The remarkable strength of a right of first refusal

A right of first refusal, or ROFR, is a common clause in contracts. It’s also remarkably powerful: by giving one party exclusive access to a transaction before anybody else, an owner limits not just the actions of interested third parties, but also of themselves.

In this video, Torys litigators Andrew Bernstein, Jeremy Opolsky and Rachael Saab explain how businesses can deploy this powerful tool with appropriate care in their commercial contracts.

We discuss:

  • Why ROFRs make negotiations more complicated
  • What to watch for when drafting a ROFR
  • What happens if a ROFR is breached
  • The interesting link between ROFRs and good faith in contracts

Click here to see other videos in this series.

Andrew Bernstein (00:07): Hi everyone, and welcome to Torys' Commercial Disputes video series. I'm Andrew Bernstein, the host and moderator of this series. I'm delighted to have two of my colleagues from Torys' litigation department, Jeremy Opolsky and Rachael Saab. And today we're going to talk about rights of first refusal. So Jeremy, let's start with you. What is a right of first refusal in common law?

Jeremy Opolsky (00:28): A right of first refusal, or as I call it, and we might call it during this seminar, a "ROFR" are contractual rights to enter into a transaction before someone else can, effectively. Or anyone else. You often see them in real estate transactions, including in leases, but you can see them in any context, shares or other assets that parties are interacting with respect to the ownership of.And generally, a ROFR has three parties. They have the property owner, they have the third-party purchaser—a purported purchaser—and they have an option holder. And the ROFR is triggered when the owner wants to sell the property. It has an offer to sell it to a third party. And it has to go to the option holder and say effectively, "Do you want to buy this property on the same terms?"

Andrew Bernstein (01:14): Rachael, how is a right of first refusal or a ROFR, as Jeremy likes to call it, different from a right of first offer or a "ROFO"?

Rachael Saab (01:23): So the ROFO is different from the ROFR in that it only obliges the owner to engage in exclusive, good faith negotiations with the rights holder before negotiating with other parties. So it's a first offer, not a first refusal. This is a place where it's really important to clearly delineate the scope of negotiation contemplated by the ROFO in the contract. So what is required of each party?How long are negotiations going to be open for? You want to make sure that all of those things are clear in the contract. And similarly, it's also important to keep the scope of a ROFR in mind. For example, is the ROFR only over specific assets and if it's only over specific assets, does that extend to a change of control?And that's likely not the case unless it's specifically indicated in the ROFR, but it's important when you're thinking about a ROFR to ask those questions when you're drafting and considering your rights.

Andrew Bernstein (02:26): Yes, and another place that I see this sometimes is in the context of inter corporate transactions, where you don't really want to transfer the asset out of the company, but you want to transfer the asset from one corporate entity to another. Does it trigger the ROFR? When does it trigger the ROFR? Okay. So we've talked a little bit about drafting the ROFR, but talk about what happens when you come up against a ROFR.

Rachael Saab (02:48): Yeah. So lots of people give ROFRs, but it's something to be really cautious about. And you might think, well, this is no big deal because they can't stop me from selling ultimately. But the reality is that ROFRs can make everything a lot more complicated in a sale process. First, it can be hard to get a third party to negotiate for an asset that's subject to a ROFR.And that's obvious why that would be the case. Why would a third party put in all the time and effort to do that when someone can just swoop in and take the deal away from you? And second, once you have a third party agree on terms, everyone just wants to sign the deal. But there's usually a notice period where everyone has to wait until the ROFR holder decides whether they want to adopt the third party's terms or reject them.And you can bet there will be fights about what are the material terms and how much flexibility the ROFR holder has to amend the agreements. And lastly, if you're the third party who is up against a ROFR, you have to think about these things and ask yourself questions like, do I want to start here? How long am I willing to remain in limbo?And what might I be revealing about my business strategy when the ROFR holder sees the agreement as they ultimately will?

Andrew Bernstein (04:07): Thank you, Rachael. Jeremy, let's change the subject a little bit and ask this question, which is, are there circumstances in which being the owner of a ROFR can hurt you? It seems like ROFR, by its nature, is an option. So what would the problem be if you are an option holder?

Jeremy Opolsky (04:26): Well, Andrew, I don't know if it can hurt you, but I think the theme that you'll hear today is that courts interpret ROFRs substantively and they give them a lot of weight both ways. If parties are going to agree to a ROFR courts have generally felt, that it has to mean something. And since the three of us are litigators, let's talk a little bit about litigation where this has come up.It's come up recently at the Ontario Court of Appeal in a case called Goodlife Fitness and Rock Developments Inc. And there, there were intersecting or overlapping contractual provisions, a ROFR and a non-compete. And the court was asked to find or was asked whether the non-compete could be exercised after a ROFR had already been raised and not taken advantage of.In that case, Goodlife had a ROFR over a property, also a non-compete both from the landlord that he would effectively, if he was going to lease for another gym, he would give Goodlife the first offer, the ROFR, right of first refusal. And there was also a non-compete to not lease it to a different gym or wellness venture.Goodlife was given the ROFR and they declined to exercise the ROFR when the lease came up and the developer went out and leased it to another gym. Later, Goodlife then said that lease was void because it violated the non-compete. The Court of Appeal disagreed and they said that the non-compete did not take precedence and could not take precedence over the ROFR and prevent the competitor from leasing that gym, where Goodlife chose not to exercise the ROFR. And ultimately the Court of Appeal foundwas that the contractual provisions, like all contractual provisions, have to be read together. And for the ROFR to have the substantive weight it needed, you couldn't allow non-compete to effectively come in and give Goodlife a second kick of the can. The plain language of the ROFR should prevail. If Goodlife decided not to exercise its right to lease the property, then the landlord was free to give it to the party that had triggered the ROFR in the first place.

Andrew Bernstein (06:31): Huh. Interesting. Okay, so Rachael, ROFRs sound pretty powerful. What else should we know about them?

Rachael Saab (06:38): That's true, Andrew. They are pretty powerful. And in fact, there is a tendency to interpret any discretionary aspects of a ROFR in favour of the ROFR holder. And we saw this in a different decision from the Court of Appeal for Ontario, which restricted the application of a specific ROFR limitation, which on its face would terminate the ROFR if either the landlord or the tenant gave notice to terminate the lease. And the Court of Appeal in that case held that the landlord couldn't just terminate the leases to avoid the ROFR,and in fact, the provision was read in a way that the tenant was actually entitled to be given a chance to exercise the ROFR before the landlord was entitled to terminate the lease.

Andrew Bernstein (07:23): Okay. Jeremy, the way that Rachael's describing the treatment of ROFRs makes me think about the duty of good faith, which I know there's another video about in this series. So does this ring some bells for you?

Jeremy Opolsky (07:36): I mean, that's right Andrew. And our audience for this video should absolutely have watched the other video as well. But it's true what Rachael was talking about. Discretion is a broader theme in recent Canadian jurisprudence, that there is a general duty of good faith in all contracts. And the duty of good faith requires parties that hold discretionary powers not to deal with them in a way that is arbitrary or capricious, deal with them in a way that is reasonable.In the ROFR context we've seen courts interpret what that reasonableness means, is to give life to the ROFR itself. To give the parties what they bargained for in a real ROFR and not allow parties to use technical discretionary choices under the ROFR provisions to defeat the purpose of the ROFR itself. A party is a real option to exercise that right of first refusal and needs to be given a real substantive right to do so.

Andrew Bernstein (08:30): I hear that the panelists in that other good faith video are not only extremely smart and very articulate, but also very attractive.

Jeremy Opolsky (08:38): I heard they were terrible.

Andrew Bernstein (08:39): Oh, okay.

Jeremy Opolsky (08:40): I heard they were terrible.

Andrew Bernstein (08:41): Rachael?

Rachael Saab (08:41): I hadn't heard that, Jeremy.

Andrew Bernstein (08:42): Okay.

Rachael Saab (08:43): I heard Andrew's rumour.

Andrew Bernstein (08:44): Yeah. I guess people will have to watch for themselves and see—

Rachael Saab (08:46): Decide for yourselves.

Andrew Bernstein (08:47): Rachael, what happens if a party breaches a ROFR?

Rachael Saab (08:53): So the general rule of remedies is that a party gets damages unless it can demonstrate that specific performance is appropriate. And that rule applies in this context as well. But you do need to consider, in the case of a ROFR, the damages may be difficult to calculate in these circumstances. It's really difficult to assess in monetary terms the damage that a party has suffered by virtue of the lost opportunity to exercise a ROFR.

Jeremy Opolsky (09:21): Rachael is entirely right and the risk here for the party that is breaching the ROFR, often the property owner, is that specific performance could be ordered by a court. Specific performance is difficult to get, but the types of property that ROFRs are granted on generally—real property, shares—are the kind of property that have that uniqueness that can give way to a remedy in specific performance.

Jeremy Opolsky (09:49): So you could find yourself saying, "Well, I'll just provide the damages if the party loses the ROFR" if you're going to breach it as a property owner, and you could find yourself instead being ordered to convey that property at great cost to you as a result of the breach.

Andrew Bernstein (10:04): Right. And presumably, there's some risk for a third-party buyer who's buying the product, or sorry, the asset when they know of the ROFR.

Jeremy Opolsky (10:14): But because we're litigators, I should add, it's case dependent. You should consult your lawyer.

Rachael Saab (10:19): It depends.

Andrew Bernstein (10:20): It depends. Okay well, that's insightful. Any takeaways other than "It depends" before we wrap up, Jeremy?I think Andrew, as I mentioned before, if you're going to grant a ROFR, you just need to expect that it's going to be given a lot of substantive weight by a court. Courts aren't going to give way to technical arguments generally about you complied technically, effectively, and didn't give the other side a real right or an option to buy the property.

Jeremy Opolsky (10:49): So if you're going to enter into a ROFR as a property owner, know what you're doing, you could be making a mess and problems for yourself later down the road.

Andrew Bernstein (11:00): Rachael, last word to you—well except for my charming outro. So last substantive word to you.

Rachael Saab (11:05): I think I'm going to leave you with a tip that, as always, clear drafting is key, especially in this context. You want to ensure that the agreement identifies the terms on which the ROFR or the ROFO can be exercised. So think about specifying how long the offer is open for, whether the rights holder should be entitled to exercise the ROFR for a specific price or on specific terms.Just think through the steps that you would need to take in the ROFR process and make sure that those are clearly set out in the contract. Because if you end up in a dispute about the ROFR, this is going to help the court determine its scope and not going to leave that to the thorny area of discretion.

Andrew Bernstein (11:50): Okay. Well, thank you, Rachael and Jeremy, for sharing your insight with us today. Watch for the next video in the series, which will be coming soon. I'm Andrew Bernstein from Torys and thanks for joining us.

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This publication is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, we would be pleased to discuss the issues in this publication with you, in the context of your particular circumstances.

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