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Havoc in the supply chain tests business interruption policies


The port explosions in Tianjin, China, caused the latest break in international supply chains. Donald J. Friedman and Thomas M. McMahon, partners at Perkins Coie L.L.P., discuss the benefits and limitations of contingent business interruption insurance in such situations.

In August 2015, massive explosions at a warehouse in Tianjin, China, caused fires, left hundreds dead or injured and destroyed much of the city's port facilities. Tianjin is in the industrial northern area of China and is a critical transit point for many global industries, including electronics, automotive, aerospace, petrochemicals and manufacturing equipment. For example, thousands of vehicles owned by Jaguar Land Rover Ltd., Hyundai Motor Co., Kia Motors Corp., Volkswagen A.G., Groupe Renault and Toyota Motor Corp. were damaged or destroyed by the explosions and fires.

And those are just the direct hits.

Like the 2011 earthquake and tsunami in northern Japan, the explosions and their resulting damage to the port and railroads that serve it have delayed and canceled international product shipments, disrupting supply chains. Component manufacturers have been forced to use alternate transportation routes. Because “just-in-time” inventory management systems that deliver parts on demand have made component supplies extremely time sensitive, there has been a ripple effect on the availability of finished goods, particularly in the automotive, aerospace and electronics industries. In many cases, these supply-chain losses are still being quantified.

Most companies have insurance coverage for losses resulting from such supply-chain disruptions, even if none of their own property was damaged in the Tianjin disaster.

First-party insurance policies typically contain contingent business interruption, or CBI, coverage. Although the policy language can vary significantly, CBI coverage usually means that if an unforeseen event such as a fire, explosion, earthquake or extreme weather causes property damage that prevents a customer from buying the company's goods or a supplier from delivering parts to the company, the insurer will indemnify the company for the resulting economic loss. Most policies provide coverage even if the customer or supplier is only partially prevented from doing business with the company.

But where things get murky is when a supplier is further downstream.

Case law offers no clear direction. For example, in Archer-Daniels-Midland Co. v. Phoenix Assurance Co. of New York, farmers damaged by Mississippi River flooding were held to be “suppliers” to ADM, an agricultural processor. However, in Pentair Inc. v. American Guarantee & Liability Co., an electrical substation damaged by an earthquake was not deemed to be a “supplier” to Pentair, a manufacturer that also provides water, fluid and thermal management systems, thereby defeating an indemnity client.

The same issue exists with respect to whether a company's “customer” is direct or indirect. In many policies, the coverage wording specifically includes both types of suppliers and customers.

A second coverage issue is the level of proof required to show that the unforeseen incident was the real cause of the company's economic losses. Many policies contain expansive language indicating that coverage exists if the unforeseen incident “directly or indirectly” caused the losses. In any case, disputes with the insurer about the “real” cause of the company's losses are likely to arise.

A third issue is whether the unforeseen incident must damage property owned by the supplier or customer in question. In some cases, an incident might damage property owned by a supplier to the supplier or even a more remote connection. Or the incident might damage the property of a supplier to a customer, so that customer then decides not to accept the company's goods.

Some policies bar coverage where the only property damage is sustained by such second- or third-tier suppliers/customers. However, many other policies do not. In most jurisdictions, any ambiguity on this point should be construed in favor of the policyholder.

The 2011 earthquake and tsunami in northern Japan provided a clear example of how CBI coverage can be critical when an unforeseen event disrupts international “just-in-time” product supply chains. In that case, the principal company whose operations were shut down by the earthquake and tsunami was an air-bag part supplier. But because many of the world's largest automobile manufacturers depended on that part, their car sales were disrupted. This, in turn, disrupted the sales of other parts suppliers to those carmakers. Hundreds of millions of dollars in claims were made and resolved based upon a close analysis of the specific wording of each company's CBI insurance coverage.

The Tianjin explosions and fires and the earthquake and tsunami in northern Japan are among the most recent and most significant events that disrupted international product supply chains. Other — and even less catastrophic — explosions, fires, earthquakes, hurricanes, tsunamis and catastrophes are bound to occur and disrupt international product supply chains.

Companies that have suffered business losses because of shipment cancellations or delays attributable, directly or indirectly, to the Tianjin port explosions, or to any catastrophe that affects international product supply lines, should carefully examine the contingent business interruption language of their first-party insurance coverage policies, notify their insurers promptly and activate accounting procedures that will accurately track the losses.

Thomas M. McMahon is a partner in Perkins Coie L.L.P.'s insurance recovery practice. He can be reached at 310-788-3209 and tmcmahon@perkinscoie.com.

Donald J. Friedman, a partner at Perkins Coie L.L.P., is chairman of the firm's commercial litigation practice in its Washington office and of its firmwide insurance recovery practice. He can be reached at 202-654-6240 and dfriedman@perkinscoie.com.