Daily Development for Wednesday, February 28, 2001

LANDLORD/TENANT; PURCHASE OPTIONS; "FAIR MARKET VALUE;" IMPACT OF EXISTING LEASE: Where lease gives tenant the option to purchase the property for its "prevailing fair market value," as determined by appraisal, appraisers are to take into account the positive or negative impact of the existing lease held by the optionee tenant in determining such value unless the language of the lease expressly precludes such consideration.

Petula Assocs. v. Dolco Packaging Corp.; No. 9911375; 2001 U.S. App. Lexis 2072 (5th Cir. 2/12/01)

Dolco had a fifteen year lease, commencing in 1985 on a commercial building with a renewal option. The lease contained an option to purchase the property for a fixed $4.3 million during the first five years, and for the "fair market value" of the property during the next five years. In 1990, one month prior to the expiration of the first five years of the lease, in connection with a corporate reorganization of the tenant, the parties amended the lease to provide that the tenant's rent would be lower during the next five years, and this reduction would be balanced by a higher rental in the last five years.

In addition, at the same time, the parties extended the fixed price purchase option until August of 1996, and agreed that the "fair market value" purchase option would be available at the end of that five year option term, but only for a period of five days after expiration of the fixed price option. In 1996, the tenant gave timely notice of its election to purchase under the fair market value option. The parties could not agree on the value, however, and the process for appointing appraisers according to the lease commenced. The parties, however, disputed whether the appraisers were to take into account the lease in connection with their estimate of fair market value. (Remember that in the next five years the rents had been pushed high to balance the lower rents for the preceding five years.) Without the lease, in the end, the fair market value of the property was around $2.75 million. Taking the lease into account, the fair market value was around $5.2 million.

Here is how the lease defined "fair market value:"

"In determining the "prevailing fair market rate" or "fair market value" for the purposes of a provision in the lease, such rate or value shall be the rate or value, as the case may be, which Landlord and Tenant shall mutually agree upon, considering like premises in the Dallas, Texas area, of the same quality and age of the building and also considering the length of the renewal term then under consideration (as to fair market rate), and the quality, utility and location of the space involved."

Dolco filed an action for declaratory relief to settle the question of the meaning of this clause, and landlord removed to federal court. The trial court found that the definition about did not require the appraisers to take into account the existing lease, as the lease was not mentioned as a factor in the list of factors that the appraiser was to take into account. (Note that the language relating to "renewal term" relates only to determinations of "fair rental value" for the lease renewal provision not at issue here.)

On appeal: Held: Reversed. The court of appeals ruled that the lease should be taken into acount, resulting in almost a doubling of the appraised value.

The court first ruled, with no analysis whatever, that the term "fair market value" in this lease was not an ambiguous term, and presumably, therefore, that extrinsic evidence of the parties' intent could not be offered.

To explain its interpretation that the lease should be taken into account, the court commented that no one in the market could buy the property free of the lease, and consequently the lease is a necessary characteristic of the property that would be offered in the hypothetical market transaction. It cited an Arizona Court of Appeals case, TCC Enters. v. Estate of Erny, 149 Ariz. 257, 717 P.2d 936 (Ariz. Ct. App. 1986), decided the same way on very similar facts, but with similarly scant analysis.

The court rejected the trial court's analysis that the term "fair market value" ought to be determined only in accordance with the factors listed in the clause defining the term in the lease. It noted that the list was not stated to be exclusive, and that there was no reason to read it that way. Further, it noted, the appraiser was to determine the value of "like premises," and "like premises" would have a similar lease or else it wouldn't be "like." Comment 1: The case is wrong, and so is the authority. Virtually all of the court's reasoning, particularly that last little piece, assumes its conclusion. Of course, if the lease is to be taken into account, other leased premises are "like." If the lease is not taken into account, then they're not. It is true that the list of terms is not exclusive, but neither is it stated to be nonexclusive. Why would the parties set forth a list of factors if the appraiser would be free to look at other factors?

If the parties were saying that the tenant's option is to "buy itself out" of the lease, then it is almost certain that a different and more elaborate formula would be developed, particularly at the time when the parties restructured the rent formula.

The editor has checked with other business lawyers on this one, and all concur that the parties almost certainly intended that the option gave the tenant the opportunity to terminate the lease by paying the fair market value of the building only. The approach taken by the court basically requires the tenant to pay the fair market value for its lease, as well as for the building. Note that the lease, in the hands of the landlord, is classically an item of personal property. Basically, the court is saying that the "premises" includes a lease. This is wrong.

Comment 2: The tenant was unable to introduce extrinsic evidence here, but it ought to try, if it still can, the remedy of reformation. Necessarily this remedy contemplates that the lease is not the final expression of the parties' intent, ambiguous or not. After this case, it is abundantly clear that there was an error in drafting, and if there is adequate documentation of the bargaining history, then the tenant still may find a way out of this.

This comment, by the way, elucidates a point the Editor has made several times recently: professionals engaged in high powered business negotiations ought to maintain clear records of the negotiation history. There is a tendency these days, in part due to constant discovery demands and in part due to the sloppiness that comes with email exchanges, to discard information that might be valuable in reconstructing what the parties had in mind. The Editor has seen parties rescued more than once by such carefully maintained records. He knows that some lawyers feel exactly the opposite, and dump every shred of paper at the end of every deal. Let's hope that they got everything right the first time, even to the satisfaction of the Fifth Circuit.

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