Resolving Commercial Disputes

Drawing the Line Between
Contract and Tort Theories
Under the Economic Loss Doctrine

By Ronald R. Ragatz

Over the last decade, the Wisconsin Supreme Court has been refining the roles of contract law and tort law in resolving commercial disputes. On Feb. 26, 1998, the supreme court took another major step in that process, ruling in Daanen & Janssen Inc. v. Cedarapids Inc. that Wisconsin's economic loss doctrine precludes tort claims by a commercial purchaser of a product against the manufacturer, even where there is no privity between the manufacturer and the purchaser.¹ This decision helps define the rights of manufacturers, sellers, and commercial purchasers of products. It also leads to questions about where the supreme court will apply the doctrine next.

The Wisconsin Supreme Court's recent decision on the economic loss doctrine - Daanen & Janssen Inc. v. Cedarapids Inc. - helps define the rights of manufacturers, sellers, and commercial purchasers of products. The question now is, where will the supreme court apply the doctrine next?

Economic loss doctrine

The economic loss doctrine precludes a commercial purchaser of a product from suing the seller in tort for solely "economic losses" where there is no personal injury or damage to property other than to the product itself or the machine of which it is a component. "Economic loss" is damage resulting from a product being inferior in quality or not working for its intended purposes.² It includes loss in value of the product itself and consequential losses such as lost profits.

The privity issue

When the Wisconsin Supreme Court first adopted the economic loss doctrine in 1989, it left open the question of whether the doctrine applies where the purchaser and the defendant are not in privity of contract. In Sunnyslope Grading Inc. v. Miller, Bradford and Risberg,³ a commercial purchaser of backhoe equipment sued the manufacturer in tort, alleging negligence and strict product liability. The purchaser had received a manufacturer's warranty on the equipment and, thus, the manufacturer and purchaser were in privity. The supreme court held that the tort claims were barred by the economic loss doctrine.

In adopting the economic loss doctrine, the Sunnyslope court followed the reasoning of the 1986 U.S. Supreme Court decision in East River Steamship Corp. v. Transamerica Delaval Inc.⁴ In East River the court reasoned that a manufacturer has no duty in tort to prevent a product from injuring itself and that claims for such damages should be addressed under contract theories, not tort theories.⁵ It based the economic loss doctrine on fundamental distinctions between tort law and contract law, and did not mention privity.

However, the Sunnyslope court confined its ruling to the question directly before it, that is whether the doctrine barred economic losses between commercial parties where there was a warranty between the parties. Two years later, the Wisconsin Supreme Court in Northridge Co. v. W.R. Grace & Co. again considered the economic loss doctrine and again discussed the fundamental distinctions between tort and contract law.⁶ However, the court did not have occasion to address the privity issue, since it concluded that the economic loss doctrine did not apply for other reasons.

In the meantime, federal courts applying Wisconsin law predicted that the Wisconsin Supreme Court would apply the economic loss doctrine even in the absence of privity.⁷

Daanen & Janssen background

In 1991 Daanen & Janssen purchased from a local dealer a replacement component part for its rock crushing machine. The component was manufactured by Cedarapids, but Daanen & Janssen never received a manufacturer's warranty.

Daanen & Janssen claimed that over the next three years the crushing machine had multiple breakdowns caused by defects in the component. The breakdowns did not cause any personal injury or damage to property other than the crushing machine. The only damages claimed were repair costs and lost profits, totaling several hundred thousand dollars.

Daanen & Janssen sued Cedarapids in tort, including negligence and strict liability claims. Cedarapids moved for summary judgment, arguing that the claims were barred by Wisconsin's economic loss doctrine. Summary judgment was granted in the U.S. District Court for the Eastern District of Wisconsin, and Daanen & Janssen appealed to the Seventh Circuit. The sole issue on appeal was whether Wisconsin's economic loss doctrine applies where there is no privity between the plaintiff purchaser and the defendant manufacturer. The Seventh Circuit certified the following question of state law to the Wisconsin Supreme Court:

"In the absence of privity, does the economic loss doctrine bar a remote commercial purchaser from recovering economic losses from a manufacturer under theories of strict liability and negligence?"

The Daanen & Janssen decision

The Wisconsin Supreme Court answered the certified question in the affirmative, ruling that Wisconsin's economic loss doctrine applies in the absence of privity. In a unanimous decision authored by Justice Donald Steinmetz, the court provided a thorough analysis of the principles underlying the economic loss doctrine:

"Application of the economic loss doctrine to tort actions between commercial parties is generally based on three policies, none of which is affected by the presence or absence of privity between the parties: (1) to maintain the fundamental distinction between tort law and contract law; (2) to protect commercial parties' freedom to allocate economic risk by contract; and (3) to encourage the party best situated to assess the risk of economic loss, the commercial purchaser, to assume, allocate, or insure against that risk."⁸

With respect to the first policy, the concept of duty is at the heart of the distinction drawn by the economic loss doctrine. Contract law seeks to hold commercial parties to their promises, ensuring that each party receives the benefit of its bargain, while tort law is rooted in the concept of protecting society as a whole from physical harm to persons or property. Therefore, a "manufacturer in a commercial relationship has no duty under either negligence or strict liability theories to prevent a product from injuring itself."⁹

Second, the economic loss doctrine protects commercial parties' freedom to contract. The marketplace operates best when commercial parties are free to factor risk allocation into their agreements. Commercial purchasers can opt for warranty protections at a higher price or can choose to bargain for a lower price and accept the risk of product failure. However, if a purchaser that has chosen the lower price without a warranty can resort to tort remedies in the event of product failure, then the bargain is frustrated. Manufacturers would have to build the cost of such risks into the price of all their products and the freedom to allocate risks by contract would be impaired.

Finally, as a corollary to the second policy, the economic loss doctrine encourages the party with the best understanding of the risks of economic loss - the commercial purchaser - to assume, allocate, or insure against the risk of loss caused by a defective product. The doctrine thus promotes efficiency and predictability in commercial relationships by basing liability solely on contract. Permitting tort theories for recovery of economic losses in commercial transactions would "make the manufacturer of products potentially liable for unbargained-for and unexpected risks."¹⁰

The court rejected arguments by Daanen & Janssen that applying the economic loss doctrine in the absence of privity would be unfair and contrary to public policy because it would leave a purchaser like Daanen & Janssen with no remedy against the manufacturer. The doctrine is intended to encourage commercial parties to negotiate protections at the time of the purchase, and permitting tort remedies after the fact would "allow an end run around contract law and would all but destroy the economic loss doctrine."¹¹

Impact of Daanen & Janssen

This decision has a real impact for commercial manufacturers, distributors, and dealers in Wisconsin. In today's marketplace, few products are sold directly by the manufacturer. Rather, most transactions involve intermediaries of some sort - dealers, distributors, or retailers.

If there were a privity exception to the economic loss doctrine, a purchaser could opt for a lower price rather than pay for a manufacturer's warranty and then could fall back on tort remedies if a problem arose. After Daanen & Janssen, the purchaser now has the incentive to bargain for a manufacturer's warranty because without one, the purchaser probably will be left with no remedy at all against the manufacturer.

The decision also alters the dynamics between dealer and purchaser and between dealer and manufacturer. If the purchaser could sue the manufacturer in tort, contract remedies against the dealer might be of secondary importance. Now, the contractual relationship between the purchaser and the dealer generally will be the focus of any product failure claims, if there is no manufacturer's warranty. The dealer either must bargain for limitations of remedies with the purchaser or make sure that its contract remedies against the manufacturer are preserved so that it can pass the liabilities up the chain of distribution.

The Daanen & Janssen decision should provide the incentives that the supreme court envisioned. It provides motivation for all of the commercial parties to think about and allocate risks in the sale of products. It is the natural completion of what the court began nine years ago when it adopted the doctrine in Sunnyslope for product liability. The question now is whether the court will apply the same principles in areas beyond product liability.

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