Last Friday, the Texas Supreme Court answered controversial coverage questions certified by the Fifth Circuit. The issues in U.S. Metals, Inc. v. Liberty Mut. Grp., Inc., No. 14-0753, 2015 WL 7792557 (Tex. December 4, 2015), arose out of damage caused by defective steel flanges installed in an oil refinery by an insured, which raised questions of whether certain types of resulting damage were excluded under the property-damage provisions of a commercial-general-liability policy (CGL). 

The insured, U.S. Metals, Inc., sold ExxonMobil Corporation several steel flanges for Exxon to use in constructing diesel units at Exxon’s refineries in Baytown, Texas and Baton Rouge, Louisiana. Exxon contracted for flanges meeting industry standards to withstand extremely high temperatures and pressures. During post-installation testing, several flanges leaked, and Exxon’s investigation revealed that the flanges failed to meet industry standards. Fixing this problem required removing the flanges and surrounding materials at significant expense, which delayed operation of the diesel units for several weeks.

Exxon sued U.S. Metals for $6,345,824, the cost to replace the flanges and $16,656,000 in damages for the lost use of the diesel units. U.S. Metals settled with Exxon for $2.2 million and then sought indemnification from its CGL insurer, Liberty Mutual Group, Inc.

The Liberty Policy provided coverage for “those sums that [U.S. Metals] becomes legally obligated to pay as damages because of…’property damage’ to which this insurance applies…” The Policy defined ‘property damage’ as “[p]hysical injury to tangible property, including all resulting loss of use of that property”, and “[l]oss of use of tangible property that is not physically injured…” Two exclusions were at issue in this case: (1) Subparagraph K for “property damage” to U.S. Metals’ products; and (2) Subparagraph M for “’property damage’ to ‘impaired property’ or property that has not been physically injured, arising out of…[a] defect, deficiency, inadequacy or dangerous condition in ‘your product’…” The Policy defined “impaired property” as “tangible property, other than ‘your product’…, that cannot be used or is less useful because (a) it incorporates ‘your product’…that is known or thought to be defective, deficient, inadequate or dangerous…if such property can be restored to use by the repair, replacement, adjustment or removal of ‘your product’…or your fulfilling the terms of the contract or agreement.”

The Court first noted that Exclusion K excluded damage to the flanges themselves. It then turned to the primary issues certified by the Fifth Circuit: (1) whether the mere installation of the flanges constituted “physical injury” to the diesel units when the only harm at that point was the risk of leaks, and not any actual manifestation of property damage; and (2) whether property is “restored to use” by replacing a faulty component when the property must be altered, damaged, and repaired.  

The first issue turned on whether mere risk of physical damage caused by a defective component was the same as “physical injury” within the meaning of the Policy. The Court observed that even though the defective flanges leaked, Exxon replaced them before they caused any actual damage. The Court looked to how courts in several other jurisdictions have split on the issue and agreed with a majority of these courts 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 noted that this result was consistent with related Texas cases that addressed the time of damage in an occurrence-based policy. For example, in cases involving damage from faulty workmanship, previous cases held that this damage “occurs” not at the time the damage manifests or when a plaintiff is exposed to the agent that will eventually cause the damage, but rather when the actual damage occurred. Applying this logic to the present case, the Court concluded that the risk of physical damage is not the same as physical damage, even though a company may proactively incur significant expense in addressing this risk through repairs.

Despite concluding that the diesel units in this case did not suffer “physical injury” by mere installation, it noted that the units were damaged during the replacement process. The issue regarding this subsequent damage was whether Exclusion M applied, which excluded coverage for property “restored to use.” U.S. Metals argued that this case required much more than simple restoration because the welded flanges had to be torn out, damaging surrounding property in the process. The Court disagreed, finding that the Policy’s definition of “impaired property” does not depend on the manner in which defective property is replaced. The Court held that the exclusion applied to the loss of use of the diesel units because they were “impaired” by the replacement of the flanges. The Court did find, however, that the insulation and gaskets were not restored within the meaning of the exclusion, but instead entirely replaced, and therefore held that the cost of replacing these items was covered.

Editor’s Note: Liberty Mutual Group, Inc. was represented by Christopher Martin, Levon Hovnatanian  and Bruce Ramage of Martin, Disiere, Jefferson & Wisdom, L.L.P. and we congratulate Liberty Mutual on this significant win.

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