Recently, the Court of Appeals for the Third Circuit decided Nationwide Mutual Insurance v. CPB International, Docket No. 07-4772 (April 14, 2009). CPB supplied chondroitin to Rexall for use in compounding tablets, including chondroitin and glucosamine. CPB supplied two batches of chondroitin that turned out to fall short of contractual specifications and to contain impurities. By the time these defects were discovered, Rexall had already compounded the CPB-supplied material with glucosamine, so that both compounds had become useless.

In the lawsuit that ensued, Rexall brought a claim for breach of contract against CPB seeking return of the purchase price it had paid for the first batch, and also seeking consequential damages for the damage to the glucosamine and economic losses. CPB tendered that claim to its CGL carrier, Nationwide, which defended under a reservation of rights and also brought a declaratory judgment action to avoid any duty to defend or indemnify.

The Third Circuit held in favor of Nationwide and discharged it from any coverage obligations.

The court first observed that the matter clearly involved a claim of property damage, so it didn’t focus on that issue. It then examined the claim made by Rexall against CPB and concluded it was solely based on breach of contract. Turning to the crux of the coverage issues, the Third Circuit, premised on the Pennsylvania Supreme Court’s decision in the Kvaerner case [Kvaerner Metals Div. of Kvaerner US, Inc. v. Commercial Union Ins., 908 A.2d 888 (PA 2006) determined that the simple allegation of delivery by CPB of defective chondroitin was an allegation of faulty workmanship that is not covered by the CGL policy. The Third Circuit went further than Kvaerner, however, deciding that, since faulty workmanship is not sufficiently fortuitous to be an accident or an occurrence, the consequential damages flowing from the faulty workmanship, being the foreseeable consequences of that faulty workmanship, are also not an accident or an occurrence. Therefore, the court held that the consequential damages were also not covered. In conclusion, the Third Circuit wrote, “We are, therefore, confident that the Supreme Court of Pennsylvania would conclude that an underlying claim alleging breach of contract would not trigger coverage under a CGL policy.”

Adding insult to injury, the court held as an alternative ground for denial of the claim that the contractual liability-exclusion of the policy applied. The policy at issue contained a standard contractual liability-exclusion stating that the “insurance does not apply to … ‘property damage’ for which the insured is obligated to pay by reason of the assumption of liability in a contract or agreement.” We have all seen this exclusion in various forms many times. We all recognize that it is designed, as is often stated expressly, to apply to a situation where the insured assumes the tort liability of another in a contract, such as by giving an indemnity. The Third Circuit did not consider this reading of the exclusion at all. This leads to the most disturbing element of this case, which is that the court did not even consider the potential alternative reading of this exclusion, such that it is interpreted as only applying to assumption of a third party’s liability. Instead, the court effectively turned the normal rules of insurance policy construction—ambiguities are construed against the insurer as drafter—on their head and gave the insurer the benefit of an inherently ambiguous policy provision.

Although the Third Circuit’s decision is unquestionably flawed, denials of coverage by insurance companies for consequential damages based on this case can be anticipated. Policyholders faced with this should point out to their carriers that the CPB case is limited to purely contract-based claims, so any suit involving a tort claim should be analyzed differently.

Even more disturbing, the CPB case may well be invoked by first-party insurers by applying and interpreting faulty workmanship exclusions in a much broader sense in first-party claims. Finally, carriers will likely be pushing the limits of their contractual liability exclusions, even when based on more traditional phrasings than the one found in CPB, to try to preclude claims wherever there is a contract involved that forms any basis of the allegations of liability on the part of the insured. It is hoped that in the not too distant future, a case will come up in the Pennsylvania state court system that will provide the Pennsylvania Supreme Court with the chance to correct some of the Third Circuit’s mistakes. Until then, however, policyholders will need to contend with the unfortunate and flawed decision in CPB.