Impaired Property Exclusion

The insured brought an action against the insurer to recover for breach of the duty to defend and indemnify against liability to a refinery for its costs to replace weld-neck flanges sold by the insured and damages from loss of use of the refineries. This case is U.S. Metals v. Liberty Mutual Group, 2015 WL 7792557.

U.S. Metals sold ExxonMobil some 350 custom-made stainless steel weld-neck flanges for use in constructing nonroad diesel units at its refineries. These 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. The replacement process delayed operation of the diesel units at both refineries for several weeks. ExxonMobil sued U.S. Metals for millions of dollars for the cost of replacing the flanges and as damages for the lost use of the diesel units. U.S. Metal settled the lawsuit and then claimed indemnification from its general liability insurer, Liberty Mutual. The insurer denied coverage and the insured then sued to determine its rights to a defense and indemnity under the policy.

The United States District Court for the Southern District of Texas entered summary judgment in favor of the insurer and U.S. Metals appealed.

The United States Court of Appeals for the Fifth Circuit certified four questions to the Supreme Court of Texas: are the terms “physical injury” and “replacement”, found in the impaired property exclusion ambiguous; if yes, are the interpretations offered by the insured reasonable; if the answer to the question about physical injury is no, does the physical injury occur at the moment of incorporation of the defective product, or does physical injury only occur 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; and, finally, if the question about replacement is answered in the negative, does replacement of the defective product irreversibly attached to the third party's product include the removal or destruction of the product.

The Texas court noted that the parties disputed whether the installation of the faulty flanges physically injured the diesel units within the meaning of the liability policy. The court said that the installation of the leaky flanges can certainly be said to have injured, that is, harmed or damaged, the diesel units by increasing the risk of danger from their operation and thus, reducing their value. However, the court continued, the fact is that physical injury resulted not from the installation but from the leak. Leaks from the U.S. Metals' flanges never caused injury because ExxonMobil replace them to avoid any risk of injury. 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. The conclusion was that the diesel units were not physically injured by the installation of the faulty flanges.

(The court said that the result in this case has a perverse aspect to it. Had ExxonMobil been negligent or reckless, that is, had it not tested the deft and an explosion occurred, U.S. Metals would not be denied coverage for the damages to persons or property. But because ExxonMobil was careful and cautious, U.S. Metals is not entitled to indemnity for the costs of remedying the installation of the faulty flanges.)

The Texas court then decided that the units were physically injured in the process of replacing the faulty flanges. Because the flanges were welded to pipes, 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 injury here was thus unquestionably physical. The court found that the repair costs and damages for the downtime were property damages covered by the policy unless the impaired property exclusion applied.

U.S. Metals conceded that if the flanges had been screwed onto the pipes, removal and replacement would have been a simple matter, but because the flanges were welded in, U.S. Metals argued that restoring the units to use involved much more than simply removing and replacing the flanges. Therefore, the insured said, the diesel units were not impaired property as defined in the policy and the exclusion did not apply. The Texas court did not agree.

The court said that the 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. However, the diesel units were restored to use by replacing the flanges and were therefore impaired property to which the exclusion applies; the court ruled that the loss of use of the units is not covered by the policy.

(On the other hand, the court did rule that the insulation and gaskets destroyed in the process were not restored to use; they were replaced and so, they were not impaired property as defined and the cost of replacing them was covered by the policy.)

The court then did proceed to answer the certified questions.

Editor's Note: Even though this is a case argued before U.S. courts, the answers to the coverage dispute come from the Texas Supreme Court. That court decided that the policy did not cover most of the damages claimed. However, the case is worth reviewing due to the court's thorough discussion of the impaired property exclusion and when physical injury occurs.

PIP Benefits

In this no-fault action to recover personal injury protection (PIP) benefits, the insurer appeals as of right the circuit court order granting summary disposition and judgment to the plaintiffs. This case is Mary Free Bed Rehabilitation Hospital v. Farmers Insurance Group, 2015 WL 9317979.

This matter arises out of an auto accident that occurred in Michigan. Chen, the passenger in the auto, was paralyzed in the accident; Chen's boyfriend, Liao, was the operator of the vehicle rented from Hertz. Farmers was the insurer for Liao. Chen filed a lawsuit against Farmers alleging that it owed her PIP benefits because it was Liao's insurer. The trial court ruled in favor of Chen and this appeal followed.

The insurer argued that the trial court erred in its interpretation of certain statutes under the state no-fault law. Farmers argued that it was not liable to pay PIP benefits because Chen was not insured by an insurer that has filed a certification in compliance with section 3163 of the no-fault law. The Court of Appeals of Michigan disagreed.

The court noted that in order to be excluded from PIP benefits, three conditions must be true at the time of the accident: the person was not a resident of Michigan; the person was an occupant in a vehicle that was not registered in Michigan; and, the person was not insured by an insurer that has filed a 3163 certification. In this instance, both parties agreed that Chen was not a resident of Michigan at the time of the accident and she was the occupant of a vehicle that was not registered in Michigan. However, the parties to this lawsuit disputed whether the motor vehicle was not insured by an insurer that has filed a certification in compliance with section 3163 of the no-fault law. Farmers did claim that it voluntarily filed a certification in compliance with the law, but denied that it is liable to pay PIP benefits because it is not an insurer of Chen under its insurance policy and the vehicle involved in the accident was not covered by its insurance policy.

The appeals pointed out that the statute provides that a person who suffers bodily injury while the occupant of a motor vehicle and who has no available insurance policy of his own or in his family shall claim PIP benefits from the insurer of the owner or registrant of the vehicle occupied, or the insurer of the operator of the vehicle occupied. Here, the parties agreed that Chen did not have any insurance of her own, nor did she have a family member under whose insurance policy she could have obtained coverage. Therefore, Chen was an insured under the Farmers policy and was entitled to PIP benefits.

The insurer then argued that the damages are limited to $500,000 in accordance with the statute. The court agreed with this and found that Chen was an out of state resident occupant of a private passenger vehicle and the limit established by law for her claims was $500,000.

The ruling of the trial court was affirmed.

Editor's Note: The Court of Appeals of Michigan interprets the state no-fault law and rules that the law unequivocally subjects the out-of-state insurer to the entire Michigan personal and property insurance system when any accidental bodily injury arising from an out-of-state insured's ownership or use of a motor vehicle occurs.

Recouping Defense Costs

Before the court are motions for reimbursement of defense costs. This case is American Economy Insurance Company v. Aspen Way Enterprises, 2015 WL 7871337.

Aspen Way was sued in two underlying proceedings known as the Byrd Action and the Washington Action. Liberty Mutual accepted Aspen Way's defense of the Byrd Action under a reservation of rights. In the reservation of rights letter, Liberty Mutual noted that it did not waive any right to seek reimbursement from Aspen Way for indemnity payment and defense costs should it be determined that the allegations of the lawsuit are precluded from coverage. Hartford Fire Insurance Company drafted a similar letter to Aspen Way when it also accepted the defense of the Byrd Action.

Liberty Mutual accepted the defense of the Washington Action under a reservation rights letter and the insurer also specifically noted that it could later seek reimbursement for attorney fees incurred in the defense. Aspen Way settled the Washington Action in exchange for, among other things, a $150,000 payment to the State of Washington. Liberty Mutual agreed to pay the $150,000 but reserved the right to recoup the settlement payment from Aspen Way upon a declaration of non-coverage.

The United States District Court, Montana, later found that Liberty Mutual and Hartford did not owe a duty to defend or indemnify Aspen Way in the Byrd Action or the Washington Action. Both Liberty Mutual and Hartford then filed this action seeking a declaration that Aspen Way had to reimburse them for defense costs and expenditures. Aspen Way challenged their right to recover those costs.

The court found that if a court declares that there is no coverage, Montana law permits the insurer to recover the expenses that the insurer incurred in defending a claim outside of the insured's policy coverage. In order to recover the expenses, the insurer must timely and explicitly reserve the right to recoup costs, and the insurer must provide adequate notice to the insured of the possibility of reimbursement. In this instance, the court found that both Liberty Mutual and Hartford met those requirements.

Aspen Way argued that it objected to Liberty Mutual's reservation of rights letter but the court said this objection was not made until nearly three years into the litigation, and Aspen Way could not receive the benefit of a defense paid for by Liberty Mutual, only to belatedly object and change the terms upon which the defense was offered.

The court noted that a majority of jurisdictions allow reimbursement of defense costs under two different theories: unjust enrichment and the creation of an implied contract. In this instance, Aspen Way received the benefit of representation on claims that were not covered by the policies and for which it did not pay premiums, and so, Aspen Way would be unjustly enriched by forcing Liberty Mutual to bear unbargained-for defense costs. Under the implied contract theory, Aspen Way accepted the reservation of rights letter by not objecting to it until nearly three years later and the court said that Aspen Way could not repudiate the implied contract after receiving its benefits for nearly three years.

The court granted Liberty Mutual's motion for reimbursement of defense and indemnity costs and granted Hartford's motion for reimbursement of defense costs.

Editor's Note: The U.S. District Court for Montana allowed for the reimbursement of defense costs and settlement expenses in this case since the insurer timely and explicitly reserved the right to recoup costs and provided adequate notice to the insured of the possibility of reimbursement. The court noted in this opinion that the majority of jurisdictions allow reimbursement of defense costs.

Spoliation of Evidence

The defendants in this case sought to exclude the plaintiff's use of any argument or evidence of alleged spoliation. This case is West v. Talton, 2015 WL 6675565.

During a deposition, the plaintiff discovered that the defendants failed to search and preserve e-mail accounts as requested during discovery. During an additional discovery period, the plaintiff discovered backup tapes were written over and an e-mail account was deleted. The plaintiff then sought a spoliation instruction to the jury regarding the deletion of e-mails, arguing that he would have discovered more e-mails to support his claims had the defendants preserved the backup tapes and the e-mail account. Defendants countered that the evidence should be excluded because the e-mails were not deleted in bad faith.

The United States District Court, M.D. Georgia, noted that spoliation is the destruction or significant alteration of evidence, or the failure to preserve property for another's use as evidence in pending or reasonably foreseeable litigation. The court added that the following factors can be used to aid a court in deciding whether to impose sanctions against litigants for spoliation of evidence: whether the party seeking sanctions was prejudiced as a result of the destruction of evidence; whether the prejudice could be cured; the practical importance of the evidence; whether the spoliator acted in good faith or bad faith; and the potential for abuse if expert testimony about evidence was not excluded.

Based on the evidence presented to the court, the court found that it was not clear that the defendants' failure to preserve the backup tapes and e-mail accounts was a malicious act or done in bad faith. On the contrary, the court found that the e-mail was deleted pursuant to a routine procedure to delete an employee's e-mail account shortly after the employee left employment and to rewrite over the backup tapes of the server every six months. The plaintiff contended that this procedure was more than just mere negligence but the court said that it was completely speculative that the plaintiff was prejudiced by these events in any way. Moreover, there was no evidence presented that showed mass destruction or wiping.

The court also found that the defendants still possessed a hard drive and hired a third-party company to search e-mails using extensive and broad search terms. Further, the defendants provided the plaintiff with a voluminous amount of documents, including e-mails to support the plaintiff's claim. Also, the plaintiff failed to show he was prejudiced by the events in this case.

The court ruled that sanctions for spoliation of evidence was inappropriate in this case. The defendants' motion to exclude evidence or argument regarding spoliation was granted.

Editor's Note: This case is presented not so much for information on insurance coverage issues as for the factors used by federal courts in deciding whether to impose sanctions for the spoliation of evidence.