Texas Supreme Court Rules Mere Incorporation of a Defective Product Does Not Equal “Property Damage”

                                                                        U.S. Metals, Inc. v. Liberty Mutual Group, Inc.,

                                                                     Cause No. 14-0753, in the Supreme Court of Texas

The Texas Supreme Court, in response to certified questions from the United States Court of Appeals for the Fifth Circuit, held that the mere incorporation of a defective part does not constitute "physical injury" under the definition of "property damage" in a commercial general liability policy. The Court also held the impaired property exclusion can apply even when the process of replacing the defective component part entails damage to or destruction of other parts of the property during the repair process.

U.S. Metals, Inc. sold ExxonMobil Corporation stainless steel flanges for use in the construction of refineries on the Gulf Coast. The flanges were designed to be welded to piping and covered with high-temperature coating and insulation. In post-installation testing, ExxonMobil determined the flanges were defective, causing leaks, and decided it was necessary to replace all of them to avoid the risk of fire and explosion. The repair process entailed stripping the coating and insulation, cutting the original flange out of the pipe, removing the gaskets, grinding the pipe surfaces, welding the new flange to the pipe, and replacing the coating and insulation. The repair process delayed operation of the refineries for several weeks.

ExxonMobil sued U.S. Metals for the cost of replacing the flanges and for damages incurred for loss of use of the refineries. U.S. Metals settled with ExxonMobil and sought coverage from its commercial general liability insurer, Liberty Mutual Group, Inc. U.S. Metals sued Liberty Mutual in federal court, and Liberty Mutual won summary judgment, which was then appealed to the Fifth Circuit. The Fifth Circuit issued certified questions to the Texas Supreme Court on various coverage issues presented.

One of the key issues presented was whether the mere incorporation of a defective component part constitutes "physical injury" to the rest of the unit without any other accompanying property damage. The Court held it did not, and noted that although a product whose use or function is diminished by the incorporation of a faulty component can be said to be "injured," that does not necessarily mean there is physical injury, which requires tangible, manifest harm.

Although the installation of the faulty flanges did not cause physical injury to the refineries, the process of replacing the faulty flanges did, since the original welds, coating, insulation, and gaskets were destroyed in the process. As a result, the Court stated the repair costs and damages for the downtime were "property damages" covered by the policy unless excluded by the impaired property exclusion. The Court held the exclusion applied, despite U.S. Metal's argument that the repair process was complicated and entailed damage to other parts of the property. The Court noted the definition of "impaired property" does not restrict how the defective product is to be replaced, and coverage did not depend on details of the replacement process. Instead, the focus is on whether the repair restores the property to use. The impaired property exclusion eliminated coverage for all damages associated with loss of use of the refineries. The only item of damages found to be covered by the Court was the insulation and gaskets destroyed in the repair process, since they were replaced rather than restored to use.

The Court's opinion answers important questions about the "physical injury" requirement and application of the impaired property exclusion, although there are other issues to be aware of with the Court's opinion. It was significant to the Court that the flanges had not yet been put into actual use. Instead, their defect was discovered through preliminary testing. Had the flanges been put into operation and a fire or explosion occurred, there would certainly be a physical injury and covered property damage, at least in the areas where an actual failure occurred. It is also significant the Court found coverage for the cost of replacing the insulation and gaskets (the cost of replacing the flanges themselves would be excluded by the "your product" exclusion). That raises the question of whether it would be possible to segregate the cost associated with replacing the insulation and gaskets from costs involved with cutting and re-welding the replacement flanges. It is also important to bear in mind that despite the Court's holding that mere incorporation of a defective part does not equal "physical injury," once destructive repairs are undertaken to replace the component part, the "physical injury" requirement is met.