Oakland, CA – Since March 2020, hundreds of businesses across the United States have filed lawsuits against their insurance carriers for coverage related to COVID-19 under their business interruption insurance policies. The scope of coverage under all-risk policies depends on each insurance contract’s specific terms and conditions and exclusions that limit coverage, including the requirement that the insured suffer a direct physical loss. However, it now appears that the outcomes of these lawsuits may also depend on how the respective jurisdiction defines “physical loss.”

Courts across the country have not articulated a uniform rule to determine when insured property has sustained a “physical loss.” They disagree on whether the term “direct physical loss” requires physical damage to property (a determination that requires a detailed analysis of each individual case’s specific facts and circumstances). While some jurisdictions require physical damage to property (i.e., a tangible, physical alteration of property) like a hurricane or hailstorm, see, e.g., Dickie Brennan & Company, Inc. v. Lexington Insurance. Co., 636 F.3d 683 (5th Cir. 2011), others have found there to be a covered loss even when a nontangible substance, such as ammonia or carbon monoxide, causes the property to be uninhabitable, see, e.g., Port Authority of New York & New Jersey v. Affiliated FM Insurance Company, 311 F.3d 226 (3d Cir. 2002). Thus, even though physical damage to property is typically a threshold requirement and is often outcome determinative in business interruption coverage litigation, a COVID-19 coverage lawsuit may live or die based on which of these two theories of physical loss is applied in that jurisdiction.

For the first time, two federal courts in different jurisdictions have addressed the issue of whether physical damage to property must exist to trigger coverage for claimed losses related to COVID-19.

On August 12, 2020, the United States District Court for the Western District of Missouri in Studio 417, Inc. v. Cincinnati Insurance Company, No. 20-CV-03127-SRB, 020 WL 4692385 (W.D. Mo. Aug. 12, 2020), denied the insurer’s motion to dismiss a lawsuit by a group of restaurants after rejecting the physical alteration theory of direct physical loss in business interruption coverage litigation related to COVID-19 losses.

One day later, on August 13, 2020, the United States District Court for the Western District of Texas in Diesel Barbershop, LLC v. State Farm Lloyds, No. 5:20-CV-461-DAE, 2020 WL 4724305 (W.D. Tex. Aug. 13, 2020), applied the same physical alteration theory that the Western District of Missouri rejected and dismissed a lawsuit by a group of barbershops seeking business interruption coverage for claimed losses related to COVID-19.

In Studio 417, the insureds sued for coverage under their all-risk policies that covered direct physical loss for revenue losses resulting from government-mandated closures of nonessential businesses. Their insurer had denied their claims for losses related to COVID-19, arguing that COVID-19 does not cause any physical damage to property and that, as a result, these losses were not covered.

Disagreeing with the insurer, the Studio 417 court compared the plain meaning of the terms “physical” and “loss” to “damage” and found physical loss to be broader than physical damage. Studio 417, 2020 WL 4692385, at *5–6 (distinguishing seminal case Source Food Tech., Inc. v. U.S. Fidelity & Guar. Co., 465 F.3d 834, 838 (8th Cir. 2006) (finding no direct physical loss to shipment of beef because no evidence of contamination by mad cow disease but signaling that, depending on policy’s language and facts of loss, contamination of insured property may constitute “physical damage” where there is satisfactory proof of contamination)). Thus, the Studio 417 court found that the insureds’ complaint alleged that COVID-19 was a highly contagious virus that was deposited on surfaces in its business (unlike in Source Food), and that these allegations were sufficient to defeat a motion to dismiss.

Oppositely, the Diesel Barbershop court in the Western District of Texas dismissed without leave to amend the insured’s lawsuit for coverage under an all-risk policy for losses caused by government closure orders, in part, because the court was persuaded by its jurisdictional case law that requires physical alternation of property to constitute a physical loss. Acknowledging the jurisdictional disagreement, the court distinguished cases that did not require physical alteration by noting that, for example, COVID-19 does not produce a noxious odor rendering a business uninhabitable. Ultimately, the Diesel Barbershop court concluded that courts within the Fifth Circuit require “distinct, demonstrable physical alteration of the property,” and that the insureds’ complaint made no such allegation.

While both lawsuits considered very similar claims for coverage under similar policies, Studio 417 in the Western District of Missouri focused on the insureds’ allegations that they had suffered physical loss because COVID-19 is a physical substance that caused interruption in business when present and found such allegations to be sufficient to state a plausible claim for relief. Contrastingly, the insureds’ in Diesel Barbershop alleged generally that the presence of COVID-19 in its county made its business properties unsafe but failed to allege the presence of COVID-19 at these properties. However, by specifically noting that COVID-19 was not a substance that rendered the insureds’ business properties uninhabitable, the Diesel Barbershop court raised but did not answer the question of whether that lawsuit would not have been dismissed if the insureds had alleged the physical presence of COVID-19.

While not binding authority, Studio 417 and Diesel Barbershop provide valuable insight for future COVID-19 coverage litigation. For instance, the specificity of an insured’s allegations related to COVID-19 claims may be outcome-determinative and an insured’s failure to allege COVID-19’s physical presence on business property may lead to an early dismissal, particularly in those jurisdictions that reject the physical alteration theory. Thus, insurers should be aware of the jurisdiction’s prevailing physical loss theory because how the jurisdiction defines “physical loss” may determine whether the insured’s lawsuit can survive a motion to dismiss.

McDowell Hetherington continues to monitor the impact of the COVID-19 pandemic on litigation in California and throughout the country. For more information, please contact McDowell Hetherington attorneys Jodi Swick and Alec DiMario.