Economic loss doctrine applies to asset purchase agreement

Listen to this article

The Seventh Circuit held on June 13 that the economic loss doctrine bars tort claims based on an asset purchase agreement, and that the "fraud in the inducement" exception does not apply to such an agreement.

Wright Medical Technology, Inc., designs, manufactures, and sells medical devices and products. CERAbio LLC is a research and development company.

In the late 1990’s, CERAbio developed a bone replacement product made from tricalcium phosphate (TCP), called Apatight, which the FDA had approved.

CERAbio obtained patents for the Apatight production process and material.

CERAbio negotiated with Wright to provide Apatight to Wright for Wright to market and sell. Eventually, the negotiations evolved and Wright decided to purchase substantially all of CERAbio’s assets, including all patents and know-how.

Prior to entering into the Agreement, CERAbio informed Wright that it had an established and repeatable process for producing Apatight and that all of the raw materials necessary were commercially available. Wright agreed to pay $3 million for the CERAbio assets with $1.5 million payable upon closing and a second installment of $1.5 million due no later than three days after Wright verified that it was able to produce Apatight.

After the closing, Wright was unable to purchase TCP powder, one of the key raw materials needed to manufacture Apatight. The manufacturer of the necessary TCP powder had started making a new TCP powder with a different particle size that would not work properly utilizing the Apatight manufacturing instructions.

Wright eventually succeeded in creating a marketable bone replacement product called Cellplex. According to Wright, the process for manufacturing Cellplex is completely different. According to CERAbio, the process is only slightly different, and the products are virtually identical.

Wright did not pay the second $1.5 million installment, and CERAbio brought suit in federal court. Wright counterclaimed, alleging breach of contract, negligence, and fraud.

Wright claimed that CERAbio knew prior to closing that the TCP powder was unavailable. CERAbio claimed that, although it knew of an availability problem, it thought that the problem could be resolved, and that Wright was aware of the problem before closing.

CERAbio moved for summary judgment on the tort claims, and District Judge John C. Shabaz granted the motion. Shabaz also held that Wright could not present any evidence that predated the closing on the Agreement, because such evidence would circumvent its holding on the tort claims.

Shabaz created what he called a "bright blue line" as follows: "Is it before the contract was entered into? It’s out. Is it afterwards? If indeed there’s no evidentiary objection to it other than that, it goes in. That’s the blue line."

The jury ruled in favor of CERAbio, and Wright appealed. In a decision by Judge Ilana D. Rovner, the Seventh Circuit affirmed that the economic loss doctrine barred the tort claims, and that the fraud in the inducement exception did not apply, but reversed and remanded, because the evidentiary ruling was overbroad.

Applying Wisconsin law, the court concluded that the Wisconsin Supreme Court, if presented with the issue, would hold that the doctrine bars tort claims growing out of an asset purchase agreement.

The court stated the doctrine as follows: "The economic loss doctrine seeks to preserve the distinction between contract and tort law and to prevent parties from eschewing agreed-upon contract remedies and seeking broader remedies under tort theory than the contract would have permitted. ‘Economic loss’ for purposes of the doctrine is ‘the loss in a product’s value which occurs because the product is inferior in quality and does not work for the purposes for which it was manufactured and sold.’ The economic loss doctrine ‘forbids commercial contracting parties (as distinct from consumers, and other individuals not engaged in business) to escalate their contract dispute into a charge of tortious misrepresentation if they could easily have protected themselves from the misrepresentation of which they now complain.’ In short, parties cannot use tort principles to circumvent the terms of an agreement. The doctrine’s purpose is to ‘maintain the fundamental distinction between tort law and contract law; protect commercial parties’ freedom to allocate economic risk by contract; and encourage the party best situated to assess the risk of economic loss, the commercial purchaser, to assume, allocate, or insure against that risk (cites omitted).’"

Although noting that Wisconsin created an exception to the doctrine for contracts for services, in Ins. Co. of N. Am. v. Cease Elec. Inc., 688 N.W.2d 462 (2004), the court found the exception inapplicable, reasoning, "the policy considerations that prompted the Wisconsin Supreme Court to exempt service contracts from the economic loss doctrine are simply not at play here."

The court noted that most service contracts are oral and informal, and parties rarely hire attorneys to allocate risks and limit remedies. In addition, in many service contracts, information disparities bet
ween the parties make it unlikely that each party can negotiate the terms with the same level of bargaining power.

Distinguishing Cease Electric, the court found, "None of these policy considerations apply in this case. Wright and CERAbio, both well-represented, sophisticated business parties, drafted complex, detailed agreements which could and indeed did allocate risks and assign remedies. We conclude, therefore, that the economic loss doctrine applies."

The court also held that the fraud in the inducement exception is inapplicable.

The court noted the uncertainty in Wisconsin over the exception created by the Wisconsin Supreme Court in Digicorp, Inc., v. Ameritech Corp., 662 N.W.2d 652 (2003), and declared, "The most we can discern from Digicorp, therefore, is that the fraud in the inducement exception to the economic loss doctrine is more narrow than that announced in Douglas-Hanson and that it does not apply when the fraud pertains to the character and quality of the goods that are the subject matter of the contract."

The court found this description enough to conclude that the exception should not apply, reasoning, "In this case, the parties to the contract were two sophisticated and well-represented business entities. The crux of their agreement centered around the sale and purchase of the assets of CERAbio’s business — primarily a process for producing Apatight. Wright’s primary concern should have been, and indeed was, whether it was purchasing a process that could be replicated by Wright. Of course, if it could not, Wright would be paying $3 million dollars for a product with no value to it. Wright was free to, and in fact did, negotiate warranty and other terms to account for the possibility that the process could not be replicated. Wright’s remedies, therefore must be limited to contract claims."

The court added, "The alleged fraud in this case pertains to the character and quality of the product that is the subject matter of the contract."

	Related Links Wisconsin Court System Related Article Case Analysis

In addition, the Agreement contained a non-reliance clause, stating that the buyer assumes all risk for decisions made or inferences drawn in reliance on the seller’s information. The court found, "These provisions allocated to Wright the risk that the information provided by CERAbio might be incomplete or incorrect. Wright assured CERAbio in writing that it would not rely on information provided by CERAbio. Not only does this non-reliance clause verify that the alleged fraud was interwoven with the parties’ contractual agreement, and thus barred by the economic loss doctrine, it also confirms the district court’s finding that Wright could not have reasonably relied on CERAbio’s oral representation as to the viability of the process or the availability of starting materials."

The court also cited extensive authority from Delaware and other jurisdictions that an anti-reliance clause in a stock purchase agreement precludes claims of deceit by prior representations.

Nevertheless, the court held that a new trial must be held, because of the evidentiary holding barring any evidence that pre-dated the closing on the Agreement.

The court acknowledged, as a legitimate concern, the possibility that Wright would try to place before the jury tort matters that the court had resolved on summary judgment. Nevertheless, the court held, "The bright blue line, however, not only excluded evidence relevant to these claims, but also excluded legitimate evidence relevant to Wright’s defenses and surviving counter claims."

Accordingly, the court reversed the award, and remanded for retrial.

Click here for Case Analysis.

David Ziemer can be reached by email.