Appeals from the United States District Court for the Northern District of Illinois, Eastern Division. No. 04 C 6543-John W. Darrah, Judge.
The opinion of the court was delivered by: Posner, Circuit Judge
ARGUED SEPTEMBER 24, 2007
Before POSNER, FLAUM, and WOOD, Circuit Judges.
This diversity suit over insurance coverage arises out of a suit filed in a Texas state court by Microtherm, a manufacturer of water heaters, against United Plastics Group (UPG). The Texas suit complained about a component that UPG had sold Microtherm. Microtherm won that case, obtaining a judgment for $26.5 million. The Wausau insurance company, UPG's primary liability insurer, brought the present suit in the federal district court in Chicago against UPG for a declaration that its policy doesn't cover the judgment. Wausau settled with UPG, but meanwhile Ohio Casualty, UPG's excess liability insurer, had intervened in Wausau's suit, seeking a similar declaration. After a bench trial-the principal evidence in which, however, was simply the record of the Texas case-the district judge ruled that Ohio Casualty was liable on its excess policy for the damages assessed by the Texas court, up to the $25 million policy limit. Other insurers had reimbursed UPG for a total of $4.8 million, but the judge declined to subtract that amount from the $26.5 million judgment in determining Ohio Casualty's liability to UPG, on the ground that it was unclear whether any part of the $4.8 million related to losses covered by Ohio Casualty's policy. In its present posture, therefore, the case is UPG versus Ohio Casualty, with Ohio Casualty the appellant, having lost in the district court. The substantive issues (all agree) are governed by Illinois law.
In an ordinary hot water heater, a tank full of cold water is heated and the heated water piped to the premises' hot water taps. Microtherm, in contrast, makes a tankless water heater, which it calls the "Seisco." Cold water enters the heater at one end, is heated as it passes through, and comes out the other end as hot water, which is piped to the hot water taps. The main component of the heater is the plastic chamber in which the water is heated. UPG made the chamber out of a plastic manufactured by DuPont called Zytel. DuPont recommended a certain temperature range for molding Zytel. But UPG used a significantly lower temperature and as a result the water chambers it made and sold to Microtherm were defective and caused many of the water heaters that contained them to fail.
In 2001 Microtherm sold 3,900 water heaters containing chambers manufactured by UPG. Between the start of the next year and the trial in Texas of Microtherm's suit against UPG, 600 of the water chambers ruptured, though only 65 to 75 ruptured while Ohio Casualty's policy, which expired in September 2002, was in force. The ruptures caused the heaters to stop working, generally by shorting the heater's circuit board. In some instances the rupture caused the heater to leak, damaging carpets or other property on the owner's premises. The various mishaps created customer dissatisfaction, leading, Microtherm complained, to a big fall off in its business. The Texas jury issued a special verdict in which it found that UPG had knowingly misrepresented the quality of its heaters by failing to disclose that it had ignored DuPont's recommendations regarding the proper temperature range at which to mold the water chambers. The jury awarded damages equal to the cost to Microtherm of repairing or replacing the water heaters, but that cost came to only $1.1 million; most of the $26.5 million jury award was for lost profits resulting from customers' anger at Microtherm, though there was also a small award ($330,000) of punitive damages.
The insurance policy that Ohio Casualty sold to UPG is a standard Comprehensive General Liability policy and obligates the insurer to indemnify the insured for sums that the insured "becomes legally obligated to pay by reason of liability imposed by law . . . because of . . . 'property damage' . . . caused by an 'occurrence' " during the policy period. "Property damage" is defined in the policy as "physical injury to tangible property, including all resulting loss of use of that property . . . or . . . loss of use of tangible property that is not physically injured." "Occurrence" is defined as "an accident, including continuous or repeated exposure to substantially the same general harmful conditions." "Accident" is not defined, but its meaning is illuminated by the exclusion in the policy of coverage for liability based on harms that are "expected or intended from the standpoint of the insured."
Property was damaged as a result of the defective manufacture of the water chambers. For example, the water chambers themselves were damaged when they ruptured. But damages resulting from physical damage to the insured's own property are expressly excluded from coverage. Ohio Casualty Ins. Co. v. Bazzi Constuction Co., 815 F.2d 1146, 1148-49 (7th Cir. 1987) (Illinois law); Hamilton Die Cast, Inc. v. United States Fidelity & Guaranty Co., 508 F.2d 417, 419-20 (7th Cir. 1975) (same); Jeffrey W. Stempel, Stempel on Insurance Contracts § 14.13, p. 213 (3d ed. 2006). The circuit boards, however, were also damaged by some of the ruptures, and they were Microtherm's property rather than UPG's. And sometimes the rupture of the water chamber caused the heater to leak onto and damage the property of the heater's owner, and that was not UPG's property either.
Even the water chambers were not its property after it sold the heaters containing them to Microtherm. But that is not the test of coverage; the test is whether the damaged property was the property of the insured when the defect on which the insured's liability was based came into being. Travelers Ins. Co. v. Penda Corp., 974 F.2d 823, 830-31 (7th Cir. 1992) (Illinois law); Stempel, supra, § 14.13, pp. 202, 218-19.
UPG manufactured only the water chamber. The rest of the heater was therefore other property; and so we have the following possible causal chains between the manufacturing defect and the business losses that were the main component of the Texas jury's verdict: (1) defect- ruptured water chamber-broken heater because the circuit board shorted-business losses as customers learn about the defective heaters and turn away from Microtherm; (2) defect-ruptured water chamber-broken heater because the circuit board shorted-damage to other property of the owner-business losses when, as before, disgusted customers turn away from Microtherm. In either situation the question is whether "because of property damage" in the Comprehensive General Liability policy makes the insurance company the insurer of those business losses.
As in tort law, e.g., McPherson v. Schlemmer, 749 P.2d 51 (Mont. 1988); Public Service Co. of Indiana, Inc. v. Bath Iron Works Corp., 773 F.2d 783 (7th Cir. 1985); 1 Dan B. Dobbs, Law on Remedies §§ 3.3(4), pp. 302-03; 5.15(1), p. 874 (2d ed. 1993), so in liability-insurance law, once there is damage to property the victim can recover the nonproperty, including business, losses resulting from that damage and not just the diminution in the value of the property. E.g., Imperial Casualty & Indemnity Co. v. High Concrete Structures, Inc., 858 F.2d 128, 135-36 (3d Cir. 1988); American Home Assurance Co. v. Libbey-Owens-Ford Co., 786 F.2d 22, 26 (1st Cir. 1986); Aetna Casualty & Surety Co. v. General Time Corp., 704 F.2d 80, 83 (2d Cir 1983); Allan D. Windt, Insurance Claims and Disputes, § 11.1, pp. 17-83 (5th ed. 2007); Stempel, supra, § 14.04, p. 35. Ohio Casualty argues that Illinois insurance law is different, citing Travelers Ins. Co. v. Eljer Mfg., Inc., 757 N.E.2d 481 (Ill. 2001). But the question in that case was not liability for consequential damages; it was whether physical damage within the meaning of the policy had occurred when a defective plumbing system was installed, or not until later, when the system broke and caused damage; the court held it was the latter.
A much better case for Ohio Casualty is Viking Construction Management, Inc. v. Liberty Mutual Ins. Co., 831 N.E.2d 1 (Ill. App. 2005). Viking contracted to manage the construction of a school for a town. Through the negligence of a subcontractor of Viking's, a wall at the construction site collapsed, causing property damage. The town sued Viking for breach of contract, seeking damages just for the cost of repairing the damage, and Viking sought indemnity from Liberty Mutual. The court held that the damages were not "because of" property damage within the meaning of the General Comprehensive Liability policy. All that the town had sought in its suit against Viking was the cost of replacing the defective wall, which the court equated to a defective product supplied by Viking. The town was not seeking recovery for a loss caused by damage to other property caused by the wall's collapse.
The Viking decision, if a sound interpretation of the CGL policy (and we're about to see that it is), scotches any claim that UPG might have to coverage of its liability for the cost to Microtherm of repairing or replacing any of the defective water chambers (or any other business losses resulting from the sale of the defective heaters), as distinct from the cost of repairing the heaters damaged by the defective water chambers (or other business losses resulting from that damage); only the latter cost arose from damage to property other than the defective product itself. This conclusion tracks the "economic loss" rule of tort law, which, with immaterial exceptions, bars the recovery by means of a tort (including products-liability) suit of business losses when there is no property damage. If the defect that gives rise to liability imposes costs, such as repair costs or loss of customer goodwill, on the purchaser (Microtherm) without physically damaging any of his property, the seller of the product (UPG) is not liable for those costs unless he has agreed by contract to indemnify them. E.g., Moorman Mfg. Co. v. National Tank Co., 435 N.E.2d 443 (Ill. 1982); Seely v. White Motor Co., 403 P.2d 145 (Cal. 1965) (Traynor, C.J.); Robins Dry Dock & Repair Co. v. Flint, 275 U.S. 303, 308-10 (1927) (Holmes, J.); East River S.S. Corp. v. Transamerica Delaval, Inc., 476 U.S. 858 (1986). (Compare Consolidated Aluminum Corp. v. C.F. Bean Corp., 772 F.2d 1217, 1222-24 (5th Cir. 1985), where recovery of such costs was allowed because there was also physical damage to the purchaser's property.)
Otherwise, as Holmes explained in the Robins case, the extent of the seller's liability would often depend on his purchaser's contractual relations with third parties, something about which the seller normally would know little. In Robins the defendant, a dry dock company, through its negligence damaged a propeller of a boat that the plaintiffs had chartered, and as a result the plaintiffs lost business and sued the dry dock company in tort for the loss. The Court held the suit barred. The relation to the famous rule of Hadley v. Baxendale should be plain: in both cases the consequences of delay were far better known to the victim of the delay than to the firm that had caused it. This reason for limiting liability is at least as persuasive as an aid to interpreting the Comprehensive General Liability policy, because the insurer is in a poor position to assess the consequences of a product defect for the business ...