Category Archives:Corporate Litigation

Court Decision May Undermine Enforceability of Contracts

By Carol L. Newman

Introduction

Imagine that your client presents you with the following set of facts:

· The client sold its existing business, a motel chain, to a competitor;
· Both the client and the competitor were represented by major law firms in the transaction;
· The client, through its counsel, clearly disclosed as a condition of the sale that it intended to open a new chain of motels, which would compete directly with the buyer of its existing business;
· Accordingly, the purchase agreement provided in precise language that the seller-client could not compete with the buyer for 2 years within one mile of an existing motel that was part of the sale;
· The purchase agreement was heavily negotiated by top lawyers at these major law firms, went through several drafts (all of which contained the above language regarding competition), and cost a great deal of money (hundreds of thousands of dollars) to perfect;
· The purchase agreement not only contained an integration clause but was a model of completeness and thorough lawyering;
· Nevertheless, after the sale closed, the buyer claimed that the seller had fraudulently promised before the transaction closed that the seller would never compete with the buyer – effectively negating the “2-years-within-one-mile” limitation on the non-competition provision in the purchase agreement. The buyer then sued the seller-client to put its new motel chain out of business.

This was an actual case in which I was one of the lawyers representing the seller. At the time this case was decided 20 years ago, the arbitrator ultimately awarded summary judgment to the seller on the grounds that the claim of promissory fraud could not succeed as a matter of law because the alleged fraudulent promise contradicted the express and precise language of the purchase agreement, relying on the California Supreme Court’s decision in Bank of America v. Pendergrass (1935) 4 Cal.2d 258.

That same result might not be possible today. In Riverisland Cold Storage, Inc. v. Fresno-Madera Production Credit Association (Jan. 14, 2013) 55 Cal.4th 1169, 151 Cal.Rptr.3d 93, the Supreme Court expressly overruled Pendergrass and its progeny as having been “poorly reasoned” (151 Cal.Rptr.3d at 101) and “an aberration” (151 Cal.Rptr.3d at 103), and held that the parol evidence rule does not bar evidence of alleged fraudulent promises even if they are clearly inconsistent with the express terms of a written agreement. This decision represents a fundamental change in California law which threatens the certainty of contracts and has the potential of allowing contracting parties to successfully challenge contracts which they did not read or did not bother to try to understand – or which they did understand and simply wish to avoid. Indeed, it eviscerates the parol evidence rule and offers little guidance to businesses as to how to assure that their contracts are respected.

The Parol Evidence Rule

An understanding of the basic principles of the parol evidence rule is necessary in order to understand the impact of the Riverisland case. Despite the fact that the rule is called the “parol evidence rule,” it is a rule of substantive law. Riverisland, 151 Cal.Rptr.3d at 96. Code of Civil Procedure Section 1856(a)[1] states:

Terms set forth in a writing intended by the parties as a final expression of their agreement with respect to such terms as are included therein may not be contradicted by evidence of any prior agreement or of a contemporaneous oral agreement.

However, there are several exceptions to this rule, including subsection (f), which permits evidence to be introduced “[w]here the validity of the agreement is the fact in dispute,” and subsection (g), which states:

This section does not exclude other evidence of the circumstances under which the agreement was made or to which it relates . . . or to explain an extrinsic ambiguity or otherwise interpret the terms of the agreement, or to establish illegality or fraud.

As the Supreme Court states in Riverisland, California always recognized a fraud exception to the parol evidence rule. 151 Cal.Rptr.3d at 101. However, this exception was never consistently applied, nor should it have been.

The Pendergrass case

Pendergrass was a lawsuit by a lender to collect on a promissory note executed by its borrowers. In that case, after the borrowers fell behind on their loan payments, they entered into a new promissory note which was secured by additional collateral and payable on demand. Shortly thereafter, the lender seized the collateral and sued on the note. The borrowers raised the defense, among others, that the new note had been obtained by fraud because the lender had promised to postpone all payments for a year.[2]

The Supreme Court held that “[o]ur conception of the rule which permits parol evidence of fraud to establish the invalidity of the instrument is that it must tend to establish some independent fact or representation, some fraud in the procurement of the instrument or some breach of confidence concerning its use, and not a promise directly at variance with the promise of the writing.” 4 Cal.2d at 263 (emphasis added). The alleged evidence that the lender had promised to postpone all payments for a year directly contradicted the unconditional promise in the new note to pay the money on demand. Therefore, the Court held that the parol evidence rule barred the admission of such evidence. 4 Cal.2d at 263-264.

The Pendergrass case was an effort to harmonize the fraud exception with the parol evidence rule – to avoid having the exception swallow the rule. If contracting parties are allowed to make claims that false promises were made to them which contradict explicit terms of the contract, they will have little incentive to read the contract. It is good policy to encourage contracting parties to read what they are agreeing to, and to require them to seek advice if they do not understand it. It is also good policy that if the written agreement in fact contradicts what was allegedly promised, the contracting parties should be encouraged to discuss the contradictions before either side relies on the contract. If a party signs a contract knowing that it says something different than what was promised, that party may not be able to prove that it reasonably relied upon what was allegedly promised.

The Pendergrass rule was criticized by some courts and commentators for allegedly providing a shield for fraudulent conduct. Nevertheless, it was the law in California for nearly 80 years.

The Riverisland Case

Like Pendergrass, Riverisland involved loan borrowers who fell behind in their payments and restructured their debt to the lender in a written agreement. The written agreement provided that the lender would take no enforcement action for 3 months if the borrowers made their payments. Additionally, in the written restructuring agreement the borrowers pledged additional collateral, 8 separate parcels of real property, and initialed pages of the agreement containing the legal descriptions of those parcels.

The borrowers failed to make the required payments, and the lender began foreclosure proceedings. The borrowers repaid the loan and sued the lender for damages, claiming that two weeks before the new written agreement was signed, the lender’s vice president had told them the lender would extend the loan for two years in exchange for additional collateral consisting of 2 parcels. They further claimed that when they signed the new agreement the vice president assured them that its term was 2 years and the 2 parcels were the only additional security. Significantly, the plaintiffs admitted that they had not read the new agreement when they signed it.

The lender moved for summary judgment, and the trial court granted the motion, relying on Pendergrass. The Court of Appeal reversed, holding that Pendergrass is limited to cases of promissory fraud, but false statements as to the contents of the agreement were not false promises, but rather factual misrepresentations, and therefore actionable. 151 Cal.App.3d at 95-96. The Supreme Court granted the lender’s petition for review.

The Supreme Court discussed at length, among other things, the parol evidence rule, the Pendergrass case, prior decisions of the Supreme Court, subsequent cases’ treatment of Pendergrass, criticism of Pendergrass, defenders of Pendergrass, and the revisions to Section 1856 in 1978 which omitted any mention of Pendergrass.[3] The Court stated:

Accordingly, we conclude that Pendergrass was an aberration. It purported to follow section 1856 . . . but its restriction on the fraud exception was inconsistent with the terms of the statute, and with settled case law as well. Pendergrass failed to account for the fundamental principle that fraud undermines the essential validity of the parties’ agreement. When fraud is proven, it cannot be maintained that the parties freely entered into an agreement reflecting a meeting of the minds. Moreover, Pendergrass has led to instability in the law, as courts have strained to avoid abuses of the parol evidence rule. The Pendergrass court sought to “prevent frauds and perjuries” . . . but ignored California law protecting against promissory fraud.

The fraud exception has been part of the parol evidence rule since the earliest days of our jurisprudence, and the Pendergrass opinion did not justify the abridgment it imposed. For these reasons, we overrule Pendergrass and its progeny, and reaffirm the venerable maxim stated in Ferguson v. Koch, supra, 204 Cal. At page 347, 268 P. 342: “[I]t was never intended that the parol evidence rule should be used as a shield to prevent the proof of fraud.”

151 Cal.Rptr.3d at 103.

Parol Evidence Rule v. the Statute of Frauds

Nearly 30 years ago, the Supreme Court had taken what it called “a similar action” (151 Cal.Rptr.3d at 103) in Tenzer v. Superscope, Inc. (1985) 39 Cal.3d 18, in which the Court overruled Kroger v. Baur (1941) 46 Cal.App.2d 801, and held that a fraud action is not barred by the statute of frauds. The Supreme Court addresses that decision briefly in Riverisland, stating that “[c]onsiderations that were persuasive in Tenzer also support our conclusion here. . . . The Tenzer court noted the principle that a rule intended to prevent fraud, in that case the statute of frauds, should not be applied so as to facilitate fraud.” (Id., citing 39 Cal.3d at 29.)

Since then, some commentators have predicted that the Supreme Court might eventually apply the same reasoning to the parol evidence rule. However, in Riverisland the Court has not limited its ruling to cases in which damages are sought, but has established a much broader principle.

Moreover, the policy considerations between the statute of frauds and the parol evidence rule are very different. The statute of frauds merely seeks to assure that competent evidence of certain discrete types of agreements will be presented to the Court and the trier of fact. The parol evidence rule, on the other hand, applies to all integrated written agreements. Riverisland affects many more agreements than does the statute of frauds. Now any allegation that any written agreement, no matter how expertly negotiated, was induced by fraudulent promises or representations will be admissible. Riverisland is potentially a much more far-reaching decision than Tenzer ever was or will be.

Suggestions for Counsel Negotiating Contracts

As indicated above, Riverisland makes it more difficult to determine whether a written contract will be enforceable in the face of an allegation that it was procured by a false promise. As the Supreme Court recognized in Riverisland, it makes no real difference whether the allegation is that the contract was procured by a false promise or that the contents of the contract were factually misrepresented. That is a false distinction without a difference. 151 Cal.Rptr.3d at fn 7. Riverisland expands exponentially the evidence a breaching party may introduce to try to invalidate a contract.

The Supreme Court’s decision gives cold comfort to counsel seeking some certainty in this regard:

Here, as in Tenzer, we stress that the intent element of promissory fraud entails more than proof of an unkept promise or mere failure of performance. We note also that promissory fraud, like all forms of fraud, requires a showing of justifiable reliance on the defendant’s misrepresentation. (Lazar v. Superior Court, supra, 12 Cal.4th at p. 638 . . .) The [defendant] contends the [plaintiffs] failed to present evidence sufficient to raise a triable issue on the element of reliance, given their admitted failure to read the contract. However, we decline to decide this question in the first instance. The trial court did not reach the issue of reliance in the summary judgment proceedings below, nor did the Court of Appeal address it.

151 Cal.Rptr.3d at 104.

As experienced business lawyers know, allegations that a contract was obtained by fraud are fairly common in business cases. This decision renders it more likely that parties seeking to enforce contracts will be put on the defensive. Breach of contract cases are more likely to turn into tort cases in which tort damages are recoverable — against the plaintiff rather than the defendant. Additionally, trial courts may be less willing to award summary judgment to plaintiffs, as the question of whether or not reliance is justifiable is ordinarily a question of fact. OCM Principal Opportunities Fund v. CIBC World Markets Corp. (2007) 157 Cal.App.4th 835, 864.

It is disappointing that the Supreme Court expressed no opinion that a party – especially a sophisticated party– should at least read the contracts it signs.[4] While the Court may have wished to overrule Pendergrass, it picked an unfortunate case in which to do so. Moreover, the Court neglected to address Civil Code Section 1625, which unequivocally provides that “[t]he execution of a contract in writing, whether the law requires it to be written or not, supersedes all the negotiations or stipulations concerning its matter which preceded or accompanied the execution of the instrument.”

Business lawyers will be assessing the effect of Riverisland going forward. Counsel should take any actions they can take to establish, at the very least, that the promisor cannot claim it reasonably and justifiably relied on anything claimed to have been said outside the four corners of the contract. At the very least, before the contract is signed, counsel should assign a competent witness to explain the material terms of the contract to the opposing party either in person or in writing, and the opposing party should acknowledge in writing in some fashion that the material terms of the contract were explained before the contract is signed.


[1] Hereafter all references are to the Code of Civil Procedure unless otherwise stated.

[2] Another defense raised, not relevant here, was violation of the one-action rule. Section 726.

[3] The modified statutory formulation adopted the Supreme Court’s liberalization of the rule as set forth in such cases as Masterson v. Sine (1968) 68 Cal.2d 222, and Pacific Gas & Electric Co. v. G.W. Thomas Drayage Co. (1968) 69 Cal.2d 33.

[4] In footnote 11, the Court addresses its own opinion in Rosenthal v. Great Western Financial Securities Corp. (1996) 14 Cal.4th 394, in which the Court ruled that negligent failure to read a written agreement precludes a finding that the contract is void for fraud in the execution. (14 Cal.4th at 423.) “Fraud in the execution” means that the party does not know what it is signing, or does not intend to enter into a contract at all. Rosenthal, 14 Cal.4th at 415. Generally, in contract litigation the party alleging fraud is not alleging fraud in the execution, but rather fraud in the inducement, in which the signing party knows what it is signing but its consent is induced by fraud. Id. The Supreme Court said in footnote 11 of Riverisland that “[w]e expressed no view in Rosenthal on the ‘validity’ and ‘exact parameters’ of a more lenient rule that has been applied when equitable relief is sought for fraud in the inducement of a contract. . . . Here as well we need not explore the degree to which failure to read the contract affects the viability of a claim of fraud in the inducement.”

de of Civil Procedure unless otherwise stated.

[1] Another defense raised, not relevant here, was violation of the one-action rule. Section 726.

[1] The modified statutory formulation adopted the Supreme Court’s liberalization of the rule as set forth in such cases as Masterson v. Sine (1968) 68 Cal.2d 222, and Pacific Gas & Electric Co. v. G.W. Thomas Drayage Co. (1968) 69 Cal.2d 33.

[1] In footnote 11, the Court addresses its own opinion in Rosenthal v. Great Western Financial Securities Corp. (1996) 14 Cal.4th 394, in which the Court ruled that negligent failure to read a written agreement precludes a finding that the contract is void for fraud in the execution. (14 Cal.4th at 423.) “Fraud in the execution” means that the party does not know what it is signing, or does not intend to enter into a contract at all. Rosenthal, 14 Cal.4th at 415. Generally, in contract litigation the party alleging fraud is not alleging fraud in the execution, but rather fraud in the inducement, in which the signing party knows what it is signing but its consent is induced by fraud. Id. The Supreme Court said in footnote 11 of Riverisland that “[w]e expressed no view in Rosenthal on the ‘validity’ and ‘exact parameters’ of a more lenient rule that has been applied when equitable relief is sought for fraud in the inducement of a contract. . . . Here as well we need not explore the degree to which failure to read the contract affects the viability of a claim of fraud in the inducement.”


Footnotes:

1. Hereafter all references are to the Code of Civil Procedure unless otherwise stated.

2. Another defense raised, not relevant here, was violation of the one-action rule. Section 726.

3. The modified statutory formulation adopted the Supreme Court’s liberalization of the rule as set forth in such cases as Masterson v. Sine (1968) 68 Cal.2d 222, and Pacific Gas & Electric Co. v. G.W. Thomas Drayage Co. (1968) 69 Cal.2d 33.

4. In footnote 11, the Court addresses its own opinion in Rosenthal v. Great Western Financial Securities Corp. (1996) 14 Cal.4th 394, in which the Court ruled that negligent failure to read a written agreement precludes a finding that the contract is void for fraud in the execution. (14 Cal.4th at 423.) “Fraud in the execution” means that the party does not know what it is signing, or does not intend to enter into a contract at all. Rosenthal, 14 Cal.4th at 415. Generally, in contract litigation the party alleging fraud is not alleging fraud in the execution, but rather fraud in the inducement, in which the signing party knows what it is signing but its rather fraud in the inducement, in which the signing party knows what it is signing but its consent is induced by fraud. Id. The Supreme Court said in footnote 11 of Riverisland that “[w]e expressed no view in Rosenthal on the ‘validity’ and ‘exact parameters’ of a more lenient rule that has been applied when equitable relief is sought for fraud in the inducement of a