Texas Law on “Justifiable Reliance” Element of Fraud

The scene: Cameron County Courthouse, Brownsville, Texas. Plaintiff’s closing argument in Carduco, Inc. v. Mercedes-Benz USA.

Ladies and gentlemen of the jury, there was a time when a handshake and a man’s word meant something here in the Rio Grande valley. If you made a deal and shook on it, you could take that to the bank.

My client Renato Carduco grew up in that era. He built his successful car dealerships on principles of honesty and hard work. If he told a customer he was going to do something, he did it. If he promised his employees something, he kept the promise. And he expected other people to keep their word too.

He certainly expected that when he made a deal with Mercedes-Benz USA. You heard the testimony. When Mr. Carduco’s son was having trouble with his Mercedes dealership in Harlingen, Mr. Carduco agreed to buy it. But he knew Harlingen wasn’t the best place for it, so he wanted the option to move the dealership to McAllen.

So Mr. Carduco did what any experienced businessman would do. He asked Mr. Oswald, the Mercedes representative, if it would be possible to move the dealership, and Mr. Oswald said “that won’t be a problem, we don’t have any other plans for McAllen.” So Mr. Carduco went into the deal believing he would have the option to move.

But then when Mr. Carduco saw the proposed contract, something was wrong. You may remember Plaintiff’s Exhibit 9, the Purchase Agreement. It had this part saying that Mr. Carduco was, and I quote, “only purchasing the right to conduct a Mercedes-Benz retail sales dealership at Purchaser’s present location in Harlingen, Cameron County, Texas.” And it prohibited Mr. Carduco from changing locations without written consent from Mercedes-Benz USA.

Well that was a red flag for Mr. Carduco. So he called up Mr. Oswald and said, “Frank, I’m concerned about this part of the contract that says I’m only getting the right to have a dealership in Harlingen, what if I want to move it to McAllen?” And you remember what Mr. Oswald said. “Renato, don’t worry about that stuff in the contract, if you decide to move, we’ll take care of you.”

Trouble is, Mr. Oswald didn’t tell Mr. Carduco the whole story. You heard the testimony and saw the emails. At the same time, Mercedes-Benz USA was talking to another Mercedes dealer about building a new dealership in McAllen. But they didn’t disclose that to Mr. Carduco until after he had signed the contract.

So, when Mr. Carduco signed that Purchase Agreement, he believed two things. One, that there were no plans for some other dealer to set up shop in McAllen, and two, that he could relocate his dealership to McAllen if he wanted to.

Ladies and gentlemen, that’s fraud. So I hope that after you consider the evidence, you will write “Yes” in response to Question No. 1.

The Real Case

This hypothetical closing argument is based on a real case, Mercedes-Benz USA, LLC v. Carduco, Inc. (Tex. Feb. 22, 2019). The jury in that case answered “yes” Mercedes-Benz committed fraud, and found actual damages of $15.3 million and punitive damages of over $100 million.

Let’s pause right there. A jury in the Valley enters a $100 million verdict for a local businessman against a big multinational corporation. Already, you know that verdict is not likely to survive a trip to the Texas Supreme Court.

And yes, the Texas Supreme Court later threw out the verdict, holding there was no evidence of fraud. The court said Carduco could not have justifiably relied on alleged statements by Mercedes-Benz USA that the written contract directly contradicted.

But what about the facts in bold in the closing argument above? Mercedes-Benz specifically told Carduco he could move and not to worry about what the contract said. How is that not fraud?

Well, here’s the thing. I made up those facts (the ones in bold). I made them up to make the case harder. To me, the key question raised by Mercedes-Benz is whether those additional facts would have made a difference to the outcome.

Let me explain.

Texas Law on Fraud, Omissions, and Justifiable Reliance

First let’s put the Mercedes-Benz case in context by laying out some basic principles of fraud law:

1. Fraudulent inducement is a type of fraud. It’s the claim that one party fraudulently induced another party to sign a contract. It allows the defrauded party to avoid the obligations of the contract and, potentially, to recover damages caused by the fraud.
2. The most basic element of fraud is a misrepresentation. There has to be a material misrepresentation made with some kind of intent. (Let’s set aside the intent and materiality elements for now.)
3. An affirmative misrepresentation is easy. If you make a statement that is not true, that’s a misrepresentation.
4. Omissions are harder. Generally, an omission is not fraud, unless there is a duty to disclose.
5. If one of the parties owes a fiduciary duty to the other, there would be a duty to disclose. But in most “arms-length” transactions between two businesses, there is no fiduciary duty relationship and no general duty to disclose.
6. A duty to disclose can arise if you make a representation that, while technically true, is rendered misleading by your omission.
7. The next most basic element of fraud is reliance. The person you make the representation to must decide to sign the contract in reliance on the representation.
8. It has to be a certain kind of reliance. Some courts say “reasonable” reliance. Recent Texas cases use “justifiable” reliance. In any case, unreasonable reliance is not going to be justifiable reliance.
9. There is often conflicting evidence regarding whether the alleged misrepresentation is made. But as long as there’s at least a smidgen of evidence, most appellate court decisions addressing fraud will assume the misrepresentation was made.

As you can gather from this summary, there are a lot of “general” rules and a lot of exceptions. But this outline will hold true most of the time.

Here’s where it gets more difficult: the contract. In almost any business transaction, there will be a written contract that contains statements that conflict with the claim of fraud. That’s because the lawyer who drafted the contract (or the form the contract is based on) wanted to avoid claims of fraud.

The most common contractual terms that conflict with a claim of fraud are:

• A merger clause, e.g. “This Agreement replaces and supersedes all prior agreements and understandings between the parties regarding the subject matter of this Agreement.”
• A disclaimer of reliance, e.g. “No party to this Agreement is relying on a representation or agreement not contained within the four corners of this Agreement.”
• A specific substantive contract term that conflicts with the alleged misrepresentation. For example, a clause that says “you cannot move your dealership” when the alleged misrepresentation is “we will let you move your dealership.”

What is the effect of such terms? Do they defeat a subsequent claim of fraudulent inducement?

There is no easy answer. Texas courts—like courts everywhere in the Anglo-American common-law tradition—have struggled with this question for decades, if not centuries. (Courts in other traditions probably struggle with it too, but I have no familiarity with that.)

There are three basic alternatives courts have to choose from:

1. The contractual terms defeat any conflicting claim of fraudulent inducement.
2. The contractual terms have no effect on a claim of fraudulent inducement.
3. It depends on the circumstances.

You can make a reasonable case for each of these, but no. 3 is the most common. Even when courts appear to endorse no. 1 or no. 2, they are probably following no. 3, because they would rule differently if presented with different facts.

The Texas Trend

Texas courts generally follow no. 3, but the pronounced trend in the Texas Supreme Court in the last 30 years has been towards holding that contractual terms negate a claim of fraudulent inducement.

The traditional rule is that “fraud vitiates a contract.” For example, in Dallas Farm Machinery Co. v. Reaves, 307 S.W.2d 233, 239 (Tex. 1957), the court held that a merger clause does not bar a claim that the contract was induced by fraud. Part of the rationale is that you shouldn’t enforce a contractual disclaimer when the disclaimer itself—as part of the contract—was induced by fraud.

The Texas Supreme Court reaffirmed the traditional principle in Williams v. Glash, 789 S.W.2d 261 (Tex. 1990). Writing for the majority, Justice Doggett said “a release is a contract and is subject to avoidance, on grounds such as fraud or mistake, just like any other contract.” Id. at 264.

But in the 1990s the Texas Supreme Court started whittling away the traditional rule. This trend coincided with complete Republican control of the court. This is not surprising, because generally conservatives favor enforcing contractual disclaimers, while liberals favor letting fraud verdicts stand. I’m generalizing, of course, but let’s not ignore the elephant in the room.

The trend began with Prudential Ins. Co. v. Jefferson Associates, Ltd., 896 S.W.2d 156, 161-62 (Tex. 1995), where the court held that an “as is” clause in a real estate purchase contract conclusively negated the reliance element of a fraudulent inducement claim.

Then in Schlumberger Technology Corp. v. Swanson, 959 S.W.2d 171, 180-81 (Tex. 1997), the court held that a disclaimer of reliance negated a claim of fraudulent inducement, where the release at issue was intended to resolve a dispute, it was an “arms-length” transaction, the parties had highly competent legal counsel, and the parties were “knowledgeable and sophisticated business players.”

After that, defense counsel in any fraud case with a disclaimer of reliance would rely heavily on Schlumberger. And in Forest Oil Corp. v. McAllen, 268 S.W.3d 51, 58 (Tex. 2008), the court extended Schlumberger to a settlement agreement intended to resolve past and future claims.

The Texas Supreme Court slightly bucked the trend in Italian Cowboy Partners, Ltd. v. Prudential Ins. Co. of Am., 341 S.W.3d 323 (Tex. 2011). The contract in that case had a merger clause, but not a disclaimer of reliance. The court distinguished a mere merger clause from a disclaimer of reliance and held that the merger clause did not negate a claim of fraudulent inducement. Id. at 336.

But the court returned to form in JPMorgan Chase Bank, N.A. v. Orca Assets G.P., L.L.C., 546 S.W.3d 648 (Tex. 2018). This time the issue was not so much the effectiveness of the contractual disclaimer, but the justifiable reliance element of the fraud claim. The court held that an experienced oil and gas business could not justifiably rely on a lessor’s statement that certain acreage was “open,” i.e. not already leased, where the contract contained an unusual negation-of-warranty clause and there were other “red flags” indicating that maybe the acreage was already leased. Id. at 660.

The court in Orca Assets approvingly cited case law holding that in an arms-length transaction, the defrauded party must exercise “ordinary care for the protection of his own interests” and “cannot blindly rely on a representation by a defendant where the plaintiff’s knowledge, experience, and background warrant investigation into any representations before the plaintiff acts in reliance upon those representations.” Id. at 654.

In February 2019, the court addressed justifiable reliance again in Mercedes- Benz (more about that later).

Then the Texas Supreme Court returned to disclaimers of reliance in IBM Corp. v. Lufkin Industries, LLC (Tex. March 15, 2019). In contrast to Schlumberger, Lufkin Industries addressed a contract signed at the beginning of the business relationship, not an agreement to resolve a dispute. But the court held that the customer’s fraudulent inducement claim against IBM was barred, where the parties were sophisticated, both sides had lawyers, and two contract clauses expressly and clearly disclaimed reliance. I wrote about this case in Can Your Business Avoid a Fraud Claim by Putting Magic Words in the Contract?

Most recently, it was justifiable reliance again in Barrow-Shaver Resources Co. v. Carrizo Oil & Gas, Inc. (Tex. June 28, 2019). The court held that a driller could not have justifiably relied on a production company’s oral statement that the company would not unreasonably withhold consent for the driller to assign its interest in a “farmout” agreement.

As these cases illustrate, the Texas Supreme Court has used both contractual disclaimers and the justifiable reliance element to steadily carve back the fraudulent inducement theory in business transactions.

Back to Mercedes-Benz 

Mercedes-Benz was part of this trend. It held that Mr. Carduco’s reliance on the alleged misrepresentation about the dealership was not justifiable, where Mr. Carduco was a sophisticated businessman, both sides had lawyers in the transaction, and the alleged misrepresentation directly conflicted with specific statements in the contract. The court also held that, even crediting Mr. Carduco’s testimony, there was no evidence that Mercedes-Benz made any affirmative misrepresentation to Mr. Carduco.

The part of Mercedes-Benz I don’t fully grasp is why it was necessary to reach the issue of justifiable reliance in the first place. Why didn’t the court just say there was no evidence of a misrepresentation and stop there? The court seemed awfully eager to write about justifiable reliance.

In any case, the result in Mercedes-Benz is not surprising. The plaintiff’s most fundamental problem was the absence of a clear, affirmative misrepresentation.

But what if the facts had been better for Mr. Carduco? What if, as hypothesized in my fictional closing argument above, the Mercedes-Benz representative had specifically told Mr. Carduco something like “don’t worry about what the contract says, we’ll let you move to another location”?

You could argue that the same reasoning in the Mercedes-Benz opinion would still apply and it wouldn’t make a difference. The rationale of Mercedes-Benz was that a sophisticated business can’t justifiably rely on a representation that is directly counter to what the contract says.

And you could cite the Texas Supreme Court’s subsequent decision in Barrow-Shaver. In that case the sophisticated and experienced parties deleted “shall not be unreasonably withheld” language from a consent-to-assign clause in the contract; thus the provision was “specifically negotiated through a back-and-forth process.” Under those circumstances, the court held that the plaintiff could not justifiably rely on the defendant’s oral promises that “it won’t be a problem,” “don’t worry about,” and “we will work with you.”

On the other hand, in Mercedes-Benz there was no back-and-forth negotiation of the term requiring consent to move the dealership. And under my hypothetical facts, you could make a case that Mr. Carduco’s reliance would have been more justifiable. It’s one thing to say that an experienced business person should not rely on his own vague “belief” that he is going to be allowed to do something the contract says he cannot do. It’s quite another to say he can’t rely on a man’s word.

UPDATE: Defendants have successfully used Mercedes-Benz to defeat fraud claims as a matter of law. See, e.g,  Wylie v. Simmons, No. 02-19-00241-CV, 2020 WL 7776797, at *10 (Tex. App.—Fort Worth Dec. 31, 2020, no pet. h.) (mem. op.) (buyer of accounting practice could not justifiably rely on seller’s representation he did not intend to re-enter the industry, where the agreement had specific two- and five-year non-compete provisions); BBVA Compass v. Bagwell, No. 05-18-00860-CV, 2020 WL 7332845, at *4-5 (Tex. App.—Dallas Dec. 14, 2020, no pet. h.) (mem. op.) (“red flags” in commercial real estate transaction negated justifiable reliance as a matter of law).

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Zach Wolfe (zach@zachwolfelaw.com) is a Texas trial lawyer who handles non-compete and trade secret litigation at his firm Zach Wolfe Law Firm (zachwolfelaw.com). Thomson Reuters has named him a Texas “Super Lawyer”® for Business Litigation every year since 2020.

These are his opinions, not the opinions of his firm or clients, so don’t cite part of this post against him in an actual case. Every case is different, so don’t rely on this post as legal advice for your case.