February 15, 2010
Author: Sean Hanlon
Organization: Holland & Hart LLP
The economic loss rule is a rule frequently invoked in construction disputes that operates to limit the types of damages that can be recovered. Understanding the limits of the economic loss rule requires a party to examine (1) the source of the duty at issue and (2) the nature of the property damage claimed.
Fundamental differences exist between contract and tort law. Obligations in tort generally arise from duties imposed by law to protect citizens from physical harm or damage to their property. And certain tort theories carry the possible imposition of punitive damages. In contrast, contractual obligations arise from promises the parties have made to each other, with the intent that their expectancy interests—created by such promises—are enforced.
Courts created the economic loss rule to enforce the parties bargained-for economic expectations and limit liability to those damage arising from contractual promises. This limit on tort damages allows contracting parties to more accurately allocate risks and build cost considerations into a contract.
But some creative parties wishing to bring tort claims are pleading damages to secondary or “other property” to avoid application of the economic loss rule. The key is to determine the source of the duty owed by the alleged tortfeasor. Does the duty of care flow from the contract, or does the duty truly arise independently of any contractual duty existing between the parties?
Economic Loss Rule
The economic loss rule provides, “a party suffering only economic loss from the breach of an express or implied contractual duty may not assert a tort claim for such breach absent an independent duty of care under tort law.” BRW, Inc. v. Dufficy & Sons, Inc., 99 P.3d 66, 72 (Colo. 2004). The focus is not on the professional status of the parties, but rather on the contractual relationship between them to determine whether there is an independent duty of care. But see Flagstaff Affordable Housing Ltd. Partnership v. Design Alliance, Inc., 212 P.3d 125 (Ariz. App. Div. 1 2009 (economic loss rule did not bar professional negligence claim against architect due to architect’s independent duty of care).
Defining “Economic Loss”
Courts generally define “economic loss” as damages other than physical harm to persons or property. If damages—for the cost of repair and replacement of property, structural damage, diminution in value of a damaged structure not repaired, loss of use or delay in utilizing property for its intended purposes—and related lost profits, revenue, and costs were the subject of the contract, such damages constitute economic loss damages. If no independent duty exists, the economic loss rule bars recovery in tort for such economic losses.
One frequently recognized exception to the economic loss rule applies in situations where the court finds that a party had a duty to the other party that was independent from the duties stated in the contract. If a duty exists, then a party can recover a damage award in tort based in tort. See e.g. Parr v. Triple L & J Corp., 107 P.3d 1104, 1108 (Colo. App. 2004).
The Key: Determine the Source of the Duty Breached, Not Whether Damages are Physical or Economic
The phrase “economic loss rule” is a bit of a misnomer and implies a primary focus on the type of damages. But the relationship between the type of damage suffered and the availability of an action in tort is inexact at best. At least one court has suggested the more accurate designation for the “economic loss rule” would be “independent duty rule.” The key is to focus on the source of the duty. If a duty has been breached that is independent of any contractual obligations, the economic loss rule has no application and does not bar a plaintiff’s tort claims because such claims fall outside the scope of the rule. But if a contract specifically imposes relevant duties of care—such as those concerning the contractor’s skill and workmanship in performing its services—those contractual duties of care will provide the basis for a cause of action, and may trump other independent common law duties of care not contemplated in the contract.
When Damage to Property Is Not an Economic Loss
While the proper focus is on the source of the duty, the type of damages suffered may assist in determining the source of the duty underlying the action. A Utah court stated that under the economic loss rule “economic damages are not recoverable in negligence absent physical property damage or bodily injury.” SME Indus., Inc. v. Thompson, Ventulett, Stainback & Assocs., Inc., 28 P.3d 669, 680 (Utah 2001) (emphasis added) (finding that application of the economic loss rule is particularly applicable in the construction setting where all parties to a construction project resort to contracts and contract law to protect their economic expectations. Id. at 681.).
But damage to property that is the subject of the contract is an economic loss—and does not qualify as “damage to other property”—while damage to secondary property is not an economic loss. Hughes Custom Building, LLC v. Davey, --- P.3d ---, 2009 WL 1260171 (Ariz. App. Div. 2 2009). Determining secondary property damage is unclear. In some construction cases, and for the purposes of the economic loss rule, courts have treated the house and its component parts as a single property. Id.
Consequently, when a defect of a particular part of the house results in damage to the whole, no negligence action is permitted for that additional property damage. Id.; see also Steineke v. Russi, 190 P.3d 60, 66 (Wash. App. 2008) (holding that persuasive authority and common sense dictate that a building constitutes a single “product” or “property,” not a series of component parts, for the purposes of the economic loss rule).
The Hughes Custom Building case, however, lists other circumstances where secondary property damage was found, and tort claims seeking relief for such secondary property damage were allowed as being outside the scope of the economic loss rule:
- Owner assembling pre-fabricated cabin contracted with insulation installer; economic loss doctrine did not bar claim against installer when faulty insulation damaged rest of cabin;
- Court declined to apply economic loss doctrine to bar claim for damage caused to home by defective installation of stone façade.
In other words, property that was not encompassed in the bargain, i.e., not the subject of the contract, constitutes “other” or “secondary” property. Damages to such other or secondary property is not an economic loss.
And when the nature of the defect is sudden, accidental, calamitous, and exposes others to harm, the economic loss rule will likely not bar tort recovery for resulting damages to property outside the scope of the contract. See e.g. Valley Forge Ins. Co. v. Sam’s Plumbing, LLC, 207 P.3d 765, 766-67 (Ariz. App. 2009). But when the duty not to cause damage to the property, or the duty to pay for damage caused is derived from the contract, the economic loss rule operates as a bar to tort claims seeking relief for those damages.
The Court of Appeals for the Fourth Circuit addressed a situation where a party asserted a tort claim, alleging damage to “other property” for the purpose of evading the scope of the economic loss rule. Palmetto Linen Serv., Inc. v. U.N.X., Inc., 205 F.3d 126 (4th Cir. 2000). The Fourth circuit explained:
Although the economic loss rule generally does not apply where other property damage is proven, courts have tended to focus on the circumstances and context giving rise to the injury in determining whether alleged losses qualify as “other property” damage. Specifically, in the context of a commercial transaction between sophisticated parties, injury to other property is not actionable in tort if the injury was or should have been reasonably contemplated by the parties to the contract. In such cases the failure of the product to perform as expected will necessarily cause damage to other property, rendering the other property damage inseparable from the defect in the product itself. Id. at 129-30. While the above analysis from the Fourth Circuit stemmed from a sale of goods, its application and reasoning may be even more suited to a construction project particularly when defects to the work would lead to foreseeable and inseparable damages that were contemplated and bargained for—or should have been—in the underlying contract.
Property damage will be subsumed as an economic loss if such property was the subject of the contract at issue. Courts will honor the terms of the parties’ bargain to accept and allocate risks associated with the construction project. If the damage to the property was unforeseeable or not properly addressed in the contract, it would likely be categorized as “other” or “secondary” property damage to which relief for such damages would be available in tort.
The proper inquiry focuses on whether the source of the duty alleged to have been breached is derived from the contract (or derived from inter-related contracts of a construction project) or derived from a duty imposed by law that arises independently of any duties imposed under the contract. If the duty derives from the contract, the economic loss rule should work to bar tort claims for such resulting property damage.