and are a known quantity. Investors know how to analyze them and what they entail. In contrast, joint venture interests vary widely and entail a closer relationship with a counterparty, perhaps unknown. Thus a Holder will probably have more trouble finding a buyer for just a joint venture interest in a property-owning entity. In the latter case, the Holder’s best execution of a “flip” seems much more likely to require the Holder to include its own interest in the property. In that case, the Holder may want the right to convert its exercise of the First Right into the joint venture’s sale of the entire property to a third party. Even in a ground lease, though, circumstances certainly could arise where the Holder decides the best possible “flip” would include the Holder’s interest in the property.

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First, if the Holder exercises its First Right, often the contractual language on the First Right requires that the Holder acquire the Seller’s Interest. The Holder does not have the right to designate someone else to acquire it, or to assign the Holder’s First Rights or any resulting contract to a Holder’s Purchaser. So the actual closing would entail two closings with potentially two sets of transaction costs. At best, the Holder might need to agree to acquire the Seller’s Interest, and then only have the right to designate the actual purchaser at closing. All of this would create uncertainties, issues, and knotty negotiations with the Holder’s Purchaser. After the burdens described in this paragraph, the “flip” transaction might not make sense.

Second, the Holder would need to negotiate a contract with the Holder’s Purchaser, covering the Holder’s sale to the Holder’s Purchaser of the Seller’s Interest, after the Holder acquired it by exercising its First Right. A different problem then arises: the Holder’s mere negotiation of such a contract will often require the Holder to give (or to have given) the Seller a First Right Notice, entitling the Seller to acquire whatever the Holder was getting ready to agree to sell to the Holder’s Purchaser. So the Holder’s mere negotiation of a simple “flip” of the Seller’s Interest will start the Holder down a separate road in giving the Seller a new First Right, with its own First Right Notice, Deadline, and issues. That prospect will at a minimum cause delay, confusion, and headaches, likely derailing the Holder’s contemplated “flip” to the Holder’s Purchaser.

Third, if the Holder wants to go a step further and offer the Holder’s Purchaser not only the Seller’s Interest but also the Holder’s Interest, then it seems even more likely that the Holder will need to give the Seller a First Right Notice based on the Holder’s sale of its own Interest. Again, this creates practical problems and delays, potentially preventing the Holder from consummating the “flip” transaction with the Holder’s Purchaser.

If the Holder anticipates entering into any flavor of “flip” transaction by exercising a First Right, then the Holder will need to make sure the First Right language allows it. Once the Seller has given a First Right Notice, it seems reasonable to allow the Holder to structure whatever transaction it wants, including any assignments it wants, as long as the Holder matches the price in the First Right Notice. At that point, the Seller has already said it wants to exit the transaction, so why should the Seller have the right to torment the Holder by claiming the Seller should have a right to claw its way back into the transaction if the Holder decides to sell?28

28 Answer: all is fair in love and real estate. And in the world of First Rights, it is particularly hard to figure out where fairness and justice end and opportunism and abuse begin. Moreover, just because a Seller wants to sell its Interest at one price, that does not mean it will not want to buy both parties’ Interests – the whole thing – at some higher price, especially if Seller and Holder have had a bad relationship. If a First Right arises in a limited liability company or a partnership, a Holder’s quick profitable “flip” might, in the Seller’s mind, constitute trickery. See Blue Chip Emerald LLC v. Allied Partners Inc., 750 N.Y.S.2d 291 (App. Div. 2002) (LLC member bought out other members, soon resold at huge profit; buyer’s superior knowledge meant disclosures and waivers could not overcome perceived breach of fiduciary duty); but see Central Empresarial Cempresa S.A. v. America Movil, S.A.B. de C.V., 952 N.E.2d 995, 1002 (N.Y. 2011) (“Where a principal and fiduciary are sophisticated parties engaged in negotiations to terminate their relationship . . . the principal cannot blindly trust the fiduciary’s assertions”). See also Steven Simkin & Manuel E. Lauredo, Wearing Two Hats at Once: Buyout

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In thinking about the Seller’s Contract and deciding how to respond to the First Right Notice, the Holder may find itself tempted to open a dialogue with the Seller’s Purchaser. For example, the Holder might offer to waive its ROFR if the Seller’s Purchaser agrees to an “adjustment” in the ground rent. Or the Holder might see an opportunity to structure a profitable transaction that would involve the Seller’s Purchaser in some way. After all, the Seller’s Purchaser represents the one party in the world that the Holder knows with certainty already has a genuine interest in acquiring the Seller’s Interest, has already completed its due diligence, and might be willing to pay something more than the price in the Seller’s Contract.

If a Holder yields to the temptation to speak to the Seller’s Purchaser, then any such conversations may at a minimum violate real estate etiquette. But do they expose the Holder to potential liability? What if they somehow lead the Seller’s Purchaser to take actions the Seller does not like?

The answer depends, as always, on all the facts and circumstances. My own limited research suggests, however, that ordinary business negotiations should not create exposure – though they could create claims, potentially involving large numbers, which could cost money and take time to defend. Thus, a Holder should probably resist the temptation to speak to any Seller’s Purchaser. And an incredibly prescient Holder negotiating a First Right should require the Seller to consent in advance to any such conversations.

As if the issues already mentioned in this article were not enough, First Rights can raise another whole set of issues if a Seller starts to think about transactions that should not trigger a First Right, and circumstances under which the First Right should go away.

For example, suppose a Seller’s overall business strategy contemplates creation of a portfolio of similar assets, which the Seller intends eventually to sell as a group or convert into a real estate investment trust. In that case, the Seller will want to make sure that any such transaction does not trigger a First Right. The parties may address that concern by agreeing that if the Seller’s contemplated sale includes other property, then the Holder’s First Right does not apply and perhaps goes away permanently.

How much other property must the transaction include to defeat the First Right? In one recent transaction with a carveout of this type, the Seller informed the Holder that the Seller might decide to throw in a small property in another state, so the transaction would include “other property” and thus not trigger a First Right.

As another possible route to the same result, that Seller, in this case the ground lessee, could have argued that (a) the First Right language exempted any transaction that involved any “other property” in addition to the leasehold, and (b) under the facts of the particular contemplated sale, the Seller would also have included a significant amount of personal property beyond the leasehold itself. Would that have constituted enough “other property” to defeat the

Transactions Between Real Estate Joint Venture Partners, Real Estate Review, Winter 2004 5, 7 (“The duty to fully disclose should cease when the parties become adversarial, in order to prevent the alleged fiduciary from occupying conflicting roles. . . . Well-drafted waivers and disclaimers should be given effect[.]”).

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ground lessor’s First Right? The question became part of the general unpleasant mix of discussions between the Seller and the Holder.

If a possible Seller is a non-real-estate company that could merge into some other entity, the Seller will want to assure that a sale of the Seller’s Interest in connection with that merger will not require the Seller to issue a First Right Notice. Exactly that state of facts arose in 2008, when The Bear Stearns Companies, Inc. (“Bear Stearns”) agreed to merge into JPMorgan Chase & Co. (“JPMC”) at the height of the financial crisis. As part of the merger agreement, Bear Stearns gave JPMC an option to acquire the leasehold of the Bear Stearns headquarters at a fixed price if the merger failed.

The landlord under the Bear Stearns ground lease asserted that JPMC’s contingent option violated a ROFO in favor of the landlord, which required Bear Stearns to offer the leasehold to the landlord before offering it to anyone else, or accepting anyone else’s offer to purchase it. But the landlord’s ROFO did not apply if “Tenant shall determine to sell, transfer or otherwise dispose of its interest in this Ground Lease to (i) any entity into which or with which Tenant may be merged, consolidated or combined or any entity which shall purchase all or substantially of the assets of Tenant.”29

The court concluded that the quoted exclusion from the ROFO was broad enough to protect Bear Stearns and JPMC from the landlord’s claims whether or not the merger actually closed. By referring to an entity into which Bear Stearns “may” be merged, the exclusion was broad enough to defeat the landlord’s claims even if the merger did not proceed; the fact that it “may” have occurred was enough to activate the ROFO exclusion.

The court’s decision reflected a simple reading of the English words of the ROFO exclusion in the Bear Stearns ground lease. When the negotiators of the ground lease threw in the word “may,” did they really mean to cover the case where a merger seemed possible but ultimately did not occur? Perhaps not, but it did not matter. The exclusion was drafted broadly enough to prevent a problem for Bear Stearns and Chase.

As another exclusion from any First Right, the drafters of First Right language usually do remember to say that a foreclosure sale affecting the Seller’s Interest does not trigger a First Right. They recognize that no lender would want to endure First Right Notice(s) and the issues in this article as the price of foreclosing on its collateral. As a practical matter, any Holder can achieve almost the functional equivalent of a First Right by bidding at the foreclosure sale, though with the added burden of having to face competitive bidding. Does that mean it is reasonable to ask the Seller’s lender to agree to notify the Holder of any upcoming foreclosure sale? Probably not. Lenders typically reject such obligations. So, if the Seller wants its Interest to remain financeable, the Holder will not be able to rely on the Seller’s lender. The Holder will need to keep its ear to the ground to find out about any upcoming foreclosure sale.30

29 383 Madison LLC vs The Bear Stearns Companies, Inc., 2800 N.Y. Misc. LEXIS 9581, at 8 (Index No. 601570/08) (Sup. Ct. 2008) (Cahn, J.).30 At a suitable time, the Holder might want to proactively reach out to the Seller’s lender and ask to be notified of any foreclosure sale or adjournment, even if the lender does not contractually agree to give that notice. In practice, the lender might welcome the Holder’s

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Any lender will probably insist that if it forecloses on the leased fee or leasehold estate, then that particular estate will no longer be burdened by any First Right. The Holder will reluctantly accept that proposition if raised in negotiation of the First Right.

First Rights also need to deal with other possible contingencies. For example, if the Seller gives a valid First Right Notice, the Holder does not exercise its First Right, and the Seller sells to a Seller’s Purchaser, should the First Right still apply when the Seller’s Purchaser later decides to sell again? If the ground lease says nothing, then the First Right could very well continue to apply – a continuing burden for every future Seller and every future sale. A careful Seller will argue that under these circumstances the Holder had its opportunity to acquire the Seller’s Interest, and should not have another opportunity. The Seller would insist that under these circumstances the First Right should no longer apply to future transactions. The Seller, and particularly the Seller’s Purchaser, may want the Holder to agree to confirm in writing that the First Right has fallen away and will never come back.31

Conversely, the Holder may want the First Right to survive a sale to a Seller’s Purchaser, and continue to apply to all future possible sales. In that case, the ground lease should say so.

As another possibility, the Holder might exercise the First Right and then fail to close. Under that circumstance, the Seller might reasonably argue that the Holder does not deserve any more bites at the apple, so the Holder’s First Right should terminate.

A Holder might have similar thoughts. For example, a Holder might point out that any First Right Notice will require the Holder to incur a great deal of trouble, expense, and disruption to figure out how to respond. Thus, if a Seller gives a First Right Notice, then perhaps the Seller should not be allowed to give another First Right Notice for a certain amount of time. Or, as an alternative, if the Seller does give another First Right Notice within a certain period, then it could have a much longer Deadline than might otherwise apply.32

interest and may fear claims from the Seller if the lender tells a likely bidder to get lost. On the other hand, the Seller might regard such communications as meddling and a breach of estate real etiquette. Thus the Holder might ask the Seller to consent to such communications in advance. California law gives anyone a statutory right to record a “request for notice” of a trustee’s sale. Cal. Civil Code § 2924b(a). The party conducting the sale must comply with such requests. Cal. Civil Code § 2924b(b)(1). A Holder may want to exercise any such right that might be available.31 At a minimum, this is an example of a nonstandard assurance that a Seller may want to incorporate into future estoppel certificates. When the parties negotiate the estoppel certificate clause of the original ground lease, they may not think of requiring this assurance, though. It demonstrates the benefits of including “catch-all” language to say estoppel certificates must include other assurances reasonably requested in the future. 32 The Holder might also propose that, under these circumstances, the First Right language should give the Holder some substantive improvement in the deal, such as a low single-digit percentage discount if the Holder exercises its First Right and actually purchases the Seller’s interest. A thoughtful Holder might ask for such a discount in any event, to compensate the Holder for the burdens of dealing with a First Right Notice. Such a discount would also incentivize the Seller not to send a First Right Notice, and to negotiate a more collegial resolution. I have never seen such a discount in any First Right; nor have I seen it in any buy-sell

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Conversely, if the Holder “passes” in response to a First Right Notice and the Seller does not close a transaction, then the Seller may want to be excused from giving any more First Right Notices for a certain time, unless the offered pricing drops by more than 5%.

As demonstrated in this article, First Rights can raise a variety of genuine legal and practical issues – many of them not obvious – both in negotiations and in real life if anyone ever actually exercises a First Right. For these and other reasons, no one should place great weight on First Rights as a source of reliable protection or value in a deal. They are functionally very much like the drain stoppers that opened this article.

First Rights may actually be worse than those drain stoppers, though, because First Rights not only do not work, they also create issues, trouble, and surprises. As a practical matter, they may just force the parties to try to negotiate an amicable parting of the ways to avoid the headaches this article describes.

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clause in a joint venture, where it seems even more appropriate.

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