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Issue  192
Published:  11/1/2011

Case Tests Enforceability of Right of First Refusal
Chris Burti, Vice President and Senior Legal Counsel

Title insurers are regularly asked to insure over rights of first refusal (ROFR) contained in instruments in the chain of title of property to be insured. The North Carolina Supreme Court in Smith v. Mitchell, 301 N.C. 58 (1980) established that a reasonable right of first refusal is not void per se and they will be enforced by the courts. The Court in Smith created somewhat of a bright line test for reasonability by setting out a rule that in order to be deemed reasonable a ROFR must be limited in duration to a period within the Rule against Perpetuities and must include a price provision that links the price to the fair market value of the land, or to the price the seller is willing to accept from third parties.

Taylor v. Miller, COA10-1535, filed on September 20, 2011 is the most recent consideration of the issue of the enforceability of a ROFR and illustrates the risk of insuring over one without curative action or without a sufficient release by the proper parties.

The facts presented in the opinion drawn from the verified pleadings and undisputed or were found by the trial court and not challenged on appeal. The plaintiff's spouse was a party plaintiff to this action, but little further mention will be made solely for the purpose of simplifying the discussion of the opinion. The plaintiff husband and defendant were married in 1982 and separated in 1993. On June 17, 1994, they joined in the execution of a warranty deed to the plaintiff for the subject property. The deed, in evidence before the trial court, is reported as containing the following provision regarding the defendant's ROFR with respect to the lands in question.

"If Grantee [plaintiff] decides to sell Lot 3, Block or Square 90, as shown on the official map or plan of the Town of Morehead City of record in Map Book 1, Page 139, Carteret County Registry, he will communicate the full terms of any bona fide offer to the femme Grantor [defendant] by certified or registered mail, return receipt requested. She will then have ten (10) days from the date of the mailing [of] such notice in which to notify the Grantee herein that she will buy the property on the same terms and conditions as contained in the bona fide offer or for the sum of $41,500.00 plus the costs of all repairs and improvements (but not maintenance) made in/or on [sic] the premises from the date of this Deed to the date of the exercise of this right to repurchase by the femme Grantor herein. Grantee will keep careful records of all such repairs and improvements and will be paid only for those for which such records exist. If the femme Grantor does exercise her right under this provision, closing shall take place in Carteret County, North Carolina, within thirty (30) days of the mailing to Grantee above the notice by femme Grantor. If the femme Grantor does not keep the Grantee herein notified of a mailing address by which she can be reached, this right given in this paragraph to her shall terminate. If the femme Grantor herein does not exercise her right given in this paragraph within ten (10) days of the mailing of the notice to her as provided herein, her rights hereunder will terminate." (Emphasis omitted.)

Subsequently, the plaintiff conveyed the property to himself and his current wife in order to create a tenancy by the entireties. After that conveyance, in 2009, he wrote a letter to the defendant reminding her of the agreement, stating that the house was badly in need of repairs and that it was impossible for him to borrow any money on the property for the purpose of making repairs or improvements. He asked the defendant to "agree to forego any rights under that provision of the separation agreement" and she did not respond.

Thereafter he wrote another letter that explained, as quoted by the trial court: "'Enclosed you will find a Non-Warranty Deed from you to ...([the defendant's] son). He has been living in the house on Fisher Street for some years. It is my intention to convey this property to him. The house is beyond the point where it would be worthwhile to spend money on it to try to refurbish it. Therefore, the plan is to raze the house and build something new on it.'" (Emphasis omitted.) The letter further stated: "'I do not believe the provision in the separation agreement has any validity. Your execution of the enclosed non-warranty deed will clear the record.'"

The trial court entered a "Declaratory Judgment" that set out "11 findings of fact" and concluded that the plaintiffs were "not entitled to a declaration that the provision is invalid." The trial court then decreed that the ROFR "is VALID AND ENFORCEABLE." The court ordered that the counterclaim for specific performance would be calendared for disposition at a later date. The plaintiff's primary contention in the appeal was that the right of first refusal in the deed is a facially unreasonable restraint on alienation and that the trial court should have granted their motion for summary judgment and entered a declaratory judgment that the provision is not valid and enforceable.

The Court of Appeals in considering this contention observed that Smith v. Mitchell, 301 N.C. 58, 269 S.E.2d 608, (1980) "established that a right of first refusal clause is not void per se and will be enforced if reasonable." In Smith, the North Carolina Supreme Court explained that "the reasons courts uphold the nearest analog to preemptive rights, the option, are equally applicable to preemptive provisions." The Smith Court rejected the argument of the defendants' that a right of first refusal is always an unreasonable restraint on alienation and held that "[c]ertain such restrictions on alienability, if defined as preemptive rights and if carefully limited in duration and price, are not void per se and will be enforced if reasonable." Id. at 61, 269 S.E.2d at 610.

The Court of Appeals said that the North Carolina Supreme Court "explained that even though a preemptive right is a restraint on alienability, which is generally disfavored, 'the minimal interference with alienability presented by a preemptive right does little violence to the primary reason for prohibiting restraints on alienation in the first place, and should not be per se void.' Id. at 63, 269 S.E.2d at 611. Further, '[j]ust as the commercial device of the option is upheld, if it is reasonable, so too the provisions of a preemptive right should be upheld if reasonable, particularly here where the preemptive right appears to be part of a commercial exchange, bargained for at arm's length.' Id., 269 S.E.2d at 612.

Finally, the Court noted that a preemptive right is a useful tool for planned and orderly real estate development. Id. The Court concluded that '[t]o hold such a provision void per se [would be] an unnecessary limiting of the right of a developer and is in contradiction to a general trend to uphold restrictive covenants running with the land if those covenants are reasonable.' Id. at 64, 269 S.E.2d at 612."

As noted above, Smith also settled the question of how to determine whether a right of first refusal is unreasonable. This is accomplished by examining "[1] the duration of the right and [2] the provisions it makes for determining the price of exercising the right." In Smith, the Supreme Court determined it best to limit "the duration of the right to a period within the rule against perpetuities and thus avoid lengthy litigation over what is or is not a reasonable time within the facts of any given case" and held that "a reasonable price provision in a preemptive right is one which somehow links the price to the fair market value of the land, or to the price the seller is willing to accept from third parties."

The plaintiffs here argued that the ROFR was unenforceable because the price was not reasonable in that it is not actually linked to the fair market value or to the price the plaintiffs are willing to accept from a third party. The Court of Appeals observed that Supreme Court's opinion in Texaco, Inc. v. Creel, 310 N.C. 695, 314 S.E.2d 506 (1984), decided after Smith construed a fixed price option provision in a lease as entitling a party to specific performance. The 35 year old lease, provided for an option to purchase the leased premises for either the fixed price of $50,000.00 or for the same price as in a "bona fide third-party offer acceptable to the lessor". The Court of Appeals construed that provision as "materially indistinguishable from the right of first refusal in this case."

The Supreme Court held that Texaco was entitled to summary judgment on its specific performance claim notwithstanding the defendants' claim that enforcing the option "would place a ceiling of $50,000.00 on the price which the lessor could obtain for the property during the entire thirty years that the lease and its renewals were in effect thus depriving lessor of all appreciation in value." The Court of Appeals quoted the Supreme Court's explanation set forth partially as follows:

"We recognize the result of this interpretation of the lease is harsh if it deprives defendants of the appreciated value of their property which exceeds the fixed price. But, as stated earlier, in construing a contract we look not only at its language, but also at the situation of the parties at the time the contract was made..."

The Court of Appeals observed that the Supreme Court recognized that at the time of the agreement, the "parties had bargained for the fixed price option and determined it to be a reasonable figure..." and that there were obvious benefits to both parties in agreeing to a fixed price:

"It is also apparent from the lease that Texaco was concerned about a third party buying the property after it had improved the property and established a business. The lessors were most likely concerned about being in a position to induce lessee to buy the property at a price more advantageous than the fixed price option, should they no longer wish to have their asset tied up in a long-term lease. The first refusal provision thus served the purposes of both parties. In addition, the actual price set in the fixed price option was obviously a bargained-for sum. It is apparent from [two cases in other jurisdictions] that Texaco did not have a uniform price it insisted upon in the fixed price option. Given that the rent on the property was only $100 per month for the entire term of the lease, it is probable that the lessors viewed the $50,000 price as being reasonable even at the end of the lease term."

Thus, notwithstanding the language in Smith, Texaco established that an option and, therefore, preemptive rights, providing for a fixed price will not be intrinsically invalid. Citing Witt v. Disque, 79 A.D.2d 419, 426-27, 436 N.Y.S.2d 890, 895 (1981) the Court of Appeals opinion states that "the courts must look to the circumstances existing at the time the contract was made to determine whether the price is reasonable. In the event that the circumstances are disputed, then genuine issues of material fact exist that preclude summary judgment." The New York Court of Appeals in Witt reversed the trial court's summary judgment order that had concluded that a fixed-price option to repurchase was void as unreasonable restraint on alienation. The North Carolina Court of Appeals adopted the reasoning of New York's highest court where it held that "(1) that reasonableness of option terms had to be determined by all circumstances at time of creation of option and (2) that bare documents relating to option were not sufficient to assess reasonableness of price because they did not establish facts relating to nature of relationship between parties, precise nature of transactions, relationship of parties to property at time of execution of option, or reason behind option terms."

Applying Texaco and adopting the reasoning of Witt, the Court of Appeals agreed with the trial court that the Taylors were not entitled to summary judgment, but disagreed with the trial court's determination as a matter of law that the right of first refusal was valid and enforceable, reversed the judgment and remand to determine the issues of material fact as to whether the right of first refusal is reasonable. The balance of the opinion deals with the dearth of evidence in the record on appeal necessitating the remand to the trial court.

It should be noted that as the ROFR which gave rise to this litigation was contained in a deed executed on 17 June 1994. In 1995 the North Carolina Legislature adopted the Uniform Statutory Rule against Perpetuities in Article 2 of Chapter 41 and in Article 3, it enacted Time Limits on Options in Gross and Certain Other Interests in Land. N.C.G.S. Section 41-29 states that "a preemptive right in the nature of a right of first refusal in gross with respect to an interest in land becomes invalid if it is not actually exercised within 30 years after its creation." Article 3 is not applicable to interests created before October 1, 1995 pursuant to N.C.G.S. Section 41-33 and was properly not considered by the Court of Appeals in this case. It should thus be noted that the rule established in Smith has been altered significantly by the legislature by codifying a "wait and see" approach to invalidity where an instrument containing a ROFR executed after the statute's effective date does not limit its effectiveness to a 21 year period as enunciated in Smith.



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