What Every Owner and Contractor Should Know About The "Economic Waste Rule"?

Stakeholders often face difficult decisions when construction work fails to conform to contract requirements but still adequately performs its intended function.  Purchasers question whether they can require removal and replacement of the non-conforming work. Contractors question whether progress upon successor activities can continue pending resolution of the nonconformity.  Designers question whether acceptance of the nonconformity will diminish the quality of the asset or increase design liability. To one extent or another, each decision has an impact upon cost, schedule and quality and each answer involves the “Economic Waste Rule”.

 The standard measure of damages for nonconforming construction work is the“cost to repair” the nonconformity.  With the rationale behind the standard being that purchasers expect to receive work that fully conforms to the agreed upon contract requirements and should be compensated accordingly for any nonconformity. However, protection of a purchaser’s expectation interests take a backseat when nonconforming work adequately performs the intended function.  Under such circumstances, the “Economic Waste Rule” substitutes “diminution in value” as the standard measure of damages for nonconforming work.  And, as its name suggests, the rationale for the Rule is that the removal and replacement of a nonconformity that adequately performs its intended function is economically wasteful. 

 Although recognized in almost every state, it should be emphasized that the “Economic Waste Rule” does not prohibit purchasers from insisting upon the removal and replacement of adequately functioning nonconforming work.  Rather, the Rule deters unnecessary removal by: 1.) limiting the purchaser’s damages to the difference in value between the specified conforming work and the installed nonconforming work, and 2.) exposing the purchaser to liability for any additional costs resulting from the wasteful destruction of the nonconformity.  Perhaps most surprising of all, the Rule generally applies even in those instances where the purchaser and contractor agree all work must be in “strict compliance” with contract requirements.

 There are two common situations in which the repair of nonconforming work is held to be economically wasteful under the “Economic Waste Rule”.  The first common situation is where the costs to repair the nonconformity greatly exceed the loss in market value caused by the non-conformance. This situation frequently arises where the installed nonconforming work differs from what was specified or approved, but still performs the intended function.  In such situations, purchasers seldom remove and replace the nonconformity, but rather pocket the “costs to repair” leaving the nonconformity in place. Alternatively, if  the nonconformity were to be repaired, the “costs of repair” incurred by the contractor would far exceed the losses incurred by the purchaser if the nonconformity were left in place.

 A classic example of situation #1, involved a contractor who mistakenly installed a shipment of nonconforming pipe that had similar characteristics to the specified pipe and performed the intended function.  When the purchaser ordered removal and replacement of the nonconforming pipe,  the contractor refused to do so and filed a lawsuit to obtain the outstanding contract balance.  In a often cited New York court case, Judge Cardozo rejected the purchasers decision to demand repairs, reasoning that the cost to remove and replace the pipe “is grossly and unfairly out of proportion to the good to be attained”.  As a result, the court ordered the purchaser to pay the remaining contract balance to the contractor minus a minimal amount for decreased market value of the asset.  But in doing so, the court cautioned the contractor that the “Economic Waste Rule” does not grant contractors an open license to intentionally substitute whatever nonconforming work they believe to be “just as good” as the contract requirements.

 The second common situation in which the “Economic Waste Rule” applies is where repair of the nonconformity requires destruction of large portions of conforming work.  This situation frequently arises where nonconforming work contains relatively minor defects not discovered until the successor activities have been completed or the asset is placed into service.  In such instances, the increased costs attributable to the nonconformity (e.g. maintenance, operation) are inconsequential in comparison to the value of the conforming work that would be destroyed during repair of the nonconformity.  Consequently, if the nonconformity were to be repaired, the “costs of repair” incurred by the contractor would far exceed the costs incurred by the purchaser if the nonconformity were left in place.

 A classic example of situation #2, involved a purchaser who required a contractor to remove and replace nonconforming, yet functional, water stop embedded within sections of a concrete lock and dam.  The contractor incurred significant costs in repairing the nonconformity and afterwards filed a lawsuit seeking to recover the resulting costs from the purchaser.  In an often cited Federal Court case, a panel of judges reasoned the purchaser could not blindly insist upon “strict compliance” with contract requirements since the water stop adequately performed its intended purpose.  As a result, the court ordered the purchaser to equitably adjust the contract to compensate the contractor for the direct and indirect costs of repairing the nonconformity based upon the “Economic Waste Rule”. 

 Of course there are circumstances under which even the “Economic Waste Rule” cannot salvage usable and functional nonconforming work from the scrap heap.  First, the Rule will generally not apply if the nonconformity poses a material risk to health, safety or the environment.  Second, the Rule will generally not apply if the nonconformity arises from fraud or results from an intentional deviation from contract requirements.  Finally, the Rule will generally not apply if the parties expressly agree the purchaser’s expectation interests supersede all concerns about any costs or losses resulting from rejection or acceptance of the nonconformity.

 So the next time you consider whether to repair or accept nonconforming work, give some thought to the “Economic Waste Rule”.  If the nonconformity still performs its intended function, then balance the “costs to repair” versus the costs or losses incurred by the purchaser if the nonconformity were left in place. It just might help you  avoid a messy legal battle.

This post contains information that may affect your business decisions, it should not be considered as legal advice, does not create a lawyer-client relationship, and the reader is cautioned that application of the "Economic Waste Rule" may vary depending upon the jurisdiction where the work is performed.