Supreme Court’s Latest Decisions Refine the Law Regarding the Economic Loss Doctrine

WDC Journal Edition: Fall 2005
By: R. Michael Waterman - Mudge, Porter, Lundeen & Seguin, S.C.

The economic loss doctrine is a judicially created doctrine intended to maintain the distinction between tort and contract. Stripped down to its basics, the doctrine bars a purchaser of a product from pursuing tort claims against the manufacturer or seller of the product for solely economic losses arising from that product. The doctrine is particularly applicable when a seller or manufacturer gives a warranty or contractually limits its liability over problems associated with the product. In the abstract, the economic loss doctrine is a relatively straightforward concept. In practice, however, the application of the doctrine has not been clear or easy, spawning increased litigation over the doctrine and its boundaries.

On July 8, 2005, the Wisconsin Supreme Court issued three decisions that provide much needed direction concerning the other property exception, the fraud in the inducement exception, and the predominant purpose test. While these concepts made frequent appearances in court of appeals decisions, Supreme Court guidance was lacking. None of the Court’s July 8 decisions disrupt the body of case law that has developed in the court of appeals. Instead, the Supreme Court demonstrated conviction to adhere to the core and fundamental principles of the economic loss doctrine.

Other Property Exception – Grams v. Milk Products, Inc.
The economic loss doctrine does not bar a product purchaser’s claims of personal injury or damage to property other than the product itself. This “other property exception” has its limitations. One established limitation applies to integrated systems. If the product at issue is a defective component in a larger system, the other components are not regarded as “other property” in a legal sense, even if they are different property in a literal sense. The Supreme Court supplied another limitation to the “other property exception” in Grams v. Milk Products, Inc.,where the Court embraced the “disappointed expectations” concept.

The Grams raised nearly 6,000 calves per year. The Grams fed calves with a milk substitute called “Half-Time,” which contained medicine designed to keep calves healthy during the first few weeks of their lives. The Grams asked the product manufacturer’s representative whether a less expensive milk substitute was available. The product representative supplied the Grams with a cheaper version of Half-Time that did not contain the medicine. After the Grams began feeding the non-medicated Half-Time to their herd, the Grams noticed that the mortality rate of the calves tripled. The Grams discontinued use of the non-medicated Half-Time and they believed that poor nutritional content in the product damaged the calves’ immune systems and was responsible for the increased mortality rate.

The Grams filed suit against the product manufacturer. Their suit included tort claims for negligence and varieties of misrepresentation. The manufacturer argued that the economic loss doctrine applied because the claim arose out of the performance of a product. The main issue was whether the calves where considered “other property” apart from the non-medicated Half-Time product.
The Supreme Court concluded that the calves were not “other property” in the legal sense. The Court borrowed principles from the integrated system concept and created a counterpart, called the “disappointed expectations” concept. The concept is grounded in contract principles of bargaining and risk sharing. The determination of whether particular damage qualifies as damage to “other property” turns on the parties' expectations of the function of the bargained-for product. The economic loss doctrine will apply when “prevention of the subject risk was one of the contractual expectations motivating the purchase of the defective product.”

When a product is intended to be used as part of an integrated system, the integrated system rule allows the manufacturer to share the risk that its product will damage the rest of the system. The same rationale applies to the “disappointed expectations” concept. “If a product is expected and intended to interact with other products and property, it naturally follows that the product could adversely affect and even damage that property. A rule that allows tort recovery based on what is damaged, rather than whether the risk of that damage was within the scope of the bargain, would leave little room for contract.”

Armed with the “disappointed expectations” concept, the Grams majority had little difficulty in concluding that the calves were not “other property.” While the calves were separate from the Half-Time product in the literal sense, they were not “other property” in the legal sense. The Grams expected the non-medicated Half-Time product would properly nourish their calves. The product did not perform as expected because the herd’s mortality rate tripled. “It is difficult to think of a better example of disappointed expectations than a product that is expected to nourish animals but leaves them malnourished.”

Fraud in the Inducement Exception – Kaloti Enterprises, Inc. v. Kellogg Sales Company
Intentional misrepresentation cases have stalked the economic loss doctrine for many years. The fraud in the inducement exception reached the Supreme Court three times, but a majority decision defining the exception remained elusive until Kaloti Enterprises, Inc. v. Kellogg Sales Company.

Kellogg Sales Company worked through an agent, Geraci, to negotiate and sell Kellogg’s Nutrigrain and Rice Krispie Treat products to food wholesalers. Kaloti was a food wholesaler that had previously purchased Kellogg products through Geraci.

After Kellogg merged with Keebler Foods, Kellogg changed its marketing practices. Instead of marketing Nutrigrain and Rice Krispie Treats through wholesalers, such as Kaloti, Kellogg decided to sell its products direct to the retailers. Although Geraci knew that the marketing practices changed, Geraci solicited a large order of product from Kaloti without disclosing that the retail market would be closed to wholesalers. Kaloti sued Geraci and Kellogg, alleging intentional misrepresentation. Geraci and Kellogg argued that the economic loss doctrine barred the intentional misrepresentation claim.

The Supreme Court adopted a narrow fraud in the inducement exception patterned after Huron Tool & Eng'g Co. v. Precision Consulting Servs., Inc. A fraud in the inducement claim is not barred by the economic loss doctrine when the fraud is extraneous to, rather than interwoven with, the contract. To invoke this narrow exception to the economic loss doctrine, the Court held that plaintiffs must 1) demonstrate the elements of intentional misrepresentation; 2) establish that the misrepresentation occurred before the contract was formed; and 3) show that the fraud was extraneous to, rather than interwoven with, the contract.

The exception applies to fraud concerning matters where the risk and responsibility did not relate to the quality or the characteristics of the goods for which the parties contracted or otherwise involved performance of the contract. Matters relating to the product’s performance or quality are interwoven in the contract and are best protected by contract. Applying this exception to Kaloti’s case, the Court concluded that the alleged fraud fit the exception because it had nothing to do with the performance or quality Kellogg’s products, but instead pertained to Kaloti’s ability to market them.

Justice Abrahamson’s dissenting opinion expresses concern that the narrow fraud in the inducement exception will defy consistent and principled application. Justice Abrahamson predicts that every type of fraud in the inducement will concern some matter interwoven in the contract – hence the inducement to enter the contract. For that reason, Justice Abrahamson predicts that the narrow fraud in the inducement exception adopted by the majority is a nullity.

The fraud in the inducement exception will be tested in future cases. Expect litigation to center on whether the fraud was interwoven in the contract and thus subject to the economic loss doctrine, or extraneous to the contract and thus within the fraud in the inducement exception. Despite the concerns raised by the dissenting opinion, resolution of this issue will invoke the core principles of the economic loss doctrine. In recognizing the fraud in the inducement exception, the Kaloti Court reaffirmed basic doctrine -- if the claim relates to the quality and performance of the product itself, the economic loss doctrine applies. Look for that core concept to be the guiding principle for determining when the fraud in the inducement exception will apply.

The Predominant Purpose Test – Linden v. Cascade Stone Company, Inc.
From its inception, the economic loss doctrine has applied to products. In 2004, the Supreme Court settled a long debate and held that the doctrine does not apply to services. Most cases, however, involve a combination of products and services or where labor is a significant part in the manufacturing process of the product. How does the economic loss doctrine operate in those cases? In Linden v. Cascade Stone Company, Inc.,the Supreme Court responded. The Court held that the predominant purpose test determines when the economic loss doctrine will apply, and that the purchaser’s contract as a whole is examined, not the individual contributions of the remote subcontractors.

Linden was a home construction case. The homeowners contracted with a general contractor for construction of a single-family home. Their contract included specific warranties against defects and faulty workmanship; however, after they moved in, the homeowners discovered water intrusion. They believed the water intrusion was caused by construction defects by two subcontractors – the roofer and the stucco contractor. The homeowners sued the general contractor, who eventually settled with the homeowners. The homeowners then tried to maintain negligence claims against the roofer and stucco contractor.

The subcontractors argued that the economic loss doctrine barred the tort claims. They argued that the predominant purpose of the homeowners’ contract was the sale of a product -- the completed house. The homeowners, on the other hand, examined the subcontractors’ individual contributions to the overall project. Because the subcontractors provided predominantly labor, they argued that the subcontractors provided mostly a service that was outside the economic loss doctrine.

The Supreme Court held that the predominant purpose test determines whether the primary purpose of the contract is products with services incidentally provided, or services with products incidentally provided. While the predominant purpose test has been frequently used in Uniform Commercial Code cases, the Supreme Court’s decision answered two pressing questions: 1) whose contract is examined, and 2) how is the test applied?

First, the Supreme Court held that the predominant purpose test must be examined from the perspective of the purchaser, not the remote subcontractors. “Focusing on the contract for which the purchaser bargained maintains the distinction between tort and contract for the purchaser who is in the best position to bargain for coverage of the risk of faulty workmanship in any part of the house.” If purchasers were able to circumvent contractual remedies they bargained for and received with the general contractor by pursuing tort remedies against the subcontractors, the purchasers would make a classic end-run around the contract, something that the economic loss doctrine was created to prevent. The contractual bargain is enforced when the purchasers enforce contract remedies against the general contractor, who may in turn enforce contract remedies against the subcontractors.

Second, the Court provided direction concerning mixed contracts for goods and services and the application of the predominant purpose test. The predominant purpose test determines whether a mixed contract is predominantly a sale of a product and therefore subject to the economic loss doctrine, or predominantly a contract for services and therefore not subject to the economic loss doctrine. The Court rejected suggestions for a rigid or mathematical approach that would calculate whether the transaction quantitatively involved more products or more services. Instead, the Court affirmed a totality of circumstances-like approach that the court of appeals has employed for many years in Uniform Commercial Code cases. In Linden, the Supreme Court paid particular attention to the language of the contract to determine the parties’ purpose behind the transaction. The Linden contract had definite attributes of a product contract including a warranty, detailed specifications for the completed house, and a firm price based upon those specifications.

Despite Linden, all home construction transactions will not automatically be considered “products contracts.” The LindenCourt did not make a broad holding concerning all houses or construction contracts. In future cases, courts will continue to examine construction projects and contracts on a case-by-case manner. Had the Lindens’ contract been worded differently or used language more akin to services (such as a time and materials-type contract, for example), the result likely would have been different.

Post-Linden litigation will likely involve creative attempts by homeowners to circumvent the economic loss doctrine. Homeowners typically lack contractual privity with the subcontractors, making breach of contract claims unavailable and putting the subcontractor responsible for the problem beyond the reach of the homeowner. When general contractors are uninsured, insolvent or bankrupt, expect aggrieved homeowners to utilize third-party beneficiary contract actions as a means to getting to the subcontractors or even arguing for judicially created exceptions to the economic loss doctrine.

Conclusions

Grams, Kaloti and Linden provide much needed definition and substance to some uncertain areas of economic loss doctrine. Some critics believe that the economic loss doctrine has expanded far beyond its original intent. However, perhaps the most important lesson from these cases is the Supreme Court’s adherence to the fundamental principles of economic loss doctrine. Each of these cases is firmly aimed at maintaining the distinction between contract and tort, and protecting parties’ ability to allocate risk. Tort imposes a duty to protect people from misfortunes that are unexpected and overwhelming. Contract, on the other hand, holds parties to agreed upon and bargained for duties. When a product fails in its intended use and injures only itself, causing economic damages to the purchaser, the reasons for imposing a tort duty are weak and those for leaving the party to its contractual obligations are strong.

See Daanen & Janssen, Inc. v. Cedarapids, Inc., 216 Wis. 2d 395, 403-04, 410, 573 N.W.2d 842, 846 (1998)

2005 WI 112, __ Wis. 2d __, 699 N.W.2d 167.

2005 WI 112 ¶¶ 4-8.

2005 WI 112 ¶ 43 (quoting Rich Products Corp. v. Kemutec, Inc., 66 F. Supp. 2d 937, 975 (E.D. Wis. 1999).

2005 WI 112 ¶ 47.

2005 WI 112 ¶ 51.

Douglas-Hanson Co. v. BF Goodrich Co., 2000 WI 22, 233 Wis. 2d 276, 607 N.W.2d 621; Digicorp, Inc. v. Ameritech Corp., 2003 WI 54, 262 Wis. 2d 32, 662 N.W.2d 652; Tietsworth v. Harley-Davidson, Inc., 2004 WI 32, 270 Wis. 2d 146, 677 N.W.2d 233

2005 WI 111, __ Wis. 2d __, 699 N.W.2d 205.

209 Mich. App. 365, 532 N.W.2d 541 (1995).

2005 WI 111 ¶ 42.

2005 WI 111 ¶¶ 42-43.

2005 WI 111 ¶ 74.

2005 WI 111 ¶ 79 (quoting Budgetel Inns, Inc. v. Micros Sys., Inc., 8 F. Supp. 2d 1137, 1146 (E.D. Wis. 1998)).

Insurance Co. of N. Am. v. Cease Elec., Inc., 2004 WI 139, 276 Wis. 2d 361, 688 N.W.2d 462.

2005 WI 113, __ Wis. 2d __, 699 N.W.2d 189.

2005 WI 113 ¶ 17.

2005 WI 113 ¶ 8.

See Van Sistine v. Tollard, 95 Wis. 2d 678, 291 N.W.2d 636 (Ct. App. 1980); Micro-Managers, Inc. v. Gregory, 147 Wis. 2d 500, 434 N.W.2d 97 (Ct. App. 1988); Biese v. Parker Coatings, Inc., 223 Wis. 2d 18, 588 N.W.2d 312 (Ct. App. 1998).

East River S.S. Corp. v. Transamerica Delaval, Inc., 476 U.S. 858, 871, 106 S. Ct. 2295, 2302 (1986).