Jeffrey Weinstein, Sara Lilling
Let’s begin with a hypothetical: An insured manufactures individually wrapped cupcake products in three flavors, chocolate, strawberry, and lemon. The products are manufactured on separate production lines at the insured’s facility, though the lines are within the same manufacturing room. Shortly following distribution to its customers, the insured discovers that the strawberry filling for the strawberry cupcakes is contaminated with Salmonella. The insured immediately shuts down production of all cupcakes, cleans its facility, and initiates a recall of the affected products.
The insured submits a claim for the accidental product contamination, an “insured event” under its product contamination insurance policy, seeking to recover losses it incurred in connection with the contamination incident and recall, including recall costs, marketing and rehabilitation costs, and business interruption losses.
The majority of the insured’s claim is for its business interruption losses. The product contamination policy covers “loss,” which is defined in this policy as the “reasonable and necessary expenses or costs incurred by the insured solely and directly as a result of an insured event.” “Loss” includes “business interruption losses” defined as “the actual loss sustained by the insured during the period of indemnity for loss of gross earnings and net extra expense as a result of an insured event.” In its claim, the insured seeks recovery for all of its business interruption losses during the policy’s period of indemnity, which is the period commencing on the date of the insured event and ending on the date on which normal operations are restored, limited to twelve months. Thus, the insured seeks recovery for all of its losses incurred during this time period for all cupcakes.
Following its review and adjustment of the claim, the insurer advises the insured that coverage will be provided under the policy, but not all of the submitted business interruption losses are covered under the policy because the insured has failed to establish that all of the losses arise out of or are the result of the insured event.
For example, as part of its claim the insured submitted its loss of sales of the chocolate cupcakes during the period of indemnity. The insured can only recover for the lost sales of the chocolate cupcakes if such lost sales were “solely and directly” because of the contamination incident. But, the insured’s records indicate that the delivery of the ingredients for the chocolate flavoring had been delayed, so there would have been no production of the chocolate cupcakes during the same time period, irrespective of the contamination incident.
Or, perhaps the insured received lemons for its lemon cupcakes, and the lemons were overripe and had to be returned to the supplier. Again, production of the lemon cupcakes would have been delayed, and sales of the lemon flavor were already expected to be down during the indemnity period, regardless of any other circumstances, such as the discovery of Salmonella at the strawberry line.
Or, perhaps the insured was experiencing labor shortages when the contamination incident occurred, and production of all cupcakes had been down. The insured’s records reflect that production of all cupcakes was expected to be lost during the same time period. Such lost production and lost sales clearly are not the result of the contamination incident.
There are a number of reasons why the insured may have experienced (and even expected) lost sales during the same time period. Other examples include but are not limited to equipment breakdown, supplier issues, a customer’s cancellation of orders because of its warehousing/storage issues affecting its ability to accept delivery, changes in customer preferences, the pandemic, a news report of a national issue with strawberries, seasonality (certain flavors are more popular in certain months) based on historical data, and a lack of capital resources.
In order for coverage under the contamination policy to apply, the insured must establish a causal nexus between its lost sales and the contamination event. To the extent that an insured can show, e.g., through historical data and projected earnings, that the loss of gross earnings was incurred “solely and directly” because of the contamination event, such losses would likely be covered, subject to any applicable policy exclusions. For instance, if the insured’s facility must be shut down for two weeks for cleaning following a contamination incident, and the insured’s customer purchases cupcakes from a different manufacturer and the insured cannot recover those sales, such losses would likely be covered under the policy. Whether the insured must show direct or indirect causation will turn on the policy language; but if the losses must “result from” or “arise out of” the insured event, it is the insured’s burden to establish causation. In the situation here, the insured would undoubtedly argue that because of the nature of the problem, Salmonella, and the proximity of the three lines to each other, it was appropriate to shut down all three lines, even though Salmonella was only discovered on one of the lines. But it is also true that the chocolate and lemon lines would have been shut down anyway because of ingredient issues. So the insurer would measure the strawberry line losses, but not necessarily the other two lines. This issue may require further evidentiary support for both arguments.
Although there is limited case law on this subject, one decision is instructive and upholds the “directly and solely” causation standard. In Foster Poultry Farms, Inc. v. Certain Underwriters at Lloyd’s London, 161 F. Supp. 3d 932 (E.D. Cal. 2016) (applying New York law), the Court analyzed the “solely and directly” language under a product contamination policy.
Thus, not all losses incurred by an insured after a product recall during a period of indemnity will be covered under a product contamination policy. Any business interruption losses incurred by an insured following a product recall must be causally related to the insured event for there to be coverage, and it is the insured’s burden to establish this causal nexus. Business losses that would have occurred anyway (e.g., losses that began before the event and would have continued through the indemnity period unrelated to an insured event, external factors, labor shortages, supply issues, equipment and machinery breakdown, changes in customer preferences) must be differentiated by the insured from those “solely and directly” caused by the insured event, as part of the proper presentation of a compensable claim. If the insured can establish such a nexus, that is the icing on its cupcake.