The Economic Loss Rule: From Where Does the Duty Arise?

When entering a contract under Colorado law or attempting to enforce your rights when the other party breaches a contract, it is important to know and understand what rights you have and what claims you can bring or defenses you may have.  One important consideration is Colorado’s version of the economic loss rule.  The Colorado Supreme Court has issued several opinions clarifying the scope of the economic loss rule since it adopted the rule in 2000.  The purpose of the economic loss rule is to maintain the boundary between contract law and tort law.

In Colorado, the economic loss rule provides that a party suffering only economic loss from the breach of an express or implied contractual duty may not assert a tort claim for the breach without an independent duty of care under tort law.  In most instances the economic loss rule will not bar intentional tort claims.  The question becomes: from where does the duty arise?  Is there an independent duty in tort law?  Did the duty arise solely from the contract?

On January 14, 2021, a division of the Colorado Court of Appeals released its opinions in McWhinney Centerra v. Paog & McEwen, 486 P.3d 439 (Colo. App. 2021), answering the question as to when the economic loss rule applies and altering Colorado’s economic loss rule. The Court of Appeals noted in its decision, that while the decision is contrary to several other decisions, it was based on the recent decision of the Colorado Supreme Court in Bermel v. BlueRadios, Inc., 440 P.3d 1150 (Colo. 2019).  The Court specifically determined that where an independent duty exists, outside the agreement, the economic loss rule does not bar a tort claim.

The McWhinney case arose from a land development deal gone bad during the real estate collapse of 2008.  McWhinney Centerra Lifestyle Center LLC (“MCLC”), a subsidiary of McWhinney Holding Company, LLP (“McWhinney”), and Poag & McEwen Lifestyle Centers-Centerra LLC (“P&M”), a subsidiary of Poag & McEwen Lifestyle Centers, LLC (“PMLC”), formed Centerra LLC.  The purpose of Centerra LLC was to acquire, develop, own, and operate an upscale shopping center in Loveland, Colorado, The Promenade Shops at Centerra.  MCLC provided the capital, land, and an established public-private partnership with the city and county entities for infrastructure financing.  P&M served as the managing member of the joint venture.  MCLC & P&M signed an operating agreement (the “Agreement”), and McWhinney and PMLC signed as guarantors.

The Agreement required P&M to obtain a construction loan for Centerra LLC and later a permanent loan.  In 2005, P&M obtained the construction loan for $116 million in accordance with the Agreement, and the shopping center opened in October 2005.  In 2006, P&M purchased a $155 million forward swap loan on behalf of Centerra LLC without first obtaining the permanent loan.  P&M’s intent for obtaining the forward swap loan was to gain the trust of other investors to obtain a loan for personal reasons not for the benefit of Centerra LLC.

In 2007, P&M entered a $40 million mezzanine loan.  A loan which the Court found P&M used for personal interests.  P&M used the $40 million dollar loan for Dan and Josh Poag to buy out their co-founder, Terry McEwen.  The Court found that P&M intentionally concealed this buyout and its intention to use these self-dealings to fund it.  P&M gave MCLC limited and misleading information or no information at all about the buyout.

Shortly after P&M’s buy out of McEwen, it began defaulting on its loans and lacked the funds to pay property taxes.  In 2008, the real estate market collapsed, and P&M allowed the construction loan to go into default.

In 2011, after the joint venture failed, MCLC sued P&M, asserting a breach of contract claim based on the Agreement and seven tort claims.  The district court dismissed all seven tort claims under the economic loss rule.  The Court of Appeals determined P&M owed a duty of fair dealing to MCLC, including a duty of disclosure and that P&M had purposefully concealed and misrepresented material facts about the $40 million loan.  Further, the Court of Appeals concluded that the district court erred when it applied the economic loss rule to bar MCLC’s common law intentional tort claims of fraudulent concealment, intentional interference with contractual obligations, and intentional inducement of breach of contract.

The Agreement between MCLC and P&M stated that P&M owed fiduciary duties of care and loyalty to Centerra LLC and MCLC.  The duty of loyalty requires that the best interest of the company and its members take precedence over any of the manager’s individual interests and that the manager act in good faith.  The duty of care requires that a manager act on an informed basis.  P&M breached its fiduciary duties under the Agreement when it purchased the forward swap, entered the $40 million mezzanine loan, and failed to secure permanent financing.

P&M’s purchase of the forward swap on behalf of Centerra LLC was a breach of P&M’s fiduciary duties because of the individual benefit P&M derived from it.  P&M used the forward swap as a tool to obtain the $40 million mezzanine loan to buyout McEwen.  P&M purposefully concealed the purpose and significant details of the $40 million mezzanine loan and failed to give MCLC a complete or accurate picture of how the loan would impact the operations of Centerra LLC.  P&M had a duty to disclose material facts related to the mezzanine loan to MCLC and they failed to do so, therefore, breaching their fiduciary duties.  

Finding that P&M owed fiduciary duties under the Agreement and breached those duties the Court of Appeals turned to MCLC’s intentional tort claims.  The Court determined that the district court erred in dismissing MCLC’s common law intentional tort claims, except for the civil conspiracy claim.  Under the guidance of the Colorado Supreme Court’s decision in Bermel the Court noted that while the intent of the economic loss rule is to prevent tort law from “swallowing” the law of contract, courts must also be cautious not to allow contract law to swallow tort law.  “The economic loss rule generally should not be available to shield intentional tortfeasors from liability that happens to also breach a contractual obligation.” Town of Alma v. AZCO Constr., Inc., 10 P.3d 1256, 1260 (Colo. 2000).

The Court reinstated MCLC’s fraudulent concealment, intentional interference with contractual obligations, and intentional inducement of breach of contract claims.  The Court reasoned that the three claims stem from a duty based in tort law independent of the Agreement.  The conduct underlying each of the claims may also support a breach of contract claim, however, in this case, the Court did not shield the intentional tortfeasors simply because the conduct also happens to breach a contractual obligation.

However, the economic loss rule did bar MCLC’s civil conspiracy claim.  MCLC alleged P&M and PMLC conspired to breach the Agreement.  As signatories to the Agreement, P&M and PMLC’s duty not to conspire to breach the contract stemmed solely from the Agreement itself.  P&M and PMLC had no independent duty in tort law not to conspire to breach the Agreement with another signatory of the Agreement.  Thus, the economic loss rule barred MCLC’s civil conspiracy claim.

Though the McWhinney decision was contrary to previous holdings, one must bear in mind, the Court had new direction from the Colorado Supreme Court’s decision in Bermel.  While the economic loss rule had barred tort claims which happened to breach a contractual obligation the court has moved away from this one-track mind analysis.  McWhinney makes it clear that the economic loss rule does not bar an intentional tort claim simply because a breach of contract claim exists.

McWhinney’s effect may be that plaintiffs’ attorneys ramp up efforts to bring intentional tort claims.  It is important for defense counsel to know to what claims the economic loss rule can serve as a defense.

For additional information regarding the McWhinney decision or Colorado construction law, you can reach Taylor Hite by e-mail at Hite@hhmrlaw.com or by telephone at (303) 653-0043.

Contractual warranty agreements may preclude future tort recovery

When a buyer purchases a product that is later discovered to be defective, the court offers a remedy to make the buyer whole.  Such remedies can arise either out of a contract, including express and/or implied warranties, or under common law through a tort theory.  However, what happens when a buyer has already received the remedy specified in the contractual warranty, only to discover the product manufacturer misrepresented the quality of its product by failing to disclose a defect?  Can the buyer subsequently recover for the same product under a tort theory of recovery?  The Colorado Court of Appeals analyzed such questions in its December 2021 decision in Dream Finders Homes, LLC v. Weyerhaeuser NR Co., 2021 COA 143.

In Dream Finders, the court examines the rights of sophisticated buyers who purchased defective products and received a warranty from the product manufacturer with purchase. The court specifically determines whether such buyers may recover under the tort theory product misrepresentation and failure to disclose when the buyers have already received the remedy specified and the warranty expressly excludes the type of damage the buyer now seeks.

The case involved two main parties, including Weyerhaeuser, a product manufacturer which designed and sold engineered joists with a fire-resistant coating to be used in residential construction, and Dream Finders, a home builder, which purchased and utilized Weyerhaeuser’s fire-resistant joists in homes it constructed and sold. Upon purchase of the joists, Dream Finders received two warranties, from Weyerhaeuser to wit: a general warranty delivered with all Weyerhaeuser products and a specific warranty relating to the joists providing that Weyerhaeuser would pay reasonable costs for repair or replacement of the covered joists for any delamination, separation, or inadequacy that might occur in the joists. The reasonable costs were to be capped at three times the cost of the joists themselves. The specific warranty also expressly stated that Weyerhaeuser would not be responsible for incidental, indirect, or consequential damages.

Three months after Dream Finders started purchasing and installing the joists into its homes, Weyerhaeuser received third-party reports indicating that the joists, which were coated with a formaldehyde-based resin, emitted a chemical-like odor that caused eye and throat irritation.  In compliance with the specific warranty, Weyerhaeuser offered remediation options to builders which installed the affected joists.  Dream Finders opted for a mechanical removal option. Weyerhaeuser complied with the request and paid for all remediation costs, which ended up being significantly greater than three times the product cost.  After the remediation was completed, Dream Finders sued Weyerhaeuser for breach of express and implied warranty, negligence, negligent failure to warn, negligence per se, strict product liability, violation of Colorado’s Consumer Protection Act (the “CCPA”), negligent misrepresentation, and fraudulent concealment.  In its claims, Dream Finders alleged that Weyerhaeuser knew that its products contained a urea-formaldehyde resin but failed to disclose the known hazardous levels of formaldehyde in the joists.  Dream Finders alleged that it incurred over $20 million in damages, including remediation costs and costs incurred because of delayed home sales.  

In evaluating the case, the Court first considered the economic loss rule, which bars recovery under tort claims for purely economic losses stemming from a breach of contract.  While Colorado law provides that construction professionals owe homeowners independent, common law, duties of care to homeowners, which do form the basis for tort-based negligence claims safe from the reaches of the economic loss rule, the Court refrained from extending this duty to a builder, which only owned the homes briefly before selling them to the ultimate purchasers. The Court held that the economic loss rule limited Dream Finders’ ability to recover damages arising from tort claims because it and Weyerhaeuser already completed the contractually mandated remedy for the defective joists.

The Court determined that the relief sought by Dream Finders was identical under both tort and contract theories.  To come to this conclusion the Court compared both the tort duties and contractual duties owed by Weyerhaeuser.  Generally, a tort duty can be distinguished from a contractually arising duty when the tort duty extends beyond the scope of duty provided for in the contract.  Dream Finders and Weyerhaeuser agreed that Weyerhaeuser complied with the terms and conditions of its warranty and that because of this compliance, Dream Finders received the benefit for the contract-based bargain.

Because Dream Finders had already received the agreed-upon contractual benefit and expressly chose to contract away any other rights to recover, the Court precluded Dream Finders from recovering anything further. Even though only one of Dream Finders’ entities entered into the warranty agreement with Weyerhaeuser, the Court held that the warranty still controlled under Colorado law.  C.R.S. § 4-2-318 provides that a manufacturer’s warranty “extends to any person who may reasonably be expected to use, consume, or be affected by the goods and who is injured by breach of warranty.”  The Court maintained that the warranty, therefore, impeded recovery under the economic loss rule because, even though one of the entities did not expressly enter into the warranty agreement, its coverage by the warranty was implied by statute.

The economic loss rule does not bar recovery for damages based on pre-contractual fraud where the fraud induced a plaintiff to enter the contract, as discussed in Van Rees v. Unleaded Software, Inc., 373 P.3d 603 (Colo. 2016).  However, in Dream Finders, the alleged claims arose from post-contractual conduct and did not fraudulently induce Dream Finders to enter the warranty agreement.  Because of this fact, Weyerhaeuser did not owe Dream Finders a separate duty apart from those specified in the warranty contract.  The Court concluded, therefore, that the economic loss rule disqualified Dream Finders from recovering anything under its tort-based claims.

There are limitations to the economic loss rule and the Court affirmed that it does not bar CCPA claims.  However, the Court ruled that Dream Finders failed to prove all elements of its CCPA claim.  Additionally, CCPA claims were created to protect individual consumers who are at a bargaining disadvantage compared to more sophisticated buyers, such as Dream Finders.  

Judge Jaclyn Brown issued a warning at the end of the Court’s decision, stating that the expansion of the economic loss rule has the frightening propensity to encourage a contracting party to act fraudulently during the contractual relationship and then attempt to escape liability by hiding behind the rule. Judge Brown further emphasized that the economic loss rule should not apply to cases where the damages arise from an intentional act as it would be bad policy for courts to shield intentional tortfeasors from liability.  Judge Brown’s fears have not yet come to fruition, but we anticipate future Colorado court decisions will further mold the trajectory of the economic loss rule.

Dream Finders now serves as a reminder of the importance of contracts and warranty clauses and why both product manufacturers and contractors should take a close look at what rights are provided or relinquished when entering into such agreements.

For additional information regarding the Dream Finders case or Colorado construction law, you can reach out to Taylor Ostrowski by telephone at (303) 653-0047 or by e-mail at ostrowski@hhmrlaw.com.