Wednesday, Jan 17, 2018

Avoiding the Bite: How to Maintain the Ability to Be Made Whole

In one of its last opinions for 2017, the Supreme Court of Virginia ruled that a misrepresentation of a stated fact in a contract likely cannot give rise to a claim of fraud by the misled contracting party. Rather, that misrepresentation will likely only support a claim for a breach of the contract itself, and any harm arising out of that misrepresentation may lead to contractual damages alone. This decision might not greatly alter the landscape, but it is still an important ruling that parties should consider when drafting agreements that are dependent upon mutual understanding of the present status of material facts.

The facts supporting the Court’s decision in the matter of MCR Federal, LLC v. JB&A, Inc.,[1] are straightforward. MCR Federal entered into a contract with the shareholders of another government contracting firm, JB&A, to buy its business. At the closing, MCR Federal certified that representations it made in the contract were true, including the representation that MCR Federal was not under any investigation or inquiry from a governmental entity that could materially harm MCR Federal’s ability to complete its purchase obligations to JB&A’s shareholders. However, as of the closing date, MCR Federal knew it was being investigated by the Air Force for allegedly lying about disseminating data it obtained from the Air Force to undercut a competitor’s bid on an Air Force contract. As a direct result of that investigation, MCR Federal was removed from federal contract consideration and thereafter defaulted on its purchase contract terms with the JB&A shareholders.

In Virginia, if a party incurs damages arising out of actions or reliance induced by another’s misrepresentations that were reasonably relied upon, that party generally may pursue a claim for fraud. If the misrepresentation induces a party to enter into an agreement it would not have otherwise entered into, that is known as “fraud in the inducement” and is a recognized claim in Virginia. For example, where a seller of a condominium complex concealed the fact that hardwood flooring installed in the complex at the time of closing was far inferior to the hardwood floor the purchaser saw in the condominium specifications, and the purchaser relied on the superior hardwood floor specifications when it entered the contract to purchase the units, the Court held the purchaser had a viable claim for fraud in the inducement.[2]

When JB&A shareholders brought suit against MCR Federal, it stated claims for breach of contract as well as actual fraud and constructive fraud in the inducement based on the falsely certified representations in the purchase contract made by MCR Federal. The Circuit Court of Fairfax County agreed with JB&A that the misrepresentations within the agreement presented to JB&A by MCR Federal were misrepresentations that induced the entry of the agreement. Therefore, the Circuit Court ruled that JB&A could bring claims of both fraud and breach of contract against MCR Federal, and ultimately entered judgments against MCR Federal based on both grounds and awarded JB&A attorneys’ fees for having proven fraud. In its final ruling, however, the Supreme Court of Virginia overturned all of JB&A’s claims based in fraud despite agreeing that the misrepresentation was otherwise proved by JB&A’s attorneys. The Supreme Court’s ruling was based on its review of the evidence and finding that the source of MCR Federal’s duty to disclose whether it was under investigation was created by the contract. Rather than being a misrepresentation stated prior to the entrance of an agreement, the misrepresentation was part of the agreement terms itself. As a result, JB&A would have to prove how its damages arose directly from the breach of that term in order to obtain judgment and was unable to obtain damages available to a party pursing allegations of fraud.

Fortunately for JB&A, the damages it suffered as a result of MCR Federal’s breach of the agreement were obvious because MCR Federal failed to pay the price of the agreement. Unfortunately for JB&A, its award of attorneys’ fees was overturned. Based on the Court’s ruling, the common-law jurisprudence this point forward suggests that if a party makes a misrepresentation of a material fact within the contract itself, there is no viable claim for fraud or fraud in the inducement and, instead, only contractual damages may be pursued.

For the rest of us, this ruling enforces the maxim that contracting parties must think twice about the value of the representations they are requiring be made part of any agreement and how they may be damaged in the event of a breach of any term. For example, had MCR Federal not yet missed a payment on its purchase price, what would the value of its misrepresentation have been to JB&A? Parties often require counterparts to make assurances or warranties in their agreements, but how often do they consider the value of that truth?

When negotiating the terms of a contract, Virginia law permits parties to narrow the scope of damages associated with a particular event of default in an effort to minimize the impact of a breach of any one term. Conversely, liquidated damages or pre-agreed awards can be built into an agreement so that the breach of any one term results in automatic payments or other awards that do not require an aggrieved party to prove the effect of any given default. These are excellent methods for analyzing and negotiating for a party’s reliance on these terms.

Parties should also be encouraged to perform due diligence to ensure a mutual understanding of underlying status of the substance of the agreement. The following are methods parties can use to ensure they are on the same page prior to and after execution of the agreement, and through closing: obtain references of each party to ensure both have always been truthful in past agreements, and both are suitable counterparts to carryout the terms of the agreement; require each party to affirm facts at the end of certain time periods after executing the agreement, which gives each party time to investigate the truthfulness of the assertions, instead of reaffirming everything at closing; and request that each party disclose certain financial or other business-related information prior to entering the contract, and that each remains under an obligation to continue disclosing such information through closing. The Court strongly suggests that these sorts of contractual responsibilities will only be enforced through damages provisions the parties include in the contract, which is why diligent parties will also negotiate for damages provisions that explicitly cover breaches of these requirements in their agreement.

Parties may also find themselves questioning whether they should include certain representations in a contract. But all parties will be safe if they negotiate damages provisions into contracts that provide a remedy for breach of the terms contained in the contract, and will make them whole in the event a material term is breached.

It is likely not reasonable to expect the party across the negotiating table to agree to include aggressive damages provisions in every contract (i.e., punitive damages) because the party would find it unreasonable to increase its potential liability when it is committed to negotiating in good faith. Alternatively, it may raise a red flag if one party negotiates fervently against adding certain damages provisions in a contract. There may be a much higher risk of contracting with a party that is reluctant to include damages provisions to account for certain types of defaults when there is no longer a remedy for those defaults outside of the contract. A truly diligent party will strive to foresee where it needs safeguards when doing business with its counterpart. If the truth of any one representation can make or break your deal, you should speak with your transactional counsel not only about ways to ensure the validity of the representation, but about ways to ensure you are made whole by any breach.

[1] MCR Federal, LLC v. JB&A, Inc., Record No. 161799 (Dec. 14, 2017).
[2] See Phillip Abi-Najm, et al. v. Concord Condominium, LLC, 699 S.E.2d 484, 490 (2010).