California Court of Appeal, Munoz v. PL Hotel Group, LLC, Docket No. D078215

 

Contract: Fraud in the Execution v. Promissory Fraud

Contract: to Sign without Reading

Duty to Read a Contract before Signing?

 

Fraud in the Execution of a Negotiable Instrument, the Uniform Commercial Code

Reformation

Letter of Intent: Binding Agreement?

Contract Law

Contract Drafting

California Law

 

 

APPEAL from a judgment of the Superior Court of San Diego County, Timothy B. Taylor, Judge. Reversed.

 

This appeal involves a form of fraud rarely seen in day to day litigation. It goes by various names—fraud in the factum, fraud in the execution, fraud in the inception—but they all describe the same genre of deceit. It occurs where, after parties have agreed upon certain contract terms, one of them surreptitiously substitutes a document for signature that looks the same as the earlier draft but contains materially different terms. Fraud in the execution is distinct from promissory fraud, which involves false representations that induce one to enter into a contract containing agreed-upon terms.

 

This case, on appeal after a demurrer was sustained without leave to amend, involves the purchase and leaseback of a vacant hotel and restaurant. The nub of the lawsuit is the buyers’/plaintiffs’ claim that the sellers/defendants surreptitiously substituted altered versions of the lease and financing instruments containing terms extremely adverse to the buyers, and which they allege were neither bargained for nor agreed to.

 

As we explain, these allegations state, quite literally, a textbook cause of action for fraud in the execution, as this illustration from the Restatement Second of Contracts demonstrates:

“A and B reach an understanding that they will execute a written contract containing terms on which they have agreed. It is properly prepared and is read by B, but A substitutes a writing containing essential terms that are different from those agreed upon and thereby induces B to sign it in the belief that it is the one he has read. B’s apparent manifestation of assent is not effective.” (Rest.2d, Contracts (1981) § 163, illus. 2.)

 

But acting under the misapprehension that plaintiffs’ theory was promissory fraud, the superior court sustained a demurrer brought by defendants Inn Lending LLC (Inn Lending) and Rajesh Patel (Rajesh) on the grounds that “insufficient facts” were alleged showing they “made promises” upon which plaintiffs relied. The court also determined that related causes of action for breach of contract, breach of the implied covenant of good faith and fair dealing, and financial elder abuse also failed. We reverse the resulting judgment of dismissal.

 

The Patels formed PL Hotel Group, LLC (PL) to hold title and listed the property for sale. They structured the transaction to remain in possession after the sale. Toward that end, the sale included a leaseback to the Patels under a triple net lease. From the buyer/landlord’s perspective, the difference between the monthly rent under the lease and cost of financing would be the return on investment.

 

A triple net lease (sometimes designated by the parties here as NNN) is one in which the lessee pays taxes, insurance, and utilities. (See Pate v. Channel Lumber Co. (1997) 51 Cal.App.4th 1447, 1450; 2A Miller & Starr, Cal. Real Est. Forms (2d ed. 2020) § 2:28.) (fn. 2).

 

On July 17, the Patels (via Davis) sent a proposed but unexecuted triple net lease to Cassidy. In an accompanying e-mail, Davis reserved the Patels’ right to “make further edits in case there was an error or oversight.” This lease, which the parties refer to as the “July 17 lease,” was circulated “multiple times” during the 60-day escrow. It was the only lease agreement ever circulated before close of escrow. It contained the agreed lease terms, and at no time before escrow closed did the Patels ever contend there was an “error or oversight” in it.

 

The July 17 lease was for a 20 year term, with specified options to renew. Rent began at $19,167 per month, and periodically increased over the 20 year term. The tenants (Patels) were solely responsible for
(1) maintenance and repairs; (2) insurance; (3) utilities; and (4) taxes.

Unfortunately for Munoz, the differences between the two leases “were not so numerous to be obvious.” For instance, the provision a landlord might be expected to check—rent payments—was unchanged. Munoz signed the September 13 lease after only a cursory review, believing it was the same triple-net lease the parties had circulated and approved numerous times.

 

But as Munoz would soon learn, the September 13 lease was anything but a triple net lease. For example:

·       Maintenance and Repair: Under the July 17 lease, the landlord (Munoz) has no obligation to maintain or repair the premises. But the September 13 lease provides the landlord “shall have the duty to repair” everything beyond normal wear and tear.

·       Renovations: Under the July 17 lease, the tenant (Patels) were obligated to complete renovations. Under the September 13 lease, the landlord is.

·       Taxes: The July 17 lease provides the tenant pays taxes relating to the premises. The September 13 lease limits that obligation to taxes “attributable solely to any business property or personal property of the Tenant” on the premises.

·       Assignment and Subletting: The July 17 lease allows the tenant to sublease to a nonaffiliated entity only with the landlord’s consent. The September 13 lease allows a sublease “without Landlord’s consent at any time.”

·       Tenant’s Continuing Liability: Under the July 17 lease, an assignment or sublease does not release tenant’s liability, including for rent. But under the September 13 lease, a permitted assignment or sublease “eliminates” tenants’ liability.

·       Landlord’s Remedy: The September 13 lease adds a new provision that makes retaking possession the landlord’s sole remedy on tenant’s default.

 

Meanwhile, as the Patels’ plan with regard to the altered lease was put in place, Munoz was unable to obtain financing from a conventional lender because the Hotel had been closed for two years. Expecting this, the Patels initiated the second phase of their plan. Not only would they be the seller/tenant in the transaction, but also the secured lender.

 

On the Patels’ behalf, Davis contacted Cassidy (Munoz’s agent) and recommend he hire David Hamilton of Pacific Southwest Realty Services (collectively, Hamilton) as loan broker. But this was all an illusion for Munoz’s consumption. Hamilton had no intention of shopping around for a loan. Instead, he placed the loan with Inn Lending—an alter ego entity of the Patels created just for this purpose.

 

(…) After conducting a hearing, the court sustained the demurrer without leave to amend and entered a judgment of dismissal in favor of Rajesh and Inn Lending. Postjudgment, the court awarded them $92,505 in attorney’s fees plus costs.

 

DISCUSSION

A. The Court Erroneously Sustained the Demurrer to the Fraud Cause of Action.

In the classic case of fraud in the execution, some limitation—such as blindness, illness, or illiteracy—prevents the plaintiff from reading and understanding the contract that he or she is about to sign. (See,
e.g., Rosenthal v. Great Western Fin. Securities Corp. (1996) 14 Cal.4th 394, 427‒428 (Rosenthal) [defendants omitted portions of the contract when reading it aloud to plaintiff, who could not read English]; Erickson v. Bohne (1955) 130 Cal.App.2d 553, 554‒557 [plaintiff’s daughter took advantage of her physical and mental illness by tricking her into signing a deed]; Jones v. Adams Financial Services (1999) 71 Cal.App.4th 831, 835‒840 [defendants tricked an elderly legally blind woman into a reverse mortgage by telling her she was authorizing them to learn the payoff on her mortgage].)

 

Closer to the facts alleged here, fraud in the execution may also occur where a contract is surreptitiously modified. In Hotels Nevada v. L.A. Pacific Center, Inc. (2006) 144 Cal.App.4th 754, for example, the owner of commercial property signed an agreement to sell the properties for $70 million in cash and another $5 million a year later. He alleged that after he signed the agreement, the buyers covertly substituted a provision entitling them to hold back the last $5 million for five years instead of one. The court held those allegations sufficed for fraud in the execution. (Id. at p. 764.)

 

Another variation is typified by California Trust, a case Munoz cited in his opposition to the demurrer. There, when the plaintiff sued to quiet title to certain real property, the defendants cross-complained alleging fraud in the execution. (California Trust, supra, 214 Cal. at p. 622.) According to the cross-complaint, the plaintiff represented that if defendants paid $7,500, he would hold title to the property, improve and sell it within a year, and pay the defendants $17,500 of the proceeds. The plaintiff prepared a written agreement and stated it contained these provisions, which defendants signed without reading it. (Id. at p. 623.) When the plaintiff demanded further payment, they read it for the first time and discovered it contained provisions significantly different from the prior oral agreement. (Id. at pp. 623–624.) The Supreme Court determined the cross-complaint alleged sufficient facts to warrant reformation, commenting, “A party to an instrument who by fraud leads the other party to sign without reading it is in no position to urge the latter’s negligence . . . .” (Id. at p. 627.)

 

Other like cases from outside California include Hetchkop v. Woodlawn at Grassmere, Inc. (2nd Cir. 1997) 116 F.3d 28, where a union secretly substituted one document for another while an employee’s back was turned. And in another labor case, Connors v. Fawn Mining Corp. (3d Cir. 1994) 30 F.3d 483, an employer signed a collective bargaining agreement that contained materially different terms than had been promised by the union. There, the Third Circuit observed that fraud in the execution occurs where one party “surreptitiously substitutes a materially different contract document before both sides execute it.” (Id at p. 493.) The Ninth Circuit reached the same conclusion in Operating Engineers Pension Trust v. Gilliam (9th Cir. 1984) 737 F.2d 1501. There, an employer was led to believe he was signing a standard union membership form. Based upon that he “did not read the documents” but merely relied on the union representative’s word. The Court of Appeals concluded, “he who signs a document reasonably believing it is something quite different than it is cannot be bound to the terms of the document.” (Id. at p. 1504.)

 

And finally, on facts not too dissimilar to those alleged by Munoz here, in Settlers’ Hous. Serv. v. Schaumburg Bank & Trust Co., N.A. (Bankr. N.D.Ill. 2017) 568 B.R. 40, the debtor alleged fraud in the execution based on claims that bank officers surreptitiously included within a large pile of documents he signed a note for a line of credit secured by debtor’s property. The court disallowed that portion of the creditor’s claim, noting that a signature procured by fraud in the execution gave no more effect to a contract than one that had been forged. (Id. at pp. 65‒67.) According to the bankruptcy court, that a more cautious person “might have smelled a rat, does not defeat liability.” (Settlers’ Hous. Serv., at p. 67.)

 

These cases reflect society’s understandable desire to repress this pernicious form of fraud. Yet at the same time, there has “always been a sharp struggle” between that policy “upon the one hand, and on the other to discourage negligence and the opportunity and invitation to commit perjury.” (California Trust, supra, 214 Cal. at p. 627.) This countervailing policy is often expressed as a duty to read a contract before signing. Generally, “ ‘ “one who accepts or signs an instrument, which on its face is a contract, is deemed to assent to all its terms, and cannot escape liability on the ground that he or she has not read it. If he or she cannot read, he or she should have it read or explained to him or her.” ’ ” (Ramos v. Westlake Services LLC (2015) 242 Cal.App.4th 674, 686 (Ramos).)

 

In balancing these competing interests, courts have required the plaintiff to have acted in an objectively reasonable manner in failing to become acquainted with the contents of the written agreement. (Rosenthal, supra, 14 Cal.4th at p. 423; Ramos, supra, 242 Cal.App.4th at p. 688.) The plaintiff must not only have been ignorant of the surreptitiously inserted terms, but must also have had no reasonable opportunity to learn that the document contains them.

 

In short, the standard is one of excusable ignorance. In making that determination in the context of fraud in the execution of a negotiable instrument, the Uniform Commercial Code explains the relevant factors include: (1) the party’s intelligence, education, business experience, and ability to read or understand English; (2) the nature of the representations that were made; (3) whether the party reasonably relied on the representations or justifiably had confidence in the person making them; (4) the presence or absence of any third person who might read or explain the instrument to the signer; (5) any other possibility of obtaining independent information about the document’s terms; and (6) the apparent necessity, or lack of it, for acting quickly. (See Cal. U. Com. Code, § 3305, subd. (a)(1)(C) & com. 1, ¶ 5.) We see no reason why these same factors would not also be relevant in determining whether a complaint adequately alleges excusable ignorance here.

 

In contrast, another plaintiff, Raul Pupo had no prior relationship with the defendant or its representative, and the representative did not purport to read the contract to him or orally explain its contents. (Rosenthal, supra, 14 Cal.4th at p. 431.) The court concluded, “Under these circumstances, Pupo’s . . . failure to take measures to learn the contents of the document they signed is attributable to his own negligence, rather than to fraud on the part of defendant or its representatives.” (Ibid.)

 

Letter of Intent:

“ ‘Preliminary negotiations or an agreement for future negotiations are not the functional equivalent of a valid, subsisting agreement. “A manifestation of willingness to enter into a bargain is not an offer if the person to whom it is addressed knows or has reason to know that the person making it does not intend to conclude a bargain until he has made a further manifestation of assent.” ’ ” (Careau & Co. v. Security Pacific Business Credit, Inc. (1990) 222 Cal.App.3d 1371, 1389.) Here, on its face the letter of intent for financing states it is not a binding agreement (p. 18).

 

 

(California Court of Appeal, Jan. 3, 2022, Munoz v. PL Hotel Group, LLC, Docket No. D078215, Certified for Publication)