Court of Appeals Narrows Scope of Economic Loss Doctrine

December 31, 2012

Wisconsin has long adhered to what is known as the “economic loss doctrine,” which stands for the basic principle that parties to a contract cannot sue each other in tort for damages relating to performance of the contract. Practically, this means that parties to a contract are limited to the remedies set forth in the contract. An exception to this doctrine applies when a defective product injures another person or “other property.” A recent decision by the Wisconsin Court of Appeals expanded the scope of the “other property” exception, thereby limiting the reach of the economic loss doctrine.

In State Farm Fire and Casualty Company v. Hague Quality Water, International, a homeowner filed an insurance claim after his water softener malfunctioned, causing his house to flood and resulting in tens of thousands of dollars in repair costs. The insurer, State Farm, paid the claim and then sued the water softener manufacturer, Hague. Hague moved to dismiss the lawsuit, arguing that the economic loss doctrine barred the claim. The trial court granted the motion. State Farm appealed, arguing that the “other property” exception to the economic loss doctrine applied.

Under the existing law, the “other property” exception has two components. First, in order for the exception to apply, the “other property” that is damaged cannot be part of an “integrated system” with the malfunctioning product. Second, under the so-called “disappointed expectations test,”  the damages cannot have been within the contemplation of the purchaser if the product malfunctioned.

As to the first element,  the court of appeals held that the water softener and the house were not an “integrated system.” The court of appeals distinguished previous cases where courts had concluded that defective windows and the surrounding drywall and siding were an “integrated unit.” According to the court of appeals, “other property” is part of an “integrated system” with the defective product only if it is integral to the function of the product. The court then held that the “other property” that was damaged in this case —drywall, flooring, and woodwork—was not essential to the function of the water softener.

Addressing the second element, the court of appeals clarified that under the “disappointed expectations test”, the damages at issue cannot be the result of the failure of the product to perform its essential purpose or function. The court stated that the test was not whether the purchaser should have foreseen the harm, but rather whether the harm was a foreseeable consequence of the product not doing what it was supposed to do. In this case, the water softener did not cause damages because it failed to soften the water. Rather, the damage was caused because it leaked water all over the house.

In summary, the court of appeals ruled that the economic loss doctrine does not apply when: 1) a product malfunctions and damages other property that is not essential to the function of the product; and 2) the damages were not caused by the failure of the product to perform its primary function. The practical result of the decision is that it will allow plaintiffs to recover tort damages in more circumstances and increase the exposure of insurance companies to loss.