The Economic Loss Rule and Investment-Related Cases
The definition, purpose, scope and application of Arizona’s economic loss rule and whether it bars tort claims in investment-related cases.
Please note that, while this article accurately describes applicable law on the subject covered at the time of its writing, the law continues to develop with the passage of time. Accordingly, before relying upon this article, care should be taken to verify that the law described herein has not changed.
I. The Definition and Purpose of the Economic Loss Rule
The economic loss rule is “a common law rule limiting a contracting party to contractual remedies for the recovery of economic losses unaccompanied by physical injury to persons or other property” than that in the subject contract. Flagstaff Affordable Hous. Ltd. P’ship v. Design Alliance, Inc., 223 Ariz. 320, 323, 223 P.3d 664, 667 (2010). Thus, the economic loss rule presents the issue of whether a court should limit a contracting party to its contract remedies for purely economic loss. Id.
at 323, 223 P.3d at 664.
Economic loss “refers to pecuniary or commercial damage, including any decreased value or repair costs for a product or property that it itself the subject of a contract between the plaintiff and defendant, and consequential damages such as lost profits. Id.
at 323, 223 P.3d at 667 (citing Salt River Project Agric. Improvement & Power Dist. v. Westinghouse Elec. Corp., 143 Ariz. 368, 379-80, 694 P.2d 198, 209-10 (1984)).
“The principal function of the economic loss doctrine ... is to encourage private ordering of economic relationships and to uphold the expectations of the parties by limiting a plaintiff to contractual remedies for loss of the benefit of the bargain.” Id.
at 327, 223 P.3d at 671. “These concerns are not implicated when the plaintiff lacks privity and cannot pursue contractual remedies.” Id.
at 327, 223 P.3d at 671 (citation omitted). In such circumstances, when there is no contract between the parties, rather than rely on the economic loss doctrine, “courts should instead focus on whether the applicable substantive law allows liability in the particular context.” Id.
at 327, 223 P.3d at 671.
II. The Scope and Application of the Economic Loss Rule
The scope of the economic loss rule is a legal issue that appellate courts review de novo. Id.
at 322, 223 P.3d at 666 (citing Dressler v. Morrison, 212 Ariz. 279, 281, 130 P.3d 978, 980 (2006)).
“The economic loss doctrine may vary in its application depending on context-specific policy considerations.” Id.
at 325, 223 P.3d at 669. To determine whether the economic loss rule should apply in a certain context, courts “must consider the underlying policies of tort and contract law” in the specific setting, such as promoting safety, deterring accidents and spreading the losses and costs of accidents with respect to tort law, and encouraging parties to contract, allocate risks and identify and specify remedies, preserving the freedom to contract, promoting the free flow of commerce, and enforcing contracts and upholding the parties’ contractual expectations with respect to contract law. Id.
at 323-25 & 328 n.5, 223 P.3d at 667-69 & 672 n.5 (citing Salt River, 143 Ariz. at 375-76, 694 P.2d at 205-06).
In 1984, the Arizona Supreme Court held the economic loss rule may apply to product liability cases, depending on: (1) the economic nature of the loss; (2) whether the defect was unreasonably dangerous or posed unreasonable risks of harm to persons or other property; and (3) whether the loss occurred in a sudden, accidental manner. Id.
at 323-24, 223 P.3d at 667-668 (citing Salt River, 143 Ariz. at 379-81, 694 P.2d at 209-11).
In 2010, the Arizona Supreme Court held the economic loss rule may apply to construction defect cases or cases involving construction-related contracts. Id.
at 324-27, 223 P.3d at 668-71. Construction-related cases include those brought against an architect, subcontractor and exterminator. See, e.g., Id.
at 321, 223 P.3d at 665 (architect); Cook v. Orkin Exterminating Co., Inc., 227 Ariz. 331, 334-35, 258 P.3d 149, 152-53 (Ct. App. 2011) (exterminator); Carioca Co. v. Sult,
2010 Ariz. App. Unpub. LEXIS 1255, at *9-14 (subcontractor). However, the three-factor test applied in product liability cases does not apply to construction defect cases or construction-related contract cases, which are simply governed by the parties’ underlying agreement. Flagstaff Affordable, 223 Ariz. at 326, 223 P.3d at 670. In other words, whether a party in a construction defect or construction-related contract case is limited to contractual remedies for purely economic losses depends on whether the parties have contractually agreed to preserve tort remedies for solely economic loss. Id.
at 326, 223 P.3d at 670.
The Arizona Supreme Court cautioned that its adoption of the economic loss doctrine in construction defect or related cases reflects its “assessment of the relevant policy concerns in that context; it does not suggest that the doctrine should be applied with a broad brush in other circumstances.” Id.
at 329, 223 P.3d at 673. Accordingly, Arizona courts have not subsequently applied the economic loss rule beyond the product liability and construction defect or construction-related contract context. See Atlas Flooring, LLC v. Porcelanite S.A. de C.V., 425 Fed. Appx. 629, 633 (9th Cir. Apr. 4, 2011); Firetrace USA, LLC v. Jesclard, 800 F. Supp. 2d 1042, 1051-52 (D. Ariz. 2010).
However, federal courts have applied Arizona’s economic loss rule outside the product liability and construct defect context to cases with contracts related to mortgages, loans and loan modifications, student information systems, credit card payment processing systems, real estate, luxury vehicles, and franchises. See, e.g., Gilbert Unified Sch. Dist. No. 41 v. CrossPointe, LLC, 2012 U.S. Dist. LEXIS 61254 (D. Ariz. May 2, 2012); Mejia v. GMAC Mortg. LLC,
2012 U.S. Dist. LEXIS 31544, at *6 (D. Ariz. Mar. 6, 2012); Gilbert Unified Sch. Dist. No. 41 v. CrossPointe, LLC, 2011 U.S. Dist. LEXIS 142259, at *38-45(D. Ariz. Dec. 9, 2011); Wilson v. GMAC Mortg. LLC,
2011 U.S. Dist. LEXIS 104331, at *9 (D. Ariz. Sept. 14, 2011); Steel v. JP Morgan Chase Bank NA,
2011 U.S. Dist. LEXIS 87235, at *3-4 n.1 (D. Ariz. May 6, 2011); TSYS Acquiring Solutions, LLC v. Elec. Payment Sys., LLC,
2010 U.S. Dist. LEXIS 104259, at *3-12 (D. Ariz. Sept. 29, 2010); Rodriquez v. Quality Loan Serv. Corp., 2010 U.S. Dist. LEXIS 91554, at *4-5 (D. Ariz. Sept. 2, 2010); Sherman v. PremierGarage Sys., LLC 2010 U.S. Dist. LEXIS 77392, at *9-13 (D. Ariz. July 30, 2010); Ireland Miller, Inc. v. Shee Atika Holdings Phoenix, LLC, 2010 U.S. Dist. LEXIS 69425, at *11-2 n.8 (D. Ariz. July 12, 2010); Colson v. Maghami, 2010 U.S. Dist. LEXIS 68957at *22 (D. Ariz. July 9, 2010).
If the economic loss rule applies, “a contract party is limited wholly to its contractual remedies for purely economic loss related to the subject of the parties’ contract” and is barred from bringing tort claims, such as negligence, misrepresentation and fraud. Cook, 227 Ariz. at 334-35 & n.6, 258 P.3d at 152-53 & n.6 (emphasis in original).
However, Arizona’s economic loss rule does not necessarily bar professional negligence claims, such as a claim for legal malpractice because “[l]awyers owe fiduciary duties to their clients and generally are barred from entering agreements that prospectively limited their liability.” Flagstaff Affordable, 223 Ariz. at 329, 223 P.3d at 673 (citations omitted). The fact that the Arizona Supreme Court has expressly recognized professional negligence claims, such as claims for legal malpractice and accounting malpractice, also leads to the conclusion that Arizona’s economic loss rule does not operate to bar professional negligence claims. See, e.g., Glaze v. Larsen, 207 Ariz. 26, 83 P.3d 26, 29 (2004); Sato v. Van DenBurgh, 123 Ariz. 225, 599 P.2d 181 (1979).
Further, the economic loss rule does not bar a statutory consumer fraud claim. See Peña v. Opic,
2010 Ariz. App. Unpub. LEXIS 5, at *17-20. There are also no cases to date in which an Arizona court has applied the economic loss rule to bar a breach of fiduciary duty claim and it has been predicted they would not do so. See B2B CFO Partners, LLC v. Kaufman, 2012 U.S. Dist. LEXIS 29009, at *32-35 (Mar. 5, 2012); cf. Flagstaff Affordable, 223 Ariz. at 329, 223 P.3d at 673 (indicating economic loss rule would not apply where professional owes fiduciary duty). Finally, a federal court has held that Arizona’s economic loss rule does not operate to prohbit tortious interference and unfair competition claims. See Firetrace, 800 F. Supp. 2d at 1050-52.
III. The Economic Loss Rule and Investment-Related Cases
Based upon the foregoing, in determining whether Arizona’s economic loss rule applies to bar tort claims in investment-related cases, it is important to consider the following:
- Did the parties enter into a contract or are the parties otherwise in privity? If so, the economic loss rule may apply. If not, the economic loss rule does not apply and the focus is whether the applicable substantive law allows liability in the particular context.
- Did the parties’ contract if any, expressly preserve tort remedies? If so, the economic loss doctrine does not apply. If not, the economic loss doctrine may apply.
- Are the aggrieved party’s losses purely economic? If so, the economic loss rule may apply. If not, the economic loss rule does not apply to those other losses.
- Do the aggrieved party’s losses relate to persons or other property outside the subject matter of the parties’ contract? If so, the economic loss rule does not apply to those losses. If not, the economic loss rule may apply.
- What are the relevant policies of tort and contract law to consider in the specific context and do they weigh in favor of or against applying the economic loss rule?
- Is there precedential or persuasive authority applying the economic loss rule in the specific context to the specific claim (e.g., claims for strict liability, negligence, fraud and misrepresentation claims in product liability and construction defect or construction-related contract cases), declining to apply the economic loss rule (e.g., negligence claims against lawyers or claims for consumer fraud, breach of fiduciary duty, tortious interference and unfair competition), or otherwise recognizing a claim and thereby implying the economic loss rule does not apply?
The application of Arizona’s economic loss rule to bar tort claims in investment-related cases has not yet been confronted and addressed by courts since Flagstaff Affordable.
With respect to at least a professional negligence claim, the Arizona Supreme Court has held the application of the economic loss rule does not depend on whether the professional’s duties are imposed by law or arise out of contract or the professional status of the individual, but on the concern and consideration of relevant tort and contract law policies in the specific context of the case. Flagstaff Affordable, 223 Ariz. at 328-29 & n.5, 223 P.3d at 672-73 & n.5.
Accordingly, investment-related cases in which courts have applied the economic loss rule because the individual was technically not a “professional” or the individuals’ duties were not extracontractual duties implied by law separate and apart from the parties’ contract, are probably not persuasive authority in Arizona. See, e.g., Pavlovich v. Nat’l Cit Bank,
2006 U.S. App. LEXIS 535, at *20-24 (6th Cir. 2006); Interstate Sec. Corp. v. Hayes Corp.,
920 F.2d 769, 773-77 (11th Cir. 1991); Anwar v. Fairfield Greenwich Ltd., 826 F. Supp. 2d 578, 593 (S.D.N.Y. 2011); Gross v. Silverberg,
2010 U.S. Dist. LEXIS 131580, at *12-14 (D. Col. Dec. 13, 2010).
Instead, in considering whether to apply Arizona’s economic loss rule to an investment-related case, at least for a negligence and breach of fiduciary duty claim, a court should consider the following factors: (1) whether the professional owes fiduciary duties; and (2) whether the professional is generally barred from entering agreements that prospectively limit their liability. Flagstaff Affordable, 223 Ariz. at 329, 223 P.3d at 673.
With respect to the first factor, Arizona courts have held that financial advisors or investment advisors owe their clients fiduciary duties. See Stewart v. Phoenix Nat’l Bank, 49 Ariz. 34, 44-45, 64 P.2d 101, 106 (1937); accord SEC v. Rauscher Pierce Refsnes, Inc., 17 F. Supp. 2d 985, 992-95 (D. Ariz. 1998). Based on the principal-agent relationship, stockbrokers also owe fiduciary duties to their clients, but only during the length of a specific transaction, unless they have discretionary authority over their clients’ accounts or act as their clients’ financial or investment advisor, in which case they have a continuing fiduciary duty. See Walston & Co, Inc. v. Miller,
100 Ariz. 48, 51-53, 410 P.2d 658, 660-62 (1966). Along those same lines, anyone who acts as an agent on behalf of investors, such as an attorney, also owes fiduciary duties to those investor principals. See In re Swartz, 129 Ariz. 288, 294, 630 P.2d 1020, 1026 (1981).
Promoters, officers, directors and managers of a corporation owe fiduciary duties to the corporation and stockholders. See Atkinson v. Marquart,
112 Ariz. 304, 306, 541 P.2d 556, 558 (1975); Kadish v. Phoenix-Scottsdale Sports Co., 466 P.2d 794, 797 (1970); Frame v. Mahoney, 21 Ariz. 282, 287-88, 187 P. 584, 586 (1920); Johnson v. Nychyk, 517 P.2d 1079, 1081 (Ariz. Ct. App. 1974); accord Facciola v. Greenberg Traurig, LLP, 781 F. Supp. 2d 913, 924-25 (D. Ariz. 2011). A shareholder of a corporation that has the ability to control and manage a corporation, such as majority stockholder, also owes fiduciary duties to the corporation and other shareholders. See Mims v. Valley Nat’l Bank, 481 P.2d 876, 878 (1971). Finally, if an operating agreement of a limited liability company is silent, a manager or member, like a corporate officer or director, could be liable for failing to fulfill fiduciary obligations while acting on the company’s behalf. See Sports Imaging of Ariz., LLC v. 1993 DKC Trust, 2008 Ariz. App. LEXIS 212, at *52-63.
Therefore, because financial advisors, investment advisors, stockbrokers, and corporate promoters, officers, directors and managers are like lawyers and owe fiduciary duties to their clients, it is doubtful that Arizona’s economic loss rule would be held by the courts operate to bar a professional negligence claim against them. See Chicago Hous. Auth. v. Chicago Hous. Auth. Ret. Trust, 1996 U.S. Dist. LEXIS 8046, at *19-22 (N.D. Ill. May 9, 1996) (finding investment advising sufficiently analogous to lawyering and accounting to deny a motion to dismiss a tort claim for professional negligence based on the economic loss rule).
With respect to the second factor, there is no Arizona statutory or common law expressly prohibiting investment professionals from prospectively limiting their liability in contracts. However, other courts have held that exculpatory clauses in investment contracts disclaiming liability for negligence are valid, but invalid for fraud or misrepresentation. See Wolf v. Ford, 644 A.2d 522, 537 (Md. Ct. App. 1994); Blankenheim v. E.F. Hutton & Co.,
Inc., 266 Cal. Rptr. 593, 599 (Ct. App. 1990).
In short, whether Arizona’s economic loss rule applies to investment-related cases depends on the parties’ contract, the specific context, and tort and contract policy concerns. However, if the investment professional owes fiduciary duties to its clients, or the investment professional is accused of misrepresenting an investment or defrauding the investor, it is likely the economic loss rule would not be applied by Arizona courts to bar tort claims.
If you would like to discuss a potential investment-related claim and the potential application of the economic loss rule, we would be happy to discuss it with you. To arrange for a consultation concerning your legal matter, please contact Robert Mitchell at email@example.com
or at (602) 452-2730.