Trust, But Verify

In commercial transactions and litigation, there is a difficult tension to maintain – building and preserving business relationships with preserving legal rights in the case of controversy.  The Russian proverb popularized by Ronald Reagan during the Cold War thaw – Доверяй, но проверяй (doveryai, no proveryai); Trust, But Verify — has served me well in my commercial transactions and litigation practice.  Negotiate terms in good faith and then verify the terms in writing!

Unfortunately, in the heat of business negotiations, I find that many clients enter into many deals by handshake (“Trust”) but forget to properly document (“Verify”) the oral understanding either in the actual language of the contract they sign or document, in writing, any modifications or amendments to an existing written contract.  When a dispute over oral discussions occurs within the jurisdiction of California, the party whose position is consistent with the terms of the written agreement usually prevails at the beginning of a litigation.  Defendants were typically able to dismiss “promissory fraud” cases at the pleading stage relying on the parol evidence rule.  The balance appears to have shifted earlier this year when the California Supreme Court, in Riverisland, joined the majority rule that allows a plaintiff to introduce evidence of fraud, usually in the form of oral statements, despite the existence of a written agreement.  See my colleague Leslie A. Baxter’s article on Riverisland.  

From a litigation perspective, this case breathes life into legitimate fraud claims for clients who trusted but failed to verify their understanding in writing.  From a transactional perspective, where it serves all parties’ best interests (except litigators) to avoid litigation, it is even more important for all parties to verify all oral understandings in writing, including explicit acknowledgment that all signers had the opportunity to review with counsel and confirmed the writing is consistent with their understanding.

 

 

Riverisland Puts Pendergrass Into Cold Storage

by: Leslie A. Baxter

 On January 14, 2013 the California Supreme Court overturned 78 years of precedent and expanded the fraud exception to the parol evidence rule.

 Introduction 

In Riverisland Cold Storage v. Fresno-Madera Production Credit Association (2013) 55 C4th 1169, reported on p 42,  plaintiffs sued  their lender, seeking damages for fraud and negligent misrepresentation, rescission and reformation of a loan.  Plaintiffs (the Workmans,) alleged that the lender’s vice president had told them that they would extend their loan for two years, in exchange for adding two more properties as collateral.  The written contract, however, recited only three months forbearance on the loan (then in arrears) and identified an additional eight properties as collateral.  The Workmans sued after the lender attempted to foreclose under the loan agreement.  The trial court granted the lender’s motion for summary judgment, relying on Bank of America N.T. & S.A. v. Pendergrass (1935) 4 C.2d 258, 263.

 The Pendergrass Rule

The Pendergrass rule is that parol evidence is admissible to establish fraud in the procurement of a contract by an independent fact or representation, but not by a promise that directly varies with the promise in the writing.  4 C2d at 263.  The Court in Pendergrass explained that it would be “reasoning in a circle” to argue by oral testimony that a written agreement is fraudulent. 4 C2d at 263.   The court left open the opportunity to prove that the agreement is invalid due to promissory fraud, through proof that there was no meeting of the minds on the terms of the  agreement because one party fraudulently induced the other to enter into a contract.  See, Riverisland, 55 C4th at 1173, n.3, citing 5 Witkin, Summary of California Law, Torts §781 (10th ed 2005).

California Case Law After Pendergrass

In California, pleading promissory fraud has been a low-yield proposition for plaintiffs attempting to invalidate an integrated, written contract.   Two years ago, with Riverisland  already on appeal to the supreme court,  the court in   Duncan v. McCaffrey Group, Inc. (2011) 200 CA4th 346, 373, overruled in Riverisland, 55 C4th at 1182 (reported at 35 CEB RPLR 57 (Mar. 2012)),  ruled that plaintiff homeowners could not proceed on claims of promissory fraud against the developer.  The Duncan plaintiffs had claimed that the developer promised them that the development would contain only custom homes.   The purchase agreements, however, reserved to the developer the right to build other types of homes.   The allegedly fraudulent representations were directly at odds with the written agreement. The court sustained the demurrer on the fraud claims, allowing plaintiffs to proceed on claims of unfair competition, false advertising, breach of fiduciary duty and constructive fraud.   The court explained that (200 CA4th at 373, quoting Alling v Universal Mfg. Corp. (1992) 5 CA4th 1412, 1436):

“’Promissory fraud’ is a promise made without any intention of performing it. [Citations.] The fraud exception to the parol evidence rule does not apply to such promissory fraud if the evidence in question is offered to show a promise which contradicts an integrated written agreement. Unless the false promise is either independent of or consistent with the written instrument, evidence thereof is inadmissible.”

Before Riverisland, there was often little factual difference between a case which was allowed to go forward on a fraudulent inducement theory and a case terminated by the Pendergrass  rule because the oral representations were at variance with the written contract.  In Pacific State Bank v. Greene (2003) 110 CA4th 375, the court held that Greene, a guarantor for her husband’s debt, could introduce evidence that a bank employee had told her that the scope of her guaranty was limited to less than her husband’s entire debt, even though that verbal assurance contradicted the terms of the written guaranty.   The court reasoned that Greene could allege that there was a misrepresentation of fact over the contents of the document at the time of its execution — the type of ‘independent fact or representation” that fit within the Pendergrass rule and the theory of fraudulent inducement.  The court did not characterize this verbal assurance as a promise at variance with the integrated, written agreement.  110 CA4th at 390.  In contrast, the homeowners in Duncan were not allowed to go forward on their fraud claim (that the developer misrepresented to them that only custom homes would be developed in their tract) because of contradictory language in their purchase agreements.  The facts in Duncan and Greene are quite similar, yet their disparate holdings  highlight the inconsistency that compelled the supreme court to  accept Riverisland for review.

Criticism of Pendergrass

The Pendergrass rule has been roundly criticized.  As the Duncan and Greene cases show, resistance to the rule by some lower courts  has led to inconsistent case law.   As the court discussed in Riverisland,  the Pendergrass rule is inconsistent with the terms of the parol evidence rule (CCP § 1856), which allows evidence of whether the writing is intended as a final expression of the agreement, exclusive of other terms outside the writing. CCP § 1856(d).  The statute also allows evidence of a mistake or imperfection of the writing.  CCP §1856(e).  Without the Pendergrass rule, an oral promise that is inconsistent with the written agreement would likely be admissible to show the  writing was mistaken, imperfect, or contrary to the parties’ agreement.

Practical Implications for Real Property Lawyers

What is the real property lawyer to do in the face of Riverisland?  To guard against claims of fraud after the contract is signed, parties will want to document (in writing)  that the other side has read the contract and understands the deal.  This will safeguard against a claim that the party reasonably relied on an oral statement at variance with the written contract     Representations and warranties in the contract should recite that

  • The parties have read and understood the contract;
  • All of the terms are correct;
  • The parties have had the opportunity to seek legal counsel or other expert advice regarding the contract terms; and
  • All of their questions regarding the terms have been answered.

If there are language barriers, steps to provide translation should be documented as well.

Businesses that typically contract with less sophisticated parties may want to implement pre-contract procedures designed to educate the other party or give them the opportunity to seek independent help and enough time to think about the contract terms.  Of course, integration clauses and representations and warranties will never provide an ironclad guarantee of the enforceability and integrity of the contract.  Whether the reliance on an oral statement was reasonable will usually be a question of fact.   The stronger the contract terms are, the more counterweight they will provide to the reliance element of a fraud claim.

An unintended consequence of Riverisland may be to squelch communication and negotiation leading up to the deal.   Loan officers or real estate agents may be discouraged from ‘thinking out loud” about possible deal terms, lest the other party interpret them as the deal itself.  Stated in a more positive way, the parties will be more careful to  communicate deal points with clarity.

What’s Next?  The Future After Riverisland

Will Riverisland  trigger a flood of litigation by parties seeking to invalidate written contracts by claiming fraud?    It depends.   Many of the cases decided under the Pendergrass rule were decided at the demurrer stage, in favor of the defendant.   Now that the fraud exception has been expanded to include oral evidence at variance with written contract, the analysis will likely shift to the trier of fact, at summary judgment or trial, to determine whether there were pre-contract misrepresentations and whether they were reasonably relied on.

Even though they triggered a sea change in California’s common law regarding parol evidence, the plaintiffs in Riverisland  have not yet prevailed.   The Riverisland action is now remanded to the trial court.  The Workmans admitted that they did not read the contract they signed — a fact the lender is expected to use to show their lack of reliance on the oral assurances.  Attorneys for borrowers and others looking to challenge written contracts through parol evidence should carefully analyze all of the facts in the client’s situation to determine the viability of an action to invalidate the contract.  If there is an attorney fee provision, the economics of a legal attack on the contract must be weighed against the expense of an unfavorable outcome. This should temper the collective impulse of contracting parties and their counsel to run to California courts to undo their written contracts.

Is an S Corporation or an LLC Right for Your Business?

The question we get asked most often by new business owners is “Should I form an S corporation or a limited liability company?”  Just what are the differences between an S corporation[1] and a California LLC?  There are advantages and disadvantages to both, so the decision as to which one is best for your new business will depend on your individual circumstances and goals:

Owner Liability

The main advantage of both types of entities is the degree of protection that each provides to its owners.  If the business is properly run, and all legal and financial corporate formalities are carefully observed, then the owners are insulated from liability for business taxes, torts, and debts. This protection is probably the main advantage that both LLCs and S corporations have over partnerships, associations, and sole proprietorships.[2]

Type of Business

Almost any type of business can form an S corporation. Banks, insurance companies, and foreign corporations are types of businesses that cannot elect to be taxed as an S corporation, and there are certain restrictions on the type and number of shareholders that the corporation can have (see below.)

Generally, California licensed professionals (attorneys, accountants, architects, doctors, and so forth) are not eligible to form LLCs.   Some licensed businesses, such as locksmiths and hair salons, can operate as LLCs.  State law has recently relaxed this restriction, now leaving the decision up to the individual governmental regulating agencies.   Licensed contractors are now for the first time permitted to form LLCs, and other licensed professions may follow suit in the future.

Ownership.

LLC owners (members) can be any individual or entity, and an LLC can have any number of members. 

S corporation owners (shareholders) are limited to natural persons (none of which can be non-resident aliens), estates, tax-exempt organizations, and certain trusts.  An S corporation must have no more than 100 shareholders, and all of the shareholders must consent to the S election.   

Either type of entity can have only one owner.

Management

California corporations are required to have at least a president, secretary, treasurer, and a director (or more directors, depending on the number of shareholders.)  The shareholders elect the directors, and the directors in turn elect the officers.  The officers of the corporation are responsible for the day to day operations of the company business and answer to the directors and the shareholders. 

LLCs can be managed either by manager(s), or by one, some, or all of the member(s).  There is no requirement that an LLC have officers, but LLCs are not prohibited from electing them, either. 

Maintenance

California Corporations Code requires that shareholders hold meetings at least once a year, and most bylaws require periodic director meetings and that meeting minutes must be kept. The law does waive the meeting requirement if issues normally covered at the meetings are consented to by written consent. 

There are no legal requirements for LLC members and/or mangers to have regular meetings or that meeting minutes be kept. It is recommended, however, that multi-member and manager-managed LLCs have periodic meetings to promote smooth and proper operation of the business.

Profits and Losses

Profits and losses are distributed to corporate shareholders based on the number of shares held by each. 

LLC members, however, can agree to distribute profits and losses on a basis other than percentage of ownership, taking into account such factors as the number of hours or level or expertise that each member contributes to the LLC business.

Taxes

S corporations are “pass-through” entities, meaning that the income is taxed only once as it is distributed to the owners. 

The same holds true for LLCs.  A single member LLC is treated as a “disregarded entity” in which the income is reported and taxed on the member’s personal income tax returns, and a multi-member LLC is taxed in the same manner as partnership income is taxed.  An LLC can elect to be taxed as a corporation, but this is not common.

In an S-corporation, only the salaries paid to officers and employees are subject to self-employment taxes. 

Members of  LLCs, however, are subject to self-employment taxes on both salaries and profits.  If the owners of the business do not intend to take a salary and there will be no employees, such as when the LLC is formed just to hold title to real estate, then this is not an issue.

Many business owners like the flexibility and ease of maintenance of an LLC.   Others prefer the checks and balances found in the more structured management of a corporation; or need an S corporation because they want to attract investors in the corporation; or they must form an S corporation because of the nature of their business.  The wrong choice may cost you in time, money and grief, so the decision should not be made without first consulting your attorney and your accountant.  If you are interested in forming or converting[3] your business to an LLC or S corporation, please feel free to contact your attorney to discuss your options.



[1] There are significant differences between “S” corporations (“Small” corporations) and  “C” corporations.  For example, if you will be seeking investors and will have a large number of shareholders, and/or will be offering more than one class of stock, then the corporation would not be eligible for S corporation status. A C corporation is subject to double taxation (i.e. profits are taxed to the corporation, then are taxed again when distributed as income to the shareholders) but the profits of an S corporation are only taxed once as the income is distributed to the shareholders.  Banks and insurance companies and foreign corporations cannot be S corporations

[2] Although members and shareholders are protected from company liabilities, their ownership interests are not protected from personal liabilities.  California law does not permit owner protection against charging orders.   In practice, a successful claimant against an owner personally would be entitled to receive only distributions of company profits, but not voting rights or management rights.  It is uncommon for a judgment debtor to obtain and subsequently enforce a lien against the ownership interest itself.

 [3] If you already have an LLC or S corporation, it is possible to convert to the other type of entity; and it may be to your advantage to do so.

New Developments In Real Estate Law

By Phillip Vermont

On July 15, 2011, California Code of Civil Procedures Section 580e was passed by the California Legislature. That section changes the law of short sales for residential properties in two significant ways. First, it expands the protection for a borrower in a short sale scenario, so that if all lenders whose loans are secured by the property approve the short sale, none of the lenders may seek a deficiency judgment against the former borrower.

Also, it adds an additional protection by stating that none of the lenders who approve the short sale may require the former borrower to pay any additional compensation, aside from the proceeds of the short sale, in exchange for the written consent of the sale.

Prior to July 15, 2011, in a short sale situation, the former borrower still had to address a second or third loan, or for that matter, an equity line, recorded against the property. Only the first lender was prohibited from seeking a deficiency judgment.

Next, a significant case was decided in 2011, protecting commercial landlords. In that case, Frittelli, Inc. v. 350 North Canon Drive LP, the California Court of Appeal enforced the landlord’s liability exemptions in a commercial lease at the summary judgment stage of a litigation brought by the tenant alleging that the landlord’s renovation of the shopping center destroyed the tenant’s business. Specifically, the exculpatory clause in the commercial lease had exempted the landlord from liability for breach of lease, breach of the implied covenant of quiet enjoyment, rescission, and ordinary negligence. The lawsuit had arisen from the landlord’s alleged interference with the tenancy in remodeling the shopping center; the clause at issue stated that the landlord had no liability under “any circumstances” for breaches of the lease, and/or negligence for damages or injury arising from any cause in the areas of the shopping center outside the leased premises, or for injuries to the tenant’s business.

The lease was a “net lease”, which the court found ordinarily signals that the parties intended to transfer from the landlord to the tenants the major burdens of ownership of the real property over the life of the lease.

The lease at issue was a standard form agreement entitled “Standard Retail/Multi-Tenant Lease-Net”. While the court’s decision did not specify which form lease was utilized, in the commercial leasing field, it is quite common to use form leases which often contain similar types of exculpatory language.

This is an excellent case for commercial landlords. It is highly unlikely though that these types of exculpatory provisions would apply in a residential lease context.

Conversely, however, a decision of the Court of Appeal in Avalon Pacific – Santa Ana LP v. HD Supply Repair and Remodel LLC reached a decision that was not favorable for the landlord. In that case, the court found that the landlord could not recover costs of repair damages for the tenant’s breach of maintenance and repair obligations when the lease had neither expired nor been terminated. Similarly, the court found that when the lease will be in effect for an extended term, the landlord may only recover waste damages before the lease expiration of termination or a showing of substantial and permanent damage resulting in a reduced market value.

In other words, the court found that the time for a landlord to raise maintenance and repair damages (arising from the condition of the property) is when the lease expired, or was terminated from some action of the landlord, such as in an eviction action.

Phillip Vermont Receives Award from East Bay Association of Realtors

Congratulations to partner Phillip G. Vermont. He was awarded the “Affiliate of the Year” earlier this month by the Bay East Association of Realtors, a professional trade association serving over 5000 real estate professionals throughout the San Francisco Bay Area.



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