Under Construction - September 2013: Application of the Economic Loss Rule in Arizona Since Flagstaff Affordable Housing Ltd. v. Design Alliance, Inc.

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In a recent ruling, the Arizona Supreme Court clarified that the economic loss rule does not apply to non-contracting parties.  See Sullivan v. Pulte Home Corporation, 667 Ariz. Adv. Rep. 36 (Ariz. 2013).  This ruling both clarifies and expands upon the Court’s seminal ruling on the application of the economic loss rule to construction contracts, in Flagstaff Affordable Housing Ltd. v. Design Alliance, Inc.

Flagstaff Affordable Housing Ltd. v. Design Alliance, Inc.

In Flagstaff Affordable Housing, the Arizona Supreme Court held that the economic loss rule applies to construction contracts and that parties to such contracts are solely limited to contractual remedies for purely economic damages.  Thus, at its core, the economic loss doctrine in Arizona “precludes tort recovery for [economic] losses absent personal injury or damage to other property” and “limit[s] a contracting party to contractual remedies for the recovery of economic losses unaccompanied by physical injury to persons or other property.” Flagstaff Affordable Housing Ltd., 223 Ariz. 320, 322-23 (2010).

The Court reasoned that the policies of contract law – encouraging parties to order their prospective relationships, allocate the risks of future losses, and identify available remedies – are particularly applicable to construction defect cases.  As a result, the goals of contract law “are best served by allowing the parties to specify the consequences of a breach of their agreement.”  Id., at 323.  The Court concluded that, “in construction defect cases, the policies of the law generally 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.”  Id., at 326.

Subsequent Analysis of the Economic Loss Rule

In the few years since Flagstaff Affordable Housing was published, Arizona courts have applied the economic loss rule in a variety of situations.  A summary of the more significant cases is provided below:

  • In Cook v. Orkin Exterminating Co., the Arizona Court of Appeals applied the rule to preclude claims for fraud in the inducement and misrepresentation.  227 Ariz. 331, 332, ¶ 4, 335, ¶ 20, 258 P.3d 149, 150, 153 (App. 2011); see also Maricopa Investment Team, LLC v. Johnson Valley Partnership LP, 2012 WL 5894849 (Ariz. App. 2012) (applying the economic loss rule to bar plaintiff’s fraud in the inducement claim).
  • In Miidas Greenhouses, LLC v. Global Horticultural, Inc., the Arizona Court of Appeals held that the economic loss rule did not bar plaintiff’s claims where it sufficiently pled damages to other property.  226 Ariz. 142 (2010).
  • In Carioca Company v. Sult, the Arizona Court of Appeals (in a Memorandum Decision) held that the economic loss rule barred the plaintiff’s tort claims, relating to an agreement to transport dirt off a construction site, even though the parties lacked any formal written contract.  2010 WL 2606623 (Ariz. App. 2010).
  • In Shaw v. CTVT Motors, Inc., the Arizona Court of Appeals held that the economic loss rule does not apply to private causes of action under the Arizona Consumer Fraud Act.  232 Ariz. 30 (App. 2013).

Sullivan v. Pulte Home Corporation

In July 2013, the Arizona Supreme Court again weighed in on the economic loss rule in Sullivan v. Pulte Home Corporation, 667 Ariz. Adv. Rep. 36 (Ariz. 2013).  In Sullivan, Pulte Homes (the Defendant) built a new home and sold it in 2000. The original buyer re-sold the home to the Sullivans (the Plaintiffs) in 2003. The Sullivans discovered certain retaining wall defects in 2009 and filed the lawsuit in 2010, which alleged both implied warranty and tort claims.  The trial and appellate court held that Arizona’s statute of repose barred the contractual implied warranty claims, but did not bar the tort claims.

The trial court also dismissed the negligence claim under the economic loss rule.  However, on appeal, both the Court of Appeals and the Arizona Supreme Court ruled that the economic loss rule did not bar the Sullivans’ negligence claim because there was no direct contract between Pulte and the Sullivans.  In its ruling, the Supreme Court expressly clarified the strong implication of Flagstaff, holding that the economic loss rule does not apply to non-contracting parties.  The Court reasoned that the doctrine is intended to protect the “expectations of contracting parties, but, in the absence of a contract, it does not pose a barrier to tort claims that are otherwise permitted by substantive law.”

The application of the economic loss rule, as recognized in Sullivan, will lead to some undesirable results for contractors and home builders.  For example, the Court of Appeals recognized that under this new rule original home buyers will have fewer remedies than a subsequent purchaser, since only subsequent purchasers can assert both implied warranty claims and tort claims.

In addition, CGL carriers may begin denying coverage over any contract claims (including implied warranty claims) where a direct contract exists and the economic loss rule applies.  See e.g. Desert Mountain Properties Ltd. Partnership v. Liberty Mut. Fire Ins. Co., 225 Ariz. 194 (App. 2010) (declining to hold as a matter of law that all CGL insurance policies do not cover liability arising out of contract, but noting that parties are free to write such exclusions into their policies).  This again could lead to the strange result where CGL coverage exists to defend claims from a subsequent purchaser, but not for the same claims by the original purchaser.

As a result, developers, contractors, subcontractors and design professionals need to be aware of the potential consequences of Sullivan v. Pulte Homes in Arizona.  At the very least, construction industry professionals should be thinking of ways to restructure construction and buyer-seller agreements to include contractual limitation periods or waivers and assignments of rights to make construction defect claims, all to try and better define contractual obligations and duties of reasonable care assumed by all parties in the chain of ownership and occupancy.