What You Need to Know about the Economic Loss Rule

The Economic Loss Rule Prevents Recovery in Tort and In Contract for Purely Economic Loss Without Showing Separate Injury or Property Damage

The economic loss doctrine is a common law rule that limits contracting parties to only their contractual remedies in the absence of a separate physical injury or property damage. The doctrine has historically been limited to construction defect and product liability cases. Some argue, however, that the rule could be extended to claims against REALTORS®.

In Flagstaff, 223 Ariz. 320, the Supreme Court held that the property owner could not recover tort damages arising from the faulty work by an architect that caused structural damage without any resulting physical injury to persons or other property. Id, 223 Ariz. at 329, 223 P.3d at 673.

The Supreme Court confirmed that tort damages are recoverable only where there is separate injury. For example, in a construction defect case, “if a fireplace collapses, the purchaser can sue in contract for the costs of remedying the structural defects and sue in tort for damages to personal property or personal injury caused by the collapse. Each claim will stand or fall on its own.” Flagstaff, 223 Ariz. at 324, 233 P.2d at 668 (emphasis added and citations omitted).

The Economic Loss Rule Still Allows For Recovery in Tort and In Contract . . . Sometimes.

The economic loss rule (“ELR”) is riddled with exceptions. ELR does not apply in the following circumstances: (1) the claim relates to the inducement; (2) cases other than product liability or construction defect; (3) a statute creates independent liability; and (4) the policies of tort law favor allowing for the claim to proceed.

  • The Economic Loss Rule Does Not Apply Where Defendants Were Induced Into A Contract Based On False, Fraudulent, or Misleading Representations.

The ELR does not extend to claims involving the contract’s inducement. In Wilson v. GMAC Mortgage, LLC, the Court explained that “[w]hen fraudulent conduct infects contract negotiations, the presumption that the parties engaged in an equal negotiation evaporates.” Wilson v. GMAC Mortgage, LLC, No. 2011 U.S. Dist. LEXIS 104331, *5, 2011 WL 4101668 (D. Ariz. Sept. 14, 2011) (citing Giles v. General Motors Acceptance Corp., 494 F.3d 865, 880 (9th Cir 2007). As a result, that Court declined to apply the ELR in a fraudulent inducement case, because doing so would “release a party from liability for even intentionally fraudulent behavior.” Id.

  • Independent Statutory Liability Precludes the ELR’s Application.

The ELR does not apply to claims for independent statutory liability. The “economic loss rule is a judicially created limitation on common law remedies. It is not a substantive restraint on the power of the Legislature to create new remedies.” Shaw v. CTVT Motors, Inc., 232 Ariz. 20, 33 (App. 2013) (Edward P. Ballinger,  [10] Jr. & Samuel A. Thumma, The History, Evolution and Implications of Arizona’s Economic Loss Rule, 34 Ariz. St. L.J. 491, 502 (2002) (“observing that . . . courts in other jurisdictions recognize that statutory claims are not barred by the economic loss rule if a contrary result would be inconsistent with the legislative purpose in enacting the statute”). As a result, the Shaw court held that Arizona’s economic loss rule does not apply to private causes of action under the Consumer Fraud Act.

Additionally, the ELR arguably does not apply to professional negligence / malpractice claims that are grounded in Title 32 of the Arizona Revised Statutes.

  • The ELR Is Limited to Product Liability and Construction Defect Cases.

In Salt River Project, 143 Ariz. 368 (1984), the Court applied the ELR to product liability case. Years later, in Flagstaff, the Court extended the ELR to construction defect case (construction defect cases are essentially product liability cases – the “product” is the structure). Following Flagstaff, in Cook v. Orkin, the Court applied the ELR to termite contractors in a construction defect context. Cook v. Orkin, 227 Ariz. 331, 258 P.3d 149 (App. 2011). Of course, Cook addressed the damage to the structure as a result of the contractor’s failure to adequately remove the termites over the course of many years.

By contrast, the courts have declined to apply the ELR outside the construction defect and product liability context. B2B CFO Partners, LLC v. Kaufman, 856 F. Supp. 2d 1084, 1096 (D. Ariz. 2012) (explaining that the economic loss rule’s application is limited to product liability and construction defect cases.); Firetrace USA, LLC v. Jesclard, 800 F.Supp.2d 1042, 1051-52 (D. Ariz. 2011) (declining to apply the economic loss rule to bar tort claims in an employment case.).

  • The Underlying Policies of Tort and Contract Law May Allow For Negligent Misrepresentation Claims.

In order to determine whether the ELR applies, the court must consider the underlying policies of tort and contract law. Flagstaff, 223 Ariz. at 325, 223 P.3d at 669. When viewed in the context of a negligent misrepresentation or non disclosure claims, these policies often weigh against the application of the ELR.

In discussing the difference between the policy considerations underlying the doctrine of strict liability in tort, which is “designed to protect the public from dangerous products,” and the policy considerations underlying contract law, which is designed to “redress loss of the benefit of the bargain,” the Arizona Supreme Court explained:

A basic policy of contract law . . . is to preserve freedom of contract and thus promote the free flow of commerce. This policy is best served when the commercial law permits parties to limit the redress of a purchaser who fails to receive the quality product he expected. When a defect renders a product substandard or unable to perform the functions for which it was manufactured, the purchaser’s remedy for disappointed commercial expectations is through contract law. Salt River, 143 Ariz. at 376, 694 P.2d at 206 (internal citations omitted).

These policy considerations certainly support the application of the ELR to a tort claim for negligence in which the plaintiff and the defendant have entered into contract for the manufacture of a product and, through the negligence of the defendant, the product as manufactured does not conform to the requirements of the contract. In such a case, the parties usually will have had the opportunity to allocate the risk of loss for a nonconforming product in their contract and, even if they fail to do so, the UCC may provide remedies for the breach. Under those circumstances, it is reasonable to limit the parties to their contractual and UCC remedies. Doing so protects the parties’ commercial expectations. See Cook, 227 Ariz. at 334, 258 P.3d at 153 (holding the ELR barred the plaintiff’s fraud and negligent misrepresentation claims for the defendant’s alleged failure to adequately perform its promises under the defendant’s agreement with the plaintiffs to treat a termite infestation.)

Indeed, the contract law policy of preserving the commercial expectations of the parties is frustrated, rather than served, when during the formation of the contract one party misleads the other party and the other party believes it will receive a service (i.e. REALTORS® must be licensed to act as a salesperson or broker) that is materially different than what was promised.

Limiting the parties to their contractual and UCC remedies under these circumstances would eviscerate the expectations of the mislead party and potentially leave that party without remedy. The mislead party would have to foresee and then contract around the misrepresentation and omissions that induced it to enter into the contract in the first place. See Ares Funding, LLC v. MA Maricopa, LLC, 602 F. Supp. 2d 1144, 1149 (D. Ariz. 2009) (applying Arizona law and holding a claim for fraud in the inducement is not barred by the ELR because “fraud in the inducement does not arise from the parties’ agreement”).

In addition to the underlying policies of contract law, the underlying policies of tort law also weigh against the application of the economic loss rule in misrepresentation cases. “Generally a cause of action for negligence arises from a duty, a determination that a person is required to conform to a particular standard of conduct.” Lips v. Scottsdale Healthcare Corp., 224 Ariz. 266, 268, 229 P.3d 1008, 1010 (Ariz. 2010). Although the law does not impose a general duty to exercise reasonable care for the purely economic well-being of others, “the tort of negligent misrepresentation recognizes a duty to exercise reasonable care in providing information to a limited class of recipients,” even though the end result of a breach of this duty is often purely economic loss. Id. at 12. Thus, when a business supplies false information for the guidance of others in their business transaction, and a member of the limited class of persons for whose benefit and guidance the business intended to supply the information suffers pecuniary loss as a result of its justifiable reliance on the information, tort law favors imposing liability on that business for its negligent misrepresentation, despite the fact that the sole damages are a pecuniary loss. See Restatement (Second) of Torts §552 (1997).

If the ELR applies to bar any such claims for negligent misrepresentation in the inducement of a contract merely because the only loss suffered were economic damages, this tort would be largely eviscerated. The result would be inconsistent with Arizona law, which recognizes negligent misrepresentation as a valid cause of action. See Evans v. Singer, 518 F. Supp. 2d 1134, 1138-1147 (D. Ariz. 2007) (holding the economic loss rule did not bar a claim for negligent misrepresentation in the inducement of a contract for the purchase of a storage facility where the alleged misrepresentations concerned the revenues, occupancy, and profitability of the storage facility). Accordingly, the ELR should not bar claims for negligent misrepresentation claims.

Similarly, the ELR does not bar non-disclosure cases, even where the party represents that the contract is taken “as-is.” In S Development Co. v. Pima Capital Management Co., 31 P.3d 123, 201 Ariz. 10 (App. 2001), the court held that a vendor may be liable in tort for failing to disclose latent defects, “notwithstanding the burden-shifting “as is” clause or disclaimer of warranties.” Although the ELR wasn’t specifically addressed, the court and the parties were likely guided by the above analysis.

Conclusion

The ELR’s scope and relevance isn’t as broad as some may suggest. The current trend is for the court to limit the ELR’s application to construction defect and product liability cases only. But when the court concludes that the ELR apply, the parties will be limited to only the remedies set forth in the contract. So REALTORS®, buyers, and sellers should be careful to ensure that their contracts adequately protect their interests in the event of a default.

Indeed, this rule is of particular concern for REALTORS® in that professional liability insurance covers only negligent acts, but that insurance may not cover breaches of contract or fraud claims, meaning that REALTORS® may be exposed to defend and indemnify themselves against claims not covered by insurance.

If you or someone you know has questions regarding their real estate contracts or a potential claim involving a real estate issue, call or email Mr. Charles today to schedule an appointment.

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