Economic Loss Rule and the Tort of Negligence

Author’s Note: This paper is only sketch of the Privity Defense, Economic Loss Rule, tort of negligent misinformation and third part beneficiaries. Be sure to research papers referred to in footnotes 3 and 4 below.  

Until its decline over the last half-century the doctrine of privity, a common law principle inherited from British law, was impenetrable defense for architects and engineers against claims brought by third parties (those not signatory to the contract) even if personal injury or ancillary property damage was involved. In 1932, Justice Benjamin Cordozo, sitting on the New York Court of Appeals and later a Supreme Court justice, described the law: “The Law of Privity provides that suits against parties to a contract for negligence in performance of the duties and obligations of the contract could only be brought by signatories to the contract, not by third-party strangers.”  The privity defense was so reliable that until fifty years ago many architects did not carry professional liability insurance. 1 

Each white rectangle identifies a defect in the construction of the balcony, Photo Permission granted by WILLIAM H. LOCKE, JR. Graves, Dougherty, Hearon & Moody

As recently as 2011, in Black + Vernooy Architects v. Smith the architect was fully acquitted from paying damages to a claimant for life altering personal injuries that could have been prevented if the architect had taken anything more than a photographic interest in the construction of his design. The privity defense protected the architect not only from responsibility for economic losses, but also from damages for personal injury and ancillary property damage.  These unfair social consequences of privity brought critical attention to the total immunity provided by privity and challenged jurists to find a legal construction that would allow suits against design professionals for personal injury and ancillary property damage (tort-like suits) to proceed where breach of contract or negligence was involved without making the contracting parties liable to a whole class of injured individuals for purely economic losses.   

Splitting the Baby 

Traditional privity defense reinforced the benefits of contract for professionals and manufacturers—securing predictable duties and obligations, providing measured and insurable risks and limiting liability to the known party in contract. Thus, privity protected providers of professional services from claims by an unlimited collection of potentially injured third parties resulting from one negligent or breach of contract event in performance of a contract.2 (see footnote 3532 Madison Ave. Gourmet Foods v. Finlandia Ctr., 750 N.E.2d 1097 (NY 2001)  

At the time privity was made law in 18th Century England it was reasoned that unpredictable risk would increase the cost of liability insurance by factors that would make professional services prohibitively expensive and discourage people from entering the professions at all. In today’s more complicated world the risk for professionals had to be balanced against the public harm that followed from total privity.  

The Economic Loss Rule 

In a 1965 product liability case the California Supreme Court defined a new legal doctrine called the Economic Loss Rule that circumscribed total privity with new boundaries that allowed tort-like suits to be brought against contracting parties for negligence causing personal injury or incidental property damage, while still prohibiting third party suits for purely economic losses (in the construction context think of claims for delay of project). For a simplified explanation of the Economic Loss Rule see Americanbar.org.3 

In the California Products Liability case, Seeley vs White Motors (1965), the owner of a truck built by White Motors brought a suit against the manufacturer for damages (financial losses) his business incurred while he waited for repairs to his truck to be completed. The repairs were covered by the warranty, a form of contract, but the lost business profits were not, and the owner of the truck sued the manufacturer for the economic losses. The Court made what has since been described as a judicial ruling that was easily interpreted but of unpredictable construction (difficult to apply). While the judgement of the court had the intent to correct for the unfairness of privity it handed nothing to the plaintiff in this case. 

The court denied the truck owner’s claim, but in its ruling it described a new limitation on how professionals were protected from risk by entering contracts. The limiting provision, called the Economic Loss Rule, continued the privity like defense against third party claims for purely economic losses, but allowed tort-like claims for personal injury and incidental property loss brought by third parties to be heard in court. In announcing the Economic Loss Rule the court created an unclear doctrine that spread unevenly across the country, resulting in one thing in one state and something different in another. 

While privity defense for architects and engineers was weakened by the Seeley ruling, the walls of the fort still stood. It took another 50 years of judicial tinkering with contract law, making it susceptible to tort remedies and finding grounds to conjure up third parties to the contract, for architects and engineers to find themselves in the heightened risk predicament they are in today.  

The American Law Institute 

Common law in the United States develops independently state by state, sometimes leaving large gaps in the law and irreconcilable differences from one state to another.  The American Law Institute (ALI), a group of 3000 or more jurists, was established in 1923 “to promote the clarification and simplification of United States Common Law and its uniform adaptation across state boundaries.”  

The ALI does not dictate law, but its publications are widely read and often integrated into state common law. By periodically publishing what is referred to as “Restatements,” the ALI attempts to realign varying interpretations of different courts around central concepts. In response to inconsistent applications of ELR, the group issued the “Restatement of Torts Second” in 1979 and the “Restatement of Contracts Second” in 1981. They became some of the most read and widely adopted provisions ever issued by the society. The restatements propagated ominous interpretations for architects and engineers. 

Tort law 

Tort law proceeds from duties imposed by lawmakers and is intended to protect unsuspecting individuals from the unlawful acts of others (e.g. fraud, defamation or negligence) this contrasts with contract law where duties and obligations are created by signatories to the contract and interpreted according to contract law. Litigators prefer to raise tort issues at civil court instead of contract ones because tort law provides a wider latitude of opportunities and benefits for plaintiffs than contract law. If not prevented from doing so, tort litigation would displace contract law altogether.  

The “Restatement of Torts Second” reaffirmed the correctness of the Economic Loss Rule as separating tort from contract law but provided litigators with the power to pierce the immunities of contract law by allowing exceptions and ways around the economic loss rule. ALI declared where a contract existed or was implied, or a third-party beneficiary was established, the parties were limited in their pursuit of losses to the terms of the contract. This seems to reaffirm the protections of privity, but, the “Restatements” went on to define two exceptions to privity of contract – third-party beneficiaries and negligent misinformation. 

Third-party beneficiaries of contract 

The idea there could be a third party to the contract in the design and construction context sharing benefits of the contract but negotiating nothing away for it, and whose identity was unknown to the signatories of the contract at the time of signing seems absurd; but, with publication of the “Restatement of Contracts, Second (1979),” the American Law Institute provided such a basis. ALI recommended using an ‘intent to benefit test’ to determine who could claim standing as a third-party beneficiary. The problem with a term like ‘intent to benefit’ is it could conceivably apply to any contractor or subcontractor that could benefit from the architect/engineer’s contractual duties and obligations to the owner in preparing construction documents. Fortunately for design professionals, exclusionary third party declarations in owner-architect agreements are generally recognized to be definitive, and they successfully bar claims by opportunistic third-party beneficiaries. For an excellent presentation of the third party beneficiary theories see Economic Loss in the Construction Context: Should Architects Be Liable for the Commercial Expectations of Contractors?4 

The tort of negligent misinformation 

In the “Restatement of Torts Second:” Section 552, “Information Negligently Supplied for The Guidance of Others,” ALI described the tort of negligent misinformation as: One who, in the course of his business, profession or employment, or in any other transaction in which he has a pecuniary interest, supplies false information for the guidance of others in their business transactions, is subject to liability for pecuniary losses if he fails to exercise reasonable care or competence in obtaining or communicating the information (negligence). 

In Guardian Construction Co. vs. Tetra Tech Richardson, Inc. (1990 Delaware) the Court, in response to the defendant’s (architect’s) request for summary judgement on the basis of lack of privity, concluded: For the foregoing reasons, “the Court concludes that as to the Plaintiffs’ claims that the negligently prepared project plans and specifications and the information conveyed at the pre-bid meeting were prepared and presented by TTR (the architect) for the use of a specific and limited class of potential users of which Plaintiffs (contractor) were known members, and because Plaintiffs were intended to and did rely to their detriment on that information in preparing their project bids, Plaintiffs’ negligent misrepresentation claims are cognizable despite the lack of contractual privity with TTR and the fact that Plaintiffs seek purely economic damages.”  

The various state courts have left a tortuous trail of divided decisions about the Economic Loss Doctrine and the introduction of third party tort suits. Some states stick with the original application of the law of privity, some states have leaped to the Economic Loss Rule with varying results and others have opened the way for many variations of the tort of negligence and who it protects.  

Conclusion 

The traditional protections of privity for architects and engineers have been circumscribed by the Economic Loss Doctrine, allowing suits by third parties against those in contract for personal injury and property damage. And, courts using modern tort theory, the Restatement Second of Tort (1979), have created pathways for contractors to pursue tort claims against architects and engineers for negligent misinformation. Today, negligent misinformation claims have become the second most common category of professional liability claims second only to owner claims.5 

Architects and engineers have responded defensively to this uncertainty by altering their standard owner-architect agreements to minimize their exposure to risk by decoupling themselves from oversight and responsibility for the contractor’s work; and minimizing collaboration with contractors during construction, believing verbal exchanges only increase the likelihood something spoken or written will be ammunition for a claim of negligence. 6 

Contractors have acquired an advantage in their risk relationship vis-a-vis the architect and engineer, and owners have acquired a small benefit in this rearrangement, but they have lost considerably in the faithfulness of the design professionals to be their representative during construction.7 

Architects and engineers have special insights into the work of constructing their designs that make their active participation in the construction essential to assuring compliance of the contractor’s work with the plans and specifications, design intent, and building codes. These new unpredictable threats have weakened the architect’s initiative to carry out oversight during construction, and owners have lost the loyalty of architects to protect them from faulty work. Contractors should be barred from bringing claims against architects, because it diminishes the architect’s incentive to carry out their oversight obligations during construction8. 

Author’s Note: This paper is only sketch of the Privity Defense, Economic Loss Rule, tort of negligent misinformation and third part beneficiaries. Be sure to research papers referred to in footnotes 3 and 4 below.  

This article represents the research and opinions of the author and is intended for general information purposes only and does not constitute legal advice. Because the interpretation of common law varies from state to state the reader should consult with legal counsel familiar with the laws in their state 

Words: Paul Potts
Photos: William H. Locke, Jr.,  

Paul Potts is a freelance writer often published in design and construction magazines. He has worked in the construction industry as an independent contractor and construtcion administrator for architects, engineers, and owners. Potts can be contacted via e-mail at paulpotts1@comcast.net. Visit his website at www.pauljpotts.com. 

Footnotes: 

  1. AIA Trust: The Architect’s Risk” Two legal doctrines – the economic-loss rule and contractual privity – shielded architects from liability. These defenses were so effective that, only a handful of decades ago, many architects did not carry professional liability insurance.

 

  1. 2. In 532 Madison Ave. Gourmet Foods v. Finlandia Ctr., 750 N.E.2d 1097 (N.Y. 2001), the New York Court of Appeals applied the Economic Loss Rule in cases involving construction disasters that resulted in streets being closed in the heart of Manhattan. Though nearby businesses were not physically damaged by the construction-related collapse, they either were evacuated and closed or were inaccessible to customers for long periods of time. The damages resulting were real and very substantial. However, the court held that a landowner did not have a common law “duty to protect an entire urban neighborhood against purely economic losses.” Id. at 1102.

 

  1. For a simplified explanation of the Economic Loss Rule see:https://www.americanbar.org/publications/under_construction/2016/winter2016/economic_loss_rule/

 

  1. For a clear presentation of the third party beneficiary theories see Economic Loss in the Construction Context: https://scholar.valpo.edu/cgi/viewcontent.cgi?referer=&httpsredir=1&article=1912&context=vulr

 

  1. 5. AIA Trust: Strangers No More? Trends in the Architect’s No Privity Defense

 

  1. 6. ammunition for a claim: http://www.theaiatrust.com/whitepapers/contractor-termination/

 

  1. 7. reduced oversight of construction: http://scholar.valpo.edu/cgi/viewcontent.cgi?

article=1912&context=vulr 

 

  1. 8. diminishes the architect’s authority to carry out their oversight obligations during construction: https://scholar.valpo.edu/cgi/viewcontent.cgi?referer=&httpsredir=1&article=1912&context=vulr