What is a Right of First Refusal?

What is a Right of First Refusal?

By Marsha L. Collett, Esq.

A right of first refusal is a contractual right granted by an owner of property. The owner gives the holder of the right an opportunity to enter into a business transaction with the owner according to specified terms, before the owner may enter into that transaction with a third party. Rights of first refusal often are entered into in real estate transactions.

Example of a Right of First Refusal. An example of a real estate right of first refusal is the following: Owner A owns a parcel of real estate that she wants to sell to Purchaser B for $1,000,000 under certain terms and conditions. However, Holder C has a right of first refusal to purchase the real estate. Before Owner A can sell the real estate to Purchaser B, she must first offer it to Holder C under the same terms and conditions as those offered by Purchaser B. If Holder C exercises the right of first refusal and follows through with the purchase, Purchaser B will have no right to acquire the real estate.

Simple? No! Although a right of first refusal at first blush may appear simple, many issues may arise from such right, typically causing problems and delays for the owner who granted the right. This article discusses many issues which, if not addressed when the right of first refusal is drafted, may cause problems for the owner at a later date.

  • Specification of Real Estate Subject to the Right of First Refusal: Property subject to a right of first refusal should be particularly defined. A right of first refusal should specify what will happen if the owner wants to sell not only the property subject to the right of first refusal, but also additional property. It also should address what will happen if an owner wants to sell a portion of the property subject to the right of first refusal. An allocation of the purchase price, or a formula for determining the same, should be set forth.
  • Non-Cash Offer: A right of first refusal should address what will happen if an offer to purchase is not for cash, but rather other property, such as an exchange for other property. Obviously, the holder of the right cannot match such an offer. The right of first refusal should set forth a mechanism to determine the fair market value of the property to be exchanged, so that the holder of the right will be able to substitute cash consideration.
  • Timing; Provisions Relating to Exercise of the Right of First Refusal: Provisions regarding timing of rights of first refusal should be carefully drafted. The owner should provide notice of the offer to the holder of the right of first refusal within a certain number of days, and the holder should have an opportunity to exercise the right within a certain number of days. Mechanisms of providing notice (delivery, certified mail, etc.) should be set forth. Closing should occur within a certain number of days, or match the offer. A right of first refusal also should set forth the date on which the right terminates.
  • Transferability: A holder of a right of first refusal, unless otherwise prohibited, may transfer the right to a third party. From an owner’s standpoint, a right of first refusal should state whether it is transferable, or personal to the original holder. A right of first refusal should also be drafted so that it is binding upon entities or trusts affiliated with the owner or under common control of the owner, or in which the principals of the owner have a direct or indirect interest.
  • Exceptions to the Right of First Refusal: Certain transactions typically may be excepted from a right of first refusal. For example, an owner should have the ability to sell or transfer property to the owner’s trust or to family members without first offering it to the holder of the right of first refusal. What happens upon death of the owner also should be expressly set forth. Otherwise, the right of first refusal may continue to the individual who inherits or acquires the property.
  • Extinguishment – Declining the Right: A right of first refusal should expressly state what will happen if the owner extends an offer to the holder of the right, and the holder declines. It should state either that the property is no longer subject to a right of first refusal, or that the right continues to the new purchaser, who will step into the owner’s shoes. In any event, an owner must close the sale pursuant to the offer. An amendment to the offer may trigger a duty to again extend the offer to the holder of the right of first refusal.
  • Extinguishment – Failed Exercise of Right of First Refusal: Some rights of first refusal provide that, if the holder of the right accepts the right but is unable to complete the transaction, the right is forever extinguished. Others provide that the right continues if the property is sold to another party. If the right of first refusal is silent on this issue, there may be differences of interpretation.
  • Varying Terms of Rights of First Refusal: Typically, slight variations to the offer by the owner and the holder who exercises the right of first refusal are acceptable. In general, a holder of a right of first refusal may not “materially vary” from the terms of the original offer. Obviously, materiality may be a disputed issue.
  • A carefully drafted Right of First Refusal addresses most of the issues set forth above, and more. However, many rights of first refusal are not completely specified. Even the best drafted right of first refusal agreements suffer a high risk of dispute in litigation, as do most agreements that anticipate future transactions and contingencies.
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