22 ORANGE COUNTY LAWYER

RESTORING THE CORNERS TO CONTRACTS: DEALING WITH THE NEW FRAUD EXCEPTION TO THE PAROLE EVIDENCE RULEby DAVID J. MYERS

Historically, the parole evidence rule has protected California businesses from claims that written contracts were fraudulent based on inconsistent alleged oral inducements. This bright line approach provided considerable comfort for clients and

attorneys, as they could limit the matters that could be considered in interpreting contracts, and make short work of litigation based on inconsistent alleged oral inducements.

Those days are now gone, however, since Riverisland Cold Storage, Inc. v. Fresno-Madera Prod. Credit Ass’n, 55 Cal. 4th 1169 (2013) called existing law an “aberration,” and brought California law into line with what the court termed “the path followed by the Restatements, the majority of other states, and most commentators.” Not that the court didn’t appreciate the benefits of the existing approach. It simply found that the importance of preventing promissory fraud is greater, such that alleged fraudulent inducements have to be considered even if inconsistent with written contract terms.

So, what can we expect going forward? Are there any limits on the types of matters that can be asserted or contradicted? Is there anything that can be done during the contracting phase to protect against unwarranted fraud claims, or conversely to preserve the right to assert unwritten inducements, for example when dealing with contracts of adhesion? What are the pleading and proof requirements? And can an actionable fraudulent inducement be used to modify contract terms or only to avoid the contract?

Generally, it is safe to say that contract expectations will be less certain, and the risks of having to deal with fraud claims and protracted litigation will be increased. Boilerplate “as-is” and “integration” clauses will be ineffective. Litigation will focus on intent and reliance on alleged oral inducements, both of which are factual determinations and thus unlikely to be resolved quickly. Reliance will involve a number of

factors, including the sophistication and relative bargaining positions of the parties, and the reasonableness of their reliance and due diligence under the circumstances. Reformation is also still available to correct the “mutual mistake” created by a fraudulent inducement.

As for limitations, it is unlikely that a party who fails to read a written contract will be able to rely on contrary alleged oral inducements, unless they can show good cause. And successors that qualify as holders in due course, bona fide purchasers, bona fide encumbrancers, and failed financial institutions and their assignees should also still be able to avoid alleged collateral oral agreements.

It is also likely that we have not heard the last word on the enforceability of as-is and merger provisions, and that we may see greater acceptance of particularized

provisions negotiated by sophisticated parties who have full access to all relevant information, especially in settlement and other commercial agreements that include “clear and unequivocal” disclaimers of reliance.

We may also see limitations on the reasonableness of reliance on matters that are so material that they could and should have been included in a final integrated contract if they were in fact part of the bargain. There are steps that parties can take to protect their contractual interests, both in drafting and record-keeping.

The New Rule The facts giving rise to Riverisland were

simple enough. According to the applicable loan documentation, a lender restructured a loan following a default to give the borrowers additional time to pay it off in exchange for a pledge of additional collateral. When the borrowers defaulted and the lender initiated foreclosure proceedings, the borrowers counterclaimed for fraud and rescission, based on alleged promises during negotiations that the extension was promised for longer than stated and without additional collateral. The borrowers also claimed that they were assured at the time of signing that the documents conformed to the alleged oral promises, and that they signed without reading the documents in reliance on the alleged assurance. Id. at 1172-73.

Historically, few California courts would have considered the counterclaims as they relied on alleged oral promises that were inconsistent with the express terms of integrated signed loan documents. The court of appeal, however, found that the “false statements about the contents of the agreement itself” were not subject to the limitation on the fraud exception to the parole evidence rule. Id. at 1173. In affirming, the California Supreme Court held that even

claims of fraud in the inducement have to be considered to prevent nullification of the fraud exception to the parole evidence

23MARCH 2014www.ocbar.org

One clear import of the new rule is the avoidance of

reliance on boilerplate provisions, especially

in higher risk transactions such as loan modifications

and sales and leases of distressed assets.

rule, and that the protection against abuse must be found in the strict pleading and proof requirements applicable to fraud claims in general. Id. at 1182-83.

Not surprisingly, the courts that have since decided cases have engaged in tortured analysis of transaction histories to resolve the numerous questions of fact involved in ascertaining the parties’ intentions and justifiable reliance. For example, in Julius Castle Rest., Inc. v. Payne, 216 Cal. App. 4th 1423, 1442 (2013), the court affirmed a fraud judgment for damages in favor of a restaurant operator tenant against its landlord. The lease included the customary “as-is” provision, a representation by the tenant that it had inspected and approved the condition of the premises, limitation of the landlord’s repair obligations to the structure, and an integration clause. Id. at 1427. However, the restaurant owner obtained a preliminary injunction restraining the sale of its liquor license, and was allowed to assert at trial claims that the landlord failed to disclose that substantial improvements were undertaken without required permits that jeopardized the ability to operate the restaurant, misrepresented that the restaurant equipment was in good working order, and falsely promised that, if it was not, he would make good on any needed repairs. Id. at 1428-29.

Similarly, in Thrifty Payless, Inc. v. Americana at Brand, LLC, 218 Cal. App. 4th 1230 (2013), the court reversed an order sustaining a demurrer without leave to amend fraud and negligent misrepresentation claims against a shopping center landlord. Id. at 1244. The basis for the claims was that the landlord charged Thrifty for 5.7% of the center’s expenses under the triple net (NNN) provision contained in its lease, more than double the 2.2% estimated in the Letter of Intent on which the lease was based, a difference of about $342,704 for the first year alone. Thrifty alleged that, despite its lease acknowledgment, the NNN charges provided by the landlord were only estimates, the landlord knew Thrifty was relying on the estimates to evaluate the suitability of the project, that its reliance on the estimates was reasonable because the landlord had all or most of the needed information and a better understanding of the needs to accurately calculate the charges since it owned a number of shopping centers, that Thrifty did not have access to the necessary records and was not in a position to discover the true ultimate operating costs, and that it had relied upon and received reliable comparable information in its past dealings with the landlord. Id. at 1241-42. In addition, Thrifty discovered

after filing its complaint, and advised the trial court at the time of hearing, that the landlord knew or should have known the estimate was inaccurate because it told other prospective tenants that their NNN shares would be substantially higher, and made a deal with a movie theater to charge it less than its pro rata share based on square footage. Finding that the estimates were “grossly inaccurate,” the court held that the facts were sufficient to support causes of action, and that Thrifty should have been allowed to amend its complaint, thus suggesting a heavy pleading requirement being imposed on Thrifty.

Potential Limitations of the New Rule 1. Failing to Read a Contract One likely limitation is if a party claims

not to have read a contract. In that case, its ability to assert an alleged oral inducement will depend on the degree of fault that may be required, in other words the “excusability,” of the failure under the circumstances.

In Riverisland, the lender claimed that the borrowers’ admitted failure to read the contract should have prevented them from demonstrating reasonable reliance as a matter of law. Since the claim was not addressed in the lower courts, the supreme court declined to address the claim. Riverisland, 55 Cal. 4th at 1183. However, in a footnote at the end of the opinion, the court noted that it has already held that a failure to read a contract will preclude a claim for fraud in the execution, but that since the issue is not currently before it, it “is not expressing any view on the ‘validity’ and ‘exact parameters’

[of a] more lenient rule that has been applied” to promissory fraud claims. Id. at 1183 n.11 

Notably, Doe v. Gangland Prods., Inc., 730 F.3d 946, 957-58 (9th Cir. 2013) allowed a claim of fraud despite the plaintiff’s failing to have read the contract at issue. There the plaintiff alleged fraud in both the execution and inducement of a television release, and was able to overcome an anti-SLAPP motion to dismiss the claim even though he did not read the release before signing, based on allegations that he was dyslexic, illiterate, told the defendant he had an extremely difficult time reading, and was told by the defendant that the document he was signing was just a receipt for the $300 payment he was receiving for his interview, so the plaintiff forewent having his girlfriend read the release to him.

Obviously Gangland was an extreme case, and should not be relied upon in business transactions, in which it would be safe to assume that, barring extreme circumstances such as a legal incapacity or fraud by a fiduciary, a failure to read a contract would likely not be well received. There may also be some lenience in consumer “contracts of adhesion,” in which arguably it doesn’t matter if you read them since you don’t have a choice anyway.

2. Sophistication of the PartiesAs things stand, a sophisticated party

will not per se be barred from asserting rights under the new rule because of its sophistication. That argument was made and rejected in Julius Castle. In disposing of the assertion, the court noted that Riverisland made no such holding, that the “blunt language” of the opinion belies the assertion, that the plaintiffs in Riverisland appeared to be “relatively sophisticated business people,” and that “distinguishing sophisticated business parties who should be barred from introducing parole evidence of fraud . . . is not as simple as defendants suggest.” Julius Castle, 216 Cal. App. 4th at 1441-42.

Thus, the sophistication of the parties is a factor, and a potentially complex one, in determining the reasonableness of a party’s conduct, in which the more sophisticated a party, the more stringently reliance will likely be judged. This view finds support in Gangland, in which great lenience was shown towards an uneducated gang member who claimed to have been duped into signing a release he didn’t understand, and in Thrifty, in which extensive pleading of diligence was required.

3. Bargaining PowerSimilarly, relief is not limited to parties

in weak bargaining positions, such as in

24 ORANGE COUNTY LAWYER

ON POINTLitigation will focus

on intent and reliance on alleged oral inducements, both of which are factual

determinations and thus unlikely to be resolved quickly.

“contracts of adhesion.” That argument was also made and rejected in Julius Castle, again as not expressed in Riverisland, and as a limitation that the court declined to read into the decision. Thus, it is reasonable to expect that the relative bargaining power of contract parties will be considered, that greater leniency will be shown to parties with lesser bargaining power, but that even sophisticated parties such as lenders and institutional consumer product providers will be able to obtain relief under appropriate circumstances. Id. at 1442.

4. Failure to InvestigateAlthough so far not specifically addressed,

by extension, it is also reasonable to assume that a complete failure to undertake any investigation will not necessarily preclude relief. For example, a party may be excused who is legally incapable or who lacks the ability or resources to investigate, and has no duty to investigate representations by a fiduciary. Davis v. Kahn, 7 Cal. App. 3d 868, 878 (1970).

By contrast, the duty of investigation by an institutional client may be greater, as suggested by Thrifty, and will extend to most parties to some extent, depending on their relative sophistication and bargaining power, and the known and reasonably available information. Bank One Texas, N.A. v. Pollack, 24 Cal. App. 4th 973, 981-82 (1994).

5. ReformationArguably the fraud exception to the parole

evidence rule may not be applied to “modify” contract terms, as in Julius Castle, in which the court allowed evidence of the alleged fraudulent oral promises at trial to prove fraud, but not to modify the applicable contracts. As a result, the landlord prevailed on its contract claim, and the restaurant prevailed on its fraud claim, resulting in a set-off and an approximate $150,000 net judgment.

In Thrifty, however, the court held that sufficient facts had been pleaded to support a reformation claim based on the “mutual mistake” created by the same facts as the alleged fraud. Julius Castle, 216 Cal. App. 4th at 1243-44. A reformation claim based on mutual mistake was also asserted but not addressed in Riverisland.

Other JurisdictionsAlthough new in California, other states

have developed some additional limitations that may prove useful in future cases.

1. As-Is ProvisionsThe Texas Supreme Court

has held that where an as-is clause is “an important part of the bargain, and not just a boilerplate

provision,” causation is generally negated as a matter

of law, unless a fraudulent misrepresentation or concealment

is shown, or other circumstances warrant intervention, such as impairment of a party’s investigation. Prudential Ins. Co. of Am. v. Jefferson Assocs., 896 S.W.2d 156, 161-62 (Tex. 1995).

Although the court did not specifically address the burden of proof, a U.S. District Court for Texas has held that once a valid written contract containing an as-is provision is established, the burden shifts to the party challenging the provision. Owens v. Mercedes-Benz USA, LLC, 541 F. Supp. 2d 869, 873 (N.D. Tex. 2008).

2. Integration Clauses and SettlementsThe Texas Supreme Court has also

recognized limits to challenges to integration clauses in settlement agreements, holding that they will be enforced if they contain a “clear and unequivocal” disclaimer of reliance, and the agreement is the product of arm’s length negotiations between sophisticated parties represented by competent counsel. Italian Cowboy Partners, Ltd. v. Prudential Ins. Co., 341 S.W.3d 323 (Tex. 2011).

A material factor in the decisions regarding settlement agreements is to promote finality in the resolution of disputes. However, the analysis has also been applied in other contexts, including a residential lease. Matlock Place Apartments, LP v. Druce, 369 S.W.3d 355, 369 (Tex. App. 2012).

3. Omitted Material TermsAnother state has also held that reasonable

reliance is precluded as a matter of law on important terms that could and should have been included in a written contract if agreed upon after prolonged negotiations between sophisticated parties. Cent. Truck Ctr., Inc. v. Cent. GMC, Inc., 4 A.3d 515 (Md. App. 2010).

Preventive Measures1. Avoidance of BoilerplateOne clear import of the new rule is the

avoidance of reliance on boilerplate provisions, especially in higher risk transactions such as loan modifications and sales and leases of distressed assets. Transaction-specific representations, warranties, disclosures, disclaimers, waivers, and acknowledgements will have a better

chance of acceptance. Addendums could be prepared for standard contracts like AIR commercial leases and CAR residential purchase and lease contracts. Initial spaces could be required for important terms. And attorney sign-offs could be required, as typical in settlements.

2. Making a RecordIn addition, the benefits of making

a detailed record cannot be overstated. The more communications that can be handled or confirmed in writing, the better, especially concerning material matters such as representations, warranties, conditions, disclosures, acknowledgements, due diligence, and performance of conditions.

3. Certificate of Independent ReviewAnother alternative would be to adopt a

procedure like the Certificate of Independent Review available under the Probate Code, section 21351(b), to insulate testamentary transfers to certain unrelated parties against claims of fraud and undue influence. The process could be used to confirm that the parties read, understand, and agree that the document they signed accurately expresses their agreement and does not contain any omissions; it could even be required if requested and paid for by any contract party.

Even without legislative authorization, as long as foundational safeguards for reliability are respected, presumably the certification would be admissible in evidence, and would at least provide independent percipient confirmation of the scope of the contract in the event of a dispute, if the mere existence of the certification isn’t enough to discourage an unmerited claim.

David J. Myers is Of Counsel at the law firm of Enenstein and Ribakoff in Santa Monica. He handles both commercial transactions and litigation, and has extensive experience litigating alleged oral side agreements and fraud claims. His email address is dmyers@enensteinlaw.com.

This article first appeared in Orange County Lawyer, March 2014 (Vol. 56 No. 3), p. 22. The views expressed herein are those of the Author. They do not necessarily represent the views of Orange County Lawyer magazine, the Orange County Bar Association, the Orange County Bar Association Charitable Fund, or their staffs, contributors, or advertisers. All legal and other issues must be independently researched.