In recent months the world has learned that China's breakneck industrialization, like that of the United States, Japan and South Korea before it, has outrun the ability of the country's regulatory regime to ensure product safety and quality control.
The recent outbreak of multiple Chinese product scandals, from tainted pet food to lead-painted toys, poses serious risk management challenges to U.S. retailers, importers and manufacturers that sell or incorporate in their own goods, products and parts manufactured in China.
U.S. companies that seek redress from Chinese partners whose goods prove to be defective are likely to be disappointed. That leaves insurance coverage as the primary bulwark against losses caused by product recalls or third-party liability suits stemming from the sale or incorporation of faulty imported goods. Coverage lies in four main areas: product recall, comprehensive general liability, first-party property insurance coverage and the insurance of other parties.
The plight of a small Union, N.J.-based importer, Foreign Tire Sales Inc., shows the risks faced by companies that find themselves selling tainted Chinese goods.
U.S. officials ordered Foreign Tire Sales to recall 450,000 radial tires after the company disclosed that its Chinese manufacturer no longer included a gum strip to prevent tread separation on its tires. The tires were manufactured by Hangzhou Zhongce Rubber Co. Ltd., a company based in eastern China that has also sold tires to at least six other importers or distributors in the United States.
Hangzhou Zhongce has admitted to unilaterally deciding to omit the gum strips. Foreign Tire Sales maintains no inventory of tires and will have to buy new tires to replace those recalled. Foreign Tire has said it cannot afford the recall, and is faced with potential bankruptcy absent assistance from the Chinese manufacturer. It has sued Hangzhou Zhongce in U.S. District Court, claiming it received improperly made tires. In short, both this U.S. company and U.S. consumers are left holding the bag.
Foreign Tire's predicament is emblematic. It is increasingly common for Chinese exporters to create a U.S. subsidiary through which to do business in the United States. At the first sign of trouble--product recall, litigation, allegations of damage from defective products, credit imbalances--these Chinese companies place their U.S. subsidiary into Chapter 7 bankruptcy liquidation or refuse to cooperate with their U.S. customers.
Although a new law allowing plaintiffs to "pierce the corporate veil" of Chinese corporations went into effect in the People's Republic of China in 2006, that law may be of limited value to U.S. companies facing recall costs and liability. It is untested, and it may take years to obtain relief. Until the situation normalizes, U.S. companies may need to work with a third-party intermediary familiar with Chinese companies that will take legal responsibility for goods manufactured in China--but such an arrangement may be extremely expensive.
Litigation against a Chinese company in an American court is only possible if the Chinese company does business on American soil. While few U.S. companies would venture to pursue redress in Chinese courts, in some cases China's relatively well-developed system of arbitration and alternative dispute resolution may offer a viable alternative.
In a Post Magazine article, "China Market Overview--Fortune Favours the Brave," published July 19, 2007, Dom Savaiano and Ryan Hemingway point out that arbitration venues in China are plentiful, arbitration cases move relatively quickly, and arbitrators--in contrast to many judges in China's People's Court--are generally trained and experienced. For many U.S. companies, however, pursuit of any recourse outside the United States is prohibitively difficult and expensive.
COVERAGE FOR DEFECTIVE PRODUCTS
Chinese products are abundant in the U.S. stream of commerce, and the discovery of serious defects will inevitably lead to costly recalls and bodily injury and property liability claims. A company dealing with Chinese manufacturers should look to product-recall, comprehensive general liability and/or first-party property policies to soften the blow.
Product-recall insurance typically covers costs associated with product-contamination, product-tampering or product-extortion, and may cover business-interruption losses or costs to restore the product. However, this relatively new coverage product can come with a big price tag, and typical provisions in the policies have largely gone untested in the courts.
The recall market is dominated by London market insurers, which provide $70 million of capacity for accidental defects and $150 million of limits for malicious product tampering, according to one estimate. A sophisticated policyholder importing goods from China should work closely with its broker or counsel to review existing policies, or consider the purchase of product-recall coverage, before recall situations arise.
Comprehensive general liability coverage is available for bodily injury or property damage sustained by third parties as a result of the defective product. However, it is not always clear that the cost of executing a recall would be covered. But, it is important to note that under typical CGL policies, "the expenses of a policyholder, incurred in order to mitigate damages that would be covered by an insurance policy, are themselves covered damages."
As such, to the extent a recall is necessary to avoid further or future damages, the recall costs should be covered. This is especially true where a defective product has been incorporated into a third party's finished product and the defective component cannot be easily removed without damaging or destroying the finished product. Unfortunately, few courts to date have agreed that recall costs should be covered as mitigation costs under CGL policies, so policyholders will likely face litigation to obtain this coverage.
Likewise, first-party property coverage may be available where the policyholder's own property is damaged by recall procedures. One court, in Pillsbury Co. v. Underwriters at Lloyd's London, found coverage under the policyholder's all-risk first-party property policy where the policyholder had to destroy its own perfectly good cans containing underprocessed corn.
The court reasoned that the loss was fortuitous, or dependent on chance, and that a loss due to a defective canning process was no different than covered losses such as those caused by defective cans. Thus, where a policyholder exercises reasonable discretion in executing a recall resulting in damage to its own property, there may be coverage under its first-party property insurance policy.
Companies should look to the insurance of others before, and after, they are faced with liability from Chinese products. Initially, most retailers require or should require suppliers and manufacturers to name the retailer as an additional insured on liability and/or product-recall policies. Retailers should follow up to make sure that additional insured endorsements are actually issued on these policies and that the endorsements correctly cover this type of liability.
In addition, companies should require in their contracts that they be named as an additional insured on the policies of suppliers and manufacturers, which may create automatic additional insured status under the language of applicable policies. Companies faced with liability should not assume that the bankruptcy of a third party--a supplier, vendor, manufacturer or importer, for example--extinguishes rights under the bankrupt's insurance policy, because generally rights to coverage are not affected by a bankruptcy.
Chinese manufacturers are only beginning to recognize the need to carry liability insurance. If they do carry it, the insurer is likely to be a Chinese company or a Chinese subsidiary of a foreign insurer. The prospects of obtaining redress from Chinese insurers are in many cases as doubtful as the prospects of success in Chinese courts.
According to Chicago-based Aon Corp., brokers and insurers are looking at offering product-recall insurance to Chinese manufacturers, anticipating that customers of Chinese manufacturers will seek to make possession of such insurance a contractual obligation. At present, however, a Chinese market for such coverage is merely notional.
Trade with China is here to stay, and issues resulting from defectively manufactured Chinese products will be on the rise until China bolsters its regulatory efforts. Indeed, Mattel Inc., the maker of Barbies and Hot Wheels cars, decided last fall to recall almost 1 million Chinese-manufactured toys because they were apparently covered in lead paint.
Given the massive liability that could be associated with defective Chinese products and sweeping product recalls, U.S. companies need to reassess their relationships with Chinese manufacturers and review their available product recall, CGL and first-party property insurance, as well as their rights under other parties' insurance.
JAMES M. DAVIS is a senior shareholder at Anderson Kill & Olick (Illinois) P.C. in Chicago, and regularly represents policyholders in insurance coverage disputes.
January 1, 2008
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