Narrow fraud-in-the-inducement
exception adopted
By
David Ziemer
Wisconsin Law Journal
June
11, 2003
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“The
misrepresentations concerned matters related to the performance
of the contract itself, and as such, cannot be found to
be extraneous to the contractual dispute. Accordingly,
Digicorp is limited to contract remedies ... The fraud
in the inducement exception to the economic loss doctrine
is inapplicable under these circumstances.”
Justice
N. Patrick Crooks
Wisconsin Supreme Court
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The
economic loss doctrine bars tort claims for fraud in the inducement
of a contract, but only when the fraud is interwoven with the
contract, in that it involved matters for which risks and responsibilities
were addressed, the Wisconsin Supreme Court held on June 3.
The
court also held that the economic loss doctrine precludes recovery
in tort for solely economic losses, regardless of whether privity
of contract exists between the parties. It also held that recovery
of the benefit of the bargain is not permissible where the fraud
in the inducement exception applies and tort remedies are sought.
Digicorp,
Inc. was an authorized distributor for Ameritech Corporation.
Bacher Communications, Inc., was not. Digicorp and Ameritech entered
into negotiations for Digicorp to sell Ameritech's calling services
and calling plans through Bacher.
Ron
Taylor, an Ameritech employee, knew, but failed to inform Digicorp,
that one of Bacher's salesmen, Dann Krinsky, had engaged in fraudulent
acts of forging customers' signatures when Krinsky had worked
for a different Ameritech distributor.
Ameritech
and Digicorp signed a contract that superseded an earlier one,
and incorporated Bacher into the distribution plan. The contract
provided that Digicorp was responsible for the actions of the
salespersons.
The
contract also provided that either party could terminate the agreement,
and that Ameritech could terminate the contract without any notice,
in the event that Digicorp submitted any sales agreements subsequently
found to contain forged customer signatures. This provision was
new and had not been included in previous contracts between Ameri-tech
and Digicorp.
Krinsky
forged hundreds of signatures, and Ameritech exercised its right
to terminate the contract. Digicorp, Bacher, and Ameritech all
subsequently filed assorted claims and crossclaims against each
other, in both contract and tort.
The
circuit court held that the tort claims were not barred by the
economic loss doctrine, because they fall into the fraudulent
inducement exception, and permitted the case to go to the jury.
The
jury awarded Digicorp damages for Ameritech's breach of contract
and intentional misrepresentation; awarded Bacher damages for
Ameritech's misrepresentation; and awarded Ameritech damages for
Digicorp's breach of contract and Bacher's negligence.
All
parties appealed, and the court of appeals agreed with the circuit
court that the economic loss doctrine did not bar the tort claims.
The
Supreme Court granted Ameri-tech's petition for review and reversed
in a decision written by Justice N. Patrick Crooks, and joined
by Justice David T. Prosser. Justice Diane S. Sykes wrote an opinion
concurring in the result, but dissenting from the reasoning.
Justice
Ann Walsh Bradley wrote a dissenting opinion joined by Justice
William A. Bablitch. Chief Justice Shirley S. Abrahamson and Justice
Jon P. Wilcox did not participate.
Economic
Loss Doctrine
The
majority opinion first held that the economic loss doctrine does
bar tort claims for fraud in the inducement of a contract, but
only where the fraud is "interwoven with the contract, and
not extraneous to it," adopting the reasoning of a Michigan
Court of Appeals case, Huron Tool and Engineering Co. v. Precision
Consulting Services, Inc., 209 Mich. App. 365, 532 N.W.2d 541
(1995).
The
economic loss doctrine serves three purposes: to maintain the
fundamental distinction between tort law and contract law; to
protect commercial parties' freedom to allocate economic risk
by contract; and to encourage the party best situated to assess
the risk of economic loss, the commercial purchaser, to assume,
allocate, or insure against that risk.
The
court concluded that the Huron standard best serves those purposes.
Distinguishing between interwoven and extraneous fraud, the court
quoted the Huron case as follows: "[f]raud in the inducement
presents a special situation where parties to a contract appear
to negotiate freely — which normally would constitute grounds
for invoking the economic loss doctrine — but where in fact
the ability of one party to negotiate fair terms and make an informed
decision is undermined by the other party's fraudulent behavior.
In contrast, where the only misrepresentation by the dishonest
party concerns the quality or character of the goods sold, the
other party is still free to negotiate warranty and other terms
to account for possible defects in the goods." Huron, 209
Mich. App., at 372-73.
Defining
the difference, the majority opinion said that extraneous fraud
concerns those matters whose risk and responsibility were not
expressly or impliedly dealt with in the contract.
Finding
the Huron standard consistent with the policies underlying the
economic loss doctrine, the Supreme Court set forth the following
standard: "The fraud in the inducement exception we adopt
is very narrow, and does not nullify the economic loss doctrine.
It seems clear that, generally, in order for the fraud in the
inducement exception to apply, the misrepresentation would have
occurred before the formation of the contract. In addition, to
constitute deceit or intentional misrepresentation, a plaintiff
would have to prove the five elements set forth in the case law
and in Wisconsin Civil Jury Instruction 2401. Those five elements
would have to be proved by 'clear, satisfactory, and convincing
evidence.' The underlying purposes of the economic loss doctrine
are preserved, since the exception is a narrow one that maintains
the distinction between contract and tort remedies in most situations.
(cites omitted)."
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What
the court held
Case:
Digicorp, Inc., v. Ameritech Corp., Nos. 01-1833 & 01-2258.
Issue:
Does Wisconsin recognize an exception to the economic loss
doctrine for fraud in the inducement?
Does
the economic loss doctrine apply, even without privity between
the parties, to all cases, or just those involving goods
sold in a chain of distribution?
Holding:
Yes. Wisconsin recognizes a narrow exception to the economic
loss doctrine, where the fraud is extraneous to, rather
than interwoven with, the contract.
Yes.
The lack of privity between the parties does not bar application
of the doctrine.
Counsel:
Michael B. Apfeld, Daniel T. Flaherty, Craig A. Kubiak,
Appleton, For Ameritech Corp.; Gregory J. Cook, Anthony
P. Hahn, Wausau, For Bacher Communications Inc.; Victor
E. Plantinga, Douglas W. Rose, Brookfield, For Digicorp,
Inc.
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Application
Applying
that standard, the majority opinion concluded that the tort claims
were barred, because the alleged fraud was interwoven with the
contract.
The
court found, "the fraud involved matters for which risks
and responsibilities were interwoven into the contract. It is
clear from the record that the parties expressly and impliedly
assigned and allocated the responsibilities and risks for the
... employees."
First,
the court noted that the agreement provided that Digicorp reserved
the right to approve all individuals engaged in the sale of Ameritech
services.
Second,
a letter from Taylor to Digicorp sets forth criteria for employees,
states that Digicorp is responsible for the actions of sales representatives,
and provides that Digicorp's status as an authorized dealer will
be jeopardized by conduct contrary to the standards.
Finally,
the agreement provided that the agreement can be terminated by
Ameritech if any representative forges customer signatures.
The
court found it clear from these facts that the parties expressly
assigned responsibility and risk for the sales representatives,
which were the subject of the alleged misrepresentation.
The
court reasoned, "Even assuming, arguendo, that the misrepresentation
made by Taylor with regard to knowledge of Krinsky's past fraudulent
behavior, was a material inducement to Digicorp to enter into
its replacement agreement with Ameritech, it was part and parcel
of an overall allocation of risks and responsibilities for ...
employees."
The
court added, "This information shows that the alleged misrepresentations
by Taylor were interwoven with the subject matter of the contract.
... The misrepresentations concerned matters related to the performance
of the contract itself, and as such, cannot be found to be extraneous
to the contractual dispute.
Accordingly,
Digicorp is limited to contract remedies ... The fraud in the
inducement exception to the economic loss doctrine is inapplicable
under these circumstances."
Privity
The
court next held that a subcontractor of the party to whom the
alleged misrepresentations were made does not avoid the operation
of the economic loss doctrine, even though it is not in contractual
privity with the party allegedly engaging in fraud.
In
Daanen & Janssen, Inc. v. Cedarapids, Inc., 216 Wis.2d 395,
573 N.W.2d 842 (1998), the court held that the doctrine bars a
party in the distributive chain from recovering losses in tort
from another party in that chain. The court concluded that the
same reasoning applies to bar Bacher's tort claims against Ameritech
as well.
Damages
Finally,
the court held that the doctrine prevents parties from both avoiding
the contract and recovering the benefit of the bargain.
The
court stated, "the application of the fraud in the inducement
exception to the economic loss doctrine renders the underlying
contract voidable, and gives the defrauded party the option of
electing either tort or contract damages. Thus, allowing Digicorp
and Bacher to avoid the contract, but recover the benefit of the
bargain contravenes not only the logic of the fraud exception,
but the core principles of the doctrine of election of remedies.
(cites omitted)."
Accordingly,
the court reversed the court of appeals, overruled the court of
appeals' published decision in Douglas-Hanson Co. v. BF Goodrich
Co., 229 Wis.2d 132, 598 NW.2d 262 (Ct.App.1999), which held that
tort claims for fraud in the inducement were not precluded by
the economic loss doctrine, and remanded for a new trial limited
to contract remedies.
Sykes'
Dissent
Justice
Sykes wrote separately, agreeing that the economic loss doctrine
applied, and barred the tort claims in this case, but concluding
that it applies in all contract cases, regardless of whether the
alleged fraud is interwoven with or extraneous to the contract.
Sykes
also criticized the majority opinion for confusing tort and contract
remedies in the final section of the opinion. Sykes wrote, "A
contract fraudulently induced is void or voidable; a party fraudulently
induced to enter into a contract 'has the election of either rescission
or affirming the contract and seeking damages.' This election
of remedies requirement does not confer upon the aggrieved party
the option of pursuing either contract or tort remedies, but,
rather, involves a choice between two different contract remedies:
damages for breach or rescission/restitution. (cites omitted)."
Bradley's
Dissent
Justices
Bradley and Bablitch dissented from the majority opinion also,
writing in favor of a broad fraud-in-the-inducement exception
to the economic loss doctrine.
The
dissent also concluded that, in practice, the rule adopted in
the majority opinion will render the fraud in the inducement exception
a nullity.
Citing
a federal case, Budgetel Inns, Inc. v. Micro Systems, Inc., 8
F.Supp.2d 1137, 1146 (E.D.Wis. 1998), the court quoted, "In
all cases cited by the parties and researched by the court, use
of the Huron limitation eliminated the claims of fraud in the
inducement. For instance, after discussing the fraud in the inducement
exception with the Huron limitation, the Huron court itself found
that the plaintiff's fraud claim was not viable apart from its
contract claims..."
Supporting
a broad exception for fraud in the inducement, the dissent wrote,
"it is difficult for a party engaged in contract negotiations
to freely assess, allocate and insure against risk when the other
party is blatantly lying regarding material terms of the contract.
The existence of tort re-medies provides a deterrent effect against
such conduct. Accordingly, it is hard to see how a party's ability
to freely assess, allocate and insure against risk is advanced
by removing the deterrent effect created by the tort remedies.
(cites omitted)."
The
dissent added, "parties should be able to operate under a
legal backdrop that promotes honest negotiation. While rescission
and restitution may be adequate remedies in many fraudulent inducement
cases, there are certainly cases in which the fraud is so blatant
and extensive as to warrant tort damages. Today, the lead opinion
takes away the possibility of tort damages in those cases."
The
dissent also disagreed with the extension of the decision in Daanen
& Janssen to this case, holding that the absence of privity
between Ameritech and Bacher is not a reason for not applying
the economic loss doctrine.
The
dissenters noted, "Since Bacher had no contract with Ameritech,
presumably the lead opinion's application of Daanen & Janssen
leaves Bacher without a tort remedy or a contract remedy. It acknowledges
that Bacher raised the concern that if the economic loss doctrine
prevents its intentional tort claim, it will be left without a
remedy for Ameritech's fraud. However, the opinion does not explain
why Bacher being left without a remedy is the correct result.
Perhaps it did not address this question because it cannot fairly
answer it."
Finally,
the dissent took issue, as did Sykes' dissent, with the majority
opinion's confusing the economic loss doctrine with the requirement
that plaintiffs elect between contract remedies.
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Case Analysis.
David
Ziemer can be reached by email.
