Insights

A harmless-looking right of first refusal in a borrower’s deed can cause major headaches for a foreclosing lender.

A right of first refusal is an agreement between a person who wants to buy property that is not for sale and the owner of the property. The agreement typically grants the prospective buyer the option to buy the property after the owner receives an offer to purchase from a third party. But what happens when the property is sold at a foreclosure sale – does the prospective buyer have the right to step in and asset the right of first refusal?

According to a recent case, the answer depends on the language of the right of first refusal agreement.

James and Norma Fleagane sold property to Dale and Deborah Michael. The deed contained the following repurchase option and right of first refusal language:

• The Sellers [the Fleaganes] shall have the prior right to purchase or repurchase this property for the sale price of $275,000.00, plus the verifiable cost of improvements made to the premises by the purchasers; in no event shall the total repurchase price exceed the sum of $425,000.00 unless mutually agreed to by the parties. Sellers shall have this right for a period of 50 years to the date of this deed, and this right shall be enforceable by the Sellers, or their direct descendants, or assigns. Sellers shall give Purchasers 120 days notice of their intention to exercise this right.
• Sellers [the Fleaganes] shall also have the right of first refusal; the Purchasers [the Michaels] shall present to the Sellers any written contract binding all parties for the sale of this property, and resulting from an “arms-length” negotiation, which Purchasers receive for the sale of this property, and for which the Sellers shall have 30 days within which to elect to purchase the property at the price offered by the prospective buyer. They shall then have an additional 30 days to close the transaction.

The Michaels obtained a mortgage loan from Novastar Mortgage, secured by the property. The mortgage was assigned to Wells Fargo Bank, N.A. The Michaels defaulted, and Wells Fargo started the foreclosure process, but failed to include the Fleaganes. The Michaels did not respond, and Wells Fargo moved for a default judgment. Wells Fargo amended the complaint and added the Fleaganes, who filed an answer asserting the two covenants as affirmative defenses to the action. The trial court held that, as to the Fleaganes, both covenants survived foreclosure. Wells Fargo appealed, arguing that the right of repurchase did not survive foreclosure and the right of first refusal could not be invoked in a foreclosure.

The Court of Appeals of Ohio reversed and remanded, holding that the repurchase option did not run with the land and, therefore, did not survive foreclosure and that foreclosure was not a contractually drafted triggering event for the right of first refusal.

The appellate court determined that the repurchase option was not a restrictive covenant because there was no intent in the language of the contract for the covenant to run with the land, and the drafted language did not indicate its application to subsequent purchasers. Also, because the drafted language of the right of refusal failed to include foreclosure as a triggering event, the right of first refusal did not survive foreclosure. The appellate court cited similar decisions from courts in Connecticut, New York, Texas, Washington and Iowa, all concluding that the right of first refusal language applied only to an “arms-length” or consensual sale. As a result, the right of first refusal was not triggered by a foreclosure sale.

However, the appellate court was clear to note that foreclosure may be a triggering event for a right of first refusal if the covenant was drafted to include such language. As a result, a lender should make sure to review any right of refusal agreement that affects its real property collateral.

Wells Fargo Bank, N.A. v. Michael, 2013 Ohio App. LEXIS 2486 (Ohio App. June 10, 2013).

Crystal Gray is an associate of Hudson Cook, LLP, in the firm’s Washington, D.C., office. Crystal can be reached at 202-327-9702 or by email at cgray@hudco.com.