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A recent pair of decisions by the 8th U.S. Circuit Court of Appeals provides a unique view of opposing lines of reasoning with regard to what constitutes "direct physical loss" for purposes of business interruption insurance.
In Source Food Technology Inc. vs. United States Fidelity & Guaranty Co., the 8th Circuit initially held, under Minnesota law, that a direct physical loss had occurred but later filed a superseding opinion finding no evidence of a direct loss. The result of these two decisions appears to confirm that actual physical contamination is required to establish a direct physical loss for purposes of business interruption insurance.
The crux of the issue in Source Food was whether an embargo that prevented shipment of uncontaminated beef products could constitute a "direct physical loss" under the policyholder's business interruption insurance.
In early 2003, the U.S. Department of Agriculture closed the Canadian border to imports of Canadian beef and beef products due to a mad cow disease outbreak. At the time of the embargo, Source Food's Canadian supplier had shipped a truckload of beef that was lost when the truck could not cross the border. Since the Canadian supplier was its sole supplier, Source Food shut down its business while it secured an alternate supplier.
It submitted a claim for business interruption benefits to its insurer USF&G. Both sides agreed that the beef product in the truck was uncontaminated and USF&G denied the claim based on the lack of a "direct physical loss." The trial court granted USF&G's summary judgment motion, finding that an embargo of an uncontaminated product was not a loss covered under business interruption insurance. Source Food appealed.
The original appeals court opinion, written by Judge Gerald W. Heaney, reversed the district court and held that direct physical loss can exist without structural damage to property. Judge Heaney relied heavily on General Mills Inc. vs. Gold Metal Insurance Co. and Sentinel Management Co. vs. New Hampshire Insurance Co., interpreting them to equate physical damage with "functional impairment" and finding "direct physical loss" despite the lack of tangible injury or destruction.
In the General Mills case, the policyholder recovered the cost of lost oats because the oats, which the parties conceded were safe for human consumption but sprayed with an unapproved pesticide, were barred from sale by the U.S. Food & Drug Administration. In Sentinel, the owner of an apartment building recovered the cost of asbestos abatement.
Judge Heaney reasoned that Source Food suffered a physical loss of the beef on the truck stuck in Canada--a loss sufficient to trigger business interruption coverage for all losses caused by the embargo.
On rehearing and after Judge Heaney's retirement, Judge Raymond W. Gruender wrote a superseding opinion, holding that Source Food had not suffered a direct physical loss. He found that in General Mills and Sentinel, both turned on actual physical contamination of the property: in General Mills, the treatment of oats with pesticides; in Sentinel, the presence of asbestos in the apartment building. Accordingly, Judge Gruender held that functional impairment--absent physical contamination--is not sufficient to create a direct physical loss.
Does this rule apply to less tangible property such as computer software?
Two opinions addressing this issue, American Guarantee & Liability Insurance Co. vs. Ingram Micro Inc. and Southeast Mental Health Center vs. Pacific Insurance Co. Ltd., both held that lost programming configurations or data corruption constituted direct physical loss because "physical damage is not restricted to the physical destruction or harm of computer circuitry but includes loss of access, loss of use, and loss of functionality."
However, this rule is not necessarily different from that of Source Food. Loss of functionality in the computer cases resulted from power outages that left the computers with different data and programming information than before the outage. In essence, the software sustained a technological form of physical damage.
Taken as a whole, Source Food and its predecessors articulate a rule that mere functional impairment is not enough; there must be physical damage or contamination to establish a direct physical loss under business interruption insurance. At the time of writing this article, a petition for rehearing by Source Food is pending with the 8th Circuit Court of Appeals.
Regardless of its eventual outcome, though, the lesson of these cases is the same one we've heard so often before: Pay attention to the language of the policy. A small effort "upfront" to make sure that both parties understand the risks that are intended to be covered and that the policy accurately reflects them, will be rewarded later, when losses happen.
Jess B. Millikan is a shareholder at law firm Bullivant Houser Bailey P.C. and chairs the firm's insurance coverage department. Stacey E. DiCicco is an associate at Bullivant. Both are based in the firm's San Francisco office.