Tort, Not Contract: An Argument for Reevaluating the Economic Loss Rule and Classifying Building Damage as “Other Property” When It Is Caused by Defective Construction Materials

J. Brandon Sieg

Introduction

The economic loss rule (ELR) precludes bringing a tort action for economic loss, such as lost profits, when the parties’ expectations are governed by a contract.  The thesis of this Note is that building damage caused by defective construction materials should not be considered economic loss under the ELR as it currently is in many states.  Instead, this damage should be recognized as property damage, notwithstanding the overarching construction contract.

Unlike product manufacturing, which places the manufacturer in the best position to guarantee the performance of its products, building construction relies on the cumulative effort of builders and designers, along with all their consultants and subcontractors, to erect a building.  Because the contractor and architect—the only parties likely to contract directly with the building owner—do not have an analogous ability to evaluate the quality of each construction material before incorporating it into the project, the ELR should not place the entire risk of product failure on their shoulders.  It should instead recognize that the architect and contractor are merely providing a service to the building owner to design and assemble the building from marketable products.  When one of these products fails and damages the rest of the building, the construction contract should not serve as an umbrella to conceptually unify the entire construction project into a single product.  Rather, the ELR should recognize that the defective construction material was the sole cause of the building owner’s loss.  In other words, the fact that a prime contractor warrants the quality of materials used in a project should not preclude the building owner from bringing a tort claim directly against the remote construction material manufacturer.  The prime contractor’s warranty may be valuable to the building owner, but it has no bearing on the manufacturer’s underlying duty to ensure that his product does not pose an unreasonable risk of harm to the owner’s other property—the rest of the building.


I.
The Construction Contract

Building construction often relies on a plethora of interrelated contracts, subcontracts, and sub-subcontracts, especially in the context of commercial construction projects. Despite this multitude of contracts, a building owner typically negotiates and contracts with only two distinct parties: (1) the architect, who is responsible for designing the project, and (2) the prime contractor, who is responsible for building the proposed design according to the architect’s drawings and specifications. Each of these parties subsequently delegates responsibility for design and construction through a series of subcontracts. It is therefore very unlikely that the building owner will ever have the opportunity, or knowledge required, to negotiate the risk of product failure directly with a construction material manufacturer, supplier, or product representative because those parties are so far removed.


II.
The Economic Loss Rule

The ELR distinguishes personal injury and property damage, which are recoverable in tort, from mere economic loss, which is recoverable only under the terms of a contract. Therefore, a contract action, such as breach of warranty, is the only way a building owner can recover damages that are classified as economic losses.  The following discussion traces the development of the ELR and begins to show how it fails to appreciate the practical realities of procuring construction materials and assembling them into a building.


A.     A. MacPherson v. Buick Motor Co.

MacPherson v. Buick Motor Co. established basic principles of modern products liability.1 The plaintiff, MacPherson, was ejected from his car and injured after one of the wheels collapsed. MacPherson sued Buick, the car’s manufacturer, for negligence arguing that Buick would have discovered the defect if it had adequately inspected the wheel. Because MacPherson purchased the car from an intermediate dealer, he lacked any contractual privity with Buick. The question therefore became whether a remote manufacturer owes downstream consumers any duty that would support such a tort claim.

The court held that because many products are dangerous if they are negligently made, a manufacturer has a duty to make its products carefully. Privity of contract does not limit this duty; “the source of the obligation [is] where it ought to be … in the law.”2 Although the court touched on the relevance of this products liability principle to property damage, its holding was limited to personal injury.3


B.     Seely v. White Motor Co.

Almost fifty years after MacPherson, the Supreme Court of California reconciled products liability with the warranty provisions of the Uniform Commercial Code in Seely v. White Motor Co.4 Seely, a trucker, purchased his truck through an intermediate dealer. The sales contract contained an express warranty by the manufacturer, White Motor Company (White). One day, as Seely drove his truck, the brakes gave out and the truck rolled over. Unlike in MacPherson, Seely did not suffer any personal injuries, but the Seely court extended the scope of Judge Cardozo’s MacPherson analysis by equating property damage with personal injury. Seely has therefore been understood to hold that the law of warranty trumps tort in the absence of personal injury or property damage. In other words, economic losses are governed by contract, not tort.


C.     East River Steamship Corp. v. Transamerica Delaval Inc.

Whereas Seely represented the majority view by denying recovery in tort for economic losses, Santor v. A. & M. Karagheusian, Inc. outlined the minority position.5 Santor interpreted strict liability as an appropriate method of shifting the total cost of a defect from the consumer to the manufacturer. In East River Steamship Corp. v. Transamerica Delaval Inc., the Supreme Court of the United States gave a unifying voice to the ELR in favor of the majority view.6

The claims in East River arose from defective turbines on four chartered ships. Each of the ships’ turbines malfunctioned and forced the charterers not only to pay the cost of repairs but also to lose profits while the ships were being restored. The charterers sued the turbine manufacturer for negligence and strict liability, arguing that the defective design of the turbines led to their repair expenses and lost profits.

The Court, however, reasoned that the charterers should not be permitted to sidestep their deliberate allocation of risk by bringing a tort claim against the manufacturer of a component of the overall product. The Court’s interpretation of the ELR barred the tort claim for repair costs and lost profits by characterizing these losses as disappointed expectations in the product itself. When a product component damages the larger product, as opposed to other property, a plaintiff must ground his claim in contract law and look to the product’s warranty for recovery. The problem after East River became how to define the scope of “other property,” which would support a products liability action.


D.     Saratoga Fishing Co. v. J.M. Martinac & Co.

In Saratoga Fishing Co. v. J.M. Martinac & Co.,7 the Court confronted the flaws of East River by looking to the practical realities of a commercial transaction. In Saratoga, a shipbuilder, Martinac, built a fishing vessel and sold it to a fisherman. This fisherman used the ship for several years. During that time, the fisherman installed nets and additional fishing equipment on the ship. He subsequently sold the ship to a fishing company, Saratoga. After the sale, a defect in the ship’s hydraulic system, which Martinac had installed, caused the ship to catch fire and sink. Saratoga sued Martinac for the cost of the added fishing equipment that sank along with the ship.

On appeal, the Ninth Circuit applied a textbook East River analysis, classifying Saratoga’s entire ship as the “product” and finding that the fishing equipment was merely a component of that product. To reverse the Ninth Circuit, the Supreme Court critically examined East River and the limits of warranty law. Although the Court acknowledged that Saratoga could have negotiated a warranty with the fisherman to cover both the ship and the equipment, it would be unreasonable to require such a warranty for recovery. The fisherman was distinguishable from a manufacturer or a component supplier because he lacked the ability to “systematically control the manufactured product’s quality or … systematically allocate responsibility for [the equipment he added] in similar ways” as those used in the manufacturing process.8 The Court explicitly held that once a buyer purchases a product from the manufacturer or distributor, any subsequently added equipment ought to be considered “other property” under the East River analysis.9

The Saratoga Court’s reasoning appreciates the purchase of a product from the marketplace as a demarcation between a product’s manufacture and its subsequent use. In the context of complex commercial transactions, such as building construction, this approach provides a logical distinction between service contracts with the consumer and sales contracts with the manufacturer. Most importantly, it suggests a clear limit to the product-component analysis of East River. As the Supreme Court reasoned, a re-seller’s warranty for a product should not eliminate the possibility of tracing a tort action back to the original manufacturer.

III. The Economic Loss Rule in Construction Material Defect Cases


A.     Application of the Economic Loss Rule in Construction Cases

States have independently adopted their own versions of the ELR, often including some form of the East River product-component analysis. Because construction law is a specialized subset of contract law, state courts frequently apply a previously established ELR to construction claims without evaluating the unique aspects of construction contracts. As a result, the East River product-component analysis, rather than the Saratoga marketplace analysis, tends to provide the framework for evaluating the ELR in construction law claims.

When applying the product-component analysis, courts will likely classify an entire building, defined by the contractual scope of work, as the product. Construction materials are therefore often classified as components of a unified product: the building. When these construction materials fail and damage the rest of the building, such building damage will likely be classified as economic loss, which is barred from recovery in tort.


B.     The Problem with Applying the Economic Loss Rule to Construction Material Defect Cases

As discussed above, a single contract rarely governs an entire construction project. Instead, a chain of contracts dictates each participant’s role in the project. These contracts include both service contracts and sales contracts. The building owner is only a party to a portion of these contracts and is rarely a party to the sales contracts for the construction materials.

This contractual paradigm severely limits each participant’s ability to negotiate the risk of defective construction materials. Although contractors typically provide a warranty to guarantee the quality of the materials used in the project, the building owner usually lacks any meaningful capacity to negotiate risk directly with a manufacturer or supplier. Liability for harm caused by defective materials is therefore forced to trickle through the chain of contracts, tracing individual warranties. Thus the ELR tends to encumber courts with complex, wasteful litigation.

To understand why this contractual structure does not represent the warranty theories of Seely or East River, one must distinguish a negotiated allocation of risk from a construction contract’s use of warranty to transfer the cost of defects back to the source of the defect. Consider Seely’s purchase of the truck. Seely approached the truck market with unilateral authority to evaluate the risk posed by each truck he encountered. He had the freedom to balance this risk against the sale price and his desire to purchase the truck. By purchasing White’s truck, Seely accepted a risk that reflected his personal valuation of these factors. The contract therefore adequately accommodated the possibility that the truck would not meet Seely’s expectations. In essence, the contract allocated risk.

As described above, construction projects use a different process. The selection of each product relies on the assent of multiple parties within the project. The contractor or subcontractor who purchases a product relies on the architect’s specifications to select adequate construction materials. Likewise, the building owner relies on the contractor or subcontractor to negotiate the purchase of the materials and screen for defects once the materials are delivered to the site. No single party has unilateral authority to make decisions about what product to use; the process is cumulative.

This lack of unilateral authority precludes any individual member of the project from conducting and overall cost-benefit analysis of a single manufacturer’s product relative to alternative products. Instead, each member must rely on the overall structure of the construction contract to transfer the potential cost of defective products to someone else. The individual construction contracts within the chain, therefore, do not represent a negotiated allocation of risk as envisioned by Seely or East River. Indeed, they merely establish a framework to transfer the cost of defects when a building owner triggers the warranty provisions.

This cost-transference role of construction contracts shows that the mere presence of a warranty should not represent the kind of deliberate contemplation and negotiation of risk that Seely or East River deemed appropriate to govern a purchaser’s expectations in a product. When warranty merely provides a structure of cost transference, contract law should not be considered superior to a legal allocation of risk in tort.


IV.
Proposed Solution

This Note criticizes the East River product-component analysis on the grounds that it relies too heavily on a desire to provide a bright-line separation of tort from contract.10 were allowed to progress too far, contract law would drown in a sea of tort.”).] This framework leaves little flexibility for complex agreements, such as construction contracts, that mix service contracts with sales contracts. Courts should distinguish the services in a construction contract from the sales contracts for construction materials. As described above, Saratoga provides a useful framework for this distinction. It appreciates the ultimate purchase of a product from the market as a static limit on the conceptual expansion of that product. Using the Saratoga analysis, courts should classify individual construction materials, rather than entire construction projects, as the products governed by the ELR.

Under this theory, an owner would be permitted to bring a tort action for the damage that a defective construction material caused to the building, regardless of the contractual fortuity surrounding the initial purchase of that material. The ELR would still apply to true economic losses, such as defective design or the harm an individual material caused to itself, because these are risks that are adequately allocated and governed by construction contracts.

Conclusion

Construction material defect claims show that the East River product-component analysis is not justified by the mere presence of an overarching contract or warranty. Courts should reevaluate this analysis to accommodate the practical application of warranty in complex contract structures, particularly in construction contracts. Saratoga has already established a useful framework to begin this reevaluation because it distinguishes between the strengths of contract and tort while appreciating the practical realities of warranty law in complex contractual relationships. Looking to Saratoga, courts should begin classifying building damage as “other property” when it is caused by defective construction materials.

Acknowledgements:

J. Brandon Sieg, J.D. Candidate 2012 William & Mary School of Law; B.S. 2005, Georgia Institute of Technology. Thank you Professor Peter A. Alces, Randy Wintory, and Pat O’Leary for your encouragement in the early stages of this Note.

A version of this article appeared in the October 2011 issue of the William and Mary Law Review: http://wmlawreview.org/files/Sieg.pdf.

Copyright © 2012 William and Mary Law Review.

  1. 111 N.E. 1050, 1053 (N.Y. 1916) (Cardozo, J.).
  2. Id. at 1053.
  3. Id. at 1053. Judge Cardozo later expanded this principle to permit tort recovery for economic loss in an analogous situation. See Glanzer v. Shepard, 135 N.E. 275, 275-76 (N.Y. 1922).
  4. 403 P.2d 145 (Cal. 1965).
  5. 207 A.2d 305, 311-13 (N.J. 1965).
  6. 476 U.S. 858 (1986).
  7. 520 U.S. 875 (1997).
  8. Id. at 884.
  9. Id.
  10. See E. River S.S. Corp. v. Transamerica Delaval Inc., 476 U.S. 858, 866 (1986) (“It is clear, however, that if this development [of products liability

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