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The Constitutionality of the Right of First Refusal

First Refusal

A question that continues to plague the Indian judiciary is whether First Rights of Refusal are an essential part of lease agreements and whether the nature of such covenants will make it void prima facie or whether the Courts must examine the extent of restriction created by it. A First Right of Refusal (FRR) is a contractual right that gives its holder the option to enter a business transaction with the owner of something, according to specified terms, before the owner is entitled to enter into that transaction with a third party.

The FRR stipulation as a restraint in trade would depend on whether such a condition restricts the other party from carrying out trade as it would like to out with free will which would make it invalid. When issuing the judgement in Mclnerney v Slights (1988 Del Ch LEXIS 47) case in United States, the concerned court in the state of Delaware state held the view that the party asserting that a pre-emptive right (FRR) is invalid bears the burden of proof as to the intent of the parties. Thus, the burden of proof will typically fall on the party seeking to establish an interpretation contrary to the default.

FRR clause is usually drafted as: “Further, the lessor hereby agrees that during the tenure if three years following the initial tenure of three years of the lease, i.e., during the 4th and 5th year of the initial lease term and subject to the lessee shall be entitled to a onetime first right of refusal to take on lease any floor (or portion thereof), wherein such space has been offered to be taken on lease by a competitor. The terms so offered to the lessee under the FRR shall be no less favourable than that being offered to the said competitor.” Thus, it is clear that such a FRR is specific in its verbatim and must depend on the presence of certain conditions which bind the parties to the agreement and a third party with whom a future agreement was to be made.

In Percept D’Mark (India) Pvt. Ltd. V Zaheer Khan and Anr (2006 4 SCC 227), the aggrieved respondent had agreed to a right of first refusal in favour of the appellant which extended beyond the term of the agreement, the apex court considered such a contract for personal services to be void and concluded that any restriction extending beyond the term of a contract is clearly hit by section 27 of the Contract Act, and is void. Accordingly the Supreme Court held that “Clause 31(b) contains a restrictive covenant in restraint of trade as it clearly restricts respondent No. 1 from his future liberty to deal with the persons he chooses for his endorsements, promotions, advertising or other affiliation and such a type of restriction extending beyond the tenure of the contract is clearly hit by Section 27 of the Contract Act and is void.

Applying the principles of the case it is clear that for as long as a FRR condition is placed within the terms of the contract and within the tenure of force of the contract, it will be valid. It is clear that as per any FRR clause of an agreement, the party claiming this right may choose to exercise his right within the initial tenure of the agreement or may at its sole option renew the lease agreement for a further term of a reasonable amount as agreed by both parties lawfully by giving sufficient notice prior to expiry of the initial lease term. This means that a lease deed containing a FRR is subject to be extended by another term and to it, the FRR becomes a part of the terms of the original agreement between the parties. When the FRR clause specifies that such a right must be available during the specific years of the contract and during any extended term if so decided, it means that this condition is in force during the tenure of the initial agreement as well as during the tenure of the extended lease which will come into force based on the terms of the agreement. If this term is deemed to be reasonable by the Courts, the FRR will not be creating a restriction beyond the term and tenure of the agreement and is valid. Thus, by principle the validity of such conditions in Indian law must be examined while limiting it with the conditions and terms of its parent agreement.

Since the FRR is a pre-emptive right to purchase in advance of all others on specified terms, it is only triggered if the owner decides to sell. The FRR allows the right holder to purchase at the same price offered by a third party. However, parties may sometimes arrange a “fixed price” right of first refusal that permits the right holder to pre-empt a third party at a prearranged price, even if the third party offers a higher price. If a party bound by such a right goes on to sell his property to a third party without offering it to the party who holds the right, it will be in violation of the FRR clause since the moment the owner of the said property who becomes the respondent in a lawsuit brought against them sold the ground floor of the property for the operation of CWSPL, it violated the conditions of the FRR since the FRR was triggered in the year when he decided to sell, which was before the agreed term of the FRR.
Understanding this limitations created, we must understand that such FRRs must never be deemed as prima facie invalid because even if it creates a restriction on a business from preventing the business from receiving or selling the said property, every such act is done with an intention which could also be to further trade and improve the socio-economic strength of such a market space because of which if the FRR in such a case was immediately struck down, the Courts would in turn be defeating the purpose of Article 19 of the Constitution which is to protect the citizens’ right of trade and profession.

– Contributed by Dylan

Picture: Representational Image Only (Credits – ipleaders.in)



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