Originally printed in the Insurance Specialist
Vol 2., Issue 6, 1997
In July of this year a Detroit grocer doing business as Produce Palace filed a lawsuit against the company from which it purchased a computer system to network its cash registers, inventory and accounting system. At the time it filed its complaint, neither the grocer nor its attorney had any reason to know that it was firing "the shot heard 'round the world" in the coming war over the Year 2000 problem.
However, as the first case uncovered by the press in which a disgruntled computer purchaser raised the Year 2000 bug as one of the alleged defects supporting its claims, Produce Palace International v. TEC-America Corporation became widely reported as the opening skirmish in what could soon become a litigation maelstrom engulfing computer users, vendors, maintenance organizations, customers and, of course, all of their insurers. Given the prospect of such a conflagration, it is worth examining briefly the origins of the dispute, the nature of the allegations and the insurance coverage implications of what is surely one of the major paradigms of future Y2K litigation.
The Allegations of the Complaint
Plaintiff Produce Palace alleges in its complaint that it purchased a new computer system to network its cash registers, monitor inventory, process credit cards and expedite accounting. The system came with the usual representations of the seller as to the superiority of the system to competitive products and with certain express warranties. While not disclosed in the complaint, one may assume that the contract also had clauses limiting liability to the express warranties in the contract, which were good only for a relatively short period of time, and restricting the buyer's remedies to certain repair or replace obligations.
The foundation of Produce Palace's claim is the loss of the use of a major business asset--the computer system itself. According to Produce Palace, the system was installed in 1995 and during the first two years it was down 20% during business hours. Typically the problems appear to have centered around "the failure of the computer to process credit cards" and especially "credit cards that expire on or after the year 2000." These system failure are alleged to have caused long lines at check-out counters and angry customers to abandon their carts and storm out of the store. In addition to lost sales and damage to goodwill, difficulties with the system are alleged to have cost the grocer excessive employee overtime and compromised the security of sensitive financial information.
The complaint alleges breach of express contractual warranties, the implied warranty of merchantability, and the warranty of fitness for a particular purpose. It also alleges violation of various Michigan consumer protection statutes, negligence in the numerous attempts to repair the system, and misrepresentation (that is, fraud) in falsely representing their ability to repair the system in a timely and effective manner. While damages are not specified, news reports suggest that plaintiff is seeking a six-figure recovery.
None of these allegations or claims are in any way unusual. In the typical case involving the failure of any computer system, the buyer will assert various breach of contract claims as well as tort claims framed in terms of both negligence and fraud. The tort theories of recovery are typically pled to try to avoid limitations on liability contained in the contract. The viability of such theories will depend on the law of the particular jurisdiction and the facts of the given case.
In cases such as this, it is not unusual to see the litigation broadened to bring in additional parties possibly responsible for the perceived problems in the system. In Produce Palace, for example, the allegations regarding the difficulties in processing credit card transactions might well lead to claims by one party or the other against the merchant bank or those responsible for the transmission of data between the merchant, the bank, data clearinghouse or others in the payments industry. In Y2K failures over the next few years, one may well see exceedingly complex interdependent relationships leading to multi-party litigation in which the parties simultaneously face both a difficult technical problem and a lawsuit driven allocation of responsibility. Each party will motivated to trace its own difficulties in a given business failure not only to particular vendors but to business partners with whom it regularly exchanges data.
But how and why are cases like Produce Palace likely to involve insurers? Just as complex environmental disputes among various potentially responsible parties in the 1980's spawned a second layer of litigation against and among the participants' insurers, Y2K litigation seems very likely to lead to coverage disputes with first party and various liability insurers. While it is impossible to predict the outcome of these future coverage wars or the specific claims that will give rise to them, Produce Palace provides a useful window through which policyholders and insurers can view the kinds of insurance coverage disputes that might erupt as the clock counts down to 2000.
Insurance Coverage Implications of Produce Palace
Both parties in the Produce Palace case should be motivated look to traditional sources of coverage to help them through their troubles. Although policyholders and insurers will face significant hurdles in attempting to establish and defeat coverage for Y2K claims, the sheer financial scope of Y2K fix costs and potential liabilities virtually ensures a series of contentious coverage disputes.
The defendants in the Product Palace case, the manufacturer and distributor of the computer system, will in all likelihood ask their general liability insurers (and perhaps also the defendant manufacturer's errors and omissions insurer) to step forward to defend the lawsuit against them.
As even the most inexperienced risk manager knows, property damage coverage under a general liability policy consists of two kinds of damage: actual physical injury to tangible property and the loss of use of tangible property. In tendering their CGL claim, the Produce Palace defendants will recharacterize the allegations against them in an effort to trigger their property damage coverage. They will argue that the claim against them arises out of the plaintiff's loss of use of the system or the computerized data in the system and perhaps also, the physical destruction or corruption of their data.
Although not without difficulties, these theories are also not altogether implausible, given that some courts have already recognized that similar claims have the potential to trigger the defense provisions of general liability policies. Centennial Ins. Co. v. App. Health Care Sys., Inc., 710 F.2d 1288, 1291 (7th Cir. 1983). And as most CGL insurers know from the pollution clean-up and asbestos experiences, defense cost liability alone can be a huge expense for insurers in complex litigation. It is likely that the policyholders will also point to the plaintiff's allegations of negligent repairs made to the Produce Palace system and the allegedly resulting data losses as an additional basis for invoking property damage coverage under their CGL.
Against these theories of coverage, the insurers will assert of litany of coverage defenses and exclusions. No doubt the first line of defense will be the argument that none of the losses constitute an "accident" or "occurrence" under their policies. Should the insureds breach that hurdle, the carriers will almost certainly fall back to the argument that the loss of use or destruction of computerized data is not injury to or the loss of use of "tangible" property. The safety of that harbor, although appealing, is far from certain under some court decisions which have held out the prospect of CGL coverage for data losses. The insurers will also argue that the losses claimed by the Produce Palace plaintiff are entirely economic in nature and therefore beyond the scope of CGL coverage. However, experienced coverage counsel will readily concede that the "economic damage" defense is imperfect at best, heavily dependent on the specific facts of the case and unlikely to offer an insurer a comprehensive coverage defense.
The CGL carriers will almost certainly make their most determined stand against this onslaught of claims through their exclusions. First, they will argue that the defendants' claim is barred under the exclusion against expected or intended damage. (Note that some carriers are still issuing the 1973 ISO CGL form which deals with this issue in the definition of "occurrence.") The insurers will contend that the Y2K problem was a known condition in the Produce Palace computer system and could have been corrected in advance of failure.
Second, the carriers will rely on the standard CGL exclusion against liability arising out of the insured's recalled products, work or impaired property. Although the insurers may have much to argue about here, the complexity of this exclusion poses the very real possibility that some courts will the exclusion ambiguous and therefore construe the exclusion in favor of the insured.
Third, insurers are likely to assert that the Produce Palace claims arise out of contract obligations and are therefore excluded by the bar against contractual liabilities.
Fourth, the insurers will argue that any damage suffered by the Produce Palace computer system is barred by the exclusion against damage to the insured's work or products. These exclusions may present special problems for those manufacturers in the computer industry seeking CGL coverage against Y2K claims based upon breach of warranty theories.
Finally, some carriers out in front of the Y2K issue, have begun endorsing exclusions onto their policies for losses arising out of "programming." While uncommon in the standard CGL forms, insureds can expect to see such exclusions with increasing frequency in the days ahead. Decisionone Corp. v. ITT Hartford Ins. Group, 942 F.Supp. 1038 (E.D. Pa. 1996).
Nor should the Produce Palace plaintiff's coverage prospects be ignored. Certainly, the plaintiff will explore a business interruption claim under its first party coverage. Such policies, assuming additional conditions for coverage can be established, may also provide a lucrative source of Y2K coverage for extra expenses or costs a company may incur to remain operational during a Y2K event. Y2K failures which spawn traditional casualty events such as fires, explosions, spills or other industrial accidents are the kinds claims insurers will find difficult to exclude or avoid. Furthermore, many first party policies provide specialty coverage for the loss of accounts receivable and other vital business documentation which might be rendered irretrievable through Y2K interruptions. As with the CGL scenarios, the insurers will again rely on a range of potential exclusions to blunt such claims.
This rich mix of coverage theories and exclusions, makes it abundantly clear that insureds and insurers will have plenty to talk about as Y2K litigation becomes more commonplace. While these claims will certainly turn on the specifics of the facts before the parties in a given case, the stakes involved in the magnitude of the Y2K problem make it very likely that coverage litigation will be an important aspect of Y2K litigation.
New Solutions to Coverage Uncertainties
The uncertainties inherent in traditional coverages may, of course, be partially alleviated by changes in standard coverage forms between now and the millennium. Such changes may either clarify the existence of coverage for certain limited types of exposure or, more likely, exclude certain categories of risk -- especially where the expectation of coverage might lessen the insured's incentives to remediate its own Y2K problems, resolve its supply chain problems and engage in responsible contingency planning.
Nevertheless, as uncertainties are sure to remain regarding the nature and scope of both first party and liability coverage, one can also expect the insurance industry to develop new products to address the market demand for protection from the unique risks posed by the Y2K crisis. The industry responded to similar demands for specialized environmental coverage in the 1980's, and analogous products are coming into the market for the Y2K risk. One can expect the demand for such coverage to increase as we approach the millennium and cases such Produce Palace become so commonplace in every sector of the economy.