Judge Rules LIHTC Program's Right of First Refusal Is Unique
Nonprofit sponsor wins in LIHTC right of first refusal case.
The LIHTC program is the largest federal resource for creating and maintaining affordable housing in the country. The program facilitates partnerships between mission-driven nonprofit organizations and for-profit investors to generate affordable rental housing for low-income families. Under the program, housing tax credits are allocated to the states based on population and, in turn, distributed to developers by state housing agencies.
When Congress enacted the LIHTC program, it was concerned with the long-term preservation of low-income housing developments. Congress recognized that nonprofits are generally more likely than for-profit developers to maintain rents at below-market levels beyond the initial compliance period. Therefore, it gave an edge to not-for-profit developers in the allocation process by requiring state agencies administering the program to award at least 10 percent of their tax credits to projects that involve nonprofit developers.
A recent decision involves a nonprofit partner seeking to exercise its right of first refusal to acquire an LIHTC site after the 15-year compliance period expired. In this case, the U.S. Court of Appeals for the Sixth Circuit reversed a district court's decision in favor of an investor and sent the case back to the district court for a trial [SunAmerica Housing Fund 1050 v. Pathway of Pontiac, May 2022].
What Is the Right of First Refusal?
The LIHTC program, through Internal Revenue Code (IRC) §42(i)(7), offers nonprofit general partners a right of first refusal (ROFR). The ROFR can be used to obtain eventual ownership of the site at a minimum purchase price equivalent to the outstanding debt plus exit taxes. The provision allows nonprofit general partners to gain ownership of LIHTC sites as their investors exit after 15 years once the investor has claimed all housing credits and before the program’s rent restrictions expire.
Generally, a ROFR is not unique to the LIHTC program and is often used in common real estate transactions. The common law ROFR is triggered by an enforceable, bona fide offer of purchase from an unrelated third party. When this offer is made, the relevant party is given the opportunity to match the third party’s offer price and purchase the property for themselves. However, the ROFR in the LIHTC program differs in that the price is not based on a third party’s offered price, but on the sum of the property’s outstanding debt plus taxes, as specified in the federal statute.
The Lower Court's Decision
The partnership owned a 150-unit elderly housing LIHTC site. A nonprofit corporation held a ROFR and an option to acquire the site "[u]pon receipt of a bona fide offer" according to the limited partnership agreement. The option was at fair market value. The ROFR was at a bargain price based on the outstanding mortgage and exit taxes.
In 2019 the general partners notified the investment partner that a development company had submitted an offer to buy the site and that the nonprofit would have 30 days to exercise the ROFR. The general partners of the site's limited partnership had received two non-binding letters of intent (LOIs), which indicated each offeror's desire to purchase the site upon specified terms. The general partners solicited at least one of the LOIs and did so to trigger their nonprofit's ROFR. When the general partners advised the investor that the nonprofit partner was exercising its ROFR, the investor sued. The investor said that it would like to continue to maintain its interest in the site and that it did not believe that the ROFR had been triggered. The investor sued for declaratory relief, breach of contract, breach of the covenant of good faith and fair dealing, and breach of fiduciary duty. The general partners brought counterclaims for breach of fiduciary duty and breach of the partnership agreement.
The district court judge ruled that the development company's offer didn’t trigger the ROFR because it wasn’t a bona-fide offer. The partnership agreement required a "bona fide offer" to trigger the ROFR but didn’t define the phrase. The district court applied the Michigan common law definition of "bona fide offer," which generally requires that the offeror have a genuine intent and the financial ability to follow through with the offer, and that the offer be binding.
In concluding that the offer was not bona fide, the district court relied upon the fact that the offer was solicited by the general partners and was not legally enforceable. The district court also found that the general partners had no intent to sell to a third party. Accordingly, the district court granted a judgment without a trial in favor of the investor and ruled that the nonprofit ROFR was not properly exercised and the general partners breached the partnership agreement and their fiduciary duties.
Court of Appeals Decision
In reversing the district court, the Sixth Circuit Court of Appeals noted that the ROFR provision of Section 42 is an important piece of the program. The ability for investors to exit after the expiration of the 15-year compliance period is important to the LIHTC program. It creates an incentive for nonprofits to participate in the program. Without it, nonprofits will be less likely to enter a partnership that includes an investor, if doing so would mean litigation after the 15th year.
The judge viewed the “bona fide offer” requirement in the ROFR context as protecting the holder from being forced to match an outlandish offer, effectively forfeiting the ability to exercise the contractual ROFR. However, those willing to submit a genuine offer that the ROFR-holder cannot match can acquire the property despite the rights of the ROFR holder. Under this general common law definition of ROFR, the attention is on the offeror, and whether its offer reflects a serious intention to purchase the property.
But in the LIHTC context, the judge concluded that the right of first refusal contemplated by the federal LIHTC program, "varies markedly" from a right of first refusal in a "typical real estate transaction," such that application of general "common law" definitions of "right of first refusal" and "bona fide offer" would go against the purpose of IRC §42(i)(7).
The judge said, "When interpreting such an ROFR provision, we must account for Congress’s goals expressed in LIHTC, including its intention to make it easier for nonprofits to regain ownership of the property and continue the availability of low-income housing. Thus, those Congressional intentions confirm that the general common law understanding of bona fide offer cannot be substituted for the ROFR mechanism created by Congress in LIHTC."
In addition, the judge determined that for Congress’s intent for the LIHTC program, IRC §42(i)(7) requires only an intent to sell generally and does not, in and of itself, require the existence of a bona fide offer. But because the language in the partnership agreement required a bona fide offer to trigger the nonprofit's ROFR and because that offer has to come from a third party, the judge agreed that "there must be an intent to sell to a third party" to trigger the particular ROFR in this case. The judge sent the case back to the District Court for a trial on the general partner's intent and stated that the receipt of two offers and solicitation of at least one of those offers suggests that the general partners "did intend to sell or entertain third-party offers."