Pure economic loss - what is it and can you recover it?

Imagine that the other day an employer client came to us with a sad tale of defective cladding on his new building and asked us whom he should sue. The possible culprits were the architect, the contractor and the cladding sub-contractor. As usual, we asked him to send us the architect’s appointment, the main contract and his warranty from the sub-contractor. We anticipated a multi-party action against all three. It would, we were sure, be a straightforward breach of contract claim for failure to exercise reasonable skill and care in design and supervision (the architect) and faulty workmanship/ defective materials (the contractor and sub-contractor).

Our optimism was short lived. As the employer’s sorry story unfolded, we learned the following things:

• the contractor had become insolvent;
• the employer had never obtained a collateral warranty from the subcontractor;
• essential terms had never been agreed with the architect and it was looking likely that there was no contract with him.

We hastily withdrew our previous view that the employer would have somebody to sue and advised him that, given the difficulties and complexities involved, and, unless something turned up from his files, it would be very risky to pursue a claim against anyone.

Can it really be that this employer has no redress against anyone for the egregious cladding? Is it right that the architect and the cladding sub-contractor, now sipping piña coladas in Barbados, have got off scotfree just because the employer overlooked a few formalities in their engagement?

Quite probably. The problem is - we advised our client - the rule that the cost of rectifying defective work is considered by the Courts to be pure economic loss which, in the absence of a special relationship giving rise to a duty of care, is not recoverable in negligence. Our client replied: “what?. It was a fair point.

The law of negligence

In the absence of a contractual relationship with the remaining two guilty parties, our fictional client would have to sue them in negligence. The law of negligence is founded upon the principle that a person should take reasonable care to avoid causing foreseeable injury to others (a "duty of care"). "Injury" means personal injury and injury to property. So when a manufacturer of a fizzy drink carelessly left a decomposing mollusc at the bottom of the bottle, he was liable to the unfortunate consumer for her illness caused by that defect.

Damage to property is less straightforward. If cracks in a negligently installed (or designed) pipe lead to an explosion which causes damage to the surrounding building, then the financial consequences of the damage to the building are recoverable. However, if the cracks in the pipe are discovered and fixed by the owner, he cannot recover that cost from the guilty party in negligence. Nor can he recover his losses occasioned by, for example, shutting down his factory while the cracks are being rectified. These two losses are known as "pure economic loss". They are generally not recoverable in negligence.

This is because a duty of care must be consistent with an assumption of responsibility. There is no presumed general duty to avoid causing economic loss to another: it must be shown that such a duty was actually and deliberately assumed. That, as Judge Dredd said, "is the law".

Rights and liabilities in construction cases are usually protected by a contractual chain. The courts consider that a duty of care to avoid causing economic loss is inconsistent with the contractual structure as other remedies are available. A subcontractor does not assume a duty of care to an employer, the courts argue, because he works for the main contractor and is answerable to him if the main contractor has to compensate the employer for faults in the subcontractor's work.

However, as we have seen from our poor client's case, there is not always a contractual remedy. Alternatively the contractual remedy may be inadequate: a contractual limitation period may have expired, whereas it may still be possible to bring a claim in negligence.Footnote 1

The exceptions to the rule

English law wouldn't be any fun if there weren't exceptions to every rule. And there are ways round the pure economic loss rule.

The case law has shown that recovery of pure economic loss may be possible where a "special relationship" between the parties exists. This relationship has been described as "almost as close a commercial relationship as is possible to envisage short of privity (i.e. of contract)". In other words, it is acknowledged that sometimes the relationship between two parties who are not actually in contract with each other, would be evidence that the negligent party had assumed a duty of care to the innocent party not to cause them economic loss.

One recognised category of such a situation is that of negligent advice ("negligent misstatement"). A person is under a duty not to give inaccurate information to another if:

• the adviser knows that the advice will be relied on by a specific person;
• the adviser knows that an inaccuracy in the statement will cause that person loss;
• the advisee does rely on the statement and
• suffers losses as a result.

You can therefore imagine our delight when our employer client found a letter written to him by the architect saying "in response to your request for advice on a spectacular titanium cladding which is absolutely fool-proof, will not come off and has a shelf-life of 25 years, we once again assure you that the system provided by Sardinetin Limited is absolutely guaranteed to work and will not under any circumstances ever fall off". Things were looking up!

The special relationship

If the ingredients of a negligent misstatement cannot be found, another "special relationship" has to be proved. Some construction lawyers nurse a secret dream of being the one to finally persuade the House of Lords that the relationship between a sub-contractor and an employer can sometimes be "so close as to justify a duty of care". It is thought that where specialists are specifically relied upon for their expertise by employers, for example where a sub-contractor is nominated, this should indicate the existence of the mysterious special relationship.

Having rummaged through our client's files, we discovered that the subcontractor, Sardinetin Limited had been specifically approached by our client for their renowned expertise in titanium cladding. Sardinetin Limited assured our client that their titanium cladding was marvellous, would never fall off and would last forever without any maintenance. They very thoughtfully put this in writing. On this basis our client named them as the cladding sub-contractor in the main contract.

This new information gave us three possible claims to raise against Sardinetin Limited: a negligence claim with a special relationship; a misrepresentation claim or a claim for breach of an implied collateral warranty. The key is that Sardinetin Limited voluntarily assumed a duty of care towards our client, knowing he would rely upon their expertise, and knowing what the financial consequences of defective cladding would be.

Returning to the architect: if a special relationship is one which is so close that it is like privity of contract, then surely there must be such a relationship where a contract was intended to arise between the parties, but failed due to lack of agreement. If the architect did not voluntarily assume a duty of care towards our client then it is hard to imagine exactly what would constitute a "special relationship". Sadly this argument has not yet reached judicial ears.

Unfortunately, before we could dream of making legal history, our client managed to sell his defectively clad building to a reckless purchaser. The purchaser did not request warranties from the consultants and subcontractors. When he discovers the true meaning of "caveat emptor" he will be without remedy: it is extremely unlikely that the above exceptions would extend to his situation.

Finally, it is worth mentioning that contract and tort are not the only sources of legal liability for defective construction, design and materials. Where the building is residential, liability may arise under statute. A defective product which causes damage to the rest of the building (e.g. a boiler which explodes) may also be covered under product liability law.

While we would love to spend your money in the House of Lords demonstrating how to find a "sufficient degree of proximity", we have a duty to practise preventative law. We hate to bang on about signing contracts and getting warranties but - as you will appreciate - all potential "special relationships" should in fact be contractual.

For further information please contact Vanessa Hall at [email protected] or on +44 (0)20 7367 2670.

Footnotes

Footnote 1

The limitation period for contract is 6 years from the date of the breach (12 years if the contract is made under deed), whether or not damage is suffered at that time. In tort, the limitation period is 6 years from when damage occurs, or 3 years from the earliest date on which the claimant had the knowledge required for bringing the action (with a longstop of 15 years from the act of negligence).