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Court Finds "Direct Physical Loss or Damage" Due to "Impairment of Function and Value"

March 2001

This article examines the recent Minnesota appellate court decision which determined that the requirement for "direct physical loss or damage" was met in the absence of tangible injury when government regulations rendered cereal unfit for sale, resulting in "an impairment of function and value" of insured property.

by Doug Berry
Butler Pappas

Previously, we reported on the American Guarantee & Liability Ins. Co. v Ingram Micro, Inc., 2000 U.S. Dist LEXIS 7299 (DC Ariz), decision, which held that the term "physical damage" included "loss of access, loss of use, and loss of functionality." Recently, another court determined that the requirement for "direct physical loss or damage" was met in the absence of tangible injury when government regulations rendered cereal unfit for sale, resulting in "an impairment of function and value" of insured property. General Mills, Inc, v Gold Medal Ins., 2001 Minn App LEXIS 139 (Feb. 6, 2001).

Gold Medal Insurance is a wholly-owned subsidiary of General Mills, the well-known cereal producer. Gold Medal was created by General Mills as a captive insurer to allow access to cost-effective insurance markets. Gold Medal issued a "Named Peril/Grain Stocks" policy that provided coverage for General Mills' grain storage facilities in Duluth and Superior, Minnesota, as well as for other storage facilities. It also issued an all-risk policy covering all real and personal property of General Mills but did not include the Duluth or Superior locations. Limits under the former policy were $65,576,000; limits under the latter policy were $3,276,890,000.

General Mills also maintained a "Malicious Product Tampering Policy" issued by National Union. This policy defined "malicious product tampering" as:

any actual, alleged or threatened, intentional, malicious, and wrongful alteration or contamination of the Insured's Product(s), whether or not by an employee of the insured, so as to render it unfit or dangerous for use or consumption or to create such an impression to the public.

During 1993 and 1994, General Mills hired George Roggy, an independent contractor, to treat the grain stocks stored at Duluth and Superior with Reldan, a Food and Drug Administration (FDA)-approved pesticide. Unbeknownst to General Mills, Roggy substituted Dursban for Reldan. Dursban and Reldan are chemically almost identical. Dursban, however, is cheaper and, although Dursban is approved for treatment on certain foods, it is not approved for use on oats. The FDA considers the presence of an unapproved chemical to be an illegal adulteration of food products, even if not dangerous for human consumption. Thus, the use of Dursban in this instance was a violation of FDA regulations.

During a routine inspection, traces of Dursban were noted in General Mills' oat stocks. Upon investigation, it was determined that 16 million bushels of raw oats and the equivalent of 55 million boxes of Cheerios and other cereals containing oats were affected. Roggy confessed he had made the substitution as a cost-saving measure and eventually pled guilty to adulteration of food and served a jail sentence for his actions.

The court noted that the use of Dursban was generally considered to present no health hazard to the consuming public. However, General Mills voluntarily withheld the products from the market based on the understanding the FDA would require it to do so if it attempted to distribute the affected product. General Mills considered petitioning the FDA for a waiver but concluded it would take too long, and, in any event, product freshness standards would have been exceeded. Eventually, General Mills destroyed the affected products. The parties stipulated that General Mills' loss due to the destruction of the oat stocks and the finished cereals and cleaning costs was $167,542,874, plus interest and costs.

General Mills sought coverage under both Gold Medal policies as well as the National Union policy. The latter claim was settled for $17.5 million without an admission of coverage after a declaratory judgment action was filed in New York. General Mills instituted suit in Minnesota state court against Gold Medal alleging breach of contract as to its two policies.

The trial court entered summary judgment in favor of General Mills, finding coverage under the all-risk policy but finding no coverage under the named-peril policy. The trial court also denied Gold Medal's effort to offset any liability it might have with the National Union payment.

The Gold Medal all-risk policy provided coverage for "all risks of direct physical loss or damage to property insured and described herein." "Direct physical loss or damage" was not defined. The policy also contained the following exclusion:

This policy does not insure against loss or damage caused by or resulting from any of the following regardless of any other cause or event contributing concurrently or in any other sequence to the loss:

Delay, loss of market or any other indirect or consequential loss or damage not specifically covered herein, gradual deterioration or leakage, seepage, inherent vice, latent defect, moth, vermin, termites or other insects, ordinary wear and tear, contamination, dampness of atmosphere, wet or dry rot, mold, shrinkage, evaporation, loss of weight, rust, corrosion, change in flavor or color or texture or finish, unless caused by or resulting from a peril not excluded hereunder. [Emphasis in opinion.]

The appellate decision affirmed the judgment in favor of General Mills and addressed the definition of "direct physical loss or damage," whether the exclusion for "contamination" was ambiguous, and whether the offset should have been applied. As to "direct physical loss or damage," the court noted:

We have previously held that direct physical loss can exist without actual destruction of property or structural damage to property; it is sufficient to show that the property is injured in some way." [citing to Sentinel Management Co. v New Hampshire Ins. Co., 563 NW2d 296 (Minn App 1997), which dealt with a first-party asbestos claim.]

The court stated the:

function of food products produced by General Mills is not only to be sold, but to be sold with an assurance that they meet certain regulatory standards. When General Mills is unable to lawfully distribute it products because of FDA regulations, that function is seriously impaired.

The court rejected Gold Medal's argument that the food could be safely consumed but for a legal regulation that did not truly affect the function of the product. The court relied on a Minnesota precedent, Marshall Produce Co. v St. Paul Fire & Marine Ins. Co., 98 NW2d 280 (Minn 1959), which found coverage under a first-party fire policy for food stuffs rejected by the U.S. Army because of exposure to smoke from a fire, in holding:

Whether or not the oats could be safely consumed, they legally could not be used in General Mills' business. The district court did not err in finding this to be an impairment of function and value sufficient to support a finding of physical damage.

The court found the ensuing loss language of the contamination exclusion ambiguous, concluding:

the very fact that [the parties'] respective positions as to what this policy says are so contrary compels one to conclude that the agreement is indeed ambiguous.

The Gold Medal policy and the National Union policies also contained virtually identical "other insurance" clauses. In resolving the claim for setoff, the court concluded the National Union policy required actual, not ordinary, malice for coverage to be found. The court reached this decision after analyzing the treatment New York courts afforded the term "malicious mischief" in property insurance cases. Relying on those cases, the court found that under New York law, "actual malice, as opposed to ordinary malice, requires a subjective intent to injure the policyholder." Since Roggy testified he assumed the substitution would not be discovered and that no one would be harmed by his actions, the court concluded he did not intend to harm General Mills and thus lacked the "actual malice" required to trigger coverage under the National Union policy.

One point raised by Gold Medal but not squarely addressed by the court was the requirement that the loss or damage be "direct." "Direct" is defined by Webster's New Collegiate Dictionary as "proceeding from one point to another in time or space without deviation or interruption" or "stemming immediately from a source." Gold Medal had argued that it was not the use of Dursban which rendered the oats unfit for human consumption—in fact, but for the FDA regulation, they were fit for consumption—but, rather, the government regulation which rendered them unfit. Other than its reliance on Marshall Produce, a case where coverage for smoke damage was found under a fire policy, the court provides no further analysis. The court also provides no insight as to why the all-risk policy, which excluded Duluth and Superior, applied while the named peril/grain stocks policy that covered those locations (and provided a lower limit) did not, although it may be that the adulteration occurred elsewhere than Duluth and/or Superior.

Whether this case, like the Ingram Micro decision, represents a trend to a more liberal definition of "property damage" of universal application remains to be seen. It is, however, consistent with Minnesota's treatment of such language in the Sentinel Management and Marshall Produce decisions.

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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