As Seen in the New York Law Journal: Rights of First Refusal: Knowing What is the Trigger
New York Law Journal (Online)
September 19, 2012 Wednesday
Copyright 2012 ALM Media Properties, LLC
All Rights Reserved
By: Andrew H. Levy and Benjamin M. Keller,Esq.
A right of first refusal is a contractual covenant given by one party (the owner) to the holder of the right of first refusal (the holder) that prohibits the owner from selling an asset to a third-party purchaser without first making an offer of sale to the holder. A right of first refusal is a commonly negotiated provision in many leases, joint tenancy agreements, tenancy in common agreements, partnership agreements, limited liability company operating agreements and other contracts where one party has an economic interest in an asset that could be compromised if the owner sells the asset in the future. A similar arrangement is a right of first offer, in which the owner covenants to the holder that it will not offer the asset for sale to any other person without first offering to sell the asset to the holder. Although there are some differences between a right of first refusal and a right of first offer, they function similarly in many respects, and this article focuses primarily on the former.
A right of first refusal contains elements of an option insofar as it becomes a binding contract of purchase and sale if the owner offers the asset for sale to the holder and the holder accepts the offer pursuant to the established terms. Unlike an option, however, which entitles the optionee to compel the owner to sell the asset to the optionee, typically on previously established terms, a right of refusal "merely requires the [owner], when and if he decides to sell, to offer the property first to the [holder] so that [the holder] may meet a third-party offer or buy the property at some other price set by a previously stipulated method."1 The right of first refusal is violated "only when the [owner] sells the property without first offering the [holder] the right to match the purchase offer."2
Due to the fact that the holder cannot independently compel the owner to sell until the conditions of the right of first refusal are triggered, one of the main issues with rights of first refusal is whether a particular act or transaction on the part of the owner triggers the holder's right of first refusal. A recent case in New York, which arose in the context of a judicial mortgage foreclosure action, has helped to clarify the legal framework that governs the triggering of rights of refusal. Understanding the case law and the key issues at stake can help the real estate practitioner provide informed legal advice when drafting, negotiating and performing due diligence on rights of first refusal.
Mortgage Foreclosure
As a matter of first impression in New York, the Appellate Division, Third Department recently held in Huntington Nat'l Bank v. Cornelius that a judicial foreclosure sale of a piece of real property did not trigger a joint tenant's right of first refusal under a joint tenancy agreement between the owners of the property.3 In Huntington Nat'l Bank, the joint tenancy agreement provided that "[s]hould either party purchase the entire property and within twenty years thereafter offer it for sale, the other party has the option to purchase the property...."4 One of the joint tenants purchased the other joint tenant's interest in the property, thus becoming the sole owner of the property.5 The sole owner then obtained a loan secured by a mortgage on the property and subsequently defaulted on the loan.6 The lender initiated proceedings to foreclose on the property and obtained a judgment of foreclosure and sale, at which time the former joint tenant filed a motion to vacate the judgment of foreclosure on the ground that the judicial foreclosure sale triggered his right of first refusal under the joint tenancy agreement.7
In analyzing this issue, the Third Department in Huntington Nat'l Bank focused on two factors: (1) the express language in the joint tenancy agreement that created the right of first refusal, and (2) the involuntary nature of the foreclosure sale. The operative language in the joint tenancy agreement stated that the right of first refusal would be triggered if one of the joint tenants purchased the entire property and then "offer[ed] it for sale."8 Looking to the plain meaning of the verb "offer," the court concluded that the right of first refusal was intended to cover "a conscious and voluntary choice" by the owner to sell the property.9
In this case, however, the owner had not made such an offer; the court had ordered the sale of the property in the judgment of foreclosure and sale, and the referee, rather than the owner, would sign the deed to convey the property at the foreclosure sale.10 Accordingly, the court held that the sale of the property pursuant to a judicial foreclosure proceeding was "not the volitional act of the owner" and therefore did not trigger the joint tenant's right of first refusal.11
The court, however, made clear that its decision in Huntington Nat'l Bank did not mean that "a right of first refusal can never ripen at a judicial foreclosure sale," and emphasized that the outcome might have been different had the right of first refusal provision been drafted with different language.12 This is sound drafting advice and makes clear that attorneys in New York should ensure that a right of first refusal provision explicitly states whether it will be triggered by a judicial foreclosure sale.
The analysis in Huntington Nat'l Bank did not cite to any other New York case expressly addressing the relationship between a right of first refusal and a judicial sale, even a 1968 case in New York Supreme Court which stated, without citation, that "a first refusal cannot apply to a judicial sale."13 One can speculate that the court in Huntington Nat'l Bank viewed this language as dicta or had other reasons for not discussing this case. It is also worth noting that a Florida appellate court recently held, as a matter of first impression under Florida law, that a right of first refusal under a partnership agreement was not triggered by a court-appointed receiver's sale of the subject property.14 In reaching this conclusion, the Florida court turned to persuasive authority from other jurisdictions and explicitly drew upon the analysis employed by the court in Huntington Nat'l Bank.15
Condemnation
While the issue in Huntington Nat'l Bank regarding the effect of a judicial foreclosure sale on a right of first refusal was a matter of first impression, New York courts addressed the relationship between condemnation proceedings and a right of first refusal several decades ago. In Kowalsky v. Familia, the county government sought to acquire a parcel of land for the creation of a water reservoir.16 The land was subject to a right of first refusal, which entitled the holder to purchase the land for a fixed price if the owner ever "offer[ed] the...premises for sale."17 The owner was informed that the county would initiate condemnation proceedings if the owner did not sell the land to the county for the appraised market value and ultimately the owner chose to sell the land to the county rather than endure the time and expense of condemnation proceedings.18 After the owner conveyed the land to the county, the holder of the right of first refusal sued the owner for specific performance on the grounds that the owner had voluntarily deeded the land to the county and had therefore triggered the holder's right of first refusal to purchase the land.19
The New York Supreme Court held that the holder's right of first refusal had not been triggered because the owner had not made an offer for sale as required by the terms of the right of first refusal.20 The fact that the owner granted a deed to convey the land to the county rather than wait for the commencement and completion of condemnation proceedings did not dissuade the court from concluding that the owner had not made an offer for the sale of the land.21 The court concluded that "[t]he attempt to distinguish this transaction from a true condemnation because here the county purchased the property rather than condemning it, is without substance."22
Deed in Lieu of Foreclosure
The question in Kowalsky—whether a right of first refusal is triggered by a seemingly voluntary transfer of property made in the shadow of a pending involuntary transfer—may also arise in the future in the context of a deed in lieu of foreclosure. A logical extension of the judicial foreclosure issue addressed by the court in Huntington Nat'l Bank, it will also be a matter of first impression in New York for a court to decide whether a deed in lieu of foreclosure given by an owner to a mortgagee triggers a holder's right of first refusal. A New York court hearing such a case would likely employ the same analysis used by the court in Huntington Nat'l Bank: evaluate the operative language in the right of first refusal provision, examine whether the owner's conveyance of the property was a voluntary action (assuming the language of the provision makes this a germane question), and review relevant case law from other jurisdictions.
If the right of first refusal provision in question specifically stated that it would not be triggered by a judicial foreclosure sale, but was silent on the effect of a deed in lieu of foreclosure, then the court might turn to the canon of construction expressio unius est exclusio alterius—"the expression of one thing implies the exclusion of the other."23
By expressly stating that a judicial foreclosure would not trigger the right of first refusal, but not addressing the effect of a deed in lieu of foreclosure, the canon expressio unius est exclusio alterius would direct the court to hold that the right of first refusal is triggered by the owner's grant of a deed in lieu of foreclosure. While New York courts continue to use the canon as a tool for statutory and contractual interpretation,24 the listing of certain trigger events in a right of first refusal provision does not necessarily preclude a finding that other, unlisted, events also trigger the right of first refusal.25
The court's next inquiry would likely be whether the owner acted voluntarily in conveying the property. The owner's grant of a deed in lieu of foreclosure can be considered voluntary to the extent that the deed is signed by the owner rather than by a court-appointed referee, as it would be at a judicial foreclosure sale. Yet a deed in lieu of foreclosure can also be considered involuntary insofar as the owner would not have transferred the property to the mortgagee were it not for the Damoclean threat of foreclosure hanging over the owner's head.
The holding in Kowalsky—that a transfer of property in lieu of condemnation does not trigger a right of first refusal—would appear to point New York courts in the direction of concluding that the owner's grant of a deed in lieu of foreclosure is involuntary and therefore does not trigger the right of first refusal. But the facts of a deed in lieu of foreclosure case are likely to be messier than those in a condemnation proceeding.
For instance, if the owner derives material benefits from the deed in lieu of foreclosure transaction, then the owner's action in giving the deed in lieu of foreclosure starts to look more voluntary than involuntary. Some examples of material benefits that an owner might receive in a deed in lieu of foreclosure transaction are releases from recourse, payment, or completion guaranties, the payment of owner's attorney fees, or even a lump sum payment. Receiving these additional benefits makes the owner's decision to grant a deed in lieu of foreclosure look like a voluntary action that would be more likely to trigger the holder's right of first refusal.
Current case law from other jurisdictions will provide little guidance to a New York court faced with the question of whether the owner's grant of a deed in lieu of foreclosure triggers a right of first refusal. An intermediate appellate court in California came close to addressing this question, but ultimately decided the case on other grounds. In Pellandini v. Valadao, the trial court had found that the owner's grant of a deed in lieu of foreclosure triggered the right of first refusal, which stated that the holder had the right to match "any bona fide offer for purchase of the property."26
The trial court's reasoning was based in part on the fact that an owner "could easily nullify a right of first refusal by orchestrating a sham loan, default, and deed in lieu of foreclosure transaction."27 While the trial court's ruling was overturned and the case decided on other grounds, the appellate court did agree with the trial court that "a deed in lieu of foreclosure could in some circumstances be used to circumvent a right of first refusal."28 The policy point that a New York court might draw from Pellandini is that if the indebtedness underlying the deed in lieu of foreclosure transaction is not a bona fide debt, then the owner's grant of a deed in lieu of foreclosure will be deemed to have triggered the holder's right of first refusal.
Conclusion
While the Third Department's decision in Huntington Nat'l Bank clarifies the law in New York regarding the effect of a judicial foreclosure sale on a right of first refusal, it will require future litigation to clarify the effect of a deed in lieu of foreclosure on a right of first refusal. Assuming that the language of the right of first refusal does not address this issue, and that the deed in lieu of foreclosure is not a sham transaction, future decisions will likely turn on the degree to which the owner's action in giving the deed in lieu of foreclosure was voluntary. The court's assessment of the owner's action will depend on the facts and circumstances of the deed in lieu of foreclosure transaction and the extent to which the owner received more than de minimis benefits from giving the deed in lieu of foreclosure.
Andrew H. Levy is senior counsel and Benjamin M. Keller is an associate at DLA Piper in New York. Peter Couto , a summer associate at the firm, assisted with the research for this article.
