January 2002 

Practice Tips 

Keep the Claims Straight and the Parties Honest: Eliminating the Fraud or Misrepresentation Claim from a Breach-of-Contract Action

by Derek W. Loeser

In breach-of-contract cases, fraud and misrepresentation claims often emerge. In a typical case, your client is sued for breach of contract because he failed to deliver what was promised under a contract. He also is sued for fraud or misrepresentation because the plaintiff claims your client provided false information about what he would deliver, the plaintiff relied on the information, and as a result, suffered damages. Such a claim is appealing for plaintiffs, because it carries the stigma of an intentionally bad act, as opposed to the morally benign breach-of-contract claim. But, before putting together your defenses to the several elements of fraud, take a look at the economic-loss rule, a little used though well-established rule in Washington that limits when a party may pursue both tort and contract claims in the same case.

The economic-loss rule prohibits tort actions for purely economic losses. Berschauer/Phillips Construction Co. v. Seattle School District No. 1, 124 Wn.2d 816, 821, 881 P.2d 986, 990 (1994). In so doing, the rule provides a "bright line" that marks the "fundamental boundary between the law of contracts, which is designed to enforce expectations created by agreement, and the law of torts, which is designed to protect citizens and their property by imposing a duty of reasonable care on others." Id. Courts applying the economic-loss rule have scrupulously maintained the boundary in order to prevent disproportionate liability and preserve the ability and incentive of parties to allocate risk by contract. 124 Wn.2d at 822, 881 P.2d at 990; Carlson v. Sharp, 99 Wn. App. 324, 330, 994 P.2d 851, 854 (2000).

Economic-loss damages are those that "fall on the contract side of the line between tort and contract." Berschauer, 124 Wn.2d 827-28, 881 P.2d at 992. (quoting Washington Water Power Co. v. Graybar Electric Co., 112 Wn.2d 847, 867 n.10, 774 P.2d 1199 (1989)). Although courts have wrestled somewhat to clearly define the standard, as a general rule, economic loss is distinguished from physical harm or property damage. Stuart v. Coldwell Banker Commercial Group, Inc., 109 Wn.2d 406, 420, 745 P.2d 1284 (1987). Lest the rule be too clear, however, courts have further refined the distinction by differentiating between indirect property damage, and direct or immediate damage, particularly to "other" objects. See, e.g., Carlson v. Sharp, 99 Wn. App. at 328-29, 994 P.2d at 853-54 (surveying Washington law, and explaining that "'defects in materials evidenced by deterioration are characterized as economic losses, for which claims sounding in tort are barred; defects causing physical injury or harm to other objects are not characterized as economic losses, and actions for such damage are not barred by the rule.'" (citations omitted)).

Stuart v. Coldwell Banker is a good example of the economic-loss rule in action. In Stuart, a condominium homeowners' association brought a negligent construction claim against the builder-vendor for defects in private decks and walkways. The defects did not cause personal injury or direct physical damage. Rather, the defects caused the decks and walkways to deteriorate over time as a result of exposure to weather. 109 Wn.2d at 421, 745 P.2d at 1292. The trial court awarded damages to the plaintiff. The Washington Supreme Court reversed, explaining:

Commentators and courts faced with this issue have found it necessary to distinguish economic loss from physical harm or property damage. The distinction is usually drawn depending on the nature of the defect and the manner in which the damage occurred. Defects of quality are evidenced by internal deterioration, and designated as economic loss, while loss stemming from defects that cause accidents involving violence or collision with external objects is treated as physical injury.… The nature of the defect here was that the decks and walkways were not of the quality desired by the buyers.

109 Wn.2d at 420, 745 P.2d at 1291. Because plaintiff's damages were purely economic, the court rejected the plaintiff's tort claim.

Similarly, in Sharp, the Court of Appeals rejected the plaintiffs' effort to recover economic damages for negligence. In the case, a developer of a mobile-home park retained a geotechnical firm to perform soil analysis of two sites in the park. The firm concluded that the sites were "suitable for the proposed development." 99 Wn. App. at 326, 994 P.2d at 852. The developer sold the sites to the plaintiffs, and placed their homes on the sites. However, shortly thereafter, the foundations began to "sink," eventually causing damage to the plaintiffs' homes. Id. at 325, 994 P.2d at 852. The plaintiffs' sued for negligence, among others, the geotechnical firm hired by the developer. The court found against the firm, and awarded repair costs, and costs to remedy the site conditions to the plaintiffs. The Court of Appeals reversed, based on its determination that the award allowed the boundary between contract and tort damages to "overlap," and exposed the firm to liability that was not contemplated in the firm's agreement with the developer. Id. at 330, 994 P.2d at 854. The court explained: "Even if the report was negligently written or the analysis negligently performed, the allocation of risk lies in the contract between those two parties." Id.

Although, as discussed above, Washington courts have applied the economic-loss rule to tort claims sounding in negligence, there are no published Washington decisions in which the rule has been applied to tort claims sounding in fraud or intentional misrepresentation. Nonetheless, the reasons for the rule are applicable to fraud or misrepresentation claims as well. In fact, these reasons apply with particular force to such claims when asserted in conjunction with breach-of-contract, as in this context it is rare for alleged misrepresentations to cause personal injury or "direct" property damage. Typically, the damages asserted are losses resulting from the defendants' alleged failures to deliver what the plaintiffs believed they were going to receive under the contract, i.e., the benefit of the bargain. Such damages are precisely what the economic-loss rule precludes.

Furthermore, in such cases it is easy to appreciate how a fraud claim based on the failure to deliver what was promised under the contract exposes the defendant to damages that exceed the allocation of liability in the contract. For example, if the parties enter into a contract for the sale of computer software in which damages are limited to a refund of the cost of the software, a misrepresentation claim in which the buyer seeks consequential damages caused by the failure of the software to function as promised, clearly undermines the allocation of risk set forth in the contract. Looked at from a pre-contract perspective, if the seller had anticipated that his exposure potentially was much greater than agreed to in the contract, he may well have insisted on a higher price for the software in order to take his true risk of loss into account. As the court explained in Berschauer:

The fees charged by architects, engineers, contractors, developers, vendors, and so on are founded on their expected liability exposure as bargained and provided for in the contract. As Justice Cardozo warned, the expansion of duty in tort to include economic interests would expose defendants to a liability in an indeterminate amount for an indeterminate time to an indeterminate class.

124 Wn.2d at 827, 881 P.2d at 992 (citing Ultramares Corp. v. Touche, 255 N.Y. 170, 179-80, 174 N.E. 441 (1931)). Thus, where a plaintiff seeks to bring a fraud or misrepresentation claim to recover benefits it was unable to obtain in contractual negotiations, the economic-loss rule should enable the defendant to restore the allocation of liability to what originally was intended by the parties.

A corollary to the economic-loss rule addressed by numerous courts in other jurisdictions is the bar against misrepresentation claims based on the same allegations asserted in a breach of contract claim. See, e.g., Sunquest Information Systems, Inc. v. Dean Witter Reynolds, Inc., 40 F. Supp.2d 644, 651 (W.D. Pa. 1999); Telecom Int'l America, Ltd. v. AT&T, 67 F. Supp.2d 189, 207 (S.D.N.Y.1999). This bar, like the economic rule itself, is premised on the fundamental distinction between tort and contract remedies, and the "well-settled principle" that "mere allegations of breach of contract do not give rise to a claim for fraud, or fraud in the inducement." 67 F. Supp.2d at 207.

Pursuant to this corollary, in order to maintain a cause of action for fraud or misrepresentation, together with a breach-of-contract claim, a plaintiff must allege: (1) a legal duty separate and apart from the contractual duty to perform; (2) a fraudulent representation collateral or extraneous to the contract; or (3) special damages proximately caused by the fraudulent representation that are not recoverable under the contract measure of damage. Bell Sports, Inc. v. System Software Assoc., Inc., 45 F.Supp.2d 220, 227 (S.D.N.Y. 1999).

In Bell Sports, the plaintiff alleged that the defendant misrepresented the capability of computer software that it sold the plaintiff, and its ability to implement and service the software. The court found that these alleged misrepresentations were not "collateral" to the parties' agreements, but were in, fact, the "very essence" of the agreements. Id. at 228. Furthermore, because the plaintiff failed to allege special damages not recoverable under a breach-of-contract measure of damages, and, in fact, sought identical damages in its fraud claims as in its contract claims, the plaintiff failed to satisfy the special-damages requirement as well. Accordingly, the court dismissed the fraud claim.

Similarly, in Telecom Int'l American, Ltd. v. AT&T, the plaintiff alleged that AT&T misrepresented the functionalities of a telephone system it sold to the plaintiff, the ability of the system to satisfy the plaintiff's requirements, and the costs associated with the system. Id. at 207. The same allegations served as the basis of the plaintiff's breach-of-contract claim. The court dismissed the fraud claim, finding that the claim was "redundant," and "seeks to enforce no more than the breached promises and obligations alleged in the breach of contract claims." Id. at 207-08; Scholastic, 1999 WL 1277246, at *10-11 (dismissing fraud claim where identical allegations serve as basis for fraud and contract claim, and identical damages sought).

While Washington courts also have not addressed this corollary, it is a sensible application of the principle underlying the economic-loss rule — the distinction between tort and contract claims. It makes sense that if a plaintiff cannot present some basis for the fraud or misrepresentation claim that is distinct from what was promised under the contract, the claim should be barred, and the plaintiff should be limited to the breach-of-contract action.

Whether this corollary and the economic-loss rule generally apply to fraudulent inducement claims requires closer examination. Courts have recognized that fraud in the inducement may present a "special situation," as the ability of one party to negotiate fair terms and make an informed decision may be undermined by the other party's fraudulent behavior. Huron Tool and Engineering Co. v. Precision Consulting Services, Inc., 209 Mich. App. 365, 370, 532 N.W.2d 541, 544 (Ct. App. 1995). This, however, is not the case where the only misrepresentation by the "dishonest party" concerns the quality or character of the goods sold, as in such situations, "the other party is still free to negotiate warranty and other terms to account for possible defects in the goods." Id., 209 Mich.App. at 372-73, 532 N.W.2d at 545. Based on this rationale, the court in Huron held that plaintiff's inducement claim was barred by the economic-loss rule.

Several other courts similarly have concluded that one may not necessarily avoid operation of the economic loss doctrine by merely pleading fraud in the inducement. Rather, the plaintiff still must show, among other elements, that the allegedly fraudulent statements were "extraneous" to the contract. As the court explained in Hotels of Key Largo, Inc. v. RHI Hotels, Inc., 694 So.2d 74, 77-78 (Fla. Ct. App. 1997): "Where the only alleged misrepresentation concerns the heart of the parties' agreement, simply applying the label of 'fraudulent inducement' to a cause of action will not suffice to subvert the sound policy rationales underlying the economic loss doctrine." Id. at 77.

Given the Washington State Supreme Court's embrace of these same policy rationales, presumably courts in Washington would arrive at the same conclusion. Defendants, thus, should have a strong argument that no matter how a fraud claim is fashioned, if it is premised on the same allegations as the contract claim, and, thus, is not "extraneous" to the contract claim, the claim should be barred by the economic-loss rule.

When confronting any fraud or misrepresentation claim that is pled with a breach-of-contract claim, look closely at the damages sought by the plaintiff, as well as at the allegedly false or misleading statements. If the damages are purely economic, or the statements relate solely to what was promised in the parties' agreement, it is likely that the fraud or misrepresentation claim is just a rehash of the contract claim under a tort heading. Move to dismiss the claim. If successful, you will remove the fraud stigma from the case, and restore the action to what it should be — a standard commercial dispute regarding performance of a contract.