Economic Loss Doctrine: A Good Defense

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J. Kent Holland, Jr.
Construction Risk Counsel, PLLC
For Freberg Environmental Insurance

Purpose of the Economic Loss Doctrine

The premise of the “economic loss doctrine” that bars recovery for purely economic loss, as explained by the recent court decision of Leis Family Limited Partnership v. Silverword Engineering, 273 P.3d 1218 (2012) is as follows:

“It ‘marks the fundamental boundary between the law of contracts, which is designed to enforce expectations created by agreement, and the law of torts, which is designed to protect citizens and their property by imposing a duty of reasonable care on others’ [and] was designed to prevent disproportionate liability and allow parties to allocate risk by contract.’ ”

In reaching its conclusion the court cited the reasoning of an important decision, Terracon v. Mandalay Resort Group, wherein the court explained that the purpose of the doctrine was “to shield defendants from unlimited liability for all the economic consequences of a negligent act, particularly in a commercial or professional setting….” The Terracon court, as quoted by the court in this current case, stated:

“In the context of engineers and architects, the bar created by the economic loss doctrine applies to commercial activity for which contract law is better suited to resolve professional negligence claims. This legal line between contract and tort liability promotes useful commercial economic activity, while still allowing tort recovery when personal injury or property damage are present….”

Doctrine Applies Even if Deviation from Standard of Care

In this current case, the court held that even if a design firm potentially deviated from industry standards of care, the economic loss doctrine barred a suit against a design firm where there it had no privity of contract with the plaintiff. Suit in the case had been filed by a project owner against professional consultants that were subconsultants to an engineer who was a subcontractor to the general contractor (GC) on a thermal energy system project. Summary judgment was granted for the subconsultants and affirmed on appeal.

Sanctity of Contract. The courts found in favor of sanctity of the contract – holding that all entities on the project had the ability to negotiate contracts and the court would honor those contracts as written. The main engineering firm had a limitation of liability (LoL) clause in its subcontract with the GC limiting its liability to the amount of its fee.

In this case, however, the suit was not filed by the GC against its engineer but was instead filed by a project owner against the engineer’s subconsultants with whom they had no contract. The LoL clause of the GC/engineer contract therefore did not come into play. Perhaps this suit was an effort by the project owner to go around the prime contracts and avoid the LoL provisions. In any event, it didn’t work.

No Duty Outside of Contract. In affirming the application of the economic loss doctrine to bar such a suit, the court also stated that sub-engineers had no liability whatsoever because they owed no duty to anyone independent of their subcontracts. Even if the court was to find that the sub-engineers deviated from the applicable standard of care, it held that this would not constitute an exception to the economic loss doctrine.

Rejecting the appellant’s argument that because the claims against the engineers were based on allegations of negligence the economic loss doctrine should not be applied, the court concluded there was no independent duty of care owed. The court explained its position by quoting from a previous case precedent as follows:

“Under the economic loss, ‘a manufacturer in a commercial relationship has no duty under either a negligence or strict products liability theory to prevent a product from injuring itself’ [citations omitted]. Even in the absence of a privity of contract between the design professional and a project owner, the law does not impose a duty in tort if it would ‘disrupt the contractual relationships between and among the various parties.’ [citations omitted].”

Contract Negotiation. Because the appellant had the opportunity to negotiate contracts to its satisfaction with the GC and any of its subcontractors, the court found “Its failure to do so, and irrespective of Appellant’s reasons for not bringing suit against those with whom it was in privity of contract, does not warrant creation of a duty in tort (negligence) on the part of the Designers.” Further, said the court,

“Allowing Appellants to recovery purely economic loss under a tort theory would allow a commercial project owner to recover product-related damages under a tort theory as a consequence of the owner’s deliberate choice not to contract with the third party (the design professional), but instead require the second party (the general contractor) to do so. There is no reason that we can perceive to make tort liability against design professionals contingent on the project owner’s election to hire a general contractor and thus ‘blur the distinction between contract and tort law.’”

Water System Design-Build Contract

The economic loss doctrine was also applied in a case to bar a design-build contractor’s claim against its subcontractor/engineer for providing defective designs used by the contractor to construct a water tank for a U.S. Navy water supply system. Maeda Pacific Corp. v GMP Hawaii, Inc. (2011).

The suit sought “only damages associated with repairing and replacing” physical damage to the contractor’s work. The designer asked the court to grant summary judgment because the repair costs were “economic losses” that are not recoverable in a negligence action. In holding that the economic loss would bar the claims regardless of whether or not the design-build contractor was in privity of contract with the designer, the court held:

“In the context of commercial construction litigation, where a party in privity of contract with a design professional is seeking to recover for economic loss damages, and no personal injury or damage to property other than the subject of the contract is alleged, such a party is limited to contractual remedies, and a negligence action may not be maintained. We reject the argument that a different standard of care should be applied to design professionals beyond what is applied to other parties. Finally, we hold that where a party reasonably could have, by contracts with the defendant or through an intermediary, protected itself from the loss, a lack of privity will not render the economic loss doctrine inapplicable.”

Implied Warranty of Specifications

The economic loss doctrine is applicable in many, but not all states. It is important to know the law of the state that will be applicable to the services performed.

There are also clever ways that some plaintiffs argue their way around the doctrine. For example, contractors in Arizona have convinced the courts in that state to permit them to sue designers under a theory of breach of an implied warranty of specifications that the designer provided to a project owner and on which the contractor claims to have relied to its detriment. The courts there hold that a designer provides an implied warranty, even to a party with whom it has not contract, “that they have exercised their skills with care and diligence and in a reasonable, non-negligent manner.” See for example, North Peak Construction, LLC v. Architecture Plus, Ltd., 254 P.3d 404 (AZ, 2011). In most states, however, the design professional is not deemed to grant implied warranties.

Although a contractor may make a claim against the project owner for breach of the owner’s implied warranty of the specifications, the contractor has no direct cause of action against the designer for its economic losses. Any suit against the designer for purely economic losses must be based on breach of contract and brought by its client.

Unless there is an independent duty owed by the design firm to a third party, and the design firms’ failure to meet its standard of care in performing that duty caused bodily injury or property damage, there is no viable cause of action. Where a project owner pays the contractor a change order for its extra costs, the owner can only recover from the design firm for those costs if it can prove the designer performed its services negligently.

Conclusion

For the reasons explained in this Report, an entity can generally only recover its purely economic losses from the party with whom it contracts. Courts generally enforce contracts as negotiated by parties and do not allow parties to the contract to avoid the contractual terms and conditions by the subterfuge of making a tort (i.e., negligence) claim against the other party. There is no independent tort duty when it comes to purely economic losses regardless of whether the allegedly injured entity or individual has a contract with the alleged wrong doer.