Liability insurance is not a warranty of an manufacturer's product. It
is only designed to provide coverage for accidental physical injury to property
of others.
In U.S. Metals, Inc. v. Liberty Mut. Grp., Inc., 2015 Tex. LEXIS
1081, 59 Tex. Sup. J. 144 (2015), the Texas Supreme Court was asked to resolve
a coverage issue by submitting certified questions to the Supreme Court so it
could resolve a coverage dispute filed in federal court.
Facts of the Case
U.S. Metals, Inc. sold ExxonMobil Corp. some 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 remove
sulfur from diesel fuel and operate under extremely high temperatures and
pressures. ExxonMobil 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 leaked. Further investigation
revealed that the flanges did not meet industry standards, and ExxonMobil
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
claimed indemnification from its commercial general liability (CGL) insurer,
Liberty Mutual Group, Inc., for the amount paid.
All damages for which U.S. Metals claimed coverage arose out of its
defective flanges. Under the policy’s Exclusion K, damages to the flanges
themselves were not covered, and U.S. Metals did not claim them. Under
Exclusion M, the policy did not cover damages to property, or for the loss of
its use, if the property was not physically injured or if it was restored to
use by replacement of the flanges.
Certified Questions
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 Fifth Circuit
Court of Appeals certified to the Texas Supreme Court the following
questions.
-
In the "your product" and "impaired property"
exclusions, are the terms "physical injury" and/or
"replacement" ambiguous?
-
If yes as to either, are the aforementioned interpretations offered by
the insured reasonable and, thus, must be applied pursuant to Texas
law?
-
If the first question above 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 court said that a thing whose use or function is diminished by the
incorporation of a faulty component can fairly be said to be injured, even if
the injury is intangible, latent, or inchoate. Here, the installation of the
leaky flanges—or at least potentially leaky and, in any event, below
standard—could certainly be said to have injured—harmed or damaged—the diesel
units by increasing the risk of danger from their operation and, thus, reducing
their value. But, the court said, if that increased risk amounted to physical
injury within the meaning of the CGL policy, then it is difficult to imagine a
nonphysical injury. The policy’s limitation of coverage to damages from
physical injury necessarily implied that there could be nonphysical, noncovered
injuries. Otherwise, the requirement that the injury be "physical"
would be superfluous. To give "physical" its plain meaning, a covered
injury must be one that is tangible.
The Texas Supreme Court agreed with most courts that have considered the
issue that the best reading of the standard-form CGL policy text is that
physical injury requires tangible, manifest harm and does not result merely
upon the installation of a defective component in a product or system. Since a
defective product that causes damage is not an occurrence until the damage
actually happens, it would be inconsistent to find that a defective product
that does not cause damage is nevertheless an occurrence at the time of
incorporation.
ExxonMobil’s diesel units were not physically injured merely by the
installation of U.S. Metals’ faulty flanges, but the units were physically
injured in the process of replacing the faulty flanges. Because the flanges
were welded to pipes rather than being screwed on, the faulty flanges had to be
cut out, the 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.
Thus, the court held, the repair costs and damages for the downtime were
"property damages" covered by the policy unless Exclusion M applied.
Exclusion M denied coverage of damages to impaired property—defined by the
policy as property that could be "restored to use by the …
replacement" of the faulty flanges.
The diesel units were restored to use by replacing the flanges and were
therefore impaired property to which Exclusion M applied. Thus, their loss of
use was not covered by the policy. But the insulation and gaskets destroyed in
the process were not restored to use; they were replaced. Therefore, they were
not impaired property to which Exclusion M applied, and the cost of replacing
them was covered by the policy.
As to the questions certified to us by the Fifth Circuit, the first asked
whether the terms "physical injury" or "replacement" were
ambiguous as incorporated into the "your product" or "impaired
property" exclusions of the CGL policy. The court said that the answer, in
the situation presented, is "no." The second question was conditioned
on a "yes" answer to the first and, thus, need not be answered. The
third question asked whether installation of the faulty flanges alone
physically injured the diesel units. The answer, the court said, was
"no."
Conclusion
The result in this case has, as the Texas Supreme Court stated, "a
perverse aspect to it." If ExxonMobil was negligent or reckless—had it not
tested the flanges, or had it found the defect but decided to risk the danger
of leaks—and an explosion had resulted, U.S. Metals would not be denied
coverage for the damages to persons and property for want of physical injury.
But, because ExxonMobil was careful and cautious, U.S. Metals was not entitled
to indemnity for the costs of remedying the installation of the faulty flanges.
The court said the text of the policy was clear and must be enforced.
© 2016 Barry Zalma, Esq., CFE