Source: http://www.texaslawyer.com, May 2, 2016
By: David Walton and
Brandan Montminy
Eight years later, in U.S. Metals Inc. v. Liberty Mutual Group Inc., the court addressed a policyholder’s effort to significantly expand CGL policies to cover construction and product defects. Focused less on the scope of the insuring agreement as in Lamar Homes and more on the meaning of “physical injury” in the exclusions, the court held 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, 2015 WL 7792557 (Tex. Dec. 4, 2015). This conclusion is consistent with the majority of state high courts that previously considered the “incorporation theory.”
In U.S. Metals, the insured sold flanges for use in a customer’s refineries. The flanges were welded to the pipes of the refineries and covered with special coating. Before the refineries were put into use, the customer discovered leaks and determined the flanges were defective and sub-standard. The customer replaced the defective flanges, which required, in part, removing the coating, cutting the flanges from the pipes, and grinding the pipe surfaces to install different flanges. The customer alleged it cost over $6,000,000 (excluding loss of use costs) to complete the replacement work, and filed suit against the insured to recover all such costs.
The insured’s CGL insurer denied coverage concerning the lawsuit. The customer and the insured settled the lawsuit, and the insured subsequently filed a coverage lawsuit against its insurer. The federal district court granted summary judgment in favor of the insurer. On appeal, the Fifth Circuit certified four questions to the Supreme Court of Texas focused, in part, on whether installation of the defective flanges physically injured the customer’s pipes if the only harm was the leaks.
Coverage was dependent on whether the customer’s property was physically injured by the insured’s defective flanges within the meaning of the CGL policy. Interpreting the policy language, the court distinguished between the meaning of “injury” and “physical injury.” The court accepted the notion that installing the insured’s defective flanges may be an “injury” to the customer based on an associated risk and value analysis, but denied it was a “physical injury” under the CGL policy. To accept the contrary, the court reasoned, would render the term “physical” superfluous because there would be no definable non-physical injury. Thus, the court rejected the “incorporation theory” in Texas by concluding 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.”
Although the court followed the national trend rejecting the “incorporation theory,” it expressly noted the perverse aspect of its decision—that is, it provides coverage to an insured selling a defective product if it’s customer does not undertake sufficient safety measures to identify the defect before the product is used, but conversely denies coverage if the customer does undertake such measures. After all, as the court recognized, had the customer “been negligent or reckless—had it not tested the flanges or had it found the defect but decided to risk the danger of leaks—and an explosion had resulted,” the insured “would not be denied coverage for the damages to persons and property for want of physical injury.” The court declined to resolve a disagreement between competing amici curiae over the practical consequences of its decision: “Our responsibility is to determine not what coverage should be available but what the CGL policy here provided.”
The court next considered whether replacing the insured’s defective flanges may be a “physical injury.” The court concluded that a physical injury did occur during the replacement process because “[t]he original welds, coating, insulation, and gaskets were destroyed in the process.” Yet, the court delineated between replacement of defective flanges, which was excluded from coverage under the CGL policy, and replacement of “insulation and gaskets destroyed in the process,” which was covered. This delineation is now the subject of motions for rehearing submitted to the court by the insured and the insurer.
Regardless, the court made clear that Texas will not follow the “incorporation theory” because to do so would be inconsistent with its earlier opinions interpreting CGL policies, such as Lamar Homes.