Legal Briefs

Landlords Must Be Specific if Including Dual-Option Terms in Leases

Landlords often offer lease options, such as the right of first refusal to purchase the property, to attract tenants in a tight market. Although more advantageous to tenants, rights of first refusal — or tenants' rights to buy properties when landlords put them up for sale or receive third-party offers — sometimes benefit landlords by encouraging tenants to invest in improvements. Fixed-price purchase options can have the same effect, yet tenants can exercise them at any time during the option period, and they are not tied to a potential sale or third-party offer.

While many leases contain at least one of these options, some contain both. Such dual-option provisions may seem too good to be true, and, as Shepherd v. Davis indicates, they often are.

In this case, decided in January, the Supreme Court of Virginia heard evidence concerning a tenant who, in response to a third-party offer, declined to exercise a right of first refusal to purchase but then attempted to exercise a fixed-price purchase option to acquire the property at a lower price.

Contradictory Lease Options

Richard and Amelia Davis leased a land parcel in Virginia Beach, Va., to William Shepherd for an initial five-year term. The lease granted Shepherd a right of first refusal to purchase as well as a $150,000 purchase option. The right of first refusal provision stated, “Notwithstanding anything contained in this agreement to the contrary, if the landlord shall receive from a third party a bona fide written offer to purchase the property or any part of it, the landlord shall send to the tenant a copy of the proposed offer, with notification that the landlord intends to accept the offer. The tenant shall have the right within 10 days thereafter to exercise the option … pursuant to the terms and conditions contained in the offer. If the landlord does not sell the property … according to the offer, then the tenant's right of first refusal shall remain in full force.”

Near the end of Shepherd's lease term, a third party offered to purchase the property for $175,000. The Davises forwarded the offer to Shepherd, who elected not to exercise his right of first refusal because the offer's terms were not acceptable to him. Instead, he sought to exercise his fixed-price purchase option. Not surprisingly, the Davises declined to proceed with the fixed-price option and signed a sales contract pursuant to the third party's offer. However, because they did not yet own clear title to part of the parcel, the Davises could not close the sale.

Both Shepherd and the third-party purchaser separately filed complaints to enforce their respective agreements and acquire the property. The main issue in Shepherd's complaint was whether or not he forfeited his fixed-price purchase option when he declined to exercise the right of first refusal to purchase the property.

After hearing the evidence, a commissioner in chancery ruled that the right of first refusal provision overrode the purchase option because it began with the phrase “notwithstanding anything contained in this agreement to the contrary….” The commissioner determined that “Shepherd was required to respond to the right of first refusal and was not entitled to ignore it by preferring the [purchase] option,” and also that the third-party sales contract was null and void because the Davises didn't own clear title to the entire land parcel.

The Supreme Court Decides

In Shepherd's appeal, the Supreme Court of Virginia primarily addressed the relationship between the fixed-price purchase option and the right of first refusal. Shepherd argued that the right of first refusal was intended to give him an additional benefit: the right to buy the property at the more favorable of the fixed-price option or the third-party offer. In Shepherd's view, the fixed-price option established a ceiling for the purchase price. Shepherd also claimed that the dual-option provisions were not contradictory — they were separate and distinct, creating two ways in which he could elect to purchase the property — and that the fixed-price option remained in effect throughout the term of the lease, even if he elected not to exercise his right of first refusal.

The court first noted other courts around the country have split on the question of whether one dual-option provision takes precedence over the other. Some courts have held that a fixed-price option remains valid and available for exercise regardless of a right of first refusal's existence. Others have concluded that the tenant forfeits the fixed-price option in declining to exercise a right of first refusal offer. The Virginia Supreme Court pointed out that “courts agree that the interpretation of dual-option provisions turns upon the particular language used.”

In the Davis and Shepherd lease agreement, the court found the phrase “notwithstanding anything contained in this agreement to the contrary” to be clear and unambiguous and held that it gave the right of first refusal precedence over the fixed-price option. Concluding otherwise would render other phrases in the right of first refusal provision meaningless, something courts avoid if reasonable meaning can be attributed. The court also pointed out that the right of first refusal's concluding language made clear that this provision would remain in effect if the landlord failed to consummate a sale to a third party after the tenant declined to exercise the offer. The court found it significant that the fixed-price purchase option was not mentioned as remaining in effect.

The court held that Shepherd's fixed-price option was no longer available once the right of first refusal offer was presented. Shepherd's right to purchase the property at that point was only on the third-party offer's terms and conditions; since he declined to accept those terms, he forfeited his right to purchase.

Consider Lease Terms Carefully

Applying the analysis and holdings of Shepherd v. Davis , it is possible to construct leases with dual-option provisions that give tenants the right to elect between the fixed-price option and the right of first refusal terms. However, achieving this requires landlords to draft leases carefully to be certain the parties intend such a result. Courts meticulously scrutinize the language used in constructing dual options and interpret the language in a way that gives meaning to every clause or phrase. Simply throwing both options into a lease agreement without considering their implications and how the provisions relate to one another may lead to unintended results.

Carol C. Honigberg, JD

Carol C. Honigberg, JD, is a partner in the real estate group at Reed, Smith, Hazel, & Thomas LLP in Falls Church, Va. Contact her at (703) 641-4220 or chonigberg@rssm.com. The discussion of legal issues in this column is for informational purposes only. Results may vary depending on state laws and individual circumstances.

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