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Using Contractual Merger Clauses in Defense of Fraud Claims

By Daniel P. Elms – January 27, 2011

 

The “merger” or “integration” clause, in one form or another, has found its way into most commercial contracts.[1] The merger clause comes in a variety of forms, but generally looks something like this:


This Agreement represents the Parties’ entire understanding regarding the subject matter herein. None of the terms of this Agreement can be waived or modified, except by an express agreement signed by the Parties. There are no representations, promises, warranties, covenants, or undertakings between the Parties other than those expressly set forth in this Agreement.


When the relationship sours and litigation results, many defendants assume that this contractual talisman will protect them from fraud, fraudulent inducement, or similar claims based on alleged precontractual promises or representations made to the plaintiff. But defendants should not rest so easy. Many courts have dramatically narrowed, or outright rejected, the use of these clauses as a per se defense to fraud claims.


In theory, a merger clause works in tandem with the parol evidence rule to ensure that the parties and courts are dealing with a fully integrated and final agreement. The parol evidence rule forbids the introduction of evidence regarding negotiations, promises, or representations that were made during the process of negotiating a contract, so long as the final contract appears to be clear and complete.[2] A merger clause is inserted to confirm that the parties intended the contract to be the complete and final manifestation of all the terms to which they agreed. In the absence of a merger clause, a party could ask a court to consider extrinsic evidence on whether the parties really did intend the written contract to be their final and complete agreement or whether there were other promises and commitments that were part of their deal.[3]


A merger clause can be implicated in two litigation scenarios: when fraud or fraudulent inducement is asserted as a cause of action or when fraudulent inducement is asserted as a defense to a breach-of-contract claim. In the first scenario, the plaintiff sues the defendant, alleging breach of an extracontractual promise, and the defendant relies on the merger clause as a prohibition on the claim. In the second scenario, the plaintiff sues the defendant for breach of contract, and the defendant claims that its nonperformance is excused because the plaintiff fraudulently induced it into the agreement. The plaintiff then uses the merger clause to preclude the defendant’s defense.


In most jurisdictions, fraud requires proof of the following:


  • A material representation was made.
  • The representation was false.
  • When the representation was made, the speaker knew it was false or made it recklessly without any knowledge of the truth and as a positive assertion.
  • The speaker made the representation with the intent that the other party should act upon it.
  • The party acted in reliance on the representation.
  • The party thereby suffered injury.[4]

A contractual merger clause attacks the reliance element. The logic of the argument is that a party cannot be said to have reasonably relied on an extracontractual representation when the contract itself says that all promises and representations between the parties are expressly recited in the contract.


Courts have developed three general approaches to the interpretation and enforcement of merger clauses. Some courts enforce them exactly as written, preventing a party from claiming that it relied on any extracontractual representation in deciding whether to enter into an agreement. Other courts will enforce merger clauses, but only when the equities demand it. They hold that a merger clause can prevent fraud claims when the provision is negotiated by sophisticated parties or when it is specific about precisely which representations are being disclaimed. Finally, some courts hold, for reasons known only to them, that merger clauses are unenforceable and shall be given no effect.


A Good Night’s Sleep for the Defendant
In some jurisdictions, the merger clause can be a defendant’s security blanket. Under California law, for example, the protection is nearly airtight. In Brinderson-Newberg Joint Venture v. Pacific Erectors, Inc., the U.S. Court of Appeals for the Ninth Circuit considered a construction dispute in which one of the subcontractors alleged that the general contractor had made various oral representations regarding the scope of the subcontractor’s work and the expected deliverable for the project.[5] At trial, the district court permitted the subcontractor to introduce parol evidence about these statements, and the general contractor appealed the jury’s verdict on this evidentiary issue. The relevant portion of the construction contract provided that “the parties shall not be bound by, or liable for, any statement, representation, or agreement not specifically set forth in this [contract].” In reversing the trial court, the Ninth Circuit reminded the parties that “an integrated contract is given legal significance under California law” and held that a plaintiff is prohibited from introducing parol evidence of fraud if such evidence contradicts the terms of an integrated contract.[6]


Georgia courts take a similar view. In Mims v. Cagle Foods JV, LLC, the parties had executed a contract for the plaintiff to build chicken houses for the defendant’s birds.[7] The contract contained a fairly standard and inclusive merger clause, providing that the contract was “the entire agreement between the parties and includes all promises and representations, express or implied, made by [the defendant]” and that “any prior oral or written representations not expressly set forth in this agreement are no longer of any force or effect.”[8] The plaintiff nevertheless alleged that he had been fraudulently induced into the agreement by the defendant’s precontractual promises about the number of birds that would be housed at the new facility.[9] Applying Georgia law, the U.S. Court of Appeals for the Eleventh Circuit affirmed summary judgment and aggressively defended the vitality of the merger clause:


[The plaintiff’s] claim is wholly precluded by the merger clause of the contract. In Georgia, “[a]s a matter of law, a valid merger clause executed by two or more parties in an arm’s length transaction precludes any subsequent claim of deceit based upon pre-contractual representations.”[10]


Defendants in these states can rest easy.[11] If the merger clause is unambiguous, a defendant can expect to defeat fraudulent inducement claims on summary judgment.


Tossing and Turning Through the Night
Other jurisdictions enforce merger clauses, but only when the representation alleged is specifically disclaimed in the agreement. A merger clause may provide some level of protection, but will not completely insulate a defendant against all claims arising out of extracontractual representations. In these states, even with a strong merger clause, an “umbrella” disclaimer shouldn’t allow a defendant to get too comfortable.


In New York, for example, the U.S. Court of Appeals for the Second Circuit considered a securities fraud case in which the plaintiff alleged that the defendant bank had made various oral representations regarding its investment and hedging strategies, and the plaintiff had relied on those representations in making certain ill-advised investment decisions.[12] The bank relied on language in the parties’ master agreement and the various trade confirmations stating that neither party was “relying on any advice, statements or recommendations (whether written or oral) of the other party regarding such Transaction, other than the written representations expressly made by the other party in the [master agreement or confirmations].”[13] The Second Circuit reversed summary judgment in favor of the bank, holding that a disclaimer of reliance “is generally enforceable only if it ‘tracks the substance of the alleged misrepresentation.’”[14] The appellate court characterized the disclaimers cited by the bank as general, not specific, and as saying nothing about the specific oral representations that the plaintiff alleged.[15]


Illinois law takes a similar approach but focuses only on the sophistication and awareness of the parties executing the agreement, rather than the specificity of the representations. In Extra Equipamentos e Exportacao, Ltda. v. Case Corp., the parties had resolved prior litigation through a settlement agreement and release that contained clear no-reliance language and a typical merger clause.[16] The plaintiff subsequently claimed that the defendant had promised to continue to use it as a distributor of the defendant’s products as part of the settlement, even though that commitment was nowhere to be found in the agreement itself. The U.S. Court of Appeals for the Seventh Circuit held that a merger clause can support judgment as a matter of law on a fraud claim only if “no reasonable jury could find that the signatory did not understand the meaning of the no reliance clause that he signed.”[17] The appellate court determined that the plaintiff was such a signatory and affirmed summary judgment against it.[18]


The most confusing treatment of merger clauses may come from Delaware. That story begins with the Delaware Supreme Court’s decision in Norton v. Poplos.[19] In Norton, the plaintiff sought to rescind a real-estate deal based on a claim that the seller had made false statements regarding the land’s zoning. The agreement contained a typical merger clause, stating that both parties “acknowledge that they do not rely on any written or oral representations not expressly written in this contract.”[20] But the Norton court refused to enforce it and, calling it the “better rule,” held that a merger clause will not preclude a claim based on a false statement, regardless of whether the misrepresentation was made fraudulently or innocently.[21]


Many years later, the U.S. Court of Appeals for the Third Circuit heard MBIA Ins. Co. v. Royal Indemnity Co., in which the defendant claimed that the plaintiff’s false statements had fraudulently induced it into issuing policies insuring the repayment of certain student loans.[22] First, the MBIA court opined that, Norton notwithstanding, the Delaware Supreme Court had never set the standards for an effective waiver of a fraudulent inducement claim or defense and committed itself to determining how that court would decide the issue. The MBIA court acknowledged the Norton case, but viewed it as turning on the boilerplate nature of the merger clause before it, and decided that Norton did not “provide a reliable guidepost for [its] decision.”[23]


Declining to follow Norton, the Third Circuit turned to the Delaware Chancery Court’s decision in Kronenberg v. Katz.[24] In that case, the plaintiffs alleged that they had been fraudulently induced into investing in a sports complex management company by defendant’s precontract misrepresentations about the feasibility and management of the project.[25] The controlling agreement had an expansive merger clause, providing that it “constituted the entire agreement and understanding of the parties . . . and supersedes all prior or contemporaneous agreements, understandings, inducements, or conditions, oral or written, express or implied.”[26] After a protracted review of the law of Delaware (and elsewhere), the Chancery Court eventually held that the merger clause did not immunize the defendant from a fraud claim because it did not reflect the plaintiffs’ “unambiguous acknowledgement” that they were not relying on factual, extracontractual statements by the defendant.[27]


Relying heavily on dicta in Kronenberg, yet apparently unconcerned that it had been decided the opposite way, the Third Circuit in MBIA held that an unambiguous merger clause negotiated by sophisticated parties will preclude a fraudulent misrepresentation claim.[28] The tension between MBIA and Norton might be reconciled by emphasizing the distinction between boilerplate merger clauses and those that are specifically negotiated between sophisticated parties. But the more likely reality is that the Delaware state and federal courts have taken different approaches to whether and when a merger clause will prevent a fraudulent inducement claim.


Time to Burn the Midnight Oil
Finally, in a few jurisdictions, a defendant should make a strong pot of coffee and get to work, because a merger clause will provide cold comfort. In Northwest Bank and Trust Co. v. First Illinois National Bank, the U.S. Court of Appeals for the Eighth Circuit considered a fraudulent inducement claim in which the agreement provided that “the [plaintiff] acknowledges that it is not relying upon [the defendant’s] judgment, and that [the defendant] has made no warranty of any kind, express or implied, in connection” with the transaction.[29] For its part, the district court enforced the clause and granted summary judgment in the defendant’s favor, noting that the parties were both “sophisticated lenders.”[30] The court of appeals reversed, holding that under Iowa law, a merger clause will not preclude a fraud claim, regardless of the sophistication of the parties:


Under Iowa law, contractual disclaimers are ineffective to bar a plaintiff from asserting a claim for fraudulent inducement. . . . We find no language in these cases to support the district court’s conclusion that the applicability of this rule turns upon the sophistication of the contracting parties. Instead, the rule is premised on the principle that the fraudulent inducement precedes the formation of the contract, and that to give preclusive effect to language contained therein would allow a party to bind the defrauded party to the contract through the use of a boilerplate disclaimer.[31]


Although this rationale might make sense in the context of adhesion contracts or when the parties’ bargaining power is otherwise uneven, the logic is suspect when two sophisticated, represented parties sign the agreement. The Northwest Bank court apparently gave little weight to the fact that the would-be defrauded party could have simply refused to agree to the no-reliance clause, thereby preserving all of its rights to assert claims based on precontractual representations. It is unclear why the Eighth Circuit felt that these circumstances compelled it to protect the plaintiff from the results of its own agreement. In any event, this decision renders a merger clause completely impotent because a plaintiff can always allege that misrepresentations and false promises were made, regardless of the parties’ express acknowledgement that they don’t exist outside the written agreement.


Recommendations
Like all questions of contract construction, whether a merger clause will function as a per se defense to a fraud claim will be determined by state law. Thus, there are at least three ways that parties can ensure their agreement’s merger clause has some teeth. First, select a governing law that recognizes and enforces merger agreements. Look for the courts that grant summary judgment on fraud claims based on the absence of any issue of fact on reasonable reliance. Second, enhance the general merger language with disclaimers of reliance that are as specific and detailed as possible. Identify exactly what the other party is not being promised. Finally, be clear regarding non-reliance—state that the parties “are not relying” on any statements or representations other than those expressly set forth in the agreement. These additions give merger clauses more traction in states that require specificity in the disclaimer and those that will enforce them only when they are the product of arms-length negotiations by sophisticated parties.


Keywords: litigation, business torts, contractual merger clauses, fraud claims


Daniel P. Elms is a partner at Bell Nunnally & Martin, LLP, in Dallas, Texas.


 

  1. These types of clauses are also sometimes referred to as “big boy” clauses, as in “we’re big boys, and we can take care of ourselves.” See, e.g., Extra Equipamentos e Exportacao, Ltda. v. Case Corp., 541 F.3d 719, 724 (7th Cir. 2008).
  2. Id. at 723.
  3. Id.
  4. See, e.g., In reFirstMerit Bank, N.A. 52 S.W.3d 749, 758 (Tex. 2001) (citingFormosa Plastics Corp. v. Presidio Engrs. & Contractors, Inc., 960 S.W.2d 41, 47 (Tex. 1998)).
  5. 971 F.2d 272, 276 (9th Cir. 1992).
  6. Id. at 281.
  7. 148 Fed. Appx. 763, 765 (11th Cir. 2005).
  8. Id. at 765.
  9. Id. at 769.
  10. Id. (quoting First Data POS, Inc. v. Willis, 546 S.E.2d 781, 785 (2001)).
  11. This is also the law in Texas. See Playboy Enterprises, Inc. v. Editorial Caballero, S.A. de C.V., 202 S.W.3d 250, 258 (Tex. App.—Corpus Christi 2006, pet. denied) (“Where a contract is negotiated at arms-length by sophisticated businessmen represented by counsel, this type of ‘merger’ clause . . . is enforceable and negates reliance on any alleged oral representation” as a matter of law) (citing, in part, Schlumberger Tech. Corp. v. Swanson, 959 S.W.2d 171, 180–81 (Tex. 1997)).
  12. Caiolo v. Citibank, N.A., New York, 295 F.3d 312, 317–18 (2d Cir. 2002).
  13. Id. at 328.
  14. Id. at 330 (citingGrumman Allied Indus., Inc. v. Rohr Indus., Inc., 748 F.2d 729, 735 (2d Cir. 1984)).
  15. Id. at 332.
  16. Extra Equipamentos, 541 F.3d at 722–23.
  17. Id. at 725.
  18. Id.
  19. 443 A.2d 1 (Del. 1982).
  20. Id. at 3.
  21. Id. at 6–7 (citing in part,Halpert v. Rosenthal, 267 A.2d 730, 735 (R.I. 1970)) (holding that either fraudulent or innocent misrepresentations would allow the seller to rescind the contract).
  22. 426 F.3d 204 (3rd Cir. 2005).
  23. Id. at 215.
  24. 872 A.2d 568 (Del. Ch. 2004).
  25. Id. at 572–73.
  26. Id. at 587.
  27. Id. at 594.
  28. MBIA, Ins. Corp.,426 F.3d at 218.
  29. Northwest Bank & Trust Co. v. First Illinois National Bank, 354 F. 3d 721, 725-26 (8th Cir. 2003).
  30. Id. at 726.
  31. Id.

 
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