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Why are ROFOs on the rise and why are they so tricky?

'Flex' is increasingly important to office occupiers. Many occupiers are still committing to long term lease arrangements but want the added contractual comfort that should additional space become available they will get 'first dibs' on it. A right of first offer (a ROFO) is a solution to meet that demand but whilst it sounds simple documenting it can be difficult with many decisions to be made by both owners and occupiers.

1. ROFOs and ROFRs

It is perhaps useful to start by distinguishing ROFOs from ROFRs. A ROFR is a right of first refusal and usually means an owner must have received a bona fide bid/offer from a tenant for the space which must then be put to the beneficiary of the ROFR. A ROFO, by comparison, doesn't require a third party to have put forward a bid but rather means the owner puts its desired terms to the beneficiary before it goes to the wider market. For obvious reasons, ROFRs are not a popular option for owners as they can result in a lot of work with a prospective tenant being 'wasted' should the beneficiary accept the offer and that can result in reputational damage for the owner. For that reason we'll be focusing on ROFOs for the purposes of this blog as they are, as a result, far more prevalent in the market than ROFRs.

2. Key features of a ROFO

In today's letting market tenants are being more cautious about taking excess space due to its cost and perceived inflexibility in terms of disposal. For that reason, tenants are increasingly looking for ways to protect their need for additional space nearby to its existing space in order to meet future expansion requirements.
In a typical pre-letting scenario (where the tenant is agreeing to lease space on completion of a development), a tenant can partially meet this concern by agreeing expansion (and contraction) options which it can exercise prior to the development being completed. A ROFO, however, is serving a more distant need and generally applies to the period following the grant of the tenant's first lease(s) and, indeed, following the first letting of the space over which the ROFO will exist (the ROFO Premises). In effect, therefore, what a ROFO is providing is first dibs on the ROFO Premises when it comes back to the owner.
The key issues that need to be addressed in the ROFO agreement are:
  • Extent of ROFO Premises – these must be clearly identified and whilst that sounds simple there are complexities. Should the ROFO Premises just relate to whole floors or should it also relate to parts of a floor too?
  • Period for ROFO – From an owner's perspective this would be as short as possible (say five years from the term start date of the existing lease) but that limits the benefit for the Tenant. From the Tenant's perspective it would want the ROFO to last as long as possible and perhaps for the entirety of its contractual existing lease term. Complexities arise here too, however, such as what happens if the Tenant's existing lease is renewable (whether by contract or statute)? Should the ROFO run with any renewal lease? If it does great care will be needed with the drafting.
  • Who is the Beneficiary? - It's clear the original Tenant should be the beneficiary of the ROFO but what about its lawful assignees? If the benefit does not extend to lawful assignees what about group companies of the original Tenant in whom the existing lease is vested?
  • Should the ROFO terminate early? – Typically an owner will want the ROFO to fall away should the beneficiary no longer be in occupation of the existing lease premises. There are often other triggers for termination, for instance if the Tenant disposes by way of subletting of a significant amount of its existing premises then there's a strong argument it should no longer benefit from the ROFO.
  • What are the terms of the ROFO lease? – Broadly speaking these should match the terms the owner wants to go out to market with so should cover: extent of ROFO Premises being offered, measured area, yearly rent, term, rent free, monetary and other inducements and any owner's works. The term and rent free can become more complex, however, as whilst the landlord may want to go to market with, say, a 10 or 15 year term, the beneficiary is likely to want a term that is co- terminous with its existing lease. That will mean the ROFO will need to provide for that and potentially adjust the rent free from an open market rent free applicable to a longer term to one that corresponds to the agreed ROFO term.
  • What is the acceptance period of the ROFO? – the owner won't want a long period of uncertainty so the offer once made should have to be accepted relatively quickly. Periods between two weeks and a month are typical. Should the beneficiary not respond then it's usual for that lack of response to be deemed as a rejection allowing the owner to proceed to market.
  • What happens if the beneficiary rejects the offer? – The parties will need to agree whether the ROFO is a one-off event or kicks back in for the ROFO period (see above). If the former, the owner would prefer to be free to then let on whatever terms if prefers but beneficiaries typically want an owner only to go to the market on terms no less favourable to a tenant than it was offered by the owner. It would also be usual for the owner to have to conclude a deal with a third party within a certain period (say nine months) otherwise the ROFO kicks back in.

3. That's just the start…

Well almost. The above will certainly take some consideration but those points are by no means the end of the discussions. There are other points that are certainly important and should, ideally, be discussed and clearly drafted for in the ROFO agreement. These include:
  • Timing for the making of the owner's offer – As we've seen above, a ROFO usually kicks in following the first letting of the ROFO Premises by the owner. From the owner's perspective, however, it doesn't want to have to wait until it obtains vacant possession before it serves the offer notice, otherwise it's looking down the barrel of a long and unwanted void period before any new letting is completed. Ideally, therefore, an owner would like to serve the ROFO offer before it gets vacant possession and that means the ROFO needs to provide for what happens if it is unable to do so (because for instance the existing tenant has security of tenure) and that usually means a termination of any contract to grant a ROFO lease to the beneficiary pursuant to that particular offer if vacant possession hasn't been obtained by an agreed long stop date.
  • Permitted disposals – The owner will want to ensure that not all disposals will oblige it to make an offer to the beneficiary. In particular, it will want to reserve its ability to charge the ROFO Premises or put in place group company leases that are 'structural' in nature rather than occupational. There may also be other specific disposals the owner will not want to trigger the ROFO and careful thought and discussion should be given to these matters.
  • The 1954 Act – Where the beneficiary's existing lease is outside of the security of tenure provisions of the Landlord and Tenant Act 1954 it's quite likely the ROFO lease should be as well. Here lies a difficulty in that certain statutory processes need to be followed to exclude effectively the 1954 Act and those need to be carried out before a binding contract for the grant of the relevant lease comes into effect. That can't necessarily be done before the ROFO Agreement is put in place as the lease terms won't be known. This can be provided for, however, through careful drafting and provisions requiring certain notices etc. to be served prior to the beneficiaries acceptance notice being served. So, legal advice certainly needed here.

4. Conclusions

ROFOs are a useful tool for both owners and occupiers in today's letting marketplace. The ability for an owner to offer a ROFO enhances its offer and for an occupier they provide some degree of contractual control over future space in the building it's chosen to occupy. That said they can become complex when, frequently, the HOTs only provide for a couple of sentences on the ROFO terms. As can be seen above, that could well be the start of a longer discussion.

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Nicholas Turner

Partner, London

Nicholas Turner

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