Contracts Class Notes 2/2/04


For today, we’re going to have Torts class: “what you should have learned in Torts.”


We will learn about the tort of fraud or deceit.  What is the “fraud exception”?  For one thing, it’s an exception to the parol evidence rule.  You can prove fraud, and the parol evidence rule is not going to block your doing that.  Check out § 214 (d): You may introduce evidence that, among other things, a contract should be invalidated due to fraud.  You could also introduce evidence that you were coerced into signing, that there was a lack of consideration, that the contract was illegal, or that contract terms were entered into by mistake.


The elements of the tort of fraud


There must be a misrepresentation of a material fact done with scienter (serious reprehensible fault on the part of the liar as opposed to innocent mistake).  There must be reliance on the part of the victim.  There must be damage or loss.


Here’s a simple hypo: say Clovis makes a contract with me to sell his horse Dobbin.  Clovis says he’s had him examined by a vet recently and that he’s in good shape.  On the other hand, the horse is ten years old and Clovis is selling him as is.  If Dobbin was in good health, he would be worth $12,000.  Clovis sells the horse to me for $10,000.  But Clovis lied: he had gone to the vet, but the vet said that he’s about to croak.  So it turns out Dobbin is worth $50 dead.  So the horse died.  First you say “damn”.  “Then you make a disparaging remark about my parentage.”  Then you seek a remedy.


When you look at the writing, it has disclaimer and merger clauses.  Does that mean that I can’t get a remedy?  I probably can’t as a matter of contract, but I may be able to as a matter of tort.  The tort of fraud or deceit has been committed.  Clovis misrepresented a material fact (the horse’s condition).  He did it with a ton of scienter (he lied and knew darn well he was lying).  I relied on Clovis’s statement and I suffered actual damages.  One measure of damages would be how much I paid minus what I actually got.  That will get me $9,950.


If I was induced to sign by Clovis’s fraud, then the writing can be set aside and I can get damages under the tort of fraud.


On the other hand, sometimes the victim can simply rescind.  That’s often fine, but in this case it’s too late because the horse has died.  It may be too late to rescind, but not too late to get damages.  So this is a really simple, garden variety example.


It’s relatively to allege fraud, even if you have to allege it with particularity.  But it might be quite hard to prove.  In this case, there was clearly fraud and there will be no problem proving it.  For example, you can put the vet on the witness stand.


The damages that Clovis has suggested are $9,950.  That’s the “out of pocket” rule.  A minority of jurisdictions have the “out of pocket” rule, while a majority of jurisdictions have “benefit of the bargain” rule.  The victim needs $9,950 to get him back to square one.  On the other hand, the “benefit of the bargain” rule would give the victim $11,950, giving the victim the benefit of the good bargain that he made with the wrongdoer.  The “benefit of the bargain” is like the expectation interest and protects your profit if you can prove it.  If the facts are right, the victim can get more of a recovery under the “benefit of the bargain” rule.


Here’s a more complicated kind of fraud that frequently comes up in a contractual setting.  Say when Clovis sells me Dobbin, our writing contains a merger and limitation clause that says the whole writing is included in our agreement.  Clovis promised me orally, but not in writing, that Dobbin was a purebred and that shortly after sale Clovis would deliver the registration papers to me.  Assume with the papers Dobbin is worth $11,000, and worth $7,000 without.  Say I pay the agreed price of $10,000, and Clovis fails to delivers the papers.  Could I sue him for breach of contract?  It will be hard to recover because it runs right into the merger clause, which says “this writing is all there is.”  The writing also said that Dobbin was being sold “as is”.  It would be pretty tough to get anywhere on a contract theory.


If you try it as a tort case, on the other hand, was there any misrepresentation of a material fact?  No, in most cases.  Clovis made and broke a promise.  If that’s all there is, Clovis is not a frauder.  If he makes a promise and later decides to break it, it will be a breach of contract, but that’s not fraud.


How do we get fraud into the picture?  We only get fraud when Clovis makes a promise with a present intent to break that promise.  Then Clovis has misrepresented a material fact, namely, his intention.  If Clovis’s present intent is to break a promise, then you are someone who has misrepresented a material fact.  There’s also scienter there when you make a promise while at the same time intending to break it.  This is sometimes (somewhat inaccurately) called “promissory fraud”.


So, if you could prove that at the moment when Clovis made his promise to deliver Dobbin’s registration papers he intended to break that promise, then you have a fraud case.  If you have a good fraud case, you’ll have a chance to rescind the contract and get damages.  If you can’t show that intent, you’re stuck.


Damages would be $3,000 under the “out of pocket” rule, and $4,000 under “benefit of the bargain” rule given the facts as stated.


Lipsit v. Leonard


A New Jersey court applies New York law, and in New York, the “out of pocket” rule is applied.  Lipsit was Leonard’s employee for about eight years under a series of annual letter agreements.  Lipsit wants to recover from Leonard for Leonard’s failure to give him a share of the business.  Lipsit did receive a salary or wages, but he didn’t get his promised share in the business.  Lipsit gives it a shot both as a matter of contract and as a matter of tort.  Attorneys like to try to make cases on more than one theory.


Lipsit strikes out pretty badly on the contract basis, according to the New Jersey Supreme Court.  The Supreme Court finds this theory not worth talking about much.  Why is it so clear that Lipsit gets nowhere on the contract theory of recovery?  Think about a couple of things that happened.


In these writings, something was said about Lipsit getting a share in the business.  He’ll get nowhere on the basis of what was said there.  First off, an agreement to agree is not enforceable.  Also, the contract terms are quite vague.  The promises are abundantly illusory.  The parties will do what they want if they feel like it.  That’s not really a contract at all.  If you try to enforce the writing, there’s nothing there to enforce and you go “wee wee wee all the way home”.


Lipsit says: “Well, each time we signed one of these agreements, Leonard also agreed orally in no uncertain terms that he would give me a 10% interest in the business.”  What happens if you try to enforce these oral agreements on the basis of the law of contracts?  You run right into the parol evidence rule.  The issue of getting a stake in the business is covered in the writings, and you’re trying to introduce a contemporaneous oral agreement that contradicts the writing.


How does Lipsit get somewhere?  He’ll have to resort to the law of torts.  Making a promise and breaking it is not a misrepresentation of a material fact, but making a promise with the intent to break it when you make it and using it to induce service on the part of an employee could be a valid suit on the theory of torts.  The argument would be that Leonard intended to break his promises when he made them, causing Lipsit to rely on the promises.  Lipsit continued his employment.  Finally, if Lipsit doesn’t get a stake, he will suffer damages.


But how do we measure the damages here?  It was easy to calculate damages in the horse example.  But how do we do it here under the “out of pocket” rule?  What did the victim give?  What did the victim get?  Lipsit gave his services, and got paid.  We need to value his services and compare that to what Leonard paid him.  If we can value Lipsit’s services (in the labor market) at more than he was paid, the difference is his “out of pocket” loss.  In a “benefit of the bargain” jurisdiction, Lipsit could go after the value of a share of the business.  In a “benefit of the bargain” jurisdiction, you get what you were promised minus what you got.


The court notes that Lipsit will have some problems of proof on remand, but says that he’s entitled to try.  On the other hand, in a “benefit of the bargain” jurisdiction, you may have trouble proving what you were promised.  But you’ll be able to try to prove “out of pocket” loss even though you’re theoretically entitled to more.


Would it make any difference in this case if the writings that the parties had signed had said: “These agreements are fully enforceable, even though induced by fraud.”  No.  That’s the case of Sabo v. Delman.


What can you do in draft a contract that could prevent fraud by the other party?  You can try to negate one of the elements of the tort of fraud so there is no tort.  Many people try to negate the element of reliance.  There is a clause written into the contract saying that one party does not rely on the statements of the other party.


LaFazia v. Howe


The Howes purchase a deli from LaFazia and Gasrow.  The Howes want to find out how much money the deli is making.  The Howes ask, and the sellers say that they don’t keep good books.  The Howes say: “What about your tax returns?”  The sellers say that the tax returns show earnings that are lower than they actually are.  The Howes have a deli-expert friend look at the documents and they’re told it’s not a viable business.  But the Howes buy the deli anyway for $90,000.


The writing that the parties sign contain a non-reliance clause and an merger clause.  The Howes have another problem!  They were represented by counsel.  Their son was a lawyer, and he had a chance to look at the writing.  They had plenty of opportunity to see what they were doing, but signed anyway.  The Howes tried to prove fraud.  They wanted to prove that the sellers made fraudulent misrepresentations, but they’re missing the element of reliance.


The court has a lot upon which to hang its hat.  The buyers must have known that the sellers were somewhat dishonest and they had a good idea that the deli was not a good buy.


Various judges have different feelings about reliance clauses.  If you try to reconcile the cases on the basis of not only the doctrine, but the facts, you’ll find that in the cases where the non-reliance clause was enforced, but also there was factually very little reliance in the case.  The victim knew or ought to have known that any representations about the manner in question weren’t meant to be taken very seriously.


This opinion talks a lot about Danann Realty.


The tort of fraud can be a way around the parol evidence rule.  Or you can simply think about it this way: when you have the tort of fraud, and when it’s proved (sometimes beyond the preponderance of the evidence and pleaded with particularity), you need to be compensated.  You either should be allowed to rescind or you should be able to get damages.


The sellers don’t look like nice people in this case, but it also doesn’t look like they deceived the Howes.  If something serious that ought to be relied upon had been said and relied upon and there is a non-reliance clause in the writing, the court may allow a tort claim to go forward.  The court might say that the clause is “boilerplate” and “non-specific”.  But in reality, the court might really be drawing a line and saying that you can’t perpetrate fraud with impunity.  But these are just Clovis’s musings.


Another exception to the parol evidence rule is found in § 214 (e): parol evidence can be used to rescind or reform contracts.  If we have a writing and it describes an agreement for the purchase and sale of 400 bales of cotton to arrive on the Peerless, can the parties admit evidence that the seller meant the later Peerless and the buyer meant the earlier Peerless, thus there is no meeting of the minds?  Sure, they can do that under § 214 (d), and claim that there is an invalidating clause, or they can do it under § 214 (e), saying that there was no meeting of the minds, either subjective or objective.


There are three kinds of mistake we will learn about in this course.  We’ll need to learn to identify and distinguish all three types.


First you have Raffles v. Wichelaus – a “failure to communicate” kind of mistake.


Another type will be found in Hoffman v. Chapman.  The parties reach agreement and having done so, they integrate their agreement.  They merge it into a writing, and make a mistake in integration.  They make a mistake in writing down just what they agreed to.  They screw up the writing.  In those circumstances, in a proper case, we’ll grant reformation.  We will reform, or fix or correct the writing if it fails to reflect the parties’ underlying agreement.  We’ll make it so that it conforms to the underlying agreement.


In this case, you learn that the parol evidence rule does not bar a claim in reformation.  Does this go too far?  Tomorrow, we’ll look at the various safeguards that are imposed on this doctrine that we can learn from this case.

Back to Class Notes