Economic Loss Lecture

What is a ‘Pure’ Economic Loss?

Not all foreseeable losses stemming from negligence are recoverable. Economic losses are treated in a significantly different manner than damages for injury or property damage. This is largely because of the self-limiting manner of injury and property damage. For example, a negligent driver who creates an accident will only cause so much physical harm - eventually the cars involved will come to a stop, no further harm will stem from the driver’s negligence.

Economic damage however, is far less easy to quantify, can grow out of proportion very quickly. Consider a situation in which a driver takes out an electricity pylon supplying a small village. If economic harm was recoverable, then the driver could be liable for the loss of business of every shop and business run from that village. Perhaps one of those businesses failed to make a sale, which in turn would have given it the ability to invest in a stock which consequently took off, meaning that even a relatively small economic loss could be linked to a huge loss in potential profits. In combination with various economic phenomena like compound interest, our negligent driver has the potential for almost infinite liability. Whilst this might satisfy a desire for absolute justice (indeed, those business owners affected by the power outage are not at fault), this is clearly an untenable situation. No insurer would be able to cover such a loss, and it would consequently become impossible to purchase effective insurance to cover this liability. As such the law places significant limits on the recovery of pure economic losses.

The presiding rule is therefore that pure economic loss is not recoverable - that is, economic losses which cannot be directly traced back to harm to a person or property. However, there exists three primary exceptions to this rule: where the loss is based on physical damage to the claimant’s property, where the negligence act causes a claimant to acquire defective goods or property, or when economic loss stems from negligent misstatement. It should be noted that the ‘usual’ rules of negligence still apply here, so there must still be a duty of care in line with Caparo, a breach of duty, and that breach must have caused the loss.

Economic Loss Due to Physical Damage

Where an economic loss stems from physical damage to a product or equipment, then it is recoverable. This principle is best understood by looking at the leading precedent of Spartan Steel & Alloys Ltd v Martin & Co (Contractors) Ltd [1973] 1 QB 27.

Case in Focus: Spartan Steel & Alloys Ltd v Martin & Co (Contractors) Ltd [1973] 1 QB 27

The claimant ran a smelting business from its factory, taking scrap metal, and melting it down in order to purify it. It should be noted that this process took some time, and that if interrupted half-way through, the metal would re-solidify, leaving a sub-par product as well as damaging the involved furnaces. The defendants were digging with an excavator nearby when they damaged a cable supplying electricity to the claimant’s factory. This cable was not owned by the claimants. The claimant’s factory consequently had to shut down for 15 hours. As a result, Spartan suffered three harms (and attempted to claim for all three).

1) During the power outage, the factory’s furnaces shutdown mid-melt, causing half-processed steel to solidify. This meant that the furnaces were damaged and the steel was unusable. The first harm was therefore the harm caused to the furnace and the damage to the steel.

2) Spartan intended to sell the steel which was damaged by the power outage at a profit. The second harm was therefore the loss of profit because Spartan could not sell it at full price.

3) Spartan claimed that it was unable to process steel during the power outage. Had the power supply been uninterrupted, it would have started another steel melt, which would have brought the factory more profit. The third harm was therefore the loss of profit due to the factory’s non-operation.

The first harm was unproblematic - the contractors were held to have a duty of care to the factory owners which was breached. This resulted in physical harm to the furnaces and the steel, and was thus recoverable. This should not be surprising - if a driver negligently drives through a shop window, then they will be held liable for the cost of replacing the shop window and any stock they damaged, and the same principle applies here.

The second harm was also held to be recoverable - although lost profits are an economic harm, it was held that the lost profits were a direct result of damaging the steel. Thus in our above example, the driver would not only be liable for the cost of replacing the damage stock, but also for the loss of profits on that stock. So, if the stock cost £500 to buy, but would have been sold for £1000, then the driver would be liable for the full amount - £500 costs plus £500 profit.

The third harm was not held to be recoverable. It was purely economic in nature - nothing had directly affected the steel which would be melted in the future, and so this was an attempt to claim a purely economic loss. This would be the equivalent of the shopkeeper claiming for the profits which were lost during time spent repairing the shop and is not recoverable.

Exam Consideration: The distinction made between the different harms in Spartan is important - the rule is that economic loss stemming directly from physical harm is recoverable. You should ask what has been damaged in a given situation, and limit recoverable economic harm to the cost of replacement (or repair) plus lost profits, but only from the damaged property. It should also be noted as a general exception that where a case involves physical harm to a claimant, then lost earnings are recoverable; but this should be considered to be a symptom of tort law’s habit of proactively compensating claimants for personal physical harm, rather than as a part of the law regarding pure economic loss.

Economic Loss Due to Negligence Causing a Claimant to Acquire Defective Goods or Property

As a general rule, tort will not compensate for the economic loss of receiving a defective product. There have been some cases which appear to ignore this rule, however. These should be treated cautiously as an eccentricity, rather than as evidence of any ongoing rule or legal principle, particularly since they have since been overturned. Nonetheless, they represent an important, if temporary, exception to the rule on pure economic loss.

Before describing the law in this area, it is worth noting the position of tort law on defective products. As a rule, it is not possible to recover damages in tort for a defective product. So, if someone sells you a new car which you expect to have a fuel consumption of 40 miles per gallon, but due to a fault it only gets 20 miles per gallon, that is not recoverable in tort. A helpful distinction between property damage and property defect can be that damage involves hurting the quality of a product, whereas defect involves a product being created in a damaged form. For example, if someone damages your new car in an accident, the quality can be described as going from 10/10 to 8/10. However, if someone sells you a new car and it is defective, you receive an 8/10 car in the first place. There’s no direct damage by the seller, the car doesn’t ‘lose’ anything: it has just always been of a sub-par quality. Its resale value will be harmed however, meaning you lose money down the line - an economic loss. Tort is prepared to deal with damage and harm, but leaves it to contract law to deal with defective products. However, contract law will often fail to cover all eventualities. In particular, it is not always the parties to a contract who will be harmed by a breach, and so the rule of privity of contract will prevent the injured party from bringing a claim in contract law. This somewhat explains law’s position on defective property - the desire to fill in a gap left by contract law.

The primary case in this area is Anns v Merton London Borough Council [1978] AC 728.

Case in Focus: Anns v Merton London Borough Council [1978] AC 728

The defendant (a local council) negligently approved plans for a block of flats which contained foundations which were too shallow (furthermore, the defendant failed to inspect the foundations during construction.) As a result several defects emerged in the properties built on the foundations, such as cracks in the walls and the sloping of floors. This meant that the claimants had to spend money correcting the fault. No physical harm to person or property was caused by the negligence, meaning that the damage was purely economic. Nonetheless, the courts ruled that negligence had occurred, causing the claimants to acquire faulty property - the economic loss here can be thought of as the difference in value between a flat in a safe condition, and one which has poorly designed foundations and is therefore unsafe.The courts ruled that a duty of care existed between the defendants and the claimants to exercise appropriate skill when inspecting the plans. The loss was held to be recoverable as a result:

"what is recoverable is the amount of expenditure necessary to restore the dwelling to a condition in which it is no longer a danger to the health or safety of persons occupying and possibly (depending on the circumstances) expense arising from the necessary displacement"
- Lord Wilberforce, at 759.

This principle was applied similarly in Junior Books Ltd v Veitchi Co Ltd [1983] 1 AC 520. The defendants negligently laid the flooring of a newly constructed factory. This meant that the floor had to be replaced before it could be used. The claimants therefore sued for the cost of replacing the floor, and the profits lost whilst the floor was re-laid. The claimants were successful, and recovered for lost profits.

The basis for these exceptions can be thought of as a type of ‘preventative compensation’ - rather than waiting for someone to be injured by a faulty building and then suing, the courts appear to have decided to make the cost of repair recoverable, before injury or damage has occurred.

However, Anns was overruled in Murphy v Brentwood District Council [1991] 1 AC 398 - making Murphy the leading case. Again, a council approved faulty plans for some buildings. The resulting properties developed cracks, causing a loss of value in the buildings. The courts ruled that this was not recoverable - it was purely an economic loss, nothing was damaged and nobody was hurt, and so the only harm was receiving a building with a lesser value.

Usefully, in Murphy, Lord Bridge points out the reasoning behind ‘preventative compensation’ of the type seen in Anns and Junior:

"If a building stands so close to the boundary of the building owner’s land that after discovery of the dangerous defect it remains a potential source of injury to persons or property on neighbouring land or on the highway, the building owner ought, in principle, to be entitled to recover in tort from the negligent building the cost of obviating the danger, whether by repair or demolition, so far as that cost is necessarily incurred in order to protect himself from potential liability to third parties."
- Lord Bridge, at 926

In essence, Lord Bridge is pointing out the odd nature of having a legal principle which dictates that someone must be injured by a negligently constructed building before the builder might be sued in tort, rather than one which states that tort should act proactively to prevent the damage from occurring in the first place.

Exam Consideration: Although overruled or otherwise ignored by the English law currently, Anns and Junior represent a distinct departure from the status quo. It is important to be aware of it when discussing the theory of economic loss. Furthermore, the position in Anns remains influential in number of commonwealth jurisdictions where it has not been overturned.

In practical situations (i.e. problem questions) it will largely be sufficient to note that whilst the Anns and Junior exception exists, Murphy takes precedence, and so it is unlikely that recovery for the acquisition of a defective product will be possible. This should not be regarded as a complete oversight - never forget that contract law exists to deal with products and transactions! At the same time, privity of contract prevents a certain proportion of claimants with no legal recourse, demonstrating the reasoning behind the law’s deviation in this area.

Economic Loss Due to Negligent Misstatement

Finally, there exist a category of cases involving economic loss due to negligent misstatement.

Case in Focus: Hedley Byrne & Co Ltd v Heller and Partners Ltd [1964] AC 265

The claimant was a marketing company which was approached by a third-party with an offer of work. The claimant then went to the third-party’s bank for a reference to ensure that it would be able to pay them for the work.  The reference was prepared without examining the company’s current financial status. Relying on the reference, the claimants contracted with the company. In actual fact, the company’s financial status was poor, and it went into liquidation before it paid the marketing agency - causing a purely economic loss. The claimant then sued the defendant (the bank). The courts ruled that the loss was of a recoverable nature. It should be noted, however, that the bank had attached a disclaimer to its advice, and so the courts rejected the claim, (although the case still stands as precedent).

Four conditions must be met before it is possible to recover economic losses due to negligent misstatement.

  1. A special relationship must exist between the parties. This will usually involve one party acting as an expert advisor. Thus, in Cornish v Midland Bank plc [1985] 3 All ER a mortgage advisor failed to explain to a client that she would be responsible for all of her husband’s debt. As a result, she lost a lot of money when the house was sold following their divorce. This relationship needn’t be particularly professional. In Chaudry v Prabhakar [1989] 1 WLR 29, the defendant was advised by a friend (who had a self-proclaimed knowledge of cars) that a car she was looking to buy had not been in any accidents. The opposite was true, and the car was in fact not road-worthy. Thus, relationship of trust does not need to be professional-to-client, it simply needs to be expert-to-non-expert.
  2. The advising party (or expert) needs to have voluntarily assumed the risk of misadvising. In Cornish Bank for example, the defendant might have chosen to not sell the mortgage to the claimant.  As seen in Hedley Byrne, it is also possible to use a disclaimer to avoid liability. In other words, someone who says ‘here is my advice but you should not rely on it’ is effectively saying ‘I do not assume the risk of misadvising’.
  3. There must be reliance on the advice by the defendant. So, in the Hedley Byrne scenario, if it could be shown that the claimant would have contracted with the third-party regardless of the bank’s advice, it would have no claim - there was no reliance on the advice given. 

    Notably, just because both parties are ‘experts’ does not mean that reliance does not exist. Whilst it used to be the case that those negotiating a contract could not be held to be in reliance on one another with regards to expert advice, this has since been overturned. Thus, in Esso Petroleum v Mardon[1976] QB 801, the defendant (Esso) was liable for negligently overstating the business prospects of one of its petrol stations. The claimant purchased the petrol station and then made large losses, and subsequently sued for negligent misstatement, successfully.
  4. The reliance on the advice must be reasonable and foreseeable. This can be thought of as a control measure, letting the courts separate worthy and unworthy cases. This is illustrated in Law Society v KPMG Peat Marwick [2000] 4 All ER 540 - the defendant negligently prepared a report on the financial status of a solicitors’ firm for the claimant (the Law Society). The firm subsequently went bankrupt, meaning the Law Society had to pay out nearly £9 million in compensation to the firm’s clients. Since the entire purpose of the report was to alert the law society to any firms which might be in financial distress, it was held reasonable for the Law Society to rely on the report, and the claim was upheld.

There are a number of other specific situations which can arise with regard to negligent misstatement. Firstly, the claimant does not have to be the individual who has commissioned the advice in the first place - although the claimant must still be in the mind of the defendant. Thus, in Smith v Eric S Bush [1990] 1 AC 831 the claimant sought a mortgage on a house, and the mortgage company employed a surveyor to check for structural defects. The surveyor acted negligently, and failed to notice such defects. The claim was upheld. Although the claimant was not the primary recipient of the report (the mortgage company was), she was held to still have a viable claim - it would take no great stretch of the imagination for a surveyor to realise that mortgage companies do not survey houses for fun, but rather in order to work out the viability of a house as security on a mortgage. In turn, this means, logically, that a potential buyer exists who will foreseeably rely on the structural report.

Secondly, it is rare that a widely disseminated statement will meet the threshold for negligent misstatement, especially where the claimant is using the misstatement for a purpose other than that which it is designed for. This can be seen in Caparo (discussed in detail in the Duty of Care chapter) - the defendant’s evaluation of the company was for the purposes of informing current shareholders of the company’s status, rather than enabling third-parties to work out the viability of a takeover. Thus, because the claimant used the report in a non-ordinary manner, the claim failed. The same principle can be seen at work in Mariola Marine Corporation v Lloyd’s Register of Shipping [1990] 1 Lloyd’s Rep 547 - the claimant relied on a report from the defendant stating that a yacht was in a good state or repair, buying it. In actual fact, the yacht had severe corrosion, devaluing it. Because the original report was only intended to denote seaworthiness, rather than economic value, the claim failed.

It should be noted that this point is not entirely intuitive - third parties often use audits of the nature used in Caparo to work out whether a company is a viable purchase, and it is arguably foreseeable that a third party will use a yacht safety report in order to work out whether a yacht is a good purchase or not. Thus, this rule should be regarded as somewhat of a legal fiction. Notably, this principle will not stand, however, should the defendant know of the claimant’s intentions. Thus, in Morgan Crucible Co v Hill Samuel & Co [1991] Ch 295 the defendant widely disseminated a negative report on its own financial state as a means of dissuading a takeover bid from the claimant. The report was later found to be inaccurate. The claimants sued and won - although the report was disseminated widely, the defendants knew that the claimants would use it to determine the viability of its bid. So, specific knowledge of a claimant’s intentions will defeat the rule against imposing liability for widely disseminated misstatements.

Thirdly, there exists a legal oddity in the form of cases regarding ‘negligent silence’. Such situations are not beyond imagination - if you always received advice from someone before you made a bad decision, it would not be unreasonable for you to assume that silence from that person would imply that the decision you are making is good. However, the law has stopped short of imposing a duty to avoid silence in such situations. See Banque Keyser Ullman (UK) Insurance Co v Skandia[1991] 2 AC 249, in which (obiter) it was stated that there was nothing, in principle, preventing silence from giving rise to negligent misstatement liability. However, it is important to note that ultimately, liability was not imposed in the case, primarily because such an approach would run contrary to the contract law on silence in negotiations.

Fourthly, negligent misstatement can occur where the defendant is a public authority. However, as noted in the chapter on duty of care, it should be assumed as a starting point that liability will not be conferred. An example of where it will be however is seen in Welton v North Cornwall District Council [1997] 1 WLR 570. A food health inspector inspected the claimant’s guest house, and noted a number of changes that the guest house must make to avoid being shut down. After making these changes (at significant expense), the claimant discovered that many of them were not actually required. The claimant sued for negligent misstatement and won.

This can be contrasted with Harris v Evans [1998] 3 All ER 522, in which a safety inspector declared that a crane used for bungee jumping had to be officially certified for that purpose. The claimant objected, and was issued a prohibition notice, preventing the claimant from operating. It emerged that the inspector was wrong, and so the prohibition notice was wrongly issued. The courts held that Parliament could not have ever intended for safety inspectors to be liable for mistakenly over-applying legislation, and so the claim failed. Notably, however, the courts held that liability might arise should an inspector give bad advice which resulted in a new danger being created. Thus, a distinction can be seen between a scenario in which a local authority acts to make a situation too safe, and one in which it acts to make a situation less safe.

Therefore, liability for misstatement can be seen to apply where public bodies are involved but they act in a way which is not consummate the purposes of their empowering legislation. Consider the difference between the two cases - in the former, the claimant unnecessarily spent money because the defendant advised that it was compulsory to do so. The purpose of the statute giving the food inspector power was to ensure a basic standard of food safety was met, but the misstatement caused the claimant to go far beyond that standard. It is unlikely that parliament intended for

In contrast, the statute giving the safety inspector power was misapplied, but it would not be sensible to have safety inspectors worry about making things too safe - this would run contrary to the statute. It should also be noted that the relevant statute included its own appeals process for prohibition noticed - this meant that there was already a remedy in place for the claimant, both lessening the need for a remedy in tort to apply, and implying that Parliament knew of the risk of overeager enforcement, and so created a process to deal with it.

Exam Consideration: Negligent misstatement is a favourite area for problem questions because it tests both your general knowledge of negligence, as well as niche knowledge of the Hedley Byrne criteria, and the further sub-rules regarding third-parties etc. Its importance should therefore not be underestimated. 

It also indicates the importance of having commercial knowledge within the law - without a basic commercial grounding, you will not be well placed to identify whether a given action in a problem question is reasonable or not.

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