In its basic form, the economic loss doctrine--a fixture in tort law--holds that a party will not be liable under a negligence theory for damages that represent the lost benefit of a bargain unless those damages are accompanied by personal injury or property damage. Since negligence requires harm to person or property, purely economic losses must be recovered in contract or warranty. While the economic loss doctrine frequently applies in the context of third-party liability lawsuits, it can also apply to parties in privity.
The doctrine has well-recognized underpinnings in the common law of England and thrives in modern California jurisprudence. It is a liability-limiting doctrine--not unlike proximate causation--but is developing into somewhat of an enigma as a result of several contradictory California decisions. Even California courts have shown confusion over their own precedents regarding the doctrine and its impact on tort duty analysis and seem reluctant to follow them.
Perhaps the most confusing wrench thrown into the doctrine's development is J'Aire v. Gregory,1 a decision in which the California Supreme Court imposed tort liability in a case of pure economic loss. Despite the pomp and circumstance of the court's methodology, its analysis--while couched in the terminology of tort law--was essentially identical to its approach for determining damages to third-party beneficiaries in contract cases.
J'Aire is still good law, and it is unclear whether the multifactored analysis it embraces is really the exception to the liability-limiting economic loss doctrine. While the J'Aire court's imposition of tort liability seems to be nothing more than a recasting, in tort parlance, of liability to intended third-party beneficiaries in contract, it remains to be seen whether the California Supreme Court will affirmatively address J'Aire's place in economic loss analysis. Doing so would provide the necessary clarity on which potential economic loss defendants can rely.
Various theories underlie the purpose and rationale of the economic loss doctrine. Commentators view it as a line of demarcation between tort and contract law.2 They also find in the doctrine a means for avoiding limitless liability.3 In addition, the doctrine is seen as a brake on damages for harm that is less concrete, or more speculative, than harm to person or property.4
Robins Dry Dock & Repair Company v. Flint5 provides the classic formulation of the economic loss doctrine. The plaintiffs in the case chartered a steamship from its owners. The charter required the ship to dock every six months for repairs, and so long as the ship was docked, the chartering parties were not responsible for any payment to the owners for the hiring of the ship.
While the steamship was in port, dock workers damaged the propeller, delaying the ship's scheduled departure by two weeks. The dock and its workers had no knowledge of the charter between the ship's owners and the plaintiffs until the delay had begun.6
The charterers sued on the theory that the two weeks of lost use caused by the dock workers violated a property right the charterers had in the ship. After they won at the district and circuit court levels, this argument did not go so well at the U.S. Supreme Court. The charterers raised the argument that they were third-party beneficiaries of the contract between the dry dock and the owners, but because the charterers and their arrangement with the ship's owners were not known to the defendant, this argument was to no avail.7 Regarding a basis of liability in tort, the Court stated, "The question is whether the [charterers] have an interest protected by the law against unintended injuries inflicted upon the vessel by third persons who know nothing of the charter."8
The Court concluded that if the charterers had a legally protected interest in the steamer, "it must be worked out through their contract with the owners, not on the postulate that they have a right in rem against the ship." Reasoning that the damage was "material to [the charterers] only as it caused the delay in making the repairs, and that delay would be a wrong to no one except for [the charterers'] contract with the owners," the Court noted the charterers loss "arose only through their contract with the owners." Moreover, "no authority need be cited to show that, as a general rule...a tort to the person or property of one man does not make the tortfeasor liable to another merely because the injured person was under a contract with that other, unknown to the doer of the wrong."9 In essence, the Court held that to recover in tort the charterers needed to show that the dry dock negligently harmed the charterers' physical property. Without that showing, the charterers had recourse only to their contract with the owners.
California's economic loss doctrine began in 1965 within the context of strict products liability in Seely v. White Motor Company.10 After the plaintiff in Seely purchased a truck from a dealership, the plaintiff discovered that the truck was defective and could not be used to advance the plaintiff's business. The plaintiff sued the manufacturer of the truck not only for out-of-pocket losses (including the purchase price and repairs) but also for lost profits. The plaintiff's claims were based on strict liability and the defendant's express warranty that its product was free from defects. The defendant raised the lack of privity between itself and the plaintiff as a defense.
After a comprehensive survey of the development of warranty and strict liability law up to the date of the ruling,11 the California Supreme Court in Seely found that warranty--a contractual promise--was the proper vehicle for the award of economic damages in the case. The defendant's express warranty of its product obviated the need for privity.12 As to whether this rationale limited recovery of economic loss to contractual situations, the court stated:
A consumer should not be charged at the will of the manufacturer with bearing the risk of physical injury when he buys a product on the market. He can, however, be fairly charged with the risk that the product will not match his economic expectations unless the manufacturer agrees that it will. Even in actions for negligence, a manufacturer's liability is limited to damages for physical injuries and there is no recovery for economic loss alone.13
After Seely, the lower courts in California applied the doctrine in construction defect cases.14 On occasion, though, the courts would issue a decision that seemed far afield from Seely. Some cases articulated an exception from the economic loss rule for "professionals," including engineers, architects, and developers.15 A similar exception was found when the contract was for the performance of services; according to the court of appeal in North American Chemical Company v. Superior Court (Trans Harbor Inc.), the plaintiff had an election of remedies--either suing in tort or contract, at the plaintiff's preference.16 However, neither of these limitations of the doctrine would survive into the twenty-first century.
Reign of the J'Aire Exception
But the decision that created the largest divergence from Seely was J'Aire in 1979. According to the supreme court in J'Aire, foreseeability of harm trumped the lack of personal injury or property damage as the most important consideration in finding a duty in tort.
For 20 years, J'Aire operated as an exception to the economic loss rule. But the J'Aire court seemed to conflate economic loss analysis with duty analysis. To understand whether J'Aire is a true exception to the economic loss doctrine in California or a hiccup in the state's stare decisis on the issue first requires an examination of its most direct progenitor, the 1958 decision Biakanja v. Irving.17
In Biakanja, the plaintiff, who was not in contractual privity with the defendant, sought damages against the defendant for loss of an expectancy, or an intangible future interest. The case involved a notary who prepared a will for the plaintiff's brother.18 While the will provided that the plaintiff would take the entirety of her brother's estate, it was denied probate because it was insufficiently attested. Instead of taking all of the estate as a bequest, the plaintiff took only one-eighth by intestate succession. The plaintiff sued the notary for the difference and won at trial. On appeal, the supreme court framed the "principal" issue as "whether defendant was under a duty to exercise due care to protect plaintiff from injury and was liable for damage caused plaintiff by his negligence even though they were not in privity of contract."19
The court addressed the issue of liability in circumstances involving harm to person or property and cited authority for the proposition that liability is present even when the harm is to intangible interests.20 However, the court's holding did not address the type of harm about which the plaintiff complained: the loss of an expectancy, which is a purely economic loss. Rather, the court addressed the issue of duty.
The Biakanja court held that liability under circumstances in which the defendant was not in privity of contract with the plaintiff is "a matter of policy" involving the "balancing of various factors." These factors include:
• The extent to which the transaction was intended to affect the plaintiff.
• The foreseeability of harm to the plaintiff.
• The degree of certainty that the plaintiff suffered injury.
• The closeness of the connection between the defendant's conduct and the injury suffered.
• The moral blame attached to the defendant's conduct.
• The policy of preventing future harm.21
Since, in the view of the Biakanja court, the "end and aim" of the transaction was to provide for the plaintiff's brother's estate to pass to the plaintiff, the defendant notary had a legal duty to prepare the will reasonably and prudently.22 The Biakanja court essentially held that the harm suffered by the plaintiff was pure economic loss--the loss of an expectancy--arising from a breach of contract to prepare a will between the plaintiff's brother and the defendant notary.23 Prior authority allowed recovery when the harm was to person or property, and authority in other states allowed recovery for intangible interests. However, the court ultimately applied a multifactor analysis to determine whether the defendant owed the plaintiff a duty of care under the particular circumstances of the case. This analysis included a factor on the certainty of the harm suffered but not its type.
The J'Aire court applied Biankanja in the context of construction defects. The dispute in J'Aire involved a delay in construction.24 The plaintiff operated a restaurant at the Sonoma County Airport in space leased from the county. The lease terms obligated the county to provide heat and air conditioning for the restaurant. The county contracted with the defendant contractor to renovate the heating and air and provide insulation. The contract did not specify a time for performing the renovation, but the defendant was urged to complete the construction promptly. Nevertheless, the defendant did not complete the work within a reasonable time. Plaintiff J'Aire sued the contractor for negligence because it suffered loss of business and lost profits during the delay. The defendant demurred successfully at trial.25
The J'Aire court began its discussion where Biakanja left off: "[L]iability for negligent conduct may only be imposed where there is a duty of care owed by the defendant to the plaintiff."26 It cited Biakanja, stating, "Where a special relationship exists between the parties, a plaintiff may recover for loss of expected economic advantage through the negligent performance of a contract although the parties were not in contractual privity."27 After applying the factors from Biakanja, the J'Aire court concluded that the defendant contractor "had a duty to complete construction in a manner that would have avoided unnecessary injury to [the plaintiff's] business."28
The court admitted that the most important factor in its view was foreseeability:
Rather than traditional notions of duty, this court has focused on foreseeability as the key component necessary to establish liability: "While the question whether one owes a duty to another must be decided on a case-by-case basis, every case is governed by the rule of general application that all persons are required to use ordinary care to prevent others from being injured as the result of their conduct....
[Foreseeability] of the risk is a primary consideration in establishing the element of duty."29
Within this discussion on duty, the J'Aire court then made the statement that appears to have injected confusion and uncertainty into economic loss analysis in California:
Where the risk of harm is foreseeable, as it was in the present case, an injury to the plaintiff's economic interests should not go uncompensated merely because it was unaccompanied by any injury to his person or property.30
The Impact of Aas
In 2000, the California Supreme Court surveyed the law of economic loss in Aas v. Superior Court, a case that was the direct progeny of Seely.31 Aas involved homeowners and a homeowners association bringing suit against the developer/general contractor and subcontractors on a condominium project.32 According to the court's characterization, the plaintiffs' homes suffered "from a variety of construction defects affecting virtually all components and aspects of construction."33 The plaintiffs alleged causes of action for negligence and strict liability in tort as well as breach of implied warranty, contract, and express warranty.34
The court began its discussion by warily providing a general formulation of the doctrine: "Speaking very generally, tort law provides a remedy for construction defects that cause property damage or personal injury."35 The court acknowledged that the legal question in the case was "fairly narrow" but "not simple" because it arose from the "nebulous and troublesome margin between tort and contract law."36 Moreover, the court noted that in California "tort remedies have been uncertain" for defective products or negligent services causing neither personal injury nor property damage.37
The Aas court attempted to clarify the application of the doctrine in California. After reciting the development of case law on the subject, including the divergence of the doctrine into strict liability and negligence theories, the court held that "appreciable, non-speculative, present injury is an essential element of a tort cause of action."38 It explained that the "breach of a duty causing only speculative harm or the threat of future harm does not normally suffice to create a cause of action."39
Much like the Robins Dry Dock court of 73 years before, the Aas court noted that the plaintiffs' recourse for economic losses should be limited to contract (or, it also noted, warranty).40 In fact, the court underscored this observation with a recounting of its ruling in another landmark case, Erlich v. Menezes:
This court recently rejected the argument that the negligent performance of a construction contract, without more, justifies an award of tort damages. (Erlich v. Menezes at pp. 550-554 [reversing an award of damages for emotional distress for negligent construction].) In so doing, however, we reiterated that conduct amounting to a breach of contract becomes tortious when it also violates a duty independent of the contract arising from principles of tort law.41
The Aas court also limited the holdings of earlier lower court decisions in such a way as to strongly imply that "professionals" (contractors, subcontractors, or design professionals) could not be held liable in negligence without actual harm to person or property.42 However, the Aas court did not criticize J'Aire in any way that could be described as direct, even though it did say that application of the J'Aire test for finding a tort duty "tends to involve a court in making fairly subjective judgments."43 An appellate court describing another court's judgments as "subjective" is certainly not a ringing endorsement.
The Aas court clearly noted the conundrum by observing that "tort remedies have been uncertain" when it comes to the economic loss doctrine as a result of case law development in California. While it reaffirmed the doctrine in California, the Aas court did not put to rest the questions springing from J'Aire or even the confusion regarding how to apply the economic loss doctrine in California in the face of J'Aire and its progeny.
Indeed, the Aas court was reluctant to acknowledge that J'Aire represents an exception to the economic loss doctrine in California and that J'Aire, from its issuance in 1979 until the decision in Aas in 2000, virtually abrogated the economic loss doctrine in the state. The fact that the doctrine has exceptions is not in itself troublesome. Good law rarely applies uniformly across a broad universe of circumstances, and exceptions and nuance are necessary to ensure just outcomes. The J'Aire exception is problematic in its insistence on imposing a legal duty in situations in which one previously did not exist as well as its brief, perhaps even dismissive, treatment of the nature of the harm that the litigation sought to remedy.
Third-Party Beneficiary Analysis
So even while Aas succeeded in providing some guidance post-J'Aire, confusion remains. Still, whether the economic loss doctrine limits liability, polices the border between tort and contract, or is a damages-certain principle, its applicability must relate to the harm caused and not whether a tort duty should be imposed. The California Supreme Court seemed to recognize this idea in Seely, and the J'Aire exception apparently does not apply in the strict products liability line of cases.44
If the plaintiff's harm is to an expectancy, or if economic losses flow from the expected performance of a party not in privity of contract with the plaintiff, the plaintiff should be limited to whatever contract remedies the plaintiff has. The plaintiff's harm is more akin to a contractual expectation interest.
J'Aire confuses the issue by injecting the question of duty, and thereby policy, into the question of the type of harm suffered by the plaintiff. The relatively easy question of whether the plaintiff experienced physical harm thus becomes a more nebulous question as to whether a duty was owed.45 Along with the confusion and greater complexity comes uncertainty. Economic transactions rely upon certainty in the law. If liability is indeterminate because of multifactored tests in situations in which the plaintiff and the defendant have no contract, and the harm is measured purely in terms of what benefit one party expected to receive, how can potential defendants adequately account for risk?
Since the harm is to an expectancy interest, and the remedy is to make good the expectation, contract law can eliminate the indeterminacy created by the J'Aire exception.46 The general rule at common law and in California is that a stranger to the agreement cannot bring an action on it.47 However, the courts recognized an exception for intended beneficiaries of the agreement,48 and this exception was codified at Civil Code Section 1559.49
The contracting parties must intend to benefit the third party.50 It is sufficient that the promisor must have understood that the promisee had this intent. No specific manifestation by the promisor of an intent to benefit the third person is required.51 Persons who are only incidentally or remotely benefited cannot enforce the agreement.52 The third party bears the burden of proving that it was an intended beneficiary.53
The situations in which the J'Aire exception applies will always be those in which the plaintiff could claim to be a third-party beneficiary on a contract claim. When analyzing the application of the J'Aire factors to a given fact pattern, "California courts have held that the defendant's transactions must have been 'specifically intended to affect the particular needs' of the plaintiff."54 If a potential plaintiff is a third-party beneficiary of an agreement, there is no need for the court to engage in "those considerations of policy" necessary to imposing a tort duty. The fact-finder need only look to the agreement between the contracting parties. If there was an intention to benefit a third party, that party's expectation interest would be protected against all breaches, negligent or otherwise. If there was no such intention, there would be no recovery: The economic loss doctrine would clearly and definitively bar recovery in tort for pure economic loss.
In this analysis, "intention" supplants "foreseeability," the keystone in the J'Aire court's imposition of tort liability.55 Indeed, one can argue that intention and foreseeability are functional equivalents--at least in light of the willful overtones that J'Aire ascribes to foreseeability.56 However, while foreseeability is expansive, and courts have virtually limitless discretion to decide what is and is not foreseeable, the parties' agreement provides structure and parameters to the parties' intentions.
Third-party beneficiary analysis takes the mystery out of what constitutes a "special relationship": It is simply the relationship of an intended third-party beneficiary to the contracting parties. Perhaps the greatest doctrinal advantage of third-party beneficiary analysis is that it unifies the interest to be protected (expectancy) with the legal apparatus (contract) designed to protect it.