This exclusion protects the named insured, as well as its insurer, from

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1 Exclusion 2: 'The insurance does not apply to any person or organization, as insured, from whom the named insured has acquired such products or any ingredient, part or container, entering into, accompanying or containing such products." This exclusion protects the named insured, as well as its insurer, from liability where the vendor has supplied defective products to the named insured who incorporates the vendor's product into the final product. This exclusion does not exclude a particular injury from the coverage, but, rather, excludes the vendor as an insured altogether. Also, the exclusion does not appear to require that the liability or injury be caused by the "products or any ingredient, part or container" supplied by the vendor. It simply states that if the vendor provides an ingredient, part or container to the named insured which is incorporated into the finished product prior to being sold by the vendor, the vendor will not be considered an "insured" under the policy. If the facts suggest that Exclusion 2 may apply, review of the law of the state involved should take place to determine whether that state has decided the issue of whether the "ingredient, part or container" must itself be defective and/or be a cause of the injury for the exclusion to apply. Example 1: The named insured is a shirt manufacturer. The vendor supplies material to the named insured who thereafter manufacturers 21

2 shirts out of that material and returns the finished product to the vendor for sale. Because the material is highly flammable, a purchaser of the shirt is injured with the shirt catches fire, and sues the vendor. Exclusion 2 would operate to preclude coverage to the vendor under the endorsement, because the named insured has acquired the defective materials from the vendor. Example 2: The named insured is a shirt manufacturer. The vendor designates the fabric to be used which is manufactured and provided by a third-party. The vendor directly pays the thirdparty for the fabric. The named insured manufacturers the shirts and returns them to the vendor for resale. Because the material used in the shirts is highly flammable, the vendor is sued after a customer is injured when the shirt catches fire. In this example, Exclusion 2 would not operate to exclude coverage. The exclusion operates only when the defective materials are supplied or manufactured by the vendor, rather than a thirdparty. If the exclusion were applicable in this example, it would operate to preclude coverage in almost all cases where the named insured did not provide or manufacture all the component parts of the finished product itself which could render the coverage offered by the endorsement illusory. 22

3 5. The duty to defend. Reservation of rights. In virtually all states of the United States, the duty to defend is significantly broader than the duty to indemnify. The duty to defend exists when the "possibility of coverage" exists under the facts. If, therefore, the facts show that the vendor did sell or distribute the named insured's product in the normal course of its business, but that one or more of the exclusions may apply, the duty to defend the vendor (or participate in its defense) may arise in most jurisdictions. The mere fact, however, that the duty to defend may be present, does not necessarily mean that the insurer which issued an Additional Insured Endorsement must assume the defense of the vendor on a 100 percent basis. Other factors, such as other insurance clause issues [see section 6] must be analyzed. A review of the legal standards in the state where the claim is pending is recommended to ultimately determine whether a defense should be accepted under the vendor's endorsement. While some states may penalize an insurer for failing to assume an additional insured's defense (such as California), other states may be less strict and allow the ultimate issue of defense to be decided after settlement or judgment, with little or no penalty attaching (such as New Jersey). 23

4 Should any insurer decide to assume the defense under the vendor's endorsement, or participate in the defense with another insurer, the same rules that apply to named insureds should be followed with respect to additional insureds. Therefore, if a question exists as to the company's ultimate responsibility to defend or indemnify under the vendor's endorsement, a reservation of rights letter should be issued, or, where required, a non-waiver agreement should be obtained. 24

5 6. "Other Insurance" clause issues. If it is determined that the duty to defend a vendor exists, this does not necessarily mean that the insurer which issued the vendor's endorsement is responsible for 100 percent of defense fees incurred in defending the vendor. It must first be determined whether the vendor has its own insurance which covers the loss. Often times, the vendor (or its lawyer) does not want to divulge this information; however, the insurer which issued the vendor's endorsement is entitled to this information and should insist upon receiving it, including insisting on receiving a copy of the vendor's policy itself. If the vendor has no insurance other than that provided by the vendor's endorsement, the insurer issuing the vendor's endorsement would be responsible to fully defend the case. However, if the vendor has its own insurance, the vendor's insurance and that provided under the vendor's endorsement would be "concurrent insurance," and the respective obligations of the two insurers will be determined by a review of policy conditions known as "other insurance" clauses. Where two or more insurance policies apply to the same loss, the respective obligations of those insurers will be determined by reviewing the other insurance clauses in each policy. Other insurance clauses generally take one of five forms: 25

6 A. A primary clause. A primary other insurance clause states that the coverage provided by the policy shall be primary and non-contributing with any other insurance. B. A pro-rata clause. A pro-rata clause states that the coverage afforded by the policy shall contribute with any other insurance either on an equal share basis, or pro-rated by limits. C. An excess clause. An excess clause states that the insurance provided by the policy shall be excess over all other insurance available to the insured. D. An escape clause. An escape clause states that if the insured has any other available insurance covering the loss, the policy with an escape clause shall be inapplicable and provide no coverage. Escape clauses are disfavored by most courts, to the extent that they can leave the insured without adequate protection for a loss; however, if the other policy (the vendor's policy) is adequate to fully cover the loss, most courts will give effect to an escape clause. If, however, the "other insurance" is not adequate to fully cover the loss, many courts will 26

7 disregard the escape clause in its entirety which has the effect of turning the clause into a primary clause. E. Escape/excess clauses. The hybrid escape/excess clause states that if other insurance is available which will fully satisfy the loss, the policy with the escape/excess clause will not apply at all; however, if the other policy is not sufficient to fully cover the loss, the policy with the escape/excess clause will be excess to the other policy. When comparing other insurance clauses, the following rules generally apply: 1. Primary clause v. primary clause = the policies will pro-rate. 2. Primary clause v. pro-rata clause = the primary clause will be effective, with the pro-rata clause policy becoming excess. 3. Primary clause v. excess clause = the excess clause will be given effect. 4. Primary clause v. escape clause = if the primary policy is sufficient to fully cover the loss, the escape clause will be given effect. If the primary policy is not sufficient to cover the loss, the escape clause will be disregarded and the policy with the escape clause will be deemed a primary policy, with both policies thereafter pro-rating. 5. Primary clause v. escape/excess clause = if the primary policy is sufficient to fully cover the loss, the escape provision will be given effect. If the primary policy is not sufficient to fully cover the loss, the excess provision will be given effect, and the other policy will be excess to the primary policy. 27

8 6. Pro-rata clause v. pro-rata clause = the policies will pro-rate. 7. Pro-rata clause v. excess clause = the pro-rata clause policy will be primary and the excess clause policy will be excess. 8. Pro-rata clause v. escape clause = if the policy with the pro-rata clause is sufficient to fully cover the loss, the escape clause will be given effect. If the policy is not sufficient to fully cover the loss, the escape clause will be disregarded and the policies will likely pro-rate. 9. Pro-rata clause v. escape/excess clause = if the pro-rata policy is sufficient to fully cover the loss, the escape provision will be given effect. If the pro-rata policy is not sufficient to fully cover the loss, the excess provision will be given effect, and the pro-rata clause policy will be primary with the other insurance being excess. 10. Excess clause v. excess clause = the ' policies will pro-rate as the clauses cannot be given effect as written. 11. Excess clause v. escape clause = if the policy containing the excess clause is sufficient to fully cover the loss, the escape clause will be given effect, and the policy containing the excess clause will be primary. 12. Excess clause v. escape/excess clause = if the policy containing the excess clause is sufficient to fully cover the loss, the escape clause will be given effect. If the policy containing the excess clause is not sufficient to fully cover the loss, the excess component of the escape/excess clause will be given effect, and the policies will pro-rate. 13. Escape clause v. escape/excess clause = because two escape clauses can never operate, the escape clause is likely to be disregarded in both policies. 28

9 While a court may give effect to the excess provision of the escape/excess clause, making the policy with the pure escape clause primary, with the other insurance policy excess, other courts may chose to pro-rate the two policies as a more equitable solution. 29

10 7. Contractual insurance/indemnity provision issues. (Contractual liability coverage). If a contract exists between the named insured and the vendor, the contract should be reviewed and in particular any provisions covering "insurance requirements" and "indemnity obligations." These provisions may effect the company's obligations both under the vendor's endorsement and independent of the endorsement. 1. Insurance provisions. Many contracts between manufacturers and vendors contain specific provisions relating to the obligations of the parties to procure and maintain insurance. Generally, the manufacturer is obligated to procure and maintain specific types of insurance covering not only the manufacturer's liability, but also that of the vendor. Such provisions, therefore, often require the manufacture to name the vendor as an additional insured on the named insured's policy. Such provisions not infrequently require that the policy under which the vendor is named an additional insured shall be "primary and non-contributing" with any other insurance. Many courts will interpret such a provision favorably to the vendor such that the manufacturer's policy will be held to be primary coverage for the vendor, without any contribution from the vendor's own 30

11 insurer, even if the vendor's policy contains a "primary" other insurance clause, while the manufacturer's policy contains an "excess" other insurance clause. Example: The named insured manufacturer and the vendor enter into a purchase and sale agreement. The named insured agrees to procure and maintain product liability insurance, and to name the vendor as an "additional insured" on the policy. The contract required that the insurance provided by the named insured shall be "primary and noncontributing." The named insured's policy contains an "excess" other insurance clause. After a loss, the vendor is sued and tender's defense under the vendor's limited form endorsement. The vendor has its own policy of insurance, which contains a "primary" other insurance clause. Therefore, there is concurrent coverage under both policies. The manufacturer's insurer acknowledges that it policy provides coverage to the vendor, but argues that its coverage is excess to that of the vendor's own policy based upon the other insurance clauses. In this example, the vendor has a valid argument that the insurance provisions of the contract should control over the language of the other insurance clauses, since the intent of the contracting parties was that the manufacturer's policy would be primary in all instances. If this circumstances arises, you should check the law of the specific state involved in the case to determine the answer to the question of which policy must respond to the loss first. 31

12 Indemnity provisions. Contracts between manufacturers and vendors often times contain indemnity provisions which generally require the manufacturer to defend and indemnify the vendor for losses which occur. Although various states have differing interpretations of indemnity agreements, and use different names for the type of agreement involved, in reality only two types of indemnity agreements are generally found in such contracts. These agreements are known as: (1) a general indemnity clause, sometimes known as a Type II clause, and (2) a specific indemnity clause, sometimes known as a Type I clause. A. The general indemnity clause. Under a general clause, the indemnitor (manufacturer) will indemnify the indemnitee (vendor) for the vendor's "passive negligence" but not for its "active negligence." When dealing with a general agreement, usually it will not be known whether indemnity is owed until the judge or jury makes findings of the classification of fault, if any, of the respective parties to the agreement. The following phrases found in indemnity agreements usually will make that agreement a general indemnity agreement: 'The indemnitor will indemnify the indemnitee for the indemnitee's liability: 32

13 (a) (b) (c) however same may be caused; regardless of responsibility for negligence; arising from the use of the premises, facilities or services of the indemnitee; (d) which might arise in connection with the agreed work; (e) caused by or happening in connection with the equipment or the condition, maintenance, possession, operation or use thereof." B. The specific indemnity clause. A specific indemnity clause requires that the indemnitor (manufacturer) indemnify the indemnitee (vendor) for any and all liability unless the vendor's liability was caused by the vendor's sole fault or willful misconduct. A specific indemnity clause is significantly more advantageous to the vendor since it provides the vendor with indemnity unless the accident is found to have been 100 percent the vendor's fault. C. Contractual liability issues. Indemnity clauses operate independently of insurance clauses or vendor's endorsements. Indemnity obligations carry with them not only the duty to indemnify, but also the duty to defend. In most states, the duty to defend under an indemnity agreement does not arise immediately upon tender, which differentiates a contract tender from a tender under the vendor's endorsement. 33

14 Often times the determination of whether indemnity (and thus defense) is owed under an indemnity agreement cannot be determined until after the case has been decided by a judge or a jury. Under a specific indemnity agreement, however, it is often times possible to decide whether indemnity is owed at the early stages of the case, if the vendor can show at least one percent of fault attributable to a party other than itself. Because the vendor is entitled to indemnity under a specific indemnity clause unless the loss was caused by its sole fault or willful misconduct, its proof of negligence or fault on the part of another party will be sufficient to result in a finding that indemnity is owed. Contractual indemnity is an all-or-nothing proposition, meaning that if indemnity is owed, the manufacturer will owe 100 percent of any liability and damages assessed against the vendor, as well as the attorney's fees incurred in defending the vendor. Because indemnity agreements are the contractual assumption of the tort liability of another party, the contractual liability coverage of the policy (if present) will cover that liability assessed against the named insured. This would be true even if the vendor would not be entitled to direct coverage under the vendor's endorsement. While the policy would owe the vendor no direct obligations, the practical effect would be the same. Example 1: The named insured manufacturers power saws. After the saws are delivered to the vendor, the vendor removes the guards on 34

15 the saw blades. After a customer is injured by the unguarded blade, he sues the vendor for his injuries on the theory that the saw was defective in design for not having a blade guard. The contract between the manufacturer and vendor contains a "specific indemnity" agreement which requires the manufacturer to indemnify the vendor for all liability unless caused by the vendor's sole negligence/fault or willful misconduct. Under this example, the vendor would not be entitled to indemnity, because its liability was as a result of its sole negligence in removing the blade guard. Additionally, if the vendor were insured under the limited form vendor's endorsement, Exclusion 1(b)(i) would operate to exclude coverage because the vendor had made changes in the named insured's product after it left the named insured's hands, and those changes were the cause of the plaintiff's injuries [see Example 2 on page 12]. Example 2: The named insured manufacturers ski bindings which are sold to the vendor. The vendor attaches a set of ski bindings to a set of skis in a negligent manner. When used by a customer, the bindings do not release the customer which causes the customer an injury. The customer sues both the manufacturer on a design defect theory, as well as the vendor on a negligence theory for having improperly mounted and adjusted the bindings. The contract between the manufacturer and vendor contains a 35

16 specific indemnity agreement running in favor of the vendor. The vendor is also named as an additional insured on the manufacture's policy under a limited form vendor's endorsement. While it is possible that Exclusion 1 (b)(iii) would operate to exclude coverage for the vendor, due to its incorrect adjustment of the bindings which the vendor "normally undertakes to make in the usual course of business, in connection with the distribution or sale of 'the named insured's products,'" the vendor under this example will likely to be entitled to full indemnity from the manufacturer. This is because the customer claims that his injury was caused both by the vendor's improper adjustment of the bindings, and also by a design defect in the bindings themselves. Since the vendor would be entitled to indemnity under a special indemnity agreement unless the cause of the loss was its "sole negligence or willful misconduct," it would be entitled to indemnity under this example. And, if the policy contains contractual liability coverage, it will, in turn, provide the named insured with full protection for the indemnity judgment against it. D. Insurance and indemnity provisions considered together. When the named insured has entered into a contract with a vendor, it is not unusual for such a contract to contain both an (1) insurance provision and (2) an indemnity provision. Some courts will read these provisions together to 36

17 override the effects of the other insurance clauses in the policy. If the contract both requires that the manufacturer name the vendor as an additional insured, and that the manufacturer indemnify the vendor for liability arising out of its sale or distribution of the manufacturer's products, some courts will require the named insured's policy to become primary coverage without reference to the other insurance clauses at all. This is because the evidence showed a clear intent on the part of the contracting parties (the manufacture and the vendor) that the manufacturer and its insurer would be fully responsible for all losses arising out of the manufacturer's products. Example: The named insured manufactures power saws. After the sale by the vendor of a saw to a customer, the customer is injured and sues the vendor on a theory of design defect. The vendor tenders its defense under the vendor's endorsement to the manufacturer's insurer. The vendor has its own insurance which contains a "primary" other insurance clause. The manufacturer's insurance policy contains a "excess" other insurance clause. The manufacturer and vendor have entered into a contract prior to the loss which required that the manufacturer (1) name the vendor as an additional insured on its policy, and (2) indemnify the vendor for all liability arising out of the sale or distribution of the manufacturer's products, unless the loss was caused by the sole negligence or willful misconduct of the vendor. In this example, if we were to analyze the respective obligations of the two 37

18 insurers only under the other insurance clauses, the vendor's policy would be primary and the manufacture's policy would be excess based on a comparison of the other insurance clauses. However, under this example, it is likely that a court could find that utilization of the other insurance clauses, would frustrate the intent of the parties to the contract and, therefore, ignoring the other insurance clauses, find the manufacture's policy to be primary and the vendor's policy to be excess. If faced with this fact situation, review of the law of the state involved should take place for further clarification. 38

19 8. Commercial Code issues. The Uniform Commercial Code has been adopted throughout the United States. Article 2 of that Code regulates the legal obligations between the buyers and sellers of goods. Section 2607(5)(a) of the Uniform Commercial Code states: "(5) Where the buyer is sued for breach of warranty or other obligations for which his or her seller is answerable over: (A) he or she may give the seller written notice of the litigation. If the notice states that the seller may defend and if the seller does not do so, he or she would be bound in any action against the seller by the buyer by any determination of fact common to the two litigation actions, then unless the seller after seasonable receipt of the notice does not defend, he or she is so bound." This Code section operates independently of any insurance obligation or contractual indemnity obligation. This Commercial Code section allows the manufacturer the opportunity to step in and defend its product on behalf of the vendor. If it chooses not to do 39

20 so after being requested to do so by the vendor, it will be bound by any determination made in the litigation. Example: The named insured manufacturers power saws. The named insured is not subject to personal jurisdiction in the state of Iowa. After a purchaser of the saw is injured while using it, he sues the vendor for strict liability in Iowa. He cannot sue the manufacturer because it is not subject to personal jurisdiction in Iowa. The vendor tenders its defense to the named insured manufacturer under UCC The manufacturer has the opportunity, at this juncture, to concede jurisdiction and appear in the lawsuit on behalf of the vendor and defend its product. In this example, however, the manufacturer chooses not to assume the defense of the vendor. Thereafter, because of limited resources, the vendor mounts a weak defense to the product liability claim, and loses the lawsuit on the basis that the power saw contained a design defect. Thereafter the vendor files a lawsuit against the manufacturer for full equitable indemnity in the state of New York, where the manufacturer is subject to personal jurisdiction. In that second lawsuit, the manufacturer will not be able to argue that its product was not defective, nor put on evidence of a proper design. Because it chose not to defend its product in the Iowa lawsuit, Commercial Code 2607 bars it from re-litigating any issue which was decided in Iowa. 40

21 If an tender is received under Commercial Code 2607(5)(A), special consideration should be given to the possible ultimate effect of not stepping in and defending the vendor -- even if no obligations are owed the vendor under either (1) the vendor's endorsement, or (2) an indemnity agreement. The practical effect of a failure to defend the named insured's product in such circumstances can be significant not only from the standpoint of the manufacture's inability to defend its product in a later lawsuit by the vendor, but also from the standpoint of a potential collateral estoppel effect on the issue of design defect which may be raised by plaintiffs in future lawsuits involving that product. 41