December 10, 2009

Why the economic loss rule matters

  • Real estate buyers may not have recourse against unscrupulous sellers because of the legal doctrine.
    Foster Pepper



    Among the few Latin phrases that people still recognize is caveat emptor — “let the buyer beware.” Historically, this phrase summarized the burden on a buyer of real estate. However, as courts and legislatures began to adopt more consumer-oriented laws, the fundamental concepts underpinning the doctrine of caveat emptor began to weaken.

    Courts and legislatures began to impose duties on sellers of real estate (and, eventually, on their brokers) to disclose known, material, and latent defects associated with the property being sold. More recently, most states have adopted seller disclosure laws that require a seller of real estate to provide buyers with a long list of disclosures related to the condition of the property.

    In Washington, these disclosures are commonly referred to as the Form 17 Seller’s Disclosure Statement. Although the Form 17 is definitely required in connection with residential sales, it is very likely that the environmental disclosures are also required in connection with commercial real estate sales.

    An analysis of the Form 17 disclosures is beyond the scope of this article. However, buyers, sellers and brokers involved in real estate transactions should understand the due diligence norms and disclosure duties that the law expects the parties to abide by, as well as the remedies that may be available in the event of a breach of these duties. It is this latter issue concerning available remedies with which this article is concerned.

    Economic loss rule

    It certainly seems reasonable to assume that a buyer of real estate who suffers financial damages as a result of a misrepresentation by the seller has a valid claim against the seller to recover those losses. In Washington, however, the unfortunate buyer in this situation may not have recourse against the seller at all — even if the seller deliberately misled the buyer — because of a legal doctrine known as the “economic loss rule.”

    The economic loss rule is a rapidly evolving concept in Washington law that has serious implications for buyers and sellers of real estate. In short, the economic loss rule bars a buyer’s tort claims (such as negligent misrepresentation and possibly even intentional misrepresentation) when property is sold under a contract and the buyer suffers an “economic” loss (i.e., any monetary loss with limited exceptions).

    The economic loss rule is intended to hold parties to their negotiated contractual remedies when a loss occurs and both contract and tort law claims could provide some measure of relief to the injured party. The reasoning behind the rule is that tort law is not intended to compensate parties for losses that arise out of a breach of contract because the parties bargained for a particular allocation of risk, and therefore the injured party must rely on the remedies agreed to in the contract.

    An example

    By way of illustration, suppose Mr. Hatfield enters into a contract with Mr. McCoy for the sale of commercial real estate owned by the Hatfield family. Hatfield provides to McCoy the environmental disclosures required by Washington law, but Hatfield fails to disclose the actual existence of certain hazardous substances on the property. For purposes of this illustration, we will not discuss whether McCoy has any remedies against Hatfield under federal or state environmental statutes. However, let’s assume that McCoy specifically discussed with Hatfield all of the disclosures that were made.

    Of course, given the famously antagonistic relationship between Hatfield and McCoy, we are not certain whether Hatfield’s failure to accurately disclose the existence of certain hazardous substances was mere negligence or intentional.

    In either event, the sale closes, and a month later McCoy discovers that the building contains copious amounts of asbestos and lead-based paint that must be remediated. McCoy sues Hatfield for both negligent misrepresentation and intentional misrepresentation, claiming nearly $30,000 in damages related to the required environmental remediation.

    As evidence of Hatfield’s misrepresentations, McCoy intends to introduce the Form 17 disclosure statement that specifically states “no” in response to the question concerning whether any asbestos or lead-based paint are in or on the property. McCoy, however, is not able to claim that there has been a breach of the purchase-and-sale contract because Hatfield did not agree to make any contractual representations or warranties concerning the physical condition of the property or the presence of such hazardous substances.

    Buyers can’t sue

    Unfortunately for McCoy, his negligent misrepresentation claims will be dismissed by the court pursuant to recent Washington case law, even if he could prove that Hatfield should have known about the existence of the asbestos and lead-based paint.

    In March of 2007, the Washington Supreme Court decided Alejandre v. Bull, in which case the court held that the economic loss rule prohibits a buyer from suing a seller for negligently misrepresenting the condition of the property. The court determined that the economic loss rule applies to claims where the risk of loss could have been allocated between the parties, even if the specific risk of loss at issue was not negotiated in the terms of the contract.

    Now, if we assume that McCoy is able to prove that Hatfield intentionally misrepresented the condition of the property, McCoy may still be denied any relief by the court. In several more recent cases, Washington appellate courts have expanded the economic loss rule to also preclude claims for intentional misrepresentations, although some of those cases are currently before the Washington State Supreme Court for review.

    For example, in Carlile v. Harbor Homes, the Washington Court of Appeals held that the rationale of the economic loss rule applies to intentional misrepresentation just as it does to negligent misrepresentation. The practical effect of these decisions is that a buyer who suffers economic losses as a result of misrepresentations made by the seller cannot sue the seller to recover those losses, unless the contract specifically permits the buyer to bring that claim.

    As the law currently stands in Washington, claims for negligent misrepresentation in real property transactions, and most likely claims for intentional misrepresentation as well, are barred by the economic loss rule. While parties may decide to explicitly allocate the risk of economic loss from misrepresentations in the contract, buyers are always best protected by completing a thorough, competent inspection of the property using professional inspectors.

    That said, it is more important than ever to carefully negotiate and draft the seller’s representations and warranty provisions of purchase and sale contracts, as well as the associated remedies that survive closing of the transaction.

    Kelly Angell is an associate at Foster Pepper specializing in real estate, municipal government, infrastructure/transportation, affordable housing, construction, and sustainable development/green building law. Thomas Parkes is a member at Foster Pepper, chair of the firm’s Real Estate Practice Group, and practices in the area of real estate development and finance.

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