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March 2010

Arizona Adopts the Economic Loss Rule in Construction Defect Cases

Flagstaff Affordable Housing Limited Partnership v. Design Alliance, Inc.

As of February, 2010, the Arizona Supreme Court recognized the economic loss rule in relation to construction claims. In Flagstaff Affordable Housing Limited Partnership v. Design Alliance, Inc., the Court applied the economic loss rule in a construction case and held that a property owner is limited to its contractual remedies when a design professional's negligent design causes economic loss, but no other physical injury to a person or other property (i.e. resultant damage).

"Economic Loss" refers to pecuniary or commercial damage, including any decreased value or repair costs for a product or property that is itself the subject of a contract between the parties, and consequential damages such a lost profits. The economic loss rule in essence precludes tort recovery for losses absent personal injury or damage to other property. It limits a party to contract remedies for such losses and encourages parties to protect their interests contractually before a project begins.

In Flagstaff Affordable Housing the Court applied the economic loss rule to deny an owner's claim against their architect for negligent design of a construction project in Flagstaff, Arizona.

Summary of Flagstaff Affordable Housing Limited Partnership v. Design Alliance, Inc.

In 1995 the project owner, Flagstaff Affordable Housing Limited, contracted with an architect, Design Alliance, Inc., to design an affordable housing project. To qualify as a low income housing project, the apartments had to comply with the federal Fair Housing Act's accessibility guidelines. The project was completed in 1996 and when the project failed to comply with those guidelines, the U.S. Department of Housing and Urban Development (HUD) filed a complaint against the owner. In 2006, the owner settled with HUD and subsequently sued the architect and the contractor that built the project for breach of contract and negligence. The contractor was later dismissed from the suit.

The architect moved to dismiss the complaint on the basis that the breach of contract claim was barred by the statute of limitations (more than 8 years after substantial completion of the project) and the negligence claim was barred by the economic loss rule. The owner's damages consisted of the cost to retrofit the project and ensure compliance with the accessibility guidelines. There were no claims for (a) anyone's death, (b) personal injury to anyone, or (c) injury to property other than the non-compliant project that the architect designed.

The owner voluntarily dismissed the contract claim but argued that the economic loss doctrine did not bar the negligence claim. The trial judge agreed with the architect and dismissed the owner's lawsuit. The owner appealed and the appellate court disagreed with the trial court and reinstated the owner's lawsuit. The architect appealed that decision to the Arizona Supreme Court, who reversed.

The Arizona Supreme Court agreed with the architect that the economic loss rule bars the owner's negligent design claim against the architect for the cost to retrofit the project.

The Court discussed the economic loss doctrine in terms of product liability case law, citing Salt River Project Agricultural Improvement and Power District v. Westinghouse Electric Corp., 143 Ariz. 368 (1984). In Salt River, the Court declined to categorically bar tort recovery of economic losses, but held that each case should be examined to determine whether the facts preponderate in favor of the application of tort law or commercial law or some combination of the two.

The Court stated that in order to determine whether the economic loss doctrine should apply to construction defect cases, that it must consider underlying policies of tort and contract law in the construction setting. The Court reasoned that in construction defect cases involving only repair and replacement of the construction work itself, there are no strong policy reasons to impose common law tort liability in addition to contractual remedies. The policies of accident deterrence and loss spreading also do not require allowing tort recovery in addition to contractual remedies for economic loss from construction defects. These considerations have less force when parties to a site-specific construction contract have allocated the risk of loss and identified remedies for non-performance in their contract. The Court stated that the principal function of the economic loss doctrine is to encourage private ordered or economic relationships and to uphold the expectations of the parties by limiting a plaintiff to contractual remedies for loss of the benefit of the bargain. These concerns are not implicated when the plaintiff lack privity and cannot pursue contractual remedies.

The Court concluded that the economic loss doctrine applies in the context of construction defect cases because construction contracts typically are negotiated on a project-specific basis and the parties should be encouraged to prospectively allocate risk and identify remedies within their agreements. The Court noted that parties can contractually agree to preserve tort remedies for solely economic loss. The Court concluded that in these cases the policies of the law will be best served by leaving the parties to their commercial remedies when a contracting party has incurred only economic loss, in the form of repair costs, diminished value, or lost profits.

Practical Effects

For Architects and Other Design Professionals: This decision will generally be beneficial. The economic loss rule will preclude parties other than those with whom the design professional contracted with from claiming damages for economic loss based on professional negligence and will limit the contracting party from asserting claims other than those allowed by the contract. In addition, the damages allowed for breach of contract claims are generally more limited than damages allowed for extra-contractual claims (e.g., negligence), and the limitations period for breach of contract claims is shorter than extra-contractual claims.

For Owners: This decision illustrates how critical it is to protect your interests in your contract with your design professional.

For Contractors: Even though this case did not involve a contractor, an argument can certainly be made that it applies to contractors as well as design professionals. The decision suggests that claims for economic losses may only arise from contract claims. Again, the damages available for those claims are more limited and terms in your contract may reduce exposure.