| P R O B A T E & P R O P E R T Y May/June 2007 Vol. 21 No.3 Other articles from this issue |
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Rights of First Refusal Poison Pills and Bad Faith
By Kevin L. Shepherd
Kevin L. Shepherd is a partner with Venable LLP in Baltimore, Maryland, and the Immediate Past Chair of the Section.
T o exercise properly a right of first refusal, must its holder accept every term of the third party’s triggering offer, even if it contains terms that the grantor knows will be repugnant to the holder and will discourage the holder from exercising the right of first refusal? A hypothetical fact pattern will bring this issue into sharper focus.
Grace Grantor (Grantor) owns a valuable undeveloped commercial parcel of land. Brittany Buyer (Buyer), a successful local developer, desires to acquire and develop the parcel as a retail center. Grantor bought the parcel 10 years earlier from Harry Holder (Holder), another local developer. As part of the acquisition, Grantor granted Holder a recorded right of first refusal to acquire the parcel should Grantor attempt to sell it to a third party within a 15-year period after the closing. Holder currently owns a neighboring tract of undeveloped land, and it is no secret in the local real estate community that Holder strongly desires to acquire the parcel should Grantor offer it for sale. Holder wishes to develop both parcels as a unified retail project.
The right of first refusal grants Holder the right to acquire the parcel on the same terms and conditions of the triggering offer. Grantor, who previously had a negative experience with a poorly drafted right of first refusal provision on another deal, thought this “mirror image” requirement would inure to her benefit when she decided to sell the parcel.
Buyer does not want to waste her time and money negotiating a contract of sale only to have the parcel sold to Holder under the right of first refusal. Buyer shares her concerns with Grantor, and Grantor notes that she does not much care for Holder these days and would prefer not to sell the parcel to him. Both Grantor and Buyer agree that it would make little sense for Buyer to expend her time and resources if she has no realistic opportunity to acquire the parcel unfettered by the right of first refusal process.
Buyer and Grantor then decide that they will defer entering into a contract of sale. Instead, Grantor grants Buyer a right of entry onto the parcel for the purpose of conducting physical due diligence on the parcel, including commissioning an ALTA survey and environmental site assessment. Buyer also directs a local title company to prepare a title insurance commitment for the parcel. Within three weeks, Buyer completes all due diligence on the parcel and has resolved a couple of title issues with the parcel. Buyer is thus satisfied with the results of her detailed due diligence investigations. Because Buyer plans to acquire the parcel through funds provided by her equity partners, no third-party financing is required.
At that point, Grantor and Buyer enter into a truncated contract of sale that contains no due diligence review period, no title and survey review provisions, an all-cash sales price, no site access or inspection rights, and no obligation for Grantor to provide Buyer with any documentary information relating to the parcel. The contract provides that the parties will close within one day of the full execution and delivery of the contract. In short, Grantor and Buyer enter into a “sign-and-close” contract.
Grantor presents the fully signed contract to Holder. Holder is astounded to learn that if he wants to exercise his right of first refusal, he will have to close immediately under the contract without the benefit of any traditional due diligence investigations. Holder also will have no time to seek third-party financing to acquire the parcel. Holder cannot believe that any buyer of commercial real estate would acquire the undeveloped parcel on such onerous terms and conditions. Through a quick investigation, Holder learns that Buyer has already performed the requisite due diligence investigations under the right of entry agreement and has completed her title and survey review. Holder is furious and believes that Grantor and Buyer have manipulated the deal terms in such a manner so as to thwart Holder’s ability to exercise his right of first refusal. To stop the sale, Holder brings suit against both Grantor and Buyer in the local court claiming, among other things, that Grantor and Buyer have acted in bad faith by structuring the transaction in a manner they knew, or should have known, would thwart Holder’s ability to acquire, or dissuade him from acquiring, the parcel under the right of first refusal. In response, Grantor and Buyer vigorously claim that they have the right to structure the deal terms as they see fit, that they are under no obligation to settle on terms beneficial to Holder, and that they have valid business reasons for structuring the deal on a sign-and-close basis.
How should the judge rule on this matter? Does Holder have a viable bad faith claim against Grantor or Buyer, or both? Should Grantor and Buyer be forced to structure the deal on terms that would inure to Holder’s benefit? A review of recent cases suggests that Holder may have the better argument.
Rights of First Refusal
Rights of first refusal are “agreement[s] between the property owner (‘grantor’) and a holder (‘preemptioner’) whereby the receipt of an offer from a third-party purchaser to buy the subject property ‘triggers’ the right of first refusal which, in turn, ‘ripens’ into an option to buy on the part of the preemptioner.” David A. Bramble, Inc. v. Thomas, 914 A.2d 136, 143 ( Md. 2007) (citing 3 Corbin on Contracts § 11.3 (rev. ed. 1996)). Rights of first refusal are the “weakest” of all options because they do not obligate the grantor—ever—to offer the property in question for sale. Miller v. LeSea Broad. Inc., 87 F.3d 224, 226 (7th Cir. 1996).
Courts have discussed the issue of whether the match between the triggering offer and the preemptioner’s offer must be exact, that is, a mirror image of each other. As Chief Judge Posner observed:
The requirement of exact matching has social as well as private value. Without it, the right is an impediment to the marketability of property, because it gives the holder of the right a practical power to impede a sale to a third party by refusing to match the third party’s offer exactly and then arguing that the discrepancy was immaterial.
Id.; see West Texas Transmission, L.P. v. Enron Corp., 907 F.2d 1554 (5th Cir. 1990) (preemptioner was required to meet all of the terms and conditions of the triggering offer, including a requirement that the preemptioner obtain Federal Trade Commission approval).
The mirror image rule, however, is not universal. In many jurisdictions, a preemptioner is not required to match immaterial terms found in a triggering offer. See Matson v. Emory, 676 P.2d 1029, 1032 (Wash. Ct. App. 1984) (“exact identity of offers is not required”; to be an effective exercise of the right of first refusal, the preemptioner’s conditions “must be virtually identical to the ‘terms and conditions’ imposed by” the triggering offer); see also Davis v. Iofredo, 713 N.E.2d 26, 28 (Ohio Ct. App. 1998) (“[I]t has long been recognized that a provision contained in a grant of a right of first refusal that states that the right must be exercised upon the same terms and conditions as are contained in a third party’s offer, requires only that the right be exercised upon the same material or essential terms as are contained in such an offer”).
Poison Pills
But even in those jurisdictions that require exact matching of the preemptioner’s offer and the third party’s offer, some courts have recognized three exceptions. First, through express or implied waiver, the grantor can waive the exact matching requirement. Second, proper names need not be matched because such a requirement would force the preemptioner to change its name to exercise the option. Third, and relevant to this discussion, a grantor cannot, for the purpose of discouraging the preemptioner from exercising its right of first refusal, insert into the triggering offer terms that it knows will be repugnant to the preemptioner. The grantor (and possibly the third-party buyer on a theory of intentional interference with the preemptioner’s right of first refusal) thus cannot insert a “poison pill” into the triggering offer for the purpose of nullifying the right of first refusal held by the preemptioner. Miller, 87 F.3d at 228; Bramble, 914 A.2d at 147 n.13. As the Miller court noted, the grantor may not, “for the purpose of discouraging the exercise of the right, procure from the third party terms that the grantor knows are unacceptable to the holder of the right of first refusal.” Miller, 87 F.3d at 228; see also Prince v. Elm Inv. Co., 649 P.2d 820, 825 (Utah 1982) (“[D]efeat of the right of refusal should not be allowed by use of special, peculiar terms or conditions not made in good faith”(quoting Brownies Creek Collieries, Inc. v. Asher Coal Mining Co., Ky., 417 S.W.2d 249, 252 (Ky. Ct. App. 1967)).
A recent right of first refusal decision deals with whether the grantor or the third party, or both, acted in bad faith by inserting a “poison pill” provision into the triggering offer. In Bramble, supra, John and Rose Lane owned a 26-acre parcel of unimproved land that bordered property owned by David A. Bramble, Inc. On January 3, 2004, Merrill and Nancy Thomas entered into a contract to buy the Lanes’ property for $105,000. This contract contained a handwritten addendum stating that the contract was contingent on Bramble releasing the right of first refusal it held on the property and an agreement by the Thomases not to use the property for mining. Bramble’s recorded right of first refusal, granted to it in 1992, provided that the Lanes would have to offer the property to Bramble “for the price and on the terms of the intended sale” and that Bramble would then have 30 days within which to accept or reject the offer.
Less than two weeks after being notified of the Thomas/Lane contract, Bramble sought to exercise its right of first refusal by executing and delivering an agreement of sale to the Lanes. Bramble’s offer matched the terms of the Thomas/Lane contract, but it did not contain the “no mining” prohibition. In early February 2004, the Lanes and Thomases amended their contract to increase the purchase price to $120,000 and to change the closing date. Bramble declined the request by the Lanes to match the revised terms. The Lanes then asserted that Bramble’s offer was actually a counteroffer and constituted an ineffective exercise of its right of first refusal because the offer failed to match all of the terms, including the mining prohibition.
In light of this brewing controversy, Bramble revised his offer to include the mining prohibition but kept the sales price at $105,000. Bramble tendered this offer 44 days after it was first notified of the Lanes’ initial acceptance of the offer by the Thomases. The Lanes then decided not to sell the property to either the Thomases or Bramble. The Thomases then brought a multi-count declaratory judgment action against the Lanes and Bramble. The Lanes and the Thomases filed motions for summary judgment. In February 2005, the trial court ruled that the right of first refusal did not violate the rule against perpetuities but that Bramble’s purported exercise of the right of first refusal was ineffectual because Bramble’s first offer failed to contain the material term dealing with the mining prohibition. The court thus granted Lanes’ motion for summary judgment on this issue, whereupon Bramble filed an appeal.
The Bramble court held that a genuine issue of material fact existed as to whether the Lanes and the Thomases, or either of them, exercised bad faith in inserting the mining prohibition into the original offer as a “poison pill” to dissuade or frustrate Bramble from exercising its preemptive right. The Bramble court pointed to the duty of the property owner and third-party purchaser to act in good faith. As a result, the court imposed a duty of good faith and fair dealing on the property owner and the third-party purchaser as striking the “proper balance.”
Based on the record, the court concluded that summary judgment was inappropriate to resolve the rights of the parties because there was “evidence in the record, if believed, that the Lanes and/or the Thomases inserted the prohibition on mining as a ‘poison pill’ . . . to discourage Bramble from exercising its right of first refusal.” Bramble was mining land adjacent to the property and intended to use the property for mining. The mining prohibition would defeat Bramble’s desire to buy the property, thereby frustrating Bramble’s bargained-for equitable interest in the property.
Determining Bad Faith
The Bramble court discussed whether a grantor or third-party purchaser may take steps to modify a nonprice term in the triggering offer so as to dissuade the preemptioner from exercising its right of first refusal. If so, these parties would then have the burden of demonstrating that they did not act in bad faith but rather had “reasonable justification” for modifying a nonprice term in the triggering offer to the disadvantage of the preemptioner. Prince, 649 P.2d at 825 (grantor must have a “reasonable justification” for its action when the preemptioner claims that the grantor acted in bad faith).
The “bad faith” rule seems reasonable on its face. Parties should not be allowed, by acting in bad faith, to defeat a right of first refusal. Despite the salutary nature of the bad faith rule, however, this rule may be thorny in practice. A grantor must now focus on how its actions will be viewed, in hindsight, by a court and the preemptioner in fashioning the terms of the sale of the property subject to the right of first refusal. The grantor must somehow divine, through clairvoyance or otherwise, whether it will be acting in bad faith if any of the terms of the triggering offer may be “repugnant” to the preemptioner’s right of first refusal or whether the grantor’s actions will be viewed as having an ulterior motive.
Of course, there will be clearcut factual situations in which it will be obvious that the grantor created nonprice terms designed to defeat the preemptioner’s right. Weber Meadow-View Corp. v. Wilde, 575 P.2d 1053, 1054 (Utah 1978) (no bad faith alleged, but triggering offer included the “trade of a unique and specific piece of real property” that made it virtually impossible for the preemptioner to match the terms). There will also certainly be a number of cases in which the preemptioner may be able to use the prospect of litigation to force the grantor to offer “vanilla” nonprice terms that may work to the disadvantage of the grantor in an open market system and would be of marginal, if any, benefit to the preemptioner. For example, suppose at the time of the creation of the preemptive right, the property in question is slated for commercial development. Later, as part of the terms of the triggering offer, the grantor desires to impose commercially reasonable restrictive covenants on the property (such as architectural control and customary use restrictions) at the time of closing. Would such a deal term be repugnant to a preemptioner who is in favor of the commercial development but who may disagree with the scope of one or more of the proposed covenants? What if the preemptioner has a reputation for, or practice of, developing commercial properties without restrictive covenants? With Bramble and related cases as support, would the preemptioner have the leverage in the negotiations at that point? Could the preemptioner strike a more favorable deal than otherwise would be the case had the preemptive right not existed in the first place?
Creativity may be mistaken for bad faith in the context of a grantor’s seeking to strike a deal with a third party rather than with the preemptioner. The grantor may have good reasons for not wanting to deal with the preemptioner. As the Miller court observed, “One [reason] is that a bird in the hand is worth two in the bush. When a real live buyer appears the would-be seller may not want to risk losing him by giving the holder of the right of first refusal a chance to match the offer.” Miller, 87 F.3d at 228. From the third party’s perspective, the third party “must undergo the transaction costs of arranging a sale without knowing whether the previous owner of the asset who has a right of first refusal will come in and take the benefits of the buyer’s negotiation.” Kaiser v. Bowlen, 455 F.3d 1197, 1206 (10th Cir. 2006).
Turning to the hypothetical discussed at the outset of this article, could Holder make a claim that Grantor acted in bad faith in structuring the transaction in such a manner as to prevent or dissuade Holder from exercising his right of first refusal? Unless Grantor, and perhaps Buyer, can show a reasonable justification for structuring the transaction in this manner (such as a custom and practice of entering into sign-and-close contracts), Holder may well have a viable claim that Grantor (and possibly Buyer) acted in bad faith and thereby thwarted Holder from exercising his right.
Conclusion
A grantor needs to be sensitive to how the structure of its real estate deal with the third-party buyer will affect the preemptioner’s right of first refusal. When inserting restrictive terms (other than price) into a contract, the grantor will need to make sure that it has a reasonable justification for its actions so that the preemptioner will not be able to make a colorable claim that the grantor thwarted or dissuaded the preemptioner from exercising its right of first refusal. In some cases, the grantor may be required to exercise clairvoyant powers in assessing what may be repugnant to the preemptioner.
