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From Products Liability Law Daily, December 7, 2015

CGL policy didn’t cover most of pipe maker’s $2.2-million settlement for faulty flanges

By Georgia D. Koutouzos, J.D.

A commercial general liability insurance policy issued to an industrial pipe manufacturer did not cover most of the damages sustained by an oil company to which the pipe maker had supplied what ultimately were determined to be defective flanges, Texas highest court advised. In so ruling, the court answered four questions related to the interpretation of the policy’s scope of coverage and exclusions certified by a federal appellate panel in that court’s review of a lower court’s grant of summary judgment favoring the insurer in the coverage dispute over the insurer’s duty to indemnify the pipe maker for a multi-million dollar settlement of the oil company’s claimed losses resulting from the leaky flanges (U.S. Metals, Inc. v. Liberty Mutual Group, Inc.December 4, 2015, Hecht, N.).

Background. An industrial pipe supplier sold a major oil company approximately 350 custom-made, stainless steel, weld-neck flanges for use in constructing non-road diesel units at two of the oil company’s refineries. Although the sales contract had called for flanges manufactured to meet industry standards and designed to be welded to the diesel units’ piping, post-installation testing by the oil company after several flanges were found to have leaked revealed that the flanges failed to meet industry standards. In order to avoid the risk of fire and explosion, the oil company decided to replace them; a laborious process that delayed operation of the diesel units at both refineries for several weeks.

The oil company sued the pipe supplier for $6.36 million for the cost of replacing the flanges and another $16.66 million in damages for the lost use of the diesel units during the flange-replacement process. The pipe supplier settled with the oil company for $2.2 million and then claimed indemnification from its commercial general liability insurer for the amount paid-out in the settlement. After the insurance company denied coverage, the pipe supplier filed suit in federal court to determine its right to a defense and indemnity under the policy. The trial court granted summary judgment favoring the insurer, the pipe supplier appealed, and a federal appellate panel certified to Texas’s highest court the following four questions regarding the meaning of “physical injury” and “replacement” in the CGL policy and their application in the insurance coverage issues underpinning the circumstances at bar:

  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 1 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 1 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?

Policy language. The standard-form CGL policy at issue obligated the insurer to “pay those sums that [the insured] becomes legally obligated to pay as damages because of … ‘property damage’ to which this insurance applies,” with “property damage” defined 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.”

Relevant among the policy’s exclusions was a “your product” exclusion (Exclusion K), which precluded coverage for “‘property damage’ to ‘your product’ arising out of it or any part of it,” and an impaired property exclusion (Exclusion M), which barred 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.’” The policy defined “your product” as “[a]ny goods or products … sold … by [the insured]” and “impaired property” as:

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

  1. It incorporates “your product” … 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 fulfilling the terms of the contract or agreement.

The parties contentions. The insured asserted that the oil company’s property had been physically injured both by the mere installation of the faulty flanges and also during the subsequent replacement process. The insured further contended that the diesel units could not be restored to use simply by replacing the flanges because the units’ welds, gaskets, insulation, and coating also had been destroyed in the process and had to be replaced as well. Because the flanges had been welded in, the diesel units’ restoration to use involved much more than simply removing and replacing the flanges alone; therefore, the diesel units were not “impaired property” under the terms of the policy and the policy’s impaired property exclusion did not apply as a coverage bar, the insured maintained.

Scope of coverage. The four questions certified by the federal appeals court raised two issues: (1) whether property is physically injured merely by installing a defective product into it; and (2) whether replacing the defective flanges restored the refinery property to use when some of the property had been destroyed in the process.

The parties disputed whether the installation of the faulty flanges had physically injured the diesel units within the meaning of the CGL policy, which covered “physical injury.” In that regard, a thing whose use or function is diminished by the incorporation of a faulty component fairly could be said to be injured, even if the injury was intangible, latent, or inchoate. Here, the installation of the leaky and/or below-standard flanges certainly could be said to have injured (i.e., harmed or damaged) the oil company’s diesel units by having increased the risk of danger from the units’ operation and thus reducing their value. But if that increased risk amounted to physical injury within the meaning of the CGL policy, then it was difficult to imagine a non-physical injury inasmuch as any lessening of property by adding a component not only would be injury but would be physical injury.

Moreover, the insurance policy’s limitation of coverage to damages from physical injury necessarily implied that there also can be non-physical, non-covered injuries—otherwise, the requirement that injury be “physical” would be superfluous. Therefore, to give the term “physical” its plain meaning, a covered injury must be one that was tangible. 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. Because a defective product that causes damage is not an occurrence until the damage actually happens, it would be inconsistent to conclude that a defective product that does not cause damage nevertheless constituted an occurrence at the time of incorporation.

For purposes of the CGL policy provision at issue, physical injury had resulted not from the insured’s defective flanges’ installation, but from their leaks. And the leaks from the flanges never caused injury because the oil company had replaced them in order to avoid any risk of injury. Consequently, it had to be concluded that the oil company’s diesel units were not physically injured merely by the installation of the insured’s faulty flanges. However, the units werephysically injured in the process of replacing the faulty flanges because the flanges had been welded to pipes rather than being screwed on. The faulty flanges had to be cut out, pipe edges resurfaced, and new flanges welded in. In the process, the original welds, coating, insulation, and gaskets were destroyed and had to be replaced. The fix necessitated injury to tangible property, and the injury unquestionably was physical. Thus, the repair costs and damages for the downtime were “property damages” covered by the policy unless the impaired property exclusion (Exclusion M) applied.

Impaired property exclusion. The policy’s definition of “impaired property” did not restrict how the defective product is to be replaced. And, while the insured’s argument required limiting the definition to property “restored to use by the … replacement of [the flanges]” without affecting or altering the property in the process, that limitation could not be fairly inferred from the text itself, nor did it make sense to do so. In the insured’s view, the diesel units could not be restored to use by replacement of the flanges—not only because the flanges had to be cut out and welded back in, but because of the wholly incidental replacement of insulation and gaskets.

However, coverage did not depend upon such minor details of the replacement process; rather, it depended upon the efficacy of that process in restoring the damaged property to use. The oil company’s diesel units were restored to use by replacing the flanges and, therefore, were impaired property to which Exclusion M applied. Thus, the units’ 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. Consequently, those items were not impaired property to which Exclusion M applied, and the cost of their replacement was covered by the policy.

Certified questions. Accordingly, the answer to the first question whether the terms “physical injury” or “replacement” were ambiguous as incorporated into the insurance policy’s “your product” or “impaired property” exclusions of the CGL policy, the answer in the situation presented was “no.” And, as the second question was conditioned upon a “yes” answer to the first, it did not warrant further elucidation.

As for the third question’s inquiry whether installation of the faulty flanges alone physically injured the diesel units, the answer was “no.” Finally, regarding the fourth question’s inquiry whether “replacement” of the insured’s defective product irreversibly attached to a third party’s product included the removal or destruction of the third party’s product, the answer depended upon the efficacy of the process of restoring the damaged property to use, with items destroyed in the process subject to coverage because they were not impaired property subject to the policy’s exclusion thereof.

The case is No. 14-0753.

Attorneys: Ryan Matthew Perdue (Fernelius Alvarez Simon PLLC) for U.S. Metals, Inc. Levon G. Hovnatanian (Martin, Disiere, Jefferson & Wisdom, LLP) for Liberty Mutual Group, Inc., d/b/a Liberty Insurance Corp.

Companies: U.S. Metals, Inc.; Liberty Mutual Group, Inc., d/b/a Liberty Insurance Corp.

MainStory: TopStory DamagesNews IndustrialCommercialEquipNews TexasNews

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