Commercial litigation update: Seventh Circuit upholds ruling that hotel cannot recover $4.2 million loss due to contract clause

by John Chapman

SAMS Hotel Group, LLC contracted with Environs, Inc., an architectural firm, to provide architectural services for the construction of a six-story Homewood Suites hotel in Fort Wayne, Indiana. Environs was to be paid a flat fee of $70,000 for its work. The contract contained the following clause limiting Environs’s liability for a breach of contract:

The Owner [SAMS] agrees that to the fullest extent permitted by law, Environs Architects/Planners, Inc. total liability to the Owner shall not exceed the amount of the total lump sum fee [i.e., $70,000] due to negligence, errors, omissions, strict liability, breach of contract or breach of warranty.

The contract was signed on March 1, 2007, and the design and construction process began soon after that. The hotel structure was nearly complete in the spring of 2008 when serious structural defects were discovered. The county building department soon condemned the structure. Attempts to remedy the structural flaws failed, and the hotel was demolished in 2009 without ever opening. SAMS estimated its loss at more than $4.2 million.

SAMS filed suit against Environs for breach of contract and negligence. The theory underlying both claims was that Environs provided a defective design and negligently performed its contractual obligations.

While SAMS’s suit was pending, the Indiana Supreme Court held in Indianapolis–Marion County Public Library v. Charlier Clark & Linard, P.C., 929 N.E.2d 722 (Ind. 2010) (“IMCPL”), that the “economic loss rule” applies to construction contracts under Indiana law. Under that rule, a party to a contract cannot be liable under a tort theory for any purely economic loss caused by the party’s negligent performance of the contract, absent any personal injury or damage to other property.

In its lawsuit against Environs, SAMS was not alleging any personal injury or damage to “other property”—i.e. property other then the subject of the contract itself. Thus, the district court applied the IMCPL decision and the economic loss rule to grant summary judgment in favor of Environs on SAMS’s negligence claim. The court also held that the limitation of liability clause was enforceable so that SAMS’s potential recovery on its surviving breach of contract claim would be limited to $70,000.

The breach of contract claim went to trial and the trial court entered a judgment in favor of SAMS for $70,000. SAMS appealed the district court’s determination that the limitation of liability clause was enforceable.

SAMS argued that the limitation of liability provision in the parties’ professional services contract was not enforceable against SAMS, regardless of what SAMS and Environs knowingly and willingly agreed. SAMS relied on the fact that the provision did not refer specifically to a limit on damages for Environs’s own negligence. According to SAMS, the provision covered only Environs’s liability for negligence of third parties.

SAMS relied primarily not on cases applying limitation of liability clauses but on cases with contract clauses that would completely indemnify or exculpate a defendant for its own negligence. In such provisions, the key contractual language must “clearly and unequivocally manifest a commitment by the plaintiff, knowingly and willingly made, to pay for damages occasioned by the defendant’s negligence.’” This is known as the “express negligence test.”

For example, in Marsh v. Dixon, 707 N.E.2d 998, 1000 (Ind.App.1999) the court held that the exculpatory clause at issue did not refer specifically to defendant’s own negligence and thus did not bar plaintiff’s negligence claim for a broken ankle suffered in defendant’s wind tunnel ride. The release in that case stated in pertinent part:

I hereby fully and forever discharge and release … Dyna-Soar Aerobatics, Inc. and all of the partners, directors, officers, employees, and agents for the aforementioned companies from any and all liability, claims, demands, actions, and causes of action whatsoever arising out of any damages, both in law and in equity, in any way resulting from personal injuries, conscious suffering, death or property damage sustained while flying Dyna-Soar.

The Indiana Court of appeals found that:

Obviously, the release fails to specifically and explicitly refer to Dyna Soar’s own negligence. “The injury sustained by Marsh was not allegedly derived from a risk which was inherent in the nature of the ride. Dixon instructed Marsh that he would only levitate three to four feet from the ground. When the ride started, however, Marsh was allegedly shot fifteen feet in the air and subsequently dropped to the ground. Such a risk is not inherent in the nature of a wind tunnel ride. Thus, if, indeed, the accident occurred as Marsh describes, the injury must have resulted from the negligence of Dyna-Soar. We conclude that the release is not sufficient to release Dyna-Soar because the release did not specifically and explicitly refer the Dyna-Soar’s “own negligence.” While this exculpatory clause may act to bar some types of liability, it cannot act to bar liability arising from Dyna Soar’s own negligence.

Marsh v. Dixon, 707 N.E.2d 998.

The Seventh Circuit rejected SAMS’ reliance on such cases. First, the contract between SAMS and Environs was not a consumer contract or a contract of adhesion. The undisputed facts showed that the negotiating parties were two sophisticated business entities of equal bargaining power who were aware of the risks involved in designing and building a hotel. They had done an earlier hotel construction project with a contract that contained a limitation of liability provision similar to this one. They were in the best position to allocate the relevant risks between them, and it was undisputed that they signed the contract with knowledge and understanding of each of its terms.

Second, although Indiana courts have made specificity a requirement in indemnification and exculpatory clauses, they have not spoken so clearly regarding limitation of liability clauses in sophisticated commercial contracts. SAMS argued that the differences among these provisions are not significant for these purposes, so that the specificity requirement should apply to the limitation of liability provision here as well. The Seventh Circuit was not persuaded:

These different types of clauses serve different purposes, and Indiana case law does not indicate that they should be analyzed alike. Limitation of liability clauses, such as the clause in the SAMS–Environs contract, do not operate as insurance the way that indemnification clauses do. They also do not entirely prevent one party to the contract from bringing a claim against the other, as exculpatory clauses do. Limitation of liability clauses serve to establish a contractual ceiling on the amount of damages to be awarded if a plaintiff prevails in later litigation between the contracting parties. We agree with SAMS that when a clause limits a party’s liability to only nominal damages, a limitation of liability clause can be as harsh as a full exculpatory clause would be. This would be particularly true if the plaintiff were an unsophisticated individual or if the plaintiff had been bound to the provision through a contract of adhesion. But SAMS and Environs were sophisticated commercial entities that knew the risks and freely bargained for the terms of the contract, including the limitation of liability clause. SAMS did not unknowingly agree to the limitation of liability clause or assume these risks. To the extent it suffered a harsh result, it cannot blame the general nature of limitation of liability clauses.

Without any indication in the Indiana case law that the Indiana Supreme Court would extend the specificity rule to a limitation of liability clause that was freely and knowingly negotiated by two sophisticated commercial entities in a dispute in which the underlying cause of action is for breach of contract and not negligence, the Seventh Circuit concluded that the district court properly held SAMS to the terms of its contract. SAMS Hotel Group, LLC v. Environs, Inc.— F.3d —-, No. 12-2979 (7th Cir. May 31, 2013).

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