One bad apple in Wisconsin Pharmacal Co. v. Nebraska Cultures of California

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The Wisconsin Supreme Court decided in 2016 several fundamental questions concerning liability-insurance coverage.

Wisconsin Pharmacal Co., LLC v. Nebraska Cultures of California, Inc., 2016 WI 14, stands out and may be remembered as the most significant decision by a Wisconsin court in 2016. In it, the state Supreme Court announced a pro-insurer application of the economic-loss doctrine to general-liability policies and erected a high hurdle to product-defect coverage. The effects of Pharmacal may be even more far-reaching, as the decision offers clarification of and insight into Wisconsin’s seminal construction defect-coverage decision, American Family Mutual Insurance Co. v. American Girl Inc., 2004 WI 2.

In this, our first installment in a two-part series, we analyze the Supreme Court’s ruling in Pharmacal and compare it with other decisions by courts nationwide with respect to product-defect coverage under general-liability policies.

Genesis of Pharmacal

Pharmacal arose out of a vendor’s providing the wrong bacteria for incorporation into a feminine probiotic chewable tablet. In 2008, Wisconsin Pharmacal Company (“Pharmacal”) contracted with Nutritional Manufacturing Services, LLC (“NMS”) to find a supplier of probiotic bacteria, Lactobacillus rhamnosus, and to manufacture the tablet. NMS identified Nebraska Cultures of California, Inc. (“NCCI”), and Jeneil Biotech (“Biotech”) then contracted with NCCI to supply the probiotic.

NMS subsequently blended NCCI’s probiotic bacteria with other ingredients and compressed the blend into a chewable tablet. NMS sold the tablets to Pharmacal, and Pharmacal, in turn, sold these tablets to CVS.

CVS soon notified Pharmacal the tablets contained Lactobacillus acidophilus, a different probiotic bacteria. Pharmacal confirmed as much. CVS then recalled the tablets and cancelled its orders from Pharmacal. Pharmacal ultimately destroyed the tablets.

Pharmacal initiated a lawsuit after receiving an assignment of NMS’ claims against Biotech and NCCI and their respective insurers. Pharmacal specifically alleged that NCCI provided the incorrect species of probiotic bacteria and asserted myriad breach-of-contract causes of action. Pharmacal did not specifically allege the tablets or conforming ingredients were altered in appearance, shape, color, or other dimension by the inclusion of the non-conforming bacteria. Instead, Pharmacal alleged the tablets were unmerchantable and had to be recalled. Notably, the parties agreed that after manufacturing the tablets, none of the ingredients could be separated from the others.

Biotech’s insurer, Netherlands Insurance Co. (“Netherlands”) moved to bifurcate and stay the merits case pending the circuit court’s determination concerning coverage. Netherlands then moved for summary judgment, and the circuit court granted its motion and held it had no duty to defend Biotech. The Court of Appeals reversed, concluding that the provision and incorporation of the wrong probiotic into the blended mixture constituted “property damage” to the tablet as a whole. 2014 WI App 111, ¶¶ 20-26.

On appeal, the Supreme Court first confronted the “property damage” question. The court specifically examined whether this claim satisfied either of the two policy definitions of “property damage”: (1) “physical injury to tangible property, including all resulting loss of use of that property,” or (2) “loss of use of tangible property that is not physically injured.” The Supreme Court ultimately concluded there was no “property damage” because the incorporation of the defective probiotic into the tablet did not damage other property or result in the loss of use of property.

The court began its analysis by citing doctrinal rules about the nature of and expectations associated with a commercial policy for general-liability insurance. That is, such a policy, which is neither a performance bond nor a warranty, offers insurance against the risk that the insured’s goods will cause damage to property other than the product itself.

With respect to the first definition of “property damage,” the Supreme Court framed the threshold question as whether the incorporation of the wrong probiotic into the tablet constituted physical injury to tangible property other than the probiotic itself. In reaching the answer, the court relied upon the integrated-system rule used principally in the context of the economic-loss doctrine, i.e., “damage by a defective component of an integrated system to either the system as a whole or other system components is not damage to ‘other property.’” See Wausau Tile, Inc. v. Cnty. Concrete Corp., 226 Wis. 2d 235, 249 (1999).

The court emphasized the importance of an “integrated system analysis” in determining what constitutes “other property” because coverage depends on “whether the product is to be treated as a unified whole or whether a defective component can be separated out such that the claimed damage constitutes damage to property other than the defective component itself.” See also Restatement (Third) of Torts, § 21 (“[W]hen a component part of … a system destroys the rest of the … system, the characterization process becomes more difficult.

When the product or system is deemed to be an integrated whole, courts treat such damage as harm to the product itself. When so characterized, the damage is excluded from the coverage of this Restatement.”); Wis. Label Corp. v. Northbrook Prop. & Cas. Ins. Co., 2000 WI 26, ¶¶ 32-33 (where packages of Maxi-Pads were mislabeled, causing them to be sold at less than half of their intended price, there was no “physical” injury to any product, as the packages were not damaged).

The court acknowledged that the economic-loss doctrine, which was critical to Wausau Tile, does not control a coverage dispute. However, the Court found highly influential the analysis in Wausau Tile about whether damage to an integrated system can satisfy the requirement of damage to “other property.”

In applying the integrated system analysis to the facts of Pharmacal and concluding the tablet was an integrated system, the Court reasoned that the probiotic could not be separated from the other ingredients, or vice versa. Since there was no damage to property other than the ingredients of the integrated system, the Court concluded there was no damage to “other property.  The court further concluded there was no “physical injury” to tangible property because the incorrect probiotic had not altered the other ingredients in a way that would have been different from the way the ingredients would have been altered had the correct probiotic been used.

With respect to the second definition of “property damage,” the court held that the diminution of the product’s value, or the product’s being rendered unmerchantable, did not constitute not “loss of use” under the policy. See Wis. Label, 2000 WI 26, ¶¶ 51-54 (mere mislabeling of the product did not cause a “loss of use”).

It thus distinguished between loss of “use” and loss of “value.”

Pharmacal’s place in national jurisprudence

At the end of 2015, 12 state high courts had considered the incorporation theory in interpreting what constitutes “property damage” in a commercial general-liability policy. Five rejected the theory explicitly, five rejected it implicitly, and two followed the theory. A myriad lower courts have considered the theory in various circumstances. See United States Metals, Inc. v. Liberty Mut. Group, Inc., 490 S.W.3d 20 (Tex. 2015) (collection of cases).

In the context of product contamination, there is a split in authority concerning whether the inclusion of a defective ingredient in a final product intended for sale constitutes “property damage” pursuant to the ISO definition of the term. Compare Nat’l Union Fire Ins. Co. of Pittsburgh v. Terra Indus., Inc., 346 F.3d 1160, 1165 (8th Cir. 2003) (incorporating contaminated carbon dioxide into a beverage satisfies the requirement of “property damage” caused by an “occurrence”), and Shade Foods, Inc. v. Innovative Products Sales & Mktg., Inc., 93 Cal. Rptr. 2d 364, 377 (1st Dist. 2000) (the insured’s roasted almonds that contained wood splinters were deemed to cause property damage to the nut clusters and cereal products in which the almonds were incorporated), with Silgan Containers Corp. v. Nat’l Union Fire Ins. Co. of Pittsburgh, PA, 2010 U.S. Dist. LEXIS 30100, at *14-22 (N.D. Cal. Mar. 29, 2010) (defective pull-tab lids for fruit cups where the fruit was inaccessible, albeit not otherwise harmed, found not to constitute “property damage”).

One court even considered this question in the context of an adulterated probiotic tablet, finding that the incorporation of a chelate product containing soy protein into a tablet marketed as soy free did not constitute “property damage” because the damage is only to the product itself. Fed. Ins. Co. v. Marlyn Neutraceuticals, Inc., 2013 U.S. Dist. LEXIS 178565, at *16-17 (E.D.N.Y. Dec. 19, 2013).

At bottom, although Pharmacal arguably broke new ground in Wisconsin, the Supreme Court certainly does not find itself alone in the national landscape.