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Recent Court Case Sheds Additional Light on Right of First Refusal

Published by Nicolo Pinoli on Wednesday, November 2, 2016

Journal cover November 2016   Download PDF

When Congress first codified the exception to permit a right of first refusal (ROFR) to exist for nonprofits involved in a low-income housing tax credit development to purchase the property after the completion of the compliance period without the ROFR affecting the tax benefits otherwise allowable to the investor, it could hardly have imagined how this provision would lead to so many unanswered questions, technical quibbling and contractual artistry. While the statutory provisions continue to provide ample fodder for boundless debate and relentless deliberation, a recent court case decided in Massachusetts gave the industry new insight regarding the interpretation of specific contractual language. Regrettably, as this was not a tax court case, the issues did not include insights into the application of tax law to the ROFR. However, we do learn how courts will go about evaluating the precise contractual rights granted to a nonprofit under a ROFR agreement.

While several issues were raised in the case by each side, the case in question, Homeowner’s Rehab Inc. and Memorial Drive Housing Inc., as plaintiffs., vs. Related Corporate V SLP LP and Centerline Corporate Partners V LP, as defendants, at its very essence considers whether a limited partner can effectively use contractual provisions in other legal documents to thwart the acquisition of an affordable housing property by a nonprofit under a ROFR agreement. Luckily, there was little to no dispute about the precise facts in the case, so the case was decided by summary judgment based on the court’s interpretation of the documents and the intent of the parties.

Not surprisingly, contractual provisions in this case were similar to those used by many other affordable housing properties. More specifically, under the contracts signed by the parties, the plaintiffs were granted two contractual mechanisms to facilitate the potential acquisition of the property. 

First, the plaintiff received a right to acquire the property under a ROFR agreement. That agreement provided that the plaintiff could acquire the property for the lesser of three prices: debt plus taxes; the price that a prospective acquirer was offering for the property; or the fair market value. The ROFR also included an expiration date of four years after the completion of the compliance period. 

Second, the plaintiff also had an option to acquire the property at fair market value. In addition to these agreements, the partnership agreement granted certain approval rights to the plaintiff. Namely, the plaintiff was granted approval rights over a sale of the property, except that the plaintiff had no right to approve a sale under the option agreement.

With real property prices at or near all-time highs, many affordable housing sponsors and investors may find themselves at a similar economic crossroads. Since the plaintiff harbored a desire to acquire the property and the property was far more valuable than the debt plus taxes associated with the property, the plaintiff’s best economic opportunity to acquire the property at the lowest possible price lay in the ROFR agreement. Conversely, for the defendant, a sale of the property to the plaintiff under the ROFR agreement would result in dramatically less residual return for its investment. Consequently, the defendant was motivated to dispute the plaintiff’s asserted acquisition right under the ROFR agreement.

With so much at stake, the relationship between the parties after the completion of the 15-year compliance period proceeded in rather dramatic fashion. At this juncture, the plaintiff invited the defendant to sell its ownership interest for a sum equal to debt plus taxes. The defendant responded by insisting that as the existing contractual arrangements only permitted the plaintiff to acquire the real estate, a sale of the defendant’s ownership interest was not contractually stipulated, and therefore such a sale would be subject to negotiation by the parties, including negotiation of the price.

With the end of the contractual window afforded by the ROFR looming, the plaintiff, unsatisfied with the defendant’s interpretation of the documents and after consultation with legal counsel, notified the defendant of its intent to pursue acquisition of the property under the ROFR. In response, the defendant stridently asserted that the ROFR could only be triggered if an offer to purchase the property were made, and further avowed that the partnership could not even entertain an offer to sell the property without the defendant’s approval.

Part of the natural challenge in any ROFR context is the implicit, yet widely understood, conundrum: no prospective purchaser would expend the effort required to properly conduct the due diligence necessary to make a bona fide offer on a property that was subject to a ROFR, as the ROFR holder would invariably exercise its rights under the ROFR and acquire the property, thereby frustrating the prospective purchaser’s efforts and rendering them functionally fruitless. Based on this fundamental challenge, by its very nature, the ROFR represents a catch-22 that resembles an endless Mobius strip with neither beginning nor end.

Faced with such a Gordian knot, and in the face of intractable opposition from the defendant, the plaintiff proceeded to struggle through the murky maw of the contractual morass by contacting a local nonprofit affordable housing developer to solicit an offer to purchase the property, which would ostensibly trigger the ROFR. Following some standard due diligence performed by this nonprofit developer, it submitted an offer to purchase the property. Third-party offer in hand, the plaintiff notified the defendant of its intent to acquire the property under the ROFR agreement. The defendant countered that the plaintiff misinterpreted the terms of the relevant agreements and claimed that the ROFR could not be triggered, absent the defendant’s consent to entertain a possible sale of the property. Seeing no way to resolve their fundamental differences, the parties filed suit and prayed for relief from the court.

The court proceeded to weigh the evidence at its disposal in an attempt to identify the correct interpretation of the various contractual agreements by divining the intent of the parties at the time the various agreements were signed.

In its decision, the court identified several key facts and contractual provisions that swayed the court. First, the court observed that the contractual language appeared to be at conflict with itself, as provisions in the partnership agreement would seem to frustrate contractual rights granted in ROFR. Specifically, the court observed that the ROFR agreement would seem to be futile if it could be unilaterally blocked by the defendant through the simple process of refusing to grant its approval for a sale. As a result, and rather critically, the court heavily weighed the language in the partnership agreement that carved out an exception to the usual limited partner approval rights over a potential sale. Since the partnership agreement granted an exception for a sale under the option agreement, the court inferred that a similar exception must exist for a sale under the ROFR agreement, as the thrust of the two agreements was so qualitatively similar.

The court also analyzed the programmatic elements associated with the ROFR, including congressional intent and public policy. Although the court analyzed these elements as a means of better understanding the intent and thinking of the parties as well as typical practices in the industry, the court expressly declared that it had no intention of attempting to advance any particular public policy.

There were additional contractual breadcrumbs sprinkled throughout the various documents executed at closing that the court cited as indicative of the intent of the parties that the plaintiff would have a real right to acquire the property for debt plus taxes. Among them, language included in the option agreement and a schedule attached to the partnership agreement both suggested that the parties intended for the property to be acquired by the plaintiff at debt plus taxes. Moreover, the financial forecast prepared by an accountant at closing was cited as further proof as schedules within the forecast calculated that the defendant would receive a very handsome economic return on its investment based solely on the tax attributes, including credits. Finally, the partnership agreement made clear that a key component of the arrangement was to maximize the tax benefits to the defendant, further supporting the plaintiff’s claim that the parties intended for the ROFR to be exercisable without the approval of the defendant.

For the industry, this case provides some important lessons. It should come as no great surprise that the precise language in contractual agreements matters. Hand in hand with that sage advice, we are reminded that an ounce of prevention is better than a pound of cure. Perhaps most pernicious is the reminder that our industry is not free of conflict, and that the same competing forces that can propel public-private partnerships to achieve tremendous public policy goals can also lead to toxic levels of discord and strife when disagreements arise. Although a multitude of debates continue to odiously malinger surrounding the precise requirements that a ROFR must meet to satisfy the legislative intent of this statutory provision, it warms the cockles of our collective hearts that the court permitted the acquisition of the property to move forward under this particular ROFR agreement.

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