California Supreme Court Threatens Enforceability of Contracts
January 22, 2013

General information

In January this year, the California Supreme Court overturned a case that had been decided by the same court in 1935.The two cases, rendered 83 years apart, involved remarkably similar facts. A borrower, falling behind in payments, works out an arrangement with the creditor to modify the terms of repayment, which are memorialized in a subsequent written agreement.The borrower defaults again and the creditor enforces the revised agreement as written.The borrower claims that the creditor made promises different from what was memorialized in the agreement.The dispute, at issue in both RiverIsland Cold Storage Inc. v. Fresno-Madera Production Credit Assn. (2013) and Bank of America v. Pendergrass (1935), was whether evidence of such oral promise that directly contradicts the written agreement should be admissible in court in order to prove the elements of the agreement.

The Pendergrass court and most subsequent decisions say no. After all, the principal function of a written agreement is to document the elements of the parties’ mutual promises. If one of the parties could simply assert different terms based on promises made orally or otherwise outside of the agreement, then what is the function of a written, integrated contract? The parole evidence rule addresses this question. It places the onus on parties to an agreement to abide by their agreements as written.

The parol evidence rule is codified in California Code of Civil Procedure Section 1856 and Civil Code section 1625. Together, they state that the terms of a written agreement may not be contradicted by evidence of any prior agreement or of a contemporaneous oral agreement. Evidence is permissible, among other things, to establish fraud. Now, clearly, if a party promises to do one thing but writes something else altogether in a contract with no intention to carry out the original promise, that normally counts as fraud (See Civil Code Section 1572).  But if one could introduce evidence of a promise that contradicts a written agreement simply by asserting it under the fraud exception, then the exception virtually swallows up the rule. A contract would have little more force than an oral agreement.

Pendergrass tackled this dilemma by striking a balance: extrinsic evidence would be admissible to establish some “independent fact or representation, some fraud in the procurement of the instrument or some breach of confidence concerning its use.” But extrinsic evidence is not admissible to establish “a promise directly at variance with the promise of the writing,” commonly referred to as promissory fraud. Subsequent courts have struggled to apply these distinctions (such as the difference between a fact and a promise) and have crafted further refinements. But Pendergrass and its progeny have served California well. The compromise preserves the important policy objectives underlying the rule, which are to encourage parties to read their contracts, hold parties responsible for abiding by their written promises, and protect the integrity of written instruments. The commercial effectiveness of financial instruments in particular, such as notes which are commonly traded and pledged, relies on legal predictability. Concomitantly, Pendergrass preserves the statutory fraud exception in instances not pertaining to promissory fraud, including evidence that undermines the validity of the agreement itself.

The current Court now questions the legitimacy of Pendergrass as having been crafted without statutory basis. Indeed, the Pendergrass distinction finds no direct support in the above-cited statutes. Specifically, the Court argued that to bar extrinsic evidence would be to make the parol evidence rule a shield to protect misconduct because false promises would never come to light in court. This concern is not without foundation, but RiverIsland upsets the long-standing balance in ways that are highly detrimental to commerce. 
In support of the decision, the Court reasoned that a party challenging an agreement not only has to prove that the defendant made a promise extrinsic to the agreement, but also had no intention of performing it. Such a showing, the Court noted, is not easily established. But the Court misses a vital practical point: in the absence of Pendergrass, plaintiffs can readily defeat summary judgment or demurrer and thereby draw defendants into potentially protracted litigation regardless of the merit of their claims. As the validity of any factual claim is not tested until trial, the road to which is exorbitantly expensive, all claims are by the RiverIsland decision suddenly imbued with extortionate settlement value.

The able attorneys from the law firm of Reed Smith, who filed CBA’s friend of the court brief to the Supreme Court in RiverIsland, put it this way: “[The parol evidence rule as interpreted by Pendergrass] prevents disgruntled parties and enterprising lawyers from stirring up mischief, such as by citing terms that have been offered and rejected in prior negotiations.” They added, “The printed page, which is fixed and plain, is more accurate than memory, which is subject to innocent fading and misrecollection and not-so-innocent shading and fabrication” (Citation omitted).

The better course to prevent promissory fraud that is less fraught with unintended consequences is to enforce the common sense self-interest of all parties to take their contracts seriously. How? Precisely by not allowing them to alter contracts later on, such as when things go wrong. Deprived of an unjustified second chance to alter the agreement, parties would be more motivated to protect themselves simply by reviewing the contract.  The integrity of agreements would be preserved when the rights and duties of the parties are defined strictly within the four corners of the document.

Lenders and any other party to an agreement will be exploring ways to hold counterparties to their promises and to minimize the availability of spurious fraud claims. But obvious remedies do not come to mind. Any solution that involves the signing of additional documents or acknowledgements is subject to the same challenge to which the subject promise is exposed. More meaningful options might be available in larger transactions that involve sophisticated parties. Peter Munoz of Reed Smith suggests that a practice of insisting that a counterparty be represented by counsel could be warranted, but notes that this option is impracticable in most instances.

Normally, a decision that poses such high risks to commerce warrants legislative reconsideration of the underlying statute. But it is questionable whether the current state legislature will be sympathetic to arguments to amend the fraud exception to the parol evidence rule.The likelihood of reinstating Pendergrass in this state as to consumers is virtually non-existent.  But perhaps the legislature would be open to reason to reinstate the exception for larger transactions or that involve business parties. There are no good policy reasons for not holding sophisticated persons to the agreements as written.

The information contained in this CBA Regulatory Compliance Bulletin is not intended to constitute, and should not be received as, legal advice.  Please consult with your counsel for more detailed information applicable to your institution.

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