It is not unusual in a failed business transaction for a disappointed party to sue to obtain what it feels entitled to or at least to get back what it lost. But be forewarned, the 7th Circuit Court of Appeals is not the place to be.

In our August 16, 2010 update, we discussed a case in which a disappointed investor was denied the opportunity to "pierce the corporate veil" on the basis of fraud when the investor knew the entity it was dealing with was insolvent. Similarly, in a recent case, a leading supplier of dairy products seeking to break into the Chinese market failed in its fraud claim. (Schreiber Foods, Inc. v. Lei Wang, No. 20-3762, July 5, 2011 7th Cir)

Lei Wang is a U.S. citizen of Chinese descent. She owned an auto parts supply business in Chicago. Ms. Wang had a cousin in China who operated a trading company called Mature Sky. Mature Sky did business with a large Chinese manufacturer of dairy products called Inner Mongolia Yili Industrial Group ("Yili").

The cousin asked Ms. Wang to find a supplier of dairy products in the U.S. After some investigation, Ms. Wang approached Schreiber Foods. Shortly afterward, Mature Sky ordered a whey protein concentrate from Schreiber for $42,240, for which Schreiber was paid.

Unfortunately, the second transaction, for a lot more money, was not as successful. Ms. Wang negotiated the sale of 200 metric tons of "Demineralized Whey Powder 70%" (D70) to Mature Sky for a price of $603,000. Schreiber Foods claimed that the parties knew and intended that the eventual purchaser would be Yili, the Chinese dairy company and that Ms. Wang falsely represented that Yili had a contract with Mature Sky to buy the D70. But the purchaser from Schreiber was Mature Sky, the Chinese trading company, not Yili.

In an interesting aside, the court noted that Schreiber Foods decided to substitute Reduced Minerals Whey Blend (RMW-2) for the D70 without telling Ms. Wang, Mature Sky or Yili. Although Schreiber claimed the two were essentially identical, Schreiber also knew that a previous shipment of RMW-2 to China had been denied entry by Chinese customs as failing to meet Chinese hygienic standards.  Schreiber even sent a sample of RMW-2 to Mature Sky, without revealing that it was not D70 and without revealing that it had been carefully blended to look and taste like D70. The court noted that it was "disappointed that a company of Schreiber's standing (it has $3 billion in annual revenues) would do what it did …"

The ersatz D70 (actually RMW-2) was shipped to China and successfully cleared Chinese customs. But Yili refused to accept it, claiming "the protein was lower, fat was higher, and … the flavor is different." Schreiber would not accept return of the perishable and deteriorating product.

Schreiber had a problem. It had no contract with Yili. The party it did have a contract with, Mature Sky, was in China and was never served (probably because it was too difficult). So that left only one defendant, Ms. Wang. Schreiber claimed that Ms. Wang committed fraud when she said that Yili had agreed to buy the D70 from Mature Sky.

Assuming Schreiber's claim to be true, the district court granted summary judgment to Ms. Wang, ruling that Schreiber's suit was barred by the "economic loss" doctrine, even if Ms. Wang had committed fraud.

Judge Posner, the author of the 7th Circuit opinion, provides an illuminating and interesting history of the economic loss doctrine.

"The aspect of the doctrine that is applicable to this case bars tort liability when the plaintiff has a contract with the defendant and contract law provides an adequate remedy for the type of injury alleged. Courts prefer parties to govern their relations through privately negotiated contracts when that is feasible (that is, when transaction costs—the costs of making an effective contract—are low), provided there are no third-party effects, as there are for example when the performance of a contract causes pollution to third parties. Contracting parties know their business better than a court can and so can allocate risk and responsibility between them more intelligently than a court could do. "[T]ort law is a superfluous and inapt tool for resolving purely commercial disputes. We have a body of law designed for such disputes. It is called contract law․ [C]ommercial disputes ought to be resolved according to the principles of commercial law rather than according to tort principles designed for accidents that cause personal injury or property damage. A disputant should not be permitted to opt out of commercial law by refusing to avail himself of the opportunities which that law gives him." [citing Miller v. United States Steel Corp., 902 F.2d 573, 574–75 (7th Cir.1990)]"

But the economic loss doctrine varies by state. Many states recognize a fraud exception, realizing that a party should not use the economic loss doctrine to avoid the consequences of willful deception. On the other hand, a disappointed party that could take steps to protect itself should not be able to use the fraud exception.

Wisconsin, the state whose law applied, recognizes a narrow fraud exception when the fraud is "extraneous" to the contract, rather than "interwoven" with it. Judge Posner called this distinction "not pellucid" (i.e., not clear). But Judge Posner cited a case in which Kellogg sold cereal to a wholesaler without telling the wholesaler that it had decided to sell to the same customers. The implied representation to the wholesaler that it could resell the cereal was an "extraneous" fraud that would not be expected to be part of the contract. So this was a type of fraud that gave Kellogg an information advantage to the contract.

But the fraud alleged by Schreiber was not this type of fraud. Schreiber knew who it was dealing with and knew that the other party was Mature Sky, "an obscure middleman in a foreign country." So it knew the risks going into the deal. But, as is frequent with Judge Posner, he does not stop there:

"Schreiber acted recklessly in failing to take steps to protect itself against a range of risks of nonpayment, of which fraud by Lei Wang, one of the go-betweens, was only one. The risk of nonpayment was so salient a risk that one would expect it to have been dealt with in the contract. It's not as if contract law contains no resources for dealing with such a matter. Schreiber could have done many things to protect itself, such as requiring Mature Sky or Yili to obtain a letter of credit for Schreiber's benefit guaranteeing payment by Mature Sky; or obtaining a contractual guaranty from Yili; or at the very least warning Mature Sky that it was shipping RMW–2 rather than D70. Schreiber failed in negotiating the contract to take elementary precautions for an international shipment and now wants the judiciary to bail it out."

So this situation was more like the "interwoven" type of fraud that Schreiber could have avoided at the outset. "[The interwoven exception] is to require private ordering of commercial relations where feasible…Just as "where there are well-developed contractual remedies, such as the remedies that the Uniform Commercial Code provides . . . there is no need to provide tort remedies for misrepresentation." (citing All-Tech Telecom, Inc. v. Amway Corp., 174 F.3d at 865 (1999)).

To Judge Posner, Schreiber was invoking tort law to recover losses in a failed business deal that it could have avoided through the contract. As such, this case shows again that the 7th Circuit will not protect supposedly sophisticated enterprises from their recklessness, failure to negotiate protections, or the consequences of their own folly. To the court, Schreiber illustrated all of these.

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