In an unpublished decision, the Ninth Circuit Court of Appeals recently used extrinsic evidence to interpret the meaning of “direct supplier” in the context of a commercial property loss.1 I previously blogged about this case in 9th Circuit to Interpret Meaning of “Direct Supplier” In Context of a Commercial Property Loss Claim.

In summary, the issues giving rise to the appeal were:

  • In 2011 monsoons flooded two factories in Thailand run by Western Digital. Western Digital was DirecTV’s exclusive supplier for hard drives used in DirecTv’s digital video recorders. The flood caused damage to the hard drives and financial losses to DirecTV;
  • DirecTV’s business interruption coverage extended to losses occurring at all insured locations, including any location “of a direct supplier, contract manufacturer or contract service provider to [DIRECTV].” Importantly, the term “direct supplier” was not defined in the insurance policy;
  • The hard drives created by Western Digital were not sent directly to DirecTV. Instead, they were first sent to third party assemblers for incorporation into DirecTV’s digital video recorders before they were sent to DirecTV;
  • Western Digital did not have a contract in place with DirecTV;
  • Although DirecTV did not have a contract with Western Digital and technically did not send the hard drives directly to DirecTV, because the insurance policy did not define the term “direct supplier” DirecTV urged the trial court to consider parol evidence to help interpret its meaning. Specifically, DirecTV asked the trial court to evaluate the trade usage of the term, and specifically that “direct supplier,” is a technical phrase that’s long been used in the supply chain industry, and should be considered synonymous with a “customer-controlled component supplier.”
  • The trial court however granted Factory Mutual’s motion for summary judgment on the grounds that Western Digital was not a “direct supplier.”

After DirecTV filed an appeal, the Ninth Circuit had to consider how the term “direct supplier” should the term be interpreted, when not defined in a commercial insurance policy, and should insurers and the courts be required to apply an industry specific definition to meet the insured’s reasonable expectations.

The Ninth Circuit Court of Appeals ruled as follows:

1. The plain and ordinary meaning of the phrase “direct supplier” does not include Western Digital. The “meaning a layperson would ordinarily attach” to the phrase “direct supplier,”… is a supplier that sends its goods or materials straight to the insured without intervening processing. Because Western Digital’s hard drives are sent to third-party set-top box manufacturers, which then assemble the set-top boxes and send them on to Plaintiff, Western Digital is not Plaintiff’s “direct supplier” under the plain and ordinary meaning of that phrase.

2. Western Digital is not Plaintiff’s “contract manufacturer” or “contract service provider” because it does not have a contract with Plaintiff.

3. In light of the extrinsic evidence of trade usage introduced by Plaintiff, the phrase “direct supplier” is “reasonably susceptible” to the meaning urged by Plaintiff. Wolf v. Superior Court, 8 Cal. Rptr. 3d 649, 655 (Ct. App. 2004). In reaching that conclusion, we rely on a prediction that the Supreme Court of California would hold that “[t]he law charges insurance companies with the duty of informing themselves as to the usages of the particular business insured, and a knowledge of such usage on the part of such company will be presumed.” … Whether the phrase “direct supplier” was intended in a trade usage sense and, if so, whether Western Digital falls within the trade usage definition are questions of fact to be resolved by a jury. City of Hope Nat’l Med. Ctr. v. Genentech, Inc., 181 P.3d 142, 156–57 (Cal. 2008).

This decision makes sense. If a business is going to pay large premiums to an insurance company to insure its business, the insurer should have a working understanding of the insured’s business. During the underwriting process, insurers have the opportunity to diligently inform themselves of the insured’s business risks. While an insurer may not wish to narrowly define insured risks in the policy itself (because insurers use the policy form for different business in different industries), it is entirely reasonable for an insured to expect that an insurer will apply an industry specific meaning to an undefined term such as “direct supplier.”
1 DirecTV v. Factory Mutual Ins. Co., No. 16-55313, 2017 WL 2629134 (9th Cir. June 19, 2017).