Texas Supreme Court rules incorporation of defective products does not constitute physical injury under the standard form commercial general liability policy

On December 4, 2015, in U.S. Metals, Inc. v. Liberty Mut. Group, Inc., 490 S.W.3d 20 (Tex. 2015), the Texas Supreme Court sided with the majority of other courts who have addressed the issue, holding 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.”

U.S. Metals sold flanges to ExxonMobil Corp. to serve Exxon’s diesel units at its refineries. Once these flanges were welded to the applicable pipes, the flanges leaked. Exxon, taking precautions, decided it must replace the flanges or expose itself to the risk of fire and explosion. Replacing the flanges to restore the diesel units to use required destroying parts of the applicable pipes and welding the new flanges into the pipes. Exxon sued U.S. Metals for damages for the cost of replacing the flanges and the damages for the loss of use of its diesel units during the replacement. 

U.S. Metals and Exxon settled their dispute and U.S. Metals sought indemnity under its CGL policy from Liberty Mutual Group, Inc. Liberty Mutual’s standard CGL policy provided that it covered “property damage,” which was defined as “[p]hysical injury to tangible property.”  Moreover, the policy excluded coverage for “[p]roperty 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.’”  Under the policy, “impaired property” included property that “can be restored to use by the repair, replacement, adjustment or removal or ‘your product.’”

Liberty Mutual denied coverage. U.S. Metals then sued Liberty Mutual in federal court. The district court granted summary judgment in favor of Liberty Mutual.  When the case was appealed to the Fifth Circuit, the Fifth Circuit certified questions to the Texas Supreme Court, and the Texas Supreme Court succinctly described those questions as follows:

• “[I]s property physically injured simply by the incorporation of a faulty component with no tangible manifestation of injury?” and
• “Is property restored to use by replacing a faulty component when the property must be altered, damaged, and repaired in the process?”

First, was Exxon’s property “physically injured” by the installation of faulty flanges such that any damage was covered under the policy?

To this first question, the Texas Supreme Court said “no.” The Texas Supreme Court analyzed the text of the policy, noting that the phrase “physical injury” must have meaning and it assumes there is certain intangible, non-physical injury, which would not be covered under the policy. Furthermore, the Texas Supreme Court analyzed decisions in other jurisdictions that have decided whether the “incorporation theory” applies to “physical injury” in a CGL policy.

The “incorporation theory” proposes that “incorporating a defective component into something” constitutes “physical injury.” The Texas Supreme Court noted that the vast majority of cases addressing this issue rejected the incorporation theory, because physical injury requires “tangible, manifest harm” and simply intangible, diminution in value is not sufficient. 

Thus, the Supreme Court determined that U.S. Metals was not entitled to indemnity for the costs of installing the new flanges because there was no “physical injury” simply by the installation of faulty flanges.

Second, was Exxon’s property restored to use such that it constituted “impaired property,” excluded from coverage?

Although the defective component itself did not cause physical injury, Exxon’s property was, without a doubt, “physically injured” during the restoration process because the original flanges had been welded to the applicable pipes. Again, “impaired property” was defined as property that “can be restored to use by the repair, replacement, adjustment or removal or ‘your product.’” 

Here, U.S. Metals argued that because replacing the flanges involved much more than removing and replacing the product, the diesel units were not “impaired property.” The Court, however, rejected this argument, noting that there is no limitation on how any defective property is restored to use. The fact that this particular replacement process affected Exxon’s property was of no consequence. Consequently, because the diesel units were “impaired property,” the exclusion applied and U.S. Metals was not entitled to coverage.

Ultimately, the only damages U.S. Metals could cover under the policy were the minimal costs of replacing insulation and gaskets destroyed while restoring the diesel units with new flanges. This decision constitutes the first time the Texas Supreme Court has addressed the “incorporation theory” for “physical injury.”

Its decision to side with the majority of jurisdictions on this issue certainly raises practical concerns for contractors.  For example, the court noted that its ruling “has a perverse aspect to it.” That is, if Exxon had not tested the flanges or found the leaks, but did nothing, any resulting damage from a fire or explosion likely would have been covered under “physical injury.”  But as the Court noted, “because Exxon was careful and cautious,” U.S. Metals could not seek indemnity.

Contractors beware:  Pursuant to the court’s ruling, if a company installs a defective product, the expenses of simply replacing that defective product are not likely covered by a CGL policy.