Watch Out for the Economic Loss Rule
The economic loss rule plays an important role in the allocation of liability for damages incurred by parties on a construction project. Often, the party harmed and the party causing the injury are not parties to the same contract — owner/subcontractor or general contractor/owner-retained design professional are two common examples. The general rule is that a party can recover economic losses for breach of contract but cannot for a claim based on negligence, absent physical injury. More specifically, in Ohio, one party cannot recover “economic losses” from another (1) absent a contract between the two, or (2) absent a “nexus” between the parties that substitutes for a contract, or (3) absent tangible, physical injury to the body or property of the party. This rule was just recently applied again in Ohio to deny recovery to the intended tenants of a new building who had suffered economic losses of almost $300,000 in the form of expenses incurred due to a delay in the construction of the new building caused by a subcontractor with whom they had no contract. Some important lessons can be drawn from this case. Federal Ins. Co. v. Fredericks, Inc., 2015-Ohio-694 (Montgomery County Ct. App.).
The logistics business at issue, that was having the building constructed, was separated into four distinct, affiliated entities. One owned the building, two others would rent it and run the business, and a fourth was the 100% owner of the other three. The property owner entity alone contracted with a general contractor to build the building and then subcontracted the entire job to a subcontractor. Unfortunately, the subcontractor failed to erect the structural steel properly and it collapsed in a wind storm. The result was five months of delay on the project in order to do the repairs.
Claims followed by the property owner and its affiliates: (1) the property owner sought $664,852 in damages for repairs, which were not economic losses; (2) the other three affiliates of the owner made a claim for $289,055 for consequential — economic loss type — damages arising from the delay, largely expenses relating to renting an alternate facility; and (3) the affiliates sought a determination that the subcontractor’s liability insurer be required to cover these consequential damages.
The trial court found that the builder’s risk insurer, which had paid for the repair and stepped into the owner’s shoes to claim reimbursement, was entitled to recovery from the subcontractor for the repair costs. It also determined, however, that the three affiliates were barred from recovery of their consequential damages due to the economic loss rule and that, since the subcontractor had no liability for those damages, its insurer had no damages to cover. The appellate court affirmed.
The key issue was the economic loss rule. The affiliates of the owner made three basic arguments in an attempt to get around it, each of which the appellate court rejected: (1) that all the affiliates were so inter-related that the tangible, physical harm to the owner’s property was sufficient to bar application of the economic loss rule to the affiliates; (2) that the affiliates were third-party beneficiaries of the subcontractor’s contract with the general contractor and, therefore, could recover contract based damages, including economic losses; and (3) that there was a sufficient “nexus” between the affiliates and the subcontractor to substitute for the absence of a contract between them and bar the application of the economic loss rule.
The appellate court’s ruling was clear:
- Corporate entities are distinct, and harm to one is not harm to another. Since there was no tangible, physical harm to the affiliates’ property, the economic loss rule barred any recovery of their economic delay damage losses.
- To prove that someone is a third-party beneficiary of a contract between others — and therefore that he or she has the right to enforce it and seek damages for its breach, including economic losses — the contract itself must indicate that the party indeed was intended to be a beneficiary. The subcontractor’s mere knowledge, as here, that the tenants would be benefited by its work was not enough.
- In order to show a “nexus” between the parties that would have avoided the economic loss rule, it had to be shown that the affiliates exercised “excessive control” over the subcontractor. Since there was no such evidence, the economic loss rule applied and barred the affiliates’ claim.
The result here was that the subcontractor ended up with a significant uninsured liability ($664,852) and could have had an even larger one (an additional $289,055). Under Ohio law, there would be no insurance coverage under a CGL policy for the $664,852 for repair of the defective work, leaving the subcontractor alone responsible to pay that cost. That is simply a business risk that CGL policies generally do not cover in Ohio. In addition, though, if the facts had been slightly different and the subcontractor had been found liable for consequential damages to the affiliates, it is possible, under Ohio law, that the subcontractor would have found itself without insurance coverage for that claim as well. In light of that possibility, subcontractors should consider the following to protect themselves going forward:
- They should resist express third-party beneficiary clauses being added to their contracts. If there had been one here, the subcontractor would have been liable for the $289,055 and might not have had insurance coverage for it.
- They should not allow themselves to be pulled into a situation where the owner or an affiliate of the owner controls their work rather than the party with which they contracted.
- They should try to have a waiver of consequential damages included in their subcontracts.
For the owner's protection against much more common claims by subcontractors based on the “nexus” argument — i.e., that the owner controlled its work and therefore should be liable for economic losses incurred by the subcontractor — the owner should always work through its general contractor and not exercise control directly over the subcontractor’s workforce. The owner should also seek to be added as a third-party beneficiary to the subcontractor’s contract, if possible, and as an additional insured. Another thing the owner might have done in this case would have been to enter into leases with its tenants/affiliates before construction started. By doing so, those affiliates would have had the additional argument that they indeed had suffered tangible, physical harm to their property, and, therefore, the economic loss rule would not apply to them. It would also have served as a basis for the owner — who was entitled in theory to consequential, economic losses, because its property clearly had been tangibly and physically damaged — to recover lost rent for the five months that it could have collected rent under such leases due to the collapse caused by the subcontractor.
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