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Economic negligence actions: a remedy for third parties.

A significant consequence of the and loan scandal and other financial disasters of the 1980s and 1990s was an increase in professional negligence actions for economic losses by third parties with whom the defendants did not have a contract.(1) Disappointed investors and lenders pursued lawyers who issued the opinions, accountants who performed the audits, and others involved in deals that went sour.

But the professionals involved in financial collapses are only the most visible targets of these suits for economic negligence. Many arise out of ordinary events. For example:

* A purchaser who suffers economic harm because of the failure of a product sues the manufacturer or component manufacturer withwhom it is not in privity.

* An owner-lessor of a truck sues the lessee's insurance agent for failing to insure the truck with a financially sound carrier.

* A beneficiary of a will sues the testator's attorney for failing to prepare an estate plan that minimizes estate taxes.

* A beneficiary of a payable-on-death bank account sues the bank for improperly establishing the account in that the beneficiary did not receive the account proceeds when the original depositor died.

* An employee dismissed for fading a drug test sues the laboratory for negligently administering the test.

* A purchaser of a defective budding sues the architect, general contractor, and subcontractors who were responsible for the construction.

* A home buyer sues the seller's real estate broker for failing to disclose defects in the house.

* A home buyer sues the seller's pest inspector for failing to discover termite infestation.

These claims follow a common pattern. Two parties have a contract that affects a third party. The breach or negligent performance by one party injures the economic interests of the third party, who sues the breaching or negligent party in tort or as a third-party beneficiary of the contract. These claims involve purely pecuniary loss--not physical injury.

Privity

From the 1870s to the 1950s, it was virtually impossible to establish a claim for economic negligence. Privity presented the most significant obstacle. Under the U.S. Supreme Court's decision in Savings Bank v. Ward(2) and Chief Judge Benjamin Cardozo's celebrated opinion in Ultramares Corp. v. Touche,(3) only a party in privity or with 'a bond approaching privity" with the defendant could sue for negligence.

Although Cardozo had mounted an "assault on the citadel of privity" in personal injury cases in MacPherson v. Buick Motor Co.,(4) his opinion in Ultramares became universally cited for the proposition that liability in an indeterminate amount for an indeterminate time to an indeterminate class" would flow from removing the privity requirement in economic loss cases.(5) Only a third-party beneficiary would have a claim for economic negligence, but the narrow doctrines of contract law at the time made recovery as a third-party beneficiary extraordinarily difficult as well.

A trend away from the privity restriction has accelerated in recent years. It began in the 1950s when courts applied general negligence principles to economic loss cases. A particular impetus was the California Supreme Court's formulation of the balance-of-factors test for negligence in Biakanja v. Irving.(6) Today, privity has been all but extinguished as a bar to actions for economic negligence. Only one or two jurisdictions apply privity to a wide range of cases.

Areas of Potential Liability

Because the plaintiffs loss in economic negligence cases is not bounded by either a direct relationship with the defendant, as in a contract case, or a physi cal cause, as in a personal injury case, there is a potential for indeterminate liability. The economic consequences of a negligent act can ripple much farther than the physical consequences, particularly where the negligent act is the communication of information, such as an accountant certifying an audit.

Courts have expanded liability for economic negligence in many areas. The following is a review of some of these. Attorneys. The traditional rule, established in Savings Bank v. Ward, is that an attorney is not liable for negligence to a nonclient.(7) This is no longer true. In nearly every jurisdiction, an attorney is liable to nonclients in some situations, and in many jurisdictions the potential liability is extensive. Also, the current draft of the Restatement of the Law Governing Lawyers would expand the liability of attorneys to nonclients.(8)

The one context in which liability is never imposed involves an action by one party to litigation against the other party's attorney for negligence in bringing a nonmeritorious claim. In litigation the attorney's duty to the client is paramount, and courts uniformly recognize that any potential liability to the adversary would undermine that duty. However, more suits are being brought by persons affected by litigation who are not wholly adverse to the attorney's client. For example, the children of divorced parents sue one parent's attorney for failing to protect the children's rights to insurance policies, as required by the divorce decree. These actions arc generally unsuccessful, but aggressive attorneys are continuing to test the limits of the doctrine.

Liability is almost always imposed where an attorney prepares a will or supervises its execution in such a manner that an intended beneficiary loses the bequest to which he or she otherwise would be entitled. Courts find the attorney owes a duty of care to the beneficiary. Although some courts limit the duty to preparing the will, others hold attorneys to a higher degree of responsibility. In a recent case, attorneys were held to owe a duty of care in effecting gifts in contemplation of approaching death.(9)

Two other areas of potential liability involve representations in business transactions and negligence in executing real estate transactions. In general, when attorneys make statements in business transactions, particularly formal opinions, where they know or should know that an identifiable person is likely to rely on them, the attorneys owe the third party a duty of reasonable care. Where they make a less formal statement in a context in which it is less apparent that a third party may rely on it, they are unlikely to be held liable.

For example, an attorney who issues an opinion letter in connection with a bond issue may be liable to a purchaser of the bonds. An attorney for the principals of a corporation, however, is not liable to share purchasers for giving erroneous advice to the principals about their ability to sell the shares.

On the same principle, an attorney for one party to a real estate transaction can be liable to another party for misrepresenting some aspect of the transaction. In a recent New Jersey case, the attorney misrepresented the findings of percolation tests to a broker, who passed the information along to a prospective buyer.(10)

An attorney who volunteers to take some action affecting the interest of a nonclient also may be liable for negligently failing to carry through. For example, an attorney who fails to file a financing statement protecting a nonclient's security in a property is liable.(11)

Accountants. There is a strong majority rule on the liability of an accountant for negligently conducting an audit and certifying an audit report.(12) Restatement (Second) of Torts [sections]552 imposes on accountants a duty to people who they intend to rely on their report or who their clients know will rely on it. The key issue is what it means to "intend" or know" of the third party's reliance. Some courts interpret the section broadly, others narrowly.(13) Approximately 25 jurisdictions have adopted some version of [sections]552.

A few courts apply a pure foreseeability test to determine liability. Others, like New York, adopt the near privity rule.(14) The principal difference between the near privity rule and [sections]552 is the latter's additional requirement of conduct, not just knowledge, linking accountant to the relying third party. A number of jurisdictions have adopted some version of this test as a result of "tort reform" efforts."

Product manufacturers Economic negligence cases involving defective products differ from the typical products liability case in that they do not involve personal injury. Instead, the product may damage other property of the user, may be damaged, or may simply fall to work as expected.

In some cases, a product user who purchases a product from in intermediate seller may have the benefit of an express warranty from the manufacturer. A growing number of courts also hold that a nonprivity user can assert an implied warranty based on the provisions of the Uniform Commercial Code.(16)

Where a commercial purchaser who is not in privity with the manufacturer suffers only economic loss because of product failure, most jurisdictions hold that the buyer has no tort action in negligence or strict liability. A line of authority in the state courts was capped by the U.S. Supreme Court decision in East River Steamship Corp. P. Transamerica Delaval, Inc., an admiralty case.(17) There, the Court held that whether stated in negligence or strict liability, no claim lies in admiralty when a commercial party alleges injury to the product resulting in purely economic loss. Because the only loss is to the buyer's expectation, contract--not tort--law regulates the transaction.

Courts differ on whether a plaintiff can recover in tort when something more is involved than the product's failing to work satisfactorily--when the product is damaged or causes other property damage. For example, a component part of a truck may break suddenly, possibly damaging the truck. Some courts hold that damage to the product is simply a form of economic loss and therefore not recoverable in tort, while others hold that property damage is a physical injury compensable in tort. In between, other jurisdictions focus on the way in which the harm occurs; a calamitous accident may be covered by tort law although gradual deterioration is not.

Drug testing laboratories. Many employers require employees or prospective employees to be tested for illegal drug use. When a drug testing laboratory negligently reports a positive test result, the employee may attempt to bring a negligence action against the laboratory.

In this emerging area of economic negligence, the jurisdictions are divided over whether the laboratory owes the employee a duty of reasonable care. A Louisiana court recognized this duty. Applying standard foreseeability analysis, the court reasoned that a laboratory should know that negligent testing will compromise an employee's job.(18) In 1995 decision, however, the Texas Supreme Court indicated the laboratory had no duty to make the employer aware of the proper interpretation of the results.(19) The Fifth Circuit extended that decision and ruled that a laboratory owed no duty of reasonable care to an employee even in conducting a test.(20)

Insurance agents. It is well-settled law that an insurance agent or broker who undertakes to procure insurance for a client but negligently fails to do so is liable to the client for any damages that result. In a number of cases, this principle has been extended to impose liability in favor of a third party who does not recover from the insured because the agent failed to procure adequate insurance.

When an injured third party cannot recover under an automobile liability policy(21) or an employee cannot recover under a workers' compensation policy(22) because the driver's or employer's agent has failed to properly obtain coverage, several jurisdictions allow an action as a third-party beneficiary or in negligence. Similarly, when an agent places a policy with a company that becomes insolvent, a loss payee under the policy has an action against the broker for its resulting loss.(23)

Other cases. Although most cases fall into established categories such as those above, others come from different factual settings, including construction,(24) banking,(21) security services,(26) and real estate brokerage.27

As a final example, consider B.L. Jet Sales, Inc. v. Alton Packaging Corp.(28) There, the purchaser of a jet aircraft sued the company that had serviced the aircraft for a previous owner, alleging the company had failed to record on the aircraft's repair log that there was substantial corrosion in the fuel tanks and that the company had made substantial repairs. As a result, the plaintiff suffered significant, unexpected repair expenses. The defendant's business practices, the custom of the industry, and federal regulations obligated the company to log the aircraft's defects and the repairs made to correct them.

Here, the defendant had a contract with the aircraft's previous owner but not the plaintiff. Under economic negligence principles, however, the court upheld the cause of action. The court reasoned that the purpose of the defendant's obligation--to advise later purchasers of the aircraft's history, maintenance, and repair--could be fulfilled by imposing liability on the defendant.

Economic negligence has become increasingly available as a remedy for the infliction of economic harm in a broad range of cases. Litigators need to be aware of its development in particular areas and its status as a distinct field of law to realize its full potential.

Notes

(1) See generally JAY M. FEINMAN, ECONOMIC NEGLIGENCE: LIABILITY OF PROFESSIONALS AND BUSINESSES TO THIRD PARTIES FOR ECONOMIC LOSS (1995). (2) 100 U.S. 195 (1879). (3) 174 N.E. 441, 444 (N.Y. 1931). (4) Ill N.E. 1050 (N.Y. 1916). (5) 174 N.E. 441, 444. (6) 320 P.2d 16, 19 (Cal. 1958). (7) 100 U.S. 195. (8) RESTATEMENT (THIRD) OF THE LAW GOVERNING LAWYERS [sections]73 (Tent. Draft Nov. 7,1994). (9) Donahue v. Shughart, Thompson & Kilroy, P.C., 900 S.W.2d 624 (Mo. 1995). (10) Petrillo v. Bachenberg, 655 A.2d 1354 (N.J. 1995). (11) See, e.g., Simmerson v. Blanks, 254 S.E.2d 716 (Ga. Ct. App. 1979). (12) Accountants also may be held liable for performing nonaudit services, such as compilation and review of financial information or tax planning. (13) Compare Blue Bell, Inc. v. Peat, Marwick, Mitchell & Co., 715 S.W.2d 408 (Tex. Civ. App. 1986) (accountant liable if he or she knows of plaintiffs reliance) with Bily v. Arthur Young Co., 834 P.2d 745 (Cal. 1992) (accountant must have intended or known of reliance in particular type of transaction). (14) Credit Alliance Corp. v. Arthur Andersen Co., 483 N.E.2d 110 (N.Y. 1985). (15) See, e.g., N.J. STAT. ANN. 2A:53A-25 (1995). (16) U.C.C. [subsections]2-314,2-315. (17) 476 U.S. 858 (1986). (18) Lewis v. Aluminum Co. of Am., 588 So. 2d 167 La. Ct. App., cert. denied, 592 So. 2d 411 (La. 1992). (19) SmithKline Beecham Corp. v. Doe, 903 S.W.2d 347 (Tex. 1995). (20) Willis v. Roche Biomedical Labs., Inc., 61 F.3d 313 (5th Cir. 1994). (21) Robinson v. John E. Hunt & Assocs., 490 So. 2d 1291 (Fla. Dist. Ct. App. 1986). (22) Sec, e.g., Rae v. Air-Speed, Inc., 435 N.E.2d 628 (Mass. 1982). (23) See, e.g., Carter Lincoln-Mercury v. EAMR Group, 638 A.2d 1288 (N.J. 1994). (24) See Jay M. Feinman, Economic Negligence in Construction Litigation, 15 CONSTR. LAW. 34 (1995). (25) See, e.g., Corning Bank v. Rice, 645 S.W.2d 675 (Ark. 1983) (bank liable for failing to property establish Totten trust account). First Nat'l Bank v. Langley, 314 So. 2d 324 Uss. 1974) (bank bable to employee of customer for negligent operation of night depository). (26) See, e.g., Gerace v. Holmes Protection of Philadelphia, 516 A.2d 354 (Pa. Super. Ct. 1986), appeal denied, 527 A.2d 541 (Pa. 1987) (security firm not bable to owner of rings kept in jewelry store for failure of security system). (27) See, e.g., Tennant v. Lawton, 615 P.2d 1305 (Wash. Ct. App. 1980) (broker liable for negligently transmitting information from seller to buyer). (28) 724 S.W.2d 669 (Mo. Ct. App. 1987).
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Author:Feinman, Jay M.
Publication:Trial
Date:Jun 1, 1996
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