March 22, 2021 Construction Law 101

Economic Loss Doctrine

Wajiha Rais and Lindy Stevens

The Economic Loss Doctrine (ELD) has been adopted by a majority of jurisdictions in the United States and exists to prohibit parties from recovering in tort when the negligence of others results in purely economic loss. The primary purpose of the ELD is to prevent a party from seeking greater recovery in tort than would otherwise be available under the agreed-upon remedies outlined in the parties’ contract.  Notwithstanding the theoretical simplicity of the doctrine, its practical application is often complex. It is highly dependent on the specific facts at issue, the nature of the parties’ relationship, the nature of the project, the terms of the contract, and several other factors.  This article examines four factors for contractors and owners to consider in determining the potential application of the ELD to construction-related claims.

1. The ELD May Be a Complete Bar to Recovery in States Applying the "Majority Rule." 

A majority of jurisdictions interpret the ELD to mean, "that a plaintiff who has suffered only economic loss due to another's negligence has not been injured in a manner that is legally cognizable or compensable," and do not permit recovery in tort for purely economic losses.  Twenty-eight states follow this majority view, including: Alabama, Delaware, Florida, Hawaii, Idaho, Indiana, Kentucky, Maine, Minnesota, Mississippi, Missouri, Nebraska, Nevada, New Jersey, New Mexico, New York, North Carolina, North Dakota, Ohio, Oklahoma, Pennsylvania, South Carolina, South Dakota, Tennessee, Texas, Vermont, Wisconsin, and Wyoming.

In states where the majority view applies, contractors and owners should be aware that courts consistently invoke the ELD to bar purely economic loss tort claims in construction-related litigation. In April 2020, the United States Court of Appeals for the Fifth Circuit applied the ELD to bar claims against a contractor for issues related to the upgrade of a steam engine turbine generator.  In reaching its decision, the Fifth Circuit in Golden Spread Elec. Coop., Inc. v. Emerson Process Mgmt. Power & Water Sols., Inc., reasoned:

[T]he problem that caused the damage to the turbine is more akin to a failure to meet contractual expectations than a dangerous defect redressable in tort. The control system did not catch fire and damage the turbine; rather, it sent the wrong commands. Improving the commands sent to the turbine was the very purpose of the upgrade contract.<\/blockquote>

Affirming entry of summary judgment for the contractor, the court found that the damage incurred was foreseeable and that, "the risk suffered here is better addressed in contract than in tort."

In another April 2020 decision, the Court of Appeals of Wisconsin also followed the majority view of the ELD, affirming entry of summary judgment in favor of one subcontractor on a $1.1 million negligence claim for delay-related damages by another subcontractor. Both subcontractors worked on the same $36-million construction project, but the subcontractors did not share a contract.  The issue presented in Mech., Inc. v. Venture Elec. Contractors, Inc., was whether the ELD barred the claim, where there was no contract between the parties. The court concluded that the ELD applied to the two "non-contracting subcontractors," as it, "encourages the subcontractors on construction projects with interrelated contracts to protect themselves from risks, holds them to the terms of their bargain, enforces their expectancy interests, and maintains the boundary between contract and tort law."  As these decisions demonstrate, contractors and owners performing work in "majority view" jurisdictions should be aware of the limitations on recovery imposed by the ELD.

2. In a Minority of Jurisdictions, Limited Recovery Under the ELD May Be Permitted, Notwithstanding Lack of Privity Among the Parties. 

 In a minority of jurisdictions, recovery in tort is permitted for purely economic losses. Courts applying this minority view allow tort recovery for economic loss in limited circumstances. This view of the ELD has been applied to varying degrees in at least seventeen states, including: Alaska, California, Colorado, Georgia, Illinois, Iowa, Kansas, Maryland, Massachusetts, Michigan, Montana, New Hampshire, Oregon, Rhode Island, Utah, Washington, and West Virginia.

In 2016, the United States District Court for the District of Alaska applied this minority view to allow claims of professional negligence and negligent misrepresentation against a design professional.  In Municipality of Anchorage v. Integrated Concepts & Research Corp., an owner brought claims against two design professionals with whom the owner had no privity of contract. The designers argued the owner's claims were barred by the ELD, as such claims were inconsistent with the parties' contractual obligations and agreed-upon risk allocation.  The court disagreed, noting:

Alaska law imposes an independent duty in tort on design professionals, regardless of the contractual allocation of liability among the various parties. [The designers] may have each bargained for specific limitations on liability to those to whom they are in privity of contract, but in the Court's view, those contractual limitations do not preclude [owner]'s claims of professional negligence against either Defendant under Alaska law.

While allowing the owner's claims of professional negligence and negligent misrepresentation to proceed, the court dismissed the owner's pure negligence claim as barred by the ELD.  As the court's decision in Municipality of Anchorage demonstrates, contractors and owners working in jurisdictions where this minority view of the ELD is applied should be aware of potential liability even where privity of contract does not exist.

3.  The Classification of Construction Contracts as Service Contracts May Preclude the Application of the ELD

As recent decisions applying both the majority and minority view demonstrate, application of the ELD is often a fact-specific, party-by-party, and jurisdiction-by-jurisdiction inquiry. Application of the ELD can also be further complicated if the contract in question is classified as a contract for services, as opposed to one for goods. This is because some jurisdictions have refused to extend the ELD to service contracts. This is significant because construction contracts may, depending on the specific circumstances and facts, be classified as service or, at the least, as mixed contracts (i.e. involving the provision of both services and goods).

In Ins. Co. of N. Am. v. Cease Elec. Inc., for example, the Supreme Court of Wisconsin found that where electricians were hired to wire a ventilation system for a chicken barn, the electricians were paid by the hour and the owner supplied all essential materials including the ventilation system, the contract was for the provision of services. By contrast, the same court held in Linden v. Cascade Stone Co., that a contract between an owner and a general contractor for the construction of a new home was a mixed contract.

In cases involving mixed contracts, courts employ the predominant purpose test to determine whether a contract is predominantly for goods or services. In Linden, after evaluating the totality of circumstances, the court determined that the primary reason for the parties entering into the contract was the construction of a home--a product. As a result, the Wisconsin court, in a jurisdiction that does not apply the ELD to service contracts, held that the ELD applied in this case. Therefore, whether a jurisdiction distinguishes between goods and service contracts in its application of the ELD has significant implications for the construction industry, as construction contracts may be classified as either.

4. The "Integrated System Rule" May Affect Application of the ELD

The general rule governing the ELD states that in the absence of personal injury, a party cannot recover in tort for purely economic losses. An exception to this general rule is when a party's negligence results in damage to "other property"-- that is, property other than the defected product contracted for with the defendant. However, when a product becomes integrated into a larger or completed product or system,  "the entire product or system cease[s] to be 'other property' for purposes of the economic loss doctrine." This is commonly referred to as the "integrated system rule."

The courts are split over the application of the integrated system rule to construction claims. Some have held that defective components, once integrated into a larger structure, render the entire structure as the "same property," barring recovery for damages caused by the defect to any part of the structure. In Calloway v. City of Reno, for example, the Nevada Supreme Court held that defective framing of townhomes, which resulted in water leaks that damaged the floor and ceiling, "constituted damage to the structures themselves--and that no 'other' property damage resulted." As a result, the ELD barred the plaintiffs from seeking recovery in tort. A minority of jurisdictions have held to the contrary. The California Supreme Court in Jimenez v. Superior Court, for example, held that a defendant manufacturer could be held liable in tort for defective windows that caused damage to other parts of the home.

As these cases demonstrate, whether the ELD will apply to bar recovery depends on the jurisdiction in question. In a majority of jurisdictions, the ELD will bar recovery in tort for damage caused by a defective component, to any part of the structure in which the component is integrated. By contrast, in California and Indiana, for example, one would not be safe from tort liability for the same.

Conclusion

As these factors demonstrate, application of the ELD is nuanced. In determining the potential impact and application of the ELD, parties to construction contracts must consider not only the terms of the contract, but also the nature of the project, the applicable law, and the parties' relationship to each other.

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Wajiha Rais

Varela Lee, Tysons Corner, VA , Division 13 (Government Construction)

Lindy Stevens

Varela Lee, Tysons Corner, VA , Young Lawyers Division