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What is a Right of First Refusal and When Is It Enforceable?
The right of first refusal sounds simple on the surface. A right of first refusal (ROFR) gives the right-holder the opportunity to enter into a business transaction with another party before anyone else. It’s most commonly seen in real estate contracts, such as when a lessor signs a contract giving them the ROFR to put in an offer to purchase the property if it ever comes up for sale.
But as straightforward as it sounds on paper, it’s not always so straightforward in the real world. Contracts that include an ROFR must be clear and detailed in order to be enforceable.
The Supreme Court of South Carolina addressed this issue in the 2023 case Clarke v. Fine Housing, Inc. (here). We’ll look at the factors required for an enforceable right of first refusal in South Carolina and how they played out in this recent case.
The Pros and Cons of a Right of First Refusal
An ROFR can benefit both parties. In the example of a lessor with the ROFR to purchase the property, if and when it comes up for sale, they can be sure not to miss out on the opportunity to put in an offer. There’s no downside for the potential buyer; if they don’t want to buy the property, they simply refuse.
The property owner can benefit by having a potential buyer already lined up when it’s time to sell, which may help them in negotiations with other potential buyers. However, the downside for the property owner is that a ROFR can restrict their power of alienation, which is their ability to dispose of property.
“South Carolina law prohibits enforcement of unreasonable restraints on alienation of real property,” the court says in the Clarke opinion. The key word here is “unreasonable.” Whether a particular ROFR is enforceable depends on whether the restraints on alienation are considered unreasonable.
Unreasonable Restraints on Alienation of Property: What is Unreasonable?
In the Clarke opinion, the SC Supreme Court turns to the Restatement (Third) of Property. The Restatements of the Law (Third) are a comprehensive set of legal treatises widely referenced and relied upon by courts, judges, lawyers, and others across the U.S. On the subject of the ROFR, it says, “Reasonableness is determined by weighing the utility of the restraint against the injurious consequences of enforcing the restraint.”
The Supreme Court of South Carolina uses the factors listed in the Restatement (Third) of Property (Comment f) to determine, on a case-by-case basis, whether a right of first refusal is enforceable. The factors are:
- The legitimacy of the purpose of the right,
- The price at which the right may be exercised, and
- The procedures for exercising the right
These factors are not exclusive.
Let’s look at each one of the factors and how they figure into the Clarke case.
Background of Clarke v Fine Housing (2023)
First, the pertinent background of 2023 Supreme Court of South Carolina case Clarke v. Fine Housing, Inc.: Barry Clarke owned a strip club in Charleston. In 1999, he entered into a lease agreement with the owners of another strip club across the street to use part of their unimproved land for parking. The lease contained the following language:
- Section 5.2. Right of First Refusal: Lessor grants the Lessee the right of first refusal should it wish to sell.
Note that there’s no mention of price, timing, how to exercise the right, or any other specifics – not even which property this right of first refusal applies to.
In 2013, then-owner RRJR conveyed the property in question to Fine Housing, Inc. Clarke learned of the sale in 2014 after it was a done deal, having had no opportunity to exercise what he believed to be his enforceable right of first refusal (Right).
In 2015, Clarke brought this action for specific performance against Fine Housing and RRJR. The case eventually came before the Supreme Court of South Carolina, which agreed with the SC Court of Appeals that the Right was not enforceable because it constituted an unreasonable restraint on alienation.
Factors for an Enforceable Right of First Refusal
Here are the three factors the Supreme Court of South Carolina uses to determine enforceability of a right of first refusal on a case-by-case basis and how they show up in Clarke.
Factor 1: Legitimacy
In Clarke, Fine Housing didn’t challenge the legitimacy of the purpose of the Right, so the court didn’t address the issue.
Factor 2: Price
Price may or may not be an unreasonable restraint on alienation. If, for example, the ROFR were dependent on a fixed price, that could restrain alienation. If the price were to be matched to a third party’s offer, there would be less restraint.
In Clarke, Clarke argued that the Right left the price to be determined entirely by RRJR and required him to match any offer from a third party. He also argued that exercising the Right would have started a bidding war that would have benefitted RRJR.
The court agreed with Fine Housing that the absence of any method for determining the purchase price in the lease constituted an unreasonable restraint on alienation. Absence of specifics on how to determine price may not be as restraining as a fixed price, says the court, but it is still a restraint, and “a right of first refusal should contain some method for determining the price at which it may be exercised.” The lease Clarke signed had no method, and therefore this factor worked against him.
Factor 3: Procedures governing the exercise of the right
Comment f to the Restatement stresses the importance of provisions governing the exercise of the right, stating, “Lack of clarity may cause substantial harm by making it difficult to obtain financing and exposing potential buyers to threats of litigation. Lengthy periods for exercise of rights of first refusal will also substantially affect alienability of the property.”
Time is also an important consideration. How soon after the owner decides to sell does the right holder have to exercise their right? An extended period of time can be a restraint on the property owner, while a “reasonable” time frame does not impose unreasonable restraint and is generally enforceable.
In Clarke, Clarke argued that a ROFR does not require detailed instructions on how to exercise it to be valid, but this directly contradicts the Restatement (Third) of Property. He also argued that the lease provided satisfactory procedures regarding the exercise of the right. The court disagreed “because the Right contains no such procedures whatsoever.”
As for timing, Clarke argued that if there’s no mention of a timeline in the language of the agreement, then it must be done within a “reasonable time.” The court disagreed, saying that the point of the Restatement is to include a predetermined time limit so as to protect the property owner’s power of alienation, rather than having the owner rely on a “judicially implied ‘reasonable time.’”
Because of the total lack of provisions regarding timing and procedures on how to exercise the Right, the court found again in favor of restraint on alienation.
Additionally: Which Property?
The court also addressed a matter specific to Clarke: to which property did the Right ostensibly apply? The entire property that includes the unimproved land Clarke leased for parking, or the unimproved land only?
Clarke argued that the Right applied to the entire property, but the court disagreed because the language in the lease was not clear. That uncertainty constitutes an additional unreasonable restraint on alienation.
Takeaway: Rely on Clear, Specific Contracts
The SC Supreme Court affirmed the appeals court’s decision, finding in favor of Fine Housing and against Clarke, stating “The Right does not identify the property it encumbers, contain price provisions, or contain procedures governing the exercise of the Right. We conclude the Right is an unreasonable restraint on alienation. We therefore affirm the court of appeals’ holding that the Right is unenforceable.”
An important takeaway for anyone entering into a contract with a right of first refusal in South Carolina: Make sure the language in your contact is clear and specific and that it addresses the three factors discussed above. It must contain language on how the price should be determined and how the right should be exercised. Language that unreasonably restrains the property owner’s power of alienation may render it unenforceable, so the right cannot be construed too favorably to the would-be buyer.
Call Gem McDowell for Contracts, Strategic Business Advice, and Commercial Real Estate
Many legal disputes come down to the language in a contract. Is it clear? Is it enforceable? Would the courts side with you if the matter were ultimately litigated? It’s critical to get the contract right before signing it, so you lessen the chances of complications and litigation down the road.
For help with business contracts and commercial real estate, call business attorney Gem McDowell at the Gem McDowell Law Group. Gem has over 30 years of experience working with business owners to help them start, grow, and protect their businesses. He and his team can help you with contracts, corporate governance documents, strategic advice, and more. He also has extensive experience in commercial real estate transactions in South Carolina. Call the Gem McDowell Law Group today to schedule a free consultation at 843-284-1021.