The Decision Is In The Bag

The Supreme Court of British Columbia, in a decision released Apr. 1, 2010, provided a comprehensive review of the principles behind the meaning of “property damage” in a CGL policy. In Bulldog Bag Ltd. v. AXA Pacific Insurance Company, 2010 BCSC 419, the plaintiff applied for judgment against the defendant insurer for the amount of $732,420.60 pursuant to a CGL policy. The policy contained the typical CGL wording of property damage, defining it as “physical injury to or physical destruction of tangible property.”

Bulldog sustained losses when it settled the claim of its customer, Sure-Gro Inc., arising from defective plastic packaging. Sure-Gro manufactured garden products for consumer use, including packaged sheep manure, cattle manure, topsoil and black earth. Bulldog was responsible for manufacturing plastic bags for Sure-Gro and for printing Sure-Gro’s product labelling information on the bags.

Bulldog used ink designed for outdoor applications. However, Sure-Gro discovered that moisture caused the ink to come off the packaging, rendering the labelling illegible. The ink did not penetrate the plastic packaging, or otherwise contaminate the packaged soil and manure. Sure-Gro concluded the bags of soil and manure with the defective packaging were not saleable to consumers. Sure-Gro incurred expenses related to repackaging its manure and soil, removing and disposing of the defective packaging and salvaging the manure and soil contained in that packaging. Further, when Sure-Gro salvaged its raw material from the defective packaging, about 10 per cent of that material was lost in the process, worth roughly $12,000.

Physical incorporation

Bulldog claimed the salvaging costs flowed from “property damage” as a result of the incorporation of the defective packaging into Sure-Gro’s final product. It relied on the decision of the B.C. Court in Gulf Plastics Ltd. v. Cornhill Insurance Co. (1990), 47 B.C.L.R. (2d) 379, aff’d 61 B.C.L.R. (2d) 64 (C. A.), which found that where a defective product is physically incorporated into a third party’s product “property damage” will have ensued.

It was AXA’s position the defective packaging and Sure- Gro’s manure and soil were not incorporated into a single product that sustained property damage. Rather, the two products were separable and the cost of repairing or replacing Bulldog’s defective work did not constitute a claim for “property damage” and therefore did not fall within the insuring agreement of the policy. It distinguished the Gulf Plastics case by arguing there was no physical incorporation of the insured’s product into the third party’s product. Alternatively, it was AXA’s position that if there was property damage, it was limited to the 10 per cent of Sure-Gro’s product that was not salvaged. However, the exclusion for loss of use of tangible property resulting from the failure of the insured’s products or work should exclude coverage for even that small amount.

Absence of third party damage

The court underwent an extensive analysis of the case law interpreting “property damage.” The court concluded that under CGL policies the insurer’s obligation to indemnify will generally not be triggered where the property damage resulting from the insured’s defective work is confined to the insured’s own property or to property for which the insured is responsible. In the absence of damage to a third party’s property, the insured will not be entitled to indemnity for the cost of replacing or repairing its own defective work or work product.

The court also referred to the line of American and Canadian cases that considered the effect of incorporation of the insured’s defective product into a third party’s product, where the two cannot be separated. It was Bulldog’s contention that its defective packaging was incorporated into Sure-Gro’s end product, which consisted of the packaged soil and manure, and that there was physical damage to that product because it was rendered useless for its intended purpose.

However, AXA argued this was not a case where the use of Bulldog’s packaging changed the essential nature of either its product, or Sure-Gro’s product, so as to make it impossible to identify which product was manufactured by the plaintiff and which was produced by Sure-Gro. Bulldog’s product was the plastic packaging, whereas the third party’s property was separate and identifiable as the soil and manure contained in that packaging.

Complete incorporation of product

The Court found that where an insured’s defective product is completely incorporated into a product of a third party, and the end product is rendered wholly useless for its intended purpose, the third party’s product has sustained property damage.

The Court then likened this case to a situation where an insured supplied a soft drink manufacturer with defective bottles which, without contaminating the contents, rendered the third party’s bottled soft drink unfit for sale. The soft drink manufacturer was able to salvage 90 per cent of the contents of the defective bottles, but 10 per cent of the soft drink was lost in the salvaging process.

In that situation, the Court said it would be possible to separate the insured’s defective product from the manufacturer’s soft drink, to replace the defective bottles and to reuse the salvaged soft drink. The insured would have no claim for the cost of the defective bottles or for the cost of salvaging the manufacturer’s soft drink and re-bottling it since all of those costs would flow from the insured’s own faulty workmanship. In the absence of property damage to the third party’s product, the soft drink, the insured would not be able to recover those costs from its insurer. At best, and depending on the language of the policy, the insured’s claim would be limited to the 10 per cent of the soft drink lost in the salvaging process.

Integral, not inseparable

That is the result the Court ultimately applied in the case at bar. Distinguishing Gulf Plastics, the court stated Bulldog’s product was an integral, but not inseparable, part of Sure- Gro’s finished product. There was no penetration or contamination of Sure-Gro’s product by the defective ink. When the ink ran, Sure-Gro’s finished product, the bagged manure and soil, was no longer suitable for its intended purpose. However, at that point, the manure and soil contained in the defective packaging was undamaged, and could be separated from the packaging.

Sure-Gro only temporarily lost the use of the undamaged product, while it was salvaged and repackaged. The costs associated with these actions all constituted economic loss flowing from Bulldog’s supply of defective packaging in breach of its contract with Sure-Gro. Bulldog was not entitled to indemnification for the costs incurred by Sure-Gro to repackage its product, unless there was physical injury to or destruction of some tangible property of Sure-Gro.

And what of the remaining 10 per cent of material that was either lost or discarded during the salvage process? The Court found that this portion of the claim constituted property damage and the failure of performance exclusion did not apply. The court found the exclusion applied only in circumstances where the loss of use of property did not involve physical injury to tangible property. The disposal of the 10 per cent of material, whether it occurred because it could not be readily extracted from the plastic packaging, could not be recovered at an economical cost or was lost during reprocessing, amounted to “physical injury.”

Partial indemnification

In summary, the Court found Bulldog was only entitled to indemnification with respect to the costs associated with the loss of 10 per cent of Sure-Gro’s product, which was roughly $12,000, and the balance of the plaintiff’s claim was dismissed (roughly $720,000).

This decision is helpful to insurers in that it reaffirms that CGL policies are not pe
rformance bonds and are only intended to cover fortuitous risks involving tangible physical property damage. Further, it clarifies that where products are manufactured and provided for use in another entity’s product, coverage will only result where that incorporation is physically indivisible.

The decision is presently under appeal. No date has been set for the hearing of the appeal.

Bruno De Vita is a partner and Hollis Bromley is an associate with Alexander Holburn Beaudin & Lang LLP. Alexander Holburn Beaudin & Lang is a member firm of The ARC Group Canada.