California Courts Confirm: Fraud Actions Can Be Used to Avoid Contractual Obligations

Many people appreciate the importance of contracts.  We sign them daily, from our agreement to pay the amount at the bottom of our lunch receipt to that pesky cell phone contract that seems to increase every month.  However, few people realize that our conduct surrounding these contracts can be just as important as the document itself if a dispute ever arises.  Indeed, as two recent California cases make clear, this conduct may even give rise to legal rights that supersede the terms of a written, signed contract.

The rule at issue here is California’s Parol Evidence Rule.  Codified at Code of Civil Procedure section 1856, the Parol Evidence Rule provides that parties may not contradict, or in some cases even add to, the terms of a contract that is in writing and signed by both parties.  For almost a hundred years, beginning with the California Supreme Court’s ruling in Bank of America etc. Assn. v. Pendergrass (1935) 4 Cal.2d 258, 263 (“Pendergrass”), parties in contract disputes have relied on this rule to exclude any evidence of promises that are not included in the disputed contract, regardless of what the parties’ intent may have been.  While in some cases this allowed parties to use their contract as a shield against obligations they agreed to but were not included in the document, most parties were able to successfully use this rule to prevent opposing parties from rewriting their contracts using the advantage of hindsight.

Now, as first stated in January by the California Supreme Court in Riverisland Cold Storage, Inc. v. Fresno-Madera Production Credit Assn. (2013) 55 Cal.4th 1169 (“Riverisland”) and recently confirmed in Julius Castle Restaurant Inc. v. Payne, --- Cal.Rptr.3d ----, Cal.App. 1 Dist., June 10, 2013 (“Julius Castle”), parties seeking to avoid or change their obligations provided in a written contract may now rely on the fraud exception to the parol evidence rule.  While this exception had previously existed, Pendergass required that the fraudulent conduct arose from some conduct other than a promise related to the contract.  In overruling Pendergass, however, California courts have clarified that any fraudulent conduct – including a promise to do something not contained in the contract – can give rise to a fraud claim based on that contract, even where the contract provides no such obligation.

Julius Castle provides a perfect example of how this change in California law is applied.  Two restaurateurs leased a historic San Francisco restaurant property for the purpose of reopening a restaurant.  The lease provided that the restaurateurs had inspected the premises and found it to be in good repair.  After taking possession, the restaurateurs discovered that the premises was actually in rough shape, as many of the appliances were broken and several unpermitted repairs would prevent the restaurateurs from receiving a health permit.  After the restaurateurs made the necessary repairs and deducted the amount from their rent, the landlord evicted the restaurateurs for nonpayment of rent.  They subsequently brought suit, claiming that the landlord had orally promised that the premises would be in good repair and to make any repairs that may have been necessary.

Under Pendergass, the parol evidence rule would have precluded the introduction of the restaurateurs’ evidence that the landlord had orally promised to make repairs and bring the premises to a state of good repair, as evidence of the oral promise directly contradicted the terms of the lease.  However, under the new rule set forth in Riverisland, the restaurateurs were permitted to introduce evidence that the landlord made the oral promise regarding the condition of the premises without any intent of performing it, constituting fraud, even though the terms of the lease provided otherwise.

Though well-intentioned, the Riverisland change to the parol evidence rule may have disastrous consequences for parties who negotiate a contract and expect other parties to that agreement to honor its terms.  In particular, parties who wish to avoid the terms of a contract to which they agreed can now claim that the opposite party promised some other term without the intent of performing it, suddenly implicating evidence of prior negotiations that would otherwise be irrelevant.  Admittedly, parties will have to prove these elements at trial, but juries are often susceptible to this type of evidence.  Indeed, this is one of the main reasons the parol evidence rule was adopted.  At a minimum, this will permit many claims to avoid initial methods of curtailing frivolous and unsubstantiated lawsuits, such as demurrers and summary judgments, despite a party’s best efforts to prepare a comprehensive, accurate written agreement.

Going forward, parties should be clear during contractual negotiations as to what promises they are making.  Contracting parties should avoid making promises they would not accept as part of a final agreement.  Ultimately, however, it may be difficult to avoid application of this rule in practice.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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