Answering certified questions from the Fifth Circuit, the Texas Supreme Court found there was no coverage for flanges that leaked after installation. U. S. Metals, Inc. v. Liberty Mutual Group, Inc., 2015 Texas LEXIS 1081 (Dec. 4, 2015).
U. S. Metals sold Exxon 350 custom-made, stainless steel, weld-neck flanges for use in refineries. Testing after installation showed the flanges leaked and did not meet industry standards. Exxon decided to replace the flanges to avoid risk of fire and explosion. For each flange, this involved stripping the temperature coating and insulation, cutting the flange out of the pipe, removing the gaskets, grinding the pipe surfaces smooth for re-welding, replacing the flange and gaskets, welding the new flange to the pipes, and replacing the temperature coating and insulation. The replacement process delayed operation of the diesel units for several weeks.
Exxon sued U.S. Metal for over $6 million as the cost of replacing the flanges and $16 million as damages for lost use of the diesel units during the process. U.S. Metals settled with Exxon for $2.2 million and then sought indemnification from its liability insurer, Liberty Mutual.
Liberty Mutual contended there was no coverage under Exclusion M, the impaired property exclusion. Exclusion M barred coverage for damages to property, or for the loss of its use, if the property was not physically injured or if it was restored to use by replacement of the flanges. After suit was filed in federal court, the district court granted summary judgment to Liberty Mutual.
On appeal, the Fifth Circuit certified questions to the Texas Supreme Court. The questions boiled down to: (1) is property physically injured simply by the incorporation of a faulty component with no tangible manifestation of injury?; and (2) is property restored to use by replacing a faulty component when the property must be altered, damaged, and repaired in the process?
Looking at cases that had interpreted the impaired property exclusion, the court noted that physical injury, for purposes of the impaired property exclusion, resulted not from the installation, but from the leak. Leaks from the flanges never caused injury because Exxon replaced them to avoid any risk of injury.
The court decided that physical injury required tangible, manifest harm which did not not result merely upon the installation of a defective component in a product or system.
The units were physically injured, however, in the process of replacing the faulty flanges. Because the flanges were welded to pipes rather than being screwed on, the faulty flanges had to be cut out, the pipe edges resurfaced, and new flanges had to be welded in. The original welds, coating, insulation, and gaskets were destroyed in the process and had to be replaced. The fix necessitated injury to tangible property, and the injury was unquestionably physical.
Therefore, the repair costs and damages for the downtime were "property damages" covered by the policy unless Exclusion M applied. Exclusion M denied coverage of damages to impaired property - defined as property that could be "restored to use by the . . . replacement" of the faulty flanges.
Here, the diesel units were restored to use by replacing the flanges and were therefore impaired property to which Exclusion M applied. Thus, their 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. They were therefore not impaired property to which Exclusion M applied, and the cost of replacing them was therefore covered by the policy.