Understanding NY's Economic Loss Rule

New York courts have articulated two reasons for the economic loss rule. The first is to preserve the distinction between contract law and tort law. If a plaintiff is looking to recover the loss of expectation damages arising out of the existence of a contract, that dispute should form the basis of an action for breaching that contract. Cornelia Fifth Avenue v. Canizalez, 2017 WL 1034644 at *3 (2017). The rule reflects an understanding that the seller and purchaser are in the best position to allocate risk at the time of their sale and purchase, and the agreed-upon risk allocation is usually reflected in the price. Bocre Leasing, 84 N.Y.2d at 688.

The second justification for the rule is that it reflects a policy interest in protecting defendants from disproportionate and potentially limitless liability. “Thus, in order to avoid 'crushing exposure' to suits by countless parties who have suffered economic loss, New York courts have concluded that '[a]bsent a duty running directly to the injured person there can be no liability in damages, however careless the conduct or foreseeable the harm.'” Cornelia Fifth Avenue, 2017 WL 1034644 at *3 (quoting 532 Madison Ave. Gourmet Foods, 96 N.Y.2d at 289). For example, the court considered a case where an explosion at a defendant's chemical manufacturing plant caused physical vibrations that rained stones and debris onto the plaintiffs' nearby factory, resulting in loss of electrical power and temporary closures. The court found that the plaintiffs could not state a cause of action, “because, to extend a duty to defendant … would, 'like the rippling of the waters, [go] far beyond the zone of danger of the explosion,' to everyone who suffered purely economic loss.” 532 Madison Ave. Gourmet Foods v. Finlandia Ctr., 96 N.Y.2d 280, 289-90 (2001) (quoting Beck v. FMC, 53 A.D.2d 118, 121 (4th Dep't 1976)).

What Is Economic Loss?

Both direct and indirect economic loss are covered by the rule. Direct economic loss includes diminution of value of the product, loss of the bargain, cost of replacement of the product, and cost of the repair of the product. Indirect/consequential economic loss includes lost profits, loss of future business opportunities, loss of ability to replace the product, etc. As subsidiaries of those categories, also included in this definition are “fitness loss” (the product's failure to perform the specific task contemplated), “expectation loss” (loss of use of the product and/or loss of a valuable deal), and “repair loss” (cost to repair or replace the product). Arell's Fine Jewelers v. Honeywell, 170 A.D. 2d 1013 (4th Dep't 1991). If these categories of damages are the only ones claimed, a plaintiff will be precluded from seeking recovery under a theory of negligence or strict products liability.

Three Approaches

In East River Steamship v. Transamerica Delaval, 476 U.S. 858 (1986), the U.S. Supreme Court outlined the three possible approaches to the economic loss rule. The majority approach disallowed tort recoveries when the product caused only economic loss regardless of the potential for serious personal injuries or property damage. The minority approach allowed tort recoveries for defective products causing only economic loss even when the malfunction was not unduly dangerous. The intermediary approach attempted to distinguish between disappointed users and endangered users, and allowed a tort recovery only when the plaintiff was placed in danger as a result of the product defect. East River Steamship, 476 U.S. 868-89 (1986); see Bocre Leasing, supra.

The Supreme Court rejected the minority approach, noting that it failed to account for the need to separate product liability and contract law, and maintain realistic limitations on damages. The Supreme Court also found the intermediate approach unsatisfactory, noting that it essentially turned on the degree of risk, which was too indeterminate to enable manufacturers easily to structure their business behavior. Accordingly, the court determined that so long as the malfunction causes only economic loss, there can be no recovery in tort (i.e., the majority approach).

The Rule's Evolution in New York

New York's interpretation of the economic loss rule has continued to evolve throughout the years. In Schiavone Constr. Co. v. Elgood Mayo, 56 N.Y.2d 667 (1982) (decided four years before East River), New York's highest court, the Court of Appeals, followed the intermediary approach and held that a remote purchaser could not recover in tort for economic losses sustained as a result of a defective product where that product was not unduly dangerous. Bellevue South Assoc. v. NRH Constr. Co., 436 N.E.2d 1322 (1982). In Bellevue South, the plaintiff entered into a contract with a contractor who then subcontracted the work for the supply of wood flooring for the project. The wood flooring was defective, and the plaintiff sued the subcontractor in tort to recover for the economic loss for the need to replace the defective flooring. The Court of Appeals found it unnecessary to adopt East River, since the plaintiff's tort claim failed under both the Schiavone approach and the East River approach. The court concluded that the wood flooring was not unduly dangerous.

New York's Appellate Division, First Department, continued to apply the intermediary approach in Trustees of Columbia University v. Gwathmey Siegel and Assoc. Architects, 192 A.D.2d 151 (1993), when the court allowed the plaintiff to recover in tort for the cost of replacing the defective façade of a building, as it found the crumbling façade was unduly dangerous.

In Bocre Leasing v. General Motors, 840 F. Supp. 231 (E.D.N.Y. 1994), the purchaser of a used helicopter brought a tort action against the manufacturer, alleging negligence and strict liability after it was forced to make a crash landing (no injuries were sustained). The court held that if faced with these facts, the Court of Appeals would apply the East River approach. The court held that the East River approach kept damages in check and also relieved courts of the burden of determining whether a malfunctioning product is “unduly dangerous.” Further, the court held that this approach allows manufacturers to structure their business affairs.

Construction Litigation

As discussed previously, the economic loss rule comes into play in product liability cases. However, it is of particular interest in litigation involving alleged construction defects. These cases are inherently complex, often involve numerous parties, multiple third- and fourth-party actions, countless contracts, and countless tenders seeking indemnification pursuant to those contracts. The economic loss rule attempts to bring some simplicity to this arena by limiting the number of potential third-party claimants, barring certain claims, and emphasizing the distinction between tort and contract.

Earlier this year, New York's Appellate Division, First Department, decided a case that embodies a very common fact pattern in construction litigation. In 610 West Realty v. Riverview West Contracting, 2015 WL 4627741 (1st Dep't 2017), the sponsor of a condominium construction project brought an action against the general contractor and its subcontractor, alleging negligence in completing the project's work. Following the completion, and after the opening of the condominium complex, it was discovered that the subcontractor had performed certain work negligently.

Citing the economic loss rule and noting that a plaintiff cannot recover contract damages under a negligence theory, the First Department affirmed the New York Supreme Court's dismissal of the cause of action alleging negligence against the subcontractor and seeking the cost of remediation and repair of the subcontractor's negligent work. The court also noted that the fact that the subcontractor's work had to do with fire-safing —€ that fire-stopping the premises was insufficient to create an independent duty toward the plaintiff (so as to form the basis of a tort action), and there was no allegation that the subcontractor launched a force or instrument of harm.

Exceptions to the Rule

There are two important exceptions to the economic loss rule worthy of discussion: the independent-duty exception and the other-property exception.

The Independent-Duty Exception

As alluded to previously, a negligence claim may be brought if the plaintiff alleges that a legal duty independent of the contract itself has been violated. In determining whether the economic loss rule applies, New York courts perform a traditional tort analysis to determine whether the asserted negligence claims “based on economic loss alone fall beyond the scope of the duty owed them by [the] defendants.” Emerald Town Car of Pearl River v. Philadelphia Indemnity Insurance Company, 2017 WL 1383773 at *4 (quoting 532 Madison Ave., 96 N.Y.2d at 292). In cases where an independent duty exists and has been breached, the economic loss rule does not apply and a negligence claim may be sustained.

The Other-Property Exception

The other-property exception is perhaps more common in construction litigation. Not surprisingly, it concerns “other property” —€ in other words, property shown to be outside the scope of the relevant contract. Bocre Leasing, 84 N.Y.2d at 694. For example, in Hodgson, Russ, Andrews, Woods & Goodyear v. Isolatek International, 300 A.D.2d 1051 (4th Dep't 2002), a plaintiff sought damages resulting from the discovery of mold and fungus on fireproofing material manufactured by the defendant and applied to the plaintiff's leased premises during renovation. The court determined that the damages sought were not the result of the failure of the product (fireproofing material) to perform its intended purpose of fireproofing. Accordingly, the damage was to “other property,” and the economic loss rule did not apply.

The U.S. Supreme Court discussed the other-property exception in Saratoga Fishing v. J.M. Martinac & Company, 520 U.S. 875 (1997). In that case, a fishing vessel (manufactured by defendant) sunk, due to an engine room fire and resulting flood. After the manufacture and sale of the vessel, the buyer had added extra equipment to the vessel, then ultimately sold it to the second owner (plaintiff). The court held that equipment added to a product after the manufacturer or distributor selling in the initial distribution chain has sold the product to an initial user is not part of the “product itself.” Accordingly, the court held that the plaintiff could recover for economic loss associated with the extra equipment, as it constituted “other property” and fell outside of the economic loss rule.

In contrast, in Archstone v. Tocci Building of New Jersey, 101 A.D.3d 1059 (2d Dep't 2012), the owner of a newly constructed apartment complex brought an action against the manufacturer of artificial stone cladding that allegedly failed to prevent water intrusion, and sought to recover economic losses with respect to the reconstruction of the buildings allegedly resulting from that failure. The court held that the plaintiff's claimed economic losses constituted consequential damages resulting from the alleged design defect and flowing from damage to property that was the subject of the plaintiff's contract with the defendant. Accordingly, those alleged damages were not outside the scope of the contractually based economic losses relative to the transaction, and the economic loss rule applied.

Similarly, in Weiss v. Polymer Plastics, 21 A.D.3d 1095 (2d Dep't 2005), plaintiffs sued the manufacturer of the stucco used on the exterior of their home, seeking damages for the resulting water infiltration. The court upheld the dismissal of all tort-based causes of action asserted against them, holding that their tort claims were properly characterized as being for “economic loss” due to product failure. As such, the plaintiffs' claims were for direct loss to the stucco siding itself and consequential damages to the plywood substrate attached to their home, both of which constituted “economic loss.” Thus, those claims were barred by the economic loss rule.

The court reached the same result in Washington Apts., L.P. v. Oetiker, 43 Misc. 3d 265 (Erie County 2013). This case concerned allegedly defective plumbing clamps installed as part of a new plumbing system during building renovation. The owner of the apartment building sued the manufacturer, distributor and supplier of the clamps, as well as the general contractor, asserting product liability and negligence causes of action. The court held that the plaintiff's allegations that the clamps failed to perform in accordance with their intended purpose, and therefore caused damage to the renovated premises, did not constitute loss to “other property” and, accordingly, these claims were barred by the economic loss rule.

Conclusion

The economic loss rule “reflects the principle that damages arising from the failure of the bargained-for consideration to meet the expectations of the parties are recoverable in contract, not tort.” Bristol-Myers Squibb, Indus. Div. v. Delta Star, 206 A.D.2d 177, 181 (4th Dep't 1994). In theory, this rule is a simple one; however, its application can be complex and nuanced. A clear understanding of this common law principle is crucial to defending many cases, obtaining dismissal of claims that are barred, and limiting exposure subject to the language of the original contract.

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Brian P. Heermance is a partner and Christopher P. Keenoy is an associate in the New York office of Morrison Mahoney. This article also appeared in the New York Law Journal, an ALM sibling publication of this newsletter.