In stark constrast to the difficulties in contractual leasehold options outlined by David Neuberger in his part of this lecture, I am going to indulge in what could be regarded as lateral thinking and start with a success story. The reasons for my doing so will, I hope, become apparent as I proceed, but my story does provide a challenge for those of us involved in the law of real property or in the landed professions to — in the vernacular — get our act together.
My story starts some time before 1978, when a group of stockbrokers perceived that investors and the investment industry could utilise a market for the selling of share options. The mechanics of such a market were researched and, I believe, drew on American experience. In 1978, a market started in a small way on the floor of the London Stock Exchange.
Because a “share option” is different in a number of essentials from a “property option” I shall spend a few moments explaining what it is and who uses it.
The chap who buys a share option purchases the contractual right, but not the obligation, to buy a given number of shares in a particular quoted company at a fixed price on or before a given date. On the other hand, the chap who sells such an option receives a monetary consideration to sell, if he is required to do so, shares in a particular company at a fixed price on or before a certain date.
The buyer buys in the hopeful expectation of a price increase in the share concerned to a level above the “strike price”, although he has to be able to buy at a point in the market when the price is above strike price plus premium if he is to make a profit. He may do this as a speculation; he may be investing funds not yet to hand because he anticipates a rising market and he wishes to purchase at present levels; or he may merely be a market-maker with an offsetting “short” position.
For every buyer there has to be a seller, so what of him? The seller may be a market-maker with an offsetting “long” position. He may be an institution uncertain about the future but wishing to lock in a profit or again he might just be a speculator anticipating a market fall.
These transactions are initially done verbally and then are confirmed by a “trade ticket”. However, those participating in the actual market are confined to market-makers and credit brokers accepted within the market. The brokers will confirm the contract to their respective clients by a simple contract note.
While in every market there is a degree of speculation, for the most part the options market is utilised by institutions and market-makers to “hedge their bets” or, in modern-day terms, to spread their risk or to “manage their risk”. Thus, although there is an element of gamble, most of the users of the market have a much more worthy commercial purpose.
Here, then, we have an options market dealing with option contracts running into hundreds of millions of pounds per week. So, to those who have listened to Mr Neuberger’s paper, the question is immediately begged: “Why is the system so straightforward and successful?”
One can give four reasons, which, taken together, answer the question:
(1) There is a common product. That is, what is bought and sold are standard contracts in a limited number of leading shares and these contracts can be conducted only at predetermined expiry dates and price step levels;
(2) All the transactions are listed by or through the Stock Exchange accounting system;
(3) The participants to the contracts are authorised traders with the deals being conducted through recognised brokers; and
(4) There is a very high volume of transactions. It is worth drawing attention to two fundamental conclusions which must already be apparent to you. First, there is nothing fundamentally complex, difficult or litigious about a contract for an option as such. It would appear only to be when the option situation is grafted on to the complexities of English law of real property that problems arise. Second, in a market economy, options have a useful commercial part to play.
Property options
Property options can be broadly put into two groups. The first group is concerned with straight options for the purchase of freehold or leasehold land. The second group is concerned with options arising out of property leasing contracts. Options contained in leases can be split into two groups, notably:
(i) Options to purchase and
(ii) Options arising from within the contractual relationship of a lease, giving either the landlord or the tenant specified rights in relation to the lease contract concerned.
The second subgroup can again be subdivided:
(a) Options to determine.
(b) Options to alter the rent or other terms.
(c) An option for renewal of the lease.
Immediately we have a clear contrast with the situation relating to share transactions with terms which are unique, or near unique, to the particular contract.
The sale and purchase of options to purchase freehold or leasehold interests in land is a widely used device. It is encountered, for example, in the case of mineral-bearing land (including coal) and is offered by the prospective purchaser to hold matters open until, for example, town planning consent has been obtained (and/or the National Coal Board has given consent for the extraction of coal) and/or the prospective purchaser has sunk some trial holes to enable him to estimate the quality and quantity of the material.
Options are commonly used where the prospective purchaser wishes to extend his adjoining excavations on to the option land concerned. (A parallel and similar example is the purchase of a property shortly ripe for redevelopment or for which planning consent for change of use is required.)
What, then, are the problems of such contracts and why an “option” rather than a “conditional contract”?
Dealing first with the conditional contract possibility, the purchaser of mineral-bearing land will make his ultimate profit from the value of the material extracted less, of course, the cost of extraction including the cost of compliance with what may be onerous or highly restrictive planning conditions. Against this profit, he has also to pay for the land. Markets for some common materials such as sand, gravel or building stone can be local and shortlived. Hence, the purchaser wishes to have the right to walk away from the contract if the commercial balance tilts against the possibility of an ultimate profit.
But what of the vendor? Well, he may take a gamble on obtaining a higher ultimate total price by this route than by conditional contract. If the worst comes to the worst, he still has ownership of his land plus the option stake money.
So what are the snags? There are several. First, it is necessary to have a watertight contract for the sale and purchase of the land interest. Additionally, there are the following problems of “options to purchase land” which are shared with conditional contracts. They are mainly questions of exact definition and include:
(1) The satisfaction of any conditions precedent.
(2) The definition of the time within which the option has to be exercised.
(3) The mechanics for initiating implementation.
(4) Whether the option is personal to the grantee.
(5) Definition and determination of the consideration where this is not specifically stated.
When the option device is used for land potentially ripe for development, there are at least two possible reasons for its use. First, it may be used in site assembly negotiations. In such a case, for example, it could be that the option will be exercised only if the grantee can reach appropriate terms for the purchase of other essential pieces of an overall site. Alternatively, the reason for the option could be the uncertainties surrounding the planning permission likely to be granted. The grantee, that is the would-be purchaser/developer, needs time and money to put in his application and to see it through the planning processes. He also may wish to be able to walk away at his discretion if the permission and associated adverse conditions are not to his liking.
Again, the problem here for advisers is not so much the option but precisely agreeing its duration and the circumstances in which it can be exercised.
So, summarising the problems for the professional adviser beyond those of a normal contract for the sale of land will include:
- If there are any “conditions precedent”, have these been adequately set out so that there can be no arguments as to whether or not they have been complied with or satisfied?
- Have the time-limits for the exercise of the option been precisely set?
- Has the procedure by which the option can be activated by the purchase been drafted in a foolproof way?
- Has the purchase price, or the way in which it is to be ascertained, been clearly stated?
In short, the problems all can be distilled as questions of precision in drafting. So long as the parties have a clear-cut agreement and this is translated into an adequately worded contract document, then there are unlikely to be inherent problems in the owner of the option effecting the purchase if he so wishes.
As the word “worth” appears in my title, I must spend a little time on questions of valuation. You will immediately appreciate that valuation angles have a fundamental simplicity. For the grantor, the value of his land may be lower than the option “strike price” but seldom, if ever, higher. If the purchase price is to be determined at a specific date, then the formula will determine the value — albeit that value has to be cautiously estimated bearing in mind that any purchaser of land subject to a purchase option may be buying litigation or may suffer a delayed completion. Even if there is neither, the price has to be discounted for such matters as uncertainty, profit and costs.
For the grantee, his option has a value only if the market value of the land is higher than the option price. To the extent that this is the case (ie market value minus option price), the grantee has an interest of value recognised both in the open market and in compulsory purchase cases.
What should an option cost? In a professional paper the question “How long is a piece of string?” may be bad style, but it sums up the answer. The grantor has to be compensated for taking his land off the market and for agreeing to such a scheme which probably will inhibit the saleability of his land for a period of time. The grantee, on the other hand, may see a chance of a future profit and may now fix the price. Hence, horse dealing and my unsatisfactory and unprofessional answer!
Options in leases
Usually the option is a subsidiary matter in the lease when granted. However, this is not always or necessarily so. The lease, for example, may be a tiding-over provision until an option to purchase exercisable by the tenant is operated (or otherwise).
Options in leases can, however, become of primary importance at a later date and it is helpful to reiterate the four main classes of case in which they occur:
(1) An option exercisable by the tenant to purchase;
(2) An option to break. Such options can be mutual or exercisable by one party only;
(3) An option, usually exercisable only by the lessor but not always so, to review the rent passing or sometimes other terms in the lease;
(4) An option exercisable by the tenant to renew the lease, on the same or on other stipulated terms as the original lease document.
An option to purchase contained in a lease will have to comply with the same requirements as such an option outside a lease. One additional difficulty to which David Neuberger has rightly drawn attention is the case where the tenant can exercise a right before a future date to purchase at open market value. Because the tenant is in occupation under a lease, it is necessary to specify clearly whether vacant possession is to be assumed or whether the value is to be calculated with the tenant in situ.
In commercial terms it would be absurd for the lease to specify that the tenant has to have complied with the exact letter of the lease up to the date of exercise of his option, as this would be immaterial if the landlord is to sell. However, the price, if it is to be determined at an open market valuation, will need to be determined on the assumption that there shall be no reduction in price for any loss of value caused by tenant’s default.
From the landlord’s point of view, the existence of such an option adds an uncertainty to his interest which is likely to depress the value if he sells subject to the option. For this reason, the consideration in rent and/or premium paid by the tenant is likely to be higher than if the lease did not contain the option.
Options to break are frequently negotiated between the parties to a lease where the landlord may wish to redevelop at an early date or where he may envisage wishing to occupy the space for his own business before the end of the full term. Likewise, a tenant may require flexibility enabling him to depart or move elsewhere before the end of the lease.
Clearly, if the property has a considerable value for early redevelopment and the option date is missed, it may be very expensive or impossible to buy out the tenant. Accordingly, such options can in such circumstances be vitally important in valuation terms. If there is any legal doubt as to the prospect of the option being enforceable, then this is a risk which would need to be reflected by the valuer in any market valuation made of the property. Similar remarks arise if the rent currently passing is below market value.
Where a tenant has an option to break and the property is essentially an income-producing investment, a capital valuation of the investment will reflect such matters as the risk of a void or of a less desirable tenant being found or, where appropriate, a lower or higher rent. There may also be a deducted allowance to be made for letting and legal fees. For this reason, the tenant may pay a higher rent than otherwise for his right and/or he may have made a concession elsewhere in the overall lease terms.
Tenants’ options for renewal and options to break which require strict compliance with the tenants’ covenants clearly give rise to many capricious problems and should, ideally, be avoided for this reason. However, some ideas may develop as to how the law might be amended to make it more certain and less harsh in enforcement against the tenant who has in practice failed to put three coats of paint on the ceiling.
Perhaps a breach of a covenant should be regarded as precluding the exercise of the option if the tenant’s breach is such as causes the landlord a material loss in terms of the value of his reversion? How to implement such an idea I leave to the legal profession.
However, where are such straightforward options (assuming their operative validity) likely to be commercially attractive devices? David Neuberger has mentioned the problem of some overseas companies whose domestic laws or customs (coupled maybe with an inflexible department at head office) necessitate short leases when what is really wanted is the prospect of a long period of occupation. Likewise, some unusual properties can be assessed as to suitability only after a trial period operating on site. (I have encountered this with an old-fashioned cold store where the tenant did not exercise his option and I understand that it is a device sometimes used in respect of theatres, cinemas and even fun-fairs.)
So, once more, there can be occasions when options may be useful although, in the case of the leisure industry, options to break may be an equally satisfactory way of achieving this end.
Valuation implications are mainly in respect of the owner/investment angle, for an option granted to a tenant makes for future uncertainty of income and/or tenant’s covenant, as I have indicated earlier. From the tenant’s angle, the option could in some circumstances have a capital market value, in which case any risk inherent in exercising the right will have to be reflected by the values — suitably legally advised.
I end more or less where I started — an “option” is a widely used useful commercial device. It is up to us in the professions to use such means as we may have to facilitate its straightforward availability for the clients we serve.