Why and How Fraud Invalidates a Contract

A contract is a binding agreement made between two or more parties who intend to create a legal obligation. It can be written or oral. However, many contracts, especially those that are business related, are usually in a written form. Examples of such contracts include sale of properties, employment, tenancy, and engagement of a builder to undertake construction work. When parties enter into a contract, they enter into a legal obligation to fulfill the requirements of the contract while observing all the terms and conditions of the contract until the term of the contract ends. However, there are some lawful reasons that can make one or more parties in a contract to reject/invalidate a contract even before the expiry of its term.

Fraud is one of the lawful reasons that can cause invalidation of a contract. According to Story (2007), fraud is “every kind of artifice employed by one person for the purpose of deceiving another”. Some law scholars view fraud as a deliberate misstatement of a fact (Getting Out of a Contract, 2010). Other definitions of fraud include “a criminal deceit aimed at getting financial or personal gain, a thing intended to deceive others, misrepresentation of a matter of fact in order to gain money or property from a victim, and intentional deceit aimed at damaging another person” (Story, 2007; Moskin, 2002).

The aforementioned definitions of fraud form a clear basis why fraud invalidates a contract. This is because, from all the definitions, it is clear that fraud is a criminal act. Because a contract is a legal document, which is enforceable by law, any criminal act that interferes with the performance of a contract is likely to cause invalidation. A fraud can invalidate a contract depending on its nature and the time when it is committed during the contract period. When fraud occurs during the inception of a contract, then the contract becomes invalid (Moskin, 2002). For example, when making a contract of sale of a property, if the seller intentionally gives wrong information concerning the value of the house, the contract can be declared invalid if such misrepresentation is discovered during the inception stage.

Fraud can also occur during the execution of a contract. Although this type of fraud is rare in commercial contracts, it occurs from time to time. Fraud in the execution involves misrepresentation in the contract document. For instance, a party in a contract can inform the other party that he/she is executing a corporate agreement while, in real sense, the party is executing a personal guarantee. This can occur even after both parties accurately understand the nature of the contract document, but one party fools the other by substituting a part of the document with another part which bears different terms. In such cases, the fraud renders the contract invalid as long as the deceived party proves that he/she did not know or did not have a reasonable chance to know the true contents of the document (Moskin, 2002).  

However, if fraud occurs during the performance of a contract after all the parties have genuinely entered into a contract, a contract could be invalidated. Instead, the contract’s provision under which a fraud has been committed is rendered unenforceable. This implies that the other parties cease from observing the provision under which the other party has committed a fraud. Nonetheless, if a fraud is committed during the performance of a contract, and it affects the focal point of the contract, then such a contract can be invalidated (Moskin, 2002).

Fraud can cause invalidation of a contract if it is induced. An induced fraud is one where one party intentionally makes a misrepresentation of a material fact despite being aware that the information provided is false and can cause damage to the other party (Moskin, 2002). Fraud under inducement automatically results into invalidation of a contract. However, the law requires that the offended party proves that a fraud has actually been committed against him/her by the other party. The offended party in a contract should demonstrate that the other party has actually misrepresented or omitted a material fact in the contract, that the party’s conduct was intentional, and that the offended party has suffered damage or injury out of the fraud.

In the business context, an example of contract invalidation under duress is an employer threatening an employee that he will kill him if he does not sign an employment contract. Such a contract is considered null and void because the fraud constitutes a criminal act. On the other hand, a contract entered under undue influence can be invalidated depending on the nature of the fraud and the relationship of the parties involved in the contract. To illustrate a contract under undue influence, we take a case of a wife who fakes her husband’s signature on some promissory notes and presents them to a bank for payment. The bank discovers the forgery and arranges a meeting between its credit officer, the wife, and her husband. During the meeting, the credit officer threatens the husband that he was going to prosecute his wife unless he agreed to mortgage his house to the bank in order to pay for the promissory note. Such a contract can be declared invalid due to presence of undue influence during the formation of the contract.

Some of the damages that a defrauded party can claim in a contract include compensatory, consequential, and punitive damages (Goldman, 2003). A defrauded party claims compensatory damages if the fraud committed made him/her incur an economic loss. A defrauded party can also claim consequential damages if the fraud committed caused him/her incur indirect economic losses. For example, a sales shop purchases a cash register from a certain dealer under the terms that the machine was capable of operating for 24 hours without breaking down. The machine breaks down after a few hours and the shop is forced to close for two days as the dealer repairs the machine. The shop owner sues the dealer for consequential damages incurred during the two days when the shop was not in operation. Unlike compensatory and consequential damages, which are in economic terms, punitive damages are awarded to the wrongdoer in the form of punishment. For instance, in the aforementioned case, where an employer threatens to kill his employee if he refuses to sign an employment contract, the employee can be awarded punitive damages whereby the employer is imprisoned for a given number of years.

Equitable remedies available in business contracts include specific performance, account of profits, and constructive trusts. Specific performance requires the wrongdoer to perform a contract. For instance, when buying a piece of land, a seller defrauds a buyer by fixing an overvalued price of the land. A court of equity can award specific performance where the seller will be required to sell the land to the buyer at the originally agreed price. Account of profits is awarded when a wrongdoer continues to benefit from the wrong committed at the expense of the other party. The wrongdoer is required to share his profits with the wronged party. On the other hand, constructive trust is awarded when a party of a contract claims that a wrongdoer has intentionally transferred his/her property to an innocent third party. Constructive trust allows such a party to recover his/her property from the third party (Goldman, 2003).

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