A “Simple” Explanation of the Economic-Loss Rule

Vol. 17 No. 3

By

Hadley v. Baxendale, 9 Exch 341; 156 Eng Rep 145 (1854)—a seminal decision taught to all first year law students—distinguished tort and contract damages. It did this by limiting contract damages to what, at the time of contracting, was or should have been contemplated by the parties to be the probable result of a breach. Id. at 354 (referring to what “may fairly and reasonably be considered either arising naturally, i.e., according to the usual course of things, from such breach of contract itself, or such as may reasonably be supposed to have been in the contemplation of both parties at the time they made the contract, as the probable result of the breach of it”). This common law rule was widely adopted in the United States. See Howard v. Stillwell & Bierce Mfg. Co., 139 US 199, 210 (1891) (no damages for consequences that were not addressed in the contract).

The modern economic-loss rule (“ELR”) has two parts. One part is a restatement of the common law rule of Hadley and Howard: “When two parties have a contractual relationship, the economic loss rule prevents one party from bringing a negligence action against the other over the first party’s defeated expectations. . . .” Annett Holdings, Inc. v. Kum & Go, LC, 801 NW 2d 499, 503 (Iowa 2011). The other part of the ELR makes an exception to Hadley and Howard by allowing tort-like damages that arise from personal injury or injury to property other than the subject of the contract (“other property”).

As simple as that may sound, applications of the ELR have generated a great deal of confusion. See Indem. Ins. Co. of N. Am. v. Am. Aviation, Inc., 891 So. 2d 532, 544 (Fla. 2004) (Cantero, J., concurring) (referring to the ELR as creating a “confusing morass”); R. Joseph Barton, Drowning in a Sea of Contract: Application of the Economic Loss Rule to Fraud and Negligent Misrepresentation Claims, 41 Wm. & Mary L. Rev. 1789 (2000) (calling the ELR “one of the most confusing doctrines in tort law”). Much of this confusion arises because courts are not clear what they mean when they refer to the ELR. As we shall see, if the ELR is understood to be an extension of the rule from Hadley and Howard and is understood to only apply to contract claims, its application as a general rule of contract law need not be at all confusing.

Many courts have trouble accepting the ELR as a general rule of contract law. That is surprising because Hadley and Howard have long been regarded as such and the ELR is an extension of those decisions. Some courts that conflate the ELR with the rule from Hadley and Howard miss that it allows additional damages in certain circumstances. See, e.g., Ramerth v. Hart, 133 Idaho 194, 983 P.2d 848, 851 (1999) (stating that “[t]he economic-loss rule applies to [preclude] negligence [claims] in general” where there is breach of contract); JMP Sec. LLP v. Altair Nanotechnologies Inc., 880 F. Supp. 2d 1029, 1042-43 (N.D. Cal. 2012) (finding fraud and negligent misrepresentation claims barred by the economic-loss rule where “[t]he tort claims consist of nothing more than [the defendant’s] alleged failure to make good on its contractual promises”). To say that the ELR bars tort-damages in breach of contract is a true but incomplete explanation of the rule.

Our task here will be as follows: (1) to distinguish what claims between contracting parties are torts that, on that basis, are not governed by the ELR; (2) to identify those contract claims where the second part of the ELR applies, the part that allows tort-like economic damages if the contract breach caused personal injury or injury to other property; and (3) to identify contexts that allow tort-like damages for contract breach notwithstanding that there was neither personal injury nor injury to other property.

ELR Does Not Apply to Torts

The ELR is a rule of contract law, no less than the rule from Hadley and Howard. Consequently, it by definition does not apply to torts. Hence, to say that the ELR does not apply to a tort is a mere syllogism. See, e.g., Robinson Helicopter Co., Inc. v. Dana Corp., 34 Cal. 4th 979, 991 (2004) (holding that the ELR does not apply to intentional misrepresentation). It confuses the issue if a court says it is “making an exception” to the ELR for torts. See, e.g., 695 Atl. Ave. Co. v. Commercial Const. Consulting, Inc., 64 Mass. App. Ct. 1109, 834 N.E.2d 322 (2005) (holding that a negligent misrepresentation claim could proceed because it is an exception to the economic-loss doctrine). A more helpful analysis would be to state that the ELR does not apply to torts. E.g., Congregation of the Passion, Holy Cross Province v. Touche Ross & Co., 159 Ill. 2d 137, 201 Ill. Dec. 71, 636 N.E. 2d 503, 514 (1994) (“Where a duty arises outside of the contract, the economic loss doctrine does not prohibit recovery in tort for the negligent breach of that duty.”).

There is some confusion—albeit unnecessary—when a tort occurs between parties to a contract relationship. There should not be any such confusion because a tort can arise in any context where there is breach of a duty imposed by law. The law imposes such duties to govern the standards of care by which certain professionals provide services to clients. Courts uniformly treat the duties owed by physicians and lawyers as extra contractual legal duties. Breaches of those standards, therefore, are torts. As such they are not governed by the ELR. Thus, “purely economic losses are recoverable in actions asserting claims of professional negligence.” Annett Holdings, Inc. v. Kum & Go, LC, 801 N.W. 2d 499, 504 (Iowa 2011).  There is simply no need to discuss the ELR in such contexts. In contrast, because design professionals such as architects can define standards in their contracts, courts treat claims for breach of duties as contract claims that are subject to the ELR. See, e.g., Flagstaff Affordable Housing Ltd. Partnership v. Design Alliance, Inc., 223 Ariz. 320, 321, ¶ 1, 223 P.3d 664, 665 (2010).

Florida’s Misapplication of the ELR

In Tiara Condominium Ass’n, Inc. v. Marsh & McLennan Companies, Inc., 110 So.3d 399 (Fla. 2013), the Florida Supreme Court had difficulty explaining why tort-damages were allowed on a claim of breach of professional standards. The claim at issue alleged that an insurance broker, Marsh & McLennan, “was either negligent or breached its fiduciary duty by failing to advise Tiara of its complete insurance needs and by failing to advise Tiara [the insured] of its belief that Tiara was underinsured.” Id. at 401. The court recognized that the insurance broker-insured relationship was a special relationship with fiduciary duties but got hung up on the fact that it was also a contract relationship. Rather than simply hold that there was a tort claim and the ELR does not apply to torts, the court just tossed the ELR aside. It held that the ELR only applied to product liability claims. Id. at 407. But, in so doing, it did not explain whether the rule from Hadley and Howard still applied to contract claims. In effect, and for no good reason, the Florida Supreme Court completely blurred the distinction between tort and contract claims.

What the Florida Supreme Court should have done is recognize that there can be tort claims between contracting parties that have a “special relationship.” See Burkons v. Ticor Title Ins. Co. of Cal., 168 Ariz. 345, 355, 813 P.2d 710, 720 (1991) (holding that there must be a “special relationship” to support a tortious breach of contract). Had it done so, it could have rejected the argument that the ELR applied at the claim because it was a tort. It could have left intact the long-recognized distinction between tort and contract claims.

Defective Product Claims

So where does the ELR apply? Courts first applied the ELR in the context of defective product claims to allow tort-like economic damages that arose from personal injury or injury to other property.[1] See Seely v. White Motor Co., 63 Cal. 2d 9, 45 Cal. Rptr. 17, 23, 403 P.2d 145, 151 (1965). The California Supreme Court explained that allowing such tort-like consequential damages in such cases met the public policy goal of protecting consumers from physical injury risks over which they had little to no control:

[a] consumer should not be charged at the will of the manufacturer with bearing the risk of physical injury when he buys a product on the market. He can, however, be fairly charged with the risk that the product will not match his economic expectations unless the manufacturer agrees that it will. 

Seely v. White Motor Co., 63 Cal. 2d 9, 45 Cal. Rptr. 17, 23, 403 P.2d 145, 151 (1965) (Traynor, CJ).

When Seely was decided, there was no question about application of the first part of the ELR—the part that was recognized in Hadley and Howard. The issue was whether the law should make an exception to the first part of the ELR and allow tort-like damages if breach of product warranty (a contract claim) caused personal injury or injury to other property. By holding that the law allowed such damages, Seely made an exception to Hadley and Howard. This exception, combined with Hadley and Howard, became known as the ELR.

Seely balanced two public policy goals. One of these goals was “to encourage parties to efficiently negotiate the distribution of potential liabilities arising from their contractual relationships.” Valley Forge Insurance Co. v. Sam's Plumbing, LLC, 220 Ariz. 512, 516, ¶ 11, 207 P.3d 765, 769 (App. 2009). The other goal was to provide a fair remedy for injuries. See Beck v FMC Corp., 53 A.D. 2d 118, 122 (1976), aff’d 42 NY2d 1027 (1977) (recognizing that application of the economic loss rule is in tension with the policy goal to provide a remedy for every wrong). As we shall see, applications of the ELR can be understood as making a similar balancing analysis.

Construction Defects

Courts next applied the ELR to construction defect cases. In a sense, a construction defect is closely akin to product defect, if the building is regarded as a product. In effect, a contractor warrants that the construction would be done to certain standards. In cases where that warranty is breached, the issue arises whether the owner can claim tort-like consequential damages. Under common law, an owner could not do so. But, if the ELR applies, an owner could claim such damages to the extent that they arise from personal injury or injury to other property. See, e.g., Woodward v. Chirco Constr. Co., 141 Ariz. 520, 516, 687 P.2d 1275, 1271 (App. 1984) (applying the ELR to a construction defect claim, explaining that “if a fireplace collapses, the purchaser can sue in contract for the cost of remedying the structural defects and sue in tort for damage to personal property or personal injury caused by the collapse”).[2]  Application of the ELR in this context entails the same balance of public policy goals that is made in the context of product liability. Between the contractor and the owner, public policy favors the contractor bearing the risk of physical injury or injury to other property.

Exceedingly Dangerous Activities and Products

Some courts have allowed tort-like consequential damages in product and construction defect cases where there was no personal injury or injury to other property, if the product or activity was exceedingly dangerous and there was a sudden accident. These courts, in effect, make a narrow exception to both parts of the ELR, and treat such claims as if there was no distinction between tort and contract claims.  

For example, the court in Vulcan Materials Co. v. Driltech, Inc., 306 SE 2d 253, 257 (Ga. 1983), held that “there is an accident exception to the general rule that an action in negligence does not lie absent personal injury or damage to property other than to the allegedly defective product.” In this context, Vulcan explained that ‘[a]n ‘accident’ should be defined as a sudden and calamitous event which, although it may only cause damage to the defective product itself, poses an unreasonable risk of injury to other persons or property. Id.

Arizona courts have applied this “accident-exception” to both construction-defect and product-liability contexts. One court allowed damages for purely economic losses that were caused by an explosion from an improperly constructed gas line. Valley Forge, 220 Ariz. at 514, ¶ 7, 207 P.3d at 767. Another court allowed such damages for losses that were caused by catastrophic failure of a gas turbine. Salt River Project Agricultural Improvement & Power Dist. v. Westinghouse Elec. Corp., 143 Ariz. 368, 381, 694 P.2d 198, 211 (1984).

In Salt River Project, the Arizona Supreme Court explained that “the unreasonably dangerous nature of the product defect and the occurrence of the loss in a sudden, accidental manner would tip the balance in favor of strict tort liability even though the damage fortuitously was confined to the product itself.” Id.; see also In re Ford Motor Co. Speed Control Deactivation Switch Prod. Liab. Lit., 664 F. Supp. 2d 752 (E.D. Mich. 2009) (finding no consensus among the states for making an ELR exception for a highly dangerous product).

Here too, application of the ELR entails a balance of the same public policy goals. Where a manufacturer or contractor makes an exceedingly dangerous product or engages in an exceeding dangerous activity, public policy favors the manufacturer or contractor bearing the risk of physical injury or injury to other property if there is a sudden accident.

Conclusion

The ELR is a rule of contract law that supersedes the common law rule set out in Hadley v. Baxendale. The ELR, in effect, restates the rule from Hadley that does not allow tort damages on a contract claim. The ELR also adds an exception to Hadley, which allows tort-like consequential damages if breach of contract causes personal injury or injury to other property. As a rule of contract law, the ELR does not apply to torts—even where such torts occur between parties to a contract.

Courts generally agree that both aspects of the ELR applies to product defect claims. Some courts apply both as well to construction defect claims. In many contexts, courts do not apply the full ELR. In other kinds of claims, many courts only apply the first part of the ELR and do not allow tort-like consequential damages in any contexts. On the other hand, in claims arising from defects in exceedingly dangerous products and activities, some courts will not apply any part of the ELR (including the part that is the rule from Hadley). In such cases, courts allow tort-like consequential damages without regard to personal injury or injury to other property.

Viewing the ELR in this light should eliminate much confusion.

Endnotes

[1] For a jurisdictional survey of the ELR, see LA Wagner, Note: The Economic Loss Doctrine: A Recommendation for the Supreme Court of Pennsylvania, 72 U. Pitt. L. Rev., 825, 832-36 (2011).

[2] California goes further and in the context of residential construction allows tort-like damages even if there is no personal injury or injury to other property. Cal. Civil Code§  895 et seq.; Greystone Homes, Inc. v. Midtec, Inc., 168 Cal. App.4th 1194, 1202, 86 Cal. Rptr. 3d 196 (App. 2008) (“The Act makes clear that upon a showing of violation of an applicable standard, a homeowner may recover economic losses from a builder without having to show that the violation caused property damage or personal injury.”).


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