Definition of Option
In its simplest form, an option contract is a unilateral offer or contract by one party (the optionor) to lease or buy property from or sell property to another party (the optionee). County of San Diego v Miller (1975) 13 C3d 684, 688.
An option contract can be based on legal consideration, in which case the option contract may become an irrevocable contract (irrevocable in the sense that the optionor cannot terminate the option contract at will anytime prior to the exercise of the option by the optionee; the parties may still agree to include termination events or circumstances in an option contract). For example, in a simple option contract the optionee will pay the optionor for the right to purchase the identified property for a certain price as long as the purchase election is made within a certain time period. When an option based on legal consideration is exercised, a bilateral agreement is created for the purchase and sale of the property on the specified terms and conditions contained in the contract. Jenkins v Tuneup Masters (1987) 190 CA3d 1, 7; Hudson Props. Co. v Governing Bd. (1985) 168 CA3d 63, 72. An option contract itself does not transfer an interest in property. Rather, it is a grant of a contractual right to purchase (or sell) the property. Claremont Terrace Homeowners’ Ass’n v U.S. (1983) 146 CA3d 398, 406. See also, Cyr v McGovran (2012) 206 CA4th 645.
Option contracts are subject to the same customary rules of construction as other contracts. See, e.g., Goodwest Rubber Corp. v Munoz (1985) 170 CA3d 919; Erich v Granoff (1980) 109 CA3d 920. To be enforceable, an option contract must involve adequate consideration and must contain the material terms of the agreement. Option contracts relating to the purchase and sale of real property fall within the statute of frauds and therefore must be in writing.
ADVANTAGES AND DISADVANTAGES FOR OPTIONOR AND OPTIONEE
Generally, options are considered to be most favorable to the person who has the option right (sometime called the optionee), whose only risk is the loss of the option price and any other investment in the transaction.
The optionor (the person who granted the option to the optionee) incurs a greater risk, for which the option price is intended to compensate.
The optionor should not consider the option price as “found” money but should seriously evaluate the detriment of the option as an element in establishing its price. An option does, however, have certain benefits to an optionor.
Substitute for Liquidated Damages
Many sellers prefer to structure their dispositions of real estate as options because they believe that the consideration for the granting of the option would provide a more certain claim to the money than an action for breach of contract or to enforce a liquidated damages provision. Payment of the option price may avoid the issue for the seller of whether retention of the deposit is enforceable as liquidated damages. Many sellers using the option consideration approach, however, include a “protective liquidated damages provision,” stating that if the option consideration is held to be liquidated damages, then those liquidated damages are enforceable as such. This provision must comply with CC §§1671–1681. Counsel should note, however, that an unreasonably high option price may cause the transaction to be recharacterized as a purchase agreement with a deposit so large as to cause an unreasonable forfeiture if the transaction is not consummated. See, e.g., Scarbery v Bill Patch Land & Water Co. (1960) 184 CA2d 87.
For tax purposes, an option payment that is too high in relation to the ultimate purchase price may cause the transaction to be recharacterized as an installment sale, with periodic option payments treated as interest on an installment note. See Johnie Vaden Elrod (1986) 87 TC 1046; Rev Rul 82–150, 1982–2 Cum Bull 110.
B. Tax Deferral
The option payment is generally not taxable to the optionor until the option is exercised. The opportunity for a tax deferral is often desirable to sellers.
C. Inducement to Investigate
Sellers of real property try to minimize their obligations of disclosure and their warranties about the property. One way to do this might be to give a prospective purchaser an option with the ability to fully investigate the property before exercising the option. This could allow the seller to effectively bargain for minimal disclosure and warranties, and can be a powerful inducement to the buyer to perform its due diligence.
D. Risk of Better Price
The principal risk to the optionor under an option contract is the potential increase in property value during the option period. Another potential buyer may even approach the optionor and offer a better price for the property during the option term. The optionee, however, has bought the optionor’s commitment to sell at a fixed price and the price the optionee paid for the option is intended to compensate the optionor for this risk.
E. Uncertainty of Sale
The most obvious disadvantage to the optionor is that the optionee may choose not to exercise the option. In the meantime, the optionor’s property has been tied up, drilling or other investigation activities may have been performed, land use applications may have been filed, or other opportunities for the property may have been missed. The optionor and the attorney should consider and address these issues in the option contract as specifically as possible in light of the particular circumstances of the property and the parties to the transaction.
Right of First Refusal; Right of First Offer
Rights of first refusal and rights of first offer could, in some respects, be considered alternative forms of option agreements. They must satisfy the same essential requirements as options, such as definiteness and consideration . However, some issues are particular to these types of agreements.
A right of first refusal affords the optionee the right to match or better an offer to purchase received by the optionor. A right of first offer requires the optionor to offer to sell the property to the optionee before offering it to anyone else. A right of first offer allows the optionor to proceed to sell the property on the same or better terms if the optionee does not accept the optionor’s offer.
In general, a right of first refusal is triggered by a proposed voluntary sale by the offeror. See Pellandini v Valadao (2003) 113 CA4th 1315. An involuntary condemnation of the property does not trigger the right of first refusal. See Campbell v Alger (1999) 71 CA4th 200.
In contrast to traditional option agreements, under a right of first refusal the optionee may not be in control of the terms and conditions set forth in the offer to purchase. In general, an optionee is not required to match exactly the offer to purchase received by optionor if the offer is of a nature that cannot be easily matched by anyone other than the offeror. Courts will consider commercial realities in evaluating whether the optionee has matched or bettered the offer to purchase. Arden Group, Inc. v Burk (1996) 45 CA4th 1409. See also San Diego Watercrafts, Inc. v Wells Fargo Bank, N.A. (2002) 102 CA4th 308; McCulloch v M & C Beauty Colleges, Inc. (1987) 194 CA3d 1338; C. Robert Nattress & Assocs. v CIDCO (1986) 184 CA3d 55, 72. But in Hartzheim v Valley Land & Cattle Co. (2007) 153 CA4th 383, 394 n6, the court seemed to imply in a footnote that because the optionee was unable to match the unique terms of the offer, the optionee could not have exercised its right of first refusal.
The mechanics of a right of first refusal or right of first offer must be addressed when drafting the agreement. The agreement should specify whether the option applies only to the first instance in which it can be exercised or whether it renews if the optionor does not successfully close the offer. For the offeree, it is useful to establish objective guidelines for the terms and conditions that the offer must follow so that there will be less room for disagreement as to whether offeree has matched such offer.
A right of first refusal is considered more likely to have an adverse, rather than favorable, effect on the price at which the offeror can sell the property. A prospective purchaser will be less inclined to spend the time and money to evaluate the property and negotiate a purchase agreement if the purchaser is aware that the offeree could step in under its right of first refusal and acquire the property by matching the purchaser’s offer.
From an offeree’s point of view, the right of first offer represents a way to validate the proposed purchase terms because an independent third party is willing to purchase the property on those terms. A right of first offer allows the offeror to market the property more easily after offering the property to the offeree. However, the offeror may not be sufficiently knowledgeable about the market value of the property to present an offer to the offeree. This deficiency can be addressed if the offeror consults brokers or appraisers or potential buyers before presenting the offer to offeree. From the offeree’s point of view, the offeree may not have a sufficient basis to determine whether the offered price and terms reflect the current market.
The parties should consider including specific requirements for the terms and conditions of the right of first offer, such as requiring the purchase price to be all cash. If the offer is not limited to a cash purchase price it may be difficult for the offeree to match the offer.
In either a right of first refusal or a right of first offer, the offeror may want to limit the representations and warranties to be made to the offeree, as opposed to the third party purchaser, because the offeree is likely to be more knowledgeable about the property than a third party purchaser. Because the right of first offer is often part of another transaction, such as a lease, it may be appropriate to limit the assignment of this right, and the offeror should consider limiting the offeree’s ability to transfer the right of first offer.
When a right of first offer or right of first refusal is part of another contractual relationship between the parties or between one of the parties and a third party, consideration should be given to establishing the date or circumstances on which the right of first offer or right of first refusal terminates. In the case of a lease, the tenant may negotiate for a right of first offer or right of first refusal to purchase the landlord’s fee estate should the landlord wish to sell the leased premises. Absent express language or other showing of mutual intent to the contrary, the right of first offer or right of first refusal may expire when the lease expires. See Smyth v Berman (2019) 31 CA5th 183, in which a right of first refusal held by a tenant to purchase the landlord’s interest in the leased property was held to terminate at the end of the lease term. The tenant in this case continued to occupy the leased premises on a month-to-month basis, which he acknowledged was a holdover tenancy. The court held that only essential lease terms carry forward from the initial lease to a holdover tenancy, such as the amount of rent payable. Absent proof of an intent by the landlord and tenant to make the right of first refusal an essential term, it expired when the initial lease ended.