In the seminal decision that is taught to all first-year law students, Hadley v. Baxendale, the court distinguished tort and contract damages. 156 Eng. Rep. 145 (1854). There, the court held that contract damages are limited to what, at the time of contracting, was or should have been contemplated by the parties to be a probable result of a breach. This common-law rule from Hadley was adopted in the in the United States and is commonly referred to as the economic-loss doctrine. Under this doctrine, if two parties have a contractual relationship, they are generally barred from bringing a tort action against one another for purely economic losses. However, exceptions to this rule exist.
The Indiana Court of Appeal’s recent decision, Magic Circle v. Crowe Horwath, LLP, clarified an important question on whether the economic-loss doctrine was applicable to accounting malpractice actions in Indiana. 71A03-1607-PL-1520, 2017 Ind. App. Lexis 101 (Ind. App. Ct. Mar. 8, 2017). Ultimately, the court held that accounting malpractice claims fell within an exception to the doctrine. This decision has interesting implications because it potentially increases the amount a plaintiff may seek in the form of their damages by bringing a tort claim.
In Magic Circle, the plaintiff was a multi-state retailer that recognized that it was having financial difficulty in 2008 and retained two experts to lead it through a turnaround. At the time of the turnaround experts’ retention, and afterwards, Magic Circle relied upon Crowe Horwath for auditing services. While the turnaround experts were managing the company, they were providing Crowe inaccurate information that did not truly depict the state of the business for the purposes of the audit. The turnaround experts’ mismanagement of the business went on for years without being discovered by Crowe, the plaintiffs’ board of directors, or its investors.
Eventually, in 2013, Crowe discovered and disclosed that Magic Circle had sustained a $14 million loss. At which time, Magic Circle retained a new audit firm that confirmed that the turnaround experts failed to provide accurate financial information to Crowe and its reports were incorrect. As a result, Magic Circle was in a dire financial situation and was sold at a substantial loss to a private investment group. After the sale, the shareholders of Magic Circle brought an action against Crowe that included an accounting-malpractice claim.
Crowe proceeded to file a motion to dismiss with respect to this count and argued that the economic-loss doctrine barred Magic Circle’s claim because their damages were purely economic. The trial court was persuaded by this argument and dismissed the claim, reasoning that it would be more appropriately determined under a contract theory rather than tort law. An appeal soon followed by Magic Circle.
At the outset of the Indiana Court of Appeal’s analysis on this issue, it noted that it had “found no Indiana case that addresses directly the question of whether the economic loss rule applies to bar actions at tort for accountant malpractice.” But, it acknowledged that the Indiana Supreme Court has made clear that the economic-loss doctrine is a general rule and certain purely economic losses can nevertheless fall within exceptions to permit recovery under a tort theory. Ultimately, the court reversed the trial court’s determination that the economic loss barred the plaintiff’s claim by finding that an exception applied in this instance.
To reach this outcome, the court was persuaded by decisions from Illinois and foreign federal courts that had previously held that the economic-loss rule does not bar claims for accounting malpractice. It recognized that the original theory behind the economic-loss doctrine was to prevent tort claims from overtaking contract law. And, therefore, the doctrine applies where the duty of the party performing the service is defined by a contract. However, an exception to the doctrine exists when the duty that was breached was extra-contractual. See also, Restatement (2nd) of Torts § 552 (exception to economic-loss rule for negligent misrepresentation). In this scenario, the duty to act with professional competence is independent of the contract; therefore, the court reasoned that the economic-loss rule is inapplicable.