SCOV Law Blog: One trick contract

Editor’s note: This analysis of a recent Vermont Supreme Court ruling is by Daniel Richardson, the founder of SCOV Law Blog.

Long Trail Condo. Assoc. v. Engelberth Construction, Inc., 2012 VT 80.

There are concepts within the law that are the legal equivalent of St. Elmo’s Fire. They are unearthly, luminescent without illuminating, and harbingers of difficulty. The Economic Loss Rule is first and foremost among these will o’ the wisps.

The rule is a court-created doctrine that serves a simple and admirable purpose: bringing order and sense to business relationships and effectuating the intent of the parties. It says this: When the primary nature of the parties’ relationship is contractual and when the damage done is limited to the object/building that was purchased through the contract, then the recovery will be under the terms of the parties’ contract and not negligence.

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Got it? Basically, if you sign a contract to purchase something, and that something breaks, then you cannot file a negligence action — no matter what damage the object causes.

The purpose of this rule is best explained through an example. Say a contractor agrees to build a metal fire pit for $500, and the parties agree that any damage associated with the pit shall be no more than the cost of the pit. Then a spark from that fire pit burns down the surrounding deck and garage. Homeowner sues in negligence for the cost of the deck and garage as well as pain and suffering.

The Economic Loss Rule blocks such an action because otherwise the parties’ agreement to limit damages would be meaningless. Moreover, if the fire pit manufacturer now has to factor in negligence liability, fire pits are going to get a lot more expensive. Of course, the homeowner can probably collect the $500 from the fire pit maker, but the fact that the homeowner knew that the fire pit maker had limited his warranty should have put the homeowner on notice that he needed to supplement his risk protection (i.e., purchased insurance).

The big idea is that contracts allow the parties to allocate risk, to disclaim and define their specific responsibility through warranty, and to make clear from the outset what each owes the other. Negligence is designed for different situations where the parties do not have the benefit of negotiating what duty is owed to the other. When you crash your car, it is negligence because chances are you never met the other driver before, let alone negotiated the terms each owed the other on the open road. Instead, the law imposes a general duty (do not crash into one another).

But when you have been working with a customer, signed a series of agreements, and created a price schedule based on the cost of the product and the potential liability, a claim for negligence starts to look like a way of going around the whole process. That is not fair, and the courts have acknowledged this.

Here is the problem that makes the Economic Loss Rule such a difficult proposition. Trying to define what is strictly an “economic loss” and the contractual nature of the parties’ relationships gets confusing once you start piling on the layers of parties, and inevitably the case involves a semi-“innocent” party who is facing a recovery shortfall due to an accident or incident beyond her control.

Here is the problem that makes the Economic Loss Rule such a difficult proposition. Trying to define what is strictly an “economic loss” and the contractual nature of the parties’ relationships gets confusing once you start piling on the layers of parties, and inevitably the case involves a semi-“innocent” party who is facing a recovery shortfall due to an accident or incident beyond her control.

Today’s case is the example that proves the rule. Plaintiff is a homeowners’ association. That means that the members are the end users, the innocents who have purchased condominiums and must live with the alleged construction defects on which the association bases its lawsuit. Defendant contractor is a construction company which performed the work, built the condos and the structures. It should also be clear that plaintiff and defendant never entered into a contract with each other. In fact, plaintiff did not exist when defendant agreed to construct the condos and signed its original contracts.

That role was filed by a variety of players, none of which are named in the case but include the developer, the architect, the engineer, and other subcontractors who may or may not have been working under the direction of the defendant who was the general contractor for the project.

No one necessarily disputes that plaintiff’s grievances are real or that the massive repairs were necessary to correct defects in the building. As the SCOV notes in the beginning of this opinion, today’s case is just the latest in a series of lawsuits and negotiations between the multiple parties trying to allocate responsibility, cost, and payments.

The association’s theory of the case is fairly straightforward. Contractor owed a duty of care to the association that it breached by negligently constructing the building. That breach led to defects that have cost millions of dollars to repair and that if left untreated would have destroyed the buildings and caused property loss and personal injury.

Contractor’s defense is the Economic Loss Rule, and it is a winner. The nature of the association’s claims are economic losses (damage to the purchased product — in this case the building) as opposed to either personal injury or collateral property damage (think falling chimney crushing parked cars).

To apply the rule, though, the SCOV has to deal with the fact that the association and the contractor lacked privity (meaning that they never entered a contract with each other). But the SCOV has little problem extending the rule to parties that, while not in privity with each other, are part of a larger series of contractual relationships where the parties could allocate the risks. Therefore, privity, or lack of it, is not determinative, and the SCOV instructs that we must look to the larger nature of the relationship. Here the association is simply at the end of a series of contracts, and its rights are primarily defined by those contracts that allowed them to initiate a lawsuit against the developer at the beginning of the problems.

The SCOV next takes up the association’s argument that contractor owed them a professional duty that cannot be eliminated or waived away through contract. This is an exception to the Economic Loss Rule that says when the seller owes the buyer a higher, professional duty (think doctor, architect, surveyor or similar licensed professional), then the rule does not prevent recovery based on a negligent breach of this higher duty.

The problem is that the association is suing a contractor — albeit one of the largest in the state. Contractors in Vermont are not licensed, have not been held to higher standards, and have rarely been defined as “professionals.” So even though this contractor is a multi-million dollar business employing professionals and a consistent workforce, it receives the benefits of Vermont’s lower contractor standard that has largely been borne out through individuals and small businesses that have lacked training, professional licensure, or even consistent industry standards.

As a friend once put it, it is easier to catch the wind then to assign a duty of care to a contractor.

Lawyers have odd senses of humor.

So lacking a distinct level of professional care, the SCOV declines to find one for contractor based upon the specialized contracting services provided here. In fairness to contractor, this is reinforced by the parties’ contracts that made clear that contractor made no warranty or promise to the quality of the construction plans — in other words, it agreed to erect the structure and its systems according to the building plans — regardless of whether those instructions made sense or made a sensible structure.

The SCOV finally takes up the question of imminent harm. The association had argued that the threat of imminent harm (falling balconies, water running through the walls, and other serious defects) required the trial court to make an exception to the rule because the damage was more of the nature of an immediate danger to person and property that negligence is intended to protect, and the mere fact that no one was hurt is a small benefit that should not prevent the association’s action.

The SCOV finally takes up the question of imminent harm. The association had argued that the threat of imminent harm (falling balconies, water running through the walls, and other serious defects) required the trial court to make an exception to the rule because the damage was more of the nature of an immediate danger to person and property that negligence is intended to protect, and the mere fact that no one was hurt is a small benefit that should not prevent the association’s action. In other words, these defects were negligent and the association should not have to wait until someone is hurt or loses their car to a falling chimney to bring a personal injury tort claim.

The SCOV rejects this argument in the broadest terms available. The SCOV takes issue with the argument as a subversion of both contract and negligence law. As the SCOV notes, negligence law, apart from any contract issues, still requires an actual injury. You cannot get around this threshold element, and its absence is fatal to both plaintiff’s specific claim and its more general negligence theory. Therefore, the mere threat of personal injury is not enough to take a case out of the Economic Loss Rule no matter how serious or imminent the threat might be.

The SCOV is clear. There is a bright-line. Someone must be hurt or collateral property damaged before it will even consider such an argument, and parties will not be able to recast an economic loss issue in such terms without such actual injury.

So contractor escapes negligence liability — despite the fact that the association suffered damages in excess of its contractual remedies and the fact that the association never got to negotiate risk of loss with contractor. As indicated in the dissent, this will strike some as unfair and leave an “innocent” party without remedy, but as the SCOV notes, it is the necessary result of keeping the spheres of contract and negligence separate and preventing the law of tort to subsume the law of warranty.

As an indication of just how contentious the Economic Loss Rule can be, the SCOV’s opinion cites to no fewer than five different decisions over the past 12 years that have addressed different parts of the rule. No doubt that today’s case is far from the last time the SCOV will likely take up the issue in the next 12 years either.

This leads to second section of the opinion and a bit of a dispute within the SCOV.

The second section deals with the implied warranty of habitability and good workmanship that attaches to every newly built house or building. Like you would expect, this warranty covers latent defects, problems, and similar issues that are not obvious to the buyer upon taking possession and which are attributable primarily to the builder.

Sounds like a winner, except we run into another privity problem. This time, it is the very lack of privity that proves fatal to plaintiff’s claim.

The warranty of habitability and good workmanship only extends to the first purchaser of the building. In this case, it was the developer who ordered the construction, took possession, and then resold the units to the individuals who took possession of the common building as the association. Because contractor did not build the structure for the association, the association cannot come back at contractor with a warranty claim. The association can only sue developer.

Before too many tears are shed, it is important to know, as the majority notes, that the developer has initiated a lawsuit against the contractor seeking many of the same damages sought by the association. Presumably if the developer is successful, that award will flow down the line to the association (unless settlement agreements to the contrary prevent such).

The SCOV is clear that only by going up and down the lines of privity (buyer sues seller who sues contractor who presumably sues subcontractor who then declares bankruptcy) can the association hope to seek recovery. Any attempt to run around this chain will be swatted down under the Economic Loss Rule or the failure of privity between parties on a warranty claim.

This does not sit well with specially assigned trial court Judge Kupersmith and Justice Johnson who joins his dissent. For the dissent, which is limited to the implied warranty portion of the opinion, applying the rule of privity to prevent the association from recovering is a meaningless extension of legal form that is unwarranted and unfair.

The dissent appears to be hunting bigger game than the present case as it endorses removing the privity rule for any home builder warranty claim. The idea is that anyone who ends up owning a defective home should have the right to pursue the builder, regardless of whether they are the first, second, third or even fourth owner. The only limit, argues the dissent, should be time. And even that should be governed by a sliding scale of reasonableness.

The idea behind the dissent is this: Builders are obligated to build good houses. We live in an increasingly mobile society where it should come as a surprise to no one that a house built today may be sold three or four times in as many years (although with Vermont’s Land Gains Tax that might not be as reasonable an assumption as other states). So it should come as no surprise to a builder if her product is sold at least once before a latent defect is discovered. Given such realities, it is unfair and somewhat absurd to force homeowners to sue up the chain of ownership and require multiple lawsuits for what might be accomplished in one.

The majority gives the dissent’s proposal short shrift because the present case represents the middle of a series of lawsuits that if not stemmed through legal doctrine, such as privity, would threaten to generate an infinite litigation loop. Moreover, the dissent’s argument is based upon cases reflecting much simpler facts. As the majority notes, nearly every case cited by the dissent concerns a single family home, a series of quick sales, and an independent builder/developer. In such cases where there is no other source for compensation, the suspension of the privity rule is more equitable. But since those facts are not present, the majority declines the dissent’s invitation to expand the law and sticks with what it knows.

Still, the dissent’s argument is beguiling, and there is some sense to its reasoning. Expect to see this portion of the opinion cited in a number of single-home-construction-defect cases over the coming year. But like the mythic will o’ the wisp, it remains to be seen whether the dissent’s reasoning will guide plaintiffs to buried legal treasure or merely mislead them from the path of solid legal argument into the swamps of speculation.

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