Fourth Circuit Rules Damage Caused by AOL Software did not Constitute Property Damage Under Insurance coverage

Within a few months of the release of America Online, Inc. (AOL) Version 5.0 access software in October 1999, consumers began filing class action lawsuits against AOL alleging that the application “altered… existing software, disrupted… network connections, caused the loss of stored data, and caused… operating systems to crash.” Forty-three of the lawsuits were consolidated in a multidistrict litigation (MDL) complaint, and were later settled under a court-approved agreement with AOL for $15.5 million in compensation to the plaintiffs.AOL tendered the defense of the class action suits to its insurers: St. Paul Mercury Insurance Company (St. Paul), its primary insurer, and Underwriters at Lloyd’s of London, its professional liability insurer. St. Paul denied coverage because, in its view, the suits did not allege damages to ‘tangible’ property or for bodily injury or property damage as defined by St. Paul’s commercial general liability coverage. On cross-motions for summary judgment, the district court denied AOL’s motions and granted St. Paul’s motion, concluding that damages to computer data and systems did not allege “physical damage to tangible property.”

AOL appealed, contending that (1) plaintiffs in the underlying complaints alleged damages to “computers,” which are “tangible property”; (2) “physical damage to tangible property” includes physical damage to software because software is comprised of atoms arranged on computer disks and has a physical property; and (3) “tangible” is an ambiguous policy term and should be construed in the insured’s (i.e., AOL’s) favor.

The Fourth Circuit rejected AOL’s arguments. The court found that damage to a “computer” could mean damage to hardware or software. Because the plaintiffs ultimately claimed damage to their software, the central issue, in the Court’s view, was whether damage to software qualifies as physical damage to tangible property.

The court concluded that while physical magnetic material on a hard drive (the medium which stores information) is tangible, the data, information, and instructions are abstract ideas and must be considered apart from the medium. Magnetic disks, switches, and other computer hardware are media, which are not damaged with the loss of software. If the software is unusable, the hardware could still accept instructions and recording. Consequently, the court held that damage to physical, hardware components of the computer is covered by insurance policy under “physical damage to tangible property,” but loss of instructions, data, and stored information is not.

As an additional contention, AOL argued that even in the absence of physical damage to tangible property, it was exposed to property damage because plaintiffs claimed damages arising from “loss of use,” which was included in the policy’s definition of “property damage.” St. Paul said and the court agreed that the “impaired property” exclusion, which precluded coverage for lost use of tangible property that is not physically damaged, applied to this claim. Because no damage to tangible or physical components of computers had occurred, the loss of use was not covered by the policy.

America Online, Inc. v. St. Paul Mercury Ins. Co., v.No. 02-2018 (4th Cir. Oct. 15, 2003).

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