Why Understanding Economic Loss Doctrine is Critical for Construction Professionals

Jason N. Smith |  Seyfarth Shaw LLP | May 1, 2017

Introduction

The economic loss doctrine is widely misunderstood and often misapplied. At its most basic, the premise of the doctrine is that a party cannot recover purely economic losses in a tort action. To understand the rationale behind the economic loss doctrine, attorneys should look to Hadley v Baxendale (9 Exch 341, Court of Exchequer 1854).

Hadley stands for the proposition that in a breach of contract action, a party may recover only the damages that naturally flow from the breach (ie, direct damages) or those that were within the reasonable contemplation of the parties at the time of contracting as arising from the breach (ie, foreseeable damages). In other words, economic losses such as lost profits, inadequate value and loss of use are not recoverable in a breach of contract action unless they were expressly contemplated by the parties at the time of contracting. This common law rule is widely applied to limit the damages available for a breach of contract.

Unsurprisingly, enterprising attorneys sought to avoid the results of this rule by suing in tort to recover economic losses sustained due to a breach. The economic loss doctrine seeks to maintain the common law rule set forth in Hadley by preventing contracting parties from using tort claims to obtain damages not otherwise available under contract law. In other words, the economic loss rule is intended to maintain the distinction between contract and tort damages by preventing a party to a contract from recovering purely economic damages due to its failed contractual expectations.

While simple in theory, the economic loss doctrine has suffered from wide variations in application. For example, states are split about whether the economic loss doctrine bars third-party claims against design professionals. A majority of states preclude third-party lawsuits against design professionals.(1)

Nevertheless, numerous exceptions abound. For instance, some states allow third-party claims by contractors or subcontractors against design professionals for defects in design plans and specifications.(2) Other states, such as Alaska, exempt all professional negligence claims from the economic loss doctrine.(3) Furthermore, other states allow tort claims against a design professional where the design professional’s work creates a “serious risk of personal injury”.(4)

Municipality of Anchorage v Integrated Concepts & Research Corp

In a recent case in Alaska, the US District Court for the District of Alaska was asked to consider the application of the economic loss doctrine to claims asserted by an owner against design professionals hired to perform geotechnical and design work for a major infrastructure project.(5) The project owner was not in privity with any of the designers and brought tort-based claims for negligence, professional negligence and negligent misrepresentation. The designers argued to the court that allowing such tort claims would upset the carefully ordered risk allocation and limitations of liabilities in the contracts executed by the parties. In other words, allowing such tort claims would upset the contractual expectations of the parties.

The court disagreed with the designers. While the court dismissed the negligence claims, it allowed the professional negligence and negligent misrepresentation claims to proceed, stating that: “Alaska law imposes an independent duty in tort on design professionals, regardless of the contractual allocation of liability among the various parties”.(6)

Balfour Beatty Infrastructure, Inc v Rummel Klepper & Kahl, LLP

A recent decision of the Maryland Court of Appeals reached the opposite conclusion, at least with respect to large government construction projects. In Balfour Beatty Infrastructure, Inc v Rummel Klepper & Kahl, LLP, Maryland’s highest court addressed the applicability of the economic loss doctrine to claims by a contractor that an engineer’s defective design and negligent misrepresentations resulted in compensable damages.(7)

In Balfour Beatty, the contractor asserted negligence and misrepresentation claims against an engineer with which it was not in privity, claiming that design defects and misrepresentations about the schedule resulted in the contractor sustaining delays and cost overruns. In rejecting the contractor’s claims, the court noted that in Maryland:

“the economic loss doctrine bars recovery when the parties are not in privity with one another or the alleged negligent conduct did not result in physical injury or risk of severe physical injury or death.“(8)

The court went on to state that:

“the reason for requiring privity or its equivalent to impose tort liability is to limit the defendant’s risk exposure to an actually foreseeable extent, thus permitting a defendant to control the risk to which the defendant is exposed.“(9)

In rejecting the contractor’s tort claims, the court found most persuasive the fact that large public construction projects have complex contracting schemes providing each party with ample opportunity to allocate risk.(10) In fact, the court stated that:

“we think the complex web of contracts that typically undergirds a public construction project should govern because parties have sufficient opportunity to protect themselves (and anticipate their liability) in negotiating these contracts.“(11)

The court also found persuasive the fact that allowing tort claims on large public construction projects would result in increased costs to the public, which the court believed weighed against imposing tort duties on parties who are not in privity.(12)

The Balfour Beatty decision may have limited applicability. Specifically, the holdings in Balfour Beatty appear to apply only to large public construction projects. For example, in stating its holding on the negligence claim the court wrote that:

“[a]lthough we decline to extend the privity-equivalent intimate nexus test to design professionals on government construction projects, we do not hold that the test cannot apply to design professionals in other contexts.“(13)

This leaves open the possibility that the economic loss doctrine may not apply in Maryland to tort claims asserted in connection with smaller public projects or to tort claims arising out of private projects.

Comment

While the recent decisions from Alaska and Maryland demonstrate the wide variation in application of the economic loss doctrine, those cases are not unique. Courts in numerous states – including Washington, Nevada, Wyoming, Colorado and Indiana – have held that the economic loss doctrine bars most tort claims against design professionals. However, courts in other states – including Montana, Pennsylvania, Rhode Island and Delaware – have refused to apply the economic loss doctrine to bar tort claims against design professionals.

Due to the dramatic variations in the application of the economic loss doctrine, construction professionals must educate themselves on the law in the project locality when negotiating contract terms or preparing claims. Failure to account for the economic loss doctrine at the outset of a project can result in unintended and unfortunate consequences when carefully negotiated contractual risk is thrown out the window and a claim of negligence or misrepresentation is allowed to proceed. Even if such claims are ultimately unsuccessful, the cost to the parties of defending such claims can be substantial.

Application of the economic loss doctrine is particularly important for large complex construction projects. While construction professionals will want to account for the economic loss doctrine on such projects to weigh risk and limit potential liability, owners must also understand the doctrine. This is particularly true when an owner is relying upon a construction manager to hold the design and construction contracts. In such a scenario the owner could potentially be left without direct claims against the design and construction teams in the event of a project failure.

While unexpected tort claims are troubling, accounting for the possibility of such claims at the outset of a project can reduce the impact of such claims. Using limitations of liability and indemnity provisions, excluding warranties and securing appropriate insurance coverage are decisions that need to be made at the beginning of a project that can significantly reduce the risk of such unintended claims. Of particular importance is understanding the coverages available to each party involved in the project in the event that a failure occurs. Ensuring that a project is appropriately insured – either through erection all risk or builders risk policies or through adequate errors and omissions coverage – is vitally important to the prevention of unwanted claims. Underinsured projects are a breeding ground for risk and potential liability.

The distinction between tort and contract damages is vitally important to the construction industry. Unfortunately, the line between tort and contract damages can be seriously blurred in many jurisdictions. Understanding the types of claims available in project locations is key to understanding and accounting for the risk being undertaken.

Endnotes