Difficulty in Proving Lost Business Income
A standard ISO definition of business income is as follows:
a. Net Income (Net Profit or Net Loss before income taxes) that would have been earned or incurred; and
b. Continuing normal operating expenses incurred, including payroll.
For manufacturing risks, net income includes the net sales value of production.[3]
In some instances, it is apparent that a policyholder suffers loss of income as a result of business interruption. Consider a policyholder that is a manufacturer under a contract to produce a certain number of goods in a specific time frame. If the manufacturer is in the process of manufacturing those goods but has to stop as a result of a business interruption and consequently loses a portion of the contract to a competing manufacturer, the policyholder clearly lost business income. Any coverage dispute will likely revolve around whether the loss is a covered loss or how to calculate the amount of the loss.
Oftentimes, however, the proof is more complicated. Without a clearly identifiable lost sale, lost earnings can be difficult to establish or calculate with precision. This fact is not lost on courts.[4] Obviously, a manufacturer that receives no new orders during the period of restoration has lost production that might otherwise be turned into profit. And if the lack of orders directly results from the covered peril (e.g., customers cannot place orders during the period of restoration, or they choose not to place orders knowing they cannot be fulfilled), the manufacturer has clearly suffered lost income. But that manufacturer may not be able to point to any particular lost contract. Similarly, a manufacturer able to fulfill all orders from existing inventory will not be able to prove any lost contract during the period of restoration, but the manufacturer has nevertheless lost production and inventory that would otherwise have been sold for profit in the future.
Net Sales Value of Production and Inventory Use
Several courts have ruled that lost production is not covered under the business interruption portion of the policy without proof of lost profits.[5] Under this reasoning, if a manufacturer is required but unable to establish lost profits, the manufacturer may recover only the “extra expense[s] necessary to prevent loss of earnings.”[6] This commonly arises in a situation where the manufacturer has excess inventory at the time of the interruption or suspension of production, and is able to fulfill all orders during the period of restoration with inventory. For example, in Northwestern States Portland Cement Co. v. Hartford Fire Insurance Co.,[7] a manufacturer sustained property damage and lost production capacity of clinker, a necessary ingredient for the production of cement, for a period of time. Although the clinker production facility suffering the interruption was otherwise in continuous operation, the court ruled that the policyholder had not proven loss of income. The court noted that clinker itself had “no readily ascertainable market price,” and observed that the policyholder’s use of excess inventory of clinker during the interruption period “prevent[ed] any loss of sales from occurring.”[8] The court allowed the policyholder to recover “such expenses, in excess of normal, as would necessarily be incurred in replacing any finished stock used to reduce the loss.”[9]
Many of the cases rejecting lost production calculations without proof of lost sales are distinguishable because they did not address policy language redefining business income for manufacturers as the “net sales value of production.”[10] Policyholders may find a receptive audience for an argument that the contracting parties’ inclusion of this language allows the policyholder to use the value of lost production as an alternative to establishing lost profits.
In Whemco-Ohio Foundry, Inc. v. Hartford Steam Boiler Inspection & Insurance Co.,[11] for example, the court held that Hartford’s policy language did not preclude a “lost production” method of calculating the amount of a manufacturer’s business interruption loss nor “indicate that a ‘lost sales’ method is the only way to determine damages.”[12] Recognizing that the manufacturer produced a made-to-order product, rather than an assembly line product, the court found “more than one way to prove a loss under the policy” and allowed the jury to consider both the manufacturer’s “lost production” methodology as well as the insurer’s “lost sales” methodology.[13]
When Production Loss Equals Lost Sales
Several manufacturers have found success in arguing that any loss of production necessarily resulted in a loss of business income, based on factors such as continuous plant operations, product demand, lack of excess inventory, value of each marginal unit produced, and business model.
The Fourth Circuit has found lost production equivalent to lost sales in establishing business interruption where a manufacturer had no warehouse stock and its other plants were operating at full capacity already.[14]
In Rubbermaid, Inc. v. Hartford Steam Boilers Inspection Co., a manufacturer failed to present any proof of lost sales to particular customers during the period of interruption, but the court nevertheless found a business interruption loss where the manufacturer established, among other things, that it “was selling all of the product it could make and had customers waiting for the product.”[15] The court also relied on evidence that sales declined during the period of restoration, on records of sales prior to the loss, on an increase in sales for the entire product line, on the pre-loss growth of business with a particular customer, on forecasted sales, and on the need for a commercially reasonable inventory.
In Vinyl-Tech Corp. v. ’Continental Casualty Co., the court rejected an insurer’s motion for summary judgment on a manufacturer’s business interruption claim because the manufacturer provided evidence the factory ran continuously 365 days a year, sold all of its production, and made a net profit from each marginal unit of production.[16] The court held that in such situations, “any interruption in production will produce an actual loss of net profit.”[17] Although the plaintiff was able to satisfy all of its sale obligations during the interruption period with excess inventory, and was therefore unable to identify any lost sales or unfulfilled orders during the interruption period, the policyholder was able to avoid summary judgment with evidence of continuous operation, demand for every unit produced, and the value from each marginal unit produced. The court explained that, while the policy required the manufacturer to use its existing inventory, under the circumstances, “such use will not prevent an actual loss of net profits because any product, including inventory, could have been sold at a net profit.”[18] The policyholder could establish lost income with proof at trial that “it could have sold all of the inventory on hand when the accident occurred and all of the output it could have produced during the interruption period or that, due to business requirements, [it] had to replenish its inventory after the interruption and lost profits on the production that was diverted to replenish inventory.”[19] Thus, the manufacturer could recover if it established it “could have filled orders, or it could have made sales, ‘but for’: (1) the interruption of its business, or (2) a business necessity to replenish its stock after the interruption.”[20] The court also held that the policy covered losses manifesting within a “reasonable or foreseeable” time beyond the period of interruption.
Similarly, a manufacturer that can show production halted during a period when each marginal unit produced would have generated a net profit has arguably established that the use of inventory did not prevent the business loss. For example, in In re S.N.A. Nut Co., the insurer initially argued that the policyholder’s business interruption claim wrongly “equated lost production with lost sales.”[21] In response, the policyholder narrowed its claim for business interruption to only that time period when the policyholder “historically . . . sells every nut it processes, arguably making [its] production capacity equal to its lost sales.”
Thus, the policyholder’s access to excess inventory and its ability to exhaust that inventory are potentially useful tools to evaluate the net sales value of production during an interruption period—and possibly even prove a business income loss absent proof of any individual lost sale. On the other hand, stagnation or growth of inventory during the recovery period tends to prove there was no business income loss. A policyholder that claims lost earnings but cannot sell the excess inventory in its possession likely cannot show any loss of business income.[22]
Incentive-Based Contracts
Incentive-based contracts have also provided courts justification to reject any lost sale requirement in favor of proof based exclusively on the lost sales value of production. In Northrop Grumman Corp. v. Factory Mutual Insurance Co., the manufacturer produced ships for the navy under long-term contracts providing reimbursement of the manufacturer’s allowable costs and an incentive fee for quicker completion.[23] Hurricane Katrina caused a shutdown of shipbuilding operations and delay in completing existing orders but did not result in the loss of any contract. The policy covered loss of “gross earnings,” defined as “the net sales value of production less the cost of all raw stock, materials and supplies used in such production.” The court held that, at least for this type of contract, requiring a lost sale as well as lost production would undermine the business interruption insurance purchased by Northrop. The court distinguished the line of cases requiring proof of a lost sale on the basis that, in those cases, “production and sales are linked together in a more direct way” than they are in a cost-reimbursement contract.[24] It also noted that the types of contracts entered into by Northrop require a different accounting paradigm based on the percentage of completion of the project. Thus, Northrop would be permitted to use that paradigm to establish lost business income at trial.
Northrop recognizes a different potential path for proving lost income even without proof of lost sales. Manufacturers with incentive-based fees in their sales contracts, or other nontraditional sales models, might establish lost income even without proof of particular lost sales.
Conclusion
Manufacturers struggling to identify specific lost sales contracts or business opportunities during the period of restoration should consider an alternative argument for lost business income based on lost production under the altered definition of business income as including the “net sales value of production” for manufacturing risks. While several courts have rejected policyholder arguments for business income loss without proof of any lost sales, others have shown a willingness to use lost production as the measure of loss where such a methodology is not precluded by policy language or where the unique aspects of the policyholder’s business support a conclusion that lost production is equivalent to lost sales. Thus, a manufacturer unable to identify lost sales with precision should consider whether it might be able to rely on the sorts of factors identified by the courts in U.S. Gypsum Co., Rubbermaid, Vinyl-Tech, and Northrop: continuous operation of the facility (or at least restrictions that limit the ability to mitigate damages through increased production); product demand in excess of production; lack of inventory (after consideration of the minimum commercially reasonable inventory level); type of sales contract; and other factors dependent on the particular business model.
Christina Arnone and Christopher Sevedge are with Stinson Leonard Street LLP in Kansas City, Missouri.
[1] See, e.g., Vinyl-Tech Corp. v. Cont’l Cas. Co., No. CIV. A. 99-1053-CM, 2000 WL 1744939, at *7 (D. Kan. Nov. 15, 2000) (policy issued to manufacturer covered losses manifesting within a “reasonable or foreseeable” time after the period of restoration); Bernstein Liebhard LLP v. Sentinel Ins. Co., Ltd., 2018 N.Y. Misc. LEXIS 322, at *4–5 (N.Y. Sup. Ct. N.Y. Cty. Jan. 23, 2018) (granting partial summary judgment in favor of law firm calculating business income losses incurred in 12-month period after a fire loss as the contingency fee revenue the firm would have received from settlements or awards in cases the firm would have initiated during those 12 months); Nat’l Union Fire Ins. Co. of Pittsburgh, Pa. v. TransCanada Energy USA Inc., 25528 N.Y.S.3d 800, 811 (N.Y. Sup. Ct. Mar. 2, 2016) (permitting insured to recover lost business income from reduced capacity to generate electricity during period of restoration to sell at auctions after period of restoration).
[2] See, e.g., ISO CP 00 30 10 12.
[3] See, e.g., ISO CP 00 30 10 12.
[4] See, e.g., Citadel Broad. Corp. v. Axis U.S. Ins. Co., 162 So. 3d 470, 475 (La. Ct. App. 2015) (declining to require the policyholder to provide customer-by-customer proof of revenue loss).
[5] Pennbar Corp. v. Ins. Co. of N. Am., 976 F.2d 145 (3d Cir. 1992); Nw. States Portland Cement Co. v. Hartford Fire Ins. Co., 360 F.2d 531, 533–34 (8th Cir. 1966); Nat’l Union Fire Ins. Co. v. Anderson-Prichard Oil Corp., 141 F.2d 443, 445 (10th Cir. 1944); Fold-Pak Corp. v. Liberty Mut. Fire Ins. Co., 784 F. Supp. 49, 53–54, 59 (W.D.N.Y. 1992); Lyon Metal Prods., LLC v. Prot. Mut. Ins. Co., 747 N.E.2d 495, 505 (Ill. App. Ct. 2001); Metalmasters of Minn., Inc. v. Liberty Mut. Ins. Co., 461 N.W.2d 496 (Minn. Ct. App. 1990).
[6] Lyon, 747 N.E.2d at 505.
[7] Nw. Portland Cement Co. v. Hartford Fire Ins. Co., 360 F.2d 531, 532–33 (8th Cir. 1966).
[8] Northwestern States Portland Cement Co., 360 F.2d at 534.
[9] Northwestern States Portland Cement Co., 360 F.2d at 534. See also Lyon Metal Prods., 747 N.E.2d at 505-507 (no business income loss where insurer paid full selling price for policyholder’s inventory); Stone Container Corp. v. Arkwright Mutual Ins. Co., No. 93-6626, 1997 U.S. Dist. LEXIS 3978 (N.D. Ill. Mar. 25, 1997) (excess stock precluded business interruption loss).
[10] The Portland Cement policy, however, defined “Gross Earnings” as the sum of “(a) Total net sales value of production, (b) Total net sales of merchandise, and (c) Other earnings derived from operation of the business, less the cost of: (d) Raw Stock from which such production is derived.” Northwestern States Portland Cement Co. v. Hartford Fire Ins. Co., 243 F. Supp. 386, 388 (S.D. Iowa 1965). The district court held that, in some situations, “an insured might well receive the market value of the loss of his production, but not in this case where the only loss was stock which was lost because of the effort to reduce the loss.” Northwestern States Portland Cement Co., 243 F. Supp. at 389. See also Stone Container Corp. v. Arkwright Mut. Ins. Co., No. 93-6626, 1997 U.S. Dist. LEXIS 3978, at *5 (N.D. Ill. Mar. 25, 1997) (rejecting manufacturer’s argument that the policy did not require it to prove lost sales because “gross earnings” were defined as “the net sales value of production” on the grounds there still had to be an “actual loss” of net sales value).
[11] Whemco-Ohio Foundry, Inc. v. Hartford Steam Boiler Inspection & Ins. Co., 2010 WL 11569521 (N.D. Ohio Nov. 23, 2010).
[12] Whemco-Ohio Foundry, Inc., 2010 WL 11569521, at *1.
[13] See also Welspun Pipes Inc. v. Liberty Mut. Fire Ins. Co., No. 4:13CV00418, 2017 U.S. Dist. LEXIS 14520, at *15 (E.D. Ark. Feb. 2, 2017) (to establish lost business income, manufacturer had to show “a decrease in the net sales value of production” under Liberty Mutual policy defining business income for manufacturing operations as “the net sales value of production less the cost of all raw stock, materials and supplies utilized in such production”).
[14] Ins. Co. of N. Am., Inc. v. U.S. Gypsum Co., Inc., 870 F.2d 148, 154 (4th Cir. 1989).
[15] Rubbermaid, Inc. v. Hartford Steam Boilers Inspection Co., 645 N.E.2d 116, 118–19 (Ohio Ct. App. 1994).
[16] Vinyl-Tech Corp. v. Cont’l Cas. Co., No. CIV. A. 99-1053-CM, 2000 WL 1744939 (D. Kan. Nov. 15, 2000).
[17] Vinyl-Tech Corp., 2000 WL 1744939, at *3.
[18] Vinyl-Tech Corp., 2000 WL 1744939, at *3.
[19] Vinyl-Tech Corp., 2000 WL 1744939, at *4.
[20] Vinyl-Tech Corp., 2000 WL 1744939, at *7.
[21] In re S.N.A. Nut Co., 210 B.R. 140, 142 (Bankr. N.D. Ill. 1997).
[22] See Felman Prod. Inc. v. Indus. Risk Insurers, No. 3:09-0481, 2011 U.S. Dist. LEXIS 112156, at *14–15 (S.D. W. Va. Sep. 29, 2011) (manufacturer unable to identify any existing contracts or business opportunities not realized could not recover for business interruption where the manufacturer also had growing inventory above its sales).
[23] Northrop Grumman Corp. v. Factory Mut. Ins. Co., No. CV 05-08444 DDP (PLAx), 2013 U.S. Dist. LEXIS 100804, at *31–32 (C.D. Cal. July 31, 2013).
[24] Northrop Grumman Corp., 2013 U.S. Dist. LEXIS 100804, at *33.