rescission: contract law remedy (bars, misrepresentation, mistake and fraud)

Rescission of Contract: Meaning

Rescission is a remedy made available when the underlying basis for making a contract is fundamentally tainted.  Some conduct on behalf of a contracting party undermines the very reason that the other party made the contract in the first place. The contract can be rescinded, at the option of the affected party.

The remedy of rescission means that an entire contract is set aside.

For legal purposes, it’s treated as though it was never made. It never took place.  

The outcome of rescission is:

• whatever was done by the parties by making the contract is reversed
• the parties are put back in the position they would have been in, as if the contract never even been made. That's the status quo ante
• it's treated as "non-existing".  

The transaction established by the contract is brought to an end with retrospective effect. 

When the right to rescind is available and properly exercised, it is said that the contract has been "rescinded". 

There cases where rescission was available even where contracts have been fully performed.

Bars to Rescission

For the remedy of rescission to be available:

• the contracting party seeking the remedy must not have affirmed the contract
• restitutio in integrum must be substantially possible: both sides of the transaction must be able to be undone
• a bona fide purchaser for value without notice must not have taken an interest in property which would be affected by the rescission 

If those bars to rescission have not been satisfied, rescission should be available as a remedy for the causes of action to which it applies as a remedy. 

 

Contrast as a Remedy

Rescission may also provide a better remedy or the best remedy for an innocent party when compared to other remedies, such as termination of a contract for breach.

For instance, when an innocent party rescinds a contract it may mean:

1. the return of valuable property as an outcome, as opposed to
2. a purely financial remedy, such as damages.

 

Grounds to Rescind

Contracts are rescinded when the parties thought they had a deal, but the basis was wrong, or didn’t exist.

Accordingly, rescission of a contract is available for causes of action such as:

• misrepresentation: whether innocent, negligent, or fraudulent 
  Rescission for misrepresentation applies in cases where a party relied on a statement by the other party to enter the contract, and the statement was not true.
• law of mistake
  The state of affairs underlying the reason for making the contract was not as one or more of the parties thought it was: one or both of the parties made a relevant mistake at law
• bribery and corruption
• breaches of fiduciary duties
  For example, secret commissions have been procured by an agent for their principal under the contract

Any sort of contract can be rescinded, such as:

• share purchase agreements
• distribution agreements
• intellectual property assignments and licences
• sales of products and services,

provided that (1) restitution in integrum is possible, and (2) the remedy is no longer available, because a bar to rescission applies to the case.

More on that below.

 

The Result of Rescission

Rescission is a reference to a result, rather than how the outcome is achieved.

When a contract rescinded, the courts apply the wide array of powers to undo the events following the formation of the contract to put the parties in the position they would have been in, as if the contract had not been made. This might mean:

• for a contract where ownership of physical property was transferred from one party to another, ordering that the property be returned to the original owner
• where a payment of money took place in reliance of the contract, ordering that money (in the form of damages) be returned to the original owner, or
• where expenses were incurred by a party in reliance of the contract, payment of damages by one party to the other to compensate them for the expense incurred in reliance of the contract.

In this way, courts orders are customised to suit the situation in the case – to undo what needs to be undone.

Therefore the remedy is fact sensitive. It permits what is practically just to restore the parties to their positions before the contract was made.

 

Legal Effect of Rescission 

In legal language, a rescinded contract is void ab initio. That is the result that courts aim to achieve.

To rescind a contract, the parties return money, property and other interests to the other party to restore themselves to their precontractual positions.

More often than not, it’s not as simple as handing back of property or repayment of money to put the parties in as good a position as before they entered into their transaction.

Adjustments

Adjustments may be necessary to be made between the parties in cases. That may require specific, customised orders for damages to give effect to the rescission.

Depending on the contract rescinded, court orders may be required to:

• return money paid over back to the original payer
• restore loss of profits: arising from transfer of a business, which needs to be undone.
  If the contract is say, for the transfer of a business, that may mean that the innocent party has lost profits as a result of reliance on a misrepresentation and making the contract. Those lost profits would need to be returned to seller.
• compensate for payment of the cost of the contract and/or out of pocket expenses: The person rescinding the contract may have incurred expenses in reliance of the contract.

Damages for Rescission

An award of damages may be available to restore the position of the innocent party to the pre-contractual position where expenses were incurred under the contract.

• restore ownership of property which was transferred under the agreement.
  Property must be able to be restored to the original owner, as it was prior to the contract.
  For instance, in transactions for the sale of business or a car, that property is revested in the original owner
• give effect to an indemnity in favour of the innocent party, which indemnifies the innocent party against the effects of entering into the contract.
• take an account of profits for the purpose of rebalancing the parties’ respective positions
• allow for deterioration in the property dealt with by the contract.

 

Electing Rescission as the Remedy

Exercising a right to rescind is an election on the part of the innocent party.

The party elects to claim a remedy which may be inconsistent with other legal remedies. 

For instance, rescission is inconsistent with terminating a contract for repudiatory breach of contract (see below).

How is a contract rescinded?

Firstly, a contracting party must establish for themselves that it has a cause of action in an area of law which provides rescission as a remedy, such as the civil form of fraud, fraudulent misrepresentation, or the law of mistake.

The offending party is notified by the innocent party that due to that cause of action, it is entitled to rescind the contract, and does rescind the contract: ie tell the other party that the contract is rescinded.

A prospective defendant to a legal claim is not likely to accept that rescission is or was  available to the innocent party, or there was some defect with the contract that entitles them to rescind.

Courts merely decide the validity of the rescission, rather than initiate it themselves. It's an enforcement of a previously exercised legal right. 

If the contract was rescinded validly, a court gives effect to it and make appropriate consequential orders.

The aim is to achieve “practical justice between the parties”.

 

Enforcement of Rescission

A party entitled to rescission is likely to apply for court orders such as:

• A declaration (ie judicial confirmation) that the rescission was effective
• Damages for reimbursement of expenses incurred as a result of the contract
• ancillary court orders to make rescission complete.

The remedy can be claimed as late as giving notice in particulars of claim, provided it hasn’t been lost in the meantime. 

 

Losing the right to Rescind

There are a series of bars to rescission. 

The right to rescind is no longer available to a claimant when:

• the contract has been affirmed: affirmation has taken place
• restitutio in integrum is not possible
• intervening third rights: a third party has acquired rights in the property subject to the rescission

1. Contract Affirmed

In common with affirmation of a contract in the context of breach of contract, the right to rescind can be lost.

There’s no turning back from an election to affirm the contract once it is made.

However, if it’s too late to rescind, the innocent party might be able to bring the contract to an end for the future, and terminate it for breach of contract. Whether that’s possible depends on precisely what has happened previously. 

For rescission to be effective the innocent party must:

• make the election to rescind, and
• not do anything which might be said to be an affirmation of the contract.  

Knowledge Requirement

There will be a point in time that the innocent party becomes aware of the right to rescind, before they rescind it.

If the innocent party with that knowledge affirms the contract – elects to continue with the contract – the right to rescind is lost.

A legally binding affirmation to continue a contract requires:

• the innocent party must be aware of all of the facts giving rise to the right to make the election
• the legal consequences of those facts
• clear and unambiguous conduct, consistent with an intention to continue with the contract. The election may be implied by conduct.

However, a relatively short period of time is allowed for the innocent party to consider their position and make their election.   They’re entitled to make all enquiries needed to learn all relevant facts.

Typically affirmation takes place by relying on a term of the contact or asserting a right under the contract.

In cases of fraudulent misrepresentation where the fraud has been concealed affirmation is not likely to be possible until the fraud could have been discovered. 

Affirmation Examples

A contract may be affirmed by:

• continuation of use of property provided under the contract (such as software or hired property)
• insistence on payment of sums under the contract.

 

2. Impossibility of Restitution

It’s a precondition of availability of the remedy that the positions of the parties must be able to be restored to their positions before the contract was made. 

It’s also a fundamental requirement feature of rescission is that the parties are placed in the position they were before the contract was entered.

That is, their positions before the contract was formed – sometimes referred to as “the status quo”.

Restitutio in Integrum

The process of restoration is known as restitutio in integrum:

• If restitutio in integrum is not possible, the remedy to rescind the contract is not available
• Both sides of the transaction must be undone: not just one side of the transaction, for one party.

In more modern times though, it’s more flexible than that. It’s not an absolute rule. 

Courts are sometimes satisfied to grant the remedy when substantial restitutio in integrum is possible. More so in cases involving fraud. It’s likely that the greater reprehensible conduct on the part of the misleading party, the less stringent the requirements on the part of the Court to insist on perfect restitution.

So restoration of the parties to their previous positions does not need to the exact or precise position.

Whether or not substantial restitution is possible depends on the facts of the case. For example:

• the nature of a business sold may have changed
• property which was the subject of the transaction is destroyed
• property has been transformed into other property, such as:
  • seeds grow into trees, or
  • flour made into bread

 

3. Intervening Third Party Rights

The law of equity treats what is known as “bona fide purchaser for value without notice” in a special way. A “bona fide purchaser for value without notice” is sometimes called “Equity’s darling”. They get special treatment, and for good reason.

That’s because a bona fide purchaser is someone that has acquired an interest in property without knowing that something might have been wrong with the property that they thought they were acquiring.

Courts will not order return of property which has been acquired for value where the acquirer had no notice or warning of the claim by the innocent party.

There’s a good chance that a court will order damages to compensate the innocent party where a bona fide purchaser has acquired property.

 

Implementation of the Remedy

There’s no single court order in all cases which gives effect to rescission.

The usual orders - such as damages and orders to revert ownership of property - may be made to give effect to the remedy.

It was said in the 19^th century:

… the injured party is entitled to be replaced in status quo with this limitation – that he is not entitled to be replaced in exactly the same position in all respects, otherwise he would be entitled to claim damages, but is to be replaced in his position so far as regards the rights and obligations which have been created by the contract into which he has been induced to enter.

That's the general principle behind rescission.

Also from that time, another judge said:

…I am inclined to hold that the [claimant] is entitled to an indemnity in respect of all obligations entered into under the contract when those obligations are within the necessary or reasonable expectation of both the contracting parties at the time of the contract.

Rescission entitles the innocent party to a sort of – roughly speaking – indemnity for entering into the contract. Sometimes an indemnity is especially ordered.

Rescission for Misrepresentation: Fraud Cases

 

Awards of damages play an important role in rescission.

Damages are awarded as compensation in money, for all the loss caused by the transaction on the innocent party. It’s direct loss to the innocent party.

However damages and will almost always be compensatory, and not penal in nature. There are very limited exceptions.

In cases of fraud the measure of damages must remain fair to both parties.

Accordingly, rescission requires:

• The innocent party to give credit for increases in the value of the property they received before the contract was rescinded; and
• The defendant must give credit for the actual proceeds of an asset received after the contract was entered and before it was rescinded.

However, damages for fraud and similar causes of action are not limited to those which were reasonably foreseeable. Consequential loss suffered by reason of having acquired assets under a contract may also need to be accounted for, and taken into consideration in a damages award.

 

Rescission vs Termination for Breach

In English law, it can be misleading to say in the context of rescission that a contract is “terminated” or “terminated ab initio”. Those terms can give rise to serious confusion as to the legal position of the parties.

In the context of rescission, a contract is “rescinded”.

Termination for breach of contract is fundamentally different. Rescission is inconsistent with termination for breach.

• rescission unravels the entire contract.
  The contract is reversed to restore the parties to the position they were in before the contract was signed.
• breach of contract asserts the existence of the contract up to the point in time that it is terminated for repudiatory breach.

The contract is terminated when the innocent party gives notice of acceptance of a repudiatory breach.
The repudiatory breach gives rise to a claim for an award of damages for failure to perform the contract.

The contract is not “undone” in the way that the remedy of rescission does.

Notices of rescission by an innocent party is not the place for lax language.

If a party attempts to rescind a contract when there is not right to do so, is arguably a repudiatory breach of contract. That hands the defendant an argument for a claim for damages.

That said, courts are likely to look at the substance of the communication rather than the precise words used to exercise an alleged right of rescission.

When both rescission and a claim for damages for breach of contract are available to a claimant, the claimant usually selects the remedy which would result in the greater sum of money or money’s worth, and pleads them in the alternative.

Examples of Rescission

Sale of Business

A claimant bought a hairdressing salon from the defendant. The defendant said that he did not intend to continue to trade in the area. That was not true, and the defendant knew it. After the sale, the defendant set up a new salon locally.
The business purchased did not retain a substantial part of its customer base.
The claimant was entitled to recover:

• trading losses as a result of loss of clientele it expected to have
• reduction of the capital value of the business on resale of the business, and
• the profits which they could reasonably have expected to make if they had instead bought another similar hairdressing business in a different part of the town.

Damages to match Representations

A business entered into two distributorship agreements. The agreements were profitable.

The agreements would have contained more favourable terms for price and the profits made by the claimants had the defendants not lied during the negotiations.

Damages are not awarded for the additional profits which would have been earned had it not been for fraud of the defendant Clef Acquitaine SARL v Laporte Materials (Barrow) Ltd [2001] QB 488

 

Loss of Chance Claims

A purchaser of a business was conned into buying a business which was worthless. There was another business which the purchaser probably would have bought (80% chance), had it known that the business that it did buy was worthless.

The claimant was awarded 80% of the income and capital gain which the claimant would have received from the investment as damages.

Summary

Rescission is the act of the person who claims to be entitled to rescind.

Courts simply approve or reject the entitlement and to make consequential orders so as to achieve restitution in integrum. 

Rescission can be awarded, even though precise restitutio in integrum is not possible.

Courts can do what is practically just between the parties, and by so doing restore the parties  substantially to the status quo to rescind the contract.