(Article from Insurance Law Alert, January 2024)
For more information, please visit the Insurance Law Alert Resource Center.
Holding
The Fifth Circuit ruled that a Texas district court erred in dismissing Southwest’s breach of contract and bad faith suit, ruling that the cyber risk policy could potentially provide coverage for losses related to a computer system failure. Southwest Airlines Co. v. Liberty Ins. Underwriters, Inc., 2024 U.S. App. LEXIS 996 (5th Cir. Jan. 16, 2024).
Background
Southwest suffered a computer failure in 2016, resulting in a three-day suspension of its flight schedule. Prior to this event, Southwest obtained a cyber risk policy that included “System Failure Coverage,” as well as a tower of follow form excess policies. Southwest sought reimbursement of approximately $77 million it allegedly incurred as a result of the system failure. A primary insurer and the excess insurers in the first three tiers of coverage paid a total of $50 million, but Liberty, the fourth-tier excess insurer, denied coverage. Liberty argued that coverage under its policy (for losses exceeding $50 million) was not implicated because five categories of claimed losses—Fare Saver Promo codes, travel vouchers, Cover Refunds, Rapid Reward Points and advertising costs—were outside the scope of coverage because they were essentially voluntary payments not caused by the computer failure.
Southwest sued Liberty, alleging breach of contract and bad faith and seeking a declaration of coverage. The district court granted Liberty’s summary judgment motion, ruling that Southwest’s expenses were not caused by the system failure, but rather were the result of “various and purely discretionary customer-related rewards programs, practices and market promotions.” It further held that coverage was barred under certain policy exclusions. The Fifth Circuit reversed.
Decision
The System Failure Coverage provision applied to “all Loss . . . that an Insured incurs . . . solely as a result of a System Failure.” Liberty argued that the system failure was not the “sole” cause of Southwest’s claimed losses and that the “independent” and “more direct” causes of those losses were Southwest’s business decisions to incur them. Rejecting this assertion, the court explained that those business decisions were not the precipitating cause of the costs, but rather “links in a causal chain that led back to the system failure.”
With respect to policy exclusions, the Fifth Circuit ruled that the district court erred in concluding that coverage was barred as a matter of law. One exclusion applied to “any Loss . . . alleging, arising out of, based upon or attributable to contractual penalties or consequential damages.” The parties disputed interpretation of the term “consequential damages.” Southwest argued that the phrase referred to harms that flow “naturally, but not necessarily” from the initial cause and that “are not the usual result of the wrong,” and would include a customer’s lost business opportunity due to a canceled flight. In contrast, Liberty argued that consequential damages included any damages that are not direct and immediate. Siding with Southwest, the Fifth Circuit held that Liberty’s interpretation would render much of the policy coverage illusory, such as coverage for costs to repair damaged computer systems or otherwise undertaken to mitigate damage.
The Fifth Circuit also addressed application of an exclusion that applied to “any Loss . . arising out of, based upon or attributable to . . . any liability to third-parties for whatever reason.” The court rejected Liberty’s assertion that the term “third-parties” included customers and thus encompassed refunds or other payment to customers. The court reasoned that such an interpretation would effectively eliminate coverage under other provisions relating to “pecuniary obligations” such as fines and employee payroll obligations.
Comments
The court did not rule that Southwest’s system failure was the sole cause of each of the five categories of costs incurred by the airline (and therefore subject to coverage), but rather remanded the matter for resolution of that and other issues. The Fifth Circuit was not persuaded by Liberty’s argument that Southwest could “literally dictate the amount of its own ‘loss’,” but noted that basic insurance principles relating to business interruption coverage necessarily limited the type of expenses Southwest could recover under the policy and that Southwest would need to demonstrate, among other things, how its expenses would not result in a windfall “that would put Southwest in a better position than it would have occupied without the interruption.”