918 (1966) quoted with approval in Washington Water Power Company v. Graybar Electric Company, 112 Wn.2d 847, 774 P.2d 119 (1989).

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1 Economic Loss Rule -- Statutory Notice and Opportunity to Cure Statute of Limitations Important Issues in Washington Construction Defect Cases By Greg Harris Shareholder-in-Charge, Construction and Litigation Groups OADC (Oregon Association of Defense Counsel) Annual Conference July, 2004 I. The Limitations of Washington s Economic Loss Rule. A. Washington s basic damage rules. The tort measure of damages in Washington is the amount that will adequately compensate for all losses suffered as the direct and proximate result of the wrongful act. Puget Sound Power & Light Company v. Strong, 117 Wn.2d 400, 403, 816 P.2d 716 (1991). The basic contract measure of damages is the amount required to give the claimant the benefit of the bargain struck in the contract. Mason v. Mortgage America, Inc., 114 Wn.2d 842, 849, 792 P.2d 142 (1990); Eastlake Construction Company v. Hess, 102 Wn.2d 30, 39, 686 P.2d 142 (1984). 1. The economic loss rule. Economic loss is damage suffered by a tort claimant that can t be either repaired or compensated by general damages. 1 Direct economic loss is the inadequacy of an object s value caused by the object s failure to perform. It is usually measured by the cost to modify the object or to replace it with an object of represented functionality. 2 Indirect or consequential economic loss is other economic damages caused by the object s failure to perform, such as lost profits. 3 The circumstance under which economic loss may be recovered in tort claims is generally regarded as one of tort law s most confusing areas. 4 Economic loss is not recoverable in Washington under any tort theory. Berschauer/Phillips Construction Company v. Seattle School District No. 1, 124 Wn.2d 816, 881 P. 2d 986 (1994) 1 Economic loss has been defined in a positive manner as the diminution in value of a particular product caused by the product itself or by the failure of the product to function as represented; in other words, to failed economic expectations. Wausau Paper Mills Company v. Charles T. Main, Inc., 789 F. Supp 968, 971 (W.D. Wis 1992). 2 See generally, Note, Economic Loss in Products Liability Jurisprudence, 66 Columbia Law Review 917, 918 (1966) quoted with approval in Washington Water Power Company v. Graybar Electric Company, 112 Wn.2d 847, 774 P.2d 119 (1989). 3 Id. 4 R. Joseph Barton, Drowning in a Sea of Contract: Application of the Economic Loss Rule to Fraud and Negligent Misrepresentation Claims, 41 William & Mary Law Review 1789 (2000). By Greg Harris Page 1 of 7

2 (professional negligence); American Nursery Products, Inc. v. Indian Wells Orchards, 115 Wn.2d 217, 230, 797 P.2d 477 (1990) (negligent performance of a contract); Griffith v. Centrex Real Estate Corporation, 93 Wn. pp. 202, 211, 969 P.2d 286 (1998) (negligent misrepresentation). The economic loss rule marks the boundary in damages between what is recoverable in tort and what is recoverable in contract. Washington Water Power Company, supra at 861. Pure economic losses are not proper tort damages because they are the type of things that the parties generally would bargain for when they negotiated a contract. The policy of Washington law is to recognize that parties typically distribute these risks in their negotiations and to encourage that conduct by enforcing the contract. Berschauer/Phillips Construction Company, supra at 82. The economic loss rule is a limitation on recoverable damages only. It does not affect the defendant s liability nor otherwise limit claims for physical damage to other property or personal harm. B. Washington s requirement of privity for construction claims. In addition to the impact of the economic loss rule, Washington s Supreme Court has done a reasonably good job of keeping separate tort and contract claims in assessing liability in the first instance. Stuart v. Coldwell Banker, 109 Wn.2d 406, 745 P.2d ) explicitly states and is relied on for the proposition that Washington does not recognize a tort of negligent construction. That case dismissed a home owner association s claims made directly against subcontractors who negligently supplied and installed private decks and walkways in common areas of a condominium complex. The Court ruled that subcontractor s failure to follow the plans and specifications would support breach of contract claims by the association against the general contractor and in turn by the general contractor against the subcontractor, but Washington does not recognize a direct action by the association against the subcontractor because the essence of the claim is breach of contract. Stuart cuts off claims of people who would pursue claims down the line of contracting attempting to hold the ultimately responsible party directly liable. It requires that either a layered approach be pursued or that for example, the association takes assignment of the general contractor s contract rights against the subcontractor and pursues those directly. The Supreme Court is consistent in the logic of this holding because Washington law also prohibits tort claims being pursued up the chain of contracting. In Berschauer/Phillips v. Seattle School District No. 1, 124 Wn.2d 816, 881 P.2d 986 (1994) the Court held that a contractor had no tort claim directly against the school district s negligent designer. The contractor incurred significant extra costs to deal with plans that were missing a main structural beam needed to hold up the gym roof. The Court refused to allow such a claim in the absence of privity and relegated the contractor to taking an assignment of the district s claims against the designer and pursuing him for breach of the design contract. The consequences for the potential damages recoverable as a result of these holdings are significant. The design contract almost assuredly will contain a limitation of liability clause, By Greg Harris Page 2 of 7

3 which restricts the designer s liability to a set amount, usually the amount of his design fees, regardless of the damages claimed. These are routinely upheld in Washington. Id. The construction contracts may contain notice and claim requirements which mandate that certain time limits be observed or risk waiver of claims. Absher Construction Company v. Kent School District No 415, 77 Wn. App. 137, 890 P.2d 1071 (1995). There may be liquidated damage provisions, disclaimers of warranty or specific warranty language. There may be a mandatory right in the subcontractor to cure the alleged defects. All of these could severely limit the injured party s remedies to far less than would be recoverable in a tort claim. 1. The test for determining whether damages are purely economic. Washington has adopted the risk of harm analysis in applying the economic loss rule. In Touchet Valley Grain Growers, Inc. v. Opp & Seibold General Construction, Inc., 119 Wn.2d 334, 831 P.2d 724 (1992) the Supreme Court enunciated the approaches allowed to determine the nature of a party s damages. The plaintiff in Touchet Valley was allowed to recover tort damages arising from the collapse of a silo. because its damages were caused by a sudden and dangerous event. The Court also said that it could reach that result either by following the sudden and dangerous or evaluative approach. The sudden and dangerous approach decides solely if the failure was caused by a sudden and dangerous event. The evaluative approach looks at the nature of the defect, the type of risk and the manner in which the injury arose. The Court following the evaluative approach determiners whether the damages sought more appropriately fall within the safety/insurance policy of tort law or the expectation/bargain protection policy of contract law. 2. The significance of requiring that economic loss claims be contract based. Washington gives the parties to a contract wide latitude in selecting the terms of the bargain and will enforce almost any provision that is clearly drafted, no matter how onerous the result. 5 Economic losses clearly may be limited by specific contract language or, as in the case of the 1997 AIA 201 General Conditions, waived completely (as to consequential losses). In addition to the damage limitations or waivers that may be imposed by specific contract provisions, rules relating to interpretation and enforcement of Washington contracts more generally may change the amounts or types of damages that may be recovered. Construction contracts in Washington are generally construed as service contracts and are not governed by the Uniform Commercial Code. 6 None of the implied warranties provided for in the UCC apply as a basis of liability for construction contract based claims. 7 5 Panorama Village Condominium Association Board of Directors v. Allstate Insurance Company, 144 Wn.2d 130, 26 P.3d 910 (2001), 6 Arango Construction Company v. Success Roofing, Inc., 46 Wn. App. 314, , 730 P.2d 720 (1986) 7 Urban Development, Inc. v. Evergreen Building Products, LLC., 114 Wn. App. 639, 59 P.3d 112 (2002). By Greg Harris Page 3 of 7

4 In Anderson Hay & Grain Co., Inc. v. United Dominion Industries, Inc., 76 P.3d 1205 (Wash. Ct. App. Div ) the Court of Appeals recently held that there is no implied warranty provision in a construction contract that the work will be performed in a workmanlike manner or that the materials provided will be free from defects (although form contracts typically such specific warranties), nor is such a clause implied because of custom and usage in the industry. Because the general contractor provides a completed project, the owner cannot easily argue that a defect in the first component caused a second component of the project to work less effectively thereby causing property damage to the second component and avoiding the consequences of the economic loss rule. Instead of following that reasoning, Washington courts look at the project as a completed whole, not a series of interrelated components. Action directly against a subcontractor would not meet this impediment because the subcontractor is typically only responsible for a limited number of building components. C. Statutory Notice and Opportunity to Cure in Residential Construction. In 2002 the Washington legislature enacted a new section of law regarding residential construction defect claims: RCW et seq. The legislature s purported intent was to give construction professionals, the right to notice and opportunity to cure as well as an opportunity to settle construction defect claims without facing a lawsuit, while preserving adequate rights and remedies for property owners who bring and maintain such actions. RCW The statute applies to actions for breach of contract, tort or indemnity brought by a homeowner against a construction professional for damage or the loss of use of real or personal property caused by a defect in the construction of a residence or in the substantial remodel of a residence. The term "action", as used in this statute, does not include any civil action in tort alleging personal injury or wrongful death to a person or persons resulting from a construction defect. RCW (1). The act applies to homeowners, including individuals and entities. It also applies to homeowners associations making claims against construction professionals, including architects, builders, builder vendors, contractors, subcontractors, engineers, and inspectors. RCW (3) & (4). "Homeowner" includes not only the original purchaser but also a subsequent purchaser of a residence from any person who qualified as a homeowner. RCW (5). Residence includes single-family homes, duplexes, triplexes, quadraplexes, or the units of a multi-unit condominium. RCW (6). It applies to both complete new construction and a substantial remodel. "Substantial remodel" means a remodel of a residence, for which the total cost exceeds one-half of the assessed value of the residence for property tax purposes at the time the contract for the remodel work was entered into. RCW (8). The statute sets out a detailed timeline of notices and responses that a homeowner must follow before the homeowner can file suit. The sanction for failure to file these steps is significant. If the homeowner files suit without complying with the statute, the suit is subject to dismissal By Greg Harris Page 4 of 7

5 without prejudice. The homeowner must then follow the notice provisions before refiling. RCW (6). If a written notice of claim is served under RCW within the time prescribed for in the applicable statute of limitations, the limitations period is tolled and doesn t begin to run again until sixty days after the period of time during which the homeowner is barred from filing an action by the terms of RCW ; RCW If the cure is not pursued and a suit is filed against a construction professional, then every claimant asserting a claim against another construction professional (including a construction professional seeking indemnity or contribution from another construction professional), must file with the court and serve on the defendant (or cross defendant or third party defendant) a list of known construction defects within 30 days of the commencement of the action, or a longer period if the court allows. RCW The list can be amended as additional defects become known. The list must specify, to the extent known, the construction professional responsible for each defect. The statute does not provide a specific penalty if the claimant fails to provide a list of defects or insufficiently identifies which professional was responsible for which defect. The statute also requires any association asserting rights in such actions to provide written notice to all of its constituent homeowners prior to filing suit against a construction professional. The notice must provide a general description of the nature of the action and the relief sought as well as the expended and projected expenses and fees that will be incurred and which will be the responsibility of the individual homeowner. RCW This notice may be part of the sales contract between the developer and the homeowner or between homeowners. In the sale of a condominium, the notice may be contained in the public offering statement delivered by the developer in accordance with RCW The statute provides specific notice language that is required. D. Statute of Limitations and Statute of Repose. The liability of contractors for faulty construction, whether it involves recoverable or economic losses, is limited by the three-year statute of limitation for actions if based in tort or on an oral contract. RCW (2) and (3). A six-year limitation applies to actions based on a written contract. RCW Washington s statute of repose, RCW , provides that actions related to construction projects, not involving a manufacturer, must accrue within six years of substantial completion of the project, or six years after termination of work of the contractor, whichever first occurs. Any claim not accruing within that period is simply not actionable. The statute of limitations and the statute of repose together create a two-step analysis for computing the limitation period for an action arising from improvements on real property. First, the cause of action must accrue within six years of substantial completion of construction. Second, suit must be filed within the applicable statute of limitation (3 or 6 years depending on whether it is based on a written contract). Del Guzzi Construction Company, Inc. v. Global Northwest, Ltd., Inc., 105 Wn.2d 878, 883, 719 P.2d 120 (1986); Architechtonics Construction By Greg Harris Page 5 of 7

6 Management. v. Khorram, 111 Wn. App. 725, 729, 45 P.3d 1142 (2002), review denied, 148 Wn.2d 1005, 60 P.3d 1212 (2003). Until recently, it was widely believed that the discovery rule, which is often applied to tort claims to extend the statute of limitations otherwise applicable, did not apply to extend the statute of limitations or the statute of repose applicable to contractually based damage claims in the construction context. The aggrieved party s claim accrued (and the applicable statute began to run) at the time of the defendant s breach, whether the fact of the breach was known or unknown at that time by the claimant. In the last year several Court of Appeals cases have changed this long standing rule, holding the discovery rule applies to breach of contract claims based on construction defects. The statute of limitations for contract actions begins to run when a party knows or, in the exercise of due diligence should know, of the other party's breach. Architechtonics, supra at 737 (In determining whether to apply the discovery rule, the possibility of stale claims must be balanced against the unfairness of precluding justified causes of action); Graoch Assocs. # 5 Limited Partnership v. Purcell, 115 Wn. App (2003); Parkridge Associates v. Ledcor Industries, 113 Wn. App. 592, 608, 54 P.3d 225 (2002). The construction industry lobbied for a legislative change in 2003 to this new application of the discovery rule to construction contracts. The problem was supposedly resolved through legislation enacted last year. House Bill 2039 took effect July 27, The bill adds RCW 4.16, which provides in relevant part: (g) To the extent that a cause of action does not accrue within the statute of repose pursuant to RCW or that an actionable cause as set forth in RCW is not filed within the applicable statute of limitations. In contract actions the applicable contract statute of limitations expires, regardless of discovery, six years after substantial completion of construction, or during the period within six years after the termination of the services enumerated in RCW , whichever is later There is concern that the new law may create some confusion in the application of the statute of repose. Before the amendment it was clear that (despite the opposition generally shown by the courts to statutes of repose) the statute of repose applied to both tort and contract based claims. By enacting this legislation and specifically applying it only to contract based claims, it may be argued that the legislature intended to create or recognize a distinction between those claims and to modify the application of the statute of repose to tort based claims. Others worry that there may be argument that the new language reinstating the application of the statute of repose only applies to homeowner claims because much of House Bill 2039 deals with affirmative defenses against claims by homeowners. There may be an argument made that the application of the discovery rule to the contract based claims of commercial claimants was unchanged by the legislation, thereby giving them a potentially longer period to bring suit than is afforded to homeowners. A final wrinkle to this scenario is provided by the recent case of Parkridge Associates, Ltd. v. Ledcor Industries, Inc., 113 Wn. App. 592, , 54 P.3d 225 (2002) which provides that a By Greg Harris Page 6 of 7

7 contractually based indemnity claim, typical of the suits brought by a general contractor against subcontractors when a construction defect claim is asserted by the property owner, does not accrue until the indemnitee (the general contractor) has paid or is adjudged to owe monies which the indemnitor (nee subcontractor) should rightfully pay. Consider the situation where the owner/condo association waits until the last month of the repose period to file suit against the general contractor. Assuming that he gets the suit before the 6 year period had run, in order to preserve his rights against the subcontractors, the general either has to pay or stipulate to be adjudged to owe amounts that he can then seek to recover from the subcontractors. He may not, as had been commonly done allege an alternative I m not liable, but if I am liable, then I am entitled to indemnity from X defense and third party claim. The inability to collect up the usual suspects as parties in that instance is driven not by any of the facts of the particular case, but solely by when in the period of potential repose the claim is asserted. A trap for the unwary at the very least. By Greg Harris Page 7 of 7