Economic Loss Rule Applies to Construction Cases

In a February 2010 decision, the Arizona Supreme Court found that Arizona’s “economic loss rule” applies to construction claims. In Flagstaff Affordable Housing Limited Partnership v. Design Alliance, Inc., the Court held that a property owner is limited to only its contractual remedies when the owner has contracted with a design professional, and the professional’s negligence causes economic loss but no “physical injury to a person or other property.”

In certain factual contexts, under Arizona law, the “economic loss rule” prevents one party to a contract from recovering economic damages under a tort theory, such as negligence, for a wrongful act by another party to the contract, unless the act results in physical harm, either in the form of personal injury or damage to property that was not central to the contract. The party that suffers monetary harm can still take legal action by suing for breach of contract, but it is limited to remedies provided under contract law as modified by the contract.

Historically, the Arizona Supreme Court had applied the rule only to products liability claims. Flagstaff Affordable Housing broke new ground in that the Supreme Court applied the economic loss rule to a construction defect case and denied an owner’s claim against an architect for negligent design of a Flagstaff apartment complex.

Background. In 1995, Flagstaff Affordable Housing contracted with an architect, Design Alliance, to design apartments for low-income residents. When the project was completed, it did not comply with the federal Fair Housing Act’s accessibility guidelines, and the U.S. Department of Housing and Urban Development (HUD) filed a complaint against Flagstaff Affordable Housing.

In 2006, Flagstaff Affordable Housing settled with HUD and then sued Design Alliance and the project’s contractor for breach of contract and for negligence (an “extra-contractual” claim). (The contractor was eventually dismissed from the lawsuit.) The only alleged damages consisted of the cost of retrofitting the project to satisfy HUD. There were no claims for damages due to injury to people or property.

Design Alliance moved to dismiss the complaint, arguing that (a) the statute of repose (per A.R.S. § 12-552) barred the breach of contract claim and (b) the economic loss rule barred the negligence claim per a 2003 ruling by the Arizona Court of Appeals in Carstens v. City of Phoenix.

Flagstaff Affordable Housing dismissed the contract claim but argued that the economic loss doctrine did not bar the negligence claim, on the grounds that “a claim for ‘professional negligence’ is based on the special relationship between architects and their clients and therefore is excepted from the economic loss doctrine.”

The trial judge agreed with Design Alliance and dismissed the suit.

Flagstaff Affordable Housing appealed the dismissal. The Arizona Court of Appeals reinstated the suit and sent it back to Superior Court for trial. In overturning the trial court’s dismissal, the Court held that the economic loss doctrine does not apply to claims for professional negligence, regardless of the type of case, because claims for professional negligence are based on a common-law duty of care that is independent of any contract.

Design Alliance appealed the Court of Appeals’ ruling. The Arizona Supreme Court concluded that, where the parties have entered into a contractual relationship, the economic loss doctrine does apply to construction defect cases because construction contracts typically are negotiated on a project-specific basis. The Court further concluded that, as part of the negotiation, the parties should allocate risk and identify remedies in the negotiated contract, which may include tort remedies if the parties agree in their contract. The Court determined that, in construction contract disputes, the policies of the law will be best served by leaving the parties to their contractual remedies when, as in this case, a contracting party has incurred only economic loss (e.g., repair costs, diminished value or lost profits).

In the end, the Supreme Court agreed with Design Alliance, finding that the economic loss rule barred Flagstaff Affordable Housing’s negligent design claim.

What the Decision Means. Obviously, the ruling in Flagstaff Affordable Housing is a welcome one for architects and other design professionals. The Supreme Court’s decision affirms that, in the construction defect setting, the economic loss rule continues to restrict the contracting party from pursuing tort claims (such as negligence) or seeking remedies other than those allowed by the contract. In addition, the remedies that are allowed for breach of contract claims may be more limited than those allowed for tort claims, and may be further restricted if so provided for in the contract.

For construction project owners, the Flagstaff Affordable Housing decision illustrates the importance of protecting the owner’s interests in its contract with a design professional.

Finally, even though in this case the contractor was dismissed from the lawsuit, an argument can be made that the economic loss rule’s protection applies to contractors as well as design professionals. The decision suggests that claims against contractors (who have a direct contractual relationship with the owner) for economic losses may be asserted only through contract claims. Again, the damages available for those claims may be more limited, and express contract terms can further reduce a contractor’s exposure.