History of the Economic Loss Rule
The economic loss rule is a principle that has been applied in Texas jurisprudence for many years in tort law, particularly with regard to the torts of negligence and fraud. At its most basic, the rule states that parties who are in contractual privity, or simply in a contractual relationship, with one another cannot sue each other in negligence or fraud unless or until there exists an independent tort duty between them, separate from their contractual obligations, that the tortfeasor breached. Further, the rule bars recovery for purely economic damages, as opposed to personal injury or damage to property, unless an exception applies. The purposes of the rule are to "protect parties from unbounded liability for economic loss" and "ensure privity of contract before imposing tort liability , " ensuring that a defendant only faces liability when it has a separate duty to the plaintiff that has been breached.
The rule was first introduced in Texas in its current form in 1989 in a Supreme Court of Texas case called Jim Walter Corp. v. Reed. There, the court held: We agree with the overwhelming body of authority holding economic losses are recoverable in tort only in cases involving the breach of an independent duty that is not related to the contract itself. In the years since Jim Walter Corp., the economic loss rule has been further developed by the Supreme Court of Texas and other state courts. However, courts in Texas have also recognized several exceptions to the economic loss rule that can allow parties to recover in tort for purely economic damages. Such exceptions include certain types of construction-defect and tortious-interference claims.
Origins of the Economic Loss Rule
The economic loss rule has its roots in the law of torts and contracts. The rule was first adopted by the Texas Supreme Court in 1982 in the case of East Texas Salt Water Disposal Company v. American Industrial Leasing. Briefly, the court ruled that a buyer’s exclusive remedy for economic losses resulting from the defendant’s failure to deliver contractual goods would be buttressed by an imputed duty to others not mentioned in the contract. Hence, the duty owed by the defendant to the buyer would be extended to a third party (i.e., unknown plants, trees, wildlife, and property).
The economic loss rule was next applied by the Texas Supreme Court to the sale of goods under the Uniform Commercial Code. In El Paso Natural Gas v. Minco Production Company, the court held that when a plaintiff’s claims for breach of contract were no more than a subterfuge for tort liability, the court would not permit a plaintiff party to a contract to recover in tort from a party not to the contract. In Texas Instruments v. Teletron International, the court adopted the rules set forth in El Paso in the context of a plaintiff suing a distributor, manufacturer and retailer for tort liability.
In 1999, the court applied the economic loss rule to plaintiffs who were not parties to the contract. In Lamar Homes v. Mid-Continent Casualty Co., a homeowner sued the general contractor and its surety for the cost to correct code violations in his home. The contractor was liable under the completion bond to repair deficiencies in the home, while the surety was liable for the superior economic loss suffered by the homeowner. However, the court expanded the application of the economic loss rule beyond the contract by ruling that a party could not sue a direct or indirect contractual privity for negligence damages. Subsequently, in Juhl v. Airington, the supreme court expressly overruled Lamar. The breadth of the economic loss rule in Texas was limited in Juhl. Rather than precluding all negligent claims, the court narrowly limited the application of the rule to instances where parties have "or could have" a contractual relationship. Thus, the economic loss rule no longer excludes all tort claims between the parties, regardless of their status under contract.
Although the judicial evolution of the economic loss rule resembles the diversity of its applications, parties and practitioners should not assume that legislative restrictions on products liability actions require the application of the economic loss. The economic loss rule is a judicially formulated rule of application in tort rather than a statute. Therefore, its application is not mandated when a tort occurs.
Texas Courts’ Application of the Economic Loss Rule
Understanding the contours of the economic loss rule in Texas requires a deep dive into many cases and legal principles in the vast body of Texas law. So, this article provides a quick overview of how Texas courts have typically applied the economic loss rule and how to best comply with it.
For more than a decade, courts have been applying the economic loss rule in an almost mechanical way to limit the types of claims that can be pursued arising out of a faulty product or service to those that arise from a defective product or service itself rather than additional consequential damages or injury. For example, the economic loss rule was recently applied to dismiss claims for negligence, negligent misrepresentation, bad faith breach of contract, and unfair insurance practices premised on the defendant’s alleged failure to comply with the Texas Prompt Payment of Claims Act or to handle a homeowner’s claim in good faith. Paxton Quarries, 682 S.W.3d at 415-16. This was so even though these claims were sufficiently distinct from the underlying breach of contract claim that the legal duties and corresponding evidence differed between them. Id.; see also, here, here, and here.
Parties and courts should be sensitive to this implied contractual relationship in determining whether these types of tort causes of action state claims for which relief can be granted. See Samson Lone Star, Ltd. v. TWM Shipping, Inc., 647 F. Supp. 2d 561, 571-74 (S.D. Tex. 2009); Korczak v. Vista Community Credit Union, No. C-11-346, 2011 WL 6016275, at *7 (S.D. Tex. Dec. 2, 2011); Paxton Quarries, 682 S.W.3d at 415-16. As the Eastern District of Texas explained in Samson Lone Star, the duties that are ordinarily substituted into a tort action to supply the missing element of a duty in the absence of a breach of a contract, will exist when the benefit of the bargain damages are already present from a breach of contract cause of action. 647 F. Supp. 2d at 570-71. Thus, regardless if an independent legal duty is imposed, any damages may only recoverable under the breach of contract claim. Id.; see Meyer Nat’l Holdings, LLC v. Catlin Mun. Agency LLC, No. 4:14-cv-00020-A, 2016 WL 369127 (N.D. Tex. Jan. 29, 2016) (construing Texas law and applying the economic loss rule to dismiss tort claims for negligence, misrepresentation, and fraud in the inducement when suing primarily for benefit of bargain damages).
But, while Texas courts force a "categorical exclusion" of tort liability for all claims falling within this rubric, the categories themselves are naturally limited by the contract context in which the economic loss rule applies. Therefore, a court will extend economic loss rule coverage to excluded claims in the appropriate circumstances. In the commercial context, for example, Texas courts have explained that the same type could be available under the same elements of recovery, the damaged property could be considered to be the subject matter of both parties’ pre-contract negotiations, and the parties contemplated that the subject matter of the contract would be subject to the same type of damage or harm. Samson Lone Star, 647 F. Supp. 2d at 574-75; City of Fort Worth v. Smith, 303 S.W.3d 290, 294 (Tex. App.—Fort Worth 2009, no pet.); Shell Oil Co. v. Ross, No. 14-04-00894-CV, 2006 WL 2077784, at *8 (Tex. App.—Houston [14th Dist.] July 27, 2006, pet. denied).
Common Law Exceptions to the Economic Loss Rule
Despite the steady development of the economic loss rule in Texas jurisprudence, there are several primary exceptions to the rule, which prevent its application to certain causes of actions. One of the most well-known exceptions to the economic loss rule is the negligent misrepresentation exception. Texas courts have long recognized an independent tort of negligent misrepresentation where: "one who, in the course of his business [or] profession…supplies false information for the guidance of others in their business transactions…for financial profit." McCamish, Martin, Brown & Assocs. v. F.E. Appling Interests, 991 S.W.2d 787 (Tex. 1999). The negligent misrepresentation exception to the economic loss rule is categorized as a tort claim, as opposed to a contract claim. However, the exception only applies if the plaintiff is a "sophisticated" party. Dow Chem. Co. v. Bright, 137 S.W.3d 674 (Tex. 2004) (transactional sophistication is a question of law to be determined by the court). Sophisticated parties are commercial actors whose expertise and bargaining power provide them sufficient bargaining and corrective opportunities, as well as stability and predictability in commercial transactions. Id. at 681. The Supreme Court recognized an exception to the economic loss rule in Lamar Homes, Inc. v. Min Jade Rong, where the Court allowed a breach of warranty claim to survive against a subcontractor. 242 S.W.3d 1 (Tex. 2007). The rationale behind the decision was that the plaintiff, as a direct purchaser from the subcontractor who performed defective work, had no remedy against the general contractor. Thus, barring the plaintiff from recovery would allow defects in construction to go unrepaired. The Court in Lamar went further in holding that a homeowner also has a strict liability claim against the residential homebuilder if the homebuilder’s work is negligent as the work applies to the construction. Id. at 9. The rationale provided for this exception furthered the concept that where the economic loss rule ousts a particular cause of action, there must be some other means of recovery available to the claimant. The last main exception to the economic loss rule in Texas is one pertaining to defective products. Texas courts hold that claims premised in product dimensional or material choice defects are barred by the economic loss rule where a buyer’s damages are the product’s defective performance because the damages are merely economic. However, Texas courts also subscribe to the principle that damages to property where the defective product is physically separate from the rest of the property are recoverable because the damaging event is not the defective performance of the product but the damage it inflicted. Latham v. Bailes, 170 S.W.3d 625, 628 (Tex. App.—Texarkana 2005, pet. denied).
Comparison with Other States’ Application
The Texas economic loss rule finds parallels and differences elsewhere in the country. For instance, Florida applies a strict version of the rule similar to modern-day Texas. Exdion Sols. LLC v. with the City of Mesquite, 430 S.W.3d at 383 n.1 (Tex. 2014). And California’s economic loss rule, like Texas’s own, prohibits recovery of purely economic damages irrespective of whether a claim sounds in tort or contract. See J’Aire Corp. v. Gregory, 24 Cal. 3d 799, 811-12 (1979).
Other states have adopted a more flexible approach. For example, in Ohio, the economic loss rule applies when "a tort claim [is] premised on the breach of duties of a contractual nature, as opposed to duties imposed by law." Floor Craft Floor Covering, Inc. v. Parma, 78 Ohio St. 3d 213, 217 (Ohio 1997). And in Minnesota, a plaintiff may, in certain contexts, bring both a contract and tort claim for the same basic injury without implicating the economic loss doctrine. See H.L. Kai kai & Assocs., Inc. v. Schubert, 555 N.W.2d 18, 21 (Minn. Ct. App. 1996).
Meanwhile, some states apply the economic loss rule only in product liability cases. Minnesota Mining & Mfg. Co. v. Atlantic Mutual Ins. Co., 324 N.W.2d 659, 662 (Minn. 1982) ("Because the presence or absence of physical harm caused by a defective product affects the nature of a plaintiff’s claims, most courts have limited the economic loss rule to products liability cases."). Other courts, too, have expressly applied the economic loss rule only to products liability actions. See, e.g., Smith v. Botany Bay Constr . Inc., 405 S.E.2d 818, 818-19 (S.C. 1991); Beal Bank, SSB v. Eureka Bank, 91 S.W.3d 787, 791 (Tex. App.—Waco 2002).
At the national level, the U.S. Supreme Court has weighed in. In the maritime context, the Court has applied the economic loss rule so as to preclude a party from asserting a strict product liability claim. East River Steamship Corp. v. Transamerica Delaval, Inc., 476 U.S. 858, 866 (1986). The Court has also implicitly recognized that the economic loss rule applies to product liability claims when dealing with UCC contracts. See Mt. Lincoln Slope Protection Ass’n v. United States, 884 F.2d 1276, 1280 (1989). Still, the Court has expressed skepticism over whether any uniform economic loss doctrine exists—at least outside the products liability context. East River Steamship Corp., 476 U.S. at 866 n.5. The Court described the economic loss rule as "perhaps more accurately viewed as a collection of rules, based on mixed judgments about the desirability of imposing tort duties in various fact situations." Id. And a plurality of justices recently called into question whether the economic loss rule should even exist. See Bldg. Indus. Ass’n of Superior Cal. v. City of Alevin, 49 Cal. 4th 244, 275-76 (2010) (Baxter, J., dissenting, joined by Chin, J., concurring in part and dissenting in part).
All of this presents some challenges for national businesses operating in Texas. And those challenges could be exacerbated by the conflicting interpretations of whether the economic loss rule applies outside the product liability context.
Impact of the Economic Loss Rule on Businesses and Consumers
The application of the economic loss rule can have far-reaching consequences for both commercial and private litigants. For businesses, the rule provides protections against a myriad of tort claims that may threaten their bottom lines. However, businesses that routinely perform services make certain sacrifices when exposed to the economic loss rule and may be unwilling to hire Texas professionals because of exposure to potential liability under this expanded rule. For consumers, a decline in formulary products that could help protect them from damages may cause increased costs to find a replacement or perhaps even result in a public grossly overpriced product.
Businesses and parties performing services that do not provide them judgment-proof immunity from claims for negligence and breach of contract should carefully draft their contracts so that they refrain from using broad language in determining the parameters of their liability. Given that the economic loss rule broadly applies to both negligence and breach of contract claims, businesses may be unable to contract around the rule and continue to utilize traditional limitation-of-liability and indemnification language that entirely caps their liability for negligence claims to contract damages recovery. Practicing businesses and commercial parties will in essence need to utilize stricter contracting terms narrowing the recoverable damages for breaches of contract claims.
Future of the Economic Loss Rule in Texas
With much of the Texas jurisprudence on the economic loss rule having finally settled, it is now appropriate to consider the future directions of the rule and how they may affect the way the rule is applied in Texas. Of all the directions, perhaps none that have greater potential impact than the discussion of statutory reform. A recent Texas Supreme Court opinion made some interesting comments in dicta regarding the potential for statutory reform of the economic loss rule. However, any such future debate will most likely not focus on the elimination of the rule, but instead on its expansion. This is especially true in the oil and gas industry , which could see legislative efforts to broaden the rule’s application in a way that comports with industry practices, norms, and lingo.
Beyond the specter of potential statutory reform, Texas courts will likely continue to address the proper means of pleading tort claims in the construction context that are subject to the economic loss rule and the inability of plaintiffs to freely allege a tort claim that would otherwise be subject to the economic loss rule. Businesses hope that the answer to the procedural questions will be the acceptance of the rule as fundamental to the understanding of what constitutes a property damage or personal injury claim as opposed to a claim for pure economic loss.