Right of first refusal: the wrong solution

We have often cautioned clients against agreeing to grant rights of first refusal, as distinct from options.  Our concerns have been brought into vivid relief by a recent decision of the English High Court, in the case of AstraZeneca UK Limited v Albemarle International Corporation and Albemarle Corporation [2011] EWHC 1574 (Comm).

The case was decided last week in the Commercial Court, by Flaux J.  Albemarle and AstraZeneca (AZ) were parties to a supply agreement under which Albemarle agreed to supply to AZ its requirements for a chemical (2,6 Di-isopropyl-phenol, or DIP), which AZ used in the manufacture of propofol, the active ingredient of an anaesthetic which AZ marketed under the brand name, Diprivan.  Readers may recall that propofol is one of the drugs that Michael Jackson’s doctor is reported to have administered to him in the hours before his tragic death.

Clause H of the supply agreement contemplated the possibility that AZ would change its purchasing arrangements.  It provided as follows:

In the event that at any time BUYER reformulates or otherwises changes its Diprivan brand to substitute propofol for the PRODUCT, BUYER will so notify SELLER and will give SELLER the first opportunity and right of first refusal to supply propofol to BUYER under mutually acceptable terms and conditions.

The key words in this clause are “the first opportunity and right of first refusal”.  We have always understood the distinction between an option and a right of first refusal as follows (in summary):

  • if A grants B an option to acquire rights, B has control over deciding when to exercise the option (subject to any time limits in the terms of the option).
  • if A grants B a right of first refusal, A has control over whether to grant the rights.  If it chooses to do so, and finds a third party buyer, before signing an agreement with the third party, A must offer the same terms to B.  If B accepts, A must enter into an agreement with B and not with the third party
  • the expression right of first opportunity is more nebulous than either of the above expressions, and its general meaning is unclear.  It could, for example, mean simply that A will notify B of its intention to award a contract and invite B to make an offer, but have no obligation to accept it.  We would avoid this expression unless the mechanism is set out in detail in the contract.

In this case, AZ decided to buy in propofol rather than make it from DIP.  They had discussions with Albemarle about the possibility of Albemarle supplying propofol, but they chose another supplier.  Flaux J’s judgment describes the sequence of events leading up to the award of the new contract in detail, and concludes that AZ failed to comply with the clause.

The factual detail of the case is perhaps less important than some general principles that can be gleaned from the judgment.  In the following comments, A is the party that has the obligation to grant a right of first refusal, and B is the beneficiary of that right.

  1. There was some brief discussion in the judgment of whether a “right of first opportunity” is binding.  Flaux J dealt only briefly with this issue, as in the present case the key words were “right of first refusal”.  The judgment does not tell us whether a right of first opportunity, on its own, is legally binding.
  2. Flaux J’s analysis of a right of first refusal coincides with our understanding of the term.  When A is minded to accept a third party offer, A is under an obligation to disclose full details of the offer to B and give B the opportunity to match the offer.  If B matches the offer, A is obliged to accept it rather than the offer from the third party.
  3. A question arose in this case as to when the right of first refusal arose.  AZ took the decision to appoint a third party supplier many months or years before the final contractual arrangements would be put in place, partly because regulatory approval would need to be obtained for the new supplier.  Flaux J decided that “the only sensible commercial construction” was that the right arose when AZ took the decision to appoint the third party.

Other points of law were discussed in the case, but are not directly relevant to this posting.

In our experience, rights of first refusal are problematic.  Take the example of a right of first refusal, contained in a licence agreement in respect of Field 1 (the field of cancer).  A (the licensor) grants B (the licensee) a right of first refusal in the event that A decides to license the product in Field 2 (eg as a hair-restoration product).

A decides to license in Field 2 and has preliminary discussions with several parties, including B.  B shows mild interest but its proposed terms are not competitive.  A’s primary licensing candidate is C; A and C start serious negotiations.

When should A tell C about the right of first refusal?  At the outset of negotiations (in which case C may not be interested in investing time and money in months of due diligence and negotiations)?  Or only when B exercises the right of first refusal (which will take C by complete surprise, and may make them very angry about A)?

Neither of these solutions is attractive.  Whilst rights of first refusal may work for supply agreements (if the parties want them to work), they don’t really work for IP licensing.  IP licensing is usually not a cold-hearted financial transaction; people need to believe in the product and the IP and to commit to its development.  Consequently, they are likely to feel “let down” if the rug is pulled from under their feet, at the 11th hour of the negotiations, by a third party’s right of first refusal.

It is clear from the AstraZeneca case that even in something as routine as a supply agreement, parties have non-financial selection criteria for their contracting partners.  Flaux J refers to AZ managers stating that the third party supplier would provide a better service, and that AZ would have an advantage in dealing with the third party as AZ would be their major customer.

Even if viewed on a purely financial level, rights of first refusal are problematic for the grantor.  As the AstraZeneca case demonstrates, party B has no incentive to offer its best price in the preliminary discussions, as it has a second bite at the cherry when the first of first refusal operates.

If we had been advising AZ on the right of first refusal in this case, we would have pointed out the dangers of accepting such a provision.  (We have not acted for AZ, but we have advised other clients on contracts with AZ.  Our experience has been that AZ is one of the “good guys” in the pharmaceutical sector, so we were surprised by some of the findings of fact in the present case.)

If, despite our advice, AZ wished to include the term, we would have recommended more detailed provisions that fleshed out the exact circumstances in which the right of first refusal would arise, including when it would arise, what criteria would be considered to “match” the third party offer, and so on.  For example, we have negotiated agreements in which the right operates at the stage of signing a non-binding term sheet.

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Filed under Contract drafting, General Commercial

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