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The Economic Loss Rule

The "economic loss doctrine" bars plaintiffs, in certain circumstances, from recovering economic damages in tort.

Litigation Update

Disclaimer: While this article accurately describes applicable law on the subject covered at the time of its writing, the law continues to develop over time. Accordingly, caution should be taken before relying upon this article, and you should verify that the law described herein has not changed.

I.   INTRODUCTION

The economic loss doctrine was developed by judges and the courts. This “common law” rule is now widely accepted and has been adopted in various forms by a majority of U.S. states and jurisdictions.

Generally speaking, the doctrine limits a contracting party to contractual remedies for the recovery of economic losses unaccompanied by physical injury to persons or other property” than that in the subject contract. Flagstaff Affordable Hous. Ltd. P’ship v. Design Alliance, Inc. It is widely misunderstood and often misapplied.

The economic loss doctrine 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. At its most basic, this means a party cannot recover purely economic losses in a tort action (which is a wrongful act or an infringement of a right other than under contract leading to civil legal liability). In other words, the economic loss doctrine addresses the question of whether a court should limit a contracting party to its contract remedies for purely economic loss.

To better understand the economic loss doctrine, the 1854 case of Hadley v Baxendale is instructive. 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). Economic losses such as lost profits, inadequate value, and loss of use would not be recoverable in a breach of contract action unless they were expressly contemplated by the parties at the time of contracting.

II.   PURPOSE OF ECONOMIC LOSS DOCTRINE

The principal function of the economic loss doctrine is to encourage private ordering of economic relationships. It upholds the expectations of the parties by limiting a plaintiff to contractual remedies for loss of the benefit of the bargain. The concept is that parties to a contract should be able to anticipate any potential injuries that may result from a breach of that agreement as well as any tort damages that might also occur. These concerns are not at risk when the injured party cannot pursue contractual remedies. When there is no contract between the parties, rather than rely on the economic loss doctrine, courts instead focus on whether the applicable substantive law allows liability in the particular context.

Economic loss refers to pecuniary or commercial damage, including any decreased value or repair costs for a product or property that is the subject of a contract between the plaintiff and defendant, and consequential damages such as lost profits. Salt River Project Agric. Improvement & Power Dist. v. Westinghouse Elec. Corp.

III.   Application of the Economic Loss Doctrine

Unsurprisingly, enterprising attorneys sometimes try to avoid the results of this rule by suing in tort to recover economic losses sustained due to a breach.

The economic loss doctrine may vary in its application depending on context-specific policy considerations. To determine whether the economic loss doctrine should apply in a certain context, courts must consider the underlying policies of tort and contract law in the specific setting, such as promoting safety, deterring accidents and spreading the losses and costs of accidents concerning tort law, and encouraging parties to contract, allocate risks and identify and specify remedies, preserving the freedom to contract, promoting the free flow of commerce, and enforcing contracts and upholding the parties’ contractual expectations concerning contract law.

A. Product Liability Cases

In 1984, the Arizona Supreme Court indicated that economic loss doctrine may apply to product liability cases, depending on: (1) the economic nature of the loss; (2) whether the defect was unreasonably dangerous or posed unreasonable risks of harm to persons or other property; and (3) whether the loss occurred in a sudden, accidental manner. Salt River Project (unreasonable risk of harm), abrogated on other grounds by Phelps v. Firebird Raceway, Inc

If a defect causes a product to malfunction and the malfunction affects the product which catches on fire and is completely destroyed, the property damage to the product itself would be recoverable in a strict tort liability action, since the defect would be unreasonably dangerous to person or property and cause accidental damage to other property.

A plaintiff may recover under tort theory if the loss was the result of an unreasonably dangerous defect in the product supplied by the manufacturer and the loss occurred by fire in a sudden accident which was of the type which could endanger persons and other property. The gist of a products liability tort case is not that the plaintiff failed to receive the quality of the product he expected, but that the plaintiff has been exposed, through a hazardous product, to an unreasonable risk of injury to his person or property. Cloud v. Kit Manufacturing (losses resulting from a sudden accident and those occurring from a slow process of deterioration). However, where economic loss is accompanied by damage to other property, strict tort liability applies.

B. Construction Defect Cases

In 2010, the Arizona Supreme Court extended the application of the economic loss doctrine to construction defect cases or cases involving construction-related contracts. Flagstaff Affordable.

Construction-related cases include those brought against an architect, subcontractor, and exterminator. However, the three-factor test applied in product liability cases does not apply to construction defect cases or construction-related contract cases, which are simply governed by the parties’ underlying agreement. In other words, whether a party in a construction defect or construction-related contract case is limited to contractual remedies for purely economic losses depends on whether the parties have contractually agreed to preserve tort remedies for solely economic loss.

When a construction defect causes only damage to the building itself or other economic loss, common law contract remedies alone provide relief. Travelers Indem. Co. v. Crown Corr, Inc.. Damage to speakers in a stadium being constructed was not considered “other property” such as to fall within the exception to the ELD. Salt River Project.

The Arizona Supreme Court cautioned that its adoption of the economic loss doctrine in construction defect or related cases reflects its assessment of the relevant policy concerns in that context; it does not suggest that the doctrine should be applied with a broad brush in other circumstances. Accordingly, Arizona courts have not subsequently applied the economic loss doctrine beyond the product liability and construction defect or construction-related contract context. Firetrace USA, LLC v. Jesclard

C. Professional Negligence Claims

Arizona’s economic loss doctrine does not bar professional negligence claims, such as a claim for legal malpractice because lawyers owe fiduciary duties to their clients and generally are barred from entering agreements that prospectively limited their liability. Flagstaff Affordable. The fact that the Arizona Supreme Court has expressly recognized professional negligence claims, such as claims for legal malpractice and accounting malpractice, also leads to the conclusion that Arizona’s economic loss doctrine does not operate to bar professional negligence claims.

D. Consumer Fraud Claims

Further, the economic loss doctrine does not bar a statutory consumer fraud claim. There are also no cases to date in which an Arizona court has applied the economic loss doctrine to bar a breach of fiduciary duty claim and it has been predicted the court would not do so.

E. Tortious Interference and Unfair Competition Claims

Finally, Arizona’s economic loss doctrine does not always operate to prohibit tortious interference and unfair competition claims.

IV.   Conclusion

Arizona’s economic loss doctrine is just another example of the importance of having strong contracts drawn up for every project. Contracts are intended to protect and compensate both sides against future potential losses. Without these protections built in to the contract, either side could lose out on the chance at compensation or relief if problems arise at a future date.

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Our contract and litigation counsel can advise on the economic loss rule, and can help with contract language to mitigate tort liability. We have 30 years of experience with Arizona law and contract negotiation. Whether you are a consumer or a contractor, or if you are anticipating litigation, you should retain an experienced attorney to ensure your rights are protected and you fully understand these risks.