Set 12 Limits on Tenant's Right of First Refusal to Buy Space

March 1, 2006

It's not unusual for a big tenant who's leasing an entire building to ask for a “right of first refusal”—that is, a right to buy the space if and when a third party offers to buy it. If you have a desirable enough tenant, you may agree to give the tenant this right. But beware: A right of first refusal may scare away prospective third-party buyers. A prospective third-party buyer probably won't want to spend time and money negotiating a sales contract on space that a tenant could snatch away at the 11th hour by exercising a right of first refusal.

It's not unusual for a big tenant who's leasing an entire building to ask for a “right of first refusal”—that is, a right to buy the space if and when a third party offers to buy it. If you have a desirable enough tenant, you may agree to give the tenant this right. But beware: A right of first refusal may scare away prospective third-party buyers. A prospective third-party buyer probably won't want to spend time and money negotiating a sales contract on space that a tenant could snatch away at the 11th hour by exercising a right of first refusal. A right of first refusal could create other problems for you too. For instance, you could get sued if you forget to notify the tenant before selling to a third party.

To minimize the disadvantages if you agree to give a tenant a right of first refusal to buy its space, you can—and should—place certain limits on that right. With the help of Syracuse attorney Stuart J. Frank, we've put together a 12-point checklist of limits that you should include in a right of first refusal clause. Plus, there's a Model Lease Clause on p. 3 that includes these limits.

How Right of First Refusal Works

In general, here's how the right of first refusal works: A third party offers to buy the space at terms you find acceptable. You sign a sales contract that includes those terms. But before the third party signs that contract, you send it, along with an offer notice, to the tenant who has a right of first refusal to buy the space. The tenant must decide whether or not to buy the space on the terms set out in the sales contract.

If the tenant accepts the terms of the sales contract, the tenant must notify you by a set deadline that it's exercising its right of first refusal. The tenant must then sign the sales contract and send it back to you. If the tenant rejects the terms of the sales contract or doesn't respond to your offer notice by the deadline, the tenant's right of first refusal lapses and you can sell the space to the third party on the terms set out in the sales contract.

12-Point Checklist Of Limits

Here are 12 limits to consider including when drafting a right of first refusal clause:

* Give Refusal Right Only if Offer for Entire Space

Make sure that the tenant's right of first refusal applies only if the third party is offering to buy the tenant's entire space and if that's the only space you're selling to the third party, says Frank [Clause, par. a]. If you're selling a portion of the space—or the entire space along with other spaces—then you should have the right to make the sale without having to satisfy your right of first refusal obligations, he says.

* Require Tenant to Meet Conditions

Require the tenant to meet certain conditions before it's allowed to exercise the right of first refusal. Frank suggests these conditions:

Tenant isn't in default. Don't reward a defaulting tenant by letting it exercise a right of first refusal. Rather, bar a tenant that's in default from exercising the right, advises Frank [Clause, par. a(i)].

Tenant hasn't assigned or sublet. Don't let a tenant that has assigned or sublet some or all of its space exercise the right of first refusal. A tenant that's no longer using all of its space shouldn't benefit from this right. Nor do you want any other entity—such as an assignee or subtenant—to take over the tenant's right of first refusal. You're giving the original tenant this right in the context of the deal you've negotiated, Frank says. No other party should reap the benefits [Clause, par. a(ii)].

Tenant isn't holding over. A tenant whose lease term has ended but is refusing to move out shouldn't be entitled to exercise a right of first refusal, says Frank [Clause, par. a(iii)].

* Make Refusal Right ‘Personal' to Tenant

Say in the lease that the right of first refusal is “personal” to the original tenant, says Frank. This is another way to keep anyone but the original tenant from exercising the right. This language means that only the tenant named in the lease can exercise the right of first refusal—not any assignee or subtenant, he says. Also say that if the tenant assigns the right of first refusal to anyone else, the right will immediately terminate, he adds. And say that no one else can exercise the right [Clause, par. f]. This prevents the assignee from getting around the restriction by asking the tenant to exercise the right of first refusal on its behalf, Frank explains.

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

* Make Right of First Refusal a One-Time Right

Don't let the tenant have a chance to exercise the right of first refusal more than once, says Frank [Clause, par. a]. Suppose a third party offers to buy the space, the tenant doesn't exercise its right of first refusal, and the third party later retracts its offer. If you've made the right of first refusal a one-time right, you won't have to offer the space to the tenant again, he explains.

* Set Short Response Time

Give the tenant a short time to let you know that it's exercising its right of first refusal and accepting the terms set out in the sales contract, says Frank. This is critical, he warns. Most likely you and the third party will want to know quickly who will be buying the space—the tenant or the third party. Frank suggests giving the tenant only five business days after it gets your offer notice to respond [Clause, par. b(i)]. The longer you wait, the more likely the third party will be to lose patience and give up on the deal.

* Require Verified Response

Require the tenant to verify that it exercised the right of first refusal on time, says Frank. To do this, have the tenant send its acceptance of the offer by registered or certified mail, return receipt requested, he says. It should be postmarked within the five business days for responding to the offer, or whatever deadline you've set [Clause, par. b(i)].

* Limit Time to Sign Sales Contract

Just as you want the tenant to quickly respond to a third party's offer, so too you want the tenant to quickly sign and return the sales contract if it chooses to exercise its right of first refusal, notes Frank. He suggests giving the tenant only 15 days after it gets the sales contract to sign it and send it back to you [Clause, par. b(ii)].

* Get Proof of Financing

If the tenant exercises the right of first refusal on time, require it to give you evidence of a financing commitment without contingencies or some other evidence of financing that's acceptable to you, says Frank. Require the tenant to give it to you within five days of signing the sales contract, he advises. You want to get this evidence quickly and make sure the tenant is able to close on the sale on or before the closing date set in the sales contract.

Also, say that if the tenant doesn't give you the financing commitment by the deadline, you're no longer obligated to sell the space to the tenant, says Frank. And the tenant's right of first refusal becomes void [Clause, par. c]. That should give the tenant an incentive to put its financing in order quickly.

* Require Sale to Close on Date in Sales Contract

After you get satisfactory evidence that the tenant is able to close, the next step is to close the sale quickly. So require that you and the tenant close the sale no later than the closing date set in the sales contract, advises Frank [Clause, par. d]. Otherwise, the tenant might try to delay the closing.

* Make Refusal Right ‘Subordinate' to Mortgage

It's crucial to get a tenant to agree that the right of first refusal will be “subordinate”—that is, lower in priority—to any mortgage on the building or center where the space is located, says Frank. Also, have this subordination requirement continue despite any renewal, modification, consolidation, replacement, extension, or refinancing of the mortgage after the lease is signed. And have the tenant agree to sign any subordination documents your lender requires. Get the right to sign those documents on the tenant's behalf if the tenant doesn't sign them quickly, advises Frank [Clause, par. h].

Without a subordination requirement, you'll have a tough time getting any financing for the building, because the right of first refusal could end up canceling the mortgage, Frank warns.

Practical Pointer: The lender may also require the tenant to either assume the loan or pay it off if it buys the space, says Frank. And the lender may demand that the right of first refusal be canceled if it forecloses on the space, he adds.

* Make Refusal Right Lapse if Tenant Delays

Make it clear that the tenant's right of first refusal ends if the tenant doesn't exercise the right to buy the space on time, or if it exercises the right on time but never signs the sales contract. You want the tenant to understand that in those circumstances, you're free to sell the space. Even if the sale to the current third party falls through, you don't have to offer the space to the tenant again during the lease or any renewals or extensions [Clause, par. e].

* List Events that Won't Trigger Refusal 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 these events:

  • You sell the space to your affiliate—that is, a company you control or that controls you—or to a government entity [Clause, par. g(i)];

  • You sell the space in connection with the sale of all, or substantially all, of your stock, other ownership interests, or assets to a third party [Clause, par. g(ii)];

  • Your stock starts or continues to be traded on any over-the counter market or stock exchange [Clause, par. g(iii)];

  • You sign a management agreement that transfers control of the space to a management company [Clause, par. g(iv)];

  • You sign, renew, or modify a ground lease, deed of trust, or mortgage affecting all or any portion of the space [Clause, par. g(v)]; or

  • The space is part of a multiple-property sale to a third party. That is, you're selling not only the space but also other spaces that you own to a third party [Clause, par. g(vi)].

This list helps protect you if any of the events occur and you don't follow the right of first refusal procedures. The tenant will have a hard time arguing that you violated the lease by letting a third party take over the space without first following those procedures, Frank says.

Practical Pointer: If the tenant's space is so valuable that a third party would want to buy it for the purpose of developing (or redeveloping) it, consider getting the right to terminate the tenant's lease if the tenant doesn't exercise its right of first refusal, says Frank. This way, you'll be able to kick out the tenant and deliver a space to the buyer that's not encumbered by the tenant's lease. If the tenant agrees to the termination right, expect it to require you to pay it the unamortized cost of its improvements if you end up terminating its lease because it didn't exercise its right of first refusal, he notes. And the tenant will likely demand that the lease not terminate unless the third-party deal actually closes. Otherwise, the tenant will fear that you'll abuse the termination right by inducing a third party to make a bogus offer so that you can kick the tenant out of its space, Frank explains.

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.

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