Resolving Commercial Disputes: Drawing the Line Between
Contract and Tort Theories Under the Economic Loss Doctrine
By Ronald R. Ragatz
Over the last decade, the Wisconsin Supreme Court has been refining
the roles of contract law and tort law in resolving commercial disputes.
On Feb. 26, 1998, the supreme court took another major step in that
process, ruling in Daanen & Janssen
Inc. v. Cedarapids Inc. that Wisconsin's economic loss doctrine
precludes tort claims by a commercial purchaser of a product against the
manufacturer, even where there is no privity between the manufacturer
and the purchaser.1 This decision
helps define the rights of manufacturers, sellers, and commercial
purchasers of products. It also leads to questions about where the
supreme court will apply the doctrine next.
The Wisconsin Supreme Court's recent decision
on the economic loss doctrine - Daanen & Janssen Inc. v.
Cedarapids Inc. - helps define the rights of manufacturers,
sellers, and commercial purchasers of products. The question now is,
where will the supreme court apply the doctrine next? |
Economic loss doctrine
The economic loss doctrine precludes a commercial purchaser of a
product from suing the seller in tort for solely "economic losses" where
there is no personal injury or damage to property other than to the
product itself or the machine of which it is a component. "Economic
loss" is damage resulting from a product being inferior in quality or
not working for its intended purposes.2 It
includes loss in value of the product itself and consequential losses
such as lost profits.
The privity issue
When the Wisconsin Supreme Court first adopted the economic loss
doctrine in 1989, it left open the question of whether the doctrine
applies where the purchaser and the defendant are not in privity of
contract. In Sunnyslope Grading Inc. v. Miller, Bradford and
Risberg,3 a commercial purchaser of
backhoe equipment sued the manufacturer in tort, alleging negligence and
strict product liability. The purchaser had received a manufacturer's
warranty on the equipment and, thus, the manufacturer and purchaser were
in privity. The supreme court held that the tort claims were barred by
the economic loss doctrine.
In adopting the economic loss doctrine, the Sunnyslope court
followed the reasoning of the 1986 U.S. Supreme Court decision in East River Steamship
Corp. v. Transamerica Delaval Inc.4
In East River the court reasoned that a manufacturer has no
duty in tort to prevent a product from injuring itself and that claims
for such damages should be addressed under contract theories, not tort
theories.5 It based the economic loss
doctrine on fundamental distinctions between tort law and contract law,
and did not mention privity.
However, the Sunnyslope court confined its ruling to the
question directly before it, that is whether the doctrine barred
economic losses between commercial parties where there was a warranty
between the parties. Two years later, the Wisconsin Supreme Court in
Northridge Co. v. W.R. Grace & Co. again considered the
economic loss doctrine and again discussed the fundamental distinctions
between tort and contract law.6 However, the
court did not have occasion to address the privity issue, since it
concluded that the economic loss doctrine did not apply for other
reasons.
In the meantime, federal courts applying Wisconsin law predicted that
the Wisconsin Supreme Court would apply the economic loss doctrine even
in the absence of privity.7
Daanen & Janssen background
In 1991 Daanen & Janssen purchased from a local dealer a
replacement component part for its rock crushing machine. The component
was manufactured by Cedarapids, but Daanen & Janssen never received
a manufacturer's warranty.
Daanen & Janssen claimed that over the next three years the
crushing machine had multiple breakdowns caused by defects in the
component. The breakdowns did not cause any personal injury or damage to
property other than the crushing machine. The only damages claimed were
repair costs and lost profits, totaling several hundred thousand
dollars.
Daanen & Janssen sued Cedarapids in tort, including negligence
and strict liability claims. Cedarapids moved for summary judgment,
arguing that the claims were barred by Wisconsin's economic loss
doctrine. Summary judgment was granted in the U.S. District Court for
the Eastern District of Wisconsin, and Daanen & Janssen appealed to
the Seventh Circuit. The sole issue on appeal was whether Wisconsin's
economic loss doctrine applies where there is no privity between the
plaintiff purchaser and the defendant manufacturer. The Seventh Circuit
certified the following question of state law to the Wisconsin Supreme
Court:
"In the absence of privity, does the economic loss doctrine bar a
remote commercial purchaser from recovering economic losses from a
manufacturer under theories of strict liability and negligence?"
The Daanen & Janssen decision
The Wisconsin Supreme Court answered the certified question in the
affirmative, ruling that Wisconsin's economic loss doctrine applies in
the absence of privity. In a unanimous decision authored by Justice
Donald Steinmetz, the court provided a thorough analysis of the
principles underlying the economic loss doctrine:
"Application of the economic loss doctrine to tort actions between
commercial parties is generally based on three policies, none of which
is affected by the presence or absence of privity between the parties:
(1) to maintain the fundamental distinction between tort law and
contract law; (2) to protect commercial parties' freedom to allocate
economic risk by contract; and (3) to encourage the party best situated
to assess the risk of economic loss, the commercial purchaser, to
assume, allocate, or insure against that risk."8
With respect to the first policy, the concept of duty is at the heart
of the distinction drawn by the economic loss doctrine. Contract law
seeks to hold commercial parties to their promises, ensuring that each
party receives the benefit of its bargain, while tort law is rooted in
the concept of protecting society as a whole from physical harm to
persons or property. Therefore, a "manufacturer in a commercial
relationship has no duty under either negligence or strict liability
theories to prevent a product from injuring itself."9
Second, the economic loss doctrine protects commercial parties'
freedom to contract. The marketplace operates best when commercial
parties are free to factor risk allocation into their agreements.
Commercial purchasers can opt for warranty protections at a higher price
or can choose to bargain for a lower price and accept the risk of
product failure. However, if a purchaser that has chosen the lower price
without a warranty can resort to tort remedies in the event of product
failure, then the bargain is frustrated. Manufacturers would have to
build the cost of such risks into the price of all their products and
the freedom to allocate risks by contract would be impaired.
Finally, as a corollary to the second policy, the economic loss
doctrine encourages the party with the best understanding of the risks
of economic loss - the commercial purchaser - to assume, allocate, or
insure against the risk of loss caused by a defective product. The
doctrine thus promotes efficiency and predictability in commercial
relationships by basing liability solely on contract. Permitting tort
theories for recovery of economic losses in commercial transactions
would "make the manufacturer of products potentially liable for
unbargained-for and unexpected risks."10
The court rejected arguments by Daanen & Janssen that applying
the economic loss doctrine in the absence of privity would be unfair and
contrary to public policy because it would leave a purchaser like Daanen
& Janssen with no remedy against the manufacturer. The doctrine is
intended to encourage commercial parties to negotiate protections at the
time of the purchase, and permitting tort remedies after the fact would
"allow an end run around contract law and would all but destroy the
economic loss doctrine."11
Impact of Daanen & Janssen
This decision has a real impact for commercial manufacturers,
distributors, and dealers in Wisconsin. In today's marketplace, few
products are sold directly by the manufacturer. Rather, most
transactions involve intermediaries of some sort - dealers,
distributors, or retailers.
If there were a privity exception to the economic loss doctrine, a
purchaser could opt for a lower price rather than pay for a
manufacturer's warranty and then could fall back on tort remedies if a
problem arose. After Daanen & Janssen, the purchaser now
has the incentive to bargain for a manufacturer's warranty because
without one, the purchaser probably will be left with no remedy at all
against the manufacturer.
The decision also alters the dynamics between dealer and purchaser
and between dealer and manufacturer. If the purchaser could sue the
manufacturer in tort, contract remedies against the dealer might be of
secondary importance. Now, the contractual relationship between the
purchaser and the dealer generally will be the focus of any product
failure claims, if there is no manufacturer's warranty. The dealer
either must bargain for limitations of remedies with the purchaser or
make sure that its contract remedies against the manufacturer are
preserved so that it can pass the liabilities up the chain of
distribution.
The Daanen & Janssen decision should provide the
incentives that the supreme court envisioned. It provides motivation for
all of the commercial parties to think about and allocate risks in the
sale of products. It is the natural completion of what the court began
nine years ago when it adopted the doctrine in Sunnyslope for
product liability. The question now is whether the court will apply the
same principles in areas beyond product liability.
Anticipating future applications
So far, the Wisconsin Supreme Court and Court of Appeals have applied
the economic loss doctrine only to negligence or strict liability claims
arising out of the sale of a product in a commercial transaction.
However, recent federal court decisions applying Wisconsin law have
extended the doctrine to claims for negligent services and pollution.
Federal courts also have addressed how the doctrine applies to fraud
claims. In addition, courts in some other jurisdictions have applied the
doctrine to consumer transactions.
Negligent services.Wisconsin courts have suggested
that the economic loss doctrine may not apply to claims for negligent
services, particularly professional services. In Sunnyslope the
Wisconsin Supreme Court distinguished prior case law allowing recovery
of economic losses in tort where the claim was for negligent services.12 Similarly, the Wisconsin Court of Appeals
declined to apply the economic loss doctrine to a case involving
negligent services.13 In Daanen &
Janssen the Wisconsin Supreme Court stated that "we have not
addressed nor do we address here whether the doctrine applies with equal
force to damages resulting from the provision of services."14
There are reasons to distinguish between claims
for services and claims for defective products. A substantial body of
law has been developed in the Uniform Commercial Code to deal with
allocation of risk in the sale of products, including implied warranties
where the parties have not expressly allocated risks. There is no
corresponding body of law that has been developed to the same extent
with respect to negligent services.
Nonetheless, federal courts applying Wisconsin law have predicted
that the supreme court would apply the economic loss doctrine to claims
for negligent services.15 As noted by Judge
Barbara Crabb, "sophisticated parties are just as capable of allocating
the risk of economic loss in a contract for services as in a contract
for a product."16
Further, even though Wisconsin courts have not applied the economic
loss doctrine to claims for negligent services, Wisconsin caselaw has
limited the scope of tort claims arising in the context of contracts for
services. There must be a duty existing independently of the contract in
order for a cause of action in tort to arise.17 These decisions are consistent with the
policies articulated in Daanen & Janssen. Since Wisconsin
courts have held already that a mere contractual duty will not support a
claim in tort, applying the economic loss doctrine to claims for
negligent provision of services may be a logical next step.
Environmental claims. Federal courts also have
applied Wisconsin's economic loss doctrine to tort claims by owners of
contaminated land, even though the Wisconsin courts have not yet done
so.18 In those cases, the current
landowners brought claims in tort, including nuisance, trespass,
negligence, and ultrahazardous activity, to recover cleanup costs from
past owners who caused the contamination.
The federal courts held that Wisconsin's economic loss doctrine
barred the tort claims. In one case,19 the
court rejected claims that there was damage to "other property" because
of groundwater contamination, despite Wisconsin caselaw that groundwater
is not owned by the landowner, but rather is public property.20 In Northridge the supreme court
declined to apply the economic loss doctrine to bar tort claims arising
from asbestos in a shopping center building, ruling that such claims
involve damage to other property and implicate the type of health and
safety concerns that are the proper subject of tort claims. Nonetheless,
the federal court rejected arguments that tort claims were proper
because of health concerns caused by groundwater contamination.
The application of the economic loss doctrine to environmental cases
extends the economic loss doctrine beyond its traditional boundaries,
particularly where the cases involve groundwater contamination. In some
cases, it will not be a problem because the landowner will have a remedy
under federal environmental laws.21
However, in other cases, there will be a real impact, because of
limitations in those federal laws.22
![Ronald R. Ragatz](/SiteCollectionImages/WisconsinLawyer/1998/07/ragatz.jpg) |
Ronald R. Ragatz, U.W. 1977, is a
shareholder at DeWitt Ross & Stevens S.C., Madison. He was attorney
of record for Cedarapids Inc. in Daanen & Janssen v.
Cedarapids. |
Fraud claims. A third issue that has been addressed
by federal courts, but not Wisconsin courts, is whether Wisconsin's
economic loss doctrine bars fraud claims.23
One federal court ruled that the doctrine does not apply to fraudulent
misrepresentation claims, reasoning that public policy would best be
served by "leaving the possibility of an intentional tort suit hanging
over the head of a party considering outright fraud."24 In two other cases, however, the federal
courts ruled that application of the doctrine depends upon the type of
fraud involved.25 Claims for fraud in the
inducement are not barred by the economic loss doctrine, because they
undermine the very freedom of contract that the doctrine is intended to
promote. However, the doctrine may bar claims for misrepresentations
about the quality or character of a product because they are interwoven
with breach of contract and, therefore, are not the proper subject of
tort claims.
The Wisconsin Supreme Court probably would agree that claims for
fraud in the inducement are not barred, because the doctrine is intended
to promote freedom of commercial parties to allocate risks, but such
fraud can defeat informed contractual allocation of risks. How the
supreme court would treat the latter category of fraud is unclear.
Consumer claims. Finally, some jurisdictions have
applied the economic loss doctrine even to consumer transactions.26 However, in the decisions of the Wisconsin
Supreme Court on the economic loss doctrine to date, the sophistication
of commercial purchasers and their relatively equal bargaining power
with sellers and manufacturers has been an important consideration in
applying the doctrine. It seems unlikely that the Wisconsin Supreme
Court would apply the doctrine to consumer claims.
Conclusion
The Wisconsin Supreme Court has just made the line between contract
and tort in product liability cases clearer. In coming years, look for
the court to begin drawing such a line in other areas, including claims
for negligent services, contamination, and fraud.
Endnotes
1Daanen & Janssen Inc. v. Cedarapids
Inc., 216 Wis. 2d 394, 573 N.W.2d 842 (1998).
2Northridge Co. v. W.R. Grace
& Co., 162 Wis. 2d 918, 925-26, 471 N.W.2d 179 (1991).
3Sunnyslope Grading Inc. v.
Miller, Bradford & Risberg, 148 Wis. 2d 910, 437 N.W.2d 213
(1989).
4East River Steamship
Corp. v. Transamerica Delaval Inc., 476 U.S. 858 (1986).
5Id. at 868.
6Northridge, 162 Wis. 2d
918, 933-34, 471 Wis. 2d 179 (1990).
7Miller v. U.S. Steel
Corp., 902 F.2d 573 (7th Cir. 1990); Midwest Knitting Mills
Inc. v. U.S., 950 F.2d 1295 (7th Cir. 1991); Midwest
Helicopters Airways v. Sikorsky Aircraft Inc., 849 F. Supp. 666
(E.D. Wis. 1994), aff'd, 42 F.3d 1391 (7th Cir. 1994).
8Daanen & Janssen, 216
Wis. 2d at 402, 573 N.W.2d at 846.
9Id. at 405, 573 N.W.2d at
847.
10Id. at 410, 573 N.W.2d
at 849.
11Id. at 413, 573 N.W.2d
at 850.
12Sunnyslope, 148 Wis.
2d at 918-19, 437 N.W.2d at 216, distinguishing A.E. Investment
Corp. v. Link Builders Inc., 62 Wis. 2d 479, 214 N.W.2d 764
(1974).
13Hap's Aerial Enter. Inc. v.
General Aviation Corp., 173 Wis. 2d 459, 496 N.W.2d 680 (Ct. App.
1992).
14Daanen & Janssen,
216 Wis. 2d at 416, n. 9, 573 N.W.2d at 852, n. 9.
15Stoughton Trailers Inc. v.
Henkel Corp., 965 F. Supp. 1227 (W.D. Wis. 1997); Wausau Paper
Mills Co. v. Chas. P. Main Inc., 789 F. Supp. 968 (W.D. Wis.
1992).
16Stoughton Trailers,
965 F. Supp. at 1233 (W.D. Wis. 1997).
17Landwehr v. Citizens Trust
Co., 110 Wis. 2d 716, 723, 329 N.W.2d 411 (1983); Greenberg v.
Stewart Title Guar. Co., 171 Wis. 2d 485, 492 N.W.2d 147, 152
(1992) (dismissing tort claims against title companies because they "did
not assume an independent duty to Greenberg to examine title and conduct
a reasonable search."); Madison
Newspapers Inc. v. Pinkerton's, 200 Wis. 2d 468, 545 N.W.2d 843
(Ct. App. 1996) (dismissing tort claims for negligent supervision of
security personnel, where the security personnel were provided pursuant
to contract).
18Metal Processing Co. v.
Amoco Oil Co., 926 F. Supp. 828 (E.D. Wis. 1996); Raytheon Co.
v. McGraw-Edison Co. Inc., 979 F. Supp. 858 (E.D. Wis. 1997);
DT Inc. v. Avatar Holdings, Case No. 97-C-447 (W.D. Wis.
1997).
19DT Inc. v. Avatar,
Case No. 97-C-447 (W.D. Wis. 1997).
20Lee Associates Inc. v.
Perers, 206 Wis. 2d 509, 522, 557 N.W.2d 457 (Ct. App. 1996).
21See, the Comprehensive
Environmental Response, Compensation and Liability Act (CERCLA), 42
U.S.C. §9601, et seq., or the Resource Conservation and
Recovery Act (RCRA), 42 U.S.C. § 6901 et seq.
22For instance, CERCLA does not
cover petroleum contamination in the absence of other contaminants. RCRA
cannot be used to recover past costs. Meghrig v. KFC Western
Inc., ___ U.S. ___, 116 S. Ct. 1251, 134 L. Ed. 2d 121 (1996).
23Stoughton Trailers,
965 F. Supp. 1227 (W.D. Wis. 1997); Raytheon Co. v. McGraw-Edison
Co. Inc., 979 F. Supp. 858 (E.D. Wis. 1997); Cooper
Power Sys. v. Union Carbide, 123 F.2d 675 (7th Cir. 1997).
24Stoughton Trailers,
965 F. Supp. at 1236.
25Raytheon, 979 F. Supp.
at 870-73; Cooper Power Sys., 123 F.3d at 682.
26See, e.g.,
Alloway v. New Hampshire Ins. Co., 695 A.2d 264 (N.J. 1997);
Danforth v. Acorn Structures Inc., 608 A.2d 1194 (Del. 1992);
Dairyland Ins. Co. v. General Motors Corp., 549 So. 2d 44, 46
(Ala. 1989).
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