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Howrey LLP
A recent decision by California's 2nd District Court of Appeal has put forward a potentially new interpretation of the "Incorporation Doctrine" for obtaining insurance coverage of property damage. Watts Industries, Inc. v. Zurich American Insurance Co., 121 Cal.App.4th 1029 (2004).
Watts was a manufacturer of parts, pipes and fittings for municipal water systems. In June 1997, a qui tam plaintiff filed a false claims action alleging that Watts sold substandard parts to Southern California municipal water agencies. The qui tam plaintiff alleged that the parts wore out sooner and contained more lead than was specified. In November 1998, the Los Angeles Department of Water and Power filed a complaint in intervention alleging LADWP would incur costs to replace nearly 300,000 substandard Watts parts to protect the water supply and public health.
In April 1998, Watts tendered the defense of the initial suit to its liability insurance carrier, Zurich. Zurich rejected the tender, asserting that the alleged damages were not covered "property damage" and were purely economic. Watts kept Zurich updated on the invention by LADWP and on other events in the litigation. Zurich continued to deny coverage.
In February 2001, Watts brought an action against Zurich to determine whether the allegations of the complaints created a potential for coverage under the Zurich liability policy. In August 2002, the trial court found that the complaints sought "damages because of property damage" and that, therefore, there was a duty to defend under the policy. The trial court granted Watt's motion for summary judgment. Zurich appealed.
Before the Court of Appeal, Zurich argued that the underling actions did not involve "property damage" as defined by the policy because the defective parts and lead contamination did not constitute "physical injury" to the municipal water systems. The Zurich policy contained the standard industry definition of "property damage" as "physical injury to tangible property, including all resulting loss of use of that property" and "loss of use of tangible property that is not physically injured."
The Court of Appeal, relying on F & H Construction v. ITT Hartford Ins. Co., 118 Cal.App.4th 364, 371-372 (2004), observed that courts generally agree that the incorporation of a defective component or product into a larger structure or system does not constitute a "physical injury" to the structure or system unless and until the defective component or product causes actual harm. The Court of Appeal noted, however, courts have found that when "hazardous materials" are incorporated into some sort of tangible property, such incorporation is found to cause "immediate harm and physical injury to the other property at the moment the incorporation occurred." The Court of Appeal cited Armstrong World Industries, Inc. v. Aetna Casualty & Surety Co., 45 Cal. App.4th 1 (1996), which considered the installation of asbestos into buildings, and Shade Foods, Inc. v. Innovative Products Sales and Marketing, Inc., 78 Cal.App.4th 847 (2000), which dealt with the inclusion of wood pieces into cereal nut clusters.
Both Armstrong and Shade specifically relied on Eljier Mfg. Inc. v. Liberty Mutual Insurance Co., 972 F.2d 805 (7th Cir. 1992). Eljier arose from the installation into houses of a plumbing system that had the potential to leak. After considering the purpose of liability insurance, the Eljier court concluded that "physical injury" included "a loss that results from physical contact, physical linkage, as when a potentially dangerous product is incorporated into another and, because it is incorporated and not merely contained (as a piece of furniture is contained in a house but can be removed without damage to the house) must be removed, at some cost, in order to prevent the danger from materializing." The Watts court observed that two other courts in California had rejected the expansive logic of Eljier: F & H Construction and Seagate Technology v. St. Paul Fire and Marine Insurance, 11 F. Supp.2d 1150 (N.D. Cal 1998).
The Watts court concluded, on a narrow reading of the Armstrong and Shade courts' holdings, that the incorporation of "hazardous" products into tangible property constituted a "physical injury" and thus "property damage." Accordingly, the Watts court found that the use of the allegedly "hazardous" parts and fittings in a municipal water system resulted in property damage to the water system. The allegations of the underlying complaints, therefore, triggered coverage under the Zurich policy.
In Watts, the 2nd District appears to have announced a new interpretation of the Incorporation Doctrine by limiting the theory to the incorporation of "hazardous products." As will be described below, the Court of Appeal ruling is the latest twist in the reluctant judicial acceptance of the Incorporation Doctrine in California.
Early Development of the Incorporation Doctrine
The question of whether incorporation of a defective or unwanted product or material into another product constitutes "property damage" has a long history. The roots of the Incorporation Doctrine usually are traced to Hauenstein v. St. Paul Mercury Indemnity Co., 65 N.W.2d 122 (Minn.1954). Hauenstein found that the incorporation of defective plaster into homes resulted in an injury measured by the "diminution in value" of the homes. Under the pre-1973 standard CGL policy form, "property damage" was defined as "injury" to "property." This rationale and logic was adopted by the California Supreme Court in Geddes & Smith, Inc. v. St. Paul Indemnity Co., 51 Cal.2d 558 (1959) [installation of doors].
Insurance Industry's Attempt to End the Incorporation Doctrine
In 1973, the insurance industry revised the language of the CGL standard policy so that "property damage" required "physical injury to tangible property." In interpreting this new definition, some courts began to reject the Incorporation Doctrine on the basis that "diminution in value" was an economic and not a "physical" injury. New Hampshire Insurance Co. v. Vieira, 930 F.2d 696 (9th Cir. 1991). It should be noted, however, that Hauenstein and Geddes found "diminution in value" was not the injury but rather the measure of the injury. Geddes, 51 Cal.2d at 565, quoting Hauenstein, 68 N.W.2d at 125.
Eljier Breathes New Life into the Old Doctrine
The 7th Circuit in Eljier considered whether the incorporation of defective plumbing systems into homes was "property damage" under the 1973 policy language. The court considered the purpose of liability insurance and the meaning of the term "physical injury." The purpose of insurance is to spread risks. Once the plumbing system is installed, the court noted, the manufacturer no longer was in control of the risk. At that point, the risk was properly transferred to insurance. Further, the addition of the adjective "physical" to "injury" in the 1973 "property damage" definition was intended to distinguish between physical and nonphysical injuries rather than injuries and non-injuries. A "physical injury" results from physical contact or physical linkage such as when a potentially dangerous product is incorporated into another. Accordingly, the incorporation of a potentially defective plumbing system into houses constituted "property damage" when defined as "physical injury to tangible property."
California Courts' Mixed Reaction to Eljier
As noted by the Watts court, Eljier has had a mixed reception in California. In 1996, the 1st District, in Armstrong, 45 Cal.App.4th 1, expressly agreed with and adopted the logic of Eljier. Armstrong noted that certain cases had interpreted the rule to be that the physical incorporation of a defective product does not, by itself, constitute "property damage." However, these cases concerned contractors or subcontractors for whom defective workmanship and products were a business risk. Armstrong, in contrast, was a manufacturer or supplier of building materials.
In 2000, the 1st District in Shade Foods, Inc., 78 Cal.App.4th 847, reaffirmed the logic of Armstrong. Shade noted that there were two different threads of the Incorporation Doctrine: one that rejected "diminution in value" as "property damage" (Vierira and Seagate) and a second holding that physical presence of a defective product which injures a larger whole constituted covered "property damage. (Eljier and Armstrong). The Shade court admitted that the distinction between the two approaches was "a fine one to draw." However, following the Armstrong decision, the court found that the incorporation of a potentially injurious material such as wood into separate nut clusters caused a physical injury to tangible property and this constituted "property damage."
In F & H Construction, 118 Cal.App.4th 364, the 3rd District Court of Appeal considered whether welding inadequate pile caps onto driven piles constituted "property damage." The F & H Construction court strongly criticized and rejected Eljier. It agreed with the dissent in the Eljier case, which asserted that there was no "injury" when a potentially defective product was installed. Relying on Traveler's Insurance Co. v. Eljier Mfg. Co., 757 N.E.2d 481 (Ill. 2001), F & H Construction found that "physical injury' required some actual alteration in appearance, shape, color or other material dimension. Accordingly, the mere presence of defective pile caps did not constitute a "physical injury" to the driven piles.
Current Status of the Incorporation Doctrine In California
The current status of the Incorporation Doctrine in California is unclear. The 3rd District in F & H Construction appears to have entirely rejected the Incorporation Doctrine, with its finding that the incorporation of a defective product into a larger whole does not constitute "physical injury" without some manifest actual deterioration of the larger whole. In contrast, the 1st District in Armstrong and Shade, relying on Eljier, has held that the Incorporation Doctrine applies when an insured supplier's defective materials or products are incorporated into a larger whole.
The 2nd District in Watts now has taken a third approach, based on a narrow reading of Armstrong and Shade. It found an "injury" when an alleged "hazardous product" is incorporated although the "hazardous product" had not resulted in any actual deterioration to the larger whole beyond its mere presence. The exact definition of "hazardous product" is far from clear.
Both Eljier (a plumbing system) and Armstrong (asbestos) found an "injury" to "tangible property" by looking to the effect of the alleged defective product on the tangible property into which it had been incorporated. Watts, in contrast, found an "injury" to "tangible property" by focusing on the effect of the alleged defective product on persons unrelated to the tangible property. In other words, Watts appears to stand for the proposition that the physical incorporation of a product into a larger whole results in an "injury" to the larger whole if that product has the potential to cause bodily injury to persons. Therefore, a product may be considered a "hazardous product" if it has the capability of ultimately causing bodily injury to persons.
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©2004 Howrey LLP
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