Drowning in a sea of contract: application of the economic loss rule to fraud and negligent misrepresentation claims.

• Author: Barton, R. Joseph
• Position: Ar

The economic loss rule is stated with ease but applied with great difficulty.... Lawyers and judges alike have found it difficult to determine when the rule applies and when an exception is appropriate.(1)

The economic loss rule is one of the most confusing doctrines in tort law.(2) The rule defines the boundary between the overlapping theories of tort law and contract law by barring the recovery of purely economic loss in tort, particularly in strict liability and negligence cases.(3) The rationale behind the rule is that contract law and the Uniform Commercial Code (UCC) are expressly designed to deal with disappointed economic expectations and, therefore, the recovery of economic losses.(4) Confusion arises, however, when courts apply the economic loss rule to torts that expressly provide for the recovery of purely economic losses,(5) such as misrepresentation.(6)

In states adopting the economic loss rule, courts struggle with the questions of if, when, and how the economic loss rule should apply to claims arising out of a defendant's fraudulent conduct. Accordingly, courts have designed diverse rationales in determining when, and if, the economic loss rule should bar recovery in a misrepresentation claim.(7)

Illustrating the diverse application of the economic loss rule is the different treatment of similar claims involving the same defective product, fire-retardant treated (FRT) plywood.(8) In the mid-1980s, the American Plywood Association notified its members that FRT plywood was subject to thermal degradation.(9) Despite this warning and without disclosing the dangers, the manufacturers continued to promote and sell the product.(10) As roofs deteriorated, they posed a risk of collapsing.(11) Accordingly, homeowners and builders sought to recover the cost to repair or replace the roof--a classic example of purely economic loss.(12) In each case, the plaintiff(s) alleged that the defendants' misrepresentations as to the suitability of FRT plywood as roofing material induced the purchase of the product.(13)

The Maryland courts dismissed the homeowners' negligent misrepresentation claims because the "plaintiffs [could not] recover in tort for ... purely economic losses,"(14) even when privity of contract barred the plaintiffs' contract claims.(15) While Maryland law would permit recovery if the FRT-plywood roof had collapsed and damaged other property(16) (e.g., the contents of the home), Michigan law does not; provide such an exception.(17) When a Michigan restauranteur's FRT-plywood roof collapsed and destroyed his business, the Michigan courts dismissed his fraud claim because "the UCC provide[d] the exclusive remedy."(18) Because the defective FRT plywood did not deteriorate and destroy his business within the UCC's four-year statute of limitations, no remedy was available.(19)

Although Maryland and Michigan courts afforded no recovery, Florida courts allowed a homebuilder's negligent misrepresentation and fraud claims that sought to recover the cost of replacing all the FRT plywood in homes the home builder had constructed.(20) The Florida economic loss rule barred claims for strict liability and negligence, but did not apply to torts that were independent of the contract, such as fraud and negligent misrepresentation, even when warranty law also afforded recovery.(21) Although the Florida plaintiff's claims were nearly identical to those of the Maryland homeowners, the economic loss rule did not apply.(22) Similarly, Virginia law allowed homeowners' fraud claims,(23) even though the condominium owners also had a viable contract claim.(24) Unlike Florida, the Virginia economic loss rule would have barred negligent misrepresentation claims.(25) Finally, Alabama allowed an architect's fraud and negligent misrepresentation claims seeking purely economic losses without any mention of the economic loss rule.(26)

As the FRT plywood cases demonstrate, states do not apply the economic loss rule uniformly to nearly identical fraud and negligent misrepresentation claims. The first section of this Note provides a general overview of the economic loss rule and its rationale. The second and third sections examine the application of the economic loss rule to fraud and negligent misrepresentation claims respectively. The fourth section analyzes these rules and suggests a rule that is the most consistent with both the purpose of the economic loss rule and the tort of misrepresentation.

AN OVERVIEW OF THE ECONOMIC LOSS RULE

Defining an "Economic Loss"

Generally, the phrase "economic loss" is defined as losses other than those resulting from an injury to the plaintiff's person or other property.(27) Economic loss is divided further into direct and consequential, or indirect, economic loss.(28) Direct economic loss is the difference between the value of the contract or product as promised, and the actual value as delivered.(29) In the context of products liability, direct economic loss occurs when a product is damaged and the buyer seeks to recover the price of the product.(30) Direct economic loss can be measured in several ways. First, an "out-of-pocket" loss provides recovery for the difference in value between what is given and what is received.(31) Second, "repair costs" provide the cost of replacement or repair to a product that is not delivered as promised.(32) Third, the "benefit of the bargain" approach measures the difference between the value of what is received and the value as represented.(33) Consequential or indirect economic loss consists of an injury extrinsic to the product and attributable to the product defect, such as lost profits resulting from the inability to make use of the product.(34)

As Judge Posner has explained, the term "economic loss" is a misnomer: "It would be better to call it a `commercial loss,' ... because personal injuries and especially property losses are economic losses, too--they destroy values which can be and are monetized...."(35) Commercial losses are not confined to transactions involving business entities; rather, the term encompasses any contractual dispute involving disappointed economic expectations.(36)

The Economic Loss Rule

The economic loss rule is a judicially created doctrine,(37) first articulated by the California Supreme Court in Seely v. White Motor Co.(38) In Seely, the plaintiff sought damages resulting from the purchase of a defective truck.(39) The plaintiff suffered no personal injury damages in the accident, but sought damages for the repair of the truck, the purchase price of the truck, and lost profits because of an inability to use the truck.(40) Recognizing the overlap between products liability and contract law, the Seely court held that in the absence of personal injuries or physical injury to property other than to the product, a buyer's sole remedy lay in warranty, not strict liability or negligence.(41)

Today, courts routinely apply the economic loss rule to both strict liability and negligence claims.(42) The economic loss rule, simply stated, is as follows:

"[W]here a purchaser's expectations in a sale are frustrated because the product he bought is not working properly, his remedy is said to be in contract alone, for he has suffered only `economic' losses." This doctrine hinges on a distinction drawn between transactions involving the sale of goods for commercial purposes where economic expectations are protected by commercial and contract law, and those involving the sale of defective products to individual consumers who are injured in a manner which has traditionally been remedied by resort to the law of torts.(43) The rule requires a purchaser to recover in contract for purely economic loss due to disappointed expectations, unless he can demonstrate harm above and beyond a broken contractual promise.(44) Quite simply, the economic loss rule "prevent[s] the law of contract and the law of tort from dissolving one into the other."(45)

Rationale for the Economic Loss Rule

The distinction drawn by the economic loss rule reaches to the heart of the differences between the underlying purposes of tort and contract law.(46) The distinction between tort and contract law rests upon the source of the duty,(47) the role that the parties' play in determining their rights and responsibilities,(48) and the time at which duties and obligations are determined.(49)

Contract law is individualistic because contractual duties and assignment of risk arise from agreements between the parties.(50) Contract law operates on the premise that contracting parties, in the course of bargaining for terms of a sale, are able to allocate risks and costs of the potential nonperformance.(51) The underlying assumption is that the contract is the result of an arms-length negotiated transaction.(52) In a negotiated transaction, the buyer either may insist on additional warranties or may assume a greater risk in exchange for a lower price.(53)

In contrast, tort law is paternalistic because tort duties arise from policy considerations with little or no regard to whether an agreement exists between the parties.(54) As a general proposition, "[t]ort law ... governs the relationship between a [buyer] and a [seller], where it is impractical or impossible ... to negotiate either the terms of a sale or each party's duty to the other."(55) Thus, tort duties arise to protect individuals unable to protect themselves from the unscrupulous actions of others and irrespective of the existence of a contract.

Both a contract claim and a tort claim, however, may arise from the same conduct.(56) For example, when a defective product physically harms the purchaser or his property, recovery is provided in both tort and contract.(57) To the extent that the legal theories overlap, they are said to be competing interests.(58) The purpose of the economic loss rule is not to bar the recovery of economic losses but is to prevent parties from recovering in tort to extricate themselves...