Practice Tip: The Economic Loss Rule

As with any doctrine, courts and legislatures continue to shape its contours and test its limits.

Setting the Stage

The U.S. Supreme Court set the stage in its seminal case East River S.S. Corp. v. Transamerica Delaval, 106 S. Ct. 2295, 2300 (1986). Without the Economic Loss Rule, the Court observed, “contract law would drown in a sea of torts” because the Rule draws the boundary between contracts and torts.

If a product fails, the Rule provides that a disappointed purchaser's remedies are limited to the remedies it negotiated when it purchased the goods. The Economic Loss Rule prevents the disappointed purchaser from claiming damages that would otherwise be available under a tort cause of action ' for example, damages for negligence or product liability.

Without the Economic Loss Rule, the limitation of remedies negotiated in a product warranty would be meaningless if the disappointed purchaser could simply take a claim barred by contract and repackage it as a tort claim to recover the very same damages negotiated away in the contract: There is “no reason to intrude into the parties' allocation of the risk” and “no reason to extricate the parties from their bargain.” East River, 106 S. Ct. at 2303, 2304.

Three recent developments or trends in the Rule merit discussion: 1) application of the Economic Loss Rule to negligent misrepresentation and fraud, torts that do not necessarily reference the character or quality of the goods; 2) application of the Rule when the product fails “suddenly and calamitously” and creates a hazard; and 3) examination of what constitutes the “product itself” for which tort damages are unavailable.

Negligent Misrepresentation And Fraud

Courts continue to wrestle with the application of the Economic Loss Rule to negligent misrepresentation and fraud. Several hold that these torts impose a duty independent of contractual duties, resulting in decisions that the Economic Loss Rule does not bar these claims. Industrial Risk Insurers v. Giddings & Lewis, 2009 Ky. App. LEXIS 106, *20 (Ky. App., July 2, 2009); Indemnity Ins. Co. v. American Aviation, Inc., 891 So. 2d 532, 537 (Fla. 2004); Loughridge v. Goodyear Tire & Rubber Co., 192 F. Supp. 2d 1175, 1183 (D. Colo. 2002).

Other courts decline to adopt an all-or-nothing approach. Instead, some decisions turn on an examination of the nature of the fraud or misrepresentation claim. If the alleged misrepresentation references the “character or quality” of the goods, courts hold such claims are interwoven with the contract and barred by the Economic Loss Rule. Cerabio v. Wright Medical Technology, 410 F.3d 981 (7th Cir. 2005) (applying Wisconsin law); The Conveyor Company v. Sunsource Tech. Serv., 398 F. Supp. 2d 992, 1012-13 (N.D. Iowa 2005) (applying Iowa law); Werwinski v. Ford Motor Co., 286 F.3d 661, 676 (3rd Cir. 2002) (applying Pennsylvania law) (noting an “emerging trend” that permits fraud claims only where they arise independently of the underlying contract).

Conversely, if a careful examination shows that the fraud or misrepresentation claim does not reference the character or quality of the product, the Economic Loss Rule does not bar the claim. Under this reasoning, the Economic Loss Rule is not implicated because it only seeks to prevent claims that would be governed by a contract's guarantees of performance. Tort claims that are not dependent on the product's level of performance arguably do not duplicate a contractual warranty and are, therefore, separate causes of action. See, e.g., Air Products and Chemicals v. Eaton Metal Products, 256 F. Supp. 2d 329, 337 (E.D. Pa. 2003) (holding that the Economic Loss Rule did not bar misrepresentation claim because it did not reference the “character or quality” of the product but rather related to the manufacturer's representation that the product complied with an industrial code).

The 'Sudden and Calamitous' Exception

The Economic Loss Rule does not prevent recovery for personal injuries caused by defective products. A significant number of courts, however, carve out an exception to the Rule if a product fails “suddenly and calamitously” and places people in a “zone of danger” ' even in the absence of any personal injuries. In these circumstances, the Economic Loss Rule does not stand in the way of recovery of economic damages. See, e.g., Muirfield Village-Vernon Hills, v. K. Reinke, Jr. and Co., 810 N.E.2d 235, 247 (Ill. App. Ct. 2004); Lloyd v. General Motors Corp., 916 A.2d 257, 266 (Md. App. 2007).

That a hazardous product damages only itself and not people, the argument goes, is simply a stroke of luck from which a manufacturer should not benefit. Under this view, imposing liability on a manufacturer furthers the public policies underlying tort law ' namely, spreading risk and encouraging the manufacture of safe products.

That the “suddenly and calamitously” exception exists at all is something of a mystery. The U.S. Supreme Court emphatically rejected the idea in East River S.S. Corp.:

Nor do we find persuasive a distinction that rests on the manner in which the product is injured. We realize that the damage may be qualitative, occurring through gradual deterioration or internal breakage. Or it may be calamitous. But either way, since by definition no person or other property is damaged, the resulting loss is purely economic. Even when the harm to the product itself occurs through an abrupt, accident-like event, the resulting loss due to repair costs, decreased value, and lost profits is essentially the failure of the purchaser to receive the benefit of its bargain ' traditionally the core concern of contract law.

106 S. Ct. at 2302; see also Industrial Risk Insurers v. Giddings & Lewis, 2009 Ky. App. LEXIS 106, *18-19 (Ky. App., July 2, 2009); Conveyor Co. v. SunSource Tech. Servs., 398 F. Supp. 2d 992, 1011 (N.D. Iowa 2005).

Almost as persuasive, the Restatement Third of Torts also rejects a “sudden and calamitous” exception to the Economic Loss Rule. Restatement (Third), Torts: Products Liability ' 21 comment d & Reporter's Notes (collecting cases from the “strong majority” of jurisdictions that apply the Economic Loss Rule and reject the “destructive occurrence” exception).

The 'Product Itself'

As noted, the Economic Loss Rule generally does not prevent recovery of damage to “other property.” Stated another way, the Economic Loss Rule only prevents the recovery of damage to the “product itself” and the resulting consequential damages.

Disappointed purchasers, however, have tried to avoid the Economic Loss Rule by advocating a very narrow definition of the “product itself.” Most commonly, this argument has traction when a product contains multiple, independent components. By defining the “product itself” as a single component that destroys other components of a product, disappointed purchasers might be able to recover damages to those other components that would otherwise be barred by the Economic Loss Rule if the entire product ' including all of its components ' were deemed to be the “product itself.”

Once again, the U.S. Supreme Court disposed of these arguments in East River S.S. Corp.:

Since all but the very simplest of machines have component parts, [a contrary] holding would require a finding of 'property damage' in virtually every case where a product damages itself. Such a holding would eliminate the distinction between warranty and strict products liability.

106 S. Ct. at 2300. See also Saratoga Fishing Co. v. J. M. Martinac & Co., 117 S. Ct. 1783, 1786 (U.S. 1997) (holding that the “product itself” is the item “placed into the stream of commerce.”); Elanco Animal Health v. Archer Daniels Midland, 2008 WL 4099881 (S.D. Ind. 2008) (holding that the “product itself” is the finished product ' not its individual components); In re General Motors Corp., 383 F. Supp. 2d 1340, 1343-44 (W.D. Okla. 2005) (holding that the relevant product is “the finished product into which the component is integrated.”).

In addition, the Restatement Third of Torts similarly holds that the product should be considered to be an “integrated whole.” Restatement (Third), Torts: Products Liability ' 21 comment e.

Despite a trend in the other direction, California seems to set itself apart by permitting recovery for damage caused to components of a larger product. In these cases, the disappointed purchaser has convinced the court that a product component is not necessarily the “product itself.” In KB Home v. Superior Court, 112 Cal. App. 4th 1076, 1087 (Cal. App. 2d Dist. 2003), the court held that the Economic Loss Rule would not apply if “the defective part is a sufficiently discrete element of the larger product that it is not reasonable to expect its failure invariably to damage other portions of the finished product.”

The Future of the Economic Loss Rule

The Economic Loss Rule remains a powerful shield against tort liability and, as a consequence, will continue to be the focus of vigorous advocacy. Courts can expect to hear arguments for the expansion of the Economic Loss Rule beyond the sale of goods and into the provision of services as well as beyond the commercial context ' where parties generally have equal bargaining power ' to the retail consumer.

Likewise, the Economic Loss Rule will continue to be attacked. There is substantial support for a “calamitous” destruction exception. Moreover, some courts appear willing to consider parties' claims for negligent misrepresentation and fraud without examining those claims for a foundation in the “character and quality” of the goods.

Conclusion

Less than 50 years old, the Economic Loss Rule will undoubtedly continue to undergo changes. Nonetheless, the Economic Loss Rule appears firmly rooted and here to stay.

Jason P. Thomas and John L. Tate are partners in the southeastern law firm Stites & Harbison PLLC, and practice out of that firm's office in Louisville, KY.

A relative youngster in terms of legal doctrines, the Economic Loss Rule has quickly gained widespread acceptance in state and federal courts. First recognized by California in 1965, it has now been endorsed in some form by the U.S. Supreme Court and nearly every state.

Kentucky and Tennessee are the two most recent states to adopt the Rule, in Industrial Risk Insurers v. Giddings & Lewis, 2009 Ky. App. LEXIS 106 (Ky. App., July 2, 2009), and Lincoln Gen. Ins. Co. v. Detroit Diesel Corp., 2009 Tenn. LEXIS 512 (Tenn. Aug. 21, 2009). Reflecting this trend, the Third Restatement of Torts also endorses the Economic Loss Rule. Restatement (Third) Torts: Product Liability ' 21.

Arkansas, Louisiana, Montana, and Puerto Rico appear to be the only jurisdictions rejecting the Economic Loss Rule. See Farm Bureau Ins. Co. v. Case Corp. , 878 S.W.2d 741, 743 (Ark. 1994); La. Rev. Stat. Ann. ' 9:2800.53(5) (2009); Thompson v. Nebraska Mobile Homes Corp. , 647 P.2d 334-, 336-37 (Mont. 1982); In re Dupont-Benlate Litigation, 877 F. Supp. 779 (D.P.R. 1995).

As with any doctrine, courts and legislatures continue to shape its contours and test its limits.

Setting the Stage

The U.S. Supreme Court set the stage in its seminal case East River S.S. Corp. v. Transamerica Delaval , 106 S. Ct. 2295, 2300 (1986). Without the Economic Loss Rule, the Court observed, “contract law would drown in a sea of torts” because the Rule draws the boundary between contracts and torts.

If a product fails, the Rule provides that a disappointed purchaser's remedies are limited to the remedies it negotiated when it purchased the goods. The Economic Loss Rule prevents the disappointed purchaser from claiming damages that would otherwise be available under a tort cause of action ' for example, damages for negligence or product liability.

Without the Economic Loss Rule, the limitation of remedies negotiated in a product warranty would be meaningless if the disappointed purchaser could simply take a claim barred by contract and repackage it as a tort claim to recover the very same damages negotiated away in the contract: There is “no reason to intrude into the parties' allocation of the risk” and “no reason to extricate the parties from their bargain.” East River, 106 S. Ct. at 2303, 2304.

Three recent developments or trends in the Rule merit discussion: 1) application of the Economic Loss Rule to negligent misrepresentation and fraud, torts that do not necessarily reference the character or quality of the goods; 2) application of the Rule when the product fails “suddenly and calamitously” and creates a hazard; and 3) examination of what constitutes the “product itself” for which tort damages are unavailable.

Negligent Misrepresentation And Fraud

Courts continue to wrestle with the application of the Economic Loss Rule to negligent misrepresentation and fraud. Several hold that these torts impose a duty independent of contractual duties, resulting in decisions that the Economic Loss Rule does not bar these claims. Industrial Risk Insurers v. Giddings & Lewis, 2009 Ky. App. LEXIS 106, *20 (Ky. App., July 2, 2009); Indemnity Ins. Co. v. American Aviation, Inc. , 891 So. 2d 532, 537 (Fla. 2004); Loughridge v. Goodyear Tire & Rubber Co. , 192 F. Supp. 2d 1175, 1183 (D. Colo. 2002).

Other courts decline to adopt an all-or-nothing approach. Instead, some decisions turn on an examination of the nature of the fraud or misrepresentation claim. If the alleged misrepresentation references the “character or quality” of the goods, courts hold such claims are interwoven with the contract and barred by the Economic Loss Rule. Cerabio v. Wright Medical Technology , 410 F.3d 981 (7th Cir. 2005) (applying Wisconsin law); The Conveyor Company v. Sunsource Tech. Serv. , 398 F. Supp. 2d 992, 1012-13 (N.D. Iowa 2005) (applying Iowa law); Werwinski v. Ford Motor Co. , 286 F.3d 661, 676 (3rd Cir. 2002) (applying Pennsylvania law) (noting an “emerging trend” that permits fraud claims only where they arise independently of the underlying contract).

Conversely, if a careful examination shows that the fraud or misrepresentation claim does not reference the character or quality of the product, the Economic Loss Rule does not bar the claim. Under this reasoning, the Economic Loss Rule is not implicated because it only seeks to prevent claims that would be governed by a contract's guarantees of performance. Tort claims that are not dependent on the product's level of performance arguably do not duplicate a contractual warranty and are, therefore, separate causes of action. See, e.g., Air Products and Chemicals v. Eaton Metal Products , 256 F. Supp. 2d 329, 337 (E.D. Pa. 2003) (holding that the Economic Loss Rule did not bar misrepresentation claim because it did not reference the “character or quality” of the product but rather related to the manufacturer's representation that the product complied with an industrial code).

The 'Sudden and Calamitous' Exception

The Economic Loss Rule does not prevent recovery for personal injuries caused by defective products. A significant number of courts, however, carve out an exception to the Rule if a product fails “suddenly and calamitously” and places people in a “zone of danger” ' even in the absence of any personal injuries. In these circumstances, the Economic Loss Rule does not stand in the way of recovery of economic damages. See, e.g., Muirfield Village-Vernon Hills, v. K. Reinke, Jr. and Co. , 810 N.E.2d 235, 247 (Ill. App. Ct. 2004); Lloyd v. General Motors Corp. , 916 A.2d 257, 266 (Md. App. 2007).

That a hazardous product damages only itself and not people, the argument goes, is simply a stroke of luck from which a manufacturer should not benefit. Under this view, imposing liability on a manufacturer furthers the public policies underlying tort law ' namely, spreading risk and encouraging the manufacture of safe products.

That the “suddenly and calamitously” exception exists at all is something of a mystery. The U.S. Supreme Court emphatically rejected the idea in East River S.S. Corp.:

Nor do we find persuasive a distinction that rests on the manner in which the product is injured. We realize that the damage may be qualitative, occurring through gradual deterioration or internal breakage. Or it may be calamitous. But either way, since by definition no person or other property is damaged, the resulting loss is purely economic. Even when the harm to the product itself occurs through an abrupt, accident-like event, the resulting loss due to repair costs, decreased value, and lost profits is essentially the failure of the purchaser to receive the benefit of its bargain ' traditionally the core concern of contract law.

106 S. Ct. at 2302; see also Industrial Risk Insurers v. Giddings & Lewis, 2009 Ky. App. LEXIS 106, *18-19 (Ky. App., July 2, 2009); Conveyor Co. v. SunSource Tech. Servs. , 398 F. Supp. 2d 992, 1011 (N.D. Iowa 2005).

Almost as persuasive, the Restatement Third of Torts also rejects a “sudden and calamitous” exception to the Economic Loss Rule. Restatement (Third), Torts: Products Liability ' 21 comment d & Reporter's Notes (collecting cases from the “strong majority” of jurisdictions that apply the Economic Loss Rule and reject the “destructive occurrence” exception).

The 'Product Itself'

As noted, the Economic Loss Rule generally does not prevent recovery of damage to “other property.” Stated another way, the Economic Loss Rule only prevents the recovery of damage to the “product itself” and the resulting consequential damages.

Disappointed purchasers, however, have tried to avoid the Economic Loss Rule by advocating a very narrow definition of the “product itself.” Most commonly, this argument has traction when a product contains multiple, independent components. By defining the “product itself” as a single component that destroys other components of a product, disappointed purchasers might be able to recover damages to those other components that would otherwise be barred by the Economic Loss Rule if the entire product ' including all of its components ' were deemed to be the “product itself.”

Once again, the U.S. Supreme Court disposed of these arguments in East River S.S. Corp.:

Since all but the very simplest of machines have component parts, [a contrary] holding would require a finding of 'property damage' in virtually every case where a product damages itself. Such a holding would eliminate the distinction between warranty and strict products liability.

106 S. Ct. at 2300. See also Saratoga Fishing Co. v. J. M. Martinac & Co. , 117 S. Ct. 1783, 1786 (U.S. 1997) (holding that the “product itself” is the item “placed into the stream of commerce.”); Elanco Animal Health v. Archer Daniels Midland, 2008 WL 4099881 (S.D. Ind. 2008) (holding that the “product itself” is the finished product ' not its individual components); In re General Motors Corp., 383 F. Supp. 2d 1340, 1343-44 (W.D. Okla. 2005) (holding that the relevant product is “the finished product into which the component is integrated.”).

In addition, the Restatement Third of Torts similarly holds that the product should be considered to be an “integrated whole.” Restatement (Third), Torts: Products Liability ' 21 comment e.

Despite a trend in the other direction, California seems to set itself apart by permitting recovery for damage caused to components of a larger product. In these cases, the disappointed purchaser has convinced the court that a product component is not necessarily the “product itself.” In KB Home v. Superior Court , 112 Cal. App. 4th 1076, 1087 (Cal. App. 2d Dist. 2003), the court held that the Economic Loss Rule would not apply if “the defective part is a sufficiently discrete element of the larger product that it is not reasonable to expect its failure invariably to damage other portions of the finished product.”

The Future of the Economic Loss Rule

The Economic Loss Rule remains a powerful shield against tort liability and, as a consequence, will continue to be the focus of vigorous advocacy. Courts can expect to hear arguments for the expansion of the Economic Loss Rule beyond the sale of goods and into the provision of services as well as beyond the commercial context ' where parties generally have equal bargaining power ' to the retail consumer.

Likewise, the Economic Loss Rule will continue to be attacked. There is substantial support for a “calamitous” destruction exception. Moreover, some courts appear willing to consider parties' claims for negligent misrepresentation and fraud without examining those claims for a foundation in the “character and quality” of the goods.

Conclusion

Less than 50 years old, the Economic Loss Rule will undoubtedly continue to undergo changes. Nonetheless, the Economic Loss Rule appears firmly rooted and here to stay.

Jason P. Thomas and John L. Tate are partners in the southeastern law firm Stites & Harbison PLLC, and practice out of that firm's office in Louisville, KY.