Defenses to enforceability - Fraud, misrepresentation, and nondisclosure

Learning Outcomes

This article examines contract defenses based on misrepresentation and nondisclosure. It details the elements required to establish fraudulent misrepresentation (including scienter), material misrepresentation, justifiable reliance, and situations where a duty to disclose arises. After reading this article, you will be able to identify when a misrepresentation or nondisclosure renders a contract voidable and analyze the available remedies for the affected party, preparing you for related MBE questions.

MBE Syllabus

For the MBE, you are required to understand the concepts that can render an otherwise validly formed contract unenforceable. This includes analyzing defenses that undermine the reality of assent, such as fraud and misrepresentation. You should be prepared to:

  • Distinguish between fraudulent misrepresentation (scienter) and material misrepresentation.
  • Identify the elements necessary to establish each type of misrepresentation.
  • Analyze the requirement of justifiable reliance by the innocent party.
  • Determine when nondisclosure is actionable (exceptions to the general rule of no duty to disclose).
  • Recognize the remedies available when a contract is voidable due to misrepresentation or nondisclosure.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

  1. For a contract to be voidable due to fraudulent misrepresentation, the plaintiff must prove all the following EXCEPT:
    1. A misrepresentation by the defendant.
    2. Scienter by the defendant.
    3. Pecuniary damages.
    4. Justifiable reliance by the plaintiff.
  2. A misrepresentation is considered "material" if:
    1. The defendant knew the statement was false.
    2. It would likely induce a reasonable person to assent to the contract.
    3. The plaintiff actually relied on the statement.
    4. It relates to an opinion rather than a fact.
  3. Generally, nondisclosure of a fact renders a contract voidable only when:
    1. The fact is easily discoverable by reasonable inspection.
    2. The nondisclosing party has a duty to disclose the fact.
    3. The fact relates to the value of the subject matter.
    4. Both parties are mistaken about the fact.

Introduction

Even when offer, acceptance, and consideration are present, a contract may be unenforceable if a party's assent was obtained improperly. This article focuses on defenses based on misrepresentation (fraudulent or material) and nondisclosure. These defenses attack the quality of the assent given, potentially rendering the contract voidable at the option of the deceived or misled party. Understanding the nuances of these defenses is essential for analyzing contract enforceability on the MBE.

Misrepresentation

A misrepresentation is an assertion that is not in accord with the facts. It can be intentional (fraudulent) or unintentional (material or innocent). For a misrepresentation to make a contract voidable, the innocent party must generally show they justifiably relied on the misrepresentation and that it induced their assent to the contract.

Fraudulent Misrepresentation (Fraud in the Inducement)

A contract is voidable by the innocent party if their assent is induced by the other party's fraudulent misrepresentation. Fraudulent misrepresentation requires proof of:

  1. Misrepresentation: A false assertion of fact. This can be an affirmative statement or, sometimes, concealment of a fact. Opinions or puffing generally do not qualify, unless stated by someone with superior knowledge or stated in a way that implies a factual basis.
  2. Scienter: The defendant made the assertion knowing it was false, or with reckless disregard for its truth or falsity.
  3. Intent to Induce Assent: The defendant made the misrepresentation with the intent to induce the innocent party to enter the contract.
  4. Justifiable Reliance: The innocent party actually and justifiably relied on the misrepresentation in assenting to the contract.

Key Term: Fraudulent Misrepresentation A false assertion of fact made with scienter and the intent to induce the other party to assent to the contract, upon which the other party justifiably relies.

Key Term: Scienter Knowledge of falsity or reckless disregard for the truth or falsity of a statement.

Material Misrepresentation

A contract is also voidable by the innocent party if their assent is induced by the other party's material misrepresentation, even if made without scienter (i.e., unintentional). Material misrepresentation requires:

  1. Misrepresentation: A false assertion of fact.
  2. Materiality: The misrepresentation must be material.
  3. Intent to Induce Assent: The misrepresentation must have induced the innocent party to enter the contract.
  4. Justifiable Reliance: The innocent party must have justifiably relied on the misrepresentation.

Key Term: Material Misrepresentation A misrepresentation that would likely induce a reasonable person to assent to the contract, or that the maker knows would likely induce this particular recipient to assent.

Justifiable Reliance

For either fraudulent or material misrepresentation, the innocent party's reliance must be justifiable. Reliance is generally justifiable even if the innocent party could have discovered the truth through reasonable investigation. However, reliance may not be justified if the assertion is obviously false or merely opinion.

Worked Example 1.1

Seller, knowing a car's engine has serious internal damage, tells Buyer, "This car's engine is in perfect condition, just rebuilt." Buyer, relying on this statement, purchases the car. Soon after, the engine fails completely. Can Buyer rescind the contract?

Answer: Yes. Seller made a false assertion of fact (engine condition) with knowledge of its falsity (scienter) and intended Buyer to rely on it. Buyer's reliance was justifiable, as the internal engine damage was not obvious. This constitutes fraudulent misrepresentation, making the contract voidable by Buyer.

Worked Example 1.2

Realtor is selling a house. Based on outdated city plans, Realtor tells Buyer the property is zoned for commercial use, honestly believing this to be true. Buyer, intending to open a shop, relies on this statement and buys the house. Buyer later discovers the zoning is strictly residential. Can Buyer rescind?

Answer: Yes. Realtor made a false assertion of fact (zoning). Although unintentional (no scienter), the misrepresentation was material because zoning for commercial use would likely induce a reasonable person intending to open a shop to assent. Buyer justifiably relied on Realtor's statement. This constitutes material misrepresentation, making the contract voidable by Buyer.

Nondisclosure

As a general rule, a party is not required to disclose facts to the other contracting party. Silence, in itself, typically does not constitute misrepresentation. However, nondisclosure can be actionable and make a contract voidable in certain circumstances where a duty to disclose exists.

General Rule: No Duty to Disclose

Parties are generally expected to exercise their own diligence in discovering facts relevant to the contract. Simply failing to disclose a fact, even a material one, does not usually make a contract voidable.

Exceptions Creating a Duty

Nondisclosure has the same effect as an assertion that the fact does not exist in the following circumstances, among others:

  1. Fiduciary Relationship: Where the parties have a relationship of trust and confidence (e.g., trustee-beneficiary, lawyer-client), there is a duty to disclose material facts.
  2. Necessary to Correct a Previous Assertion: A party must disclose facts necessary to correct a previous assertion that, due to later events or discovered falsity, is no longer true or is now materially misleading (a "half-truth").
  3. Necessary to Correct a Basic Mistaken Assumption: A party must disclose a fact if they know that disclosure is necessary to correct a mistake the other party is making about a basic assumption of the contract, provided the nondisclosure amounts to a failure to act in good faith and in accordance with reasonable standards of fair dealing.
  4. Active Concealment: An affirmative act intended or known to be likely to prevent another from learning a fact is equivalent to an assertion that the fact does not exist.

Exam Warning

Be careful to distinguish mere nondisclosure (generally not actionable) from situations where a duty to disclose arises due to a special relationship, a half-truth, or a known basic mistake by the other party. Also, differentiate nondisclosure from active concealment, which is treated as a misrepresentation.

Remedies

If a party's assent is induced by a fraudulent or material misrepresentation, or by an actionable nondisclosure, the contract is voidable by that party.

Rescission and Restitution

The primary remedy is rescission, where the innocent party avoids or cancels the contract. Upon rescission, each party must return any benefit received from the other (restitution).

Damages

In addition to or instead of rescission, the innocent party may be able to recover damages.

  • Fraudulent Misrepresentation: The victim may typically recover damages, often calculated either as "benefit-of-the-bargain" (value as represented minus value as received) or out-of-pocket losses. Punitive damages may also be available for fraud.
  • Material (Non-fraudulent) Misrepresentation: Damages may be available, often limited to reliance or out-of-pocket losses, especially if rescission is also granted.

Key Point Checklist

This article has covered the following key knowledge points:

  • Misrepresentation involves a false assertion of fact.
  • Fraudulent misrepresentation requires scienter (knowledge of falsity or reckless disregard for truth).
  • Material misrepresentation requires that the false assertion would likely induce assent in a reasonable person.
  • Both require justifiable reliance by the innocent party.
  • Generally, there is no duty to disclose facts during bargaining.
  • Nondisclosure is actionable when a duty to disclose exists (e.g., fiduciary relationship, half-truths, basic mistakes known to one party).
  • Active concealment is treated as misrepresentation.
  • Contracts induced by fraudulent or material misrepresentation, or actionable nondisclosure, are voidable by the innocent party.
  • Remedies include rescission, restitution, and potentially damages.

Key Terms and Concepts

  • Fraudulent Misrepresentation
  • Scienter
  • Material Misrepresentation
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