Understanding Right of First Refusal
The right of first refusal (ROFR) is a contractual right between two parties: the grantor and the holder. The grantor owns an asset which the holder may, at some future date, want to purchase. An ROFR ensures that, in the event a third party makes a bid for the asset, the grantor must first offer it to the holder for the same price and conditions.
Right of first refusal is most commonly seen in real estate, although it is also found in most LLC Operating Agreements, where it resides as one of a number of preemptive rights. Though simply enough on the surface, ROFR agreements can easily go astray.
How ROFR Works
To understand right of first refusal at its most basic, let’s look at an example.
Jane owns ten acres of empty land. Joe lives next door. Jane and Joe sign an ROFR agreement. The agreement states that if a third party ever makes an offer for the acreage, Jane must first offer to sell the property to Joe for the same price and under the same conditions.
Years later, Brian offers $50,000 for the land. Per their ROFR agreement, Jane contacts Joe and offers to sell him the land for $50,000. Joe considers the deal but eventually declines. Jane sells the property to Brian.
Two things to note: first, an ROFR agreement requires that Joe be given the same offer (Jane could not request Joe pay $75,000 for the property); second, an ROFR is not an obligation (Joe can legally decline the offer).
Structuring a Right of First Refusal
An ROFR agreement must have clear and absolute definitions. For example, ROFR depends upon specific triggers. An offer made for the property triggers the ROFR, requiring the grantor to contact the holder. But what precisely qualifies as a trigger? A letter of interest? A written offer? A verbal bid? Can any offer trigger the holder’s right, or only an offer the grantor might actually accept?
For an ROFR agreement to succeed, such elements must be clear and well-defined.
Questions to Consider:
- Is the agreement limited to cash offers, or can it be triggered by an offer to exchange property?
- Is the agreement triggered by offers that include the property in addition to other property?
- Is the ROFR triggered by offers for only a portion of the property?
- What happens if the third-party offer is withdrawn?
- What mechanism should be in place to assess the Fair Market Value of the property?
Timing of the ROFR
- How long does the grantor have to contact the holder after an offer has been made?
- How long does the holder have to exercise their right?
Timing is crucial to right of first refusal agreements. Without specific deadlines, the agreement is meaningless, as there is no way to determine whether the grantor and holder have adhered to the contract or not.
Deadlines are beneficial to both parties. A holder knows they will be given reasonable time to consider an offer, and a grantor is guaranteed that the ROFR is not perpetual.
- If a holder dies, does their ROFR pass to their inheritors?
- Can the ROFR be signed over to another individual or entity?
- If the grantor passes away and the property transfers to their descendants, it the ROFR agreement still valid?
Addressing transferability ensures that both parties to the agreement understand who they will be dealing with, both at the start and into the future.
Grantor and holder may wish to carve out exceptions to their contract. In other words, situations which do not trigger the ROFR agreement.
For example, the grantor may want to transfer the property to an LLC, corporation or trust controlled by the grantor. In this situation, it is clear the grantor does not want to sell the property, and thus an exception should be made.
Cancellation of a right of first refusal is called extinguishment. This can happen for two reasons:
- The right may be declined (the holder passes on the option to purchase)
- The holder may fail to exercise the right in the allotted time period
Whichever case applies, after extinguishment occurs the holder has no additional rights, and the grantor is free to sell the property.
Acting in Good Faith
A final note about right of first refusal agreements: both parties must act in “good faith” in honoring the agreement. In other words, neither the grantor nor the holder may collude with a third party in an effort to subvert the ROFR.
For example, in the case Bramble v. Thomas, the grantor accepted an offer from a third party with a clause attached that the grantor knew would be rejected by the holder. The grantor, John and Rose Lane, entered into an agreement to sell a parcel of land to a third party, Merrill and Nancy Thomas. The agreement stipulated that the land could not be used for the purpose of mining. The Lanes informed the ROFR holder, David Bramble, of the offer, but Bramble, who owned a mining company, naturally found the offer with its stipulation unacceptable.
While a Maryland Court of Special Appeals found no issue with the Lanes acceptance of the Thomas offer, the Maryland Court of Appeals disagreed and reversed the lower court’s ruling, stating that there was reason to question whether or not the Lanes had acted in good faith or had accepted an offer they knew would be unappealing to the ROFR holder.