A right of first refusal (“ROFR”) is a preemptive right to purchase specific real property at some future time upon certain defined terms and conditions. ROFRs do not specify a price. Circumstances vary, and therefore the language of a ROFR clause will vary as well. For example, a ROFR may be triggered by an offer received by the owner from a third party; in such a case, the owner is obligated to first offer the property for sale to the holder of the ROFR at the same price and upon the same terms. Another scenario may occur if the owner makes the decision to sell the property but does not yet have a buyer; the ROFR may obligate him to offer the property first to the holder of the ROFR.
Avoiding the Executory Contract Trap
The principal benefit to a ROFR is that it is not an executory contract, even when combined with a lease. This is a critical advantage, since the executory contract rules contained in Property Code Section 5.061 et seq. impose burdensome rules and liability upon the seller. For executory contracts longer than 180 days, the landlord-seller must provide the Buyer with a recent survey or a current plat; copies of liens, restrictive covenants, and easements; a statutory disclosure; a disclosure for non-subdivision properties stating utilities may not be available until the subdivision is recorded; tax certificates; a copy of the insurance policy showing the name of the insurer and insured along with a description of the insured property and the policy amount; a seven-day notice letter; and an annual accounting that includes amounts paid, amounts owed, payments remaining, taxes paid, and the amount paid for insurance premiums plus an accounting for any insurance proceeds. All of this must be done before the contract is signed. Prop. Code Sec. 5.069 et seq.
So caution is in order: as soon as a specific price is included, it is likely that a ROFR will be transformed into an option and then fall within the definition of an executory contract. ROFRs are therefore not an effective tool for an investor seller who wants to pre-set an above-market price in order to lock in a long-term profit.
ROFR Versus Options
Certain characteristics are shared by ROFRs and options. Both are exercisable in the future. The validity of both can be limited to certain time periods or terms, i.e., either may expire before it is exercised. They can occur in both residential and commercial situations. Also both ROFRs and options grant the holder the power but not the obligation to act. There is generally no breach or liability for damages if the holder of an option chooses to do nothing.
However, a ROFR differs from an option in that it is conditional, not fixed, and does not specify a dollar price. An option to purchase, on the other hand, is a unilateral contract which gives the holder the right to compel sale of property at a certain price within a certain option term. When an owner gives notice of intent to sell, the ROFR matures or ripens and then becomes enforceable.
The terms of an option consist of the contractual provisions granting the option along with the terms and conditions of any third-party offer. Once the property owner has given the holder notice of his intent to sell, the terms of the option cannot be changed for as long as the option is binding on the owner. City of Brownsville v. Golden Spread Elec. Coop., Inc., 192 S.W.3d 876 (Tex. App.—Dallas 2006, pet. denied).
What if an investor-seller gets creative with document wording and deletes the word “option” from the document, substitutes ROFR language in its place, and then goes on to specify a dollar price? Under the Brownsville case, once price is specified, it is likely that the ROFR becomes an option and therefore an executory device. Further, courts are more likely to interpret a contract clause in light of what it actually is rather than what it pretends to be (the “quacks like a duck” rule). The result could be a finding that executory contract rules have been violated, or worse, that fraud has been committed by the investor.
Drafting ROFR Language
All of this presents an interesting challenge when attempting to draft a ROFR. Here is one example:
In the event Owner offers the Property for sale, then Holder [of the ROFR] will have the right (but not the obligation) to purchase the Property under the following terms and conditions: (1) Once Owner has established an asking or listing price for the Property, Owner must first notify Holder in writing of Owner’s intent to sell and shall then offer the Property for sale to Holder at this price. Holder will have 10 days from receipt of such notice to consider this offer, and if Holder accepts, Holder will have 45 days to close. Consideration may be cash or third-party financing or, if agreed between Owner and Holder, by assumption, wraparound, or owner finance. (2) If Holder declines or fails to purchase the Property at the listing or asking price, Owner will be free to offer the Property for sale to others. However, if a bona fide offer is received from a third-party prospective buyer, then Owner must again notify Holder in writing and offer the Property to Holder at the price and upon the same or better terms as named by the prospective buyer. Holder will have 10 days from receipt of such notice to consider this offer, and if Holder accepts, Holder will have 45 days to close. Holder may shorten or eliminate any applicable time periods in this paragraph by waiving or declining in writing to exercise Holder’s right of first refusal. The right of first refusal described in this section shall entirely expire on ______________20___.
The advantage of the foregoing method is that the ROFR sales price is ultimately set by a third-party buyer. However, what if the ROFR as drafted merely gives the holder a general right? Some method has to be found to establish price. In the following instance, value is determined by reference to prevailing fair market value:
In the event OWNER intends to offer the Property for sale, OWNER must first offer the Property for sale to HOLDER at a price equivalent to prevailing fair market value. Terms of sale shall be cash or third-party finance, and closing shall be within 45 days.
If the parties cannot agree on what constitutes fair market value, then two appraisers shall be promptly selected, one by OWNER and another by HOLDER. The two appraisers selected shall proceed to promptly determine the fair market value of the property, taking into consideration its condition, the comparables, and any outstanding indebtedness, liabilities, liens, and obligations relating to the Property. The appraisers shall deliver their respective reports within thirty (30) days. If the two appraisers arrive at different valuations, then these two valuations shall be averaged in order to produce a final valuation. The final valuation shall be binding on both parties. Each party waives the right to contest the final valuation in court. The costs of the appraisals shall be split equally between OWNER and HOLDER.
The ROFR is a useful tool which stops short of being an executory device, but only so long as one does not try to stretch the language in order to make it an option by a different name.
Statute of Frauds Applies
A ROFR must be express (not implied) and in writing in order to comply with the statute of frauds. Provisions of the Statute of Frauds applicable to real estate are found in Business & Commerce Code section 26.01 and 26.02(b): “[A] contract for the sale of real estate is not enforceable unless the promise or agreement, or a memorandum of it, is (1) in writing; and (2) signed by the person to be charged with the promise or agreement. . . . “The statute of frauds requires that a memorandum of an agreement, in addition to being signed by the party to be charged, must be complete within itself in every material detail and contain all of the essential elements of the agreement so that the contract can be ascertained from the writings without resorting to oral testimony.” Sterrett v. Jacobs, 118 S.W.3d 877, 879-80 (Tex.App.—Texarkana 2003, pet. denied). Note, however, that the contract need not be contained with the four corners of a single document. “A valid memorandum of the contract may consist of numerous communiques [or emails] signed by the party to be charged. . . .” Key v. Pierce, 8 S.W.3d 704, 708 (Tex.App.—Fort Worth 1999, pet. denied). For more information on the Statute of Frauds, see our companion web article on this subject.
There is another statute that may be applicable: Property Code section 5.021, sometimes referred to as the “Statute of Conveyances,” which states: “A conveyance of an estate of inheritance, a freehold, or an estate for more than one year, in land and tenements, must be in writing and must be subscribed and delivered by the conveyor or by the conveyor’s agent authorized in writing.”
Other Preferential Rights
There are similar preferential rights that also falls within this general category. One is a right of first negotiation (“ROFN,” sometimes called a right of first opportunity) which means exactly what the title suggests and no more. The seller is obligated to notify the holder of a ROFN of his intention to sell, and the holder will then have the right to negotiate and make an offer, which the seller is not obligated to accept. There is no mention of price and no obligation to conclude a deal. Another somewhat lesser right is a right of first offer (ROFO) which obligates the seller to notify a buyer of his intention to sell, and the buyer will then have the right to make an offer, the terms of which are not specified in advance. There is no right to negotiate ROFRs, ROFOs and ROFNs are potentially useful substitutes for a lease-purchase, but they must be carefully structured and worded so as not to fall into the executory conveyance trap.
Caution to Investors: Avoid the Courtroom
Preferential rights like ROFRs, ROFNs, and ROFOs, when properly written, have the advantage of avoiding the requirements and liability imposed upon executory contracts by the Property Code and the Deceptive Trade Practices Act. They are nonetheless creative techniques that may not be readily understandable by a jury. Combine this with the fact that real estate investors are often viewed as predators who exploit the weak, and the courtroom can become a dangerous place. Even if executory contract rules are inapplicable, a court can still look to DTPA Section 17.50(a)(3) which prohibits “any unconscionable action or course of action by any person”—a multi-edged weapon to say the least. Investors should find a good real estate lawyer, one with courtroom experience, and pay attention to what he or she says about how a judge or jury may react to a proposed deal and the documents that underlie it, particularly if the parties are significantly unequal in experience and expertise. A good lawyer knows that real estate documents should always be drafted as if one will someday have to defend them in court.
Information in this article is provided for general informational and educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. No attorney-client relationship is created by the offering of this article. This firm does not represent you unless and until it is expressly retained in writing to do so. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well.
Copyright © 2019 by David J. Willis. All rights reserved worldwide. Mr. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his web site, www.LoneStarLandLaw.com.