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Manufacturer's All Risk Insurance Doesn't Cover Loss of the Product due to "Faulty Workmanship"

Sometimes things go wrong in the performance of a contract. A failure to meet contractual requirements may result in a significant financial loss. Before making an agreement that it has not met required standards, a party should examine whether there is insurance coverage for the loss.

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The Massachusetts Appeals Court considered whether insurance covered losses resulting from products that did not meet quality testing in H.P. Hood, LLC v. Allianz Global Risks U.S. Ins. Co. The plaintiff was contracted by Abbott Laboratories to manufacture a shelf stable milk-based beverage, with strict requirements to ensure the bottle would stay sealed and the product would not spoil.

The contract required the plaintiff to conduct quality assurance testing. The "secure seal test" checked whether the bottles would stay sealed with increased pressure inside when submerged in water. The plaintiff began a production run in May 2009. When one bottle failed the secure seal test, the plaintiff temporarily halted production but concluded it was an isolated issue and resumed production. Another bottle failed within a few days, and the investigation found a seven percent seal failure rate.

The plaintiff reported to Abbott Laboratories, who rejected all bottles from that production run. The plaintiff continued the investigation and testing, finding a nine percent failure rate on tested bottles. Abbott Laboratories and the plaintiff agreed to destroy the nearly two million bottles from that run.

The plaintiff later discovered that the age of the bottle cap liners affected how much torque was needed to properly seal the bottles. The May 2009 production run did factor into that difference, so some of the bottles did not receive the appropriate torque.

The plaintiff sued its insurer to determine if its losses were covered under its "all risks" property insurance policy. The policy covered "all risks of direct physical loss or damage to Insured Property at Insured Location(s)," subject to the policy's terms, conditions, exclusions, and limitations. The insurer argued the circumstances merely presented an increased risk of property damage, while the policy required actual property damage. Only bottles that had been destructively tested by the plaintiff lost their seal. No other property damage had actually occurred. The defendant argued that the bottles could have been legally and safely sold, but the plaintiff chose to destroy them.

The plaintiff argued that products designed for human consumption should be treated differently and that the product lost its value as soon as there were doubts that it was fit for human consumption. The trial court granted summary judgment in favor of the defendant insurer, finding that the losses fell within an exclusion for "faulty workmanship, material, construction or design, from any cause." The appeals court agreed, finding that the exclusion would apply here regardless of whether the problem with the cap liners was considered faulty material, faulty workmanship, or faulty design.

The appeals court rejected the plaintiff's argument that the exclusion did not apply because the defect was in the packaging, not the "product" as defined under its contract with Abbott. The court noted that the policy exclusion did not use the word "product" at all and that the bottling process was "an essential aspect" of the production.

The plaintiff pointed to the "ensuing loss" provision that preceded the exclusion and argued that the exclusion, if applicable, should only apply to the bottle caps but not the product inside the bottle. The appeals court noted the difficulty courts have had in interpreting such provisions, pointing out that the language does not "purport to reduce the breadth of the exclusion," but it seems to recognize coverage for some "resulting physical loss[es] or damage." Case law is not consistent in interpreting ensuing loss provisions, with some cases finding coverage only for property damage that is "wholly separate" from that caused by the excluded event, and others allowing coverage when the damage was not wholly separate but was different in kind.

The plaintiff argued that the provision was ambiguous and should therefore be given a lenient interpretation. The appeals court found, however, that there was not a "reasonable interpretation" of the provision that would allow the plaintiff to recover damages. The court found that none of the plaintiff's losses were "separable" from the problem with the bottle cap liners. The exclusion applied to the loss of the entire product. The appeals court affirmed the trial court's judgment.

Although this case was not between the parties to the contract, it does illustrate some important points regarding contractual arrangements and disputes. First, it is important that the standards set out in a contract are appropriate to the work to be performed. It is unclear from the opinion whether the "secure seal test" was specifically required by the contract, but questions were raised regarding the test's appropriateness for the particular product. Failing a quality assurance test can have significant consequences, so the parties should ensure that any testing is an appropriate measure of the quality of the product.

Additionally, a party should not assume that losses will be covered by insurance. Faulty workmanship exclusions are common in both general liability and all risks policies. The company may not have any recourse for such losses, making it even more important to ensure that the standards are appropriately set during the contracting process and to be sure that those standards are not met before agreeing that the product will not be accepted.

If you have a business dispute, contact a skilled Massachusetts business litigation lawyer immediately before making any major decisions. Call the Law Offices of Richard Mucci at (781) 729-3999 to schedule an appointment.

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