The following is a case update written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., Ret.), analyzing a recent decision of interest:
Two recent published decisions addressed the applicability of the economic loss rule to claims for damages, one in the California Court of Appeal, M & L Financial, Inc. v Sotheby’s, Inc., 2022 WL 2734399 (July 14, 2022), and the other in the 10th Circuit Court of Appeals arising out of a bankruptcy appeal, Glencove Holdings, LLC v. Bloom (In re Bloom), 2022 WL 2679049 (10th Cir. July 12, 2022). The California case ruled that the rule prevented the plaintiff from stating a cause of action which sounded in tort (negligence), whereas the federal decision found the rule inapplicable in a complaint for nondischargeability based on the intentional tort of fraud. Although the outcomes differed, the reasoning behind the decisions was compatible.
M & L FINANCIAL VS. SOTHEBY’s FACTS
Jona Rechnitz owed M & L Financial (M & L) substantial sums; as security for his debt, he transferred ownership of 45 vivid yellow diamonds to M & L on the understanding that he could repurchase them. Instead, Rechnitz proposed that M & L list the diamonds with Sotheby’s, an auction house, with whom he had a longstanding relationship. He introduced M & L to an executive there, Quig Bruning, whom he knew personally. These parties met in April 2019 and M & L gave the diamonds to Sotheby’s, with the intent they would be appraised. M & L was presented with a Consignment Listing Agreement (“Listing Agreement”) to initiate that process. If the price was right and M & L agreed, they would enter into a further Consignment Agreement. In the place on the Listing Agreement for the consignor’s name, Bruning wrote in the names of both M & L and Rechnitz’s company, Jadelle Jewelry. When M & L protested the accuracy of including Jadelle on the form since it was not a consignor, Bruning said he understood and Rechnitz did not disagree. But M & L signed the form as written, with the Jadelle name still on it as owner.
In late 2019, M & L learned that Sotheby’s had given the diamonds to a person named Levin Prado, who told it he was picking up the diamonds for Rechnitz. M & L never recovered the diamonds. It sued Sotheby’s for breach of contract, negligence and conversion in a second amended complaint; The trial court sustained a demurrer to the contact and conversion claims without leave to amend, but allowed amendment of the negligence claim. The trial court then sustained a demurrer to the negligence claim without leave to amend, ruling that the economic loss rule (sometimes “the Rule”) meant a person may not ordinarily recover in tort for breach of duties that merely restated contractual obligations. M & L appealed to the Court of Appeal (the California Court), which reversed on the contract claim but affirmed on the negligence claim, as pertinent to this review.
The California court ruled that the economic loss rule governed the negligence claim. Citing recent California Supreme Court authority, it observed that “]i]n general, there is no recovery in tort for negligently inflicted ‘purely economic losses,’ meaning financial harm unaccompanied by physical or property damage.” Sheen v. Wells Fargo Bank, N.A, 12 Cal. 5th 905, 922 (2022). The parties had a contract and there was no reason to depart from the stated Rule. M & L cited to Civil Code section 1852, which created a duty of ordinary care for depositories for hire, and argued that it was an exception to the Rule. The California Court rejected that argument, citing policy concerns in a law review article and the Restatement which stated the rationale for the Rule: using contract law to govern commercial transactions was proper because it met the parties’ expectation that their relationship would be governed by the written words of the contracts. Allowing a party to abandon the contract and sue in tort would diminish the significance of the contractual process which was the underpinning of the business relationship. Implementation of the Rule prevents the law of contract and the law of tort “from dissolving one into the other.”
GLENCOVE HOLDING VS. BLOOM FACTS
Debtor Steven Bloom was an aircraft sales consultant, who did business as the sole member and manager of Bloom Business Jets, LLC (“BBJ”). Jennifer and Huw Pierce contracted with Bloom through their LLC, Glencove Holdings, to help them locate a pre-owned private jet for purchase. Bloom located a jet for purchase and then negotiated a deal, fraudulently representing to Glencove the asking price of the seller and causing them to pay almost $300,000 more than the seller’s demand. BBJ and others (not Bloom directly) pocketed the difference without the knowledge of Glencove. During the sale process, the aircraft was inspected and $67,000 of airworthy items were required to be repaired before closing. After the seller refused to perform the repairs, Bloom convinced the inspector to delete some items from the list. The seller agreed to fix that shorter list of items and the sale closed, but Bloom told Glencove all airworthy repair items had been completed, which was false.
Glencove hired BBJ to manage the jet’s operations which eventually led to state court litigation about the management agreement. In the course of discovery for that lawsuit, Glencove learned of Bloom’s fraud and countersued on that basis. Bloom filed for bankruptcy and Glencove filed a complaint for nondischargeability based on fraud and willful and malicious conduct, §§ 523 (a)(2)(A) and (a)(6). After a trial, the bankruptcy court granted a nondischargeable judgment for more than $450,000 on both grounds. Bloom appealed to the Tenth Circuit Bankruptcy Appellate Panel (the BAP), arguing in part that that Colorado’s economic loss rule barred tort claims. The BAP affirmed the judgment. Bloom further appealed to the Tenth Circuit (“the Circuit”) which also affirmed, ruling that the Rule was inapplicable in this circumstance.
The Circuit found that Colorado law applied and looked at the Rule as construed under state law. It provides that “a party suffering only economic loss from the breach of an express or implied contractual duty may not assert a tort claim for such a breach absent an independent duty of care under tort law.” Alma v AZCO Constr., Inc., 10 P. 3d 1256, 1264 (Colo. 2000). The key to Colorado courts’ inquiry is the source of the duty that is the linchpin of the action. If the contract is the sole source, then the Rule bars tort claims. However, if the source is common law claims that sound in tort and are “expressly designed to remedy economic loss,” then the Rule does not control. The implementation of the Rule in Colorado stumbled through some uncertainty when appellate courts noted that all contracts contain an implied covenant of good faith and fair dealing, which would include the duty not to commit fraud. Those courts concluded that the contract therefore controlled the breach of duty and even fraud suits were barred.
The Colorado Supreme Court weighed in in Bermel v BlueRadios, Inc., 440 P. 3d 1150, 1155 (Colo 2019) to clarify that the Rule might bar negligence and negligent misrepresentation claims but not necessarily intentional torts, remarking in a footnote that “the economic loss rule generally should not be available to shield intentional tortfeasors from liability for misconduct that happens also to breach a contractual obligation.” Id. at 1154, n.6. This statement by Colorado authority laid the groundwork for the Circuit to find the Rule did not bar the nondischargeability claims, since the actions of Bloom to defraud Glencove of substantial sums were without question intentional torts. However, to arrive at that conclusion, the Circuit had to consider the impact of the contract being with BBJ, not Bloom. It determined that because Bloom was the sole member of BBJ and it acted only through him and because the duty to not commit fraud arises from the common law, notwithstanding the existence of a contract, Bloom was not protected by the Rule. Moreover, the policy behind the statement made by the Colorado Supreme Court in the Bermel footnote would be eschewed if Bloom could evade the nondischargeable consequence of his fraud by essentially asserting that all post-contractual torts were barred from action by the Rule.
In an analysis not germane to this review, the Circuit also joined the Fourth and Fifth Circuits in holding that a debtor need not have personally obtained or benefited from “the money or property obtained by fraud” in order for the damages to fall under the exception created by § 523(a)(2)(A). Earlier decisions by several courts to the contrary had been laid asunder by the Supreme Court’s decision in Cohen v de la Cruz, 523 U.S. 213 (1998) where it held that § 523(a)(2)(A) prevents the discharge of any liability arising from the fraud, whether or not the debtor directly benefited.
The Circuit therefore affirmed the nondischargeability judgment.
To understand my opening comment that despite the differing outcomes, these cases are not in conflict regarding the application of the economic loss rule, it will help to look briefly at the recent California Supreme Court case which was the basis for the Appellate Court’s sparse analysis of the application of the Rule. In Sheen v Wells Fargo Bank, N.A., 12 Cal 5th 905 (2022) a mortgage borrower had filed a tort action against the original mortgage lender, successor lender and servicer, alleging negligent treatment of his mortgage modification application and similar negligence claims. In holding that a lender had no duty to process, review and respond carefully to a borrower’s loan modification application, the California Supreme Court supplied an extensive review of the contours of the economic loss rule. That analysis began with the recognition that the Rule barred recovery in tort for “negligently inflicted ‘purely economic losses,’ meaning financial harm…,” a principle recognized by California cases going back 100 years and also by the Restatement of Torts. Similar to the Tenth Circuit’s analysis, the California courts relied largely on the policy that applying the Rule to contractual parties “protects the bargain the parties have made against disruption by a tort suit” and “allows parties to make dependable allocations of financial risk without fear that tort law will be used to undo them later,” quoting from the Restatement, § 3. It noted, however, that this application was limited to unintentional infliction of economic loss and that losses caused by fraud or other intentional actions were not barred by the Rule. Sheen, 12 Cal 5th at 922-923.
The analyses of the economic loss rule under Colorado law in Bloom and under California law in M & L Financial are really no different. The California case asserted a negligence claim against Sotheby’s for letting a stranger walk away with the diamonds whereas the Colorado case turned on the intentional infliction of harm caused by the fraud and willful and malicious conduct of Bloom. The negligence claim was barred; the fraud claim was not. Had the actions been switched between the states, the outcomes would have been the same.
The bankruptcy lesson here for debtor’s counsel is that attempting to assert the economic loss rule as a defense to a nondischargeability action will have no legs. The nonbankruptcy lesson is to analyze your damages, consider whether they arise from negligent conduct under a contract, in which case you cannot sue in tort, or intentional wrongdoing, in which case you can.
This review was written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., Ret.), a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.