© 2018 The Texas Lawbook.
By T. Ray Guy of Weil, Gotshal & Manges
(April 9) – On March 23, the Texas Supreme Court issued a unanimous opinion with significant implications for fraud and negligent misrepresentation claims asserted by one contracting party based on alleged extra-contractual representations by its counterparty.
The Court in JPMorgan Chase Bank v. Orca Assets reaffirmed two principles grounded in common sense that courts in some jurisdictions nonetheless fail to recognize and apply: (1) a party cannot justifiably rely on an extra-contractual representation that is directly contradicted by the unambiguous language of the parties’ contract; and (2) reliance on a representation is not justifiable if enough “red flags” indicate that such reliance is unreasonable.
The context of the case
The issue arose in an all-too-familiar context. Sophisticated parties negotiate and sign a purchase agreement, lease, settlement agreement or other document that ostensibly embodies the entirety of their agreement. That document may also include a merger clause and multiple disclaimers. But the plaintiff later sues claiming that the defendant misrepresented material facts leading up to the execution of the agreement and that the misrepresentations induced the plaintiff’s execution of the agreement. The defendant then moves to dismiss or for summary judgment or, as in this case, for limitation of issues for trial under Texas Rule of Civil Procedure 166(g).
The consequences of allowing claims based on extra-contractual misrepresentations to survive motion practice and proceed to trial can be significant. If such claims are deemed cognizable, the plaintiff will be allowed to present evidence of pre-execution representations to prove fraudulent inducement, even if the contract is unambiguous and the alleged representations are inconsistent with the express wording of the contract.
The addition of tort causes of action grounded in misrepresentations brings other measures of damages into play and may support punitive damages not available for breach of contract claims. Limitations of liability negotiated into the agreement may no longer protect the defendant. Individual officers or employees of a corporate defendant may find themselves named as defendants for alleged representations made, if at all, on behalf of their employer.
The dispute between the parties
In the case decided last month, plaintiff Orca was a lessee of Eagle Ford oil and gas properties. JPMorgan, the trustee of a trust that owned the properties, was the lessor. In June 2010, JPMorgan leased the properties to GeoSouthern, which did not immediately record its lease.
That November, Orca entered into discussions with JPMorgan for a lease of the same properties. Orca presented evidence that in its initial discussions with the bank – after JPMorgan had already leased the properties to GeoSouthern – JPMorgan’s trust officer represented that the acreage in question was open for lease. JPMorgan conceded that the representation was made by the trust officer and was false.
On Dec. 6, 2010, the parties signed a letter of intent giving Orca a thirty-day option period to determine which properties it would choose to lease. The letter of intent recited in part that Orca “has caused a search to be made in the records … and has preliminarily determined that [the] Trust is the owner and holder of the mineral estate underlying the following lands … which lands ORCA has further determined to be free of any recorded oil and gas lease.” The letter of intent also specified that a new Paragraph 18, containing language that did not appear in previous leases between the parties, would be included in any leases executed pursuant to the option:
Negation of Warranty. This lease is made without warranties of any kind, whether express or implied, and without recourse against Lessor in the event of a failure of title, not even for the return of the bonus consideration paid for the granting of the lease or for any rental, royalty, shut-in payment, or any other payment now or hereafter made by Lessee to Lessor under the terms of the Lease.
During the option period, GeoSouthern caused its lease to be recorded. But after signing the letter of intent, Orca conducted no new title searches, instead limiting its title-related work to reviewing the title examination it had obtained in November before meeting with JPMorgan.
In January 2011, when Orca exercised its option and signed six leases – identical except for property descriptions – it was unaware of the prior GeoSouthern lease. The new Paragraph 18 with its disclaimers appeared in each of the six leases, for which Orca paid $3.2 million.
Orca presented evidence that when the payment was delivered, its representative asked JPMorgan’s trust officer – an individual defendant – whether the properties were “still all open” and that the JPMorgan officer “looked at something below his desk” and his computer and responded that the properties were still open for lease.
The double-leasing came to light when Orca recorded its leases and GeoSouthern contacted JPMorgan about the situation. JPMorgan, realizing its error, attempted to return Orca’s payment. Orca refused to accept the return payment and instead sued JPMorgan and the individual officer for $400 million. Orca asserted claims for breach of contract, fraud, statutory fraud and negligent misrepresentation, among others.
After a pretrial conference pursuant to Rule 166 of the Texas Rules of Civil Procedure, the District Court ruled that the letter of intent and the six leases were unambiguous; that Orca could not establish justifiable reliance, an element of its claims for fraud, statutory fraud and negligent misrepresentation; and that the unambiguous terms of the leases and letter of intent barred recovery for breach of contract. Based on these rulings and others not appealed by Orca, the district court rendered judgment for JPMorgan.
The Dallas Court of Appeals affirmed the dismissal of Orca’s breach of contract claim, but found error in the dismissal of Orca’s claims for fraudulent inducement and negligent misrepresentation and remanded them for trial. The Texas Supreme Court granted JPMorgan’s petition for review. Orca did not concurrently seek further review of the dismissal of its breach of contract claim.
The underlying facts must have enhanced JPMorgan’s chances that the Supreme Court would find the case worthy of discretionary review. The trust officer’s misrepresentation was almost certainly inadvertent rather than a deliberate falsehood. There was no conceivable possibility that the trust or the bank could benefit from the double-leasing, the eventual discovery of which was inevitable. Promptly after discovering the problem, JPMorgan attempted to return Orca’s $3.2 million. Orca refused to accept it and instead filed suit claiming damages of more than a hundred times that amount. In short, Orca appeared opportunistic and anything but a sympathetic litigant.
Prior law on contractual disclaimers of reliance
In a series of cases starting with Schlumberger Technology Corp. v. Swanson, the Texas Supreme Court considered and ruled on various examples of contract language in which parties disclaimed reliance on outside-the-contract representations in order to foreclose extra-contractual liability.
In Schlumberger, for example, a settlement agreement acknowledged the absence of promises or agreement not included within the document itself, and further provided that the parties were not “relying on any statement or representation of an agent or party being released” and that each party was “relying on his or her own judgment.” The Court held that “a release that clearly evidences the parties’ intent to waive fraudulent inducement claims, or one that disclaims reliance on representations about specific matters in dispute, can preclude a claim of fraudulent inducement.”
Similarly, in Forest Oil Corp. v. McAllen, the Court held that a settlement agreement that, among other things, disclaimed reliance “upon any statement or any representation of any agent of the parties” in connection with execution of releases, was not boilerplate and was sufficiently specific and binding.
The final case in the trilogy was Italian Cowboy Partners v. Prudential, a dispute between a commercial landlord and its restaurant-owner tenant, which terminated its lease because of a consistent bad odor on the premises. The Court held that exculpatory language in the lease – that the landlord had made no representations not set out in the lease and that the lease constituted the entire agreement between the parties – was nothing more than a merger clause that did not disclaim reliance on the landlord’s representations that the property was “in perfect condition, never a problem whatsoever” and that “there had been nothing wrong with the place at all.”
In Orca, the Court of Appeals held that the negation-of-warranty language in Orca’s leases – which “[did] not mention the word reliance or purport to disclaim any earlier statements or representations of JPMorgan” – was not sufficient to disclaim reliance. JPMorgan did not challenge that conclusion when it sought and obtained review by the Supreme Court.
The holding: “red flags” and “direct contradiction”
Instead, JPMorgan, in its petition for review and subsequent briefing and argument, chose to fight at two other hedgerows, contending that its trust officer’s erroneous representations were in conflict with the language of the letter of intent and leases, and that Orca was not entitled to rely on those representations because of several circumstances indicating that any such reliance would be unreasonable.
The Supreme Court had earlier held in National Property Holdings v. Westergren that even absent a binding disclaimer of reliance, a contracting party may not justifiably rely on extra-contractual misrepresentations that “directly conflict with the content of the [contract] itself.” In Orca, JPMorgan contended that the alleged representation that the properties were “open” was directly contradicted by the negation of warranty of title and Orca’s lack of recourse for failure of title.
And in Grant Thornton v. Prospect High Income Fund, the Court had held that “red flags,” individually or in combination, could suffice as a matter of law to preclude justifiable reliance on extra-contractual representations. Grant Thornton involved claims by a hedge fund investor that had, in a series of transactions, purchased bonds issued by a timeshare resort company – allegedly in reliance on audit reports signed by Grant Thornton. Noting that a plaintiff cannot justifiably rely on a representation “if there are ‘red flags’ indicating such reliance is unwarranted” (quoting Haralson v. E.F. Hutton Group), the Court affirmed summary judgment in favor of the auditor, citing among other things the facts that the hedge fund employee who made the decision to purchase the bonds was an “experienced bond investor with a bachelor’s degree in finance and a master’s in business administration”; that he continued purchasing bonds after the issuer lost its credit facility, which he had described as “the lifeblood of the company”; and that many of his purchases were at deep discounts, as low as 23.5 percent of par value, which reflected the market’s perception of a substantial risk of default.
The representations on which Orca grounded its tort claims against JPMorgan were the trust officer’s statements – allegedly made during an initial meeting and repeated at closing – that the acreage was “open.” Conceding for purposes of appeal that the statement was made and was false, JPMorgan argued that under the circumstances Orca could not have justifiably relied on this statement.
Reversing the Court of Appeals, the Supreme Court held for JPMorgan on both of its asserted grounds for review. Addressing the Grant Thornton “red flags” impediment to justifiable reliance, the Court “expressly reject[ed] the notion that the mere use of the negation-of-warranty and no-recourse provision in the letter of intent and the leases could wholly negate justifiable reliance,” choosing to “instead view the circumstances in their entirety while accounting for the parties’ relative levels of sophistication.” Initially noting that both JPMorgan and Orca were sophisticated business entities engaged in a “complicated, multi-million dollar business transaction” who should expect to recognize red flags that less experienced businesspeople might overlook, the Court found the following facts significant:
• Two of Orca’s three witnesses concerning the trust officer’s representation at their initial meeting testified that the representation was equivocal at best – “I’ll have to check.”
• When the trust officer repeated the representation at the closing, he did so in response to an Orca employee’s request for verification that the tracts were still “open” – indicating an unusual level of skepticism for a purchaser preparing to part with $3.2 million for the properties.
• The letter of intent contained no assurances that the trust had title, instead reciting that “Orca has caused a search to be made of [the county] records … and has preliminarily determined that [the trust] is the owner and holder of the mineral estate.”
• Although the new negation-of-warranty language in the letter of intent wasn’t sufficient of itself to disclaim reliance, an Orca landman admitted that it amounted to a “curveball” that “raised a red flag” and that he advised Orca to obtain a legal opinion as to title.
• Orca had regularly checked the county records for newly-filed leases until it executed the letter of intent – and then stopped doing so.
In light of Orca’s sophistication in the industry, the Court concluded that these red flags in combination were sufficient to negate justifiable reliance on the trust officer’s representations.
The Court next addressed conflict between the language of the letter of intent and the trust officer’s oral representation and concluded that the former directly contradicted the latter, rendering reliance on the representation unreliable. Agreeing with the Court of Appeals on the applicable standard – whether “a reasonable person can read the writing and still plausibly claim to believe the earlier representation” – the Supreme Court held that the intermediate court misapplied that standard. The representation that the acreage was “open” amounted to a representation that the trust had good title – for which a negation-of-warrant clause is “just the opposite” – a disavowal of any guaranty of title:
If [the officer’s] earlier representation amounts to a guarantee of title … the negation of warranty was exactly the opposite. And no reasonable, sophisticated entity could read the latter and plausibly believe the former.
Summing up, the Supreme Court – reversing the Court of Appeals and reinstating the District Court’s take-nothing judgment – held that either the “red flags” or the direct contradiction between oral representation and written language would suffice to preclude justifiable reliance.
Conclusion
To those of us who regularly represent defendants in commercial transactions, it’s a source of continuing frustration that a multi-page, single-spaced contract specifying in great detail the parties’ mutual rights and obligations can be supplanted if a creative plaintiff pleads and testifies that the execution of the contract was induced by pre-execution oral representations that are at odds with the carefully-negotiated language of the written agreement.
Obviously the best protection against such fraudulent inducement claims is contract language that explicitly disclaims reliance on extra-contractual representations, with the specificity required by the Supreme Court in Schlumberger and Forrest Oil and Italian Cowboy. But the Orca holding also relieves that frustration, to some degree, by reaffirming that in a transaction governed by Texas law, a sophisticated party cannot overturn its agreement and prevail in litigation by relying on alleged representations that are directly contradicted by the written agreement or ignore obvious indications that the ostensible representations are not to be relied upon.
For that matter, Italian Cowboy might have been decided differently if it had been preceded by Westergren and the parties had argued, and the courts had considered, the “direct contradiction” doctrine. Evidence that a property manager made representations concerning the premises would seem to be directly contradicted by recitations in the lease that “neither Landlord nor Landlord’s agents … have made any representations or promises … except as expressly set forth herein.” It will be interesting to watch and see whether Westergren and Orca are as prominently cited and outcome-determinative in contract and fraud litigation as Schlumberger and Forest Oil have been to this point.
In the meantime, it’s refreshing to see that – at least for once – rationality prevailed over a predictable effort to transmute a defensible breach-of-contract claim into lucrative tort causes of action.
T. Ray Guy is a seasoned trial lawyer at Weil, Gotshal & Manges. In 2017, The Texas Lawbook named Guy one of its 50 Lions of the Texas Bar.
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