Court denies coverage in Y2K sue-and-labor suit

SEATTLE-Policyholders seeking insurance coverage for their costs of avoiding the Y2K computer bug have been dealt a blow by a state appeals court ruling that the Port of Seattle's insurers cannot be required to pay a claim brought under the sue-and-labor clause in the port's property policies.

In what is the first substantive appellate decision on the issue of coverage for Y2K remediation costs, the Court of Appeals for the State of Washington rejected the Port's arguments that insurers should pay its $10 million to $11 million in Y2K remediation costs because it incurred those costs through an attempt to prevent a future loss.

The court ruled that, because the expected loss would have occurred in a different policy year from those in which the remediation efforts took place, the remediation cost was not covered. The court also rejected the Port's argument that the Y2K bug constituted a computer virus and, therefore, was covered by the "data processing media" clause in the property policies.

The May 28 decision by the appeals court in Seattle is a setback for policyholders that are seeking coverage for their Y2K remediation costs, which in many cases totaled in the millions of dollars, attorneys say.

The Port of Seattle was one of the first large commercial policyholders to claim that its remediation costs should be covered under the sue-and-labor clause in its property policies, which provides that insurers will pay costs that policyholders incur in efforts to prevent a larger loss. The clause dates back to marine policies that were designed to pay for the costs of, for example, cargo that had been jettisoned in order to prevent a ship from sinking.

Policyholders have argued that the sue-and-labor clause, which is still contained in many property policies, should also apply to modern-day efforts to prevent a loss, such as reprogramming computers to ensure that they do not malfunction and cause other losses (BI, Jan. 15, 2001).

Insurers have vigorously denied Y2K remediation claims, and though the Washington appeals court did not specifically address the question of whether the sue-and-labor clause applies to Y2K remediation, the ruling is a significant defeat for policyholders, attorneys say.

About a dozen Y2K remediation cases are still being litigated today, and some of those might be withdrawn as a result of the decision, attorneys said. In addition, policyholders are less likely to file future Y2K claims, they note.

"I think it's the nail in the coffin, and I don't think we'll see any more litigation on this issue," said Walter J. Andrew, a partner at Shaw Pittman in Washington who has represented insurers in Y2K coverage disputes.

The state of Washington has traditionally been a seen as a pro-policyholder legal venue, and policyholders in other venues will likely be unwilling to pursue costly litigation in light of the decision, he said.

"People will see this and say, `We are wasting our money,' " Mr. Andrew said.

The ruling in a state that is generally more sympathetic to policyholders than to insurers might discourage other policyholders from filing claims, acknowledged Laurence J. Eisenstein, a partner at Swidler Berlin Shereff Friedman, a policyholder law firm in Washington.

"But I fully anticipate that we will see other decisions in the future," he said.

Although the decision did involve some issues that were specific to the Port of Seattle's claim, parts of the ruling could also apply to other Y2K remediation cases, Mr. Eisenstein said.

In Port of Seattle vs. Lexington Insurance Co. et al., the Port sought coverage for Y2K remediation costs under policies that were issued for 1997 and 1998, the years in which it incurred much of the costs it spent on modifying its computer system to ensure it would continue to function normally after the date change at midnight on Dec. 31, 1999. The Port, like many organizations, used computer systems that did not have the capacity to read four-digit years. Prior to the date change, it was widely feared that malfunctions and widespread damage could result if the computer systems were not upgraded to read four-digit years.

The Port sought coverage under the sue-and-labor provision in its property policy. In addition, it argued that the Y2K problem was a computer virus and was, therefore, covered under the data-processing portion of its policy.

The court ruled, however, that the sue-and-labor clause applies only to losses for which the insurer would be liable.

"The insurers did not have a duty to reimburse the Port for expenses spent to prevent a loss for which the insurers would not be liable. Because the Port sought to prevent losses that would occur on or after Jan. 1, 2000, after the policies expired, there was no covered loss," the ruling states.

The court also ruled that the Y2K problem was not a computer virus.

"We hold that the Port's Y2K problem was not a computer virus because it was not able to replicate itself and it could not infect other programs by modifying them to include a version of itself," the ruling states.

Furthermore, the court held, the Y2K problem was an "internal" problem in the computer systems and not an external one, so it is excluded under the "inherent vice" exclusion in the Port's policy.

"The Port's Y2K problem is an excluded inherent vice because the date field is an internal quality that brought about its own problem," the ruling states.

The ruling that the Y2K bug was not a computer virus is unlikely to affect many of the other Y2K remediation costs cases currently being litigated, said Mr. Eisenstein, the policyholder attorney.

However, if other courts follow the rulings on the sue-and-labor clause and the inherent vice exclusion, the ruling could shape the outcome of other cases, he said. He noted, though, that state appeals court rulings generally are not as influential as federal court rulings, as individual states often differ on insurance coverage issues.

Port of Seattle vs. Lexington Insurance Co. et al., Court of Appeals of the State of Washington, No. 49640-9-I.