Property Is Not “Physically Injured” Merely by Installation of a Defective Product, Texas Supreme Court Holds

The Texas Supreme Court, on certified questions from the U.S. Court of Appeals for the Fifth Circuit, has ruled that property was not physically injured for purposes of the “your product” and “impaired property” exclusions in a standard-form commercial general liability (“CGL”) insurance policy merely by the installation of a defective product into the property.

The Case

U.S. Metals, Inc., sold ExxonMobil Corp. 350 custom-made, stainless steel, weld-neck flanges for use in constructing non-road diesel units at its refineries in Baytown, Texas, and Baton Rouge, Louisiana. The units removed sulfur from diesel fuel and operated under extremely high temperatures and pressures. ExxonMobil had contracted for flanges made to meet industry standards and designed to be welded to the piping. The pipes and flanges, after they were welded together, were covered with a special high temperature coating and insulation.

In post-installation testing, several flanges allegedly leaked. After further investigation, ExxonMobil said it determined that the flanges did not meet industry standards, and it decided it was necessary to replace them to avoid the risk of fire and explosion.

For each flange, this process involved stripping the temperature coating and insulation (which were destroyed in the process), cutting the flange out of the pipe, removing the gaskets (which were also 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 delayed operation of the diesel units at both refineries for several weeks.

ExxonMobil sued U.S. Metals for $6,345,824 as the cost of replacing the flanges and $16,656,000 as damages for the lost use of the diesel units during the process. U.S. Metals settled with ExxonMobil for $2.2 million and then sought indemnification from its commercial general liability (“CGL”) insurer, Liberty Mutual Group, Inc., for the amount paid.

Liberty Mutual denied coverage, and U.S. Metals sued in federal district court to determine its right to a defense and indemnity under the policy. The court granted summary judgment for Liberty Mutual.

On appeal, the U.S. Court of Appeals for the Fifth Circuit certified to the Texas Supreme Court a number of questions inquiring about the meaning of “physical injury” and “replacement” in the CGL policy and their application in this situation, including:

In the “your product” and “impaired property” exclusions, are the terms “physical injury” and/or “replacement” ambiguous?
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?
The Texas Supreme Court’s Decision

The court ruled that the installation of the allegedly faulty flanges did not physically injure the diesel units when the only harm at that point was the risk of leaks.

In its decision, the court found that the heart of the dispute was whether property was physically injured simply by the incorporation of a faulty component with no tangible manifestation of injury.

It decided that physical injury for purposes of the standard-form CGL policy required tangible, manifest harm and did not result “merely upon the installation of a defective component in a product or system.” According to the court, any physical injury in this case would have resulted not from the installation of the flanges but from resulting leaks. However, the court pointed out, U.S. Metals’ flanges had never caused any injury because ExxonMobil had replaced them to avoid any risk of injury.

Therefore, the court stated, U.S. Metals was not entitled to indemnity for the costs of remedying the installation of the allegedly faulty flanges.

In summary, the court answered “no” to the first certified question – whether the terms “physical injury” or “replacement” were ambiguous as incorporated into the “your product” or “impaired property” exclusions of the CGL policy.

With respect to the question asking whether installation of the allegedly faulty flanges alone physically injured the diesel units, the court concluded that the answer to that also was “no.”

The case is U.S. Metals, Inc. v. Liberty Mutual Group, Inc., No. 14-0753 (Tex. Dec. 4, 2015).

Rivkin Comment

The Texas Supreme Court decision provides a nice survey of the law on this issue. Twelve state supreme courts in addition to the Texas Supreme Court have considered whether to adopt the “incorporation theory” in interpreting “physical injury” in CGL policies.

Of those dozen, five have rejected the theory expressly. See, U.S. Fire Ins. Co. v. J.S.U.B., Inc., 979 So. 2d 871 (Fla. 2007) (recognizing that the “mere inclusion of a defective component” is not property damage); Travelers Indem. Co. of Am. v. Moore & Assocs., Inc., 216 S.W.3d 302 (Tenn. 2007) (same); United Natl Ins. Co. v. Frontier Ins. Co., 99 P.3d 1153 (Nev. 2004) (determining that damage to a welded steel sign occurred at the time the sign collapsed in a windstorm, not at the time the sign was negligently attached to its frame); Wyo. Sawmills, Inc. v. Transp. Ins. Co., 578 P.2d 1253 (Ore. 1978) (rejecting the insured’s argument that defective studs “became integrated into and were made a part of the building and their subsequent warping was damage to the building whether the damage was limited to the studs or not”); see also Taylor Morrison Servs., Inc. v. HDI-Gerling Am. Ins. Co., 746 S.E.2d 587 (Ga. 2013) (quoting the decision in J.S.U.B. approvingly but failing to reach the “property damage” issue).

Five state supreme courts have implicitly rejected the incorporation theory by holding that property damage covered under a CGL policy did not include defective work or a defective component alone, but would include damage caused by that defective work or component to other property. See, Capstone Bldg. Corp v. Am. Motorists Ins. Co., 67 A.3d 961 (Conn. 2013); Crossmann Cmtys. of N.C. Inc. v. Harleysville Mut. Ins. Co., 717 S.E.2d 589 (S.C. 2011); Concord Gen. Mut. Ins. Co. v. Green & Co. Bldg. & Dev. Corp., 8 A.3d 24 (N.H. 2010); Vogel v. Russo, 613 N.W.2d 177 (Wis. 2000) (abrogated on other grounds); cf. Mut. of Enumclaw Ins. Co. v. T & G Constr., Inc., 199 P.3d 376 (Wash. 2008) (damage caused by the defective siding to the subsurface and interior walls, installed not by the insured but by others, was property damage covered by the policy; thus, removal and reinstallation of the siding to repair damage to the walls was within the scope of property damage).

Only two state high courts have followed the incorporation theory. In a 1999 decision, the Wyoming Supreme Court noted, without further analysis, that “[i]t is well-recognized that the installation of a defect into a building is physical injury as defined in insurance policies.” Helm v. Board of County Comm’rs, 989 P.2d 1273 (Wyo. 1999). The Supreme Court of Montana adopted the incorporation theory for a case involving the application of defective paint to water pipes and tanks. Swank Enters., Inc. v. All Purpose Servs., Ltd., 154 P.3d 52 (Mont. 2007) (holding that “physical injury” for purposes of “property damage” under a CGL policy refers to a physical and material alteration resulting in a detriment).

It is worth noting that New York’s highest court, the New York Court of Appeals, in applying the incorporation theory in a limitations case, cited approvingly insurance coverage cases holding that injury-in-fact occurred when a defective component was integrated into a larger product, and that the trigger date for coverage was the date of installation. See MRI Broadway Rental, Inc. v. U.S. Mineral Prods. Co., 704 N.E.2d 550 (N.Y. 1998) (citing Sturges Mfg. Co. v. Utica Mut. Ins. Co., 332 N.E.2d 319 (N.Y. 1975) (explaining, in a case involving defective components in ski bindings, that “[w]hen one product is integrated into a larger entity, and the component product proves defective, the harm is considered harm to the entity to the extent that the market value of the entity is reduced in excess of the value of the defective component”), and Md. Cas. Co. v. W. R. Grace & Co., 23 F.3d 617 (2d Cir. 1993) (“holding that installation of asbestos is an occurrence of damage-in-fact and triggers the insurance coverage in effect at that time”)); see also Hoechst Celanese Corp. v. Certain Underwriters at Lloyd’s London, 673 A.2d 164 (Del. 1996) (rejecting, as a matter of New York law, that “‘property damage’ occurs only at the time of a leak in the plumbing system, or when the homeowner decides to replace the system”).

Several other state and federal courts have rejected the incorporation theory. For example, the U.S. Court of Appeals for the Eighth Circuit has concluded that the incorporation of defectively welded pipe sections into a larger piping structure was not physical injury: “[T]here is no ‘property damage’ unless and until the incorporation of a defective product or component results in ‘physical injury to tangible property’ in at least some part of the system.” Esicorp, Inc. v. Liberty Mut. Ins. Co., 266 F.3d 859 (8th Cir. 2001). In New Hampshire Insurance Co. v. Viera, 930 F.2d 696 (9th Cir. 1991), the Ninth Circuit concluded that the policy’s 1973 addition of “physical” meant that mere diminution in value caused by the incorporation of the insured’s defective products was not covered property damage under the post-1986 version of the policy.

An appellate court in Texas found no coverage for costs to repair defective welds where “the welds were never ‘in an initial satisfactory state that was changed by some external event into an unsatisfactory state'” because they were defective to begin with. N. Am. Shipbuilding, Inc. v. S. Marine & Aviation Underwriting, Inc., 930 S.W.2d 829 (Tex. Ct. App. 1996) (quoting Trinity Indus., Inc. v. Ins. Co. of N. Am., 916 F.2d 267 (5th Cir. 1990)).