I have just received an otherwise desirable offer on one of my listings. Unfortunately, it is not clear whether the purchaser will be able to qualify for the loan. My seller is inclined to accept the offer, but wants to preserve the flexibility of replacing this first purchaser with another one, if a better offer comes along. How can I put a “first right of refusal” in the contract?
It is important to understand that in most of these situations, neither the listing broker nor seller desire a true “first right of refusal.” A true first right of refusal would give the buyer the ability to meet or beat the terms of a bona fide offer from a competing buyer of the property.
Yet, financial terms are rarely an issue in these matters. Rather than creating rights in buyers, sellers wish to give themselves the right to terminate the contract with the first buyer (to move on to a better purchaser) unless the first buyer removes all or some of the contingencies in the contract. It would be more accurate to label these clauses as “kick out” clauses and, for purposes of this answer, we will refer to such clauses as “kick out” clauses.
There are certain issues which all good kick out clauses must address. A kick out clause provides that upon the occurrence of some event (seller’s acceptance of a new offer, seller’s notice to purchaser of its intent to accept a new offer . . . etc.) that the purchaser has a specific period of time to act to avoid being “kicked out” of the contract. Any kick out clause must specify precisely what the seller must do to invoke its rights under it. Must seller accept a new offer? Must seller simply notify the purchaser of its intent to accept an offer? Must that notice be in writing? How much time does the purchaser have to perform?
A kick out clause should also address what the purchaser must do to avoid being “kicked out.” There are essentially three types of kick out clauses. One would require that upon the seller’s invocation of its kick out rights, the purchaser must close within a short period of time. The second type requires that upon the seller’s invocation of the kick out rights that the purchaser waive all of the purchaser’s contract contingencies. The third type of kick out clause merely requires the purchaser to waive some, but not all, of the contingencies to avoid being “kicked out.”
Conceptually, the first type of kick out clause is simplest to draft. The purchaser either closes or does not close within the specified time. If the purchaser does not close, the first contract terminates, and the purchaser (typically) receives a return of its earnest money. The second and third scenarios are more complicated.
While the second scenario is easy to draft, the language may create some false expectations in your seller. The purchaser may waive all of its contingencies in a contract, but still not have the practical ability to close. If a purchaser is buying your listing with new financing, it needs to qualify for a loan. If it has waived its financing contingency, but can’t qualify for the loan, it is unlikely that the contract will close. Your seller may be limited to pursuing the seller’s breach remedies. With the Real Estate Commission approved form, this will always include withholding of the earnest money. As a practical matter, with a back-up contract ready to replace the “kicked out” contract, sellers will be reluctant to bring a specific performance lawsuit against the first purchaser. Consequently, with this second type of kick out clause, it is especially important that the amount of earnest money be sufficient to satisfy your seller in the event the first contract doesn’t close. To avoid a subsequent earnest money dispute, the kick out clause could also require the buyer to authorize the release of the earnest money to the seller upon waiving all of its contingencies in the contract.
The third type of kick out clause (in which the buyer waives some, but not all, of its contingencies) is the one most likely to create false expectations in your seller. For example, a contract might contain a property inspection contingency which the purchaser waives after the seller invokes its kick out rights. Yet because interest rates have gone up, the purchaser can’t get the financing it initially wanted. In spite of the fact that the purchaser might be able to get financing at a higher rate, the purchaser would be entitled to terminate the contract pursuant to the financing contingency and receive a refund of its earnest money. This often disappoints a seller who thinks that there is a “firm” deal after invoking the kick out rights.
The emotional environment in which these cases unfold compounds the scrutiny with which the parties’ attorneys will review your drafting. Instead of being disputes amongst two parties (seller and purchaser), they are often disputes involving at least three parties (seller and two purchasers). There may also be two brokers working with the separate buyers who have a co-op commission at stake in the outcome of the dispute. Tempers and emotions flare, especially in purchasers who have missed out on other properties. In light of this, special care should be taken to draft these clauses carefully.
A version of this article appeared in the Colorado REALTOR® News, the monthly publication of the Colorado Association of REALTORS®.