The Economic Loss Rule: An Under-Utilized But Not-So-Secret Weapon

In a decision issued on March 7, 2013, the Supreme Court of Florida reaffirmed Florida’s commitment to adherence to the economic loss rule in product liability litigation. In Tiara Condominium Association, Inc. v. Marsh & McLennan Companies, Inc. etc., et al., No. SC10-1022, the high court provides a helpful discussion of the origin and development of the economic loss rule. In summary, the economic loss rule is described as “the fundamental boundary between contract law, which is designed to enforce the expectancy interests of the parties, and tort law, which imposes a duty of reasonable care and thereby encourages citizens to avoid causing physical harm to others.” Thus, economic loss has been defined by Florida courts as “damage for inadequate value, costs of repair and replacement of the defective product, or consequent loss of profits – without any claim of personal injury or damage to other property.” In other words, economic losses are “disappointed economic expectations,” which are protected by contract law, rather than tort law.

Despite the rule’s underpinnings in the product liability context, the economic loss rule has also been applied to circumstances when the parties are in contractual privity and one party seeks to recover damages in tort for damages arising in contract.

In a product liability context, the economic loss rule was developed to protect manufacturers from liability for economic damage caused by a defective product beyond those damages provided by warranty law.  In discussing the development of economic loss rule principles, the Florida Supreme Court analyzed the California Supreme Court’s holding in Seely v. White Motor Co., 403 P.2d 145 (Cal. 1965). In Seely, the California Supreme Court held that the doctrine of strict liability in tort did not supplant causes of action for breach of express warranty.

In that case, the court was confronted with a situation in which plaintiff sought recovery for economic loss resulting from his purchase of a truck that failed to perform according to expectations. The court concluded that the strict liability doctrine was not intended to undermine the warranty provisions of sales or contract law, but was designed to govern the wholly separate and distinct problem of physical injuries caused by defective products. In East River Steamship Corp. v. Transamerica Delaval, Inc., 476 U.S. 858 (1986), the U.S. Supreme Court adopted the reasoning of Seely when it considered the issue of economic loss resulting from defective products in the context of admiralty.

According to the Supreme Court, when the damage is to the product itself, “the injury suffered – the failure of the product to function properly – is the essence of a warranty action, through which a contracting party can seek to recoup the benefit of its bargain.” Recognizing that the extending strict product liability law to cover economic damages would result in “contract law… drowning in a sea of tort,” the Supreme Court held that “the manufacturer in a commercial relationship has no duty either under a negligence or a strict products liability theory to prevent a product from injuring itself.” Thus, from the outset, the focus of the economic loss rule was directed to damages resulting from defects in the product itself.

In a  Client Alert, dated July 5, 2011, Stites & Harbison lawyers John L. Tate and Cassidy R. Rosenthal wrote about the Kentucky Supreme Court’s adoption of the economic loss rule in Giddings & Lewis, Inc. v. Industrial Risk Insurers (6/18/11). The Court unanimously held that “a manufacturer in a commercial relationship has no duty under a negligence or strict products liability theory to prevent a product from injuring itself.” The Court wrote: “We believe the parties’ allocation of risk by contract should control without disturbance by the courts via product liability theories.”

As discussed by Mr. Tate and Ms. Rosenthal, in Giddings & Lewis, the manufacturer sold a sophisticated machining center to an industrial concern. The parties set forth their mutual obligations in a detailed commercial contract. After seven years of continuous operation, and after the contract’s express warranty expired, the machining center malfunctioned in a spectacular fashion – throwing chunks of steel weighing thousands of pounds across the factory floor. The costs to repair the machining center and to get the business up and running again were almost $3 million. After reimbursing the machine’s owner for its losses, a consortium of insurance companies asserted a subrogation claim against the machining center’s manufacturer. With the warranty expired, the insurance companies sued in negligence, strict liability, negligent misrepresentation, and fraudulent misrepresentation. What could be more tortious conduct that this?  

Applying the economic loss doctrine, the Kentucky Supreme Court agreed with Mr. Tate holding that the purchaser could not recover from the manufacturer under any tort theory. The consortium was limited to contractual remedies, all of which expired years earlier.

Despite such groundbreaking decisions, is the economic loss rule  under-utilized in products liability and commercial litigation today?  Of course, if personal injury results from an alleged defect, the rule does not apply. However, not infrequently, complaints alleging damages arising from a defective product that purportedly caused economic loss sound in negligence or strict products liability. Are defense lawyers seeking dismissal of these tort claims on the basis of the economic loss rule as often as they should?.

Strong Contractual Terms Can Deflect Tort Liability

Well drafted contracts provide an effective means to mitigate tort liability. In particular, contractual risk allocation provisions can assist companies in better controlling their litigation disposing of claims when they arise.

In an article titled, “Minimizing Tort Liability with the Right Terms,” which appeared in Law360 on February 29, 2012, Shook Hardy & Bacon authors, Paul A. Williams,Charles C. Eblen andKristina L. Burmeister, discuss the importance of various contractual provisions in blunting tort liability.
To illustrate their point, the SH&B lawyers discuss the Third Circuit’s opinion in Greenspan v. ADT Security Servs., Nos. 10-2901, 10-202 (3d Cir., Sept. 20, 2011). The case involved property damage claims resulting from a fire at the plaintiffs’ Pennsylvania residence. The Plaintiffs sued ADT for breach of contract and negligence, claiming that ADT insufficiently repaired and monitored their fire alarm system.

On appeal, the Third Circuit agreed with ADT that the contract’s risk allocation provisions provided a valid defense against all of plaintiff’s claims, including gross negligence. The court ruled that plaintiff could recover in contract only, not tort, because the common law did not impose a separate tort duty to monitor an alarm system. By strictly enforcing the contractual risk allocation provisions in the contract, jurisprudence such as Greenspan provides business with the ability to mitigate tort risk and litigation costs through well drafted contracts.

Increasingly, plaintiffs are attempting to broaden what should be contractual disputes into tort litigation. Greenspan is a perfect example of this trend. In addition to a well drafted contract, defendants are often able to escape tort liability by invoking the economic loss rule. In practice, courts have generally applied the economic loss rule either when the loss claimed in tort is the subject matter of a contract between the parties, or when the plaintiff asserts product liability claims and the defect harmed the product only and not people or other property.

The SH&B article advises that an effective risk-allocation framework should contain the following provisions:

• Waiver of Subrogation;
• Limitation of Liability;
• Limitation of Action;
• Insurance Requirements; and
• Indemnity Clause

In drafting each of these provisions, it is necessary to be mindful of the legal requirements underlying each of these contractual terms. General contractual construction rules to keep in mind include:

1. An effective contract spells out the expectations to ensure that the waiver of subrogation provision is deemed a true waiver of subrogation and not merely an exculpatory provision;

 2. The waiver of subrogation provision should provide that the customer agrees to procure insurance for damages that might arise in connection with the performance of the contract and that the company be named as an additional insured;

 3. The customer should be required to waive all right of recovery beyond the proceeds of his insurance policy and agree that his insurer will not have a right of subrogation against the company;

 4. Each of these contractual provisions should be placed under separate headings in the contract so that they do not blend into and become obscured by other provisions in the contract;

5. Effective contracts should be signed by both parties and definitively indicate if the contract contains more than one page. The customer should sign or initial each page of the contract, or acknowledge that she has read and agrees to all terms and conditions of the contract on each page;

6. It is good practice for language disclaiming consequential damages or otherwise limiting recovery under warranty appear conspicuously in the contract, preferably in bolded caps; and

7. Indemnification provisions should explicitly state that the company has the right to select its own counsel to represent it in any action subject to the indemnification clause in the contract.

What’s Next?

Now that the company has a well drafted, legally binding contract with the customer, the company must take steps to ensure that it doesn’t misplace the contract. The SH&B authors point out that document management is essential to the defensive use of a contract in litigation. If the contract at issue cannot be found, it may be difficult to assert contractual offenses and may unnecessarily expose the company to significant liability.

 Or, as famed criminal defense lawyer, Johnnie Cochran, might have cautioned, “If you lose it, you can’t use it!”