The Source of Duty Rule

Zealous lawyers seeking to maximize their clients’ monetary recovery in court will often sue for as many different claims as their highly trained legal minds can conjure up. And they will usually try to come up with at least one viable tort claim (such as fraud or business conspiracy) to pursue in addition to any breach-of-contract claims, because tort claims often allow the recovery of punitive damages in addition to compensatory damages. But there are important differences between the law of contracts and the law of torts. The law of torts is designed to protect broad societal interests such as safety of persons and property. Contract law, on the other hand, is concerned with the protection of bargained-for expectations. Therefore, several rules have developed to prevent turning every breach-of-contract claim into a tort action.

The economic loss rule, for example, holds that where a contracting party’s loss is limited to disappointed economic expectations, his remedy is limited to one for breach of contract. A similar rule is known as the “source of duty” rule. It looks to the source of the duty alleged to have been violated. Before a court will allow a contracting party to recover on a tort theory, it must be satisfied that the duty tortiously or negligently breached is a common law duty, and not one existing solely by virtue of a contract between the parties. If the source of the duty allegedly violated is a contract, then the plaintiff should be limited to remedies available in breach-of-contract actions.

Determining the source of the duty is not always clear cut. Confusion arises when a contract contains a misrepresentation of fact. Misrepresentations of fact are normally governed by the common law of fraud. If the misrepresentation comes in the form of a contractual representation and/or warranty, can a defrauded plaintiff sue for fraud? According to a recent decision of the Supreme Court of Virginia, the answer is no, if the source of the duty to represent a certain fact is a contract between the parties.

MCR Federal, LLC v. JB&A, Inc. was a dispute between government contractors. MCR, a government contractor specializing in strategic planning, agreed to purchase JB&A, a government contractor that provided services to U.S. intelligence agencies. The parties signed an Asset Purchase Agreement on May 5, 2011, which contained the following representation:

There is no private or governmental action, suit, proceeding, claim, arbitration, mediation, investigation, litigation, or inquiry pending or, to the knowledge of Buyer, threatened before, with or by any Governmental Entity or other Person against Buyer or any of its Affiliates that would cause a Buyer Material Adverse Effect… To the knowledge of Buyer, no event has occurred or circumstances exist that could reasonably be expected to give rise to, or serve as a basis for, any such action, suit, proceeding, claim, arbitration, mediation, investigation, litigation or inquiry that would cause a Buyer Material Adverse Effect.

The APA further stated that the representations and warranties of MCR Federal “shall be true and correct in all respects…on and as of the Closing Date as though such representations and warranties were made on and as of such date.” As a condition precedent to closing the deal, MCR had to certify that the representations and warranties were true.

During the 21-day trial, it was revealed that the representation was not, in fact, true. On May 19, 2011, an Air Force contracting officer had inadvertently sent an MCR employee a competitor’s bid in an email attachment. sign_contract-300x200By the time the contracting officer had realized her mistake, the MCR employee who received the errant email had already sent it to several people. After an investigation, the Air Force decided to suspend MCR from participating in government contracting, though it would eventually lift the suspension.

The trial court allowed JB&A to sue for both breach of contract and fraud, but the Supreme Court of Virginia reversed that decision. The court held that the source of the duty to certify the accuracy of the contract’s representations and warranties as of the closing date arose from the APA itself, not common law, so JB&A should not have been permitted to recover on a fraud theory.

JB&A argued that the source of the duty was not the contract because the issuance of the certificate was a condition precedent to the APA. In other words, MCR didn’t really have a “duty” to produce the certificate because if it failed to deliver it, the APA would not have been signed on the closing date. The court, however, held that this distinction was insufficient to “take the fraud outside of the contractual relationship.” The representation concerning government investigations was a bargained-for expectation. It was expressly included in the APA. The representation and warranty that was breached “existed solely because of the contractual relationship between the parties.” For these reasons, the court held that the APA was the source of the duty that was breached, and that JB&A was therefore limited to contractual remedies.

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