Nationwide Mutual Insurance Co. vs. CPB International, Inc., 562 F.3d 591 (3d Cir. 2009), presents the question of whether an insurer, Nationwide Mutual, was obligated to defend and indemnify its insured, CPB, against an action brought by Rexall Sundown for breach of contract by providing a defective product. Applying Pennsylvania law, the court held that the “Contractual Liability” exclusion excluded coverage for the claim.

CPB is an importer and wholesaler of chondroitin, a nutritional supplement made from animal cartilage. Rexall combines chondroitin with glucosamine and other ingredients to form nutritional tablets. The tablets are beneficial to people who suffer from osteoarthritis.

CPB obtained a CGL policy from Nationwide. The standard-form “Contractual Liability” exclusion provided that “the insurance does not apply to ‘property damage’ for which the insured is obligated to pay damages by reason of the assumption of liability in a contract or agreement.”

The exclusion had two carve-outs: “(1) That the insured would have in the absence of the contract of agreement; or (2) Assumed in a contract or agreement that is an ‘insured contract,’ provided the ‘property damage’ occurs subsequent to the execution of the contract or agreement.”

CPB has been a Rexall vendor since 1997. Pursuant to the agreement, CPB promised to deliver products of the highest industry standards, and Rexall was entitled to reject nonconforming goods. On October 1, 2004, Rexall ordered 10,000 kilograms of chondroitin from CPB, billing Rexall $760,000. CPB filled the order and billed Rexall by invoice. Rexall paid the invoice. Rexall did not, however, pay for a second shipment, after discovering that the product was deficient.

In April of 2005, CPB filed suit against Rexall for breach of contract and demanded payment for the second shipment. Rexall filed a counterclaim, alleging that the chondroitin that was shipped to it was deficient, of improper composition, and unusable for its intended purpose, and that the delivery of the material constituted a material breach of contract. Rexall sought return of its initial $760,000 payment and consequential damages (Rexall did not discover the improper composition of the product until it had been combined in nutritional tablets) in an amount exceeding $1,195,465 for the shipment of the allegedly defective chondroitin.

CPB tendered the underlying claim to Nationwide pursuant to the policy. Nationwide assumed defense of the action under a reservation of rights.

The court characterized the inquiry as “straight forward.” Id. at 595. Applying Pennsylvania law, the court stated that where “a single claim in a multi-claim lawsuit is potentially covered, the insurer must defend all claims until there is no possibility that the underlying plaintiff could recover on a covered claim.” Id. at 596 (internal quotation marks and citation omitted).

CPB conceded that Rexall’s claim that it provided defective chondroitin would not trigger coverage. The court responded that “CPB is correct – Rexall’s claim that CPB delivered chondroitin of defective quality is an allegation of faulty workmanship that is not covered by the policy, although the workmanship involved here is a failure to perform quality control as to the product to be delivered rather than a failure to [manufacture] to the proper specifications.” Id. The court, however, rejected CPB’s further argument that because Rexall’s action alleges consequential damages, it comes within the ambit of the policy. The court characterized the argument as unpersuasive, explaining that “it is largely within the insured’s control whether it supplies the agreed-upon product, and the fact that contractual liability flows from the failure to provide the product is too foreseeable to be considered an accident.” “It is certainly foreseeable that the product CPB sold would be used for the purpose for which it was sold,” so that the loss was not gratuitous. Id. at 596-97.

The court further rejected CPB’s argument that because the Supreme Court of Pennsylvania had not specifically held that actions for breach of contract are not covered by CGL policies, the issue remains open and coverage should not be denied on that basis. The court remarked that it was “confident that the Supreme Court of Pennsylvania would conclude that an underlying claim alleging breach of contract would not trigger coverage under a CGL policy.” Id. at 598.

The court reinforced its holding with its conclusion that “even if the underlying claim alleged in the occurrence covered by the policy, it fits within the contractual-liability exclusion.” Id. at 599.