United States: Economic Lost: The Return of the Specter of Punitive Damages in Contract Cases

Simply put, the economic loss doctrine holds that a plaintiff cannot recover under tort law (e.g., negligence) for a defective product if there is no damage to anything other than the product itself. In 2000, real estate practitioners applauded the California Supreme Court when it upheld the "economic loss" doctrine in Aas V. Superior Court, 24 Cal.4th 627 (2000). In the real estate context, this means that the remedy for a breach of contract - such as the improper construction of a home - is found under contract law and is limited to the economic losses suffered by the plaintiff, and is not found in tort law. The inability to sue under tort law means the inability to recover punitive damages, and that was a big reason for the cheer when Aas was rendered. While case law has established many exceptions, the real estate industry was hopeful that the Supreme Court carved out real estate from tort damages.

But a company and its flying machines may bring back the pre- Aas uncertainty.

In Robinson Helicopter Company, Inc. v. Dana Corporation (04 C.D.O.S. 11271), Robinson Helicopter Company purchased parts from Dana Corporation to be used in the helicopters manufactured by Robinson. During the course of the contract, parts were shipped and Dana provided a written certificate stating that each shipment conformed to the approved specifications set forth in the written purchase contract. Unknown to Robinson, after execution of the purchase contract, Dana changed its manufacturing process, with the result that the parts did not conform to the specifications. Dana disclosed the manufacturing process change three months after Robinson had notified Dana that it had experienced a higher-than average failure rate for the parts. Although it was possible that both physical injury and property damage could have resulted from Dana's failure to provide parts which met the required specifications, fortunately no such damage occurred.

Robinson sued Dana for (i) breach of contract and breach of warranty and (ii) negligent and intentional misrepresentations. The jury found that Dana had breached both its contract and warranty, and that Dana knowingly made false misrepresentations of fact. The jury awarded Robinson $1,533,924 in compensatory damages and $6,000,000 in punitive damages, with the punitive damage award being based on Dana's intentional misrepresentations. Dana appealed. The Court of Appeal affirmed the judgment on the contract and warranty causes of action, but overturned the punitive damage award by applying the economic loss doctrine and disallowing recovery under the tort claims of negligent and intentional misrepresentations. Robinson appealed the latter finding.

On appeal, the California Supreme Court concluded that the economic loss doctrine is not a bar to tort recovery, including punitive damages, for intentional misrepresentation or fraud in the performance of a contract if the plaintiff relied on affirmative misrepresentations that exposed it to personal damages independent of the plaintiff's economic loss. Despite the fact that no one was hurt and no property was damaged, the Court found that the situation exposed the defendant to the possibility of personal injury or property damage, and allowed the plaintiff to recover both compensatory and punitive damages in tort.

The court found the economic loss rule did not apply to the misrepresentation claims made by Robinson, because those claims were independent of Dana's breach of contract. The court found that Dana made knowingly false certifications, which amounted to fraud. The economic loss rule was meant to limit liability in commercial activities that either negligently or inadvertently went awry, the Robinson court noted, and was not meant to reward those who affirmatively misrepresent and put others at risk. Accordingly, the court held that tort liability is available in a case in which the plaintiff is exposed to a risk of personal damages independent of economic loss - with actual injury or property damage not being required.

Is Robinson simply the recognition of a long-standing exception to the economic loss rule, or does it chip away at the Aas decision? And, how will the case affect real estate agreements? The answers may not be known for several years, as the courts grapple with the Robinson decision. However, given the threat of punitive damages, it behooves all real estate participants to evaluate and perhaps modify their contracts in light of the Robinson decision. Practitioners must be aware of the possibilities of more costly disputes and the specter of claims of intentional conduct for which insurance coverage and other indemnity is customarily not available. While it is safe to say that tort claims will now be made in many more disputes, there are some ways to mitigate their impact.

For example, in purchase and sale contracts and in some leases, language is often used to limit representations about the knowledge of one party concerning the condition of the property, the adequacy of due diligence, or other material information. Arguably, that information could give rise to tort damages because of the possibility of personal injury or property damage arising from conditions at the property. It can also expose the party making the representation to fraud claims. The party making the representations should limit them to the "actual knowledge" of specifically named individuals at specifically identified dates. The representations should also be as well-defined and limited as possible to help prevent later argument about their meaning.

Parties making representations should not risk punitive damage claims by making statements or submitting information that either may be, or is known to be, false or even questionable. The potential downside is too great. Had Dana stopped sending certificates stating that its parts conformed with the purchase contract, Robinson would still have had a breach of contract claim, but it could have been resolved simply by replacing the non-conforming parts or paying Robinson for the costs of obtaining similar parts elsewhere. The misrepresentations opened the door to a tort claim, which opened another door to punitive damages.

In agreements such as purchase and sale contracts, leases, and construction contracts, parties may eliminate the argument that one party is relying on the other (one of the conditions for the tort claim cited in Robinson) by allowing for an audit or review of ongoing performance. This can be accomplished by allowing the other party to review documents relating to performance periodically. Ongoing review of performance shifts the burden to the party that may at some point try to claim tort damages. If the party has availed itself of the review process, it is less likely to prevail on a claim of misrepresentation. If the party has the opportunity to review and fails to do so, the likelihood of prevailing decreases even further.

After Robinson, it is not clear whether common real estate contract provisions limiting exposure to certain types of claims or damages will be upheld. Contracting parties typically provide that punitive damages will not be recoverable, or state an amount of liquidated damages to be awarded the non-breaching party, concluding that the determination of damages would be difficult. Those provisions, especially in commercial contracts, have survived, for the most part, in the courts, with the exception of attempts to limit liability for the personal injury of others. Parties should continue to use limiting provisions in their agreements, but recognize that courts may look to the circumstances of the case and, when the facts indicate a risk of personal injury or property damage, ignore the contract's limitations. Identifying the appropriate contracting parties has always been important in real estate agreements. Now, it is vital. Punitive damages are based, in large part, on the wealth of the defendant. To avoid the worse case scenario of parties facing punitive damages, contracting parties should contemplate limiting that exposure at the contracting stage - for example, through the use of single-purpose limited liability companies.

Until the implications of Robinson are better understood through subsequent decisions, parties performing contracts subject to California law should be aware that their written and oral representations about performance, including products and services, might expose them to liability for tort damages. Practitioners should act defensively in negotiating their agreements and in performing them by (i) clearly defining the requirements of performance, (ii) identifying and limiting the representations about performance, (iii) allowing the other party an opportunity to audit performance, (iv) identifying the appropriate contracting parties to limit exposure, and (v) adding carefully-drafted language to their agreements limiting the types of damages to which they are exposed. In this way, perhaps practitioners can preserve the economic loss doctrine as it relates to real estate matters.

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