The Essence of California’s Economic Loss Rule
The general concept of the economic loss rule is that there is no tort liability if the only injury is to the subject of a contract and is purely economic. The rule has been described as "a judicially created doctrine of common law applications."
The rule applies where a plaintiff seeking economic loss in tort has an alternative remedy in contract law, generally under the law of contracts. California courts have applied the rule to noted that "when a plaintiff suffers purely economic damages arising from a contract, its remedy lies in contract law and not tort law."
Originating in the 19th century, often in the construction defect context, the economic loss rule denies recovery in tort for economic losses when the defendant’s conduct breaches a duty that defines the contract. In construction defect cases , for example, the rule would bar tort recovery where the construction contract prescribes a specific standard of care or type of work. The rationale is that it is economic loss and contractual recovery that the parties bargained for; thus economic losses should be recoverable against any tortfeasor regardless of whether or not the contract or agreement has been breached.
The rule has an exception when a plaintiff suffers physical injury or property damage that is "independent" of the economic loss. In the construction defect context, where that physical injury is "integral" to the defect in question, recovery is permitted even though damage is otherwise barred by the economic loss rule.
How The Economic Loss Rule Finds Usage In California
In California, the Economic Loss Rule bars tort recovery for purely economic losses. Purely economic losses are defined as damages that do not result from personal injury or property damage. The Economic Loss Rule bars tort recovery where the plaintiff alleges a contract breach: "Plaintiffs alleging a breach of contract who seek to recover solely economic damages may pursue their claims only in contract." Commercial Ca. Deer Ass’n v. Aetna Cas. & Sur. Co., 15 Cal.3d 128, 139 (1975). This holds true even when the breach also amounts to negligence. See Weinberg v. Panasonic Corp., No. 16-CV-01517-MMC, 2018 WL 1932800, at *5 (N.D. Cal. Apr. 24, 2018); AAS v. Superior Court, 24 Cal.4th 676, 694 (2001).
Where the plaintiff alleges physical harm however, the Economic Loss Rule does not apply. When a tort "also cause[s] injury to a person, the measure of the tort damages is the physical harm and not the financial loss resulting from the harm." Aas, 24 Cal.4th at 691. The California Supreme Court has stated that: "The rationale for this exception . . . is that the law should not permit a commercial company to escape liability by insulating itself against ordinary business risks and then seeking indemnification from other parties by converting to tort the breach of its privately made contractual obligations." Seely v. White Motor Co., 63 Cal.2d 9, 18 (1965). As such, the Economic Loss Rule negatively impacts the ability of commercial companies to convert contractual obligations into tort liability by alleging negligence.
Exceptions To The Use Of California’s Economic Loss Rule
Notable exceptions to California’s application of the economic loss rule are fraudulent inducement and professional negligence. In an action for economic damages based on intentional or negligent misrepresentation, the parties are not limited to contract remedies. In such an instance, a tort and contract action may be maintained simultaneously. Robinson Helicopter Co., Inc. v. Dana Corp., 34 Cal.4th 979 (Cal. 2004). Accordingly, a party can pursue a tort action where the tort concerns a harm resulting from the breach of a duty separate from that imposed by law or assumed by the contract itself. Navallier v. Sletten, 29 Cal.4th 82 (Cal. 2002). Fraudulent inducement is one exception to the economic loss rule. When one party to a contract misrepresents information about the contract to the other party regarding subject matter that is critical to the contract, allowing a fraud action, the negligent misrepresentation tort is a proper remedy even though the misrepresentation was made to induce contract formation. Id.; Comet Metal Prods., Inc. v. Ins. Co. of State of Pa., 80 Cal.App.4th 747 (Cal. Ct. App. 2000); Ingrid & Isabel, Inc. v. Baby Be Hip, Inc., 214 Cal.App.4th 1300 (Cal. Ct. App. 2013) (citations omitted). Professional negligence is another exception. Adapting the economic loss rule to suit the problem at hand, California courts recognize that professionals owe a duty of care to non-clients in some circumstances. Bily v. Arthur Young & Co., 3 Cal.4th 370 (Cal. 1992). In Amabilis v. Jumbo, Inc., 234 Cal.App.2d 1, 5 (Cal. Ct. App. 1965), the court stated that liability in tort is considered when a single act constitutes two different wrongs against two different persons. There, the plaintiffs were a group of licensed dentists and their professional corporation. These dentists also owned an interest in a corporation which purchased dental implants from defendants. The doctors alleged that due to defects in the product and misrepresentations by defendants regarding the safety of the product, the dental implants caused serious injuries to the patients, who were not parties to the contract. The trial court concluded that the only basis of liability would be found pursuant to the Uniform Commercial Code. The reviewing Court disagreed, holding that although the plaintiff-dentist’s purchases of the dental implants were governed by the U.C.C., the plaintiffs could also proceed with an action in tort, independently of their claim for breach of warranty. Id.
Key Cases Relating To California’s Economic Loss Rule
In the case of Callahan v. Boozer (2007), the Court of Appeal for the Second District provided a thorough analysis of the economic loss rule in California. The Court of Appeal for the Second District expressly addressed the application of the economic loss rule to a negligent misrepresentation claim by a plaintiff purchaser against the defendant builder and real estate brokers. The court found that negligent misrepresentation claims that do not allege as fraudulent the defendant’s intent to include a material fact have been deemed to sound only in tort and not in contract. Thus, a negligent misrepresentation claim against the builder was allowed to proceed as a tort claim, notwithstanding the parties’ contractual relationship.
In Economy Plumbing & Heating Co. v. Beverly Hills, Etc. (1966), the Court of Appeal for the Second District applied the economic loss rule to determine whether a property owner could hold a plumbing subcontractor liable for economic damages as a result of faulty plumbing work. The court found that a property owner’s tort claim against a plumbing subcontractor employed by the general contractor was barred because the owner failed to show that the plumbing subcontractor had a duty to provide any contractual protections toward the owner beyond that which the general contractor was obliged to provide.
In J’Aire Corp. v. Gregory (1979), the Supreme Court of California determined that a negligence claim for purely economic damages resulting from a contractual breach would lie when the plaintiff showed that the defendant owed a separate duty of care outside of the alleged contract. In that case , the plaintiff contracted to purchase pre-cast concrete steps and other materials for an apartment development. The defendant failed to provide all the materials as ordered, which delayed the completion of the development. The Supreme Court held that the economic loss rule should not bar a claim where the defendant was an experienced supplier of the item that was never delivered, the defendant was aware that prompt delivery was essential to the successful completion of the project, and the plaintiff was a sophisticated customer that was in direct contact with the defendant.
In Aas v. Superior Court (2000), the Supreme Court of California determined that homeowners could not recover lost profits in negligence against their homebuilder for economic damages resulting from latent defects that were not readily apparent. The court reversed the judgment with directions that the trial court: 1) delete the phrase "or negligence" from the finding in paragraph 11 on page 10 of the trial court’s order, 2) modify the judgment to exclude any references to "negligence," and 3) enter a new judgment.
In Jimenez v. Superior Court (2002), the Supreme Court of California determined that an owner-occupier could not recover economic damages from a defendant subcontractor for construction defects that occurred during the construction of an office building. The Supreme Court stated that its prior decision in South Central Farmers exited the realm of economics for government tort liability in California and could not be reconciled with the economic loss rule. Jimenez distinguished its ruling from the court’s decision in Aas by noting that the plaintiffs in Aas were more akin to remote owners that the court excluded from the class of potential tortfeasors under its decision in Jimenez.
What The Economic Loss Rule Means For Businesses And Consumers
For California businesses, the economic loss rule creates a nuanced landscape for managing the risk of liability. Contractually, parties may be able to allocate risk through carefully drafted agreements, such as limiting both contract and tort liability in what is known as a "concurrent liability waiver." This type of waiver typically stipulates that parties’ liability in tort will be limited to the amount of liquidated damages specified in the contract. As an alternative to concurrent liability waivers, parties may opt to require the parties to submit tort claims to binding arbitration pursuant to the contractual terms of arbitration. These strategies can be useful in protecting against excessive liability in tort where limited or no contractual damages are available.
For consumers, the economic loss rule can preclude consumers from altogether recovering for defects or even serious personal injury when such injury is the result of defects in a defective product. Consumers may be able to recover for personal injury or other tort damages if such claims qualify as "wrongful" under tort law and fall outside the ambit of the economic loss rule. However, the practical reality is that many nuanced questions are involved in assessing whether a claim is merely a breach of warranty claim or qualifies as an independent wrongful acts claim. As discussed above, the California Supreme Court’s decision in Robinson Helicopter v. Dana Corp provides courts guidelines for analyzing this question of differentiation. It remains to be seen whether this decision provides sufficient protection for consumers given other conflicting California Supreme Court authority interpreting California’s Unfair Competition Law (Cal. Bus. & Prof. Code § 17200 et seq.) as creating a "private right of action" where there is "liability for breach of a non-competition agreement even if the wrong complained of constitutes the breach of a duty or agreement arising out of a contract." (See Stop Youth Violence Coalition v. Chevron U.S.A. (18 Cal.4th 75, 1998).)
Discussion And Discourse Around The Economic Loss Rule
One of the most debated issues related to the economic loss rule in California is whether a plaintiff is precluded from recovering purely economic damages for tortious breach of the insurance contract with their insurance company. One of the objectives of the economic loss rule is to prevent the law of torts from becoming a substitute for the law of contracts. However, much of the legal authority that has developed to bolster California’s current iteration of the economic loss rule is premised not on contract law principles but instead based on a categorical distinction between tort and contract law grounded in notions of duty, causation and foreseeability. With regard to recovery for purely economic losses, the primary "duty" statutorily recognized in the insurance context relates to an insurer’s duty to defend. Some courts appear to be expanding this "duty" further to compel rote payment of claims without conducting an analysis of whether the type of loss covered by the policy at issue is allowable.
Because the economic loss rule is an evolving doctrine, the scope and application of the economic loss rule in California is presently in flux. For example, in State Farm Mutual Automobile Insurance Co. v. Campbell, the Supreme Court suggested that tort liability may be imposed for an insurer’s fraud, malice or intentional infliction of emotional distress against an insured based on an insurer’s breach of the implied covenant of good faith and fair dealing.
More recently, the California Supreme Court expanded tort liability to encompass an insurer’s duty to its insured, independent of contract, as a tort to exercise reasonable skill and care in the gathering and evaluating of information during the course of settlement negotiations. See Croskey, 83 Cal. Rptr.3d at 593 (citing McKee v. State Farm Fire & Casualty Ins . Co., 772 P.2d 1044 (Wash. 1989)). The Croskey court reasoned: Although perhaps a contractual relationship is a prerequisite, a contractual relationship is not by itself sufficient to give rise to a tort duty. Nor does a contractual relationship give rise to that duty if there is nothing beyond a simple breach of the contract to indicate that the party has engaged in outrageous conduct beyond the breach itself.
Id.
Although the ruling in Croskey was apparently limited to the realm of unreasonable failure to settle a claim, the broader implication of the court’s holding is that an insurer’s unreasonable conduct (intentional or negligent) may serve as a basis for tort-based liability against the insurer. Interestingly, the Seventh Circuit in a non-California case, also implied that an insurer may be liable on a tort theory for an unreasonable denial of coverage. See Hurst v. Pace Suburban Bus Service, 223 F.3d 707, 713 (7th Cir. 2000) ("The reason why the insurer’s breach of its contract with the insured can give rise to a tort claim is that the breach is a breach of a duty owed to the insured independent of the contractual obligation. That independent duty in turn gives rise to a liability in tort; it is negligence of the insurer that causes harm to the insured.").
While some legal commentators have argued that tort liability should not exist in the insurance context because sanctions are available through the regulatory process and various causes of action may provide similar recovery as a tort action, the more appropriate policy rationale would seem to focus on whether the current frameworks fail to adequately protect consumers who are harmed by unfair insurance practices. Many of these issues will eventually culminate in judicial resolution, which in turn will shape the contours of California’s economic loss rule.