Avoidance and Remedies

Avoidance and Remedies

A successful misrepresentation defense ends in a remedy. Restatement (Second) of Contracts § 164(1) states the consequence: when a fraudulent or material misrepresentation induces a party's assent and the recipient was justified in relying on it, the contract is voidable by the recipient.¹ Every earlier section asked whether the defense exists: whether the assertion was false, whether it was fraudulent or material, whether it moved the recipient, and whether the recipient was entitled to rely on it. This section asks what a successful claimant receives.

The word voidable has a precise meaning. The contract binds both parties until the recipient chooses to undo it, and that power belongs to the recipient alone. The first thing a victim gets, then, is a choice among forms of relief that suit different kinds of loss.

Three forms are available. A victim who wants out can avoid the contract and recover restitution, giving back what was received and recovering what was given, so that the parties return to where they began. A victim who still wants the bargain can keep the contract and seek damages for the shortfall between what was represented and what was delivered. A victim whose problem is a document that misstates what the parties agreed can ask the court to correct the writing. That remedy is called reformation, and Restatement § 166 allows it only on conditions that include the recipient's having been justified in relying on the misrepresentation.² The subsections below develop the conditions and limits of each.

The law offers several remedies because no single one fits every victim. If undoing the contract were the only option, a buyer who loves the house and discovers a concealed defect would have to surrender the house to obtain any relief. If damages were the only option, a buyer who would never have bought on the true facts would be held to a deal that rested on a lie. The choice belongs to the deceived party for the same reason the contract is voidable in the first place: the wrongdoer cannot be allowed to decide whether the bargain survives. A party who lied cannot use the lie to escape a deal that has turned sour, and cannot force the victim to stay in one either.

These remedies assume that a contract exists to be undone or adjusted. The preceding section showed that a deception about the character or essential terms of the document itself prevents assent from forming at all, so no election arises in that case. The material below concerns the far more common situation in which a contract was formed and is voidable. The first question is how the victim exercises the power to avoid, and what happens when the victim affirms instead.

Rescission and Election

Section 164(1) gives the deceived party a power over the bargain. When a fraudulent or material misrepresentation induces assent and the recipient justifiably relied, the contract is voidable by the recipient.³ The contract continues to bind both sides until the recipient acts, and the recipient alone decides whether to act. Two courses are open. The recipient may avoid the contract by rescission and recover restitution of what was given, or may keep the contract in force and seek damages for the shortfall. Each course has its own conditions and limits, and the history of how fraud entered the common law explains why the law offers both.

Early English common-law courts generally did not treat fraud as a defense to a suit on a contract. They gave indirect relief instead: the victim could recover the damage fraud had caused in a separate action, the forerunner of the tort of deceit.⁴ Courts of equity, which could shape remedies to circumstances, let a defrauded party avoid the contract through rescission, a judicial return of the parties to their pre-contract positions in which each side gave back what it had received.⁵ The law courts eventually recognized a legal right of rescission much like the equitable one, with one technical difference: a party rescinding at law first had to make a tender, meaning an actual offer to return what had been received, while equity excused tender.⁶ The merger of law and equity in the nineteenth century has made that difference minor, but it can still matter. A party who satisfies the requirements of legal rescission, tender included, is entitled to avoid the contract, whereas a court may refuse equitable rescission if it concludes that fairness does not warrant it.⁷

Rescission at law follows a sequence. The party gives notice of the intent to rescind, offers to return the benefits received, and demands back the benefits conferred. If the other side complies, restitution is accomplished by agreement; if it does not, the contract is treated as rescinded and the victim pursues relief in court.⁸ Where the property is unique, a court sitting in equity may order that very property conveyed back.⁹ Because the aim is to unmake the whole contract, courts do not order partial rescission unless the contract is divisible and the parties can be fairly returned to their original positions.¹⁰

The duty to hand back what was received follows from what avoidance does to the contract. Once the contract is undone, nothing justifies either side's keeping what the other supplied, so the principle of unjust enrichment, which forbids keeping a benefit that has no legal basis, requires its return.¹¹ A victim excused from returning the goods could collect the price and keep the goods, and would finish better off than if the contract had never been made. The law nonetheless shields the victim from the wrongdoer's own product. Benefit is measured by the value of the property, which may differ from the contract price; doubts about the value of the wrongdoer's performance are resolved against the wrongdoer; and the victim need not return property, or its value, to the extent that it was worthless when received or deteriorated because of its own defects.¹² Courts therefore adjust the exchange to fit the facts. In Holcomb v. Zinke the court ordered rescission of a house sale, charged the sellers with the buyers' expense in curing defects, and charged the buyers with the reasonable rental value of the home they had occupied. In Johnson v. Davis the sellers had to repay what they had received from the buyers, with interest.¹³

Rescission also asks nothing about whether the deal cost the victim money. A party seeking rescission of a transfer induced by fraud need not show that the other side profited or that the victim suffered an economic loss.¹⁴ The reason lies in the wrong being repaired, which is defective consent, and in how the remedy works: avoidance returns both sides to the status quo, so no loss has to be measured to know what to award, whereas a damages claim cannot be priced without one. A victim who does not want the contract because of the misrepresentation is entitled to avoid it, and the injury can lie simply in having been brought into a contract that the victim would not otherwise have made.¹⁵ In Stambovsky v. Ackley the buyer objected to a house's reputation as haunted, and had that reputation left the market price untouched, the buyer would still have been drawn into a purchase that the truth would have prevented.¹⁶

The dispute between Ventura and Titan shows rescission operating on agreements that had been performed for years. Ventura worked as a commentator for Titan under a series of annual fee agreements. Each year his negotiator asked whether Titan had changed its policy on videotape royalties and was told that only featured performers received them. Relying on that policy, Ventura accepted agreements that waived royalties, although Titan was in fact making royalty payments that contradicted the policy it described.¹⁷ The district court found the statements false and found that Ventura would not have accepted a deal without royalties had he known the truth. It rescinded the agreements and allowed recovery in quantum meruit, a restitution remedy that measures recovery by the reasonable value of what the claimant supplied, and the appellate court upheld that result.¹⁸ Rescission did the decisive work, because proof of an express contract ordinarily bars quantum meruit recovery, and avoiding the contracts that waived royalties removed the bar.¹⁹

Because the contract is voidable and not void, the recipient makes an election: one of two courses that cannot both be followed. The court in Halpert v. Rosenthal put the choice this way: a party induced by fraud to contract may rescind and recover what was paid under the contract, or may affirm the contract and sue for damages in an action for deceit.²⁰ A recipient who affirms is entitled to the difference between the actual value of the performance received and the value it would have had as represented, which includes lost market value or the cost of bringing the property up to the condition represented.²¹ The facts usually decide which course serves the victim better. Take the buyer who discovers that a termite letter was procured by bribery. A buyer who loves the house keeps it and recovers the cost of the termite problem; a buyer who has lost faith in it gives it back and recovers the price.²²

The right to avoid can be asserted in two procedural settings: as a defense when the other side sues to enforce the contract, or in an affirmative action for restitution of benefits already conferred.²³ The buyers in Weintraub v. Krobatsch were sued for specific performance and countered with a claim for rescission, and the court ordered rescission.²⁴ Defense fits a contract that is still largely unperformed, where the victim's main aim is to avoid being held to it. The affirmative action fits a contract already performed, as in Ventura's case, where the victim needs the benefits returned.

Rescission also reaches misstatements that no tort action for damages would reach. A party may rescind for a material misrepresentation even without fraudulent intent, since § 164(1) makes the contract voidable for a material misrepresentation as readily as for a fraudulent one. The law, however, may deny a tort remedy or limit its scope when the maker lacked scienter, the knowing state of mind that fraud requires.²⁵ Courts that allow rescission for innocent misrepresentation have sometimes refused damages in the same case, as the court did in Bortz v. Noon.²⁶ The split makes sense. Rescission asks the maker of an innocent misstatement only to give back what the misstatement helped to obtain, while damages would impose a liability on someone who did nothing culpable. Suppose an art dealer honestly but wrongly tells a buyer that a painting is an original. The dealer has misrepresented a fact central to the bargain, and since the buyer may justifiably rely on a dealer in the trade, the buyer can rescind without proving fraud or negligence. A tort claim for damages would require negligence or scienter, though a claim for breach of express warranty under UCC § 2-313 may supply a contract route to damages or rescission.²⁷

The tort route differs from rescission in what it measures and what it adds. Courts measure damages for fraud in two ways, both aimed at the plaintiff's actual loss. The out-of-pocket measure gives the difference between the price paid and the value received, and the benefit-of-the-bargain measure gives the difference between the value as represented and the value received.²⁸ The restitution measure focuses on what the defendant gained, which can exceed the plaintiff's loss, and it can reach the defendant's property in kind, which helps when the defendant is insolvent.²⁹ A court may award punitive damages on a tort claim of fraudulent inducement but generally cannot do so in equity through restitution, and attorneys' fees are generally unavailable on claims that sound in tort.³⁰

The election is real only while rescission remains available, and two things can end it. The first is conduct and delay. A court grants rescission only if circumstances have not so changed as to make it inequitable, and the remedy is subject to timeliness rules and other equities.³¹ A victim who learns the truth and goes on using the property as an owner has acted consistently with keeping the contract, and the other side is entitled to treat that conduct as a choice. The rule also keeps the option from becoming free, because a victim allowed to wait and rescind only if the property later lost value would shift the risk of the market onto the party who spoke falsely. The second is inability to make restitution. Because rescission restores both sides, a victim who cannot return the property received, as when it has been transferred to a third person, may be denied rescission.³² That limit is narrower than it sounds, since the victim is excused from returning property that was worthless when received or that deteriorated through its own defects.³³

A buyer who resold the generator to a stranger before discovering the lie stands where the second buyer stands, for a different reason: with nothing to hand back, that buyer turns to damages. An exam stem that reports a buyer's attempt to rescind therefore calls for two checks: what the buyer did after learning of the falsehood, and whether the buyer still holds what was received.

Misrepresentation by a Non-Party

Section 164(2) carries the misrepresentation defense past the two signatories to the contract. If a party's assent is induced by a fraudulent or material misrepresentation made by someone who is not a party to the transaction, and the recipient is justified in relying on it, the contract is voidable by the recipient, unless the other party to the transaction, in good faith and without reason to know of the misrepresentation, either gives value or relies materially on the transaction.³⁷ Subsection (1), which this chapter has used throughout, speaks of a misrepresentation by the other party to the contract.³⁸ Subsection (2) takes up the lie that arrives from an outsider, such as a referral agent, or a debtor who persuades a friend to guarantee a loan. It begins from the same answer as subsection (1) and adds a qualification that protects the counterparty. The other requirements are unchanged: the misrepresentation must still be fraudulent or material, must still have induced the assent, and must still have been justifiably relied on.

The starting point favors the deceived party for a reason that has nothing to do with who spoke. Avoidance repairs a defect in the recipient's consent, and the consent is equally defective whether the false statement came from the counterparty or from a stranger. A buyer who reasoned soundly from an outsider's falsehood has been misled as completely as one who heard the same words from the seller. Rescission also asks little of the victim, since it only restores the situation that existed before the transaction.³⁹ The difficulty is that avoiding the contract reaches the counterparty, who may have done nothing wrong, and the exception in subsection (2) is the law's answer to that difficulty.

The exception has two layers, and each does separate work. The first concerns the counterparty's state of mind: the counterparty must act in good faith and without reason to know of the misrepresentation. That condition screens out a counterparty who arranged the lie, who knew of it, or who saw signals pointing to it and looked away, since such a party shares the taint. The second layer concerns what the counterparty has done, and either of two alternatives satisfies it: giving value, or relying materially on the transaction. Those alternatives mark the point at which avoidance stops returning the counterparty to the starting line and begins to take something real from it, such as a payment already received or a replacement purchase already committed. Past that point, unwinding the contract would put the loss on a party who did nothing wrong, and the deceived party is left to pursue the outsider who actually spoke falsely. Before that point, the counterparty loses only the expectation of a bargain it has not yet acted on, and the deceived party's defective consent decides the matter.

An exam stem that pairs an outsider's lie with an innocent seller invites the conclusion that the seller's innocence settles the buyer's claim. Innocence supplies only the good-faith half of the exception, so the answer turns on what the innocent counterparty has done.

The exception reaches only a true outsider, so the first task in any problem is to decide who spoke. A misrepresentation must come from the other party or from someone acting on the other party's behalf to fall under the general rule, and principals are responsible for the misrepresentations of their agents.⁴⁰ An agent's lie within the scope of the agency is therefore the principal's own, subsection (1) governs, and the protection for an innocent counterparty never comes into play. The reason is a matter of allocation. The principal chose the agent and takes the benefit of the agent's work, and a principal who could disown the agent's lies would shift the cost of that choice onto the customers who dealt with the agent. A debtor who fraudulently induces a friend to guarantee a debt, without the creditor's knowledge of the lie, stands on the other side of the line.⁴¹ The debtor is not the creditor's agent, and the creditor who extended credit in good faith on the strength of the guaranty is the counterparty that subsection (2) protects. The guarantor therefore cannot avoid the guaranty against that creditor, and the guarantor's recourse runs against the debtor who lied.

Reformation of the Writing

Section 166 provides a remedy for a deception that produces a real bargain but corrupts the paper that records it. If a party's assent is induced by the other party's fraudulent misrepresentation as to the contents or effect of a writing that evidences or embodies the agreement in whole or in part, the court at the recipient's request may reform the writing to express the terms of the agreement as asserted.⁴³ Two limits qualify that power. The recipient must have been justified in relying on the misrepresentation, and reformation gives way to the rights of third parties, such as good faith purchasers for value, to the extent those rights would be unfairly affected.⁴⁴ Rescission unmakes the contract; reformation keeps it in force and corrects the writing, so a victim who obtains it ends up with the contract the other party said the paper contained.

The remedy is shaped to fit the complaint. Reformation is an equitable remedy that conforms a written agreement to the parties' true understanding, and unlike rescission it does not terminate the contract but corrects an inaccuracy in the written terms.⁴⁵ A recipient who was promised one deal and handed a paper stating another has a complaint about the record of the bargain, and the bargain itself is what the recipient wants. Rescission would make that recipient surrender the deal and return whatever had been received, while reformation delivers the deal. When misrepresentation made the record inaccurate, both remedies are open, so the recipient can choose according to whether the bargain as asserted is still worth having.⁴⁶ An honest mistake that produced the inaccurate record is a different matter, because there reformation is usually the only remedy.⁴⁷

Reformation reaches only misrepresentations that relate to the content or legal effect of the record. Misrepresentations about the qualities of the subject matter, or about other factors that affect the desirability of the bargain or the economic equivalence of the exchange, are not grounds for reformation, since granting it would require the court to remake the agreement itself.⁴⁸ The line follows the stage at which the lie did its work. Fraud in expressing an agreement warrants reformation, whereas fraud in inducing the agreement warrants rescission or damages and never reformation, because reformation in that setting could only impose a contract to which the parties did not agree.⁴⁹ The difference lies in what the court would have to write. A lie about contents leaves a definite term, the one the maker asserted, and the court copies it onto the page. A lie about a quality leaves only a statement about the world, and no revision of the paper can make the world match it, so the court would have to invent a price or a promise the parties never fixed.

Able's lie succeeded because it went to the paper. A lie of equal wickedness aimed at the thing sold produces a different result, because the paper then says exactly what the parties agreed, and the remedy moves away from reformation.

The second buyer is not left without a remedy, because the claim moves to the avoidance and damages routes described earlier in this chapter.⁵⁰ The line between the two scenes is sometimes hard to see. Deviations from the principle have been few, and Brandwein v. Provident Mutual Life Insurance is one apparent departure: the plaintiff there signed a written agreement on the fraudulent promise that additional promises omitted from the writing would be recorded in the corporate promisor's records, and the court upheld a complaint seeking reformation.⁵¹ The deception may look like fraud in the inducement, yet it went to how the deal was transcribed and had nothing to do with whether the deal was desirable, and for that reason the result appears sound.⁵² A second blur arises when the parties agree on a general formula and later on a precise term that they take to follow from it. A judge who treats all my land as the agreement will reform a deed listing only lots 1 and 2 when the grantor owns more, while a judge who treats the agreement as induced by a misstatement of how much land was involved will rescind instead.⁵³ In either case the first task is to identify what the parties actually agreed to, since reformation corrects the paper to that agreement.

Section 166 speaks only of a fraudulent misrepresentation, which is narrower than § 164(1), where a material misrepresentation is enough to make a contract voidable.⁵⁴ Fraud means that the maker intended the assertion to induce assent and had one of the three culpable states of mind studied earlier in this chapter.⁵⁵ Silence can supply the assertion, because nondisclosure is treated as the equivalent of misrepresentation where one party knows that the record does not express the other's intention and knows what that intention is.⁵⁶ That is the situation § 161(c) describes, in which a party who knows that disclosure would correct the other's mistake about the contents or effect of a writing is treated as having asserted that no mistake exists.⁵⁷ A drafter who quietly changes an approved draft and says nothing therefore faces reformation as well as avoidance, and the knowledge that turns the silence into an assertion also makes the misrepresentation fraudulent.⁵⁸

The first limit, found in § 166(a), requires that the recipient have been justified in relying on the misrepresentation.⁵⁹ It is the same requirement § 164(1) imposes on avoidance, so the reasonableness standard developed earlier carries over.⁶⁰ Reformation is the remedy most likely to meet a failure-to-read answer, because the recipient signed a writing that contradicts the deal as asserted. A recipient who simply trusted a drafter's assurance that the paper matched the agreement stands on firm ground, since the assurance was the very thing that made reading look unnecessary, which is why Baker prevails in the lease scene above. A recipient who was handed a writing with the changed term plainly marked, or who had reason to suspect the assurance, has gone ahead in the face of a warning, and relying on the other side's description is then harder to defend. The requirement also reflects the position of the other party, because reformation holds that party to terms the paper does not contain, and justified reliance is what makes the recipient's expectation of those terms worth enforcing.

The second limit, found in § 166(b), protects people who took on the faith of the record.⁶¹ A good faith purchaser for value paid or gave something of worth without notice of the fraud and relied on the writing as it stood. Reforming the writing against that purchaser would take what was paid for in order to repair a wrong done by someone else, and the law leaves the loss with the wrongdoer. The words to the extent make the protection proportionate, so the court may reform as between the parties and withhold relief only where reformation would unfairly affect the third party. The qualifiers good faith and for value do the sorting, since a buyer who knew of the fraud shares the taint and a donee has given nothing that reformation would take away.

Because reformation corrects the paper to the terms as asserted, the recipient must prove what was asserted, and the proof is where many claims succeed or fail. The parol evidence rule does not stand in the way, since it does not apply to evidence offered to establish a right to an equitable remedy such as reformation.⁶² The evidence is offered to show that the writing fails to record the agreement, and it is not offered to alter a writing that records it correctly. The standard generally stated for reformation is clear and convincing evidence that the parties really intended the writing to contain the term in question, which makes the recipient's proof of the asserted term the center of the case.⁶³

Section 166 shares territory with § 163, and the facts decide which one governs. A misrepresentation as to the character or essential terms of a proposed contract makes the signer's conduct ineffective as assent when the signer neither knows nor has reasonable opportunity to know them, so no contract arises on the paper.⁶⁴ Reformation proceeds on the opposite footing, because the signer did assent, to the bargain as the maker described it, and the court conforms the writing to that bargain.⁶⁵ A signer who had no real chance to learn what the paper said, such as one who could not read it and had no one to read it aloud, sits at the § 163 end of the range. A signer who held the document and could have read it, but was justified in trusting the maker's assurance that it matched the deal, sits at the § 166 end, with reformation or avoidance available. A signer who was not justified in that trust, because a warning was in plain view, may have neither claim and remain bound by the paper as written.

The first step eliminates the most claims, because the instinct on an exam is to reach for reformation whenever the other side lied. The question is what the lie was about, and only a lie about the contents or legal effect of the writing supports the remedy.