In a June 20 decision, the Texas Supreme Court applied the
economic loss rule to preclude a direct claim for negligent
misrepresentation by a construction contractor against an
owner's architect based on flawed design documents. LAN/STV
v. Martin K. Eby Constr. Co., No. 11-0810, 2014 Tex.
LEXIS 509, at *1-2 (Tex. Jun. 20, 2014). After undertaking an
in-depth examination of the normative principles forming the
backbone of the economic loss rule, the court departed from the
Restatement of Torts ("the Restatement") and ultimately
concluded that the economic loss rule barred recovery against the
architect—notwithstanding the fact that the architect knew
its plans would be relied upon by the general contractor in
preparing and submitting its bid. In reaching its holding, the
court reasoned that risk allocation in most construction situations
is better left to the realm of contract law and to negotiations
between the participants involved in the project.
The Eby decision is good news for design professionals, as
the court ruled decisively on an issue that divides courts across
the country.1 Still, the decision reinforces the need
for design professionals, as well as owners and contractors, to
address practical considerations concerning contract drafting and
negotiation at the front end of the process, in order to avoid
unintended consequences when a dispute arises. Indeed, Eby
makes clear that parties are free to agree on a potentially
different outcome than would result from the Texas Supreme Court
decision by modifying contractual language. Therefore, it remains
important that design professionals, owners, and contractors review
contract language to ensure that construction contracts and
professional services agreements contain no surprises or unintended
consequences.
Background of the Eby Dispute
In 1997, the Dallas Area Rapid Transportation Authority
("DART") contracted with LAN/STV to prepare plans,
drawings, and specifications for the construction of a light rail
transit line running from Dallas's downtown West End to the
American Airlines Center. LAN/STV agreed to "be responsible
for the professional quality [and] technical
accuracy ... of all designs, drawings, specifications,
and other services furnished," and to be "liable to
[DART] ... for all damages to [DART] caused by
[LAN/STV's] negligent performance of any of the services
furnished." DART incorporated LAN/STV's plans into a
solicitation for competitive bids to construct the transit line,
which was awarded to the low bidder, Martin K. Eby Construction
Company, in 2002. Importantly, this was a traditional
design-bid-build project where LAN/STV as the architect was in
contractual privity with DART as the owner, and DART was in
contractual privity with Eby as the contractor. Eby and LAN/STV,
however, had no contract with one another.
Just days after beginning construction, Eby discovered that
architectural plans provided by LAN/STV were replete with errors.
According to Eby, 80 percent of the architect's drawings had to
be changed, which disrupted the construction schedule and forced
Eby to provide additional labor and materials. Eby filed a breach
of contract action against DART as the owner, which was initially
dismissed for failure to follow the contract's claim
procedures. Eby continued to pursue its claim against the owner
through the administrative claim process, seeking $21 million in
damages. However, the administrative officer rejected Eby's
claim and awarded the owner $2.4 million in liquidated damages. Eby
filed an administrative appeal and eventually obtained a $4.7
million settlement in its favor.
Eby opened a second front in its battle to recover its claimed
damages by filing a separate tort action against LAN/STV. Eby
alleged that the architect had been negligent and had negligently
misrepresented the work to be done. Only the negligent
misrepresentation claim was presented to the jury, which found that
LAN/STV was liable and assessed Eby's damages at $5 million.
(The amount was later reduced to $2.25 million under the Texas
proportionate responsibility scheme.) Both parties appealed, and,
following the appellate court's affirmance, both petitioned for
review. LAN/STV argued that the economic loss rule applied and that
allowing tort recovery here—where relationships are
contractual and certainty and predictability in risk allocation are
crucial—would be highly disruptive to the construction
industry. Eby argued that the economic loss rule did not apply to
actions for negligent misrepresentation, as in the case at
hand.
Normative Principles of the Economic Loss Rule
Before analyzing the issues presented, the Eby court first examined the history of the economic loss rule in Texas. In its analysis, the Texas Supreme Court recognized the absence of one rigid rule and instead identified the series of normative principles shaping the economic loss rule:
- First, there is "'no general duty to avoid the unintentional infliction of economic loss,'" with recovery of purely economic loss based on a negligence theory permitted in only limited circumstances. Eby, No. 11-0810, 2014 Tex. LEXIS 509, at *20 (quoting Restatement (Third) of Torts: Liability for Economic Harm § 1 (Tentative Draft No. 1 2011) [hereinafter Restatement, T.D. 1]).
- Second, courts are concerned about the "'[i]ndeterminate and disproportionate liability'" that can arise for purely economic losses unaccompanied by personal injury or property damage. Id. at *11-*19 (quoting Restatement, T.D. 1, § 1 cmt. d).
- Third, economic loss is well suited to allocation by contract, including by insurance and indemnity clauses, so courts should give deference to contracts and should be reluctant to upset the allocation of risk made by a contract. Id. at *18-*19 (quoting Restatement, T.D. 1, § 1 cmt. d).
Application of the Economic Loss Rule to Contractor Claims Against Architects
With these principles in mind, the Eby court turned to
the matter at hand and examined the two issues in dispute: (i)
whether application of the economic loss rule should turn on
whether the claim is for negligent misrepresentation as opposed to
negligent performance of services; and (ii) whether a claim
involving an architect in a construction setting should be treated
differently because the plans drawn by the architect are intended
to be relied upon by the contractor when preparing a bid to be
submitted to the owner.
With regard to the first issue, the court noted that both the torts
of negligence and negligent misrepresentation are based on the same
logic and that the general theory of liability is the same. The
court therefore concluded that "[t]he economic loss rule
should not apply differently to these two tort theories in the same
situation." Eby, No. 11-0810, 2014 Tex. LEXIS 509, at
*38. Accordingly, under Texas law, a contractor will not be able to
pursue a direct claim against the owner's architect on facts
similar to those in Eby merely because the claim is framed
as one for negligent misrepresentation rather than
negligence.
As to the second issue, the court commented on the traditional
contractual relationships in construction projects:
Construction projects operate by agreements among the participants. Typically, those agreements are vertical: the owner contracts with an architect and with a general contractor, the general contractor contracts with subcontractors, a subcontractor may contract with a sub-subcontractor, and so on. The architect does not contract with the general contractor, and the subcontractors do not contract with the architect, the owner, or each other.
Id
. at *36. Setting aside the architect, the court broadly stated
that "[w]e think it beyond argument that one participant on a
construction project cannot recover from another ... for
economic loss caused by negligence. If the roofing subcontractor
could recover from the foundation subcontractor damages for extra
costs incurred or business lost due to the latter's negligent
delay of construction, the risk of liability to everyone on the
project would be magnified and indeterminate...." Id.
(emphasis added).
The court examined the underlying assumptions that are viewed
differently in jurisdictions across the country when it comes to
whether the economic loss rule precludes direct negligence claims
by a contractor against the owner's design professional. The
Restatement and some jurisdictions find it significant that design
documents are prepared by design professionals with the knowledge
that bidders, and ultimately the selected contractor, will be
required to rely on them. According to the Restatement,
"'the architect's plans are analogous to the audit
report that an accountant supplies to a client for distribution to
potential investors—a standard case of liability [for
negligent misrepresentation].'" Id. at *38-39
(quoting Restatement, T.D. 2, § 6 cmt. b).
Interestingly, the Restatement distinguishes between negligence
claims against subcontractors and those against architects. On the
one hand, the Restatement indicates that an owner may not sue a
subcontractor for negligence and one subcontractor may not sue
another subcontractor for economic loss: "'A
subcontractor's negligence in either case is viewed just as a
failure in the performance of its obligations to its contractual
partner, not as the breach of a duty in tort to other
subcontractors on the same job, or to the owner of the
project.'" Id. at *37 (quoting Restatement, T.D.
2, § 6 cmt. b). In this setting, according to the
Restatement, "'the rule of no liability is made especially
attractive by the number and intricacy of the contracts that define
the responsibilities of subcontractors on many construction
projects,'" and allowing such tort actions would disrupt
this "'web of contracts.'" Id. at *37-38
(quoting Restatement, T.D. 2, § 6 cmt. b).
On the other hand, the Restatement reaches a different conclusion
when it comes to contractor claims against architects:
"'Allowing a suit against the architect of a project by a
party who made a bid in reliance on a defective plan does not
create comparable problems.'" Id. at n. 51
(quoting Restatement, T.D. 2, § 6 cmt. b). Under this
reasoning, the economic loss rule's fundamental
objective—avoiding liability in an indeterminate amount for
an indeterminate time to an indeterminate class—is not
implicated because the only claim allowed is the contractor's
claim against the design professional.
The Texas Supreme Court, however, took the opposite view, diverging
from the Restatement on this point, and sided with other
jurisdictions holding that the economic loss rule precludes direct
claims by contractors against subcontractors. The Eby
court focused less on the foreseeability that the architect's
plans will be reviewed and relied upon by the contractor, but
rather on the contractual position of the parties. According to the
Eby court, "the contractor's principal reliance
must be on the presentation of the plans by the owner, with whom
the contractor is to reach an agreement, not the architect, a
contractual stranger. The contractor does not choose the architect,
or instruct it, or pay it." Id. at *39.
In discussing its rationale, the court noted that the Restatement,
which would permit direct claims against architects in negligence,
notes that if this is not desirable by the parties to the project,
"'they are free to change it in the contracts that link
them.'" Id. (quoting Restatement, T.D. 2,
§ 6 cmt. b). The Restatement worries that were the rule
otherwise, unsophisticated parties might be left without a remedy
because they did not have the foresight to address this
contractually. Id. at *42 (citing Restatement, T.D. 1,
§ 3, reporter's note to cmt. f). The Eby
court simply disagreed with this assumption: "We think it more
probable that a contractor will assume it must look to its
agreement with the owner for damages if the project is not as
represented or for any other breach." Id. The court
recognized that "[t]hough there remains the possibility that a
contractor may not do so, we think the availability of contractual
remedies must preclude tort recovery in the situation generally
because, as stated above, 'clarity allows parties to do
business on a surer footing.'" Id. at *42
(quoting Restatement, T.D. 2, § 6 cmt. b).
Interestingly, neither the Eby court nor the Restatement
discusses the distinction between public and private contracts and
how the negotiation process plays out in the real world.
Construction contracts on public works contracts oftentimes must be
awarded to the lowest responsible bidder, and the contract
language, which is distributed with the invitation for bid, is not
subject to traditional negotiation.
While the Eby decision brings a degree of clarity to the
Texas construction landscape in situations like those that
confronted the court, there are still circumstances where
contractors may try to assert direct claims against an owner's
design professionals. First, Eby does not address whether
claims for fraud or intentional misconduct by design professionals
are precluded by the economic loss rule (many courts carve out an
exception for these claims and allow them to be brought by
contractors, although there are many challenges to asserting such
claims).
Second, Eby does not address how the decision will affect
Integrated Project Delivery ("IPD") agreements where the
owner, contractor, and design professional all sign a single
contract. It remains to be seen whether Texas courts will be more
inclined to permit direct claims against an architect by a
contractor who is a party to an IPD contract along with the owner
and the architect, should the contract itself not expressly
foreclose such claims.
Third, the contractor in Eby did not allege that it was a
third-party beneficiary of the agreement between the architect and
the owner, so this issue was not addressed. Id. at n.6.
Where the professional services contract contains an express
disclaimer of third-party beneficiaries, design professionals have
some extra protection from these types of direct claims that are
not based on tort theories.
Implication for Drafting and Negotiating Construction Contracts
With the Texas Supreme Court's clear emphasis on the
parties' bargained-for agreements, it is more important than
ever for parties to focus on the drafting and negotiation of their
construction contracts for traditional design-bid-build projects.
Design professionals, owners, and contractors should keep the
following practical considerations in mind.
Design Professionals' Perspective. There are
two important provisions that design professionals like in their
contracts with owners, which limit the ability of construction
contractors to bring direct claims. First, design professionals
like to include a contractual provision that disclaims any intent
to create third-party beneficiaries. For example, Section 10.5 of
the American Institute of Architects Form B201 (2007) (Standard
Form of Agreement Between Owner and Architect) provides:
"Nothing contained in this Agreement shall create a
contractual relationship with or a cause of action in favor of a
third party against either the Owner or Architect." In the
wake of the Eby decision, contractors will be incentivized
to seek damages in contract that they can no longer seek in tort. A
disclaimer of third-party beneficiaries can help close the door to
such an argument and ensure that the design professional limits its
exposure to the extent possible. Second, design professionals are
sometimes able to persuade owners to include a provision in the
construction contract that expressly bars direct claims from
contractors related to the design professional's performance of
its contract with the owner (with potential carve-outs for personal
injury claims and claims for damages to the contractor's
property). Such a provision is in line with the Eby
holding, but it may afford even broader protection to design
professionals. Of course, owners are not always willing to insert
such a provision into their construction contracts.
Owners' Perspective. The Texas Supreme Court
suggests that the new Eby rule results in seamless
liability: "[I]f the architect is contractually liable to the
owner for defects in the plans, and the owner in turn has the same
liability to the contractor, the contractor is protected."
Eby, No. 11-0810, 2014 Tex. LEXIS 509, at *39-41 &
n.55. But there is not always true seamlessness, a situation to
which owners must be alert. The contractor may be able to recover
against the owner for breach of contract or breach of the implied
warranty of the correctness of the plans and specifications where
there is a defect attributable to the architect or engineer. The
owner may then bring a claim against the design professional for
indemnity or breach of the design professional's contract with
the owner. However, the design professional's contract and
indemnity provisions in favor of the owner may be worded to impose
liability only to the extent the design professional fails to meet
the standard of care for professional liability. This standard of
care does not require perfection. Thus, a situation may arise where
the owner is liable to the contractor because of a defective
specification or design error, yet be unable to pass the liability
on to the design professional where the design, though deficient,
does not fall below the standard of care. When this happens, the
owner is stuck holding the bag.
Because of this potential gap, owners may seek to impose as much
contractual liability on the design professional as
possible—including contractual liability not governed by the
standard of care. Design professionals frequently claim that such
contractual liability is not insurable and therefore they cannot
agree to accept liability beyond the standard of care. The
Eby court does not address this dynamic when it relies on
the Restatement, which suggests that a party to a construction
contract "'has a full chance to consider how to manage the
risks involved, whether by inspecting the item or investment,
obtaining insurance against the risk of disappointment, or making a
contract that assigns the risk of loss to someone else.'"
Eby, No. 11-0810, 2014 Tex. LEXIS 509, at *18 (quoting
Restatement, T.D. 1, § 1 cmt. c). Nonetheless, owners
frequently try to expand the scope of the design professional's
liability to better protect the owner and to narrow the potential
gap between the owner's potential strict liability to the
contractor for breach of contract or implied warranties, and what
can be pushed back to the design professional due to its errors or
omissions.
Contractors' Perspective. As the Eby
decision notes, a contractor has a direct claim against the owner
when there are defects in the design furnished by the owner. To the
extent Eby cuts off under Texas law a contractor's
ability to sue a design professional for negligence or negligent
misrepresentation, contractors may look to explore whether the
owner-design professional contract expressly denies third-party
beneficiary status to contractors and whether pursuing such a claim
is possible. In many cases, contractors are content to sue the
owner directly and to wait and see whether the owner brings in the
design professional, a development that contractors usually view as
favorable as the owner and design professional end up pointing
fingers at each other. On negotiated contracts, some contractors do
not balk at including provisions that preclude direct claims
against the owner's design professional because the contractor
knows that it has a direct claim against the owner for defects in
design.
Conclusion
The Eby decision provides clarity as to the application of the economic loss rule in Texas and puts a premium on the contract drafting process. Parties to construction contracts must review contracts carefully and negotiate accordingly.
Footnote
1 According to the Eby decision, courts across the country that have considered the issue are divided 10–8 on whether the economic loss rule applies to bar the claims brought by the contractor against the design professional. Eby, No. 11-0810, 2014 Tex. LEXIS 509, at *47 & n.60. Jurisdictions applying the economic loss rule on these facts to preclude such claims include Colorado, the District of Columbia, Illinois, Nevada, Ohio, Utah, Virginia, Washington, Wyoming, and now Texas. Id. at n.60. Jurisdictions refusing to apply the rule include Arizona, Florida, Massachusetts, Minnesota, Pennsylvania, Rhode Island, South Carolina, and West Virginia. Id.
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