Expert Commentary

The New Business Risk Rationale:

This second article addresses the economic loss rule—how it is applied by the courts, insurance coverage for the exposure, and why it’s important to bother with the concept.


Construction Defect Coverage
December 2003

Part 1 of this article dealt with the debate surrounding the commercial general liability (CGL) insurance coverage for the defective workmanship myth which holds that where the property damage is to property that is the subject matter of the insured’s contract, there can be no “property damage” or even no “occurrence.” This second part addresses the economic loss rule analysis.

Enter the Economic Loss Rule

Obviously, cases that address mere economic loss are of limited utility as applied to claims involving occurrences of physical injury to tangible property, as is the case with many defective work claims. As a result, an argument has emerged that seeks to meld concepts from economic loss cases with an additional argument to deny coverage for claims involving physical injury to tangible property without the necessity of resorting to the policy exclusions and in the process risk a finding of coverage. This argument borrows from an unlikely source: the economic loss rule.

The economic loss rule provides that a cause of action for negligence is not available when the only loss or damage is to the subject matter of the contract. In that case, the plaintiff’s action is ordinarily limited to one in contract. See Southwestern Bell Telephone Co. v Delanney, 809 SW2d 493 (Tex 1991); Hininger v Case Corp., 23 F3d 124 (5th Cir 1994). In other words, in determining whether to apply the rule, the court assesses whether the cause of action is in contract or tort, and when the loss is only the economic loss to the subject matter of the contract itself, the action stands in contract alone.

A case applying the economic loss rule in the construction context is CBI NA-CON, Inc. v UOP, 961 SW2d 336 (Tex App—Houston [1st Dist] 1997, review denied). In that case, UOP, an engineering firm, entered into a contract with Fina for the design of a fluid catalytic cracking unit. In addition, Fina entered into a contract with Chicago Bridge & Iron (CBI) to build the unit at Fina’s facility.

The unit did not operate properly after completion, and Fina sued CBI under various theories, including negligence, for the defective construction. Fina did not sue UOP, the engineer, and CBI filed its own third-party action against UOP for contribution. In that action, CBI alleged that the damages complained of by Fina were the result of UOP’s faulty design.

The court held that CBI could maintain a contribution claim against UOP only if they were both joint tortfeasors, so that the court was required to determine whether or not Fina could maintain a negligence action against UOP. In doing so, it applied the economic loss rule and found that the only damages being claimed by CBI were economic damages which were the subject matter of the contract between Fina and UOP. Therefore, Fina’s only cause of action was in contract and not in tort. Finally, since CBI was not a party to that contract, it had no right to sue UOP for contribution under Texas law.

However, an exception to the economic loss rule exists where the conduct of the wrongdoer causes damage to property other than the subject matter of the work itself. That exception was applied by the court in Thomson v Espey Houston & Assoc., Inc., 899 SW2d 415 (Tex App—Austin 1995, no writ). In that case, the court upheld an apartment complex owner’s cause of action for negligence against an engineer in the face of an economic loss rule defense.

Unlike the typical construction relationship, the engineer had been hired by the contractor and not the owner, and as a result, the owner had no direct contractual relationship with the engineer. The engineer’s negligence in designing the drain system and testing the soil quality were alleged to have caused damage to other parts of the apartment complex. This resulted in cracking walls, doors that would not fit properly, mildew, standing water, shifting, and formation of water pools that blocked the street and spilled into adjacent property.

The court held that because of the defective design, there was damage to property beyond the subject matter of the contract so that a viable negligence cause of action was stated as to that property damage. At the same time, the court upheld the engineer’s economic loss defense as applied to the owner’s cause of action against the engineer for negligent approval of draw requests since it did not go beyond the subject matter of the contract to perform those services.

Another example of application of the economic loss rule is Alcan Aluminum Corp. v BASF Corp., 133 F Supp 2d 482 (ND Tex 2001). In that case, Alcan manufactured panels that were used for gas station facia in sunrooms. Alcan sprayed foam urethane into its panels to create a rigid core. That foam was manufactured by BASF, and complaints were received after panels developed bubbles and deformed. As a result, Alcan sued BASF for the cost of making good on its warranties issued for the panels, including allegations of negligent misrepresentation and professional negligence.

The court ruled that the negligence claims were barred by the economic loss rule, again, since Alcan did not suffer personal injury or property damage. Due to the fact that BASF’s foam was only a component part of the entire panel, the court considered the issue of whether the claim involved damage to other property as well to avoid the application of the economic loss rule. The court concluded that damage to a product as a whole caused by a defective component assembled by the buyer constituted an economic loss, rather than damage to other property, so that the negligence claims were barred.

While the economic loss rule developed as an offshoot of products liability law, its utility in the construction context is obvious. Construction work is performed pursuant to contracts. Construction claims involving construction failures, including defective workmanship, are prosecuted under various theories, including breach of contract, breach of warranty, and negligence. Again, where the defective workmanship is performed on the work contracted for under the construction contract, the possibility of an economic loss defense exists, particularly where no damage in third-party property has occurred.

In construction litigation, motions for summary judgment based on the economic loss rule are commonplace, and are sometimes granted, thus eliminating the negligence cause of action, a tort cause of action perhaps giving rise to more remote damages that are not recoverable under a breach of contract theory.

The Economic Loss Rule and Insurance Coverage

Keep in mind that the economic loss rule is a liability defense; it is not necessarily dispositive of insurance coverage. Nevertheless, insurers will frequently state the position that once the economic loss rule has eliminated the negligence cause of action, the insurer no longer owes a duty to defend and indemnify an insured contractor as to the remaining breach of contract cause of action. (This position is sometimes based on the discredited notion that a CGL policy provides coverage only for tort damages, and not breach of contract.) Moreover, of late, the economic loss rule has been offered up in support of the argument that damage to a project arising out of the insured contractor’s defective work is an economic loss due to the applicability of the economic loss rule.

Particularly, in the case of a general contractor or homebuilder, the entire project or home may constitute the “subject matter” of the contract with the owner. Taken to its illogical extreme, application of the economic loss rule dictates that since damage to the subject matter of the contract is economic loss, ergo, it cannot be property damage covered under the CGL policy.

Once again, this argument ignores the remainder of the policy, including the property damage exclusions which carve out coverage for elements of the work which is the subject matter of the contract, particularly after the application of exclusions (j) and (l). Of course, it goes without saying that the CGL policy makes no reference to the economic loss rule, and the applicability of that rule to insurance coverage ignores the definition of “property damage,” i.e., physical injury to tangible property or loss of use of tangible property that has not been physically injured.

Obviously, “physical injury to tangible property” can occur to a construction project, the subject matter of the contract between the insured contractor and the owner. For example, consider a home that is subject to water infiltration due to defective installation of the windows and exterior cladding. Water infiltrates the home and causes damage to interior finishes, rotting of the wooden structural members, and mold, requiring that the home be torn down and rebuilt.

Obviously, there has been “physical injury to tangible property,” the home, but at the same time, that home is the subject matter of the contract between the homebuilder and the homeowner. At that point, there has clearly been an “occurrence” of “property damage” as those terms are defined in the policy, and to determine the scope of insurance coverage for the loss, you must look to the policy’s property damage exclusions. If the homebuilder constructed the home through subcontractors, there is likely a considerable amount of insurance coverage available.

A few cases have addressed the interplay of CGL coverage and the economic loss rule. For example, in Jacob v Russo Builders, 224 Wis 2d 436, 592 NW2d 271 (1998), one court fitted the operation of the property damage exclusions into existing principles of law, including the economic loss rule. There, the owners of a newly built home sued the general contractor, the masonry subcontractor, and the subcontractor’s CGL insurer for damage arising out of the mason’s failure to install the masonry with adequate mortar, resulting in massive leakage of water into the home.

The court denied coverage for the cost of replacing the masonry itself based on an exclusion in the insured mason’s policy as to the completed operations hazard, denying coverage for work performed by the named insured arising out of the work or any portion of the work. Nevertheless, the court upheld coverage for relocation costs, temporary repairs, interior repairs, and loss of use and enjoyment of the home, none of which constituted work performed by the named insured. The court bolstered its conclusion with an economic loss rule analysis, holding that the cost of replacing the masonry itself constituted economic loss flowing from the mason’s breach of its subcontract, while the other damages constituted property damage and loss of use damages not barred under that rule.

The particular policy before the court in Jacob v Russo fitted neatly into an economic loss rule analysis since the insured was a masonry subcontractor. Thus, the named insured’s work was limited to the masonry work it performed, and the policy did not exclude coverage for damage to the work of other trades. It is unclear what the court’s analysis would have been had it been called on to apply the economic loss rule rationale to the general contractor’s coverage, including the exception for subcontractors’ work. Under those circumstances, the court may well have impermissibly regarded the entire home as the subject matter of the contract and all damage to be an economic loss. As pointed out above, this type of analysis would run contrary to the policy language.

This type of situation occurred in Wausau Tile, Inc. v County Concrete Corp., 226 Wis 2d 235, 593 NW2d 445 (1999). There, the manufacturer of concrete paving blocks brought an action against a cement supplier and its CGL insurer under theories of breach of warranty, breach of contract, negligence, indemnification, contribution, and strict liability arising out of the property damage and personal injury caused by expansive pavers. The expansion was caused by a defective additive in the pavers.

The court held that the manufacturer’s claim against the supplier was for purely economic loss since the manufacturer was not the real party-in-interest with respect to personal injury and property damage claims of purchasers of allegedly defective paving blocks. This ruling was based on the economic loss rule.

As to CGL coverage for the supplier, the court held that since the negligence and strict liability claims against the supplier were barred by the economic loss doctrine, its insurer likewise had no duty to defend it against those claims. It should be noted that the court dealt with coverage under the supplier’s CGL policy in a cursory fashion, stating that, “It is undisputed that the breach of a contract or warranty is not a covered ‘occurrence’ under the Travelers policy.” Id. at 460.

Apparently, the parties stipulated that there was no occurrence resulting from the breach of contract, or the issue was overlooked. For whatever reason, it was not argued by the insured that the focus should have been on the occurrence of property damage and personal injury, as defined in the policy, and not the label of the cause of action.

For another example, see Commercial Union Ins. Co. v Roxborough Village Joint Venture, 944 F Supp 827 (D Colo 1996), in which the court soundly rejected the economic loss analysis. In that case, Pulte, the homebuilder, sued Roxborough, the developer, due to its negligent installation and maintenance of utilities, and misrepresentation and concealment of conditions making the land unsuitable for construction. Roxborough raised the economic loss rule as a defense to Pulte’s claim.

In refusing to apply the economic loss rule, the court held that while the rule prevents recovery in tort where the duty breached is a contractual duty and the harm incurred is the failure of the purpose of the contract, the rule is not absolute, and its application is limited to cases involving economic loss only. As to the allegations of Pulte against Roxborough, the court held that the claims involved allegations of intentional misconduct on the part of Roxborough and breaches of duties of care independent of contractual obligations. Therefore, the economic loss rule did not apply.

As far as the reliance by Commercial Union, the insurer, on the economic loss rule, the court stated as follows:

  • I find the use of the rule in the insurance context troublesome generally and specifically question its applicability in this case. As an initial matter, Commercial Union’s argument that it owed Roxborough no indemnification duty under the Policies because Pulte’s claims Roxborough settled sounded in contract, rather than tort, is a novel one.
  • Commercial Union cites no case in which an insurer invoked the rule in this manner and I find no reasoned basis for doing so.

The court added the following at footnote 5:

  • In essence, Commercial Union argues application of the economic loss rule to “protect” the contractual relationship between Pulte and Roxborough. Citing Adventura, Commercial Union argues that a characterization of Pulte’s claims in the Underlying Case as sounding in tort will “undermine” the Pulte-Roxborough relationship and “frustrate” the ability of commercial entities like them to allocate the risk of pecuniary loss. [Citation to Pulte’s brief omitted.] Commercial Union’s use of the economic loss rule in this manner is strained and self-serving.

As the Roxborough court observed, the applicability of an economic loss rule analysis to coverage under a CGL policy for defective work impermissibly mixes liability and coverage concepts. Quite predictably, this “strained and self-serving analysis” invites the parties, and the courts, to ignore the remainder of the policy, that is, the property damage exclusions, where the complete coverage analysis is intended to be played out. That analysis may result in coverage for property damage to and arising out of defective work.

Why Bother?

The application of the definitions of “occurrence” and “property damage” are essentially separate steps to be applied prior to applying the “business risk” notions that are embodied in the property damage exclusions that are most often invoked by a defective workmanship claim. Those exclusions include the following.

  • Exclusion j(5)—property upon which operations are being performed;
  • Exclusion j(6)—the faulty workmanship exclusion;
  • Exclusion (l)—the work performed exclusion; and
  • Exclusion (m)—the impaired property exclusion.

One may ask, “Why bother?” or “What's the difference?” Hopefully, the answers to these questions have been suggested in this article. The difference is that when business risk-type notions get applied to the definitions of “occurrence” and “property damage,” limitations as to those concepts get applied to all claims, rather than to those which embody only the true “business risks” as excluded by the property damage exclusions listed above. The presence of the property damage exclusions clearly indicates that there are instances in which property damage to the insured's own work is not excluded under the CGL policy.

This proposition is far from new and astounding, and the classic example was provided nearly 25 years ago by Insurance Services Office, Inc. (ISO), the drafter of the policy forms, in one of its circulars regarding the scope of property damage provided under a CGL policy. In that example, an insured subcontractor is erecting steel beams furnished by the general contractor. After erecting four of the steel beams, the subcontractor is in the process of erecting a fifth steel beam when this beam falls, resulting in damage to all five beams.

Under present day Exclusion j(5), only the “particular part” of the property on which operations are being performed is excluded. In other words, coverage would be provided for the four beams that had already been erected, and only coverage for the fifth beam, the particular part on which the insured was performing operations, is excluded. Note that there is coverage for the first four beams despite the fact that they are clearly part of the insured's own work, and not third-party property.1

This simple example illustrates the danger in applying business risk notions to the definitions of “occurrence” and “property damage.” Other examples can be constructed out of the property damage definitions, all of which illustrate the principle that while occurrence, third-party property damage, and even economic loss may be important elements in the ultimate determination of coverage in any defective work claim, they are not determinative of the existence of an “occurrence” or “property damage” for purposes of the definitions in the policy. To uphold the intent behind the CGL policy to provide a certain amount of coverage for these types of claims, the notions of business risk and third-party property damage should seldom become part of the mix until the exclusions are applied.

Again, “Why bother?” Because if the insured and its counsel are not bothered, or do not bother with, these concepts, they may be giving up a major source of funding for the repair of a considerable number of defective work claims.

________________________

1Insurance Services Office, Inc., Broad Form Property Damage Coverage Explained, ISO Circular General Liability GL 79-12 (January 29, 1979)


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