Is a Tenant's Option to Purchase Assignable?

Last year, a Missouri appellate court affirmed a lower court's holding that where a lease prohibited a tenant from assigning its interest in the lease without the landlord's consent, the tenant also could not assign an option to purchase the real property the tenant was leasing from the landlord, without the landlord's consent. That court held that a tenant's rights under an option to purchase were a covenant that ran with the land, and that the tenant could not assign those rights without the landlord's consent because the lease limited assignment of the lease generally. Megargel Willbrand & Co., LLC v. Fampat Limited Partnership, No. ED 86570, 2006WL956963 (Mo. Ct. App. Apr. 11, 2006)

The court in the Megargel case treated the lease's limitation on assignment as applying to the option to purchase as well as to the remaining provisions of the lease. In other cases, however, courts have held that an option to purchase is a covenant independent from the lease in which that covenant is contained. See, e.g., Holmes v. Harris, 110 A.2d 329, 334 (N.J. Super. Ct. App. Div. 1954) (citing other cases). In the case of such treatment, even where a lease contained a limitation on assignment that applied to the lease generally, the tenant's rights under an option to purchase contained within that lease could be freely assigned.

This article discusses the consequences of different interpretations of the assignability of a tenant's option to purchase. These consequences should be considered by tenants, landlords, the successors-in-interest (or potential successors-in-interest) of either of them, and the counsel who advise each of them. The article offers practical tips for how to prepare a lease provision regarding the assignability of rights under an option to purchase in a manner that will clarify the parties' rights and minimize the possibility of a failed exercise of an option to purchase.

Although this discussion is focused upon options to purchase, its suggestions should be useful in the context of other options that might be granted to tenants, including, among others, those options commonly referred to as options to expand or as rights of first offer. (The article refers to rights of first refusal and similar concepts universally as 'options to purchase.')

Evaluating the Assignability of a Tenant's Option to Purchase

Courts have considered a number of different factors when evaluating litigants' respective rights with respect to the assignability of a tenant's option to purchase. Among these are:

• The lease's language regarding assignability generally;
• Whether the landlord has consented to the purported assignment;
• Whether the subject transfer was a sublease or an assignment; and
• Whether the right of first refusal is severable from the remainder of the lease.

See, e.g., Megargel, 2006WL956963 at *1; Lehrer v. Waste Management of Wisconsin, Inc., 476 N.W.2d 27, 27 (Wis. Ct. App. 1991); Holmes, 110 A.2d at 331-32; Lehrer v. Wegenhoft, 203 S.W.2d 245, 249 (Tex. Civ. App. 1947).

Arguably, a tenant that wants to assign its rights and obligations under its option to purchase (with or without assigning any of that tenant's rights and/or obligations under the remainder of the lease) can minimize the possibility of failure of that assignment due to any of the factors described above by precisely drafting the lease's provisions and notices among the parties. (This conclusion should not surprise, but is worth stating due to the frequent lack of drafting precision in many real estate-related agreements and other documents.) A tenant may minimize the possibility of failure of an attempted assignment of a tenant's option to purchase due to the fourth factor described above by paying particular attention to the law governing the lease, which may or may not treat the option to purchase as severable from the remainder of the lease.

Severability of a Tenant's Option to Purchase

The facts in Megargel involved the attempted assignment of a tenant's rights under a tenant's option to purchase. That option to purchase contained typical provisions requiring the landlord to notify the tenant of any proposed purchase of the property by a third party and to describe to the tenant the terms of such proposed purchase. Thereafter, the tenant had a fixed period of time within which to respond to exercise its right under the option to purchase the property from the landlord (rather than the third party purchasing such property).

The lease allowed the tenant to sublease the property or any portion thereof freely but prohibited the tenant from assigning the lease without the landlord's consent. Megargel, 2006WL956963 at *1. After the commencement of the lease, the tenant subleased a portion of the property to the plaintiff subtenant and, in a document titled 'Additional Provisions to Sublease,' the tenant attempted to assign to the subtenant all of its rights under the option to purchase. When the landlord notified the tenant of a proposed purchase of the property by a third party, the subtenant attempted to exercise the option to purchase, but the landlord refused to accept that exercise, and the subtenant commenced litigation among the parties.

The court noted that the case raised an issue of first impression in Missouri, but relied upon authorities from other jurisdictions for its holding. The court observed that 'it is generally accepted that just as the assignment of a lease includes the assignment of the [option to purchase], a prohibition against assignment of a lease also prohibits assignment of the [option to purchase].' Id. at *3. The court adopted that position as its own and affirmed the lower court's holding granting summary judgment in favor of the landlord.

In Holmes, the case had facts nearly identical to Megargel but a different outcome based upon different reasoning. The option to purchase at issue was similar to the option described in Megargel. As was the case in Megargel, the lease allowed the tenant to sublease the property or any portion thereof freely, but prohibited the tenant from assigning the lease without the landlord's consent. The tenant subleased the property and attempted to assign to the subtenant the tenant's rights under the tenant's option to purchase. See Holmes, 110 A.2d at 331.

Later during the term of the lease, the landlord notified the tenant of a proposed purchase of the property by a third party. The next day, seemingly ignoring any party's rights under the option to purchase, the landlord entered into an agreement with a third party whereby the landlord agreed to sell the property to that third party 'subject to the rights of [tenant] or any sub-tenant or assignee thereof.' Id. at 332. A few days later, but still within the required time frame for exercising the option to purchase, the subtenant notified the landlord of the subtenant's desire to exercise the option.

With two purchasers for only one piece of property, the subtenant commenced litigation seeking an order requiring the landlord to sell the property to the subtenant or requiring the landlord to pay damages to the subtenant. In its consideration of whether the subtenant had succeeded to the tenant's interest under the option to purchase, the court separately considered the lease's 'general' discussion of the tenant's rights to assign or sublease and the lease's provision describing the option to purchase (which, the court noted, contained no restriction on assignment).

Such a separate evaluation was necessary due to the state of the law in New Jersey:

[I]t is recognized … in this jurisdiction that an option to purchase the demised premises such as this constitutes a covenant independent and separable from the lease as such, and in the absence of a negative provision the option is as assignable as any other contractual right … An option is a right which, by its inherent nature, is incapable of being leased. It is a right granted to the lessee of an essentially different character than that of the letting, although perhaps frequently it is a component of the transaction in its entirety. Id. at 334 (omitting citations).

The court held that there was no limitation upon the tenant's right to assign its rights under the option to purchase to the subtenant and that the landlord, therefore, was required to sell the property to the subtenant. Id.

Drafting a Tenant's Option To Purchase

The possibility of unintended outcomes raised by the different treatments of the issue of the assignability of an option to purchase in Megargel and in Holmes should be reason enough for attorneys to recommit themselves to precise, comprehensive drafting of options to purchase. No matter the jurisdiction (and no matter how much of a minority position may be evidenced by the court's ruling in Holmes), clients are best served by such drafting.

As with any drafting, a finally negotiated lease primarily will be the result of the parties' respective goals and their competing abilities to persuade each other as to what terms will be included. Nonetheless, the following considerations should be entertained when drafting an option to purchase:

1) An option to purchase commonly is automatically terminated upon the satisfaction of certain conditions. For instance, the lease may state that the tenant's rights under the option no longer exist after the tenant, on one occasion, has refused to exercise the option to purchase. If the proposed purchase by the third party fails to close, the property will remain owned by the landlord, but the tenant will have no continuing rights under the option to purchase. This result may be the goal of the parties, but it also may be merely the result of sloppy drafting. For this reason and others, the parties should state clearly in the lease the 'term' of the option and any conditions affecting the tenant's rights thereunder. Such clearly stated provisions will allow a potential assignee of a tenant's rights under an option to purchase to make a more certain determination regarding whether any rights remain in that option.

2) The option to purchase may affect multiple parcels of land. If the parties desire to treat different parcels differently with respect to the assignability of the corresponding option to purchase, the lease should so state.

3) If the option may be assigned to a subtenant or other assignee, must that party act through the tenant or will the landlord recognize notices directly from that other party? Leases should clearly state the manner in which the landlord will communicate with and accept communication from the party attempting to exercise (or delivering notices with respect to) an option to purchase.

4) An option to purchase requires mechanical provisions about notice and timing. Precision on these provisions should not be sacrificed for the sake of devoting resources to a discussion of the option's assignability.

5) Consider whether, if the landlord is willing to allow assignment of the tenant's rights under an option to purchase, the landlord desires to treat the tenant differently from an assignee. For instance, the landlord may be willing to allow a tenant to purchase at 95% of the purchase price proposed by a third party for the property but may require an assignee of the tenant's rights under an option to purchase to tender 105% of that purchase price to exercise the option effectively. The landlord also may desire to grant an assignee a longer or shorter period of time within which to respond to notice of a proposed purchase by a third party.

6) To further demonstrate the independence of the option to purchase, place it within a separate document and recite consideration separate from the companion lease.

Conclusion

Clients likely will have difficulty understanding why a limitation or prohibition on assignment contained within a lease does not always govern an option to purchase contained within that lease. As described above, counsel who consider a variety of matters when preparing or reviewing such a lease and who utilize or insist upon precise drafting will best serve these clients.

Aaron L. Pawlitz is an associate in the St. Louis office of Lewis, Rice & Fingersh, L.C. He counsels clients on a variety of real estate transactions, including purchases, sales, leases, construction, development, development incentives, and municipal finance and also practices in the areas of mergers and acquisitions, corporate law, and securities law.

Last year, a Missouri appellate court affirmed a lower court's holding that where a lease prohibited a tenant from assigning its interest in the lease without the landlord's consent, the tenant also could not assign an option to purchase the real property the tenant was leasing from the landlord, without the landlord's consent. That court held that a tenant's rights under an option to purchase were a covenant that ran with the land, and that the tenant could not assign those rights without the landlord's consent because the lease limited assignment of the lease generally. Megargel Willbrand & Co., LLC v. Fampat Limited Partnership, No. ED 86570, 2006WL956963 (Mo. Ct. App. Apr. 11, 2006)

The court in the Megargel case treated the lease's limitation on assignment as applying to the option to purchase as well as to the remaining provisions of the lease. In other cases, however, courts have held that an option to purchase is a covenant independent from the lease in which that covenant is contained. See, e.g. , Holmes v. Harris , 110 A.2d 329, 334 (N.J. Super. Ct. App. Div. 1954) (citing other cases). In the case of such treatment, even where a lease contained a limitation on assignment that applied to the lease generally, the tenant's rights under an option to purchase contained within that lease could be freely assigned.

This article discusses the consequences of different interpretations of the assignability of a tenant's option to purchase. These consequences should be considered by tenants, landlords, the successors-in-interest (or potential successors-in-interest) of either of them, and the counsel who advise each of them. The article offers practical tips for how to prepare a lease provision regarding the assignability of rights under an option to purchase in a manner that will clarify the parties' rights and minimize the possibility of a failed exercise of an option to purchase.

Although this discussion is focused upon options to purchase, its suggestions should be useful in the context of other options that might be granted to tenants, including, among others, those options commonly referred to as options to expand or as rights of first offer. (The article refers to rights of first refusal and similar concepts universally as 'options to purchase.')

Evaluating the Assignability of a Tenant's Option to Purchase

Courts have considered a number of different factors when evaluating litigants' respective rights with respect to the assignability of a tenant's option to purchase. Among these are:

• The lease's language regarding assignability generally;
• Whether the landlord has consented to the purported assignment;
• Whether the subject transfer was a sublease or an assignment; and
• Whether the right of first refusal is severable from the remainder of the lease.

See, e.g., Megargel, 2006WL956963 at *1; Lehrer v. Waste Management of Wisconsin, Inc. , 476 N.W.2d 27, 27 (Wis. Ct. App. 1991); Holmes, 110 A.2d at 331-32; Lehrer v. Wegenhoft , 203 S.W.2d 245, 249 (Tex. Civ. App. 1947).

Arguably, a tenant that wants to assign its rights and obligations under its option to purchase (with or without assigning any of that tenant's rights and/or obligations under the remainder of the lease) can minimize the possibility of failure of that assignment due to any of the factors described above by precisely drafting the lease's provisions and notices among the parties. (This conclusion should not surprise, but is worth stating due to the frequent lack of drafting precision in many real estate-related agreements and other documents.) A tenant may minimize the possibility of failure of an attempted assignment of a tenant's option to purchase due to the fourth factor described above by paying particular attention to the law governing the lease, which may or may not treat the option to purchase as severable from the remainder of the lease.

Severability of a Tenant's Option to Purchase

The facts in Megargel involved the attempted assignment of a tenant's rights under a tenant's option to purchase. That option to purchase contained typical provisions requiring the landlord to notify the tenant of any proposed purchase of the property by a third party and to describe to the tenant the terms of such proposed purchase. Thereafter, the tenant had a fixed period of time within which to respond to exercise its right under the option to purchase the property from the landlord (rather than the third party purchasing such property).

The lease allowed the tenant to sublease the property or any portion thereof freely but prohibited the tenant from assigning the lease without the landlord's consent. Megargel, 2006WL956963 at *1. After the commencement of the lease, the tenant subleased a portion of the property to the plaintiff subtenant and, in a document titled 'Additional Provisions to Sublease,' the tenant attempted to assign to the subtenant all of its rights under the option to purchase. When the landlord notified the tenant of a proposed purchase of the property by a third party, the subtenant attempted to exercise the option to purchase, but the landlord refused to accept that exercise, and the subtenant commenced litigation among the parties.

The court noted that the case raised an issue of first impression in Missouri, but relied upon authorities from other jurisdictions for its holding. The court observed that 'it is generally accepted that just as the assignment of a lease includes the assignment of the [option to purchase], a prohibition against assignment of a lease also prohibits assignment of the [option to purchase].' Id. at *3. The court adopted that position as its own and affirmed the lower court's holding granting summary judgment in favor of the landlord.

In Holmes, the case had facts nearly identical to Megargel but a different outcome based upon different reasoning. The option to purchase at issue was similar to the option described in Megargel. As was the case in Megargel, the lease allowed the tenant to sublease the property or any portion thereof freely, but prohibited the tenant from assigning the lease without the landlord's consent. The tenant subleased the property and attempted to assign to the subtenant the tenant's rights under the tenant's option to purchase. See Holmes, 110 A.2d at 331.

Later during the term of the lease, the landlord notified the tenant of a proposed purchase of the property by a third party. The next day, seemingly ignoring any party's rights under the option to purchase, the landlord entered into an agreement with a third party whereby the landlord agreed to sell the property to that third party 'subject to the rights of [tenant] or any sub-tenant or assignee thereof.' Id. at 332. A few days later, but still within the required time frame for exercising the option to purchase, the subtenant notified the landlord of the subtenant's desire to exercise the option.

With two purchasers for only one piece of property, the subtenant commenced litigation seeking an order requiring the landlord to sell the property to the subtenant or requiring the landlord to pay damages to the subtenant. In its consideration of whether the subtenant had succeeded to the tenant's interest under the option to purchase, the court separately considered the lease's 'general' discussion of the tenant's rights to assign or sublease and the lease's provision describing the option to purchase (which, the court noted, contained no restriction on assignment).

Such a separate evaluation was necessary due to the state of the law in New Jersey:

[I]t is recognized … in this jurisdiction that an option to purchase the demised premises such as this constitutes a covenant independent and separable from the lease as such, and in the absence of a negative provision the option is as assignable as any other contractual right … An option is a right which, by its inherent nature, is incapable of being leased. It is a right granted to the lessee of an essentially different character than that of the letting, although perhaps frequently it is a component of the transaction in its entirety. Id. at 334 (omitting citations).

The court held that there was no limitation upon the tenant's right to assign its rights under the option to purchase to the subtenant and that the landlord, therefore, was required to sell the property to the subtenant. Id.

Drafting a Tenant's Option To Purchase

The possibility of unintended outcomes raised by the different treatments of the issue of the assignability of an option to purchase in Megargel and in Holmes should be reason enough for attorneys to recommit themselves to precise, comprehensive drafting of options to purchase. No matter the jurisdiction (and no matter how much of a minority position may be evidenced by the court's ruling in Holmes), clients are best served by such drafting.

As with any drafting, a finally negotiated lease primarily will be the result of the parties' respective goals and their competing abilities to persuade each other as to what terms will be included. Nonetheless, the following considerations should be entertained when drafting an option to purchase:

1) An option to purchase commonly is automatically terminated upon the satisfaction of certain conditions. For instance, the lease may state that the tenant's rights under the option no longer exist after the tenant, on one occasion, has refused to exercise the option to purchase. If the proposed purchase by the third party fails to close, the property will remain owned by the landlord, but the tenant will have no continuing rights under the option to purchase. This result may be the goal of the parties, but it also may be merely the result of sloppy drafting. For this reason and others, the parties should state clearly in the lease the 'term' of the option and any conditions affecting the tenant's rights thereunder. Such clearly stated provisions will allow a potential assignee of a tenant's rights under an option to purchase to make a more certain determination regarding whether any rights remain in that option.

2) The option to purchase may affect multiple parcels of land. If the parties desire to treat different parcels differently with respect to the assignability of the corresponding option to purchase, the lease should so state.

3) If the option may be assigned to a subtenant or other assignee, must that party act through the tenant or will the landlord recognize notices directly from that other party? Leases should clearly state the manner in which the landlord will communicate with and accept communication from the party attempting to exercise (or delivering notices with respect to) an option to purchase.

4) An option to purchase requires mechanical provisions about notice and timing. Precision on these provisions should not be sacrificed for the sake of devoting resources to a discussion of the option's assignability.

5) Consider whether, if the landlord is willing to allow assignment of the tenant's rights under an option to purchase, the landlord desires to treat the tenant differently from an assignee. For instance, the landlord may be willing to allow a tenant to purchase at 95% of the purchase price proposed by a third party for the property but may require an assignee of the tenant's rights under an option to purchase to tender 105% of that purchase price to exercise the option effectively. The landlord also may desire to grant an assignee a longer or shorter period of time within which to respond to notice of a proposed purchase by a third party.

6) To further demonstrate the independence of the option to purchase, place it within a separate document and recite consideration separate from the companion lease.

Conclusion

Clients likely will have difficulty understanding why a limitation or prohibition on assignment contained within a lease does not always govern an option to purchase contained within that lease. As described above, counsel who consider a variety of matters when preparing or reviewing such a lease and who utilize or insist upon precise drafting will best serve these clients.

Aaron L. Pawlitz is an associate in the St. Louis office of Lewis, Rice & Fingersh, L.C. He counsels clients on a variety of real estate transactions, including purchases, sales, leases, construction, development, development incentives, and municipal finance and also practices in the areas of mergers and acquisitions, corporate law, and securities law.