Court Refuses to Enforce a Right of First Refusal

January 2019

In a decision passed down earlier this month, a California court of appeal ruled that a right of first refusal contained in a written lease is a nonessential term that expires when the lease term ends and the tenant becomes a holdover tenant, unless the parties specifically indicate that the right of first refusal shall carry forward into the holdover tenancy. In so doing, California joins the majority of states on this issue, declining to adopt the minority rule that would carry rights of first refusal over into holdover tenancies.

The case, Smyth v. Berman (Jan. 10, 2019, B286609) ___ Cal.App.4th ___ [2019 WL 156761], was filed by a tenant (Smyth) who had leased a building under several written leases from the landlord (Berman). The lease in dispute was signed on December 2, 2011, and was set to expire on December 15, 2012.  The lease contained a three-year option to extend the term to December 15, 2015, and included the following language: “If the Tenant remains in possession after this lease ends, the continuing tenancy will be from month to month.”  The lease also included a hand written insertion from Smyth that both parties initialed which stated, “Right of 1st refusal to purchase.”

Smyth exercised his option to extend the lease to December 15, 2015. Thereafter, Smyth continued to occupy the building as a month-to-month holdover tenant. In June 2016, Berman received a written offer from another party (Santa Maria) to purchase the building. The offer was for $500,000.00 and included a seller take-back loan for $440,000.00 based on a ten year term at 4% interest. Provided the loan was repaid over the full term, Santa Maria would end up paying a total of $676,000.00. In August 2016, Smyth submitted an offer to buy the building for a total of $505,000.00, consisting of $101,000.00 in cash and the balance from a $404,000.00 loan from a third-party lender.  Berman ultimately rejected Smyth’s offer because Santa Maria’s offer was “higher” and for “considerably more money.”  It is debatable if that statement is accurate based on the two offers, but the court does not address this issue in its decision.  On August 16, 2016, Smyth filed suit against Berman for specific performance of the right of first refusal.  Despite Smyth’s lawsuit, three days later, Berman closed the sale with Santa Maria.

The trial court found that Smyth was not entitled to exercise the right of first refusal because such right did not carry forward as a term of the “holdover” tenancy under Spaulding v. Yovino-Young (1947) 30 Cal.2d 138 (which held that an option to purchase does not carry forward during a holdover tenancy).  Smyth filed several amended complaints adding additional theories to support his claims but each time he lost.  Ultimately, Smyth appealed.   On appeal, the court characterized the issue as follows: “If the expired lease contained a right of first refusal, is that right one of the ‘terms’ that presumptively carries forward into the holdover tenancy?”  The court concluded that the answer is “no” and cited two reasons.

First, the court heavily relied on Spaulding and noted that only the “essential” terms of a lease are presumed to carry over into a holdover tenancy, such as the “amount and time of payment of rent.”  Drawing support from Spaulding, the court ruled that, like an option to purchase, a right of first refusal is nonessential.  The court noted that the parties here could have ensured the right of first refusal carried over during the holdover tenancy had the parties written it into the holdover provision, but because the parties failed to do so, it did not carry over.

Second, the court stated that public policy supports a rule presuming that rights of first refusal do not carry over. Observing that holdover tenancies exist to provide tenants with stability because it allows them to remain in possession without disruption (even if only on a month-to-month basis), the court said a rule presuming rights of first refusal carry over would result in perverse incentives that would undermine the stability that holdover tenancies provide. The court presented the idea that a landlord who wanted to nullify a holdover tenant’s right of first refusal would seek to evict the holdover tenant, and then sell the property the next day, both of which landlord would be permitted to do. Under a rule presuming that a right of first refusal carries over into holdover tenancy, landlords would be incentivized to evict holdover tenants as soon as possible, thus destroying the very stability of a holdover tenancy.

The court’s decision in this case presents both landlords and tenants with a very clear message. Those who wish for rights of first refusal to carry into a holdover tenancy are well-advised to make that intent known with clearly drafted language in the lease. Those who do not wish for rights of first refusal to carry over need only to make sure they do not have language that might be construed as permitting the right of first refusal to carry over.

Practically, the effect of this holding is that tenants under many leases will lose their non-essential rights during a holdover tenancy because many leases do not state that all terms carry forward during a holdover tenancy (e.g., the AIR Lease Form does not include carry-forward language). That begs the question: Other than rent and timing of payment, what else is an “essential” term of a lease?  The result of this case may be fair—after all, a tenant could avoid this outcome by negotiating an extension of its lease that includes all of the lease terms—but to suggest that a tenant could easily avoid this eventuality by simply drafting language that all essential and non-essential terms carry forward during a holdover tenancy is not realistic.  Why would or should any landlord agree to this request during lease negotiations?

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UPDATE: California Civil Code Section 1542, which governs general releases, has been revised effective January 1, 2019. The statute now reads:

“A general release does not extend to claims that the creditor or releasing party does not know or suspect to exist in his or her favor at the time of executing the release and that, if known by him or her, would have materially affected his or her settlement with the debtor or released party.”

The following is a redline showing the changes that were made to the existing language:

“A general release does not extend to claims which that the creditor or releasing party does not know or suspect to exist in his or her favor at the time of executing the release and thatwhich if known by him must or her, would have materially affected his or her settlement with the debtor or released party.”

All forms and any other writings quoting this statute should be updated accordingly.