Using the Economic Loss Rule to Your Client's Benefit

by Lewitt Hackman

All lawyers can benefit from having a toolbox of general legal knowledge with which to frame a case to their client's advantage.

For business attorneys the economic loss rule is a particularly useful tool. At its simplest, the rule prohibits claimant from recovering damages for purely economic loss unless the claimant also suffered directly related physical injury to his or her person or property from another's tortious conduct. First recognized in products liability cases, the economic loss rule has been applied across a broad spectrum of commercial relationships based in contract.

The economic loss rule can be stated with seeming clarity, but when it comes to applying the rule, appellate courts have struggled. Moreover, exceptions and nuances vary among jurisdictions.

Some jurisdictions limit the rule to products-liability, sales, and construction cases. Some do not apply its damages limitation in fraud claims. The most common approach in fraud cases strikes an uneasy balance by permitting an intentional fraud action to proceed as long as the claimed damages arise from a representation of fact not contained in the parties' contract.

Fraud in the inducement is an exception to the economic loss rule. This type of fraud presents a special situation in which the contracting parties appear to have negotiated, which would normally be grounds to invoke the rule's limitation of damages. But one party's ability to negotiate fair terms and reach an informed decision is undermined by the other party's fraudulent behavior. Thus, the reason courts do not apply the economic-loss rule to fraud in the inducement is that the fraud destroys consent, thereby vitiating the contract.

To invoke the fraud exception, a transacting party's failure to disclose material facts serves as a basis to claim fraudulent inducement. In the context of business transactions, such as franchisor-franchisee relationships, one party (such as a franchisee), may show that there was an intentional misrepresentation by the other party (the franchisor), that the misrepresentation occurred before the contract was formed, and that the fraud concerns a matter not covered by the contract.

Common law fraud requires proof that a claimant reasonably relied on the defendant's false statement. To neutralize this claim, many commercial contracts include a "disclaimer of reliance" provision, requiring an investor or buyer to agree that it did not receive or rely on any extra-contractual representation from the seller.

Under California law, a contract's integration or merger clause will not bar a fraudulent inducement claim if fraud is alleged sufficiently.

Common statements that form the basis of fraud in the inducement claims, such as an alleged representation concerning profits a franchisee or other investor can expect, can potentially be avoided if the agreement includes statements that explicitly disclaim such representations or advice that the franchisee make its own investigation. Though a merger provision and "disclaimer of reliance" clause may not be enough to win a demurrer or summary judgment, the clauses are still factors tending to disprove the justifiable reliance element of fraud.

In assessing reliance, courts look to all the factual circumstances, including the parties' relative knowledge of specific facts; the speaker's position within a defendant's corporate organization and his authority to make the statements; whether the defendant gave plaintiff access to the underlying information; sophistication and experience of the plaintiff; and the context in which the statements were made.

Moreover, whether a plaintiff justifiably relied is judged subjectively. In litigation, attorneys for franchisors or other defendants should consider the business experience of a failed franchisee or other plaintiff. If a particular plaintiff is sophisticated, a fact-intensive inquiry may be to the defendant's advantage. If a plaintiff knew or should have known that a speaker had no authority, the plaintiff could not have justifiably relied on the statement.

Analytically, it is important to remember that the fact of reliance is different from the right of reliance. Under California law, justifiable reliance cannot be established where the complaining party's conduct was manifestly unreasonable in light of his intelligence and information, or ready availability of information. Accordingly, a plaintiff usually will be charged with increasing knowledge and sophistication as time passes, and failure to discover the fraud at some point in time will break the chain of reliance. Moreover, at some point a claimant's actual or constructive knowledge of acquiescence in the fraud may be deemed ratification.

A number of courts have held that is it is unreasonable as a matter of law for a plaintiff to rely on oral statements that are directly contradicted by the written contract.

Some courts have imposed a duty on franchisees to inquire further and obtain assurances or clarification before relying on oral statements. At the other end of the spectrum, a sophisticated plaintiff who has access to the relevant facts but chooses to ignore them cannot as a matter of law have relied on the misrepresentation. The evidentiary presumptions in Evidence Code Sections 622 and 623 have been cited to estopp a franchisee from pursuing claims based on alleged pre-contract misrepresentations concerning profitability where an acknowledgment in the franchise agreement states that the franchisee received "no warranty or guarantee, expressed or implied," regarding the "potential sales, income, profits or success" of the business.

For franchise and other business attorneys, knowing the intricacies of the economic loss rule is important. Franchise lawsuits and most business litigation are usually economic in nature, and application of the rule will often narrow the scope of the claims and damages available as a remedy. Litigation attorneys who possess a solid understanding of the rule can use it to develop a framework to successfully nail down a claimant's theories at deposition or trial.

Familiarity with the rule is important to transactional attorneys as well, because the terms of the parties' agreement often become the focal point in ligation and the rule can be helpful in deciding what contractual disclaimers to include when drafting franchise and other business agreements. Quite simply, all general business litigators can benefit from being familiar with cases on the economic loss rule as a way to obtain an advantage over opponents. The stakes are far from academic as the availability of tort and punitive damages may hinge on whether or not a court decides to apply the rule.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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