American Bar Association Forum on the Construction Industry

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WHO IS GOING TO PAY FOR MY IMPACT? A CONTRACTOR’S ABILITY TO SUE THIRD PARTIES FOR PURELY ECONOMIC LOSS

Anthony L. Meagher and Michael P. O’Day DLA Piper Rudnick Gray Cary US LLP

Baltimore, Maryland

April 7-9, 2005 Sheraton New Orleans—New Orleans, LA

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© 2005 American Bar Association

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INTRODUCTION

Under the economic loss rule, courts generally have barred negligence or product liability

suits unless the plaintiff has suffered personal injury or property damage. This rule, therefore,

has prevented contractors from pursuing third parties, such as architects, engineers and

construction managers, for delay or other impact costs resulting from their negligence. Seizing

on the level of control such third parties often have over the construction process, however,

courts increasingly have permitted such recovery. This trend not only affects contractors and

design professionals,1 it directly affects the bargain of the project owner, who might be

implicated in such a claim, either directly in litigation after the fact, or on the front end, by virtue

of increased project costs.2 This paper examines the origins of the economic loss rule, the

current state of the rule as applied to contractor claims against third-party professionals and the

implications of such claims to the owner.

I. THE ECONOMIC LOSS RULE—ORIGIN AND PURPOSE

The economic loss rule traces its origin to the Supreme Court’s decision in Robins Dry

Dock & Repair Co. v. Flint.3 There, the Court barred a negligence action by a plaintiff who

chartered a boat and later sought damages for loss of use of the boat occasioned by the

defendant’s negligent repairs. Because “a tort to the person or property of one man does not

make the tortfeasor liable to another merely because the injured person was under a contract with

that other, unknown to the doer of the wrong,” the Court rejected the claim.4 This holding

evolved into the general rule prohibiting tort recovery in negligence or products liability absent

personal injury or property damage.

More recently, in East River Steamship Corp. v. Transamerica Delaval, Inc.,5 the

Supreme Court discussed the purpose of the economic loss rule. There, a shipbuilding company

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contracted with a turbine manufacturer to design, manufacture and install turbines in four

supertankers that the shipbuilder was under contract to build for its sister company. After

construction, the owner of the tankers leased them to yet another sister company. When three of

the turbines proved defective and the fourth proved to be improperly installed, the lessee sued the

turbine manufacturer in negligence and products liability for the costs of repairing the turbines

and for lost profits during the period in which the tankers could not be used.6 The Court rejected

these claims, holding that contract law provides the more appropriate remedy for the wrongs

alleged. When no person or property is damaged by the failure of the defective product, the

harm, which is to the product itself, is “essentially the failure of the purchaser to receive the

benefit of its bargain—traditionally the core concern of contract law.”7 Focusing on the reasons

for this distinction the Court stated:

The distinction that the law has drawn between tort recovery for physical injuries and warranty recovery for economic loss is not arbitrary and does not rest on the “luck” of one plaintiff in having an accident causing physical injury. The distinction rests, rather, on an understanding of the nature of the responsibility a manufacturer must undertake in distributing his products. When a product injures only itself the reasons for imposing a tort duty are weak and those for leaving a party to its contractual remedies are strong.

* * *

Contract law, and the law of warranty in particular, is well suited to commercial controversies of the sort involved in this case because the parties may set the terms of their own agreements. The manufacturer can restrict its liability . . . . In exchange, the purchaser pays less for the product. Since a commercial situation generally does not involve large disparities in bargaining power, we see no reason to intrude into the parties’ allocation of the risk.8

Plainly construction disputes are “commercial controversies,” and construction projects

typically are based on a comprehensive scheme of contracts between the various participants.

Nonetheless, courts often have failed to leave the parties to the “terms of their own agreements”

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and have not shared the Supreme Court’s reluctance to “intrude into the parties’ allocation of the

risk.”

II. APPLICATION OF THE ECONOMIC LOSS RULE TO CONTRACTOR CLAIMS AGAINST DESIGN PROFESSIONALS

Many of the potential causes of increased costs or other damages to contractors or

subcontractors on a construction project—design errors, failure to timely approve shop drawings

or respond to RFIs and other failures to properly administer the construction contract—may be

traced to the acts of design professionals. Although contractors may sue the project owner for

such matters (either directly if they are in privity, or indirectly, through those with whom they

are)9 many contractors and subcontractors also have sought to bring direct actions against design

professionals for negligence. When the owner has limited assets, financial trouble or is

insolvent, the reasons for such a claim are all the more acute.10

Several courts have rejected these claims because of the general prohibition against

negligence recovery for purely economic loss.11 A growing number of courts, however, have

permitted negligence actions by contractors or subcontractors against design professionals for

purely economic losses.12 Despite the seeming trend in favor of permitting these claims, some

courts continue to adhere to the economic loss rule in this context.13

Courts permitting these actions generally have done so on one of two theories:

(1) foreseeability of the damages caused by the design professional’s negligence; and (2)

negligent misrepresentation.14 Other theories also have been employed, such as breach of

warranty and third-party beneficiary.

A. Recovery permitted because of foreseeability of damages

The most common theory on which courts permit recovery by contractors and

subcontractors against design professionals for purely economic losses is the foreseeability of the

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damages caused by the design professional. As a matter of general negligence law, a plaintiff is

entitled to recover all damages that are the reasonably foreseeable result of the defendant’s

negligence.15

Not only do design professionals prepare the plans and specifications from which the

project is built, they routinely have significant obligations for contract administration. These

obligations include approving payment applications, reviewing the progress of the work,

rejecting defective work, approving changes, certifying substantial and final completion and

even resolving disputes between the owner and contractor. Negligent performance of these

obligations can impact contractors and subcontractors, resulting in plainly foreseeable damage.

Accordingly, some courts have deemed it appropriate to permit direct claims in tort.16

[T]he position of and authority of a supervising architect are such that he ought to labor under a duty to the prime contractor to supervise the project with due care under the circumstances, even though his sole contractual relationship is with the owner. . . . Altogether too much control over the contractor necessarily rests in the hands of the supervising architect for him not to be placed under a duty imposed by law to perform without negligence in his functions as they affect the contractor. The power of the architect to stop the work alone is tantamount to a power of economic life or death over the contractor. It is only just that such authority, exercised in such a relationship, carry commensurate legal responsibility.17

Courts have held that this close relationship between the design professional and the

contractor makes the foreseeable damages flowing from the design professional’s negligence

recoverable.18

B. Liability based upon negligent misrepresentation

Other courts have used a negligent misrepresentation theory to find a design professional

liable in a direct action by a contractor or subcontractor, often looking to section 522 of the

Restatement (Second) of Torts.19 In these cases, the affirmative representation by the design

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(e.g., defective plans or specifications), rather than the failure to act (e.g., the failure to timely

approve shop drawings or respond to an RFI) that creates liability.20 Such an affirmative

representation has been held to result in a duty independent of a design professional’s contractual

obligations. The main difference between negligent misrepresentation and negligence is the

requirement that the defendant knew of or intended the plaintiff’s reliance.21 In the construction

context, however, that distinction has little meaning because ordinarily design professionals

know that contractors rely on their plans and specifications. Accordingly, courts permit recovery

of economic losses where a design professional prepares plans and specifications with the

knowledge that (1) the owner would provide the design documents to the bidders, and (2) the

successful bidder would be injured if the design documents were erroneous.22

Despite their relative similarity in this context, claims for negligence and negligent

misrepresentation have proven not to be interchangeable. In some instances, aggrieved

contractors and subcontractors have had greater success circumventing the economic loss rule by

alleging negligent misrepresentation as opposed to mere negligence.23 The reason for the

different treatment appears to be the finding that negligent misrepresentation serves as a source

of an independent duty to supply correct information for the guidance of others, whereas a claim

for negligent supervision or negligent performance of duties defined by the design contract does

not state an independent duty under which an exception to the economic loss rule can be

sustained.24

C. Other arguments for imposing liability on third parties

Despite the absence of privity, contractors and subcontractors seeking to recover

economic losses from third parties also have styled their claims in contract. For example, in

Utah, a subcontractor sought economic damages for an alleged breach of an implied warranty.25

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Rejecting the subcontractor’s claim, the court stated: “a solid majority of jurisdictions have

refused to hold that architects and design professionals impliedly warrant perfect plans or

satisfactory results.”26 The court went on the find, however, that “when architects or design

professionals bind themselves by contract to do a work or perform a service, they agree by

implication to use reasonable care and skill in doing it.”27 Such a duty to use reasonable and

customary care for services arising from contract is owed only to the entity or person that is the

other party to that contract. Thus, although an implied warranty exists, it does not extend to third

parties.

At least a few courts have held to the contrary, finding that a contractor may state a claim

for breach of an implied warranty where a design professional has failed to prepare the design

documents “with the ordinary skill, care and diligence commensurate with that rendered by

members of his or her profession.”28

Contractors and subcontractors also have claimed third-party beneficiary status to the

design contract. Such claims consistently have failed for a variety of reasons, including the fact

that the plain language of many design contracts expressly prohibits such a claim.29 For

example, a provision in the AIA Standard Form Agreement between Owner and Architect

provides that nothing contained in the Contract Documents shall create any contractual

relationship between the Architect and Contractor.30

III. THE CURRENT STATE OF THE ECONOMIC LOSS RULE AS APPLIED TO CONTRACTOR CLAIMS AGAINST DESIGN PROFESSIONALS

The application of the economic loss rule to contractor claims against design

professionals reveals a split of authority. 31 Indeed, the two most recent opinions on the subject

issued by the highest courts in the Commonwealth of Pennsylvania and the State of Colorado

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reach opposite results, apply conflicting reasoning, and serve to highlight the uncertain and

divergent treatment of the issue.32

A. Recent cases finding that certain contractor claims are exempt from the economic loss rule

In Bilt-Rite Contractors, Inc. v. The Architectural Studio,33 the East Penn School District

contracted with an architect to prepare plans and specifications for the construction of a new

school. Based upon those plans and specifications, the contractor submitted its bid and was

awarded the contract. After beginning construction, the contractor experienced increased costs

allegedly caused by erroneous design plans. The contractor sued the architect for negligent

misrepresentation under section 552 of the Restatement (Second) of Torts, seeking purely

economic damages.

The trial court dismissed the complaint and the intermediate appellate court affirmed,

finding, as a matter of law, that absent privity of contract the contractor could not maintain a tort

action against the architect. The contractor sought further review from the Supreme Court of

Pennsylvania. The court addressed the history of section 552, and the propriety of finding a duty

in tort from the architect to the contractor:

An architect, in the performance of his contract with his employer, is required to exercise the ability, skill, and care customarily used by architects upon such projects. . . . Where breach of such contract relates in foreseeable injury, economic or otherwise, to persons so situated by their economic relations, and community of interests as to impose a duty of care, we know of no reason why an architect cannot be held liable for such injury. Liability arises from the negligent breach of a common law duty of care flowing from the parties’ working relationship. Accordingly, we hold that an architect in the absence of privity of contract may be sued by a general contractor or the subcontractors working on a construction project for economic loss foreseeably resulting from breach of an architect’s common law duty of care in the performance of his contract with the owner.34

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The court imposed a duty on design professionals because (1) the design professional

intends others to rely and use his or her design in their work, (2) public policy dictates that a

design professional should not be exempt from tort consequences, (3) section 552 is narrow

enough to account for the nature of the risk the duty imposes and the foreseeability of the

prospective harm, (4) the duty is not unreasonable or unduly burdensome, and (5) tort liability

will benefit the construction industry by discouraging negligence among design professionals.35

Thus, the court adopted section 552 and held that the economic loss rule does not bar recovery in

such a case.

The Kentucky Supreme Court, in a claim by a contractor against a construction manager,

also recently adopted section 552.36 “[B]y adopting [section] 552, we agree that the tort of

negligent misrepresentation defines an independent duty for which recovery in tort for economic

loss is available.”37 The contractor claimed that the construction manager failed to properly

stage and schedule the work, failed to coordinate the project and supplied faulty information and

guidance to those working on the project. The contractor sought damages for the cost of

correcting work that other contractors had destroyed. Under section 552, the court held that the

contractor stated a claim by merely alleging that the construction manager supplied “faulty

information and guidance;” however, the court rejected the contractor’s claim for negligent

supervision of the project because it failed to articulate a duty independent of the construction

manager’s contractual duties.

Recently, West Virginia’s highest court reached a similar conclusion.38 “We expressly

hold that a design professional (e.g., an architect or engineer) owes a duty of care to a contractor,

who has been employed by the same project owner as the design professional and who has relied

upon the design professional’s work product in carrying out his or her obligations to the owner,

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notwithstanding the absence of privity of contract between the contractor and the design

professional, due to the special relationship that exists between the two.”39 The project involved

the installation of sewer lines and allegedly took the contractor longer to complete than expected

because the design professional failed to (1) disclose sub-surface rock conditions and existing

utility lines on the design documents, and (2) properly administer and manage the project. The

contractor sued the design professional for negligence, breach of the implied warranty of plans

and specifications and as a third-party beneficiary to the design contract.

The court found that the relationship among a design professional, owner and contractor

created a duty requiring the design professional “to render his or her professional services with

the ordinary skill, care and diligence commensurate with that rendered by members of his or her

profession in the same or similar circumstances.”40 Furthermore, the court emphasized that

because specific contractual provisions and rules of professional conduct may impact the scope

of the duty of care, a design professional’s duty must be defined on a case-by-case basis.41

B. Recent cases upholding the economic loss rule

The Supreme Court of Colorado’s opinion in BRW, Inc. v. Dufficy & Sons, Inc.,42

represents a return to the origins of the economic loss rule. The project at issue involved the

erection of two steel bridges in Denver, Colorado. The owner contracted with a single design

firm to design the bridges and provide construction administration. That firm subcontracted the

construction administration to a sub-consultant. The designer completed plans and

specifications, which were put out to bid. The general contractor was awarded the contract and

then subcontracted for fabrication, painting, and shipment of the steel. The subcontractor in turn

sub-subcontracted with another company to perform that same work.

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The sub-subcontractor experienced problems with the design. Specifically, the paint

system specified was inappropriate for use in Denver because of the altitude and climate. As a

result, the paint system took longer than expected to cure, causing delay damages to the sub-

subcontractor, which filed suit against the designer in tort. The trial court dismissed that claim

based on the economic loss rule.

The Colorado Court of Appeals reversed,43 holding that a licensed engineer owes a duty

of care to the contractors and subcontractors with respect to the plans and specifications drafted

and prepared by the engineer and relied upon by the contractor and subcontractor.44 The court

reasoned that (1) contractors are subject to a foreseeable and substantial risk of loss by relying on

plans and specifications that are faulty, (2) extending the duty of care to engineers does not

impose a great burden because engineers already are regulated by their licensing authority, (3)

the construction industry will benefit from imposing such a duty, and (4) the risk of loss should

be placed on the engineer who is in the best position to control or avoid that risk.45 Applying this

reasoning, the court further held that the designer’s sub-consultant “owed the contractors and

subcontractors an independent professional duty of care in inspecting and directing the work of

the project.”46 These holdings imposing an independent tort duty did not stand for long.

The Supreme Court of Colorado reversed,47 finding that “[o]ur economic loss rule

requires the court to focus on the contractual relationship between the parties, rather than their

professional status, in determining the existence of an independent duty of care.”48 The sub-

contractor had argued that the economic loss rule was not applicable because the rule limited to

cases where the parties contracted directly with each other. The court disagreed, stating that the

designer’s and its sub-consultant’s duty of care arose from interrelated contracts.49 The court

recognized that in the construction context, the multiple parties involved in a project typically

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rely on a network of contracts to allocate risks, duties and remedies.50 Further, “[c]ontract law is

intended to enforce the expectancy interests created by the parties’ promises so that they can

allocate risks and costs during their bargaining.”51 For example, at the contracting stage, the

subcontractor knew it was bound to follow the plans and specifications and had the opportunity

to allocate the risk of following these plans and specifications, but the subcontractor failed to do

so.

The court further held that the intermediate appellate court erred by applying a four-part

test to determine whether the defendants owed an independent duty. The appropriate analysis

requires first determining whether the defendants’ contracts created and contained their duties.

Accordingly, the court concluded that because the sub-subcontractor’s tort claims were based

upon the same duties required by contract, contract law provides the remedies and the economic

loss rule bars such tort claims.52 Moreover, applying the economic loss rule encourages a

subcontractor to protect itself from perceived risk, holds the parties to the terms of their

agreement, enforces their expectancy interests, and maintains the delineation of contract from

tort law.

Other cases enforcing the economic loss rule likewise support the delineation of contract

from tort and focus on the expectations of the parties as bargained for in contract.53 For

example, in Utah, Washington and Wyoming, the economic loss rule bars contractor and

subcontractor claims for both professional negligence and negligent misrepresentation against

third parties. The Supreme Court of Utah emphasized that contractors and subcontractors have

the ability to allocate risk in the contracting process. “Protection against economic losses caused

by another’s failure to properly perform, including an architect or design professional, is but one

provision a contractor, subcontractor, or sub-subcontractor may require in striking his or her

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bargain.”54 Indeed, the economic loss rule was developed to allow parties to allocate risk by

contract, and, therefore, it serves as a bar for a claim of professional malpractice against a design

professional. Further, recognizing a claim for negligent misrepresentation against a design

professional would allow parties to “essentially sidestep contractual duties by bringing a cause of

action in tort to recover the very benefits they were unable to obtain in contractual

negotiations.”55

The Utah court’s decision in SME Industries illustrates these points. The plaintiff agreed

by subcontract to fabricate and erect the structural steel portion of the renovations at the Salt

Palace Convention Center in Salt Lake City. Because of alleged problems with the plans and

specifications, the plaintiff claimed $2,193,000 in excess construction costs.56 The owner paid a

small portion of the claim to the general contractor and assigned all rights, causes of action, and

claims that it had against the design professional related to the structural steel. The general

contractor in turn assigned these rights to the subcontractor. The subcontractor sued the design

professional directly and pursuant to the assignment in tort to recover economic losses. The trial

court applied the economic loss rule and dismissed both claims. The Supreme Court of Utah

affirmed, finding that contractors and subcontractors must resort to contract law to protect their

economic expectations.57 The court concluded: “[the subcontractor] did have the opportunity to

allocate the risks associated with the costs of the work when it entered into a subcontract

agreement with [the contractor], which proved to be an adequate contractual remedy considering

the fact that [the subcontractor] settled with [the contractor] for $150,000 and the assignment of

[the contractor’s] claims. . . ‘To allow the claims would be to impose [the subcontractor’s]

economic expectations upon parties whom [it] did not know and with whom [it] did not deal and

upon contracts to which [it] was not a party.’”58

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Likewise, notwithstanding that Wyoming courts generally have recognized section 552 of

the Restatement (Second) of Torts as a viable basis for a negligent misrepresentation claim, the

Supreme Court of Wyoming held that “when the plaintiff has contracted to protect against

economic liability caused by the negligence of the defendant, there is no claim under [section

552] for purely economic loss.”59 There, the contractor built a water distribution center

according to the plans and specifications prepared by the design engineer. Because of the delay

on the project caused by defective plans and specifications, the contractor sought an increase in

the contract price and an extension of time, both of which were denied by the owner. The

contractor then sued the engineer for negligence and negligent misrepresentation. Applying the

economic loss rule, the trial court dismissed the tort claims. The Supreme Court of Wyoming

affirmed, finding that, despite the absence of privity and opportunity for the contractor to

negotiate the limits of liability with the engineer, “[the contractor] had the opportunity to allocate

the risks associated with the costs of the work when it contracted with [the owner] and, in fact,

entered into a detailed contract which allowed it the means, method and opportunity to recover

economic losses allegedly caused by [the engineer’s] negligence.”60 Emphasizing the

importance of the freedom of contract, the court concluded: “We believe that this ruling not only

encourages the parties to negotiate the limits of liability in a contractual situation, but it holds

parties to the terms of the agreement.”61

Under a similar fact pattern, the Supreme Court of Washington reasoned that “the

preservation of the contract represents the most efficient and fair manner in which to limit

liability and govern economic expectations in the construction business.”62 Indeed, a bright line

rule between the remedies in tort and contract with respect to economic damages “encourages

parties to negotiate toward the risk distribution that is desired or customary. We preserve the

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incentive to adequately self-protect during the bargaining process.”63 The court concluded that

because contract principles override tort principles, there can be no recovery of purely economic

losses against third parties.64

Illinois courts apply a slightly different reasoning to achieve the same result. In Illinois,

the economic loss rule is sometimes referred to as the Moorman doctrine and has two exceptions:

(1) negligent misrepresentation by a defendant who is in the business of supplying information

for the guidance of others, and (2) fraudulent/intentional misrepresentation. Contractors have

relied on the first noted exception as a ground for seeking recovery of purely economic damages

from a third party caused by inadequate design documents. Illinois courts have rejected such a

claim however because an architect or engineer is not in the business of supplying information;

instead, the end result of the architect’s or engineer’s work is a tangible object, i.e., a building,

bridge, structure, etc., and any information supplied is merely incidental to that end result.65

In the context of construction claims, Virginia retains a traditional application of the

economic loss rule. In Blake Construction Co., Inc. v. Alley,66 the owner hired a design firm to

provide architectural and engineering services, including the creation of plans and specifications,

inspecting the construction, certifying completion of the work, and approving payment

applications. The general contractor alleged that the design firm acted negligently, causing the

contractor to suffer $3.8 million in damages. The Supreme Court of Virginia affirmed the

dismissal of the contractor’s claim. The court simply held that “there could be no recovery by

[the contractor] from [the design firm] in tort for only economic loss in the absence of privity.”67

In a later decision, the court further explained its adherence to the economic loss rule: “[t]ort law

is not designed . . . to compensate parties for losses suffered as a result of a breach of duties

assumed only by agreement. That type of compensation necessitates an analysis of the damages

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which were within the contemplation of the parties when framing their agreement. It remains the

particular province of the law of contracts.”68

IV. IMPLICATIONS TO THE OWNER

A project owner retains more than a passing interest in the debate over whether its

contractors and their subcontractors should be permitted to sue the design professional(s) who

designed the project and administered the construction contract. Such claims raise at least three

concerns for owners. First, permitting such actions is unlikely to keep the owner out of

litigation. Although the owner’s interests generally are aligned with the design professional, the

potential exists for the design professional to point to the owner as an independent cause of the

contractor’s damages. Second, permitting such claims likely increases the owner’s design costs

because of the increased insurance costs to the design professional. Third, and perhaps most

importantly, permitting such claims may do violence to the owner’s contractual bargain by

permitting the contractor to circumvent provisions of the construction contract such as

limitations on the recovery of damages, a waiver of jury trial, dispute resolution provisions,

jurisdiction and venue provisions and other fairly bargained for provisions.

A. Conflicting interests between the owner and contractor

Even if a contractor is permitted to bring a direct action against a design professional, the

contractor almost certainly will sue the owner for breach of contract as well. Owners often

believe that because they neither designed the project nor built it, they are insulated from

ultimate liability for construction disputes on the project. This ignores, however, the potential

claim that the owner was an independent cause of the contractor’s damages. For example, the

design professional could point to problems with the owner’s program, the owner’s interference

with the design process or owner-initiated changes as independent causes of the contractor’s

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damages. Although this could happen even when the contractor is not permitted to directly sue

the design professional, the owner is more likely to be able to manage and maintain its

relationship with the design professional when the design professional is not a party to the case.

In addition, the architect’s duty to administer the construction is set forth in its agreement

with the owner. Permitting a contractor’s direct claims in tort against the architect muddies that

water. Now, the architect owes contractually defined duties to the owner and an additional duty

of care, enforceable in tort, to the contractor. Those duties may conflict during the project,

forcing the architect to choose one liability over another.69 For example, an architect that

requires too much performance of the contractor may be liable in tort for the excess; although, if

that architect requires too little, it may be in breach of the contractual duties owed to the owner.70

B. Increased design costs

Permitting direct claims by a contractor or subcontractor against a design professional

likely will increase the owner’s design costs. Design professionals practicing in jurisdictions that

permit direct tort claims by contractors and subcontractors for purely economic loss necessarily

will face higher insurance costs. In its contract with the owner, a design professional’s

obligations are clearly spelled out; and, in an action by an owner, those contractual obligations

influence the standard of care by which the design professional’s liability will be judged. In an

action by a contractor or subcontractor, however, there is no contract between the parties from

which to measure the design professional’s performance. Although the design professional may

argue that it should not be held to any greater obligations than it assumed in the design contract

with the owner, the contractor will argue that it is not bound by such limits. A trier of fact, not

specifically saddled by the limits of the design contract, could impose greater liability on the

design professional.71 This increased risk likely translates into higher insurance premiums which

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the design professional will pass on to the owner as part of its design fee. In addition, prudent

owners in jurisdictions permitting these direct actions against design professionals may require

higher insurance limits in their design contracts. This too will increase the insurance costs that

ultimately are paid by the owner.

C. The risk of circumventing provisions of the construction contract

As discussed above, one of the main reasons that courts have enforced the economic loss

rule to bar tort actions for purely economic loss is that parties typically use contracts to distribute

the risk of economic losses. Many courts view the contractual framework as preferable to tort

law in apportioning liability between the various contracting parties. The construction context

provides an apt illustration of why enforcement of the rule is the better course.72

In the construction industry, both form and manuscript contracts contain numerous

provisions designed to address financial and other risks likely to be encountered on a

construction project. Limitations on the extent and types of damages that may be recovered are

common. For example, waivers of consequential damages and no damage for delay clauses are

significant provisions which owners use to limit their exposure on construction projects. In

states where direct actions by contractors against design professionals for economic losses are

permitted, a real potential exists for the contractor to circumvent these provisions and recover the

types of damage which it specifically agreed by contract that it could not recover.

For example, if a construction contract contains a no damage for delay clause and the

contractor experiences increased costs because of delays caused by defective plans and

specifications, then the contractor would not have the right to recover such costs from the owner.

If the court permits a direct action by the contractor against the design professional, however,

then, because the design professional is not a party to the construction contract, the contractor

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would be free to seek delay damages from the design professional. If the design professional

views the owner as potentially responsible for the design errors, then it is possible for the design

professional to state a claim against the owner for indemnification or contribution for these

damages. If the indemnity claim is successful, the owner would be forced to pay just the type of

damages that it thought it had protected itself against in the construction contract.

Similar problems exist with other provisions in the construction contract. Owners often

require contractors to agree to a waiver of jury trial. In a direct claim by the contractor against

the design professional, however, there is no contractual jury trial waiver between them, so the

contractor would be free to pray a jury trial. If the contractor joins its breach of contract claim

against the owner in the same action, then, at the very least, the owner would find itself party to a

more cumbersome proceeding, with a jury deciding the contractor’s claim against the design

professional and the judge deciding the contractor’s claim against the owner.

The same is true of the dispute resolution provisions in the construction contract.

Construction contracts often require mediation and binding arbitration. Because there is no

contract between the contractor and the design professional, the contractor could not be

compelled to arbitrate its claim against the design professional. If the contractor’s claim against

owner is subject to arbitration, then the owner could be subject to two separate proceedings and

face not only the additional cost of defending two actions, but the specter of inconsistent results.

In Floor Craft Floor Covering, Inc. v. Parma Community General Hospital,73 the

Supreme Court of Ohio identified similar concerns. There, a flooring contractor alleged that it

suffered economic damages arising from defective plans and specifications and brought a direct

claim against the design professional. The court rejected such a claim, concluding that “recovery

for economic loss is strictly a subject for contract negotiation and assignment.” The court cited

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several provisions from the general contract concerning the contractor’s remedy for alleged

defective plans and specifications. None of the provisions permitted a direct claim against the

design professional; instead, the exact opposite was true: the provisions shielded the design

professional from liability. For example, section 1.1.2 of the contract between the contractor and

owner provides that the contract documents “shall not be construed to create any contractual

relationship of any kind between the Architect and the Contractor;”74 section 2.3.5 provides that

the architect is not responsible for the construction methods or procedures or for the failure of the

contractor to perform work according to the design;75 and section 2.3.16 provides that the

architect’s decisions made in good faith whether to reject work that did not conform with the

plans and specifications shall not create any duty or responsibility of the architect to the

contractor.76 Allowing the contractor’s negligence claim against the architect would circumvent

these bargained for contractual provisions.77

V. PREVENTATIVE MEASURES

Construction lawyers already have their work cut out for them in trying to anticipate and

fairly allocate the risks on construction projects between contracting parties. Trying to deal with

risks from third-party claims is beyond the traditional risk of claims for personal injury or

property damage, and poses an even more complex challenge. By definition, these claimants are

strangers to the contract, who will argue that they are not bound by the contractual limitations.

Although there is little if any guidance in the current case law concerning efforts to expressly

limit such claims, here are a few ideas:

1. Expressly waive such claims in the general contract (and require such a waiver in

subcontracts) and expressly state that the design professionals are intended beneficiaries of such

waivers.

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2. Expressly extend the breadth of no damage for delay clauses, waiver, dispute resolution

provisions, venue and jurisdiction and other such provisions beyond just claims between the

owner and contractor.

3. Carefully consider insurance provisions and limits.

CONCLUSION

As the Supreme Court said in East River Steamship Corp., contract law is “particularly

well suited to commercial controversies . . . because the parties may set the terms of their own

agreements.” In such a context, the Court saw “no reason to intrude into the parties’ allocation

of the risk.” The intrusion of courts into the contractual framework bargained for by participants

in a construction project by allowing extra-contractual claims for economic losses poses

significant risks to the project owner, exposing it to risks from which it thought it was protected.

Care must be taken to anticipate attempts to dispel the additional risks associated with such

claims.

22

1 Although the discussion below focuses on claims against “design professionals,” the concepts have equal import to claims against other third-party professionals, such as a consulting engineer, testing agency or a construction manager serving as the owner’s agent. 2 Tort claims by or against an owner for purely economic losses are the subject of a companion paper, and, accordingly, are not addressed here. 3 275 U.S. 303 (1927). 4 Id. at 309. 5 476 U.S. 858 (1986). 6 Id. at 861. 7 Id. at 870. 8 Id. at 871-73 (internal citations omitted). 9 Under United States v. Spearin, 248 U.S. 132 (1918), a project owner warrants the adequacy of the project’s plans and specifications. Under basic agency principles, an owner also is liable when a design professional’s failure to properly administer the construction contract results in a breach of the owner’s obligations under that contract. 10 Matthew S. Steffey, Negligence, Contract, and Architects’ Liability for Economic Loss, 82 KY. L. J. 659, 700 (1994) (recognizing, however, that the architect and contractor can apportion the risk of owner insolvency in the contract bargaining process). 11 See, e.g., Williams & Sons Erectors, Inc. v. South Carolina Steel Corp., 983 F.2d 1176 (2d Cir. 1993); Widett v. United States Fidelity & Guar. Co., 815 F.2d 885 (2d Cir. 1987); Bryant Elec. Co. v. Fredericksburg, 762 F.2d 1192 (4th Cir. 1985); Texas Tunneling Co. v. Chattanooga, 329 F.2d 402 (6th Cir. 1964); National Steel Erection, Inc. v. J.A. Jones Constr. Co., 899 F. Supp. 268 (N.D. W. Va. 1995); Fireman’s Fund Ins. Co. v. SEC Donohue, Inc., 679 N.E.2d 1197 (Ill. 1997); Floor Craft Floor Covering, Inc. v. Parma Community Gen’l Hosp. Ass’n., 560 N.E.2d 206 (Ohio 1990); David Pflumm Paving & Excavating, Inc. v. Foundation Servs. Co., 816 A.2d 1164 (Pa. Super. 2003); Berschauer/Phillips Constr. Co. v. Seattle Sch. Dist. No. 1, 881 P.2d 986 (Wash. 1994); Blake Constr. Co., Inc. v. Alley, 353 S.E.2d 724 (Va. 1987). 12 See, e.g., United States ex rel. Los Angeles Testing Laboratory v. Rogers & Rogers, 161 F. Supp. 132 (S.D. Cal. 1958); Mayor & City Council v. Clark-Dietz, 550 F. Supp. 610 (N.D. Miss. 1982); Donnelly Constr. Co. v. Oberg/Hunt/Gilleland, 677 P.2d 1292 (Ariz. 1984); Guardian Constr. Co. v. Tetra Tech Richardson, Inc., 583 A.2d 1378 (Del. Super. Ct. 1990); A.R. Moyer, Inc. v. Graham, 285 So.2d 397 (Fla. 1973); Craig v. Everett M. Brooks Co., 222 N.E.2d 752 (Mass. 1967); Bacco Constr. Co. v. American Colloid Co., 384 N.W.2d 427 (Mich. App. 1986); Waldor Pump & Equip. Co. v. Orr-Schelen-Mayeron & Assoc., Inc., 386 N.W.2d 375 (Minn. App. 1986); Jim’s Excavating Serv., Inc. v. HKM Assoc., 878 P.2d 248 (Mont. 1994); Conforti & Eisele, Inc. v. John C. Morris Assocs., 418 A.2d 1290 (N.J. Super. Ct. Law Div. 1980; Shoffner Indus., Inc. v. W.B. Lloyd Constr. Co., 257 S.E.2d 50 (N.C. Ct. App. 1979); Voren v. Thompson & Assocs., 999 P.2d 438 (Okla. 2000); Mid-Western Elec., Inc. v. DeWild Grant Reckert & Assocs. Co., 500 N.W.2d 250 (S.D. 1993); Forte Bros., Inc. v. National Amusements, Inc., 525 A.2d 1301 (R.I. 1987); John Martin Co. v. Morse/Diesel, Inc., 819 S.W.2d 428 (Tenn. 1991); Eastern Steel Constructors, Inc. v. Salem, 549 S.E.2d 266 (W. Va. 2001). 13 See infra Section III.B. (discussing recent cases upholding the economic loss rule). Commentators also have criticized the erosion of the economic loss rule in this context. See

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William K. Jones, Economic Losses Caused By Construction Deficiencies: the Competing Regimes of Contract and Tort, 59 U. CIN. L. REV. 1051, 1102 (1991) (concluding that, in the construction context, tort law should be limited to instances of fraudulent misrepresentations or concealments only); Steffey, supra note 10, 82 KY. L. J. at 701 (arguing that a contractor seeking to recover purely economic losses caused by a design professional should be limited to contract remedies); Michael T. Terwilliger, Economic Loss in the Construction Context: Should Architects be Liable for the Commercial Expectations of Contractors? 31 VAL. U. L. REV. 257 (1996) (advocating a per se rule against design professional liability for the economic losses of a contractor). 14 A more obscure tort claim that may be available to a contractor in pursuing a third party is negligent interference with an economic interest. Contractors also may assert direct claims to recover economic losses as intentional torts, e.g., fraud. 15 See, e.g., Bacco Constr. Co., 384 N.W.2d at 434 (discussing the foreseeability of harm resulting from defective plans and specifications). 16 See, e.g., Rogers & Rogers, 161 F. Supp. at 134-36 (architect’s control over the prime contractor renders the architect liable). 17 Id. at 135-36. 18 See, e.g., Tommy L. Griffin Plumbing & Heating Co. v. Jordon, Jones & Goulding, Inc., 463 S.E.2d 85, 89 (S.C. 1995) (finding that design professionals, like lawyers and accountants, owe a professional duty arising separate and distinct from any contractual duties between parties or with third parties, and that a “special relationship” exists between engineer and contractor where engineer designed project, supervised construction, and had right to inspect and halt contractor’s work); Reliance Insurance Co. v. Morris Assocs., P.C., 200 A.D.2d 728, 729 (N.Y. App. Div. 1994) (relationship approaching privity where defendant knew of the definable class that would rely on its plans and specifications for preparing bids). 19 “Information Negligently Supplied for the Guidance of Others” provides in part:

(1) One who, in the course of his business, profession or employment, or in any other transaction in which he has pecuniary interest, supplies false information for the guidance of others in their business transactions, is subject to liability for pecuniary loss caused to them by their justifiable reliance upon information, if he fails to exercise care or competence in obtaining or communication the information. (2) Except as stated in Subsection (3), the liability stated in Subsection (1) is limited to loss suffered

(a) by the person or one of a limited group of persons for whose benefit and guidance he intends to supply the information or knows that the recipient intends to supply it; and (b) through reliance upon it in a transaction that he intends the information to influence or knows that the recipient so intends or in a substantially similar transaction.

(3) The liability of one who is under a public duty to give the information extends to loss suffered by any of the class of persons

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for whose benefit the duty is created, in any of the transactions in which it is intended to protect them.

20 See, e.g., Robert & Co. Assoc. v. Rhodes-Haverty Partnership, 300 S.E.2d 503 (Ga. 1983); Davidson & Jones, Inc. v. New Hanover, 225 S.E.2d 580 (N.C. Ct. App. 1979); John Martin Co. v. Morse/Diesel, Inc., 819 S.W.2d 428 (Tenn. 1991). 21 Illustration 9 to section 552 draws out this element through the following example:

9. The City of A is about to ask for bids for work on a sewer tunnel. It hires B Company, a firm of engineers, to make boring tests and provide a report showing the rock and soil conditions to be encountered. It notifies B Company that the report will be made available to bidders as a basis for their bids and that it is expected to be used by the successful bidder in doing the work. Without knowing the identity of any of the contractors bidding on the work, B Company negligently prepares and delivers to the City an inaccurate report, containing false and misleading information. On the basis of the report C makes a successful bid, and also on the basis of the report D, a subcontractor, contracts with C to do a part of the work. By reason of the inaccuracy of the report, C and D suffer pecuniary loss in performing their contracts. B Company is subject to liability to C and D.

22 Hewett-Kier Constr., Inc. v. Lemuel Ramos & Assocs., Inc., 775 So.2d 373, 375 (Fla. Dist. Ct. App. 2001) (citing the Restatement (Second) of Torts § 552). Delaware similarly has adopted the Restatement (Second) of Torts § 552, finding that:

If, in the course of its business, [the design engineer] negligently obtained and communicated incorrect information specifically known and intended to be for the guidance of [the contractor and its subcontractors], and if it is specifically known and intended that [the contractor and its subcontractors] would rely in calculating their project bids on that information, and if [the contractor and its subcontractors] rely thereon to their detriment, then [the design engineer] should be liable for foreseeable economic losses sustained by [the contractor and its subcontractors] regardless of whether privity of contract exists.

Guardian Constr. Co. v. Tetra Tech Richardson, Inc., 583 A.2d 1378, 1386 (Del. Super. Ct. 1990). But see SME Indus., Inc. v. Thompson, Ventulett, Stainback & Assocs., Inc., 28 P.3d 669, 684 (Utah 2001) (“We see no principled reason why the application of section 552 would not extend liability beyond contractors and subcontractors to an unlimited number of materialmen and workmen who suffer economic injury as a result of a design professional’s alleged negligence, which is precisely the type of situation the economic loss rule was designed to prevent.”); Floor Craft Floor Covering, 560 N.E.2d at 211 (refusing to allow contractor’s negligent misrepresentation claim against architect, the court recognized that “[a]lthough architects may anticipate that certain subcontractors will contribute to a construction project, the architects’ services are generally extended to an unresolved class of persons unfixed in number.”).

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23 See, e.g., Malta Constr. Co. v. Henningson, Durham & Richardson Inc., 694 F. Supp. 902 (N.D. Ga. 1988). In Malta, the plaintiff general contractor sued an engineering firm in tort for purely economic damages, alleging negligent misrepresentation (supplying deficient drawings) and professional negligence (negligent review of shop drawings). The United States District Court for the Northern District of Georgia permitted the negligent misrepresentation claim but found that the claim alleging negligent review of shop drawings was barred by the economic loss rule. Id. at 906-07. The court also noted that allegations of negligent failure to supervise and to approve change orders are claims similarly barred by the economic loss rule. Id. at 907. See also Presnell Constr. Managers, Inc. v. EH Constr., LLC, 134 S.W.3d 575 (Ky. 2004). 24 See, e.g., Presnell, 134 S.W.3d at 582-83 (claim for negligence does not state an independent duty). 25 SME Indus., 28 P.3d at 678. 26 Id. 27 Id. 28 Eastern Steel Constructors, Inc. v. Salem, 549 S.E.2d 266, 276-77 (W. Va. 2001) (discussing cases from South Carolina and Arizona). 29 See, e.g., id. at 278 (finding that the design contract was not for the sole benefit of the contractor); M.D. Thomson and Austin Banister Joint Venture v. Espey Huston & Assocs., Inc., 899 S.W.2d 415, 418 (Tex. App. 1995) (recognizing the presumption against third-party beneficiary contracts). 30 AIA Standard Form Agreement Between Owner and Architect B141-1997, section 1.3.7.5. See also General Conditions of the Contract for Construction A201-1997, section 1.1.2. 31 Bilt-Rite Contractors, Inc. v. The Architectural Studio, 2005 Pa. LEXIS 99, *8 (Pa. Jan. 19, 2005) (recognizing the split in state courts, federal courts, and among the lower Pennsylvania courts); John Martin Co., Inc. v. Morse/Diesel, Inc., 819 S.W.2d 428, 434-35 (Tenn. 1991) (“We have examined the competing views. Our conclusion is that there is no clear majority; instead, we find a split of authority among the states.”); Bryant Electric Co., Inc. v. Fredericksburg, 762 F.2d 1192, 1196 (4th Cir. 1985) (same). 32 See infra pp. 8 to 9 for a discussion of Pennsylvania law, and see infra pp. 10 to 12 for a discussion of Colorado law. 33 No. 74 MAP 2002, 2005 Pa. LEXIS 99 (Pa. Jan. 19, 2005). 34 2005 Pa. LEXIS at *45 (quoting Davidson and Jones, Inc. v. New Hanover, 255 S.E.2d 580, 584 (N.C. App. 1979)). 35 Id. at **47-48. 36 Presnell, 134 S.W.3d at 581-82. 37 Id. at 582. 38 Eastern Steel Constructors, 549 S.E.2d at 275. 39 Id. 40 Id. 41 The specific nature of a design professional’s duties may be impacted by (1) the contracts entered among the parties (e.g., the design contract and the contract between the owner and the contractor) and (2) the rules of professional responsibility (e.g., the West Virginia Rules of Professional Responsibility for Professional Engineers and the West Virginia Rules of Professional Conduct for Architects). Id. 42 99 P.3d 66 (Colo. 2004).

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43 74 P.3d 380 (Colo. App. 2003), rev’d 99 P.3d 66 (Colo. 2004). 44 Specifically, BRW owed “an independent duty to employ that degree of knowledge, skill, and judgment ordinarily possessed by members of that profession and to perform faithfully and diligently any service undertaken as an engineer in the manner a reasonably prudent engineer would under the same or similar circumstances.” 74 P.3d at 384. 45 Id. at 383. 46 Id. at 384. 47 BRW, Inc., 99 P.3d at 68. 48 Id. at 67. 49 “The essential difference between a tort obligation and a contract obligation is the source of the parties’ duties.” Id. at 72. 50 Id. (quoting Fundamentals of Construction Law 4-5 (Carina Y. Enhada et al., eds., 2001)). 51 Id. (emphasis added). None of the policy reasons underlying the economic loss rule depend upon the existence of a two-party contract. 52 Id. at 74-75. 53 “The economic loss rule marks the fundamental boundary between the law of contracts, which is designed to enforce expectations created by agreement, and the law of torts, which is designed to protect citizens and their property by imposing a duty of reasonable care on others.” Berschauer/Phillips Constr. Co. v. Seattle Sch. Dist. No. 1, 881 P.2d 986, 989-90 (Wash. 1994). See also Bilt-Rite, 2005 Pa. LEXIS at **52-63 (Cappy, C.J. dissenting) (Saylor, J. dissenting). 54 SME Indus., 28 P.3d at 681. 55 Id. at 683. 56 Id. at 672-73. Specifically, SME claimed that the defective specifications resulted in over 450 RFIs, numerous requests for change orders and requests for clarifications of the plans and specifications. 57 Id. at 683-84. The only possible claims available to the subcontractor against the design professional were those assigned by the owner based upon an alleged breach of contract and breach of warranty. The propriety of these claims was questionable because of an anti-assignment clause in the design contract. The Supreme Court of Utah found that the clause was ambiguous, and, therefore, a determination of the scope of the anti-assignment provision was a factual issue that was inappropriate for resolution on summary judgment. Id. at 674-77. 58 Id. at 684 (quoting American Towers Owners Ass’n v. CCI Mech., Inc., 930 P.2d 1182, 1192 (Utah 1996)). This reasoning applies equally to any claim by the contractor for negligence against the design professional for economic damages. 59 Rissler & McMurray Co. v. Sheridan Area Water Supply Joint Powers Bd., 929 P.2d 1228, 1235 (Wyo. 1996). 60 Id. 61 Id. 62 Berschauer/Phillips Constr., 881 P.2d at 993. 63 Id. at 992. 64 Id. at 993. 65 2314 Lincoln Park West Condo. Ass’n v. Mann, Gin, Ebel & Frazier, Ltd., 555 N.E.2d 346 (Ill. 1990); Tolan & Son, Inc. v. KLLM Architects, Inc., 719 N.E.2d 288 (Ill. App. 1999). Under limited circumstances an engineer or architect may be in the business of supplying information, e.g., where he or she was retained to provide an analytical end product. 719 N.E.2d at 437-38.

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66 353 S.E.2d 724 (Va. 1987). 67 Id. at 727. 68 Sensenbrenner v. Rust, Orling & Neale, Architects, Inc., 374 S.E.2d 55, 58 (Va. 1988). 69 Jones, supra note 13, 59 U. CIN. L. REV. at 1095-96 (analyzing McKinney Drilling Co. v. Nello L. Teer Co., 248 S.E.2d 444 (N.C. App. 1978) and Bagwell Coatings, Inc. v. Middle South Energy, Inc., 797 F.2d 1298 (5th Cir. 1986) (Mississippi law)). 70 Id. 71 Bechtel & Co. Contractors, Inc. v. Providence Hosp., 454 So.2d 496 (Ala. 1984) (third parties not entitled to the benefit of contract standard which differed from the standard of care in negligence actions). 72 The Supreme Court of Washington recognized the additional complexities of allowing tort and contract remedies to overlap in the construction industry. Berschauer/Phillips Constr., 881 P.2d at 826-27. The court stated:

[I]t is in this industry that we see most clearly the importance of the precise allocation of risk as secured by contract. The fees charged by architects, engineers, contractors, developers, vendors, and so on are founded on their expected liability exposure as bargained and provided for in contract. As Justice Cardozo warned, the expansion of duty in tort to include economic interests would expose defendants

to a liability in an indeterminate amount for an indeterminate class. The hazards of a business conducted on these terms are so extreme as to enkindle doubt whether a flaw may not exist in the implication of a duty that exposes to these consequences. Ultramares Corp. v. Touche, 255 N.Y. 170, 179-80, 174 N.E. 441, 74 A.L.R. 1139 (1931).

Id. 73 560 N.E.2d 206 (1990). 74 Id. at 212 n.4. 75 Id. 76 Id. 77 In support of its reasoning, the court cited other construction cases, which similarly expressed concern that permitting a claim in tort may allow a contractor to avoid its contractual bargain. Id. at 212. For example, in Bryant Electric Co., supra, the contractor filed suit against the project owner for breach of contract and the architect for negligence in the United States District Court for the Eastern District of Virginia. 762 F.2d at 1193. The Court of Appeals for the Fourth Circuit recognized that permitting such claim to proceed would avoid the forum selection clause agreed to by the contractor and owner. Similarly, in Bates & Rogers Constr. Corp. v. North Shore Sanitary Dist., 471 N.E.2d 915 (Ill. App. Ct. 1984), the contract between the owner and contractor included a no damage for delay clause. By allowing the contractor’s negligence claim against the engineer seeking excess construction costs caused by delay of the project, the agreed to no damage for delay clause would be rendered meaningless. Id. at 976. See also BRW, Inc., 99 P.3d at 73 (recognizing that the subcontract required the subcontractor to resolve all

28

disputes arising from the contract pursuant to the administrative claims procedure required by the general contract); Jones, supra note 13, 59 U. CIN. L. REV. at 1097 (“Tort law should not be employed as a means of rewriting the owner-contractor agreement and affording the contractor compensation and protection in excess of that agreed to by the parties.”).