Economic loss doctrine inapplicable to service contracts

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“Unlike contracts for products or goods, which enjoy the benefit of well-developed law under the U.C.C., no such benefit exists for contracts for services.” Hon. Ann Walsh Bradley Wisconsin Supreme Court

The economic loss doctrine does not apply to contracts for services, the Wisconsin Supreme Court held on Nov. 9.

Cold Spring Egg Farm raises chickens to produce eggs, and had a long-standing business relationship with Cease Electric, Inc. In the summer of 1996, Cold Spring entered into an oral contract with Cease Electric to upgrade the ventilation system in one of its barns. Ventilation systems are required to bring fresh, cool air into the barns so that the chickens have sufficient oxygen to live.

The new system was designed so that a single controller would operate all fans in stages. As the temperature in the barn rose, the fan control would engage different fans to bring fresh air into the barn. Conversely, when the temperature in the barn fell, the controller would turn off fans accordingly.

The main fan control unit was purchased by Cease Electric from Aerotech, Inc. Aerotech designed the system to have a backup thermostat as a safety device in the event the primary fan control failed. It recommended wiring the backup thermostat separately from the power source for the primary fan control.

In January 1997, the ventilation system failed, resulting in the loss of nearly 18,000 chickens. Cold Spring hired Al Dittmar, an electrician, to investigate, and Dittmar concluded that Cease Electric had improperly wired the main fan control unit to the same power circuit as the backup thermostat.

Pursuant to its insurance contract, Insurance Company of North America (INA) paid Cold Spring $118,339 for the loss of income and $40,705 for the loss of chickens. Cold Spring, meanwhile, sustained a loss of $39,761 due to its policy deductible.

INA and Cold Spring brought suit against Cease Electric, alleging negligence in its performance of services. A jury found that Cease Electric was negligent, and Walworth County Circuit Court Judge John R. Race inserted the stipulated amount of damages into the verdict.

Cease Electric appealed, arguing that the negligence action was barred by the economic loss doctrine, but the court of appeals affirmed in a published decision, Insurance Co. of North America v. Cease Electric Inc., 2004 WI App 15, 269 Wis. 2d 286, 674 N.W.2d 886.

The Supreme Court granted review, and affirmed, in a unanimous decision by Justice Ann Walsh Bradley.

The court first concluded that the contract at issue was one for services, rather than for goods. The court found, "it was Aerotech’s ST-4026 that created the ventilation system in the barn, not Cease Electric. All Cease was required to do was to follow the one-page wiring schematic to ensure that the controller was properly wired to ventilation fans and a power source. It failed to do so, and Cold Spring brought suit, alleging negligent performance of services."

The court also noted that billing was done on an hourly basis, rather than by the job.

Having determined that the contract was for services, the court determined that service contracts do not fit within the purpose of the economic loss doctrine.

Pursuant to the doctrine, a commercial purchaser of a product cannot recover solely economic losses from the manufacturer under negligence or strict liability theories.

"Economic loss" is the loss in a product’s value which occurs because the product is inferior in quality and does not work for the general purposes for which it was manufactured and sold, including both direct economic loss and consequential loss.

Noting that there is a split among jurisdictions whether the doctrine applies to contracts for services, the court concluded that the better weight of authority is that it should not, for a variety of reasons.

First, the court noted that the Uniform Commercial Code sets forth a comprehensive system to govern transactions between commercial parties, but that the UCC only applies to sales of goods, not services.

Under the UCC, purchasers of defective products are able to recover costs and lost profits, placing them in the same position as if the product had functioned properly, while manufacturers can restrict their liability by explicitly limiting remedies in the contract.

The court found, "It is the existence of these rights and remedies that serves as one of the critical rationales underlying the economic loss doctrine. After all, if a commercial purchaser were allowed to sue in tort to recover solely economic loss, the U
.C.C. provisions designed to govern such disputes could be circumvented entirely."

The court added, "The major problem with Cease Electric’s argument is that it assumes that contract law is better suited than tort law for dealing with purely economic loss in the context of service agreements. It is not. Unlike contracts for products or goods, which enjoy the benefit of well-developed law under the U.C.C., no such benefit exists for contracts for services. This is because the U.C.C. does not apply to service contracts."

Another factor weighing against application of the doctrine to service contracts is the frequent lack of any written agreement. The court found, "Like many agreements between purchasers and providers of services, the agreement between Cold Spring and Cease Electric was oral rather than written. Because of the informal circumstances surrounding most oral contracts for services, the policy provisions underpinning the application of the economic loss doctrine do not readily apply."

The court acknowledged that parties to service contracts, oral or written, can allocate risk and limit remedies with contractual provisions. But the court concluded, "given the informality of such agreements, few parties actually address the allocation of risk or the limitation of remedies. They neither discuss it themselves nor hire attorneys to draft written agreements."

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The court continued, "Although the freedom to allocate economic risk by contract should not be impinged, applying the economic loss doctrine to limit recovery based on the premise that the parties have indeed exercised that freedom simply makes no sense."

Finally, the court found that it neither party is necessarily in a better position to assess the risk of economic loss, but that the assessment will vary on a case-by-case basis. Therefore, this policy factor neither supports, nor negates application of the doctrine.

The court also noted that application of the doctrine to service contracts could have wide-ranging unintended ramifications, inasmuch as professional malpractice actions would fit into the category and may be extinguished, although such actions have long been permitted.

Accordingly, the court held the doctrine inapplicable, and affirmed.

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David Ziemer can be reached by email.