Case Briefs

Damage to Computer Systems Caused by Installation of Software Not Covered Property Damage

In America Online v. St. Paul Mercury Insurance Co., No. 02-2098, ___ F.3d ___ (4th Cir. October 15, 2003), the U.S. Court of Appeals for the Fourth Circuit held that, under Virginia law, an insurer has no duty to defend or indemnify its insured, America Online (AOL), against claims that installation of version 5.0 of its internet-access software caused significant damage to its customers' computer systems and data.

In October 1999 AOL released Version 5.0 of its access software, used by its subscribers to access the Internet and AOL's content services. Soon thereafter, AOL was sued in numerous class actions by subscribers who claimed that installation of the software caused interference with their computers' communications settings, rendered non-AOL programs inoperable, altered hundreds of files on their computer hard drives (including critical system files), and was difficult to remove once installed. Many of the underlying plaintiffs alleged that their computer systems had become totally inoperable as a result.

AOL tendered the defense of these claims to its general liability insurer, St. Paul Mercury Insurance Company (“St. Paul”), who denied coverage claiming that the suits did not seek coverage for damage to “tangible” property, that there was no “event” giving rise to the damage, that the damage was the result of an expected or intended act, and that the “impaired property” exclusion in the policies precluded coverage. Thereafter, AOL initiated coverage litigation seeking a defense and indemnification for these claims from its insurer. On appeal, the Fourth Circuit affirmed the trial court's rulings that injury to software did not constitute damage to “tangible” property and that the “impaired property” exclusion precluded coverage.

Relying on dictionary definitions, Judge Paul V. Niemeyer, writing for the majority and joined by Judge J. Harvie Wilkinson, held that the word “tangible,” as used in the definition of property damage in the policy, was unambiguous and meant “capable of being touched: able to be perceived as materially existent esp. by the sense of touch: palpable, tactile” and “having physical substance apparent to the senses.” The court acknowledged that the magnetic disk of a hard drive was tangible property, but held that the software, data, and instructions stored on such hard drives do not constitute tangible property. Likening the inability of users to interface with computer code and data to the loss of a combination to a padlock, the court found that the rearrangement of data on a drive does not physically affect the capabilities or physical properties of the hard disk itself. Concluding that subscribers' inability to fully utilize their computer systems resulted from the rearrangement, deletion and corruption of data, the majority held that there was no coverage because no “tangible” property had been damaged.

The majority also held that AOL was not entitled to coverage under the second prong of the definition of “property damage,” which provides coverage for the loss of use of tangible property that is not physically injured. The court relied on that portion of the “impaired property” exclusion that precluded coverage for “property which isn't physically damaged that results from: your faulty or dangerous products or completed work.” Notwithstanding the broad grant of coverage for loss of use of property that is not physically injured, the court held “this exclusion bars coverage for loss of use of tangible property of others that is not physically damaged by the insured's defective product,” even if the damaged property was not “impaired property” (as defined). Thus, because the damaged data was not “tangible” property and the physical properties of the computer systems were not otherwise altered, the court concluded that the loss of use of the subscribers' computer systems was excluded.

In writing the decision for the majority, Judge Niemeyer, without citation, adopted the reasoning of his dissent earlier this year in NMS Services, Inc. v. The Hartford, 62 Fed. Appx. 511, 2003 WL 1904413 (4th Cir., April 21, 2003), where the majority, in an unreported case, held that, under a first-party property insurance policy, erasure and destruction of data during a hacker attack constituted covered “direct physical loss or destruction” of property. Notwithstanding Fourth Circuit precedent that an opinion of a panel can be overruled only by an en banc decision of the entire court (or the Supreme Court), Judge Niemeyer did not cite or seek to distinguish the seemingly contrary NMS Services holding (also under Virginia law) that erasure or destruction of data constitutes insured “physical” loss of property.

In the AOL case, one judge dissented. The dissent indicated disagreement with the majority's position on the tangible nature of data ' pointing out, for example, that data stored on a magnetic disk can be observed through a microscope ' and noted that the allegations contained in the complaints alleged far more than loss of data; the complaints alleged that subscribers had suffered the physical disabling of their entire computer systems, which should be sufficient to trigger the duty to defend. Particularly in view of the conflict with NMS Services, the dissent's suggestion seems well taken that the question of whether injury to data constitutes damage to “tangible” property should be certified to the Virginia Supreme Court.

Insurer Has Duty to Disclose Impending Policy Changes

In Pastoria v. Nationwide Insurance Co., 2003 Cal. App. LEXIS 1638 (Cal. Ct. App. Oct. 31, 2003), the California Court of Appeal addressed a claim by individuals who had purchased health insurance policies from two insurers. The individuals alleged that the insurers had failed to tell them about impending changes in their policies before they purchased them. These changes involved deductibles, co-payments, deductions in amounts paid for outpatient services, and reductions in prescription drug benefits. The plaintiffs alleged that less than 2 months after their policies took effect, they received a notice of material changes. The insurers contended that they had complied with California law because, pursuant to California Insurance Code section 10199.1, they had given 30 days' notice of benefit changes and premium increases. The court of appeal rejected this argument. It found that the insureds had stated a claim for unfair competition under California Business and Professions Code section 17200. The court noted that the “sweeping language” of the section was intended to include “'anything that can properly be called a business practice and that at the same time is forbidden by law.'” The court stated that the insureds' contention that the insurers had a duty to disclose that “there were impending amendments to the policies changing premiums and benefits, even before the [insureds] purchased their policies,” is “not without merit.” However, the court held that “an impending change to be actionable must be one that is in fact already established according to the insurer's operating procedures, but not implemented at the time a policy is purchased.” The court then noted that several California Insurance Code sections could be read to impose a statutory duty upon insurers to disclose impending amendments to their policies and that if an insurer failed to make such a disclosure, then “there is an unlawful act upon which to base an unfair competition claim under Business and Professions Code section 17200.” The court also concluded that such a failure to inform could give rise not only to an unfair practices claim, but also to claims for fraud and negligent failure to disclose. In so holding, the court rejected the insurers' argument that the duty to disclose imposed by the California Insurance Code applies only to applicants for insurance and insureds, but not to insurers. The court held that such a “distinction is absent from the plain language” of the Insurance Code and that the Insurance Code establishes “a duty to disclose” applicable to insurers.

'Related Acts' Predating Policy Bar Coverage

In Medical Care America, Inc. v. National Union Fire Insurance Company of Pittsburgh, Pennsylvania, 2003 WL 21788994, ___ F.3d ___ (5th Cir. Tex. August 5, 2003) the U.S. Court of Appeals for the Fifth Circuit (applying Texas law) affirmed the judgment of the District Court in favor of an insurer holding that the “prior acts” endorsement in a policy expressly excluded losses that resulted from wrongful acts if those acts were related to wrongful acts that predated the coverage period despite the fact that the applicable binder did not reference “related acts.”

In anticipation of a merger, Medical Care America (“Medical Care”) sought to purchase directors and officers (D&O) liability insurance “going forward” from the date of the merger. A binder issued by an agent for National Union Fire Insurance Company (“National Union”) to Medical Care provided $10 million of D&O coverage going forward from Sept. 9, 1992. The binder provided that the policy would exclude “all prior acts [that occurred] prior to policy inception date.” Thereafter, National Union issued the D&O liability policy which included the following endorsement: “In consideration of the premium charged, it is hereby understood and agreed that this policy only provides coverage for Loss arising from claims for alleged Wrongful Acts occurring on or after September 9, 1992 and prior to the end of the Policy Period and otherwise covered by this policy. Loss(es) arising out of the same or related Wrongful Act(s) shall be deemed to arise from the first such same or related Wrongful Act.” (Emphasis added.)

On Sept. 25, 1992, the new company announced flat earnings, causing the share value to plummet more than 50% in one day. The shareholders filed class action lawsuits alleging SEC violations against the companies and the directors and officers.

The complaints alleged that the defendants, including the directors and officers, made misrepresentations and failed to make disclosures in public statements and filings. National Union denied coverage relying on the related acts language of the prior acts endorsement.

After settling the underlying shareholder suit, Medical Care filed the instant suit against National Union seeking coverage under the D&O policy. The District Court granted in part and denied in part competing motions for summary judgment and ruled that: “the binder agreements are the controlling contracts of insurance at issue in this case.” Medical Care's claim for breach of contract was tried to a jury. At the close of the evidence, the parties filed motions for judgment as a matter of law (JMOL). The court denied Medical Care's motion and granted, in part, National Union's JMOL, ruling that the insurance contract included the related acts exclusion. The court further held that National Union was not equitably estopped from relying on the related acts exclusion. Thereafter, the jury concluded that Medical Care was not entitled to coverage. The jury found that the related acts exclusion barred Medical Care's claim for losses arising after Sept. 9, 1992 because the wrongful acts that gave rise to the loss were the same as or were related to wrongful acts which occurred prior to Sept. 9, 1992.

The Fifth Circuit conducted a de novo review of the District Court's rulings on the summary judgment motions and the JMOL. It was undisputed that, under Texas law, an insurance binder provides coverage according to the terms of the ordinary form of the contemplated policy. Although the binder was clear that the policy would exclude “all prior acts,” it was silent as to whether there was coverage for subsequent acts that were related to the prior acts. The District Court granted JMOL for National Union and held that Endorsement #7 (prior acts and related acts) “was the standard form normally or ordinarily issued by National Union” in its D&O policies. All the witnesses who testified at trial stated that it was National Union's standard practice to include the related acts language in the prior acts endorsement in the policies that it issued. Medical Care offered no contradictory evidence. After a complete review of the evidence, the Fifth Circuit affirmed the JMOL in favor of National Union.

Additionally, the Fifth Circuit found that Medical Care had failed to meet its burden of proving the five essential elements of equitable estoppel under Texas law. The Fifth Circuit specifically found that there was no evidence that National Union misrepresented or concealed the coverage terms. Moreover, the court found that Medical Care failed to use due diligence to ascertain the scope or effect of the prior acts endorsement.

Damage to Computer Systems Caused by Installation of Software Not Covered Property Damage

In America Online v. St. Paul Mercury Insurance Co., No. 02-2098, ___ F.3d ___ (4th Cir. October 15, 2003), the U.S. Court of Appeals for the Fourth Circuit held that, under Virginia law, an insurer has no duty to defend or indemnify its insured, America Online (AOL), against claims that installation of version 5.0 of its internet-access software caused significant damage to its customers' computer systems and data.

In October 1999 AOL released Version 5.0 of its access software, used by its subscribers to access the Internet and AOL's content services. Soon thereafter, AOL was sued in numerous class actions by subscribers who claimed that installation of the software caused interference with their computers' communications settings, rendered non-AOL programs inoperable, altered hundreds of files on their computer hard drives (including critical system files), and was difficult to remove once installed. Many of the underlying plaintiffs alleged that their computer systems had become totally inoperable as a result.

AOL tendered the defense of these claims to its general liability insurer, St. Paul Mercury Insurance Company (“St. Paul”), who denied coverage claiming that the suits did not seek coverage for damage to “tangible” property, that there was no “event” giving rise to the damage, that the damage was the result of an expected or intended act, and that the “impaired property” exclusion in the policies precluded coverage. Thereafter, AOL initiated coverage litigation seeking a defense and indemnification for these claims from its insurer. On appeal, the Fourth Circuit affirmed the trial court's rulings that injury to software did not constitute damage to “tangible” property and that the “impaired property” exclusion precluded coverage.

Relying on dictionary definitions, Judge Paul V. Niemeyer, writing for the majority and joined by Judge J. Harvie Wilkinson, held that the word “tangible,” as used in the definition of property damage in the policy, was unambiguous and meant “capable of being touched: able to be perceived as materially existent esp. by the sense of touch: palpable, tactile” and “having physical substance apparent to the senses.” The court acknowledged that the magnetic disk of a hard drive was tangible property, but held that the software, data, and instructions stored on such hard drives do not constitute tangible property. Likening the inability of users to interface with computer code and data to the loss of a combination to a padlock, the court found that the rearrangement of data on a drive does not physically affect the capabilities or physical properties of the hard disk itself. Concluding that subscribers' inability to fully utilize their computer systems resulted from the rearrangement, deletion and corruption of data, the majority held that there was no coverage because no “tangible” property had been damaged.

The majority also held that AOL was not entitled to coverage under the second prong of the definition of “property damage,” which provides coverage for the loss of use of tangible property that is not physically injured. The court relied on that portion of the “impaired property” exclusion that precluded coverage for “property which isn't physically damaged that results from: your faulty or dangerous products or completed work.” Notwithstanding the broad grant of coverage for loss of use of property that is not physically injured, the court held “this exclusion bars coverage for loss of use of tangible property of others that is not physically damaged by the insured's defective product,” even if the damaged property was not “impaired property” (as defined). Thus, because the damaged data was not “tangible” property and the physical properties of the computer systems were not otherwise altered, the court concluded that the loss of use of the subscribers' computer systems was excluded.

In writing the decision for the majority, Judge Niemeyer, without citation, adopted the reasoning of his dissent earlier this year in NMS Services, Inc. v. The Hartford , 62 Fed. Appx. 511, 2003 WL 1904413 (4th Cir., April 21, 2003), where the majority, in an unreported case, held that, under a first-party property insurance policy, erasure and destruction of data during a hacker attack constituted covered “direct physical loss or destruction” of property. Notwithstanding Fourth Circuit precedent that an opinion of a panel can be overruled only by an en banc decision of the entire court (or the Supreme Court), Judge Niemeyer did not cite or seek to distinguish the seemingly contrary NMS Services holding (also under Virginia law) that erasure or destruction of data constitutes insured “physical” loss of property.

In the AOL case, one judge dissented. The dissent indicated disagreement with the majority's position on the tangible nature of data ' pointing out, for example, that data stored on a magnetic disk can be observed through a microscope ' and noted that the allegations contained in the complaints alleged far more than loss of data; the complaints alleged that subscribers had suffered the physical disabling of their entire computer systems, which should be sufficient to trigger the duty to defend. Particularly in view of the conflict with NMS Services, the dissent's suggestion seems well taken that the question of whether injury to data constitutes damage to “tangible” property should be certified to the Virginia Supreme Court.

Insurer Has Duty to Disclose Impending Policy Changes

In Pastoria v. Nationwide Insurance Co., 2003 Cal. App. LEXIS 1638 (Cal. Ct. App. Oct. 31, 2003), the California Court of Appeal addressed a claim by individuals who had purchased health insurance policies from two insurers. The individuals alleged that the insurers had failed to tell them about impending changes in their policies before they purchased them. These changes involved deductibles, co-payments, deductions in amounts paid for outpatient services, and reductions in prescription drug benefits. The plaintiffs alleged that less than 2 months after their policies took effect, they received a notice of material changes. The insurers contended that they had complied with California law because, pursuant to California Insurance Code section 10199.1, they had given 30 days' notice of benefit changes and premium increases. The court of appeal rejected this argument. It found that the insureds had stated a claim for unfair competition under California Business and Professions Code section 17200. The court noted that the “sweeping language” of the section was intended to include “'anything that can properly be called a business practice and that at the same time is forbidden by law.'” The court stated that the insureds' contention that the insurers had a duty to disclose that “there were impending amendments to the policies changing premiums and benefits, even before the [insureds] purchased their policies,” is “not without merit.” However, the court held that “an impending change to be actionable must be one that is in fact already established according to the insurer's operating procedures, but not implemented at the time a policy is purchased.” The court then noted that several California Insurance Code sections could be read to impose a statutory duty upon insurers to disclose impending amendments to their policies and that if an insurer failed to make such a disclosure, then “there is an unlawful act upon which to base an unfair competition claim under Business and Professions Code section 17200.” The court also concluded that such a failure to inform could give rise not only to an unfair practices claim, but also to claims for fraud and negligent failure to disclose. In so holding, the court rejected the insurers' argument that the duty to disclose imposed by the California Insurance Code applies only to applicants for insurance and insureds, but not to insurers. The court held that such a “distinction is absent from the plain language” of the Insurance Code and that the Insurance Code establishes “a duty to disclose” applicable to insurers.

'Related Acts' Predating Policy Bar Coverage

In Medical Care America, Inc. v. National Union Fire Insurance Company of Pittsburgh, Pennsylvania, 2003 WL 21788994, ___ F.3d ___ (5th Cir. Tex. August 5, 2003) the U.S. Court of Appeals for the Fifth Circuit (applying Texas law) affirmed the judgment of the District Court in favor of an insurer holding that the “prior acts” endorsement in a policy expressly excluded losses that resulted from wrongful acts if those acts were related to wrongful acts that predated the coverage period despite the fact that the applicable binder did not reference “related acts.”

In anticipation of a merger, Medical Care America (“Medical Care”) sought to purchase directors and officers (D&O) liability insurance “going forward” from the date of the merger. A binder issued by an agent for National Union Fire Insurance Company (“National Union”) to Medical Care provided $10 million of D&O coverage going forward from Sept. 9, 1992. The binder provided that the policy would exclude “all prior acts [that occurred] prior to policy inception date.” Thereafter, National Union issued the D&O liability policy which included the following endorsement: “In consideration of the premium charged, it is hereby understood and agreed that this policy only provides coverage for Loss arising from claims for alleged Wrongful Acts occurring on or after September 9, 1992 and prior to the end of the Policy Period and otherwise covered by this policy. Loss(es) arising out of the same or related Wrongful Act(s) shall be deemed to arise from the first such same or related Wrongful Act.” (Emphasis added.)

On Sept. 25, 1992, the new company announced flat earnings, causing the share value to plummet more than 50% in one day. The shareholders filed class action lawsuits alleging SEC violations against the companies and the directors and officers.

The complaints alleged that the defendants, including the directors and officers, made misrepresentations and failed to make disclosures in public statements and filings. National Union denied coverage relying on the related acts language of the prior acts endorsement.

After settling the underlying shareholder suit, Medical Care filed the instant suit against National Union seeking coverage under the D&O policy. The District Court granted in part and denied in part competing motions for summary judgment and ruled that: “the binder agreements are the controlling contracts of insurance at issue in this case.” Medical Care's claim for breach of contract was tried to a jury. At the close of the evidence, the parties filed motions for judgment as a matter of law (JMOL). The court denied Medical Care's motion and granted, in part, National Union's JMOL, ruling that the insurance contract included the related acts exclusion. The court further held that National Union was not equitably estopped from relying on the related acts exclusion. Thereafter, the jury concluded that Medical Care was not entitled to coverage. The jury found that the related acts exclusion barred Medical Care's claim for losses arising after Sept. 9, 1992 because the wrongful acts that gave rise to the loss were the same as or were related to wrongful acts which occurred prior to Sept. 9, 1992.

The Fifth Circuit conducted a de novo review of the District Court's rulings on the summary judgment motions and the JMOL. It was undisputed that, under Texas law, an insurance binder provides coverage according to the terms of the ordinary form of the contemplated policy. Although the binder was clear that the policy would exclude “all prior acts,” it was silent as to whether there was coverage for subsequent acts that were related to the prior acts. The District Court granted JMOL for National Union and held that Endorsement #7 (prior acts and related acts) “was the standard form normally or ordinarily issued by National Union” in its D&O policies. All the witnesses who testified at trial stated that it was National Union's standard practice to include the related acts language in the prior acts endorsement in the policies that it issued. Medical Care offered no contradictory evidence. After a complete review of the evidence, the Fifth Circuit affirmed the JMOL in favor of National Union.

Additionally, the Fifth Circuit found that Medical Care had failed to meet its burden of proving the five essential elements of equitable estoppel under Texas law. The Fifth Circuit specifically found that there was no evidence that National Union misrepresented or concealed the coverage terms. Moreover, the court found that Medical Care failed to use due diligence to ascertain the scope or effect of the prior acts endorsement.