Is Privity of Contract Dying a Slow Death in Construction Law?

Vol. 15 No. 4

By

Samuel Goldwyn, a famous film producer, once famously quipped that “a verbal contract isn’t worth the paper it’s written on”.  Recent developments in construction law suggest that the lack of a written contract may not be a much better defense if the current trends continue.

The law relating to construction contracts, the defenses associated with privity of contract, and the interpretation of the economic loss rule seem to be undergoing a paradigmatic, yet imperceptible, shift.  For years, courts and contractors alike seemed to respect the time honored principal that a claim was generally not brought against another participant in a project if a contract did not exist between the parties.  Nowhere was this idea more prevalent than in the AIA form contracts.  Each iteration contained new approaches to try to restrict claims by contractors against the design professional.

As projects have become more integrated and complex, however, there is a growing inclination to permit tort based claims for economic damages against parties with whom a project participant does not have a direct contract.  For instance, all three states in the Third Circuit now allow these types of claims in one form or another.  The law in the 3rd Circuit seems to be reflective of a larger national movement.  Construction lawyers, as a result, have a new tool in their arsenals to effectively represent their clients.  These developments come with risks.

Test Borings:  A Review of the Third Circuit (Delaware, Pennsylvania and New Jersey)

While the law in the Third Circuit is not dispositive of the issue on a national scale, it reflects the trend toward permitting tort based claims for economic loss.   

Delaware  Permits a Cause of Action Against Designers for Negligent Misrepresentation

Courts in Delaware permit the use of Section 552 of the Restatement (Second) of Torts in claims by contractors against design professionals.  The cause of action, for negligent misrepresentation, rests on the assumption that contractors may reasonably rely on the plans and specifications prepared by the design professional since the information is provided with the intention to be used by others.

In Guardian Construction Co. v. Tetra Tech Richardson, Inc., 583 A.2d 1378, 1990 Del.Super. LEXIS 322 (1990), Tetra Tech was the design professional hired by the Delaware Department of Natural Resources to prepare plans and specifications for a breakwater structure.  Guardian Construction then used these plans and specifications to prepare and submit a bid to the Department for the work.  Guardian’s bid was accepted and it was hired as the general contractor.  Guardian then subcontracted out a relevant portion of the work to another company.  No contract existed between Guardian or its subcontractor and Tetra Tech.

Guardian started the work and proceeded based on Tetra Tech’s tidal height calculations and projected benchmarks.  The plans and specifications, being based on those miscalculations and faulty assumptions, were inaccurate.  As a result, Guardian’s bid was too low and it incurred additional costs of nearly $200,000 for extra labor and equipment.  A claim for, among other things, negligent misrepresentation under Section 552 was brought by Guardian against Tetra Tech.

In considering whether Guardian may recover what were clearly pure economic losses using a negligence theory against Tetra Tech, the Court concluded that Tetra Tech should be liable for foreseeable economic losses by parties who they could reasonably expect to rely on their plans and specifications.  Citing “modern legal authority”, the Court went on to state that one of the primary purposes of the plans and specifications was to provide information to contractors so that they could properly prepare their bids.  It continued by stating that the use of the information negligently provided by Tetra Tech was not an indirect or collateral consequence of the design professional’s work.  Rather, it was the purpose of the transaction calling for the plans and specifications in the first instance.

For these reasons, the Court held that the lack of contractual privity between Guardian and Tetra Tech did not preclude a claim for negligent misrepresentation.  It further clarified that any claim for negligence is permitted when the case falls within the purview of Section 552.  In so stating, Section 552 became an exception to the requirement that a party have privity of contract in order to recover economic losses in Delaware.

Pennsylvania Also Permits Cause of Action for Negligent Misrepresentation against Designer if Plans and Specs are Incorrect

The seminal case on the subject in Pennsylvania is Bilt-Rite Contractors, Inc. v. The Architectural Studio, 866 A.2d 770, 581 Pa. 454 (2005).  Handed down in 2005, it also permits a contractor to bring a claim against a design professional for negligent misrepresentation if the plans and specifications are incorrect.

In Bilt-Rite, the East Penn School District entered into a contract with The Architectural Studio for the design of a new school.  Among the services to be provided by the design firm was the preparation of plans, drawings, and specifications to be submitted to the contractors for the purpose of preparing bids for the project.  The School District then solicited bids from contractors based on the plans and specifications prepared by the design professional.  Relying on those plans and specifications, Bilt-Rite submitted a bid that was ultimately accepted based on those plans and specifications.

 The plans called for the installation of an aluminum curtain wall system, sloped glazing system, and metal supports.  The documents prepared by the design professional indicated that standard construction means and methods could be used to build these systems; but Bilt-Rite started work and later learned that the use of standard means and methods could not be employed to complete the work on this portion of the project.  Accordingly, Bilt-Rite incurred a substantial increase in the cost to complete the project.

It was this misrepresentation that Bilt-Rite contended was negligent and the basis of a proper claim against the design firm.  While Bilt-Rite had no contract with the design firm, the Pennsylvania Supreme Court eventually accepted Bilt-Rite’s argument that Section 552 of the Restatement (Second) of Torts supported its claim and provided a work around of the economic loss rule.  In effect, a recovery of economic damages was possible in tort without the existence of privity of contract. 

Because it was an issue of first impression in Pennsylvania, the Bilt-Rite Court carefully scrutinized Section 552.  The Court’s opinion concluded that there is a duty owed when one supplies information to others for pecuniary gain and “intends or knows that the information will be used by others in the course of their own business activities”.  The Supreme Court narrowly applied the principle to cases where businesses provide services or information that they know others will rely upon in furtherance of their own business.  Foreseeability is a necessary component to the claim and a “reasonable man standard” applies.

In its holding in Bilt-Rite, the Pennsylvania Supreme Court formally recognized the tort of negligent misrepresentation as an exception to the economic loss rule.  Privity of contract is no longer required between the design professional and the contractor if the design professional could reasonably expect that the contractor would rely on the plans and specifications to prepare its bid or perform its work.  There has not been a wider application of this narrow holding in Pennsylvania though.

New Jersey: Almost any Party on a Project May Bring a  Tort Action

The most recent case to consider this subject is SRC Construction Corp. of Monroe v. Atlantic City Housing Authority, Civil No.:  10-3461 (D.N.J., Irenas).  While only a trial court decision in the federal district court, the analysis is persuasive and shows a much wider allowance of tort claims.  Evaluating the status of New Jersey law on the subject, the opinion effectively stands for the proposition that almost any participant in a construction project in New Jersey may have a remedy in tort. 

In SRC, the Atlantic City Housing Authority entered into a contract with SRC to build a senior living center. The Housing Authority entered into a separate contract with a design professional to design and administer the project.  In a slightly different scenario than the aforementioned cases, there was no claim for defective plans and specifications.  Instead, the contractor alleged that the architect increased the contractor's performance costs by delaying the acquisition of building permits, submitting drawings that did not meet the building codes, failing to timely respond to the contractor's Request for Information, and verbally ordering changes that were not honored by the Housing Authority.

Because the contractor did not have a contract with the architect, it made tort allegations to claim what were solely economic losses from the design professional.  Section 552 was not part of the analysis; rather, the contractor asserted a basic theory of negligence against the design professional.  The architectural firm defending the case maintained that the economic loss rule precluded the contractor's claims and, in the alternative, that the contractor's claims were barred because it had the same causes of action in contract against the owner. 

The court undertook a review of New Jersey state law on the economic loss rule and affirmed the long held belief that the concept was designed to maintain the distinction between contract and tort claims. The only exception - which it did not apply to the SRC case - is if a Plaintiff can establish an independent duty of care separate from the contract between the parties.  The SRC Court maintained that Plaintiffs should generally not be permitted to enhance the benefits of the bargain they struck in the contract by bringing an action in tort. 

Analyzing the New Jersey Supreme Court’s opinion in Saltiel v. GSI Consultants, the Court arrived at the strikingly broad conclusion that the economic loss rule only applied to bar certain tort claims between parties who specifically have a contract.  According to the Court, “the absence of a contract between a plaintiff and defendant in a negligence suit precludes the application of the economic loss rule”.  The plain language of the opinion suggests that any participant in a New Jersey construction project may bring suit in tort against a party with whom it does not have a contract.  

Looking a little closer, the SRC Court saw a distinction when it juxtaposed the state court cases of New Mea Construction v. Harper and Juliano v. Gaston.  In New Mea, a claim against a builder that installed lesser grade materials was effectively seen as a breach of contract action; and attempts by the Plaintiff to cast it as negligence were improper under the economic loss rule. Conversely, homeowners were permitted to pursue the subcontractor in negligence for faulty workmanship since they had no contract with that subcontractor in Juliano v. Gaston.

Based on these two cases, the SRC court determined that a claim for negligence was not barred by the economic loss rule because there was no contract between the contractor and the architect. Because there was no contract, the tort claim cannot be a "contract claim in tort clothing".  Therefore, the negligence claim was an independent and valid cause of action to which the economic loss rule did not apply.  Similarly, the assertion that the existence of a similar claim against the owner affords the architect protection was deemed to lack merit.

If the SRC Court’s analysis is correct, the interplay between the economic loss rule and privity of contract, as well as their impact on breach of contract and negligence claims in New Jersey, has changed.  A basic negligence claim, outside the narrow scope of negligent misrepresentation, is now plausible.

Cave-In of the Economic Loss Rule

The “fence line” that protected against tort claims of these kinds for years was the economic loss rule.  By its classic definition, the economic loss rule operates to limit a Plaintiff to a recovery of the economic damages that flow from a breach of contractual expectations.  Perhaps the Bilt-Rite Court summarized it best by quoting another opinion in Palco Linings, Inc. v. Pavex, Inc., 755 F. Supp. 1269 (M.D. Pa. 1990)(citations omitted):

The rationale of the economic loss rule is that tort law is not intended to compensate parties for losses suffered as a result of a breach of duties assumed only by agreement.  Compensation in such cases requires an analysis of damages that were contemplated by the parties at the origination of the agreement, an analysis within the sole purview of contract law.  On the other hand, the policy consideration underlying tort law is the protection of persons and property from losses resulting from injury, while the policy consideration underlying contract law is the protection of expectations bargained for.  Thus in light of these distinctions, to recover in tort a plaintiff must allege facts showing a breach of some duty imposed by law.  In other words, to recover in negligence "there must be a showing of harm above and beyond disappointed expectations" evolving solely from a prior agreement.  A buyer, contractor, or subcontractor's "desire to enjoy the benefit of his bargain” is not an interest that tort law traditionally protects.

Generally stated, the effect of the economic loss rule is to prevent contract based actions from being converted into tort claims with more subjective and, often times, higher damages calculations.

While not advocating for either side, the increasing permissibility of tort claims for economic damages – particularly to the degree suggested in SRC – is a direct attack on the economic loss rule.  The damages sustained by those involved in construction projects are most typically economic in nature and implicate the rule.  By allowing tort claims against a party with whom a contractor has no contract, a broader array of damages becomes available and the line between economic and non-economic damages is blurred.

By definition, tort claims have no link to the expected benefit of the bargain.  Among the expectations of a party to a contract is that the other party may not be able to provide the agreed upon consideration.  Attached to this is the understanding that you don’t have a contract with anyone else and that those “other” parties cannot be expected to compensate you for your losses when the deal falls through.  The introduction of a tort claim eliminates, at least in part, this distinction by giving the contracting party another bite at the metaphorical apple and putting other parties on notice that they may be responsible to “fulfill” the terms of a contract they did not enter into with the aggrieved party.

If not managed carefully, this modification of the law could have significant practical implications on construction projects.  What happens when an owner or design professional begins accounting for the fact that they each could be held liable for promises made by others?  What does an owner do when the potential for damages in tort far exceeds what an owner plans to spend on a project or can afford to risk?  Admittedly carried to an extreme to illustrate the point, these are but two of the questions to be considered.

The increased potential for liability could mean a decrease in the number of projects as owners elect not to move forward with work.  Those projects that move forward will see owners, design professionals, and many other parties searching for ways to minimize their legal exposure.  Some of the results may include:  (1) indemnity clauses growing in prevalence and reach; (2) growth in the scope and number of additional insured clauses; (3) the broadening of waivers and other documents acknowledging the assumption of the risk; and (4) more limitation of liability clauses included in contracts.  Changes like these will undeniably result in increased costs of construction and slower projects.

Practice Tips

As this area of the law goes through a metamorphosis, construction professionals should prepare themselves. The easiest tip is to be aware of whether the law in your jurisdiction permits tort claims when there is no privity of contract.  Don’t get stuck in the past and assume that the only avenue for recovery is against the party with whom you have an agreement.  Beyond that, construction professionals should go one step further by understanding the law in the applicable jurisdiction.  The scope and reach of this concept varies from state to state.  New Jersey, for instance, gives more flexibility to parties than Pennsylvania or Delaware.

Armed with this information, consult with your clients and help them to understand the differences between contract and tort claims.  Among the most important differences for them to understand is the variation in the proofs.  Construction companies and their personnel should be advised on how to document their project files given these disparities.  If the plans and specifications are defective, for instance, memorialize this fact in an RFI, a letter asking for clarification, or otherwise pointing out the problem in writing.  A change order for the associated increased cost may not be enough to demonstrate the legal liability by itself.

A warning is in order too though: be careful not to overplay the theory.  Parties who routinely sue all the other participants in a project every time something goes wrong lose credibility.  This is especially the case when the accusations come along with bizarre legal theories that don’t work.  A fact finder will ultimately have to decide whether the cause of action merits a recovery.  Tort theories are not cure-all substitutes for situations when there is no real claim to start, and watering down your case with a theory that doesn’t work comes with considerable risk to the rest of your arguments.  Finally, abuse of this concept could further break down the traditional relationships that have defined construction for years.  From a public policy standpoint, this continued degradation of the economic loss rule in construction could make the market a “wild west” that scares off all but the bravest of contractors.

Summary

Regardless of whether construction professionals agree with it, the law surrounding the economic loss rule and privity of contract is changing.  It is incumbent upon those in the industry to understand this reality, contemplate the changes, and make adjustments.  The law does nothing more than set the “rules of engagement”.  While some changes to those rules are small and inconsequential, others are large and require a shift in company cultures and internal protocols.  The increased permissibility and use of tort claims in the non-traditional setting of economic losses is a change closer to the latter.


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