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By Kristin C. Cummings
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On Sept. 19, the Fifth Circuit certified four questions to the Texas Supreme Court regarding coverage under a commercial general liability policy in U.S. Metals Incorporated v. Liberty Mutual Group Incorporated, No. 13-20433, 2014 WL 4652892 (5th Cir. Sept. 19, 2014). The questions specifically address the meaning of the terms “physical injury” and “replacement” in two exclusions, the “Your Product” exclusion and “Impaired Property” exclusion, commonly found in CGL policies. The case specifically examines whether damage caused when an insured’s defective product is installed and then removed from a third-party’s property is covered under the insured’s CGL policy.

In U.S. Metals, Exxon Mobil Corp. and U.S. Metals entered an agreement whereby U.S. Metals would manufacture and sell to Exxon 350 standard, weld neck flanges for installation in Exxon’s refineries. The flanges were irreversibly incorporated into the facilities by welding and bolting the flanges onto pipes. About a year after installation, Exxon discovered a leak in one of the flanges. Exxon’s subsequent investigation revealed that U.S. Metals had subcontracted out the manufacturing of the flanges to Maass Flanges Corp. and that they had been improperly manufactured.

Exxon argued that the only way to mitigate its damages was to order new flanges from a different manufacturer and replace all the flanges supplied by U.S. Metals. The replacement required stripping the temperature coating, removing and damaging the bolts and gaskets, and grinding down millimeters of the pipes to which the flanges were attached. The replacement also required portions of the refineries to be shut down for several weeks.

Exxon brought suit against U.S. Metals seeking damages for the costs associated with investigating the flange defect, replacing the defective flanges and the resulting loss of use of Exxon’s property. U.S. Metals requested that its CGL carrier, Liberty Mutual, defend and indemnify U.S. Metals in the lawsuit filed by Exxon.

Liberty Mutual denied the request based on two exclusions. First, the “Your Product” exclusion bars coverage for “‘property damage’ to ‘your product’ arising out of it or any part of it.” The policy defined property damage as “physical injury to tangible property, including all resulting loss of use of that property.”

Second, Liberty Mutual relied on the “Impaired Property” exclusion which bars coverage for:

“Property damage” to “impaired property” or property that has not been physical impaired, arising out of:

(1) A defect, deficiency, inadequacy, or dangerous conditions in “your product” or “your work”; or 

(2) A delay or failure by you or anyone acting on your behalf to perform a contract or agreement in accordance with its terms.

“Impaired property” was defined as:

Tangible property, other than “your product” or “your work,” that cannot be used or is less useful because[:]

(1) it incorporates “your product” or “your work” that is known or thought to be defective, deficient, inadequate or dangerous; or 

(2) you have failed to fulfill the terms of a contract or agreement 

if such property can be restored to use by the repair, replacement, adjustment, or removal of “Your Product” or “your work” or your fulfilling the terms of the contract or agreement.

U.S. Metals sued Liberty Mutual alleging the insurer breached its duty to defend and indemnify. Liberty Mutual filed for summary judgment on the exclusions above, which a district court granted it. U.S. Metals appealed to the Fifth Circuit.

In its appeal, U.S. Metals first argued that the Impaired Property exclusion didn’t apply for two reasons. First, U.S. Metals argued that Exxon’s property to which the defective flanges were attached was not “property that has not been physical[ly] impaired,” as referenced in the exclusion, because the attachment of the defective flanges to the property caused physical damage to Exxon’s property. Additionally, U.S. Metals argued that Exxon’s property was not “impaired property,” because Exxon’s property could not be restored simply by the replacement of the defective flanges; such replacement caused additional damage not directly related to the defective flanges. Accordingly, U.S. Metals argued the Impaired Property exclusion did not bar coverage.

With regard to the “Your Product” exclusion, U.S. Metals argued that it did not bar coverage for the costs claimed, because the property at issue was not the defective flanges, but the other components damaged by the installation or removal of the flanges.

Deciding the Texas Supreme Court had never analyzed the terms “physical injury” and “replacement” in the Your Product and Impaired Property exclusions, the Fifth Circuit certified the following questions to the state high court:

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 one 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 one 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?

On Sept. 26, 2014, the Texas Supreme Court accepted certification and requested briefing from the parties on the issues.

Perhaps the most significant issue to be decided by the Texas Supreme Court in answering these questions is whether the incorporation of a defective product into other property constitutes “physical injury” to other component parts of the property. In 2006, the Texas Court of Appeals in Houston held that mere incorporation of a defective product into covered property is not “damage.” Lennar Corp. v. Great Am. Ins. Co., 200 S.W.3d 651 (Tex. App. – Houston [14th Dist.] 2006), abrogated on other grounds by 327 S.W.3d 118. However, Lennar did not address the question of damage to component parts and/or whether “damage” means the same thing as “physical injury.”

Since Lennar, Texas practitioners have generally understood the Texas rule to be that mere incorporation of a defective product into insured property is not itself “damage.” In the coming months, the Texas Supreme Court will have an opportunity to fully examine this issue for the first time. 

—By Kristin C. Cummings, Zelle Hofmann Voelbel & Mason LLP

Kristin Cummings is a senior associate in Zelle Hofmann Voelbel & Mason's Dallas office. 

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.