I have long maintained that the Supreme Court of Texas is the most important in the country when it comes to liability insurance coverage matters. So just as it was with E.F. Hutton, when the Supreme Court of Texas talks, well, you know.

Late in the year, as the Top 10 was in its final stages, and with one spot still open, and several cases vying for it, the Texas Supreme Court decided U.S. Metals, Inc. v. Liberty Mutual. The fat lady sang.

The decision is brief – mercifully, as I was getting antsy to be done – and addresses the “impaired property” exclusion in a products liability scenario. But the case’s impact will be felt so much further.

The claims at issue in U.S. Metals are no doubt highly complex and technical from an engineering standpoint and could probably take up pages to explain. But Chief Justice Hecht does a great job of laying out the facts in three paragraphs. I’d be crazy to not simply quote them here verbatim:

“U.S. Metals, Inc. sold ExxonMobil Corp. some 350 custom-made, stainless steel, weld-neck flanges for use in constructing nonroad diesel units at its refineries in Baytown, Texas, and Baton Rouge, Louisiana. The units remove sulfur from diesel fuel and operate under extremely high temperatures and pressures. ExxonMobil contracted for flanges made to meet industry standards and designed to be welded to the piping. The pipes and flanges, after they were welded together, were covered with a special high temperature coating and insulation.

In post-installation testing, several flanges leaked. Further investigation revealed that the flanges did not meet industry standards, and ExxonMobil decided it was necessary to replace them to avoid the risk of fire and explosion. For each flange, this process involved stripping the temperature coating and insulation (which were destroyed in the process), cutting the flange out of the pipe, removing the gaskets (which were also destroyed in the process), 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 at both refineries for several weeks.

ExxonMobil sued U.S. Metals for $6,345,824 as the cost of replacing the flanges and $16,656,000 as damages for the lost use of the diesel units during the process. U.S. Metals settled with ExxonMobil for $2.2 million and then claimed indemnification from its commercial general liability insurer, Liberty Mutual Group, Inc., for the amount paid.”

Liberty Mutual denied coverage. Essentially before the court (on certification from the Fifth Circuit) -- under the “convoluted provisions of the standard-form CGL policy,” as the Chief described it – was the applicability of the impaired property exclusion (first acknowledging the obligation for “property damage” under the CGL insuring agreement). The impaired property exclusion reads:

“Property 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.’”

“Impaired property” means: tangible property, other than “your product” ..., that cannot be used or is less useful because: a. It incorporates “your product” ... that is known or thought to be defective, deficient, inadequate or dangerous; or b. 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 court described the issues as follows: “[I]s property physically injured simply by the incorporation of a faulty component with no tangible manifestation of injury? And second: is property restored to use by replacing a faulty component when the property must be altered, damaged, and repaired in the process?”

Turning to the “incorporation” issue, the court noted that different approaches exist nationally and then chose to follow the majority view: “We agree with most courts to have considered the matter 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.” Thus, the conclusion of the court was that the installation of U.S. Metals’s faulty flanges, into the ExxonMobil units, did not physically injure them.

But while the diesel units were not physically injured merely by the installation of U.S. Metals faulty flanges, there is another part to the story: the units were physically injured 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, pipe edges resurfaced, and new flanges 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.” Thus, as the court laid it out as clear as a bell: “[T]he repair costs and damages for the downtime were ‘property damages’ covered by the policy unless [the impaired property] exclusion applies.”

So now it was time to delve into the “impaired property” exclusion – not so clear as a bell. The impaired property exclusion is that one that you kinda, sorta, understand, but not really, and try to avoid having to deal with it at all costs. Here is how the impaired property exclusion was described by Austin’s Shidlofsky Law Firm in a U.S. Metals case alert: “[the] exclusion as a whole is utterly confusing and requires several shots of Tequila before it even remotely makes the slightest bit of sense. To the extent that you try this route in analyzing the ‘impaired property’ exclusion, please do not operate a vehicle or heavy machinery. And, if you have a headache for more than four hours, call a doctor.” [The boys from Shidlofsky Law are superb coverage lawyers; so what hope do the rest of us have?]

U.S. Metals argued that the impaired property exclusion did not apply for this reason: “[I]f the flanges had been screwed onto the pipes, removal and replacement would have been a simple matter, readily restoring the diesel units to use, and making them ‘impaired property’. But because the flanges were welded in, U.S. Metals argues, restoring the diesel units to use involved much more than simply removing and replacing the flanges alone, and therefore the diesel units were not ‘impaired property’ and Exclusion M does not apply.”

The Texas Supreme Court disagreed: “The policy definition of ‘impaired property’ does not restrict how the defective product is to be replaced. U.S. Metals argument requires 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 cannot be fairly inferred from the text itself, nor would it make sense to do so. In U.S. Metals’ view, the diesel units could not be restored to use by replacement of the flanges, not only because they had to be cut out and welded back in, but because of the wholly incidental replacement of insulation and gaskets. Coverage does not depend on such minor details of the replacement process but rather on its efficacy in restoring property to use. The diesel units were restored to use by replacing the flanges and were therefore impaired property to which Exclusion M applies. Thus, their loss of use is not covered by the policy.”

However, the court did acknowledge that “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.”

U.S. Metals is a brief opinion but Chief Justice Hecht made the most of the words and I believe that they will be heard far and wide into the future.

In my experience, insurers have shied away from asserting the “impaired property” exclusion for the very reason that U.S. Metals provided (and which was rejected): since flanges had to be cut out and welded back in, the diesel units could not be restored to use simply by replacement of the flanges. In other words, as U.S. Metals conceded: “[I]f the flanges had been screwed onto the pipes, removal and replacement would have been a simple matter, readily restoring the diesel units to use, and making them ‘impaired property.’” U.S. Metals, especially coming from the Texas Supreme Court, is likely to cause some insurers to take another look at the impaired property exclusion in these product liability “incorporation” situations.

But the bigger impact may be felt in the context of the more common construction defect landscape. Consider an insured-contractor’s defective work on a building. There is no coverage for the cost to replace the insured’s faulty work (no “occurrence” or the “your work” exclusion applies). That much we know. But will U.S. Metals now cause insurers to argue that the impaired property exclusion precludes coverage for any loss of use damages, since the building can be restored to use by the repair/replacement of the insured’s faulty work, notwithstanding that other parts of the building are damaged in the process? Incidentally, that the court held that coverage existed for the insulation and gaskets destroyed in the process was no small victory for policyholders. Is the court saying that, in a construction defect case, “rip and tear” costs are covered property damage when on account of uncovered repair and replacement of faulty workmanship?