Product Recall: Determining Quantum

Article, Commercial Litigation JournalJanuary 2007

Insurance / Liability / Casualty

Tony Levitt investigates the cost of product recall and how claims should be quantified, highlighting pitfalls and problem areas.

The past 12 months have seen two very significant product recalls. First of all, in June this year we saw Cadbury Schweppes recall a range of products that the firm believed could potentially have been exposed to the bacteria which causes salmonella. Cadbury claimed that this incident would cost it around £20m. Then Dell recalled a number of laptop computers that were prone to spontaneous combustion when paired with Sony batteries. Again, it is expected that this will cost the business millions. In a typical product recall case, much time is spent on legal and insurance issues, such as determining the cause of the recall, whether laws or regulations were contravened, and who is responsible. However, the calculations for examining the actual cost of a recall are as important to understand as the cause.

The question of quantum is often overlooked while the initial energy is put into the product recall, followed by liability and blame. However, if quantum questions are not examined early on, the claims process can become extremely difficult, and could impact on the final settlement between the parties involved.

It is important to have a broad understanding of costs and damages before approaching the quantum of a specific claim.

Stages of product recall

The specific circumstances of any product recall need to be considered in determining quantum. However, certain characteristics often recur. These include:

1. Actual recall of the product
These costs are usually incurred at the time of the recall of the product.

2. Damage control
It is often necessary to advise customers and provide reassurance. This could include advertising, mail shots or broadcasts to the public.

3. The period when the product is not available to the market
Once the product has been removed from circulation, there may be a period during which there is no product to sell. Lost sales and increased costs could result during the period of re-organising and restarting production.

4. Relaunch of the product
There may be an ongoing loss of sales during the relaunch of the product on the market due, for example, to a continuing shortage of product.

5. Regaining market share and recovery of profit margin
The costs will depend on the measures required to recover normal levels of sales and could include an ongoing loss of sales and increased costs during the rehabilitation period.

6. Costs incurred
The costs of a product recall fall into two broad categories: actual costs and loss of profit. The actual costs comprise those incurred specifically as a result of the recall.

Examples are:

  • transport and logistics 
  • disposal/destruction 
  • warehousing/storage 
  • advertising 
  • repayments to customers for product withdrawn; and 
  • third party consultants or contractors.

The other area of quantum is loss of profit, where there has been a reduction in sales of the product as a direct consequence of the withdrawal, and increased costs of working as the company may have incurred an increase in its own operating costs as a result of the withdrawal. These costs could include staff overtime and increased production and/or packaging costs.

However, this does raise a problem in determining quantum. Although it may appear self-evident that the costs should be incurred before making a claim, in practice this does not always happen. The damaged items may not be replaced, or the company could claim
for a recall that has not yet taken place. In these circumstances, the company
often seeks indemnity from its insurer or a third party on the basis that it will incur the costs once it has received the funds to do so. This raises two questions: whether the recall is really necessary; and whether it will ever take place even if funds are received.

The argument as to whether there is actual damage to the product or merely potential damage has a bearing on quantum and whether costs will ever be incurred and, if so, to what extent.

7. Insurance
There may be an insurance policy to cover the cost of a product recall. This will provide the framework for calculation of quantum. It could identify specific costs to be covered (or excluded) and may stipulate that the costs must be reasonable. It will also specify whether a loss of profits is to be covered and, if so, the period of indemnity.

These policies often cover three types of insured events:

  • Accidental contamination (such as the Cadbury salmonella case) – this occurs when there is a problem in the production, preparation, manufacture, packaging or distribution of a product which could give rise to personal injury, including illness, or death of a person. The policy may also respond if the event could give rise to physical damage or destruction to insured property. 
  • Malicious contamination (or tampering) – this occurs when there is actual, alleged or threatened wrongful alteration or contamination to products, making them unfit or dangerous for their intended use or consumption. 
  • Product extortion – this involves a threat to commit malicious tampering with the purpose of obtaining money under duress from the insured.

One of the issues that arises from the policy wording is that the damage may not have occurred. It may be only the threat or possibility of damage, or even an impression created with the public. So if the public thought that a product was contaminated, a recall
may be appropriate. The policy may stipulate that the costs need to be reasonable, having regard to the specific circumstances giving rise to the recall.

Many of the costs incurred will be similar in nature irrespective of whether the
contamination is accidental or malicious. However, the policy may provide for specific costs to be included (or excluded) under certain circumstances.

Problem areas
There are a number of areas that give rise to questions in determining quantum in a product recall. Some of these are discussed below.

Proportion
Although there may be no difficulty with the type of costs incurred, questions arise regarding the amounts and whether they needed to be incurred. If remedial costs were incurred, then how much is enough? An investigation may be required to determine whether all the costs were necessary, or if they are excessive – for example, expenditure on advertising and marketing to rehabilitate the product could be substantial.

The proportion needs to be a balance between the cost of restoring the product in the shortest time, and the loss of sales that could arise if the costs are not incurred. One measure of proportionality that impacts on quantum is to consider when the benefit of costs such as advertising and marketing will be felt. If this is after the period of claim, then the costs are likely to be considered excessive.

Period of loss
When there is a claim for loss of profit, there is often a question as to the length of the period of the loss. In the absence of a defined period of indemnity in the policy, it could be open-ended. In general, it should end when the product returns to pre-loss levels of sales, but this is not always the case.

There may be various factors unrelated to the loss which could extend the time it takes for the product to regain its market share -for example, the company may have decided to use the opportunity to redesign its product, the packaging or the production process. It then becomes a question as to when the loss period should be cut off to account for the longer period of rehabilitation.

Loss of sales
The starting point for a quantification of a loss of sales is to consider the level of sales of the affected product prior to the recall and to measure the shortfall until sales recover their pre-loss levels. However, there are many other factors to be considered. It may be that the company sells complementary products and customers may switch to those other products (for instance, in the Cadbury case, looking at whether sales of Fruit & Nut bars compensated for a drop in sales of Dairy Milk). If so, this ‘make-up’ needs to be deducted from any loss of sales. Even if there is no make-up due to product substitution, there may still be a credit to the claim for other reasons. It is possible that customers will wait until the product is again available for sale and then make the purchase. This often relates to products that are not bought frequently, such as computers, but would not apply to a bar of chocolate.

The loss of sales identified must be related directly to the product recall. Where a company is experiencing difficulties, either internally or through competitor activity, it is tempting to blame all its misfortunes on the incident. The investigation into the loss of sales will need to focus on the reasons for it and to ensure it has arisen as a direct result of the product recall.

Conclusion

It is possible to identify the costs likely to be incurred in a product recall. However, in quantifying the damage arising from one, there are many issues that could impact on the amount to be indemnified. The company’s reaction to the problem, the extent of the recall and the timing will all affect quantum, as will the company’s ability to restore its product in the most cost effective manner.

Instead of leaving the analysis of quantum to the end of the claim review process, it should be addressed at the time of the recall to assist in the decisions about how much to spend and when to do so. The anticipated costs and benefits should be properly considered to avoid arguments in determining quantum.

 

As appeared in Commercial Litigation Journal, January 2007.

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