• Tenant's Right Of First Refusal Not Triggered By Owner's Transfer To A Controlled Entity
  • September 11, 2003 | Author: Harris Ominsky
  • Law Firm: Blank Rome LLP - Philadelphia Office
  • A recent New York case highlights how careful an owner must be in giving a tenant a first right of refusal to purchase its property. In the case of New York Tile Wholesale Corp. v. Thomas Fatato Realty Corp., DOI; VOL. 229; pg. p. 19, col. 4 (June 4, 2003), reported in the New York Law Journal, of New York's Kings County Supreme Court held that a tenant's right of first refusal, exercisable in the event of the sale of the property, was not triggered by a transfer to a limited liability company in which the landlord held a 60% interest and retained management control.

    What's a "Sale?"

    The lease had provided simply that "[I]n the event of a sale of this property, the tenant has the first right of refusal." Apparently, no other definition of that right was provided in the lease, and that's what got the owner into trouble when it decided to develop the property into residential rental apartments in a joint venture with a real estate developer and a construction company.

    The landlord, Thomas Fatato Realty Corp. decided to form a limited liability company, Garden, in which it would join with these others to develop the new property. Garden's members were set up so that Fatato retained a 60% interest. The governing operating agreement of Garden provided that the members' capital contributions were those amounts necessary to acquire and develop the property, and that to the extent that any member contributed funds in excess of that member's proportionate share of the capital contributions due, the excess would be considered a loan owed to such contributing member. Since the market value of the property contributed by Fatato greatly exceeded the value of Fatato's proportionate contribution to Garden, Garden agreed to pay Fatato the sum of $2,295,000, which was reflected in cash, credits and mortgage obligations owed to Fatato.

    The tenant contends that the transfer to Garden constituted a "sale" of the property and that triggered the tenant's right of first refusal under the lease. In light of that, it sought a judgment rescinding the transfer of the property to Garden, and directing Fatato to perform its alleged obligation under the lease to transfer the property to it upon the same terms as the transfer to Garden. The tenant argued that the transfer of title was the result of an arm's-length negotiation with a third party for the market value of the property and that Garden's operating agreement divested Fatato of substantial control of the property because it permitted the joint venturers to share responsibility for the management of Garden's business and affairs.

    The Kings County Supreme Court rejected that argument and held that the transfer was not a "sale" triggering a right of first refusal. The transfer of title was not the result of an arm's-length negotiation with a third party for the market value, and under the terms of the operating agreement, Fatato retained ultimate control and veto power over Garden's decisions.

    Other Transfers

    In reaching its decision, the court reviewed other transfers that were held not to be legally synonymous with a "sale" of the property. Those include the following transfers:

    • A transfer of a building from the individual heirs of a corporation under a will to a corporation in exchange for shares in a new corporation;
    • Transfer of real estate by a corporation to its sole shareholder upon dissolution of the corporation;
    • Transfer of assets, including leased real estate, of a dissolved corporation to a partnership formed by the shareholders;
    • Transfer of real estate by a partnership to its general partner upon dissolution of the partnership.

    According to the court, a common characteristic of all of these cases is that the transfers achieved no change in the substance of control of the parties who owned the leased property, and control was also retained by the landlord in this case.

    The court also cited cases where the sale of stock in a corporation did not trigger the right of first refusal, even when the applicable property was the corporation's only asset, where the tenant failed to establish that the stock sale was entered into in bad faith in order to avoid the tenant's right of first refusal. In the Fatato case, the court held that not only was there no sale of the property itself, but also there was no showing by the tenant that the transfer to Garden "was a sham or otherwise entered into [in] bad faith for purpose of defeating plaintiff's rights."

    The court pointed out that the documents submitted to the court had referred to the transfer of the real estate as a "sale." Also, they had referred to the $2,295,000 as the "purchase price." The court held that these characterizations were not controlling on the issue of whether the transaction was a "sale" for purposes of triggering the option of first refusal and for that purpose the court looked to the actual nature and effect of the transaction.

    Expensive Lesson

    Even though Fatato won the case, it must have served as an expensive lesson. Generally, landlords that give options of first refusal, do so only because they think that it will not cost them anything. Essentially, they believe that, at worst, the tenant will pay them the same price offered by a third party. Unfortunately, the reality of that theory will be achieved only if the right of first refusal is carefully defined to exclude joint ventures and the kind of non-arm's length transfers cited above.

    In addition, many purchasers resent being treated as a "stalking horse" for another possible bidder, and therefore owners should generally resist rights of first refusal. If owners must give the tenant some concession like that to close a deal, they should offer instead, a carefully limited "right of first offer." That would obligate those owners only to present their asking terms first to the holder of the option, and once those terms are rejected, they can then freely offer the property without the burden of going back to the option holder. Even those limited options sometimes give owners grief because an option-holder will sometimes challenge any transaction that varies, even slightly, from the terms of the rejected first offer.