Seventh Circuit Clarifies Applicability of Economic Loss Doctrine to Liability Insurance Coverage

Published by Bruce Huibregtse, Gregory M. Jacobs on

The Seventh Circuit recently clarified the potential impact of Wisconsin’s Economic Loss Doctrine on the availability of liability insurance coverage for commercial insureds facing defective product claims.  See Haley et al. v. Kolbe & Kolbe Millwork Co. et al., Nos. 16-3563 & 16-3648 (7th Cir. 2017).  In holding that coverage was available for the defective residential windows claims at issue in this case, the Seventh Circuit concluded that Wisconsin common law requires a case-by-case analysis to determine liability insurance coverage for underlying claims subject to the Economic Loss Doctrine, thus rejecting the more broad proposition that any claim subject to the doctrine is per se not covered.

The Economic Loss Doctrine is a common law rule that has been adopted by the Wisconsin courts to allocate monetary risks arising from the purchase of commercial goods between buyers and sellers.  The rule eliminates a purchaser’s access to tort-based causes of actions to recover purely economic losses from the manufacturer of a defective product.  Injuries to people or third-party property continue to be redressable in tort, but purely economic claims (i.e., loss of economic value of the product itself and/or consequential monetary loss arising from the product’s failure to function as expected) can be compensated only under contract law. 

Wisconsin courts also have expanded the Economic Loss Doctrine by adopting the integrated-system rule. Under that rule, when a defective product has been incorporated with other products to function cohesively as an “integrated system,” the Economic Loss Doctrine applies to preclude tort-based claims for damage to any other component of that system.  See, e.g., Wausau Tile, Inc. v. County Concrete Corp., 226 Wis. 2d 235, 249-53 (1999).

In March 2016, the Wisconsin Supreme Court applied the Economic Loss Doctrine and the correlating integrated-system rule to hold that no liability insurance coverage was available for defective product claims brought against a pharmaceutical supplement supplier.  See Wis. Pharmacal Co. v. Neb. Cultures of Cal., Inc., 367 Wis. 2d 221 (2016).  In that case, Pharmacal was sued for producing defective daily supplement tablets; the tablets as a whole were alleged to be defective because they contained an incorrect probiotic bacterial species. Pharmacal had obtained that probiotic species from a downstream supplier and combined it with other ingredients when formulating the defective tablets.

Pharmacal’s liability insurance policies included standard coverage for damage to other property, but excluded coverage for damage to Pharmacal’s own property.  The Pharmacal Court, citing the Economic Loss Doctrine and the integrated-system rule, concluded that no coverage was available.  The Court reasoned that, although only one ingredient used in the supplement tablets was defective, the ingredients were combined into an inseparable integrated system.  As a result, damage to any component of the tablets was considered damage to Pharmacal’s own property.

Based on the Pharmacal decision, Kolbe & Kolbe Millwork’s insurers argued that they had no obligation to defend the defective windows claims at issue. They started from the proposition that in prior decisions Wisconsin courts have applied the Economic Loss Doctrine to defective windows claims, holding that windows form an integrated system with the other structural components of a house.  They then argued that, just as Pharmacal’s insurer had no duty to cover damage to an integrated system, they had no duty to cover the alleged damages to any component of the plaintiffs’ homes.

The Seventh Circuit rejected the broad proposition that Pharmacal required an integrated system analysis under all circumstances.  In doing so, the Court noted that whether insurance coverage exists depends instead on the nature of the underlying plaintiff’s alleged loss.  In contrast to the claims at issue in Pharmacal, where the plaintiff sought to replace the supplement tablets entirely because the defective ingredient was indistinguishable from the non-defective ingredients, here the class-action plaintiff homeowners were seeking repairs to identifiable components of the houses other than the defective windows themselves.  The Seventh Circuit accordingly concluded that the resulting damage to the drywall, wood framing, and brick surrounding the defective windows constituted damage to “other property” under the policy language, thus triggering the insurers’ coverage obligations notwithstanding that the claims were subject to Wisconsin’s Economic Loss Doctrine.

Assuming the Seventh Circuit has interpreted the Pharmacal decision correctly, Kolbe & Kolbe Millwork serves as a significant clarification regarding the impact of the Economic Loss Doctrine on liability insurance coverage under Wisconsin law.  As a result, commercial insureds facing product defect claims alleging damages to distinguishable components of integrated systems should be able to assert the Economic Loss Doctrine as an absolute defense to any tort-based causes of action without in turn eliminating their liability insurers’ obligation to defend the litigation.

From a practical standpoint, it is also noteworthy that in this case the Western District of Wisconsin federal court denied the insurers’ request to stay the underlying product defect lawsuit when they intervened to litigate the related insurance coverage issues for the matter.  As a result, the insurers were forced to continue to pay to defend Kolbe & Kolbe Millwork in the ongoing defective windows litigation while simultaneously seeking a ruling that they were not obligated to do so under their liability insurance policies.

Going forward, therefore, insurers may be better off litigating any defense coverage disputes for underlying product defect claims in Wisconsin state courts, where it is standard practice for courts to stay the underlying litigation pending resolution of an insured’s defense obligations and where an insurer may have more success in arguing that the Seventh Circuit inappropriately narrowed the Wisconsin Supreme Court’s holding in Pharmacal.

Filed Under: Seventh Circuit, Wisconsin Supreme Court

« Back to Latest Entries