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Beware the Economic Loss Rule

  • October 2006

    For decades, courts have struggled to determine whether to award economic damages in disputes involving commercial transactions when there has been no physical property damage or personal injury. The economic loss rule -- developed to chart the boundary between contract and tort law -- can be stated with some clarity, but applying this rule has proven difficult, resulting in a variety of exceptions.1 As a result, the boundary between contract and tort theory is ill-defined, even though some jurisdictions have interpreted statutes to define what damages are recoverable or have expressly addressed the applicability of the rule by statute.2

    The economic loss rule "is one of the most confusing doctrines in tort law," according to one commentator3. Simply, the rule is this: Damages for economic loss are not recoverable based on tort theory when unaccompanied by physical property damage or personal injury. This rule, which is almost universally accepted4, has three variants:

    • prohibiting recovery for economic loss in tort where there is no personal injury or property damage, without regard to contract
    • prohibiting recovery for economic loss in tort where the loss is also compensable by a breach of contract claim
    • prohibiting recovery for economic loss on both contract and tort theories, unless the tort is separate and independent from the claimed contract breach.5

    Understanding this rule and its exceptions requires knowledge of its historical development. In the 19th century, the boundary between contract and tort theories in a commercial context was well defined -- contract law enforced expectancy interests created by agreement between the parties in privity; tort law compensated people for physical harm to ones person or property caused by tortuous conduct, without regard to contract.

    By negotiating contract terms, commercial parties could predictably allocate risk and limit potential liability to an agreed amount. Contract law limited recovery to expectation damages, which the parties reasonably expected to flow from the breach. On the other hand, tort law allowed all damages proximately resulting from tortious conduct, without any privity requirement or other limitations imposed under contract theory.

    The economic loss rule developed in the products liability context. In Seely v. White Motor Co., the California Supreme Court held that the rule barred an action against a truck manufacturer.6 A brake failure damaged the plaintiffs truck, and the plaintiff sued the manufacturer to recover the purchase price and lost profits.

    The court rejected the plaintiffs strict liability claim, holding that the law of sales -- the Uniform Commercial Code (UCC) -- governed economic relationships among suppliers and consumers and that the law of strict liability was not meant to undermine the UCCs warranty provisions.

    In another seminal case, East River Steamship Corp. v. Transamerica Delaval, Inc., the issue was whether the buyer of a ship could recover on both contract and tort claims against the seller when turbines on the ship malfunctioned, damaging the turbines.7 The U.S. Supreme Court held that no products claim lies in admiralty when the only injury is economic loss.

    The Court reasoned that the distinction between tort and contract principles must be maintained, for when a product injures only itself the reasons for imposing a tort duty are weak and those for leaving the party to its contractual remedies are strong.8 Using an apt metaphor, the Court stated its concern that if products liability claims were viable in such cases, contract law would drown in a sea of tort.9

    The underlying purpose of the economic loss rule is to preserve the distinction between contract and tort theories in circumstances where both theories could apply.

    Tort law should not be expanded to undermine basic contract principles. Contract law protects parties in the enforcement of their bargained-for promises, and it awards damages based on the loss of expectation. Tort law protects interests independent of any bargained-for agreement.

    For example, in Daanen & Janssen, Inc. v. Cedarapids, Inc., the Wisconsin Supreme Court articulated three policy considerations for the economic loss rule:

    • maintain the distinct functions of tort and contract law
    • protect commercial parties freedom to contract
    • encourage the party who best understands the risk of economic loss the commercial purchaser to assume, allocate, or insure against the risk of loss caused by a defective product.10

    However, the bright line between contract and tort theories has proven unworkable in a variety of contexts, and several exceptions to the economic loss rule have developed.11

    Physical Injury

    Some courts have held that when the injury is to property other than the subject of the commercial transaction, the economic loss rule does not apply. This can be viewed as an exception, or as a claim not within the rule.

    However, distinguishing between types of property injured is usually not simple; the issue is discussed in Restatement (Third) of Torts: Products Liability §21, comments (d) and (e).

    In brief, when a product defect results in harm to the product itself, the law of commercial transactions governs the parties rights and obligations. But when a product defect causes harm to surrounding property, the resulting economic loss is recoverable.

    This distinction blurs when a machine or system component destroys the rest of the machine or system. Generally, courts hold that where the product or system is deemed to be an integrated whole, such damage is harm to the product itself and the ecomonic loss rule applies.

    Examples allowing recovery under the physical injury exception include a claim that labeling ink contaminated the contents of packages to which it was applied, as the claim was for physical injury to property other than the product itself;12 a cheese manufacturers claim for lost profits against a dairy equipment seller because the equipment heated milk excessively, causing damage to the milk and decreasing cheese yield;13 and a claim that the defendants lubricant applied to repair the plaintiffs pipeline contaminated the natural gas in that pipeline.14

    Service Contracts

    Some jurisdictions have avoided distinguishing contracts for the sale of goods from contracts for the sale of goods from contracts for the sale of services by rejecting a service-contract exception in actions against, for example, architects, accountants, engineers, and other professionals.15 Courts in these jurisdictions have found that, since there is no reasoned basis to distinguish between contracts for goods and contracts for services, any failure of a bargained-for consideration is recoverable only in contract, not in tort.

    This reasoning was well stated in a Maine federal court opinion:

    The policy interest supporting the ability to comprehensively define a relationship in a service contract parallels the policy interest supporting the ability to comprehensively define a relationship in a contract for the sale of goods. It is appropriate, therefore, that [the economic loss doctrine] should apply to the service industry. Just as a sellers duties are defined by his contract with a buyer, the duties of a provider of services may be defined by the contract he enters into with his client.16

    The fundamental problem with this analysis is that there is no product -- the historical underpinning for application of the economic loss rule -- that is the subject of the commercial transaction. None of the artfully crafted remedies provided in the UCC applies to services. Typically, the only damage from breach of a service agreement is economic loss. If economic loss were recoverable for breach of service contracts only under contract theory, the party that suffered the loss could be left without any effective remedy.

    The argument against applying the rule to professional service contracts is that the service provider relationship creates an independent duty under tort law to provide services consistent with the care, skill, knowledge, and competence of members of that profession. As one commentator put it, The contractual relationship is merely the soil in which the seeds of professional negligence are sown.17 Most jurisdictions that recognize a service exception limit remedies to those in privity and those who are identifiable third-party beneficiaries of the contract to provide services.18

    Yet court rulings on tort liability of accountants, lawyers, engineers, architects, insurance brokers, and other professionals are hardly consistent. At one end of the spectrum, some courts hold that the rule does not apply to any service contract, with a professional or not.19 They reason that because UCC statutory remedies are inapplicable to service contracts, a plaintiff might be denied any meaningful recovery, and that the economic loss rule cannot be permitted to eliminate claims for professional negligence.

    For example, in Insurance Co. of North America v. Cease Electric, Inc., a chicken ranch and its insurance agent sued an electrical contractor, claiming that the contractor negligently installed a ventilation system in the ranch barn, resulting in the loss of about 18,000 chickens and consequential lost profits.20 At trial, the electrical contractor was found negligent, and judgment was entered for the rancher.

    The Wisconsin Supreme Court affirmed, noting that UCC remedies are unavailable; contract law is not better suited than tort law to deal with economic loss arising from service contracts; the policy considerations underlying the economic loss rule do not apply to service contracts; and extension of that rule is unacceptable.

    Because actions against professionals often involve purely economic loss without personal injury or property damages, the economic loss doctrine could be used to effectively extinguish such causes of action in tort, the court wrote.21 To paraphrase the U.S. Supreme Courts statement in East River Steamship Co., tort law would drown in a sea of contract.

    In other jurisdictions, there is no blanket service exception to the economic loss rule.22 However, courts accepting some form of service contract exception have difficulty explaining their logic. As one scholar noted:

    Most courts creating an exception to the economic loss rule for specific claims of professional negligence appear to know that denying recovery has to be wrong but have not been able to articulate either any intelligible exception to the rule or any intelligible rationale for allowing recovery on some claims but not others.23

    In one case, the Illinois Supreme Court withdrew an earlier opinion and held that an action for legal malpractice may be brought in both contract and tort, despite application of the economic loss rule. The court applied its long-standing precedent permitting tort damages for legal malpractice with this curious observation: While we do not fault its logic [of a precedent applying the economic loss rule], we do not follow its ruling. Rather, we adhere to long-established practice and custom. Logic may be a face card but custom is a trump.24

    Other courts avoid this analytical quagmire by permitting recovery for malpractice without ever discussing the rule.25

    Fraud

    Courts have taken three distinct approaches to applying this rule to fraud claims, each with its own rationale.26 The first one exempts fraud and fraudulent inducement based on the following conclusions:

    • The viability of a fraud claim rests on the defendants conduct and not on the type of damages or the existence of an underlying contract.
    • The source of the defendants duty arises out of tort, not contract.
    • The measure of damages for fraud is benefit of the bargain, based on the defrauded partys expectations.27

    The second approach allows a limited exception to the rule for cases where damages are not related to an underlying contract. If misrepresentations concern the subject matter of the contract, such as the quality or characteristics of the goods, they are deemed to be interwoven with the contract. In such instances, no independent intentional misrepresentation exists, and a plaintiff is restricted to contractual remedies.28

    The third approach allows no exception to the economic loss rule when the claim is for fraud, because the rule bars recovery in tort. Fraud is a tort, and therefore recovery for purely economic loss is barred.29 One commentator condemned this simplistic syllogism:

    Misrepresentation almost never produces property damage or personal injury, but only economic loss. Application of the [economic loss] rule to a misrepresentation claim leaves no damages recoverable for the tort . The rule collides with centuries of precedents in thousands of cases. The broad statements applying the economic loss rule to allegations of negligence in the manufacture of defective products should not be taken out of context to support application of the rule where an independent tortious misrepresentation is alleged.30

    Negligent Misrepresentation Exception

    Courts have had difficulty analyzing whether the rule applies to negligent misrepresentation claims.31 The many cases homeowners and builders brought against manufacturers of defective fire-retardant treated plywood that caused roofs to fail as a result of thermal degradation are an excellent example of inconsistent rulings in different states.32

    The disparate rulings regarding negligent misrepresentation claims take four approaches. The first allows a blanket exception on the theory that even when a contract exists, a tort action will lie for either intentional or negligent misrepresentation independent of acts that breached the contract. This approach would, for example, allow economic damages where the claim is based on negligent inducement to enter into a contract, rather than on performance of the contract.

    The second approach, which provides an exception limited to defendants in the business of supplying information for the guidance of others, was taken by the Illinois Supreme Court. This exception applies when the duty is extracontractual, that is, when the information is conveyed not merely as a part of a sale or contract. It depends on the defendants profession and the nature of the parties relationship. If the relationship pertains to something intangible, this exception applies.

    For example, in Congregation of the Passion v. Touche Ross and Company, a church sued the accounting firm that prepared its financial statements for negligence in the manner in which certain investments were reported in the statements.33 The Illinois Supreme Court limited the application of the economic loss doctrine to the service industry only where the duty of the service provider is defined by the contract with the client. When a duty arises outside the contract, the economic loss doctrine does not apply.

    The court held that the accountants duty was extracontractual, because an accountant must make independent decisions for many significant matters that are not contingent on the contract. A client has the right to rely on an accountants knowledge and expertise when those decisions are made -- independent of contractual obligations. This relationship, the court found, pertains to something intangible because, unlike an architect who produces a tangible structure, an accountant -- like a lawyer -- provides services whose value lies in the ideas behind the documents produced, not the documents themselves. On this theory, since the duty to observe reasonable professional competence exists independently of contract, the economic loss doctrine does not bar recovery in tort.

    Based on this exception, Illinois Courts have allowed claims against health care professionals, insurance brokers, accountants, and attorneys, but not against advertising firms, architects, or engineers. The distinguishing characteristic is that the first group contains members of skilled professions who have long been held liable for negligent failure to observe reasonable professional standards of competence.34

    The third approach avoids the questionable distinction among types of service providers by focusing on privity. An action does not lie for negligent misrepresentation when there is privity of contract between the parties. But tort liability does apply when a negligent misrepresentation induces third parties to rely on a defendants tortious conduct.

    The final approach does not provide any exception for negligent misrepresentation, reasoning that if courts required only an allegation of negligent misrepresentation to avoid application of the economic loss rule, every contract dispute would potentially turn into a negligent misrepresentation claim. One Florida court held, though, that there is no policy justification for this approach, stating that the economic loss rule was

    never intended to bar well-established common law causes of action . Rather, the rule was primarily intended to limit actions in the product liability context, and its application should generally be limited to those contexts or situations where the policy considerations are substantially identical to those underlying the product liability-type analysis.The ruleshould not be invoked to bar well-established causes of action in tort, such as professional malpractice.35

    As the economic loss rule has evolved over nearly half a century, judges have had some difficulty defining its contours. If strictly applied, the rule can have draconian consequences. As a result, judges have fashioned a variety of exceptions to its application. Even so, the economic loss rule must be reckoned with. When seeking recovery for commercial economic loss, it is imperative that you know how this rule has been applied in your jurisdiction.


    Notes

    1 R. Joseph Barton, Drowning in a Sea of Contract: Application of the Economic Loss Rule to Fraud and Negligent Misrepresentation Claims, 41 WM. AND MARY L. REV. 1789 (2000) and n. 3 thereof, at 1844, that cites numerous articles discussing problems created by application of the economic loss rule; see also Edward T. O'Donnell, David I. Weiss & Daniel L. Kaplan, On the Differences Between Blood and Red Ink: A Second Look at the Policy Arguments for the Abrogation of the Economic Loss Rule in Consumer Litigation, 19 NOVA L. REV. 923 (1995).

    2 F. Malcolm Cunningham, Jr., & Amy L. Fischer, The Economic Loss Rule: Deconstructing the Mixed Metaphor in Construction Cases, 33 TORT & INS. L.J. 147, 155 nn. 37-38 (1997). For examples of such statutes, see Fla. Stat. § 718.203 (providing for certain warranties from contractors, subcontractors and material suppliers to condominium unit purchasers) and Conn. Gen. Stat. §52-572n (distinguishing between consumer and commercial applications of the rule).

    3 Barton, supra note 1.

    4 Amanda K. Esquibel, The Economic Loss Rule and Fiduciary Duty Claims: Nothing Stricter Than the Morals of the Marketplace? 42 VILL. L. REV. 789 (1997).

    5 Cunningham, supra note 2; 1 ROBERT L. DUNN, RECOVERY OF DAMAGES FOR LOST PROFITS, §3.6-3.13, at 265-94 (6th ed. 2005).

    6 476 U.S. 858, 866 (1986).

    7 Daanen & Janssen, Inc. v. Cedarapids, Inc., 573 N.W.2d 842, 846-50 (1998); see also RESTATEMENT (THIRD) OF TORTS: PRODUCTS LIABILITY §21 (1998), which limits recovery of economic loss in a product defect claim to that arising from injury to persons and property.

    8 For a list of the states that have adopted the economic loss rule, and exceptions to it, with case citations, see Christopher Scott D'Angelo, The Economic Loss Doctrine: Saving Contract Warranty Law From Drowning in a Sea of Torts, 26 U. TOL. L. REV. 591 app. at 609 (1995).

    9 Paper Manufacturers Co. v. Rescuers, Inc., 60 F. Supp.2d 869 (N.D. Ind. 1999).

    10 LeSeur Creamery, Inc. v. Haskon, Inc., 660 F.2d 342 (8th Cir. 1981), cert. denied, 455 U.S. 1019 (1982).

    11 Transwestern Pipeline Co. v. Monsanto Co., 46 Cal. App.4th 502 (1996).

    12 Fireman's Fund Insurance Co. v. Childs, 52 F. Supp.2d 139, 145 (D. Me. 1999).

    13 RECOVERY OF DAMAGES, supra note 5, §3.12 at 289-93; Kurt Olafsen, Daniel Rapaport, Sigmund D. Schultz & Jonathan Mermin, Tort Killer: The Applicability of the Economic Loss Doctrine to Service Contracts, 20 MAINE BAR J. 100 (2005).

    14 Olafsen, et al., supra note 13, at 103.

    15 Cunningham, et al., supra note 2; see also

    16 RECOVERY OF DAMAGES, supra note 5, §3.11a at 281-88.

    17 Insurance Company of North America v. Cease Electric Inc., 688 N.W.2d 462 (2004).

    18 Insurance Company of North America, supra note 17, at 481; see also McCarthy Well Co. v. St. Peter Creamery, Inc., 410 N.W.2d 312 (Minn. 1987).

    19 RECOVERY OF DAMAGES, supra note 5, §3.12 at 289-93.

    20 RECOVERY OF DAMAGES, supra note 5, §3.11 at 286.

    21 Collins v. Reynard, 607 N.E.2d 1185, 1186 (1992).

    22 RECOVERY OF DAMAGES, supra note 5, §3.11 at 288 & §3.13 at 293-94.

    23 Barton, supra note 1; Steven C. Tourek, Thomas H. Boyd & Charles J. Schoenwetter, Bucking the "Trend": The Uniform Commercial Code, the Economic Loss Doctrine, and Common Law Causes of Action for Fraud and Misrepresentation, 84 IOWA L. REV. 875 (1999); Christopher J. Faricelli, Wading Into the "Morass": An Inquiry Into the Application of New Jersey's Economic Loss Rule to Fraud Claims, 35 RUTGERS L.J. 717 (2004); RESTATEMENT (SECOND) OF TORTS §531 (1976).

    24 Barton, supra note 1, at 1802-05.

    25 Barton, supra note 1, at 1806-10.

    26 Barton, supra note 1; Peter J. Donoghue, Young Lawyers Journal: The Economic Loss Rule and Contractual Fraud: Now is a Time for Change, 17 CBA RECORD 37 (2003).

    27 RECOVERY OF DAMAGES, supra note 5, §3.29 at 336.

    28 Barton, supra note 1, at 1812-24 and RECOVERY OF DAMAGES, supra note 5, §3.29 at 334-36.

    29 Barton, supra note 1, at 1790-93.

    30 DUNN, supra note 5, §3.29, at 336.

    31 Barton, supra note 1, at 1812-25; DUNN, supra note 5, §3.29, at 336.

    32 Barton, supra note 1, at 1790-92.

    33 636 N.E.2d 503 (1994); see also RESTATEMENT (SECOND), supra note 18.

    34 See Thomas J. Cunningham, Orphans of the Economic Loss Doctrine: Tort Liability of Information Providers and Preclusion of Comparative Negligence, 8 DEPAUL BUS. L.J. 41 (1995).

    35 Moransaid v. Heahman, 744 So. 2d 973, 983 (Fla. 1999); see also Comptech Intl, Inc. v. Milam Commerce Park, Ltd., 753 So. 2d 1219, 1226 (Fla. 1999).

Beware the Economic Loss Rule

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