Construction Contracts: Liability for Negligent Performance

In the construction industry, disputes often result in litigation or some form of alternative dispute resolution. Claims against contractors may seek recovery for injury caused by alleged negligent performance, and contractors should be prepared to limit their exposure to such claims.

When the alleged economic loss is only to the subject matter of the contract itself, the plaintiff ’s claim is based in contract alone. This is known as the "economic loss" rule. The economic loss rule precludes punitive damages, which are not available for claims based only on breach of contract. Such damages are available only if a breach of duty of care (a tort) alleges injury beyond economic loss to the subject of the contract.

The economic loss rule and its application can best be illustrated by examining court cases. In the 1947 case that established the economic loss rule in Texas, a claim was made in tort for residential fire damage that resulted from alleged negligence of the defendant’s employee while repairing and adjusting a kerosene hot water heater in the plaintiffs’ home.

Did the plaintiffs have a valid claim in tort if the relationship of the parties was governed by contract? The court held that a party to a contract owes a duty to perform the agreed-upon task with care, skill, reasonable expedience and faithfulness. A negligent failure to observe such a duty is a tort, as well as a breach of contract.

The court found that if the duty is violated, either by negligent performance or negligent nonperformance, the breach of duty can constitute actionable negligence.

In another case, plaintiffs sought damages in contract and tort arising out of the construction and sale of a house. At trial, the jury found the defendant had breached the warranty of good workmanship in the contract and that it was grossly negligent in supervising the construction of the house. The homebuilder was found liable in punitive damages.

On appeal, however, the Texas Supreme Court held that the award of punitive damages was improper. Although the contractual relationship of the parties may create duties under both contract and tort law, the court held that the plaintiffs’ injury was that the house they were promised and paid for was not the house they received. The court characterized this as a breach of contract and held that when the injury is only the economic loss to the subject of a contract itself (which was the case here), the action is based in contract alone. Thus, breach of contract cannot support recovery of punitive damages.

In contrast, the 1947 case involving the hot water heater addressed injury to the entire house, not just the subject matter of the contract. Even when a negligent or grossly negligent performance of a contract takes place, if the loss suffered by the injured party is only related to the subject matter of the contract itself, the sole remedy is an action for breach of contract, which does not allow a claim for punitive damages.

In another case, a plastic re-processor claimed an electric utility negligently per­formed a contract to establish electrical service for a new plastic extruder, thereby causing abnormally low usage readings that falsely suggested energy savings and prompted the re-processor to remove an older extruder from its production line. Following trial, the jury found in favor of the plastic re-processor.

On appeal, the court held that the re­processor’s claim for lost profits caused by the utility’s negligent performance of the contract represented economic loss to the subject of the contract itself and did not constitute a tort.

In a final example, a hospital contracted for the design, supply and installation of a power supply system. Following completion of the work, the hospital asserted various claims, including negligence and gross negligence, as a result of the alleged failure of the materials used in the system’s construction. Again, the court looked at the substance of the action to determine whether the alleged injury concerned matters other than economic loss to the subject of the contract. The court held that the plaintiff ’s claims of negligence and gross negligence, among others, were untenable because the alleged injury concerned economic loss only to the subject of the contract.

With so much attention from the courts, it’s clear there are no concrete guidelines regarding the application of the economic loss rule. A cause of action can be found in tort where an incident gives rise to a claim of personal injury or damage to property other than that covered by the contract itself.

So, what can be done to avoid facing not only claims for breach of contract, but also additional claims of negligence when construction disputes arise? The answer is simple: Contracting parties can limit their liability to a specified amount by employing "limitation of liability" clauses in construction contracts.

An example of a limitation of liability clause is:

"Notwithstanding anything to the contrary, the contractor shall not be liable for any special, indirect, consequential or incidental damages, including, without limitation, loss of profits or business interruption, even if the damage is to property beyond the subject matter of this agreement, and even if caused by the contractor’s negligence."

Generally, such clauses are used to exempt one party from future liability for negligence. However, a limitation of liability clause will be enforceable only if a fair bargaining position exists between the parties when the contract is negotiated. In this regard, a court will consider the conditions in which the agreement was made and will look at the parties’ bargaining process.

A court will evaluate the fairness of the contractual provision in question by determining whether legitimate commercial reasons justify its inclusion as part of the agreement. Provided steps are taken to ensure these conditions precedent to the enforceability of such a clause are met, liability may be limited without the need for reliance on the economic loss rule.