America Online, Inc. v. St. Paul Mercury Ins. Co.

• Decision Date: 15 October 2003
• Docket Number: No. 02-2018.,No. 02-2084.,02-2018.,02-2084.
• Citation: 347 F.3d 89
• Parties: AMERICA ONLINE, INCORPORATED, Plaintiff-Appellant, v. ST. PAUL MERCURY INSURANCE COMPANY, Defendant-Appellee. America Online, Incorporated, Plaintiff-Appellee, v. St. Paul Mercury Insurance Company, Defendant-Appellant.
• Court: U.S. Court of Appeals — Fourth Circuit

347 F.3d 89

AMERICA ONLINE, INCORPORATED, Plaintiff-Appellant, v. ST. PAUL MERCURY INSURANCE COMPANY, Defendant-Appellee.

America Online, Incorporated, Plaintiff-Appellee, v. St. Paul Mercury Insurance Company, Defendant-Appellant.

No. 02-2018.

No. 02-2084.

United States Court of Appeals, Fourth Circuit.

Argued: May 6, 2003.

Decided: October 15, 2003.

ARGUED: John Edward Heintz, GILBERT, HEINTZ & RANDOLPH, L.L.P., Washington, D.C., for Appellant.

James E. Rocap, III, BAKER BOTTS, L.L.P., Washington, D.C., for Appellee.

ON BRIEF: Donna L. Wilson, Scott N. Godes, GILBERT, HEINTZ & RANDOLPH, L.L.P., Washington, D.C.; John Foster Anderson, RICHARDS, McGETTIGAN, REILLY & WEST, P.C., Alexandria, Virginia, for Appellant.

Mark A. Miller, Christopher T. Stidvent, BAKER BOTTS, L.L.P., Washington, D.C., for Appellee.

Before WILKINSON, NIEMEYER, and TRAXLER, Circuit Judges.

Affirmed by published opinion. Judge NIEMEYER wrote the opinion, in which Judge WILKINSON joined. Judge TRAXLER wrote a dissenting opinion.

OPINION

NIEMEYER, Circuit Judge:

After America Online, Incorporated ("AOL") released to the public its Version 5.0 access software, consumers filed numerous class actions against AOL, alleging that the software had substantial "bugs" in it and was incompatible with their computers' other applications software and operating systems, causing the computers to be damaged. AOL tendered the defense of these actions to its insurers, St. Paul Mercury Insurance Company ("St.Paul"), its primary insurer, and to Underwriters at Lloyd's of London, its professional liability insurer. St. Paul denied coverage mainly because the damages claimed by the consumers were not "property damage" as defined by the relevant provisions of the applicable policy. AOL commenced this action against St. Paul for a declaratory judgment that St. Paul owed AOL a duty to defend and indemnify and for damages.

The district court granted summary judgment to St. Paul on the grounds that the consumers' underlying complaints did not allege physical damage to tangible property and that any damage from loss of use of tangible property fell within a policy exclusion. We affirm.

I

AOL, a Delaware corporation with its principal place of business in Dulles, Virginia, is an Internet service provider whose proprietary software products enable consumers to access the Internet and AOL's online services, such as e-mail.

In October 1999, AOL released to the public its Version 5.0 access software, and within a few months, consumers began filing class-action lawsuits against AOL in state and federal courts throughout the country, alleging damage from the installation and operation of Version 5.0. These plaintiffs alleged that Version 5.0 was rushed to market after minimal testing to mark AOL's tenth anniversary and, as a result, was not yet free of "substantial bugs and incompatibility with numerous applications and operating systems." They asserted that the software's installation process was "defectively designed and/or unreasonably dangerous," causing "serious injury to their computer system and preexisting software." Specifically, the plaintiffs alleged:

(1) interference to users' host systems' communications configurations and settings such as non-AOL communications software and online services the plaintiffs are using or might want to use in the future;

(2) the inability of users to connect to other [Internet service providers], competitors of AOL;

(3) the inability to run non-AOL e-mail programs, or connect to local networks;

(4) the addition or alteration of hundreds of files on the users' system, including many essential components of the Windows operating system, which may cause the system to become unstable; and

(5) the inability of users to remove the AOL 5.0 software completely, so as to restore their computer's communications configuration, so that other competitor online services could be used.

For many of the plaintiffs, "the only reported remedy [was] to reinstall Windows, which may [have] involve[d] the more extreme step of first reformatting the hard drive on their personal computer." In short, the underlying complaints alleged that Version 5.0 altered the plaintiffs' existing software, disrupted their network connections, caused the loss of stored data, and caused their operating systems to crash.

Forty-three of the lawsuits were consolidated by the judicial panel on multidistrict litigation ("MDL") for pre-trial proceedings in the Southern District of Florida, pursuant to 28 U.S.C. § 1407, and the plaintiffs in those cases filed a consolidated MDL complaint. Certain of the claims, dubbed the "Bermuda Triangle" claims because of their "catch-all" allegations that could not be recreated or explained in laboratory testing, were handled separately from the MDL complaint. The parties to the multidistrict litigation later settled their disputes, and under a court-approved agreement, AOL established a cash fund of $15.5 million to compensate the plaintiffs.

As the individual class-action suits were filed against AOL, AOL tendered the defense to its insurers, St. Paul and Underwriters at Lloyd's of London. St. Paul denied coverage, explaining:

The claimants do not seek damages for bodily injury or property damage or for any injury or damage that was caused by an event as those terms are defined by the St. Paul [commercial general liability] coverage. The policy language excludes any loss or damage arising out of or caused by intentional or expected acts.

Later, St. Paul particularized this position to state that the plaintiffs' claims "do not allege damage to `tangible' property and are not property damage as defined by the St. Paul [commercial general liability] policy." Later yet, St. Paul also pointed to its "impaired property" exclusion which denies coverage for loss of use of tangible property that was not physically damaged. In response to the denial of coverage, AOL commenced this action against St. Paul, alleging breach of contract and seeking declaratory judgment that St. Paul was obligated to defend and indemnify AOL. It also demanded defense costs and compensatory damages.

On cross-motions for summary judgment, the district court denied AOL's motions and granted St. Paul's motion, making a distinction between computer software and computer hardware and concluding that the underlying suits alleged damage to computer data and systems but did not allege "physical damage to tangible property." Although the court recognized that property damage under the policy also included "loss of use of tangible property" and that the plaintiffs alleged loss of use of their computers, it concluded that coverage for loss of use was excluded by the impaired property exclusion.

From the district court's judgment, AOL filed this appeal, contending (1) that the damages claimed in the underlying complaints amounted to "physical damage to tangible property," and (2) that the complaints alleged "loss of use of tangible property" that was not excluded from coverage by the impaired property exclusion. St. Paul filed a cross-appeal, challenging the district court's conclusion that the underlying complaints alleged "loss of use" of tangible property.

II

Because this diversity action was filed in the Eastern District of Virginia, we apply Virginia choice-of-law rules to determine which state's substantive rules apply. See Klaxon Co. v. Stentor Elec. Mfg. Co., 313 U.S. 487, 496-97, 61 S.Ct. 1020, 85 L.Ed. 1477 (1941) (holding that a federal court with diversity jurisdiction must apply the choice-of-law rules of the State in which the federal court sits). In this case, the insurance contract between AOL and St. Paul was formed in Virginia and therefore we apply Virginia substantive law. See Buchanan v. Doe, 246 Va. 67, 431 S.E.2d 289, 291 (1993).

Under Virginia law, an insurer's obligation to defend an action "depends on comparison of the policy language with the underlying complaint to determine whether any claims alleged [in the complaint] are covered by the policy." Superformance Int'l, Inc. v. Hartford Cas. Ins. Co., 332 F.3d 215, 220 (4th Cir.2003) (internal quotation marks and citation omitted). And the obligation to defend is broader than the obligation to indemnify. "The obligation to defend arises whenever the complaint against the insured alleges facts and circumstances, some of which, if proved, would fall within the risk covered by the policy." Brenner v. Lawyers Title Ins. Corp., 240 Va. 185, 397 S.E.2d 100, 102 (1990) (internal citations omitted); see also Solers, Inc. v. Hartford Cas. Ins. Co., 146 F.Supp.2d 785, 791 (E.D.Va.2001). Adhering to the canon of construction that ambiguous terms in insurance agreements are construed against the insurer, Virginia law elaborates:

If the language of an insurance policy is unambiguous, we will give the words their ordinary meaning and enforce the policy as written. On the other hand, because the principal purpose of insurance is protection and insurance policies are drafted by insurance companies, if the language of a policy is capable of different interpretations, we will construe it in favor of coverage or indemnity and against a limitation of coverage.

United Servs. Auto. Ass'n v. Webb, 235 Va. 655, 369 S.E.2d 196, 198 (1988).

The underlying complaints allege in general that AOL's Version 5.0 access software altered the customers' existing software, disrupted their network connections, caused them loss of stored data, and caused their operating systems to crash. AOL contends that these claims are for physical damage to tangible property as covered by St. Paul's policy, making essentially three arguments in support of this contention. First, it argues that because the plaintiffs have alleged damage to "computers," they have alleged "physical damage to tangible property." Second, it argues that because software involves the arrangement of atoms on computer disks, software has a physical...