Today, in
U.S. Metals, Inc. v. Liberty Mutual Insurance Corp., the Supreme Court of Texas (i) rejected the so-called “incorporation theory” and held that the mere installation of faulty materials into a larger whole does not cause “physical injury” to that larger whole and, therefore, does not cause “property damage”; but also (ii) held that otherwise unimpaired property destroyed during repair/replacement of the faulty materials may be covered “property damage” under a standard form commercial general liability (“CGL”) policy.
A. Background Facts
Exxon Mobil Corporation (“Exxon”) filed suit against U.S. Metals, Inc. (“U.S. Metals”) in Texas state court, alleging that U.S. Metals agreed to manufacture standard, weld neck flanges meeting industry standards for installation in Exxon refineries. These flanges were irreversibly incorporated into the facilities by welding and bolting the flanges into insulated pipes of non-road diesel units at the refineries. Exxon discovered a leak in one of the installed flanges while conducting testing before putting the systems into operation. Exxon’s subsequent investigation revealed that U.S. Metals had subcontracted to a third-party the manufacturing of the flanges, and that the flanges had been improperly manufactured, not meeting the contractually required industry standards.
Exxon alleged that the only way to mitigate its damages and to avoid the risk of fire and explosion was to order new flanges from a different manufacturer and replace all the flanges supplied by U.S. Metals. Replacement of the flanges involved stripping the temperature coating and insulation (which were destroyed in the process), cutting the flange out of the pipe, removing the gaskets (which also were destroyed in the process), grinding the pipe surfaces smooth for re-welding, replacing the flange and gaskets, welding the new flange to the pipes, and replacing the temperature coating and insulation. The replacement process required portions of the refineries to be shut down for several weeks, resulting in the loss of use of the refineries.
In June 2011, Exxon brought suit against U.S. Metals seeking damages for the costs associated with investigating the flange defect, acquiring replacement flanges, removing and replacing the defective flanges, and the resulting loss of use of Exxon’s property, and incidental and consequential damages. Exxon alleged the replacement damages were $6,345,824 and the loss of use damages were $16,656,000. In August 2011, Exxon and U.S. Metals reached a settlement for $2.2 million.
U.S. Metals then claimed indemnification from its CGL insurer, Liberty, for the amount paid. U.S. Metals claimed coverage with Liberty based on a policy providing coverage for “bodily injury” and “property damage” (the “Policy”). Liberty denied U.S. Metals’ request based on policy the “your product” and “impaired property” exclusions.
B. The Certified Questions
U.S. Metals sued Liberty on December 8, 2011, in Texas state court, and the case ultimately was removed to federal district court. U.S. Metals’ First Amended Complaint alleged, among other causes of action
, breach of contract regarding Liberty’s duty to defend and indemnify. Liberty filed a motion for summary judgment and U.S. Metals filed an amended partial motion for summary judgment on the issue of liability. The district court granted Liberty’s motions and denied U.S. Metals’ motions. After U.S. Metals appealed, the Fifth Circuit certified the following four questions to the Supreme Court of Texas:
1. In the “your product” and “impaired property” exclusions, are the terms “physical injury” and/or “replacement” ambiguous?
2. If yes as to either, are the aforementioned interpretations offered by the insured reasonable and thus, must be applied pursuant to Texas law?
3. If the above question 1 is answered in the negative as to “physical injury,” does “physical injury” occur to the third party’s product that is irreversibly attached to the insured’s product at the moment of incorporation of the insured’s defective product or does “physical injury” only occur to the third party’s product when there is an alteration in the color, shape, or appearance of the third party’s product due to the insured’s defective product that is irreversibly attached?
4. If the above question 1 is answered in the negative as to “replacement,” does “replacement” of the insured’s defective product irreversibly attached to a third party’s product include the removal or destruction of the third party’s product?
C. The Court’s Analysis
The Supreme Court of Texas stated that these four questions boiled down to two issues. “One is whether property is physically injured merely by installing a defective product into it. . . The other issue is whether replacing the flanges restored the refinery property to use when some of the property was destroyed in the process.”
The Court began its analysis by reviewing the “convoluted provisions of the standard form CGL policy.” In particular, the Court set out the terms of the insuring agreement; the definitions of “property damage,” “your product” and “impaired property;” and the exclusions upon which Liberty relied—the “your product” and “impaired property” exclusions.
The Court then looked at what constitutes “physical injury.” The Court discussed the plain meaning of “physical” and “injury,” and the Court then reviewed a pair of cases that “explored” the meaning of “physical injury” under Illinois law. According to the Court, “the salient point to be drawn from
Eljer II is that physical injury, for purposes of the same CGL policy provision at issue here, resulted not from the mere installation but from the leak. Leaks from U.S. Metals’ flanges never caused injury because ExxonMobil replaced them to avoid any risk of injury.” The Court agreed with the Supreme Court of Illinois and the vast majority of courts that have read the standard form CGL policy to mean “that physical injury requires tangible, manifest harm and does not result merely upon the installation of a defective component in a product or system.” The Court recognized that its rejection of the incorporation theory results in a “perverse aspect” insofar as there is no coverage for a diligent and responsible insured that repairs defective work whereas there may be coverage for the negligent or reckless insured that allows the flanges to explode injuring people and property. Nonetheless, the Court concluded that the text of the policy was clear and that its role is “to determine not what coverage should be available but what the CGL policy here provided.” As such, the Court held that there was no physical injury “merely by the installation of U.S. Metals’ faulty flanges.” In doing so, the Court rejected the so-called “incorporation theory” and any life/safety exception to the “physical injury” requirement of the definition of “property damage.”
Having concluded that there was no physical injury as a result of the installation of the faulty flanges, the Court then held that there was physical injury as a result of replacing the faulty flanges. The faulty flanges could not be easily removed and replaced with new flanges. “Because the flanges were welded to pipes rather than being screwed on, the faulty flanges had to be cut out, pipe edges resurfaced, and new flanges welded in. The original welds, coating, insulation, and gaskets were destroyed in the process and had to be replaced. The fix necessitated injury to tangible property, and the injury was unquestionably physical.” In other words, the Court held that physical damage caused by the repair of merely defective work constitutes “property damage” under the terms of the CGL policy. Having found “property damage” caused by the repair, the Court then had to turn to the two exclusions raised by Liberty Mutual.
With respect to the “your product” exclusion, the Court noted that the defective flanges were unquestionably U.S. Metals’ product and, thus, there was no coverage for the flanges themselves. That, however, did not end the inquiry as the replacement of the flanges caused physical damage beyond the flanges. At least implicitly, the Court held that the “your product” exclusion is limited to the defective product itself.
Next, the Court turned to the ever-so-clear “impaired property” exclusion. U.S. Metals argued that the repairs involved much more than simply replacing the flanges, and as such, the refineries were not “impaired property”—property that could be “restored to use by the . . . replacement” of the faulty flanges. The Court rejected that argument, finding that replacing the faulty flanges is exactly what was required to restore the use of the refineries, and the policy made no distinction between an easy fix and a difficult one. The Court explained as follows:
The diesel units were restored to use by replacing the flanges and were therefore impaired property to which Exclusion M [i.e., the “impaired property” exclusion] applies. Thus, there loss of use is not covered by the policy. But the insulation and gaskets destroyed in the process were not restored to use; they were replaced. They were therefore not impaired property to which Exclusion M applied, and the cost of replacing them was therefore covered by the policy.
For those of you playing along at home, the faulty flanges did not create physical injury merely by being incorporated into the final project. Further, the loss of use of the refineries during the course of replacing the faulty flanges also was not covered because the refineries were “impaired property” subject to the “impaired property” exclusion. However, the gaskets and insulation that were destroyed during the process of cutting out the faulty and otherwise non-covered flanges suffered “property damage” that was covered by the policy.
Oh, and what about the Fifth Circuit’s four certified questions. No, the terms “physical injury” and “replacement” are not ambiguous. The second question does not require an answer because it is conditioned on a “yes” answer to the first question. No, the incorporation theory and the mere installation of faulty flanges into a larger project is not a “physical injury” and, therefore, not “property damage.” With regard to the fourth question, the answer is – dare we say – a convoluted “it depends.”
Commentary:
Although Lee claims he “predicted” this result at a speech he gave a few weeks back, the rest of us were not there, so we call “BS.” (After all, if a tree falls in the woods and no one is there to hear it, did it really make a sound?) For the record, Lee says that a tree that falls in the woods still makes a sound.
In all seriousness, the Court’s rejection of the “incorporation theory” is not surprising as the vast majority of courts across the country have done so. Likewise, it is not at all surprising that the Court concluded that the terms “physical injury” and “replacement” are not ambiguous. That being said, the “impaired property” exclusion as a whole is utterly confusing and requires several shots of Tequila before it even remotely makes the slightest bit of sense. To the extent that you try this route in analyzing the “impaired property” exclusion, please do not operate a vehicle or heavy machinery. And, if you have a headache for more than four hours, call a doctor.
The “rip and tear” ruling, however, is a potentially monumental sea-change in insurance coverage law in Texas. While some commentators thought the Court would find “physical injury” by way of the incorporation doctrine in situations where life/safety issues exist, the Court was not willing to rewrite the “convoluted” CGL policy—the Court’s words, not ours—to achieve that result. Nevertheless, the Court did find that the repair of
uncovered defective work could cause
covered “property damage.” In doing so, Texas arguably joins only a handful of other courts (see footnote 26 of the Court’s opinion).
Further, while some will argue that the Court’s holding simply follows from its prior ruling in
Lennar Corp. v. Markel American Insurance Co., 413 S.W.3d 750 (Tex. 2013), the two cases are different. In
Lennar Corp, the Supreme Court of Texas found coverage for removing defective EIFS and replacing it with traditional stucco. The Court, in that case, found that the costs to remove the EIFS and replace it with traditional stucco was damage
because of “property damage” because the defective EIFS had caused covered water damage to the homes. Here, on the other hand, the defective flanges had not caused any resulting damage upon installation. Rather, the only physical damage occurred during the replacement of the defective flanges themselves. Accordingly, if anything, the
U.S. Metals decision is an expansion of
Lennar Corp. and a good one at that—at least for policyholders.
The extent of that “rip and tear” coverage remains to be seen and we expect it will be heavily litigated in the coming years (and perhaps even on rehearing). In the meantime, stay tuned . . .
We’ve Got You Covered.
Sincerely,
Lee H. Shidlofsky
Member of Shidlofsky Law Firm
Douglas P. Skelley
Member of Shidlofsky Law Firm
Henri E. Nicolas, Jr.
Sr. Counsel of Shidlofsky Law Firm
