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Mar 27, 2013

Legal Update: The Parol Evidence Rule Gets Clipped: Contract Fraud Cases are Expected to Spike

In a contract law decision with far-reaching implications for the business community, Riverisland Cold Storage v. Fresno-Madera Production Credit Association, the California Supreme Court has reversed course after 75 years and held that evidence of oral promises or agreements at variance with the terms of a written contract may be considered to determine if the contract should be invalidated as having been procured by fraud. 

Previously, in Bank of America etc. Assn. v. Pendergrass, decided in 1935, the Supreme Court had specifically limited the fraud exception to California’s version of the “parol evidence rule” (Code of Civil Procedure section 1856 and Civil Code section 1625) to preclude introduction of such evidence to challenge the validity of a written contract.  The result was that written contracts were routinely upheld by the courts and enforced according to the terms set forth in the contract.  That sanctity of contract so heavily relied upon in business (particularly in California’s very litigious environment) may now be threatened as aggrieved contracting parties will likely attempt to avoid their obligations by claiming that the written contract was not the intended deal.  This decision has potentially far-reaching negative implications for the business community, and it will almost assuredly result in a significant spike in contract fraud litigation.

The case may be an example of “bad facts make bad law” as the Court was dealing with a situation involving alleged misrepresentations by a lender made to relatively unsophisticated borrowers.  The borrowers, Pamela and Lance Workman and their operating entities, were in default on agricultural loans from their local production credit association (PCA).  The Workmans and the PCA entered into a fairly typical written forbearance agreement pursuant to which the Workmans pledged 8 additional parcels of property as collateral, and the PCA agreed to forbear from enforcement action for approximately 3 months as long as specified payments were timely made.  The forbearance agreement contained the customary integration clause confirming that all prior or contemporaneous discussions and agreements were integrated into and superseded by the written contract.  Although most of the pages of the forbearance agreement had been initialed by the Workmans, they apparently never read the agreement and simply signed the documents presented to them. 

After the Workmans failed to make the payments required pursuant to the terms of the forbearance agreement, the PCA began enforcement of the loans by recordation of a notice of default.  The Workmans eventually paid off the loan and filed an action against the PCA for fraud, negligent misrepresentation, rescission and reformation.  The action was predicated on their claim that the PCA’s vice president had previously, and at signing, told the Workmans that the forbearance would be for a term of two years and that only 2 additional properties would be required as collateral.

The trial court applied Pendergrass to exclude evidence of the claimed conflicting contract terms and entered summary judgment in the action in favor of the PCA.  The Court of Appeal reversed and the California Supreme Court affirmed allowing the Workmans’ action against the PCA to proceed.  In affirming, the California Supreme Court expressly overruled its prior decision in Pendergrass which it characterized as “ill-considered” and (i) being unsupported by the California statute codifying the parol evidence rule, (ii) conflicting with the law in other states, and (iii) providing a shield for fraudulent conduct rather than preventing fraud.  The result is that the Workmans will have their day in court to assert that they were fraudulently induced into signing the forbearance agreement and that the signed contract does not embody the terms agreed upon.  Responding to the fact that the Workmans had failed to read the forbearance agreement, the Court did note that a showing of justifiable reliance would still be necessary to establish the alleged fraud but left that issue for determination by the trial court in further proceedings.

The Court’s decision in Riverisland will have broad implications and leaves open many significant questions.  Although the case involved a real estate finance transaction, the Court’s expansion of the exception to the parol evidence rule will be applicable to virtually all contracts regardless of context.  Early resolution of contract and fraud claims through summary judgment will now be much more difficult or impossible, as the mere allegation of oral promises and/or misrepresentations will create a question of fact to be decided at trial.  How can a lender or other contracting party be assured that the borrower or other contracting party does not think it was promised something different than or in addition to what is contained in the written contract?  What protective steps can the lender or other contracting party take to prevent or discourage these claims?

Although there is likely no bullet-proof way to completely avoid this expanded exposure to contract fraud claims, there are some steps that lenders and others can take to reduce their risks:  (i) provide final copies of complex documents to the other parties well in advance of closing to allow sufficient time for such parties’ review, (ii) encourage or require that the other parties (particularly less sophisticated parties) have legal counsel review and advise them with regard to the contract documents, and (iii) have the other parties confirm verbally before witnesses (who in turn sign a confirming declaration) or on audio tape (to be retained for the life of the contract), or in a separate hand-written statement, that they have read and understood the documents and that no contradictory or supplemental representations or promises have been made and are being relied upon

The unavoidable outcome of the Court’s decision in Riverisland will be an increase in litigation.  Contracting parties should be increasingly careful with whom they deal and how they document their transactions.

Article submitted by Scott Rogers of Rutan & Tucker, LLP (srogers@rutan.com) and Ted Klaassen of Rutan & Tucker, LLP (tklaassen@rutan.com).   Scott is a partner in the Palo Alto office of Rutan & Tucker, LLP where he specializes in real estate finance, equity and lease transactions, title insurance and real estate litigation.  Ted is senior counsel in the Palo Alto office of Rutan & Tucker, LLP where he represents developer, investor, corporate, and institutional clients in a broad spectrum of real estate transactional and litigation matters.



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