Reduce Risks of Giving First Refusal Right for Additional Space

A thrifty tenant may decide to rent only the space it needs at the start of the lease—even if it anticipates business growth and increased space needs in the future. But to give itself flexibility, the tenant may demand a right in its lease to expand into additional space during the lease. If the tenant is very desirable, you may want to give in to its demand and give it a “right of first refusal” on that additional space, even though that creates an obstacle for you when renting space in your center or building.

If you agree to give a “right of first refusal” in the lease, you can—and should—place certain limits on this right. And you should also add protections to minimize the disadvantages and risks of giving the tenant this right. With the help of Syracuse attorney Stuart J. Frank, we've put together a 13-point checklist of limits and protections that you should include in a right of first refusal clause. Plus there's a Model Lease Clause on pp. 4–5 that includes these limits and protections.

How Right of First Refusal Works

Here's how a right of first refusal works: A third party offers to rent certain space—for example, the space adjoining the tenant's current space—at terms that are acceptable to you. Before accepting the third party's offer, you must notify the tenant of the offer's terms and give the tenant the opportunity to take the additional space on the same terms.

To exercise the right of first refusal, the tenant must send you a written acceptance within a set period of time. If the tenant exercises its right of first refusal, you'll have to rent the additional space to the tenant on the third party's terms. If the tenant doesn't exercise its right of refusal and if the lease says that the right then lapses, you can rent the additional space to the third party.

If you rent the additional space to the tenant, you'll need to decide whether to sign an amendment to the tenant's lease (so that the lease will also cover the additional space) or to sign a new lease with the tenant covering just the additional space.

If the additional space is connected or adjacent to the tenant's current space so that the tenant will have one enlarged store or office, it's best to sign an amendment to the lease, says Frank, unless you have significantly revised your lease form since the tenant signed the original lease. If the additional space isn't adjacent—so the tenant will end up with two separate spaces—sign a separate lease for the additional space, he says. Covering two nonadjacent spaces in one lease can be complicated and confusing, he explains.

13-POINT CHECKLIST OF LIMITS AND PROTECTIONS

While getting a right of first refusal is worthwhile to a tenant, giving the right can be risky to you. For instance, it could drive away prospective tenants. A third party probably won't want to waste time and money negotiating a deal that your tenant could steal away at the 11th hour. A right of first refusal also holds a significant legal danger to you, which could last for years. You might forget that you're responsible for notifying the tenant about a third party's offer. If you forget to do that and you lease the space to someone else, the tenant could sue you.

To minimize these and other risks, consider adding the following limits and protections when drafting the right of first refusal clause:

* Designate Additional Space

The right of first refusal should apply only to a specific space, says Frank. You don't want any mix-up over what space the tenant is entitled to lease under the right. Otherwise, the tenant may argue that it has a right of first refusal to space that you planned to lease to another tenant. To avoid disputes, clearly describe the additional space in the lease by using a floor number and space number if it's in a center (or a suite number if it's in an office building). Also, attach a floor plan to the lease with the additional space clearly marked, he says [Clause, par. a].

* Limit When Right Can Be Exercised

Say that the tenant's right of first refusal applies only through a certain point during the lease—for example, until the end of the second year of a 10-year lease, says Frank. The tenant should know by then if it needs to expand. In any event, it's important to bar the tenant from exercising its right near the end of the lease [Clause, par. a].

Why is this important? You'll want the lease on the additional space to end at the same time that the tenant's current lease ends. But if you let a tenant exercise its right of first refusal too close to the end of its current lease, the tenant would only briefly occupy the additional space, assuming it doesn't renew its lease. You'll have lost the chance to lease the additional space for a longer time. Plus, you'll have wasted time and money negotiating what turned out to be a very short-term lease, he explains.

Practical Pointer: To compromise on this point, let the tenant exercise its right of first refusal near the end of its lease—during, say, the ninth or 10th year of a 10-year lease—but only if it has exercised any lease renewal or extension option it has on its existing space or if it renews its existing lease on terms that are acceptable to you, says Frank. Then you're sure that the tenant will stay in the existing space before you let it exercise its right on the additional space, he explains.

* Limit Number of Times Right Can Be Exercised

Limit how many times the tenant may exercise the right of first refusal, says Frank. The Model Lease Clause says that the tenant gets only a one-time right [Clause, par. a]. And make it clear that your obligations are over if the tenant doesn't exercise the right for the additional space on time, or if it exercises the right on time but then doesn't sign an amendment or new lease on time. You want the tenant to understand that in those circumstances you don't have to offer the additional space to it again during the lease or any renewals or extensions [Clause, par. d].

* Restrict Use

Limit the tenant's right of first refusal by saying that you must offer the additional space to the tenant only if a third party wants to rent the space for the same use as the tenant's use, says Frank [Clause, par. a]. This way, if the third party wants to rent the space for a completely different use, the tenant's right of first refusal isn't triggered, he explains. A savvy tenant is likely to balk at this restriction.

* Require Tenant to Meet Conditions

Require the tenant to meet certain conditions before it may exercise its right of first refusal. Frank suggests the following conditions:

Open and operating. Don't let a tenant that has gone dark in your center exercise a right of first refusal, says Frank. Otherwise, the tenant could rent the additional space but leave it dark too—for example, to keep out competitors. So to exercise the right of first refusal, require the tenant to be open and operating in all of its spaces, he says [Clause, par. a(i)].

No default. A tenant that's in default is a problem. Why let it become a bigger problem by letting it rent more space? So bar the tenant from exercising its right of first refusal if it's in default either when it exercises its right or when it's supposed to take possession of the additional space, says Frank [Clause, par. a(ii)].

The tenant may try to modify this condition, arguing that it should be barred from exercising the right of first refusal only if its default hasn't been corrected within the appropriate cure period.

Limited number of defaults during lease. Also, protect yourself from having to rent the additional space to a chronic defaulter. You might first try the hardball approach and say that if the tenant commits even one “material”—that is, substantial—default, the right of first refusal will be lost forever, says Frank. But expect a strong tenant to balk at this, he says. Instead, try this compromise: Disqualify the tenant from exercising the right of first refusal if its number of lease defaults have exceeded a set cap—say, three defaults—even if the defaults were cured, says Frank [Clause, par. a(iii)].

Solid financial condition. Bar the tenant from exercising its right if its financial condition has weakened since it signed the existing lease, says Frank. You don't want to have a financially shaky tenant taking on more rent than it can afford, he warns.

To ensure that the tenant is financially solid, Frank suggests that you require it to satisfy one of two financial standards before it can exercise the right:

• 1) Its net worth when it exercises the right must at least equal its net worth when it signed the lease; or

• 2) It must meet acceptable financial criteria that you set at your sole discretion [Clause, par. a(iv)].

To check the tenant's financial well-being, require it to send you its financial statements and any other financial information that you request along with its acceptance notice, says Frank [Clause, par. c(i)].

* Set Short Response Time

Give the tenant a short time period in which to exercise its right of first refusal and accept the lease terms offered by the third party, says Frank. This is critical, he warns. Most likely you and the third party will want to know quickly who will be getting the space. Frank suggests giving the tenant only two business days after it gets your offer notice to respond [Clause, par. c(i)]. The longer you wait, the more likely the third party is to lose patience and look elsewhere for space.

* Require Verified Response

Require the tenant to verify that it exercised the right of first refusal on time, says Frank. To do this, he suggests having the tenant notify you of its acceptance of your offer by registered or certified mail, return receipt requested, he says. It should be postmarked before the notice deadline [Clause, par. c(i)].

* Limit Time to Sign Amendment or New Lease

Just as you'll want a quick response from the tenant to the third party's offer, so too you'll want a quick return of the signed amendment or new lease from the tenant, says Frank. He suggests giving the tenant only three business days after it gets the amendment or new lease to sign it and send it back to you [Clause, par. c(ii)].

* Get Extended Guaranty

If a third party has guaranteed the tenant's current lease, you'll want it to also guarantee the amended lease or the new lease. Don't let the tenant exercise the right of first refusal without the guarantor extending its guaranty obligations to the amended lease or to the new lease, says Frank. Otherwise, a court could throw out the original guaranty if the amended lease or the new lease increased the guarantor's responsibilities without the guarantor's consent [Clause, par. c(iii)].

* Give Right to Tenant Only

Don't let any other entity—say, a subtenant or assignee—take over the tenant's right of first refusal. You gave the tenant this right in the context of the deal you negotiated, says Frank. Why should you let a subtenant or assignee reap the benefits? So say in the lease that the right is “personal” to the tenant, meaning that no one else can exercise it [Clause, par. e].

Practical Pointer: Expect the tenant to fight you on this point. It's likely to demand that the right continue for any assignee or subtenant that's a subsidiary, because it enhances the value of the lease, says Frank.

* Keep Right Not to Rent Additional Space to Anyone

Say that if the additional space becomes available but there's no third-party offer for it, you're not under any obligation to rent it to the tenant, says Frank [Clause, par. f]. You may want to use the additional space for your own purposes—for instance, for your administrative offices. You don't want to be forced to rent it by the tenant's right of first refusal.

* List Events that Don't Trigger Right

To avoid potential disputes with a tenant, it's a good idea to list in the lease those events that won't trigger the right of first refusal, says Frank. Your list should include the following:

• The sale or transfer of your stock or other ownership interests to a third party, or to any party under an estate plan;

• Your stock starts trading or continues to be traded on any over-the-counter market or stock exchange;

• You sign a management agreement that transfers control of the space to a management company;

• You sign, renew, or modify a ground lease, deed of trust, or mortgage affecting all or any portion of the space; or

• You sell your building or center (which includes the additional space) to a third party [Clause, par. g].

Otherwise, if any of those events occur, a tenant might try to argue that you violated the lease by letting a third party take over the additional space without first following the right of first refusal procedures, Frank warns.

* Add Cross Default Provision if Signing New Lease

To protect yourself if the tenant will sign a new lease for the additional space, say that a default under the original lease will be a default under the new lease, says Frank. Also, require the new lease to include a provision stating that a default under it will be a default under the original lease [Clause, par. h].

This is known as a cross default provision. It will entitle you to terminate both leases and recover all of the tenant's space (the original space plus the additional space) if the tenant defaults on any obligation under either lease.

Practical Pointer: If you sign a lease with the third party, make sure that you insert a clause that says that the lease won't be effective unless the tenant fails to exercise its right of first refusal or doesn't meet the conditions for the right of first refusal, says Frank. Otherwise, you could be caught between two claims for the same space, he warns.

CLLI Source

Stuart J. Frank, Esq.: Special Counsel, Hinman, Howard & Kattell, LLP, 224 Harrison St., Ste. 500, Syracuse, NY 13202; (315) 473-9414; SFrank@HHK.com.