The Economic Loss Doctrine’s Relevance To Construction Cases And Recent Application In Arizona And North Carolina

By Jessica Scarbrough

INTRODUCTION

Understanding and calculating damages that may be recoverable is an essential element in any claim or lawsuit, as such informs on how to defend and how to work toward a resolution.  This is especially relevant in construction litigation where damages can be large and accrue over a sustained period of time.  Of equal import is knowing what is not recoverable.  The economic loss doctrine (“ELD”) is one limitation on recoverable damages that will often apply to construction cases.  Its meaning and application are also in flux. 

A majority of jurisdictions have adopted some form of the ELD; however, interpretation and application of the ELD vary widely.    Case in point, the highest courts in both Arizona and North Carolina recently addressed the ELD and did so in distinct ways.  This article serves to review and analyze the implications of the recent Arizona and North Carolina decisions, with special attention paid to how their holdings impact contractors and subcontractors for commercial construction projects.

WHAT IS ECONOMIC LOSS DOCTRINE?

There is no uniform definition, but broadly speaking the ELD is a prohibition of recovery in tort (i.e., a claim for negligence) for purely economic losses. Such losses are generally limited to a claim in contract. A threshold question when evaluating the applicability of the ELD is whether the alleged damages arose out of conduct that is fundamentally tortious or contractual in nature. Said differently, the ELD does not permit recovery from another’s allegedly tortious conduct where the alleged damages are not for physical injury or property damage (in other words, injury to property or person is not considered economic loss).  Consequently, economic losses (e.g., delay damages, cost to redesign, etc.) are not recoverable in most instances if there is no contractual privity.

While seemingly simple on its face, the ELD has been complicated by differing judicial interpretations in many states and modern project delivery methods which can blur the lines of contractual privity.    Thus, an important baseline question, especially as it applies to construction and design professionals, is whether contractual privity exists with whoever is asserting the claim.

ARIZONA

Decided on May 23, 2022, by the Supreme Court of Arizona, Cal-Am Properties Inc. v. Edais Engineering Inc. held that design professionals are not liable to third-parties with whom there is no contractual privity for purely economic losses. See generally Cal-Am Properties Inc. v. Edais Engineering Inc., 509 P.3d 386 (Ariz. 2022).  Though never expressly stated in the opinion, the legal reasoning employed in the Cal-Am case rested on the principles of the ELD.

Facts

Cal-Am Properties Inc. (“Cal-Am”) was a developer of RV and mobile-home parks.  In 2014, Cal-Am leased an RV resort in Arizona (the “Property”), intending to construct a banquet and concert hall on the premises (the “Project”). The owner of the Property funded, and Cal-Am managed. the Project.  Cal-Am hired a contractor, VB Nickle, to design and construct the hall.  VB Nickle hired Edais Engineering, Inc. (“Edais”) as a subcontractor to survey the Property and mark the permitted location of the hall.  Cal-Am and Edais did not have contractual privity.   Edais conceded that it erred in placement of the markers for the location of the hall, and Cal-Am sued Edais for various claims, including negligence.

Edais successfully moved for summary judgment on the grounds that Cal-Am’s damages were purely economic, and  Edais did not owe a duty to Cal-Am.  The Court of Appeals affirmed the trial court’s decision and the Supreme Court of Arizona granted review to “reexamine” its holding from a 1984 case, Donnelly Construction Company v. Oberg/Hunt/Gilleland, that allowed design professionals to be held liable to third parties who suffered purely economic damages resulting from foreseeable harm following professional negligence.  See generally Donnelly Construction Company v. Oberg/Hunt/Gilleland, 677 P.2d 1292 (Ariz. 1984).

Cal-Am Decision

The Arizona Court summarized its prior holdings in Donnelly and explained that in a 2007 decision, Gipson v. Kasey, it held that Arizona courts should not consider foreseeability as a factor when making determinations of duty.  See generally Gipson v. Kasey, 150 P.3d 228 (Ariz. 2007).  The Court stated that its prior holdings in Donnelly had been repeatedly rejected since Gipson, but that, in rejecting Donnelly, it had not foreclosed the possibility that a duty may exist between design professionals and those not in privity with them.

Utilizing a post-Gipson framework, the Arizona Court explained that duties are based on special relationships or public policy.  In Arizona, special relationships are what give rise to a duty in negligence and/or relationships recognized under contract law.  The Court stated that a special relationship required a “preexisting, recognized relationship between the parties,” and  that was not present between Cal-Am and Edais simply because Cal-Am was the project owner and Edais a subcontractor who worked on the Project.  Unequivocally, the Court wrote that “Arizona has yet to recognize the relationship between a design professional and an owner as a categorical special relationship. We decline to do so now.”

Further, the Court held that “although liability for a joint undertaking may exist despite a lack of privity” between Cal-Am and Edais, that concept would require Edais’ conduct to have been undertaken directly with or for Cal-Am.  However, the Court explained that no such liability would exist where parts of an overall enterprise were organized by another entity.  Ultimately, the Court held that because Edais’ actions were with and for VB Nickle there was no special relationship between Cal-Am and Edais.

The Court also examined Arizona’s public policy framework, similarly holding that public policy was not implicated as a result of Cal-Am suffering a purely economic injury.  In Arizona, a duty based on public policy is created by state statutes and, to a lesser extent, the state’s common law. For an Arizona statute to create a duty based on public policy, the plaintiff must be “within the class of persons to be protected by the statute,” and the harm must be of the type “the statute sought to protect against.”

The Court ruled that state statutes and administrative regulations governing qualification and minimum standards for design professionals did not support recognizing a special relationship.  The purpose of the statutes and regulations governing design professionals was not to protect project owners like Cal-Am from economic harm, but rather, to protect the safety, health, and welfare of individuals who would enter the buildings and structures, by preventing injuries resulting from poor workmanship.  

The Court concluded its decision, writing:

Our holding does not render Cal-Am or similarly situated plaintiffs devoid of a remedy. In general, when a project owner is economically harmed due to a subcontractor’s negligence, it ‘is viewed just as a failure in the performance of [the subcontractor’s obligations] to its contractual partner, not as a breach of duty in tort to…the owner of the project.’ Restatement (Third) § 6 cmt. b. The remedies available to the project owner sound in contract, not tort. For example, in a case of a subcontractor's defective workmanship, as here, the project owner could sue the general contractor it hired for breach of contract and, perhaps the subcontractor for breach of contract as a third-party beneficiary… or obtain an assignment of liability from the contractor.

Takeaways for Design Professionals

The Court in Arizona has clarified design professionals’ responsibilities toward other parties where there is no privity.  However, it must be noted Arizona permits parties to contract out the ELD at the time they negotiate project contracts.  Care must be taken in reviewing contracts to be sure this important protection is not impacted.   

NORTH CAROLINA

North Carolina jurisprudence has taken a different approach to the ELD, finding that lack of contractual privity is immaterial to the application of the ELD.  The Court in Crescent University City Venture, LLC v. Trussway Manufacturing, Inc., 852 S.E.2d 98 (N.C. 2020), held that a negligence claim against a product manufacturer was precluded by the ELD, even though there was no contractual privity between the owner and manufacturer.  This holding has since been distinguished by federal district court opinions and an additional North Carolina Supreme Court decision.

Facts

Crescent University City Venture, LLC (“Crescent”) was the owner and developer of an initiative to build and lease several student apartment buildings (the “Project”) near the campus of the University of North Carolina at Charlotte (the “Property”).  In 2012, Crescent entered into a contract with a general contractor to construct the Project.  The general contractor entered into a variety of agreements with subcontractors to facilitate the construction, including a subcontract with Madison Construction Group, Inc. (“Madison”).  Madison was responsible for the provision and installation of wood framing for the Project. 

Madison executed a purchase order with Trussway Manufacturing, Inc. (“Trussway”) for trusses.  The purchase order included the Project specifications for the trusses needed and an express warranty.  Construction was completed and ceilings thereafter began to crack and sag.

An investigation was conducted, and it was determined that there were “systemic and pervasive” floor-truss defects throughout the Project.  Crescent and the general contractor disagreed on how to conduct repairs.  As a result, Crescent developed a repair plan with the engineering firm it had hired to investigate the Project.

Litigation ensued among the general contractor, Crescent the general contractor’s parent company and Trussway.  Trussway filed a motion for summary judgment, alleging that Crescent’s negligence claims against it were barred by the ELD.  The Business Court agreed with Trussway, dismissing Crescent’s negligence claim and applying the ELD “irrespective of the existence or lack of a contractual relationship between Crescent and Trussway”.  

Crescent Decision

On appeal, the North Carolina Supreme Court began by stating that when applying the ELD, North Carolina courts have long refused to recognize breach of contract claims disguised as negligence claims.  Adopted by the Court in N.C. State Ports Authority v. Lloyd A. Fry Roofing Co., the ELD bars recovery in tort by a plaintiff against a promisor for the simple failure to perform the contract, even if such failure was a result of negligence or lack of skill.

Analyzing and applying precedent from the U.S. Supreme Court, the North Carolina Supreme Court focused on the purpose of the ELD, citing East River S.S. Corp. v. Transamerica Delaval, Inc., when writing that the ELD served to prevent contract law from drowning in a sea of tort.  East River S.S. Corp. v. Transamerica Delaval, Inc., 476 U.S. 858 (1986). 

Crescent argued that the application of the ELD hinged on the existence of a contract between parties; however, the North Carolina Court rejected that premise.  Instead, it reasoned that Crescent’s position was in conflict with the Court’s decision in Ports Authority, highlighting that the decision was specific to the commercial-development context.  The North Carolina Court found that:

The lack of privity in the commercial context between a developer and a subcontractor, supplier, consultant, or other third party—the potential existence of which is readily known and assimilated in sophisticated construction contracts—is immaterial to the application of the economic loss rule.

The Crescent Court took care to differentiate and emphasize the importance of the commercial relationship(s) between the parties, citing policy considerations when applying the ELD to private residences and/or homeowners.  The Court reasoned that there are different considerations between the type of entities involved, as homeowners are often less sophisticated or knowledgeable while investing in homes.  However, given that Crescent, Trussway, and the other relevant entities were all sophisticated, commercial parties, the North Carolina Court took a different approach toward Crescent’s negligence claim and held that the ELD applied.

The Court concluded by holding that, when there is a contract in existence that covers the injury complained of, the ELD bars tort claims seeking economic losses.  Where a contract exists, plaintiffs like Crescent are required to look toward contractual remedies.

Additional Decisions

Slip opinions from a federal district court applying North Carolina law and a subsequent North Carolina Supreme Court case have uniquely discussed and distinguished Crescent’s holding.

New Dunn

Shortly after the Crescent decision, the United States District Court for the Eastern District of North Carolina issued a slip opinion in New Dunn Hotel, LLC v. K2M Design, Inc., No. 5:20-CV-107-FL, 2021 WL 1910033, *1, (E.D. N.C. May 12, 2021).  In this opinion, the District Court explained that, under North Carolina law and application of the ELD, a tort action does not lie against a party to a contract, and that it is contract law – not tort law – that defines the obligations and remedies of the parties in relevant circumstances.  Stated differently, the District Court explained that the relevant inquiry is whether the plaintiff has a basis for recovery in contract or warranty.  If they do, the ELD applies.  If they do not, then the ELD is not applicable and will not limit plaintiffs’ claims. 

The District Court distinguished the New Dunn facts from Crescent by reasoning that, in Crescent, even if contractual privity did not exist between Crescent and Trussway, Crescent had contractual avenues for recovery for the claims brought under negligence.  Mainly, Crescent could – as the North Carolina Supreme Court suggested – sue the general contractor and go down the line in that manner to recover its losses.  However, in disavowing the application of the ELD in New Dunn, the District Court reasoned that the plaintiff did not have that bargained-for means of recovery.  Utilizing that understanding, the District Court held that the ELD did not apply to the plaintiff in the New Dunn action because the contracts at issue did not address the claims the plaintiff had brought.  Thus, the plaintiff had no remedy under contract law. 

United States for use and benefit of Schneider Electric

In United States for use and benefit of Schneider Electric Building Americas, Inc. v. CBRE Heery, Inc., No. 5:20-CV-00257-BR, 2021 WL 5114653, *1 (E.D. N.C. July 26, 2021), the United States District Court for the Eastern District of North Carolina issued another slip opinion speaking to North Carolina’s application of the ELD and the Crescent decision.  In this matter, the District Court responded to arguments regarding both the application of North Carolina law and adherence to federal Circuit Court precedent.

The District Court rejected arguments that the ELD was applicable to a plaintiff who had some contract privity but where said contracts did not address the claims filed.  The Court held that because the contracts did not account for the plaintiff’s claims, the plaintiff otherwise lacked a basis for recovery in contract or warranty.  Further, the District Court rejected arguments that the Crescent decision made a prior Fourth Circuit decision, Ellis v. Louisiana-Pac. Corp., unviable.  See generally Ellis v. Louisiana-Pac. Corp., 699 F.3d 778 (4th Cir. 2012).  To the contrary, the District Court held that both decisions were in accordance with the other, as Ellis had determined that the relevant ELD inquiry was whether the plaintiff had a basis for recovery in contract or warranty.

The District Court also commented on the narrowness of the Crescent holding, emphasizing that it was applicable only in commercial settings.

Cummings

At the end of 2021, the North Carolina Supreme Court issued a decision in Cummings v. Carroll, where it touched on its prior holdings in CrescentSee generally Cummings v. Carroll, 866 S.E.2d 675, 686 (N.C. 2021).  In the Cummings action, the North Carolina Court held that the ELD did not bar plaintiffs’ claims of fraud, negligence, and negligent misrepresentation against various defendants where the alleged conduct underlying the claims at issue were not enumerated in the contracts.  In finding that the ELD did not apply to plaintiffs’ claims, the Court advanced two main justifications; i) the claims did not implicate the terms of the contracts between the parties, and ii) it was not a commercial transaction. 

The Court wrote that because certain language was not incorporated into the contract that language could not serve as a basis for the application of the ELD.  Specifically, the Court reasoned that important representations were omitted from the agreement.  Thus, the defendant(s) had not been bound to the performance of the contract or the personal liability it would have otherwise contemplated.  As such, the Court held that the defendants lacked the privity of contract necessary to support the invocation of the ELD.

The North Carolina Court dispatched arguments regarding Crescent’s applicability to Cummings and similarly situated plaintiffs though, emphasizing that Crescent’s holdings were only applicable to commercial transactions.  That being said, its holding in Cummings supports the reasoning employed by the United States District Court for the Eastern District of North Carolina in its opinions regarding commercial transactions. 

Takeaways for Design Professionals

North Carolina’s application of the ELD appears to rest on contract formation and the terms within a contract’s four corners.  While Cummings discussed non-commercial transactions, its reasoning paralleled that of the United States District Court for the Eastern District of North Carolina slip opinions.

As such, the general rule in North Carolina is that if a contract or warranty of some kind specifically enumerates or contemplates the claims alleged in a complaint, the courts will apply the ELD and bar tort recovery for purely economic damages.  However, in circumstances where the contracts are ill-formed, missing terms relevant to the claims, and/or non-existent, the courts may permit tort recovery for purely economic damages.  Though not binding to North Carolina state courts, the opinions from the United States District Court for the Eastern District of North Carolina raise concerns for design professionals.  In New Dunn, Schneider, and in a subsequent matter, Walbridge Aldinger LLC v. Cape Fear Engineering, Inc., the District Court permitted tort damages against design professionals.  Further, Schneider reasoned that unless there is a contract that contemplates the alleged claims, parties are not barred from seeking tort damages.  This is contrary to many other jurisdictions that bar tort recovery when a contract exists but provides courts with more nuance and aggrieved parties more flexibility.