New York Appellate Court Holds that Faulty Ingredients that Seriously Impair a Product's Function and Value Constitute "Physical Damage" Under an All-Risk First-Party Property Policy
February, 2006
Beginning in 1999 and through 2000, Pepsico, Inc. (“Pepsico”) claimed that faulty and contaminated ingredients from a third-party supplier rendered its products unfit for consumption. In each instance, the faulty ingredients caused the finished product to have an “off-taste.” While not harmful to customers, the off-taste rendered the products unmerchantable and necessitated their destruction, which resulted in large property losses. Pepsico filed a claim with its insurer, Winterthur International America Insurance Company (“Winterthur”), which claim was denied. Pepsico then filed a declaratory judgment action against Winterthur. See Pepsico, Inc. v. Winterthur International America Insurance Company, 6 Misc.3d 1005(A), 800 N.Y.S.2d 354, 2004 WL 3092342 (N.Y. Sup. Ct. 2004).
Pepsico moved for partial summary judgment. In response, Winterthur cross-moved for partial summary judgment. The trial court granted Pepsico’s motion for partial
summary judgment and denied Winterthur’s cross-motion in its entirety. Winterthur appealed the decision. The Appellate Division, Second Department, affirmed the lower court’s holding in Pepsico, Inc. v. Winterthur International America Insurance Company, 24 A.D.3d 743, 806 N.Y.S.2d 709 (2d Dep’t 2005).
The Appellate Court rejected Winterthur’s contention that Pepsico’s products were not physically damaged under the policy. The Court disagreed that “physical damage” required plaintiff to prove that “there has been a distinct demonstrable alteration of [the] physical structure [of the plaintiff’s products] by an external force,” i.e. the product has gone from good to bad. Rather, the Court held that an all-risk first-party property policy that covered, but did not define, “physical damage” did not require Pepsico to prove that there had been a distinct demonstrable alteration of the product’s physical structure by an external force. Instead, in a case involving unmerchantability of products, it is sufficient to show that the product’s function and value were seriously impaired, such that it could not be sold. In so ruling, the Court cited supporting case law from around the country, including General Mills, Inc. v. Gold Medal Ins. Co., 622 N.W.2d 147 (Minn. Ct. App. 2001).
In General Mills, the insured sought recovery for loss of a cereal product when a contractor treated oats with an unapproved pesticide. As in Pepsico, the policy did not define “direct physical loss or damage.” Although the products were not rendered unfit for human consumption, the court held that their function and value had been impaired because the manufacturer could not legally sell them. As such, the court stated that the insured had suffered direct physical loss under the policy. “[D]irect physical loss can exist without the actual destruction of property or structural damage to property; it is sufficient to show that the insured property is injured in some way.” Id. at 152.
The Pepsico Court also rejected Winterthur’s argument that there was no coverage because the alleged defects in Pepsico’s products and ingredients passed quality control tests without detection and, therefore, were latent defects. Instead, the Court noted the policy’s ensuing loss provision, which provided coverage for latent defects if the defects resulted in covered physical damage. The Court further rejected Winterthur’s argument that the “manufacturing or processing” exclusion in the policy precluded coverage. Pepsico asserted that this exclusion was inapplicable because it was not part of the policy. The Court agreed, stating that the record did not support that there was a “meeting of the minds” on this provision at the time the policy was issued. Lastly, the Court held that the proper measure of damages applicable to the loss was the regular cash selling price, and not, as Winterthur contended, replacement costs.
Learning Point:
Under Pepsico, an insured is not required to prove a distinct demonstrable alteration of its product’s physical structure by an external force for coverage under an all-risk first-party property policy that provides coverage for “physical damage.” Rather, where the policy fails to define the term “physical damage,” it is sufficient for the insured to show that the value and function of its products have been so seriously impaired that the product cannot be sold. •
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