False Reps and Warranties: Is it Fraud or Breach of Contract?

The case, MCR Federal, LLC v. JB&A, Inc., is the most recent and stringent application by the Supreme Court of the “Source of Duty Rule.” In MCR, the Supreme Court held that fraud claims do not exist when the “source of the duty” breached arises from a contractual relationship. The source of duty rule is intended to prevent “every breach of contract [claim from turning] into an actionable claim for fraud.” The decision represents a strict application of prior cases and significantly limits a party’s ability to bring a claim for actual or constructive fraud.

What Happened?

Two government contractors entered into a Purchase Agreement for an acquisition that closed on May 31, 2011. The Purchase Agreement required the seller, MCR, to represent that it was not under government investigation and knew of no existing circumstances that could reasonably be expected to give rise to an investigation or action against it. However, while the parties were preparing to close the sale, MCR was also competing for an Air Force contract. As part of that process, on May 19, 2011, an Air Force contracting officer inadvertently sent an MCR employee a copy of its competitor’s bid. The MCR employee forwarded the competitor information to six other MCR employees. The Air Force contracting officer quickly noticed the mistake, and on May 20, 2011, the MCR employee who received the information told the contracting officer that he had received and distributed the information.

As a result, and on the same day, the Air Force sought affidavits from the six MCR employees stating how the information was used and confirming its destruction. Affidavits were submitted to the government on June 7, 2011. On August 23, 2011, the Air Force suspended MCR and four of its employees from government contracting. The suspension was based on the Air Force’s finding that the four MCR employees helped prepare MCR’s final bid, despite having its competitor’s bid information. The Air Force and MCR entered an Interim Administrative Agreement limiting the suspension in September 2011. The Air Force later discovered that one of the MCR employees made false statements in their affidavit and reissued the suspension. MCR and the Air Force reached a new agreement lifting the suspension in October 2011, after MCR argued that the suspensions had caused it to suffer “catastrophic” losses.

The Purchase Agreement required a “bring down” certificate at closing to certify that the representations and warranties remained true and correct at the time of closing. MCR issued the bring down certificate at closing on May 31, 2011, but MCR did not disclose the issue that had developed with the Air Force or the Air Force’s request for affidavits on May 20, 2011.

The Decision

The trial court found MCR liable for both constructive fraud and breach of contract, and awarded $1.9 million in attorneys’ fees based on the fraud count. As to the fraud count, the trial court ruled that when a party is induced to perform a contract by the defendant’s false representation that a condition precedent was satisfied, then claims for both fraud and breach of contract are proper.

On appeal, however, the Supreme Court reversed and held that the duty breached arose under the Purchase Agreement, and as such no independent duty supported a fraud claim. In other words, the Court stated that because the Purchase Agreement required MCR to certify that the reps and warranties remained true at closing, then any duty breached “arose solely by virtue of the Purchase Agreement” and the parties’ contractual “relationship.” As to the reps and warranties being conditions precedent to closing the transaction, the Court stated:

The fact that delivery of the bring down certificate was a condition precedent to closing, rather than a contractual duty, ‘does not take the fraud outside of the contractual relationship.’ [Rather,] MCR Federal’s representation concerning government investigations was a ‘bargained for expectation.’

The Court’s decision analyzes a number of its prior cases on the issue of fraud versus contract and the related “Source of Duty” rule and litigants should expect the rule will be applied strictly and fraud claims connected to contracting will rarely be available in Virginia.