CONFIDENTIAL AND PRIVILEGED ATTORNEY-CLIENT COMMUNICATION

TO: Mary J. Novak

FROM: *********

DATE: November 12, 1998

RE: Parlay Contract with Thayser & Associates: Excuse of Contract Performance by the Doctrine of Frustration of Purpose

For purposes of this memorandum the following facts are assumed to be true.

Sally Tanner, a Silicon Valley venture capitalist, and one of the partners in the venture capital firm "Parlay," has asked for our help in getting out of a contract ("the Contract") between Parlay and Dr. Paul Thayser's company, "Thayser & Associates" ("T&A"). The focus of the Contract is the development of lead-acid battery technology to be used in electric vehicles.

After finishing a Ph.D. at the Massachusetts Institute of Technology in 1994, which focused on design of lead-acid batteries for use in electric vehicles, Thayser moved to California. Bringing his lab assistants with him, he started his own company in order to continue his work. One of the primary reasons Thayser chose California was the fact that it had the most extensive zero-emission vehicle ("ZEV") program in the country. The ZEV program was part of a plan adopted by the California Air Resources Board ("ARB") in 1991 to reduce emissions. In June 1995, the ARB further implemented the ZEV program by passing a regulation mandating that a certain percentage of automobiles manufactured for sale in California by 2000 would be ZEVs. The regulation, Cal. Code Regs. tit. 13, Section 1960.1(g)(2), mandated that this percentage increase from two percent to ten percent over a of five year period.

Tanner read about the ARB regulation and decided it would be a welcome change from computers which she had been working with for some time. In July 1995, after getting approval from her partners, Tanner met with Thayser to discuss a proposal for a potential contract in which Parlay would pay T&A $100,000 per month to develop, as fast as possible, the first pilot lead-acid battery for use in ZEVs. Parlay agreed to be responsible for all marketing and sales of the design to auto manufacturers. Other terms of the Contract included that the work would be confidential and that T&A would work exclusively for Parlay doing the developments and improvements on the battery for ten years. She also talked with Thayser about the "expanding market" for ZEVs in general, as well as the market created by the ARB's regulation. He accepted these propositions during the conversation, and Tanner gave him a check for $100,000 to get started. Thayser and his associates immediately began work. A few days after this discussion, the Contract which was written by Parlay, arrived at Thayser's office for his signature. Thayser did not concentrate much on what he called "administrative matters" and quickly read the Contract, signed it for T&A and sent it back to Tanner. The Contract included the following purpose section:

In May 1998, the ARB amended its regulations, repealing Cal. Code Regs. tit. 13, §1960.1(g)(2). In a statement of reasons for the repeal the ARB cited a "substantial risk of market failure associated with adhering to the original ZEV program," and that it decided the "market should shape the outcome for this technology." The ARB did say that while they were confident the "ZEV market is developing sufficiently," there was the possibility that the repeal "may cause some ZEV-related businesses to fail." Additionally, "the ARB has full authority to amend its requirements to meet changed circumstances."

When Tanner first heard about the ARB's repeal, she called Thayser and told him to "stop working, the contract is off!" Thayser sent back a letter requesting mediation of the dispute. A few days later, while Tanner was preparing to respond to a mediation request from Thayser, Tanner's staff presented evidence to her that the ZEV market was developing rapidly without the ARB regulation. She called Thayser on June 2^nd and told him to "continue working under the Contract because the market for ZEVs is there, even though the ARB's regulation is not." Work resumed, and Parlay continued to pay T&A $100,000 in June and July.

In August 1998, Tanner discovered that a new advanced battery technology had emerged, which threatened to make Thayser's lead-acid battery obsolete. A competing company announced a pilot advanced battery would be ready by December 1998. After holding Thayser's August check and confirming this information, Tanner decided to "cut Parlay's losses" and end the Contract with T&A. In September, she again called Thayser and told him to stop working. Thayser offered to take less money under the Contract and to start doing research in the area of advanced batteries. She refused and then contacted us for advice in getting out of the Contract.

This memorandum discusses only the issue of whether Parlay's performance under the Contract can be excused by the doctrine of frustration of purpose. A prior memorandum concluded that Tanner's statements on June 2^nd to Thayser and Parlay's June and July payments to T&A are most likely not admissible under the rule of practical construction for purposes of contract interpretation. For the same reasons, everything subsequent to the first dispute, Thayser's request for mediation, is inadmissible. In addition, a prior memo also concluded that the statements made during contract negotiations were admissible under the parole evidence rule.

Can Parlay be excused from performance under the Contract with Thayser & Associates by the doctrine of frustration of purpose?

Parlay most likely cannot be excused from performance under the Contract with Thayser and Associates by the doctrine of frustration of purpose. Under the doctrine of frustration, a party must prove that the risk of the frustrating event was not reasonably foreseeable and the basic reason for entering into the contract is totally or nearly totally destroyed. The first step is to show the risk of the frustrating even was not foreseeable. Two possible frustrating events are present here: the development of the new battery technology and the ARB repeal of its regulation. The development of new technology was likely foreseeable but the ARB repeal was likely unforeseeable.

Next, it must be determined if the purpose of the Contract was frustrated by the ARB repeal. Although there is some evidence pointing to a narrow interpretation of the purpose of the Contract, the evidence supporting a broad interpretation is much stronger. Under a broad interpretation, the purpose of the Contract is the design and development of ZEV battery technology for the market created by the ARB regulation as well as for the ZEV market in general. Because the ARB repeal only affects the portion of the Contract that refers to the ARB regulations, and not the portion dealing with the ZEV market in general, the reason for entering into the Contract has not been completely frustrated. Therefore Parlay most likely will not be excused from performance under the Contract with Thayser and Associates by the doctrine of frustration.

Parlay most likely cannot be excused from performance under the doctrine of frustration of purpose. Under California law, frustration of purpose is defined as follows:

Lloyd v. Murphy, 25 Cal. 2d 48, 55, 153 P.2d 47, 50 (1944). The possible frustrating event must first be found to be unforeseeable. Then, once the purpose is determined, it is possible to decide whether the purpose was totally or nearly totally destroyed. Foreseeability

The first step in determining if frustration of purpose is applicable, is to show the risk of the frustrating event was not reasonably foreseeable. In order for frustration of purpose to apply, the frustrating event must have been unforeseeable. The possible frustrating event is unforeseeable if it is "an unanticipated circumstance wholly outside the contemplation of the parties." Lloyd, 25 Cal. 2d at 56, 153 P.2d at 51. In Lloyd, the lessee who had leased the premises for purposes of displaying and selling new automobiles, contended that the war-time restrictions placed by the federal government on the sale of automobiles constituted complete frustration. Id. at 55-56, 153 P.2d at 51. Because there was public anticipation of government restrictions on the sale of new automobiles, and the parties knew for over a year the government had the power to restrict sales, it could not be said the restrictions were unforeseeable, and therefore they were not a frustrating event. Id. The prevailing conditions and the absence of a provision contracting against the effects of war showed the frustrating event was assumed. Id. The Court held the relations of the parties, terms of the contract, and circumstances surrounding its formation must suggest evidence of foreseeability. Lloyd, 25 Cal. 2d at 54, 153 P.2d at 50. See also Dorn v. Goetz, 85 Cal. App. 2d 407, 193 P.2d 121, (1948) (the possible frustrating event, government regulation on the construction of new homes, which delayed the sale of the old house, was provided for in the contract, and therefore foreseeable).

Here, the development of new technology, and the repeal of the ARB regulations are both possible frustrating events. The emergence of new technology is analogous to the facts in Lloyd and Dorn where the risk of the frustrating event was assumed. The ARB regulation created a market where one did not exist before which forced development of new technology. Tanner should have expected new technology to arise because of her prior experience in the computer field where new technology is driven by fierce market demand. Therefore it cannot be said emergence of new technology was "outside the contemplation of the parties." The development of new technology, "under the circumstances" of a developing market was reasonably foreseeable.

The other event, the repeal of the ARB regulation, was unforeseeable. Both Tanner and Thayser were inexperienced in working with ARB regulations and had no reason to expect the ARB to repeal its regulation. As held in Lloyd, because the relations of the parties, terms of the contract, and circumstances surrounding its formation provide no evidence the repeal of the ARB regulations was foreseeable, nor was it within the "contemplation of the parties," this is the possible frustrating event.

Even if the ARB regulation repeal was unforeseeable, that unforeseeable event cannot be used as an excuse under the doctrine of frustration purpose, unless the fundamental purpose as construed by the parties, for entering into the contract has been destroyed. Dorn 85 Cal. App. 2d 407, 193 P.2d 121. Before it can be decided if Parlay can be excused from the Contract under frustration of purpose, the purpose of the Contract must be determined.

First it must be decided if "the basic reason for entering into the contract, which it is claimed has been destroyed by the supervening event, [is] recognized by both parties." Dorn, 85 Cal. App. 2d at 411, 193 P.2d at 123. In Dorn, because the plaintiffs were building a new home, they made the sale of their old home to defendants contingent upon their new home being ready for occupation. Id. at 409, 193 P.2d at 122. The defendants argued that the purpose of the contract was only for the sale of the old house, while the plaintiffs contended that because the new house could not be built, the contract for the sale of the old house was excused. Id. at 410, 193 P.2d at 123. The court found the purpose of the contract to be only the sale of the old house, and that the building of the new house "was merely an event by which consummation of the sale was to be timed." Id. at 413, 193 P.2d at 125. Because the building of a new house was the desired object of only one of the parties, this was not the purpose, as the purpose was the desired object of both parties. Id. at 411, 193 P.2d at 123.

When the courts are examining a contract in review of a frustration of purpose claim, they tend to view the purpose broadly. Lloyd, 25 Cal. 2d 48, 153 P.2d 47. In Lloyd, the lessee had leased a property that was to be used primarily for the sale of new automobiles, although the contract contained a provision that the purpose could be expanded upon consent of the lessor. Id. at 50, 153 P.2d at 48-49. When the government began to regulate the sale of new cars, plaintiffs waived the rights of requiring the property to be used for only what was specified in the lease, which then enabled the property to be used for "many commercial purposes" such as selling gas and general service. Id. at 57, 153 P.2d at 52. By giving this contract a broad interpretation, the Court held "[d]efendant may use the premises for the purpose for which they were leased," even though a portion of the contract was restricted by the governmental regulation. Id. at 56, 153 P.2d at 51.

Finally, in order to find out what the fundamental purpose of a contract is, the intentions of the parties must be examined to see if the purpose was narrowly construed would have they entered into the contract. Federal Leasing Consultants v. Mitchell Lipsett Company, 85 Cal. App. 3d Supp. 44, 49, 150 Cal. Rptr. 82, 84 (1978). In that case, appellant and respondent entered into a lease for a burglar alarm system which later became unusable. Id. at 47, Cal. Rptr. at 83. Upon becoming aware of the problem respondent took steps to rescind the lease. Id. Appellant then brought suit seeking recovery of the remaining lease payments. Id. Appellant argued a narrow purpose which was only to provide financing and that it was not responsible for the functionality of the alarm system. Id. at 49, 150 Cal. Rptr. at 84. The court held the narrow interpretation was contrary to the intentions of the parties as there is no reason to think one would want financing for an unusable product. Id. at 49, 150 Cal. Rptr. at 84. The fundamental purpose of the contract was to provide a functioning burglar alarm system and therefore the obligation to continue to make lease payments was discharged. Id. at 49, 150 Cal. Rptr. at 84.

Both parties probably took a broad view of the purpose of the Contract. The purpose of the Contract construed broadly, was not only for design and development of battery technology because of the ARB regulation, but also for the ZEV market in general. Although the Contract states "the purpose of this contract is for the design and development of the first pilot lead-acid battery for use in the ZEVs required by [the ARB regulation]," that section is open to interpretation. Unlike in Dorn, where the building of a new home was the desired object of only one of the parties, here the broad definition can be shown to be the desired object of both of the parties. Tanner made statements to Thayser, while negotiating the terms of the Contract, about the "expanding market" for ZEVs in general, as well as the market created by the ARB's regulations. The fact that she gave Thayser a check for $100,000 following this discussion, but before the Contract had been prepared, indicates her agreement to a broad purpose. Thayser demonstrated his agreement to a broad purpose by accepting the check before he signed the Contract, and by immediately beginning work.

As was held in Federal Leasing, a contract should not be interpreted so narrowly as to make its purpose ludicrous, the same can be said for our case. If the Contract was interpreted strictly by looking at the exact language of the purpose section, like in Federal Leasing this would be a ludicrous interpretation. A narrow interpretation of the purpose section would mean the Contract's purpose was only for developing lead-acid battery technology for the market created by the ARB requirements, which was to begin in 2000 and was mandated to be a specific percentage of the market. The effect of using this narrow definition would have been to severely limit Parlay in benefits it could stand to gain. If circumstances had been different, for instance, if the ZEV market grew unexpectedly before 2000, under this narrow contract interpretation, Parlay could not take advantage of it. Also, if the market was so big in 2000 that it was more than ARB's mandated percentage, then, under the Contract narrowly interpreted, Parlay would only be allowed to take advantage of the mandated percentage. Thus, a broad interpretation of the Contract must be used.

Parlay's strongest argument is that the purpose of the Contract was narrow; that the ARB requirements were the only reason it contracted with T&A to design and develop lead-acid batteries. It may argue that the Contract itself states "the purpose of this contract is for the design and development of the first pilot lead acid batteries for use in ZEV's as required by [ARB regulations] . . . ." Parlay may also cite Dorn and argue that both parties agreed to this narrow purpose. The fact that Thayser read and signed the Contract which sets forth the narrow purpose that the Contract existed only because of the ARB regulations, shows that this was the intent of both parties. Another argument in favor of a narrow purpose was the timing of the Contract. Tanner approached T&A only a month after the ARB adopted the regulation to include mandatory ZEV production, suggesting the new requirement was the reason Parlay contracted with T&A. Parlay was not even aware of the ZEV market before learning about the ARB regulation.

Parlay may also argue that Lloyd is inapplicable because, unlike here, a provision existed in the contract which specifically allowed for expanding the purpose of the contract. There, pursuant to the contract, the landlord was able to waive the clause in the lease that restricted the activities on the land to "only those specified in the lease", to use of "the premises for any legitimate purpose." Lloyd 25 Cal. 2d at 57, 153 P.2d at 52. Although to the parole evidence rule allows statements other than those in the Contract to be admitted, Parlay will argue the wording of the Contract is all that really matters, and therefore is all that should be considered in determination of the purpose of the Contract. The Contract did not contain a clause that allowed the purpose to be broadened as in Lloyd, and therefore the Contract should be interpreted based only on the actual wording. Because the wording of the Contract suggests a narrow purpose, Parlay will argue Tanner's statements during negotiations are inconsequential.

Tanner's arguments for Parlay should not prevail. Her strongest argument that the purpose is spelled out in the Contract ignores statements she made while in negotiations with Thayser about interest in the "expanding market" for ZEVs in general, and his agreement to them. The mere fact he signed the Contract is not evidence he ruled out a broader meaning. As he was new to the business world and unfamiliar with administrative matters such as this, and anxious to begin work, he signed the Contract with the expectation that it contained the same information as was discussed in prior conversations with Tanner. The fact that he accepted a check for $100,000 and immediately began work although the Contract had not been signed suggest his understanding of a broad purpose of the Contract. For these reasons Dorn requires the finding that the parties agreed to a broad purpose. Additionally, the Contract reads "The purpose of this contract is . . . ." If this was intended to be the sole purpose, then it should have been stated as such.

Now that it has been determined that the purpose of the Contract was broad, including both the development of ZEV battery technology for the market created by the ARB regulations and for the expanding ZEV market for in general, Parlay cannot use frustration as a reason to be excused from performance under the Contract. "[L]aws or other governmental acts that make performance unprofitable or more difficult or expensive do not excuse the duty to perform a contractual obligation." Lloyd, 25 Cal. 2d at 55, 153 P.2d at 51. The repeal of the ARB regulation may only make it "more difficult" but in no way does it entirely frustrate the purpose of the Contract. Although the portion of the Contract that refers to the ARB regulation is no longer applicable, T&A can still develop lead-acid batteries for the ZEV market in general. Therefore the reason for entering into the Contract, the fundamental purpose, has not been frustrated.

Because of the foregoing reasons, Parlay will not be excused from performance under the Contract with T&A by the doctrine of frustration of purpose. As suggested in footnote one, more research must be performed to ensure that the repeal of the ARB regulation was truly unforeseeable. As explained above, Parlay's best chance of being excused is if a narrow purpose of the Contract can be shown. Currently the facts supporting a narrow interpretation are weak. Parlay's arguments may be considerably strengthened by undertaking research in order to discover additional facts that may support a narrow purpose.