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The consequences of mutually mistaken facts in contracting; thoroughly examining the contract, including risk shifting and indemnification provisions, prior to executing a contract can avoid the unnecessary legal costs associated with bringing a claim.

The concept of mutual assent, or a meeting of the minds, is basic to contracting. (1) Yet, after the ink on the contract has dried, sometimes the parties discover that a key factual assumption on which they based an agreement is mistaken. The proper term of art to describe this situation is "mistake of fact."

A mistake of fact is "a mistake which takes place when some fact which indeed exists is unknown, or a fact which is thought to exist, in reality does not exist." (2) The mistake present in the contractual dealings may constitute a valid defense to enforcement of the contract. In other words, a party can sometimes avoid liability under the contract entirely through the equitable remedy of rescission, or a party may be able to convince a court to alter the contract consistent with the understanding of the parties at formation through the equitable remedy of reformation.

A mutual mistake of fact occurs where both parties are mistaken about a key factual assumption. In contrast, a unilateral mistake is a different situation where only one of the parties is mistaken. Mistakes of law are distinguishable from mistakes of fact and occur "where the facts are known, but their legal consequences are not known or are believed to be different than they really are." (3) The exclusive focus of this article, however, is on mutual mistakes of fact.

Mutual Mistake of Fact Doctrine and Application

The well-known seminal case establishing mutual mistake of fact doctrine in its modern form involved a contract for the shipment of cotton from the Port of Bombay to Liverpool, England, on a ship known as "Peerless." (4) The contract did not specify a delivery date. Although the shipper, in fact, delivered the cotton to Liverpool on a ship called Peerless, the receiving merchant, refused to accept delivery and tender payment for the goods.

To the surprise of both contracting parties, there were two different ships named Peerless operating out of the Port of Bombay operating on different delivery schedules. The shipper had procured usage rights for one of the Peerless ships for purposes of performing the contract, but the receiving merchant had intended that the goods be delivered on the second ship known as Peerless. Both parties to the contract, therefore, were mistaken as to a material term of the contract, and the court found the contract was not binding on the parties in light of the mistake present in the dealings.

Similarly, when both parties to a government contract are materially mistaken at the time they execute the contract, the adversely affected party is in a position to seek rescission of the contract. Alternatively, the adversely affected party may seek reformation of the contract. It is noteworthy, however that "the courts generally ... have been wary in granting relief from innocent mutual mistakes embedded in, or underlying, consummated contracts." (5) So, while obtaining relief on the basis of mutual mistake is far from certain, the chance of securing a remedy varies as a function of the importance, or materiality, of the mistake involved.

In government contract cases, mutual mistakes typically occur in two forms. The first is where the parties have reached an express agreement, but an error occurs in translating the express agreement into a writing. In this instance, the memorialized agreement fails to reflect the true intent of the parties. The second type of mistake occurs where the parties both make a mistaken assumption regarding a material fact that was a basis for their agreement, and which existed at the time of contract formation. Courts reason that when a contract fails to reflect the parties' intent and sufficient facts exist demonstrating the actual intent, reformation is often appropriate to establish binding terms consistent with the parties' meeting of the minds. (6) However, if insufficient facts exist to support reformation or reformation is otherwise inappropriate, (7) impractical, (8) or unlawful (9) then a court may rescind the contract with the aim of putting the parties back into their positions had there been no contract. (10)

In Atlas Corporation v. United States, (11) the Court of Appeals for the Federal Circuit articulated the elements an adversely affected party must prove to establish a mutual mistake defense to contract enforcement. These elements are

(1) The parties to the contract were mistaken in their belief regarding a fact;

(2) That mistaken belief constituted a basic assumption underlying the contract;

(3) The mistake had a material effect on the bargain; and

(4) The contract did not put the risk of the mistake on the party seeking reformation or rescission. (12)

In addition, some courts have considered whether the non-adversely affected party would have nevertheless agreed to the contract terms as reformed, if he had known the true facts. (13) The application these elements is discussed below.

Element 1: The parties to the contract were mistaken in their belief regarding a fact

The first element means that the mistake of fact must relate to something the parties were capable of knowing at the time they entered into the agreement, and was not something appearing to be a fact on reflection, but at formation was mere speculation. For example, in Atlas Corp. v. United States, a group of companies sought reformation of contracts for the production of uranium and thorium. At the time of contract execution, the parties were aware that producing uranium and thorium created a sand-like substance called tailings, which emitted low-level radiation, but the parties did not understand the environmental consequences of this fact.

Several years later, Congress enacted the Uranium Mill Tailings Radiation Control Act, (14) making the companies responsible for remediation and stabilization, which required them to decontaminate the land surrounding the mill plants rendered unsafe by the tailings. Complying with the new federal law, the companies began necessary work at significant expense. Ultimately, the court rejected the companies' claims stating, "If the existence of a fact is not known to the contracting parties, they cannot have a belief concerning that fact; therefore there can be no mistake." (15) In other words, the court reasoned that because the existence of the tailings hazard was not recognized by the parties they could not have formed a mutually mistaken belief concerning it and, therefore, no mistake was extant giving rise to a remedy. (16)

In another case, Dairyland Power Cooperative v. United States, (17) a corporation contracted with the government for the sale of a nuclear reactor plant, two nuclear fuel cores, and spare parts for the total monetary consideration of one dollar, but an additional contract term called for the company's release of the government from all claims it may have had under a previous contract. While the price of the plant may not have reflected its fair market value at the time of the sale, the company also assumed the significant risk that the plant could become valueless. The company knew about and understood this risk, too, as evidenced by a corporate representative's comment that the purchase involved "a calculated risk" and "a gamble." (18)

Later, the company contracted with another corporate entity to reprocess spent nuclear fuel from nuclear cores purchased under its contract with the government. Shortly thereafter, under presidential ban, commercial processing was suspended, and the reprocessing industry never recovered. Furthermore, Congress enacted the Nuclear Waste Policy Act, (19) which required the company to shoulder the significant cost of permanently storing its spent fuel from the reactor plant. In light of these developments, the company sought rescission of its contract with the government, arguing that the availability of commercial reprocessing was a basic premise in the contract and that the parties never considered the possibility of the industry's subsequent demise.

Essentially, the company wanted the court to undo the release of claims so the government could share in liabilities arising under the subsequent legislation. Denying the requested remedy, the court held that the availability of commercial reprocessing in the future was not an existing fact at the time of contract formation. The court observed, "mutual mistake of fact cannot lie against a future event." (20) Thus, the important lesson of this case is that the requirement for an "existing" mistaken fact at formation means that misguided predictions or forecasts about future events, whether explicit or implicit, do not constitute legally recognizable mistakes.

Element 2: The mistaken belief constituted a basic assumption underlying the contract

The second element requires that the mistake of fact relate to a fundamental basis for the agreement. As the court observed in Smelser v. United States, (21) "an assumption is considered basic if it is a significant part of the bargaining process." (22) In Smelser, a contractor asserted that the Department of Energy (DOE) had breached a settlement agreement containing numerous terms. One of the terms gave the contractor the right to remove and retain excess equipment located at a worksite. The DOE, however, refused to permit the removal of certain heat exchangers because they were donated to a third party with the assent of the contractor and prior to the settlement agreement.

Nevertheless, the heat exchangers appeared as an item listed for transfer to the contractor in the settlement agreement, although the DOE no longer had title to them. Despite obvious confusion over the heat exchangers, the court declined to grant the contractor relief relying on the idea that "[c]ourts generally ... have been wary in granting relief from innocent mutual mistakes imbedded in ... contracts." (23) Essentially, the court reasoned that if the parties had known of the mistake they would have nonetheless gone forward with the agreement. (24)

Element 3: The mistaken belief had a material effect on the bargain

The third element requires that the adversely affected party show the mistake had a material effect on the bargain reflected in the contract. In some cases this takes the form of proving that the change "is not only less desirable to him but is also more advantageous to the other party." (25) For example, in Southwest Welding & Manufacturing Co. v. United States, (26) a contractor sought reformation of a contract calling for the company to furnish all labor and materials for construction and installation of steel structures for a reservoir project. The conflict surrounded an increase in the price of steel.

When the parties executed the agreement, they set forth the current market price of steel, but also included language suggesting at least inferentially that the contractor was to be reimbursed for direct costs plus certain percentages of that amount for profit, overhead, and bond. This contract did not contain a provision allocating the risk of future fluctuations in market price. Although the future increase in the price of steel could not have been known at the time of formation, the court found that this particular contract reflected the parties' intent that the contractor would be reimbursed based on the actual market price of steel and that "the agreement, as written, conferred benefits upon the government, which neither party desired or intended." (27) Consequently, the contractor achieved the desired remedy.

Element 4: The contract did not put the risk of the mistake on the party seeking relief

The fourth element requires that the contract did not allot the risk of mistake to the adversely affected party. Because many contracts purport to allot risk, this is a particularly difficult element to satisfy, and a survey of mutual mistake cases shows that the claims of many litigants fail on this point. Furthermore, courts do not always adhere strictly to the language of the contract to determine whether a party has assumed risk. Rather, courts often examine the circumstances surrounding contract execution to determine whether a party assumed the risk of mistake. Generally, a party bears the risk of mistake when:

(1) The risk is allocated to him by agreement of the parties; or

(2) He is aware, at the time the contract is made, that he has only limited knowledge with respect to the facts to which the mistake relates but treats his limited knowledge as sufficient; or

(3) The risk is allocated to him by the court on the ground that it is reasonable in the circumstances to do so. (28)

In Emerald Maintenance, Inc. v. United States, (29) a contractor agreed to remove, replace, and repair roofs on military housing. In the contract, the parties had erroneously omitted a classification for roofers and had only provided a description for laborers, which was inconsistent with the Davis-Bacon Act wage rate clause as well as area practice. Because of the omission, the contractor was required to remit payments to roofing workers at the higher wage rate than anticipated. When the contractor failed to remit the required payments, the government withheld funds and made direct wage payments to the workers.

The contractor brought a claim to recover the withheld funds and sought reformation on grounds that the omission of the roofer classification was a mutual mistake of fact. Finding a contract clause expressly placed the burden of investigating area practice on the contractor, the court observed, "[A] mutual mistake as to a fact or factor, even a material one, will not support relief if the contract puts the risk of such a mistake on the party asking for reformation." (30) Thus, the court refused to reform the contract.

In McNamara Construction of Manitoba, Ltd. v. United States, (31) the court reached a similar result. In McNamara, the contractor agreed to construct a canal lock and related structures, but the contractors progress on the project was severely delayed due to labor strikes, slowdowns, and harassment. Although the government granted time extensions due to the delays, it disclaimed any obligation to pay additional monies because of them. The contractor sought reformation suggesting that neither party could have anticipated the magnitude of labor problems. The court, however, disagreed asserting that the parties were well aware of the potential for labor difficulties and that the contract expressly, albeit generally, placed the risk of such problems on the contractor's shoulders.

Additional Factor: The non-adversely affected party, if aware of the fact, would have agreed to the change.

Even if an aggrieved party is successful in satisfying the elements of mutual mistake of fact, an additional hurdle may exist, if reformation is the remedy sought. In some instances, courts analyze, based upon the facts and surrounding circumstances, whether the non-adversely affected party would have agreed to the terms of the contract as reformed, had he known of the mistake. While not formally considered an element of mutual mistake of fact, this factor often remains an important consideration. (32) Courts use this test only in entertaining a proposed reformation, not rescission. The limitation is sensible because the question would be unimportant in a situation where a plaintiff is requesting rescission. Moreover, it is consistent with the policy supporting the reformation remedy, which is to repair a flawed contract in such a way as to implement the parties' actual intended agreement. (33)

Conclusion

Certainly, not every mutual mistake in contracting leads to rescission or reformation of a contract. As we have seen, courts often are reluctant to undo a memorialized agreement. Yet, if one of the parties can show that both of the parties to the contract were mistaken in their belief regarding a fact, that the mistaken belief constituted a basic assumption underlying the contract, the mistake had a material effect on the bargain, and that the contract did not put the risk of the mistake on the party seeking reformation or rescission, then a contractor stands a fair chance of obtaining a remedy.

Of course, defending against a claim of mutual mistake may involve convincing a court that one or more of these elements are not fulfilled. While a contractor can never extinguish all possibility that litigation surrounding a mutual mistake will arise, a tightly drafted contract concerning the expectation of the parties is the first step in avoiding this type of dispute. Although disputes over mistakes are certainly not limited to these areas, paying special attention to risk shifting and indemnification provisions can avoid much of the potential litigation. Furthermore, thoroughly examining the contract, including risk shifting and indemnification provisions, prior to bringing a claim can avoid the unnecessary legal costs pursuing faulty claims.

Endnotes

(1.) Restatement Second of Contracts, [section]20.

(2.) ITT Corp. v. United States, 24 F.3d 1384, 1386 (Fed. Cir. 1994).

(3.) Executone Info. Sys. v. United States, 96 F.3d 1383, 1386 (Fed. Cir. 1996).

(4.) Raffles v. Wichelhaus, Court of the Exchequer, 2 Hurl. & C. 906, 159 Eng. Rep. 375 (1864).

(5.) National Presto Indus., Inc. v. United States, 338 F.2d 99, 106-07 (Ct. Cl. 1964).

(6.) American President Lines, Ltd. v. United States, 821 F.2d 1571, 1582 (Fed. Cir. 1987).

(7.) See Henderson Cty Drainage Dist. v. United States, 53 Fed. Cl. 48, 57 (2002).

(8.) See National Elec. Laboratories, Inc. v. United States, 180 F. Supp. 337, 342 (Ct. Cl. 1960).

(9.) See California-Pacific Utilities Co. v. United States, 194 Ct. Cl. 703, 716 (1971).

(10.) See Rash v. United States, 360 F.2d 940 (Ct. Cl. 1966).

(11.) Atlas Corp. v. United States, 895 F.2d 745 (Fed. Cir. 1990).

(12.) Id. at 750; see also Knieper v. United States, 38 Fed. Cl. 128, 139 (1997); Morris v. United States, 33 Fed. Cl. 733, 747 (1995) (applying the Atlas Corp. framework to claims for rescission on grounds of mutual mistake).

(13.) See McNamara Constr. of Manitoba v. United States, 206 Ct. Cl. 1, 509 F.2d 1166, 1182 (Ct. Cl. 1975); see also Institutional and Environmental Mgmt, Inc., ASBCA Nos. 32924 and 34948, 90-3 BCA 23, 118 (1990).

(14.) 42 U.S.C. [section][section] 2022, 2113, 2114, 7901 42.

(15.) Atlas Corp. v. United States, 895 F.2d at 750 (emphasis in original) (internal quotations omitted).

(16.) Id.

(17.) Dairyland Power Cooperative v. United States, 16 F.3d 1197 (Fed. Cir. 1994).

(18.) Id. at 1200.

(19.) 42 U.S.C. [section][section] 10101-10226.

(20.) Id. at 1203.

(21.) Smelser v. United States, 53 Fed. Cl. 530 (2002).

(22.) Id. at 545.

(23.) Id. citing National Presto Industries, Inc. v. United States, 338 F.2d 99, 106-07 (Ct. Cl. 1964).

(24.) Id. at 545 46.

(25.) Restatement Second of Contracts [section] 152, comment c.

(26.) Southwest Welding & Mfg. Co. v. United States, 373 F.2d 982 (Ct. Cl. 1967).

(27.) Id. at 990.

(28.) Restatement Second of Contracts [section] 154.

(29.) Emerald Maint. Inc. v. United States, 925 F.2d 1425 (Fed. Cir. 1991).

(30.) Id. at 1429 (citations omitted).

(31.) McNamara Constr. of Manitoba, Ltd. v. United States, 509 F.2d 1166 (Ct. Cl. 1975).

(32.) Flippin Materials Co. v. United States, 312 F.2d 408 (Ct. Cl. 1963); McNamara Constr. of Manitoba, Ltd. v. United States, 509 F.2d at 1169.

(33.) American President Lines, Ltd. v. United States, 821 F.2d at 1582.

About the Authors

MICHAEL D. SCHAG is a counsel attorney in the St. Louis area office of Heyl Royster Voelker & Allen. He is a member of the NCMA Gateway Chapter and has served on the board of directors for the Denver Chapter. For comments about this article, he can be reached at mschag@hrva.com.

PHILLIP R. SECKMAN is an associate at the Denver office of McKenna Long & Aldridge and is a member of the NCMA Denver Chapter. Send comments on this article to cm@ncmahq.org.
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Date:Jan 1, 2005
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