Rethinking Rights of First Refusal

Abstract

As typically employed, the contract provision known as the right of first refusal provides the grantee with a contingent option to purchase an asset if the grantor elects to sell. Conventional wisdom teaches that rights of first refusal are employed to avoid a costly future breakdown in bargaining between the grantor and the grantee and to guard against a sale to an undesirable party. In this Article I argue that the traditional justification is faulty. Because the provision deters potential buyers, the right of first refusal is costly for the contracting parties, and, if the sole aim of the contracting parties is to eliminate a future breakdown in bargaining, that goal can be achieved at a lower cost by committing to a paper auction. Having rejected the traditional justification, I go on to argue that the real motivation behind the adoption of rights of first refusal, at least in co-venturing relationships, must be a desire to inhibit the unilateral departure of a participant. I also argue that the use of rights of first refusal in other relationships, such as the lessor/lessee relationship, may be explained as an example of suboptimum standardization of contract terms. I conclude with a few thoughts concerning the implication of this analysis for private contracting and for legislatures that are considering mandating rights of first refusal.