Case of the Mistaken (Illusory) Investment

Sherwood v Walker.jpgCan a spouse rescind a divorce settlement contract if it turns out that the valuation assigned to assets the spouse retained in exchange for a cash payment to the other was inflated due to fraud by a third party?

Several years ago, Husband, a prominent New York real estate attorney at a large firm, and Wife, entered into a contract as part of an uncontested divorce. In the negotiations, the two listed their marital assets, including several homes, and divided them roughly fifty-fifty.

The homes aside, it appeared that the couples’ total assets to split amounted to $13.2 million. The agreement apparently provided that Husband would retain these assets, in their extant form, in exchange for making a cash payment to Wife in the amount of $6.6 million.

It turns out, several years later, that the value of these other assets was overstated by $5.4 million. That portion of the assets are actually worth zero, because they were held in an investment account managed by Bernard Madoff, whose fund turned out to be a Ponzi scheme.

According to the New York Daily News, Husband seeks rescission and reformation of that part of the contract, along with restitution from Wife in the amount of $2.7 million (half the amount of the original valuation of that account). Can he? What grounds are available to do so?

Mutual mistake? That would require concluding that Husband and Wife were both mutually mistaken about a fundamental assumption of the contract, whose risk was neither foreseeable nor allocated by the contract. Is this likely?

It would seem unlikely that a mere change in the market value of appraised property would justify rescission under this doctrine. Suppose that the settlement payment was also based, in part, on the appraised value, at the time of contract formation, of an art collection.

The fact that the art collection probably has declined in value in the several years since contract formation would not provide a basis for rescission under mutual mistake. The relevant basic assumption would be that the art collection existed and was authentic, not that its value would never change.

In contrast, perhaps, in the case of the fraudulent investment account, the assumption is not that its value would never change, but that it existed and was not a mere fraud-induced illusion. Which seems more likely as the basic assumption of the contract?

Unilateral mistake? This would require concluding that Husband was unilaterally mistaken as to the legitimacy of the account that turned out to be fraudulent. Unilateral mistake may be a ground for rescission and reformation when the mistake concerns a matter of computational, mathematical or clerical error, something objectively true or false, as opposed to errors of judgment. Is a mistaken assumption that a fraudulent account is a legitimate one more nearly a clerical error or an error of judgment?

Fraud, somehow? The common law slogan is fraud vitiates all contracts. Does that apply here? Neither Husband nor Wife has engaged in any fraudulent activity. To what extent may a third party’s fraud provide a basis to vitiate contracts between others?

Anything else? Should special rules apply to a divorce settlement agreement? Is it important to know more about the background of the parties and their divorce proceedings and settlement negotiations? Would those factors bear on the question of whether one or the other should or did bear the risk of third party fraud or related mistake?

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3 Responses

  1. dave hoffman says:

    Assuming that this ought to be analyzed under common law contract doctrine(s), which I’m not sure is true, I’d think a bit about frustration of purpose. The principal purpose of the contract was equitable distribution of the estate. That purpose was substantially frustrated by the fraud and its revelation, the non-occurance of which was I think arguably a basic assumption on which the contract was made. Hard to imagine the parties allocated the risk between them…

  2. Edward Swaine says:

    Neat question (and illustration!). Fraud and mutual mistake should be available in principle to attack the agreement. If they took the same exact form as contract law doctrine, I think fraud is the better ground. The third-party aspect wouldn’t necessarily be fatal, but Wife should argue inter alia that she relied insofar as didn’t withdraw Madoff monies.

    It is the fraud element, in any event, that separates this from a garden-variety division of assets in which one side takes cash and the other takes a really bad investment. So for mutual mistake, allocation of risk looks like a problem for Husband. They didn’t just misunderstood the amount of their mutual assets; they also divvied them up. Maybe this subordinate transaction could be viewed as one in which he pays her cash in order to obtain her half of the Madoff asset, which would make it look more like a classic mutual mistake. But it seems more realistic to say that Husband surrendered a more liquid position in order to have the investment’s upside; there were (perceived) barriers to becoming an investor with him and Husband might have preferred to avoid liquidating (perhaps he could even have done so, back then).

    Upshot: this looks to me at first blush like a case in which the parties actually allocated risk, but simply made a mutual mistake about the extent of the risk — which is a far less persuasive case for Husband.

  3. Josh says:

    I was under the impression that frustration only applies to intervening events between formation and execution. So, if we are to use contracts analysis, the question would be: when is performance rendered under a divorce decree? On another note, if we were to vitiate this contract, how causally related would the fraud have to be in future cases? What about an Enron type event – if Enron shares had been used to satisfy a divorce decree and it was later found that the share prices were fraudulently inflated, would that decree be vitiated – I wouldn’t think so.