On April 20, 2012, the Virginia Supreme Court unanimously affirmed a trial court decision holding that product exclusion endorsements precluded coverage under first-party property insurance policies for contaminated infant formula manufactured by the insured. In doing so, the court made new law in the commonwealth of Virginia. PBM Nutritionals LLC v. Lexington Ins. Co., et al., 724 S.E2d 707 (Va., April 20, 2012). Richard Bennett handled the trial and represented the insurers on appeal.
The policyholder was PBM Nutritionals, LLC, a Virginia infant formula manufacturer. PBM manufactured its products at a Burlington, Vt., plant by mixing dry ingredients with heated, filtered water. To heat the water, the insured used a heat exchanger that passed steam along the outside of tubes containing the process water. Once heated, the water then passed through filters downstream from the heat exchanger.
In December of 2008, the insured discovered that the valve that controlled the flow of steam into the heat exchanger was leaking steam in the closed position, and it ordered a replacement valve. It then continued to manufacture infant formula with no problems. Between January 20 and January 22, 2009, before the new valve had arrived, PBM conducted an extensive cleaning of the system in preparation for the manufacture of Profylac, a hypoallergenic baby formula product. Routine cleanings for other product runs take no more than four to six hours, but the Profylac cleaning process is 42 to 46 hours long. During this cleaning, the process water that was sealed in the heat exchanger's tubes and the filter housing became superheated by steam leaking through the defective valve, and that eventually caused the water filters to disintegrate into their constituent components (melamine, cellulose, and other filter materials).
After the cleaning, PBM – unaware that it was using process water with dissolved filter elements in it – manufactured 25 batches of Profylac. FDA-mandated melamine testing subsequently disclosed that all of the batches contained that substance, and PBM decided to destroy the entire Profylac run because it was convinced that melamine and other filter media had infiltrated all 25 batches. As its executive vice-president testified at trial, the product had no salvage value, was unfit for human consumption, and was unmarketable as a result of the contamination. The loss exceeded $6 million.
PBM made a claim under a product contamination policy issued by a London syndicate, and it recovered the policy limit of $2 million from that insurer. It then sought to recover the balance of its loss from three first-party property insurance companies – ACE American Insurance Company, Arch Insurance Company, and Lexington Insurance Company. All three carriers denied the claim on the basis of product exclusion endorsements that they had added to the manuscript policy form provided by PBM's insurance broker. These product exclusion endorsements barred coverage for loss caused by the "alleged or threatened release, discharge, escape or dispersal of CONTAMINANTS or POLLUTANTS;" the capitalized terms were defined to mean "any material which after its release can cause or threaten damage to human health or human welfare or cause or threaten damage, deterioration, loss of value, marketability or loss or use to property insured."
PBM filed suit in the state court in Richmond, Va., and the case was ultimately bench-tried in October of 2010. The Circuit Court judge found that the product exclusion endorsements were clear and unambiguous and that there was "no liability for coverage of [PBM's] contamination losses" as a result.
On appeal, PBM argued that the contracts of insurance contained two "directly conflicting policy provisions" that created an ambiguity that should have been resolved in favor of coverage. The broker's manuscript form contained Exclusion 9(H), captioned "Pollution;" this provision excluded loss caused by the "presence, release, discharge or dispersal" of pollutants unless the pollution was "itself caused by a peril insured against." The insurers did not contend that 9(H) was applicable because they admitted that the leaking valve was "a peril insured against." PBM argued that the exception to 9(H) "provided coverage" under the facts and thereby created "coverage inconsistencies" with the product exclusion endorsements.
The policyholder also contended that the product exclusion endorsements' language was overly broad and should be limited to only "traditional environmental pollution."
The Virginia Supreme Court rejected both arguments. In a ground-breaking decision, the commonwealth's highest court held that:
[a]n exception that serves to negate the applicability of one particular exclusion does not create a "conflict" with another policy provision that operates to bar coverage. An exception to an exclusion only has bearing on that exclusion's applicability – it is without force with respect to other provisions of the policy. ... In other words, an exception to an exclusion does not create coverage where none exists.
The court noted that the product exclusion endorsements were "unambiguous" and recognized that under "established principles of insurance law" endorsements modify or alter the manuscript form's terms and conditions.
The court also rejected PBM's "traditional environmental pollution" argument. According to Justice Goodwyn's opinion:
none of the pollution exclusion endorsements reference any terms such as "environment," "environmental," "industrial," or other limited language suggesting that the exclusions are limited to "traditional" rather than "indoor" pollution. No language in any of the relevant endorsements suggests discharges or dispersals of pollutants or contaminants must be into the environment or atmosphere. ... According to their plain language, the pollution exclusions are not restricted to traditional environmental pollution.
The high court noted in passing that both the Fourth Circuit Court of Appeals and the Eastern District of Virginia had reached the same conclusion in a number of Chinese drywall opinions construing pollution exclusions in third-party liability policies.
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