Economic Loss Rule

Economic Loss Rule Impacted by Recent Colorado Supreme Court Decision

Daniel E. Evans | Gordon & Rees LLP
February 28, 2015

The Colorado Supreme Court in a recent decision, S.K. Peightal Engineers, LTC v. Mid Valley Real Estate Solutions V, LLC, 2015 Colo. 7, revisited Colorado’s economic loss rule, which in some other jurisdictions is also known as the “independent duty rule.”  The Court specifically analyzed what class of plaintiffs can invoke the “homeowner exception” to the economic loss rule.  Of particular significance are the Court’s statements that the homeowner exception only applies to subsequent—and not original—homeowners. 

In S.K. Peightal Engineers, engineer defendants contracted with an owner/developer to perform soil analysis and engineering for construction of a “spec” home.  Alpine Bank financed the project through a construction loan contract and other documents.  The house did not sell for some time and, after the construction loan contract came due, the owner/developer and Alpine Bank entered into a deed-in-lieu of foreclosure agreement.  Alpine Bank avoided taking title itself by creating a wholly owned subsidiary, Mid-Valley Real Estate Solutions V, LLC, to take title pursuant to the deed-in-lieu. 

After Mid-Valley put the house on the market, the home developed large cracks as a result of settling soils.  Mid-Valley filed suit against the soil engineers and others for purely economic damages under a negligence theory. 

The Court first summarized Colorado’s fairly well-developed economic loss rule which bars a plaintiff from suing in tort when the duty allegedly breached arises under a contract.  Said differently, a breach of a duty arising under a contract must be redressed under the terms of the contract as opposed to an action in tort.  However, a tort action is viable if the duty breached arises independently of any contractual duties between the parties.   

Two other important aspects of Colorado’s economic loss rule impacted the Supreme Court’s analysis in S.K Peightal Engineers.  First, the economic loss rule bars negligence claims by third party beneficiaries to a contract that defines the duty of care.  Second, the “homeowner exception” to the rule provides that construction professionals owe an independent duty of care to purchasers of homes to use reasonable care. 

The rule in Colorado also provides that a contractual duty barring the ability to assert tort claims can be found in a series of interrelated contracts.  If a duty is defined in one of a series of contracts involving a construction project, for example, the duty contained in one of the contracts can possibly be applied so as to bar the assertion of a tort claim.  This is known in Colorado as the “interrelated contract doctrine.”

The first issue the S.K. Peightal Engineers Court considered was whether the economic loss rule barred Mid-Valley’s negligence claim even though that entity did not exist at the time the contract containing the duty of care was formed.  The Court held that the economic loss rule can apply, thereby barring a claim in tort, to an entity that did not exist at the time the duty-containing contract was formed if that entity is a party to, or is a third-party beneficiary of, the contract or an interrelated contract containing a duty of care.  Finding Mid-Valley was a third party beneficiary of the deed-in-lieu, and that the deed-in-lieu was interrelated with the construction loan contract, the Court remanded the case to the trial court to determine whether the construction loan contract interrelates to the duty provisions in the engineers’ contracts with the owner/developer.   

The S.K. Peightal Engineers Court next took on the issue of whether a subcontractor’s independent duty to construct a home in a non-negligent manner extends to a party such as Mid-Valley that receives a home via a commercially negotiated contract that interrelates to the underlying contract responsible for construction of the home.  The Court explained that, even if Mid-Valley is barred by the engineers’ contract through the interrelated contracts doctrine, the economic loss rule would not bar a negligence claim if the engineers owed Mid-Valley an independent tort duty.  The Court’s prior decision in Cosmopolitan Homes v Weller, 663 P.2d 1041 (Colo. 1983), held subcontractors owe an independent duty of care to subsequent purchasers of homes.  The question before this Court, therefore, was whether a party like Mid-Valley is a “subsequent purchaser” to which an independent duty is owed.

The S.K. Peightal Engineers Court held that parties like Mid-Valley are not “subsequent purchasers” to whom a subcontractor owes an independent duty of care.  Rather, Mid-Valley was just a third-party beneficiary of a contract that facilitated construction of the home.  Because Mid-Valley was not a subsequent purchaser, the defendant engineers did not owe it an independent duty.  The Court explained that, unlike individuals who purchase homes from other individuals, parties in Mid-Valley’s position—who stand in the shoes of one of the parties to the loan that financed the construction of the home at issue—have the ability to negotiate rights and remedies into their agreements. As a third-party beneficiary to the interrelated contracts they also have the ability to enforce rights under those contracts.  Accordingly, such parties are limited to claim breach of duties contained in the interrelated contracts only, and do not have a viable claim in tort. 

The Court’s decision on the economic loss rule issue mandates a factually-intense analysis of whether the subject contracts are “sufficiently” interrelated.  Where the plaintiff and plaintiff’s contract did not exist at the time the duty was formed, the factual inquiry will undoubtedly lend itself to varying interpretations by the parties.  This factual inquiry will in all probability result in parties disputing facts, preventing entry of summary judgment early in cases.  Courts may be inclined to allow the determination of whether contracts are “sufficiently” interrelated to be resolved at trial.  

Beyond the obvious point that lenders who create new entities to hold distressed homes are barred by the economic loss rule from asserting tort claims against construction professionals, the more significant impact of S.K. Peightal Engineers may be whether original homeowners who purchased a home directly from a builder/vendor—as opposed to subsequent home purchasers—have viable negligence claims for construction defects under Colorado law, or whether they can only assert contract claims. 

The Colorado Supreme Court’s 1983 decision in Cosmopolitan Homessupra, held that “an obligation to act without negligence in the construction of a home is independent of contractual obligations.”  663 P.2d at 1042.  A later decision by the Colorado Court of Appeals held the Cosmopolitan Homes independent duty rule applied to an original home purchaser.  Stiff v. BilDen Homes, Inc., 88 P.3d 639 (Colo. App. 2003).  However, in S.K. Peightal Engineers, the Court went out of its way to state—three separate times—that the duty to build in a non-negligent manner is owed only to subsequent homeowners.  It held the independent duty requiring builders to construct homes without negligence “is only owed to subsequent purchasers and transferees.”  S.K. Peightal Engineers at para. 18 (emphasis in original).  The Court then made clear that its decision in A.C. Excavating, 114 P.3d 862 (Colo. 2005), did not use the word “subsequent” in holding that subcontractors owed the Cosmopolitan Homes independent tort duty to homeowners.  S.K. Peightal Engineers, at footnote 10.  The Court distinguished its holding in A.C. Excavating saying its focus there was on the class of defendants, i.e. subcontractors, that owe an independent duty and that the plaintiff homeowners association in A.C. Excavating was a “representative of ‘subsequent purchasers’”.  According to the Court, its decision in S.K. Peightal – which focuses on the class of plaintiffs permitted to invoke the homeowner exception to the economic loss rule -- is not inconsistent with A.C. Excavating

Because of the Court’s decision, practitioners representing homeowners and construction professionals in Colorado will need to closely analyze how S.K. Peightal Engineers impacts their claims and, in particular, whether tort claims are viable given the facts of their case.  

The content of this article is intended to provide general information and as a guide to the subject matter only. Please contact an Advise & Consult, Inc. expert for advice on your specific circumstances.

SOURCE: www.lexology.com

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