America Online Inc v. St. Paul Mercury Ins

PUBLISHED

UNITED STATES COURT OF APPEALS
FOR THE FOURTH CIRCUIT

AMERICA ONLINE, INCORPORATED, 
Plaintiff-Appellant,
v.
 No. 02-2018
ST. PAUL MERCURY INSURANCE
COMPANY,
Defendant-Appellee.

AMERICA ONLINE, INCORPORATED, 
Plaintiff-Appellee,
v.
 No. 02-2084
ST. PAUL MERCURY INSURANCE
COMPANY,
Defendant-Appellant.

Appeals from the United States District Court
for the District of Virginia, at Alexandria.
Gerald Bruce Lee, District Judge.
(CA-01-1636-A)

Argued: May 6, 2003

Decided: October 15, 2003

Before WILKINSON, NIEMEYER, and TRAXLER, Circuit
Judges.

Affirmed by published opinion. Judge Niemeyer wrote the opinion,
in which Judge Wilkinson joined. Judge Traxler wrote a dissenting
opinion.
2 AMERICA ONLINE v. ST. PAUL MERCURY INSURANCE
COUNSEL

ARGUED: John Edward Heintz, GILBERT, HEINTZ & RAN-
DOLPH, L.L.P., Washington, D.C., for Appellant. James E. Rocap,
III, BAKER BOTTS, L.L.P., Washington, D.C., for Appellee. ON
BRIEF: Donna L. Wilson, Scott N. Godes, GILBERT, HEINTZ &
RANDOLPH, L.L.P., Washington, D.C.; John Foster Anderson,
RICHARDS, MCGETTIGAN, REILLY & WEST, P.C., Alexandria,
Virginia, for Appellant. Mark A. Miller, Christopher T. Stidvent,
BAKER BOTTS, L.L.P., Washington, D.C., for Appellee.

OPINION

NIEMEYER, Circuit Judge:

After America Online, Incorporated ("AOL") released to the public
its Version 5.0 access software, consumers filed numerous class
actions against AOL, alleging that the software had substantial "bugs"
in it and was incompatible with their computers’ other applications
software and operating systems, causing the computers to be dam-
aged. AOL tendered the defense of these actions to its insurers, St.
Paul Mercury Insurance Company ("St. Paul"), its primary insurer,
and to Underwriters at Lloyd’s of London, its professional liability
insurer. St. Paul denied coverage mainly because the damages
claimed by the consumers were not "property damage" as defined by
the relevant provisions of the applicable policy. AOL commenced this
action against St. Paul for a declaratory judgment that St. Paul owed
AOL a duty to defend and indemnify and for damages.

The district court granted summary judgment to St. Paul on the
grounds that the consumers’ underlying complaints did not allege
physical damage to tangible property and that any damage from loss
of use of tangible property fell within a policy exclusion. We affirm.

I

AOL, a Delaware corporation with its principal place of business
in Dulles, Virginia, is an Internet service provider whose proprietary
 AMERICA ONLINE v. ST. PAUL MERCURY INSURANCE 3
software products enable consumers to access the Internet and AOL’s
online services, such as e-mail.

In October 1999, AOL released to the public its Version 5.0 access
software, and within a few months, consumers began filing class-
action lawsuits against AOL in state and federal courts throughout the
country, alleging damage from the installation and operation of Ver-
sion 5.0. These plaintiffs alleged that Version 5.0 was rushed to mar-
ket after minimal testing to mark AOL’s tenth anniversary and, as a
result, was not yet free of "substantial bugs and incompatibility with
numerous applications and operating systems." They asserted that the
software’s installation process was "defectively designed and/or
unreasonably dangerous," causing "serious injury to their computer
system and preexisting software." Specifically, the plaintiffs alleged:

(1) interference to users’ host systems’ communications
configurations and settings such as non-AOL communica-
tions software and online services the plaintiffs are using or
might want to use in the future;

(2) the inability of users to connect to other [Internet service
providers], competitors of AOL;

(3) the inability to run non-AOL e-mail programs, or con-
nect to local networks;

(4) the addition or alteration of hundreds of files on the
users’ system, including many essential components of the
Windows operating system, which may cause the system to
become unstable; and

(5) the inability of users to remove the AOL 5.0 software
completely, so as to restore their computer’s communica-
tions configuration, so that other competitor online services
could be used.

For many of the plaintiffs, "the only reported remedy [was] to rein-
stall Windows, which may [have] involve[d] the more extreme step
of first reformatting the hard drive on their personal computer." In
4 AMERICA ONLINE v. ST. PAUL MERCURY INSURANCE
short, the underlying complaints alleged that Version 5.0 altered the
plaintiffs’ existing software, disrupted their network connections,
caused the loss of stored data, and caused their operating systems to
crash.

Forty-three of the lawsuits were consolidated by the judicial panel
on multidistrict litigation ("MDL") for pre-trial proceedings in the
Southern District of Florida, pursuant to 28 U.S.C. § 1407, and the
plaintiffs in those cases filed a consolidated MDL complaint. Certain
of the claims, dubbed the "Bermuda Triangle" claims because of their
"catch-all" allegations that could not be recreated or explained in lab-
oratory testing, were handled separately from the MDL complaint.
The parties to the multidistrict litigation later settled their disputes,
and under a court-approved agreement, AOL established a cash fund
of $15.5 million to compensate the plaintiffs.

As the individual class-action suits were filed against AOL, AOL
tendered the defense to its insurers, St. Paul and Underwriters at
Lloyd’s of London. St. Paul denied coverage, explaining:

The claimants do not seek damages for bodily injury or
property damage or for any injury or damage that was
caused by an event as those terms are defined by the St. Paul
[commercial general liability] coverage. The policy lan-
guage excludes any loss or damage arising out of or caused
by intentional or expected acts.

Later, St. Paul particularized this position to state that the plaintiffs’
claims "do not allege damage to ‘tangible’ property and are not prop-
erty damage as defined by the St. Paul [commercial general liability]
policy." Later yet, St. Paul also pointed to its "impaired property"
exclusion which denies coverage for loss of use of tangible property
that was not physically damaged. In response to the denial of cover-
age, AOL commenced this action against St. Paul, alleging breach of
contract and seeking declaratory judgment that St. Paul was obligated
to defend and indemnify AOL. It also demanded defense costs and
compensatory damages.

On cross-motions for summary judgment, the district court denied
AOL’s motions and granted St. Paul’s motion, making a distinction
 AMERICA ONLINE v. ST. PAUL MERCURY INSURANCE 5
between computer software and computer hardware and concluding
that the underlying suits alleged damage to computer data and sys-
tems but did not allege "physical damage to tangible property."
Although the court recognized that property damage under the policy
also included "loss of use of tangible property" and that the plaintiffs
alleged loss of use of their computers, it concluded that coverage for
loss of use was excluded by the impaired property exclusion.

From the district court’s judgment, AOL filed this appeal, contend-
ing (1) that the damages claimed in the underlying complaints
amounted to "physical damage to tangible property," and (2) that the
complaints alleged "loss of use of tangible property" that was not
excluded from coverage by the impaired property exclusion. St. Paul
filed a cross-appeal, challenging the district court’s conclusion that
the underlying complaints alleged "loss of use" of tangible property.

II

Because this diversity action was filed in the Eastern District of
Virginia, we apply Virginia choice-of-law rules to determine which
state’s substantive rules apply. See Klaxon Co. v. Stentor Elec. Mfg.
Co., 313 U.S. 487, 496-97 (1941) (holding that a federal court with
diversity jurisdiction must apply the choice-of-law rules of the State
in which the federal court sits). In this case, the insurance contract
between AOL and St. Paul was formed in Virginia and therefore we
apply Virginia substantive law. See Buchanan v. Doe, 431 S.E.2d
289, 291 (Va. 1993).

Under Virginia law, an insurer’s obligation to defend an action "de-
pends on comparison of the policy language with the underlying com-
plaint to determine whether any claims alleged [in the complaint] are
covered by the policy." Superformance Int’l, Inc. v. Hartford Cas.
Ins. Co., 332 F.3d 215, 220 (4th Cir. 2003) (internal quotation marks
and citation omitted). And the obligation to defend is broader than the
obligation to indemnify. "The obligation to defend arises whenever
the complaint against the insured alleges facts and circumstances,
some of which, if proved, would fall within the risk covered by the
policy." Brenner v. Lawyers Title Ins. Corp., 397 S.E.2d 100, 102
(Va. 1990) (internal citations omitted); see also Solers, Inc. v. Hart-
ford Cas. Ins. Co., 146 F. Supp. 2d 785, 791 (E.D. Va. 2001). Adher-
6 AMERICA ONLINE v. ST. PAUL MERCURY INSURANCE
ing to the canon of construction that ambiguous terms in insurance
agreements are construed against the insurer, Virginia law elaborates:

If the language of an insurance policy is unambiguous, we
will give the words their ordinary meaning and enforce the
policy as written. On the other hand, because the principal
purpose of insurance is protection and insurance policies are
drafted by insurance companies, if the language of a policy
is capable of different interpretations, we will construe it in
favor of coverage or indemnity and against a limitation of
coverage.

United Servs. Auto. Ass’n v. Webb, 369 S.E.2d 196, 198 (Va. 1988).

The underlying complaints allege in general that AOL’s Version
5.0 access software altered the customers’ existing software, disrupted
their network connections, caused them loss of stored data, and
caused their operating systems to crash. AOL contends that these
claims are for physical damage to tangible property as covered by St.
Paul’s policy, making essentially three arguments in support of this
contention. First, it argues that because the plaintiffs have alleged
damage to "computers," they have alleged "physical damage to tangi-
ble property." Second, it argues that because software involves the
arrangement of atoms on computer disks, software has a physical
property and, on that basis, the complaints’ allegations of damage to
software allege "physical damage to tangible property." Third, it
argues that, at best for St. Paul, the scope of the policy term "tangible"
in defining property damage is ambiguous and, as such, must be con-
strued in favor of AOL.

St. Paul contends that the underlying complaints allege two types
of harms: (1) "interference with or reconfiguration of non-AOL soft-
ware, including communication configurations, networking mecha-
nisms and operating systems" and (2) "the loss of ‘data’ and
‘information.’" St. Paul argues that these injuries are not covered by
the policy because computer software and data are not "tangible prop-
erty." It asserts that computer software and data are "nothing more
than information and ideas that happen to be stored in electronic
form." Moreover, it maintains that "[t]here are no allegations in the
MDL Complaint that hardware — tangible property — was physi-
 AMERICA ONLINE v. ST. PAUL MERCURY INSURANCE 7
cally damaged." Finally, St. Paul contends that nothing in the com-
plaints amounts to allegations of loss of use of computer hardware.
On the basis of this contention, it has pressed its cross-appeal.

The parties do not dispute the controlling language of the applica-
ble policy. That language provides that St. Paul will "pay amounts
[AOL] is legally required to pay as damages for covered . . . property
damage." Property damage in turn is defined as

• physical damage to tangible property of others, including
all resulting loss of use of that property; or

• loss of use of tangible property of others that isn’t physi-
cally damaged.

The "impaired property" exclusion in the policy provides that St. Paul
is not obligated to cover

property damage to impaired property, or to property which
isn’t physically damaged, that results from:

• your faulty or dangerous products or completed work; or

• a delay or failure in fulfilling the terms of a contract or
agreement.

And the policy defines impaired property as:

tangible property, other than your products or completed
work, that can be restored to use by nothing more than:

• an adjustment, repair, replacement, or removal of your
products or completed work which forms a part of it; or

• your fulfilling the terms of a contract or agreement.

AOL’s first argument, that by alleging damage to computers, the
consumers have alleged they sustained property damage, fails for its
lack of specificity. Because a "computer" consists of hardware (con-
8 AMERICA ONLINE v. ST. PAUL MERCURY INSURANCE
cededly tangible property), an operating system, and applications soft-
ware, as well as peripheral devices with their own hardware and
software, a general allegation that a computer was damaged may refer
either to damaged hardware or damaged software. See Alan Freed-
man, The Computer Glossary: The Complete Illustrated Dictionary
173, 364 (9th ed. 2001) ("In operation, a computer is both hardware
and software. . . . The hardware design specifies the commands it can
follow, and the instructions tell it what to do"). But because the
underlying complaints ultimately claim damage to the consumers’
software, we are brought to AOL’s central argument — that damage
to software is physical damage to tangible property.

Although AOL acknowledges that software is distinct from hard-
ware and that software provides instructions to the hardware to per-
form, it argues that the particular physical properties of the hard drive
of a computer that contains instructions and data indicate that soft-
ware can be tangible property:

As stored on a hard drive, data consists of the arrangement
"of hundreds of thousands of atoms" of "cobalt, iron, and
other magnetic materials" in a perceivable and unique pat-
tern. The data consists of small electromagnets in certain
alignments. Once data is stored in a cell of a hard drive, that
cell is physically different from a cell without data, and the
physical differences between the two cells can be detected
through the use of certain tools. Data stored on a hard drive
is visible with the use of a microscope.

Because these atoms in the form of cobalt, iron, and other magnetic
material are physical, AOL argues, the data and instructions retained
on them are tangible property.

Taking "tangible" to have its usual and ordinary meaning, see
American Health Ins. Corp. v. Newcomb, 91 S.E.2d 447, 451 (Va.
1956) (instructing that contract terms "‘be given their usual, ordinary
and popular meaning’") (citation omitted), we understand the term to
mean "capable of being touched: able to be perceived as materially
existent esp. by the sense of touch: palpable, tactile," see Webster’s
Third New Int’l Dictionary of the English Language Unabridged 2337
(1993). And, specifically, "tangible property" means "having physical
 AMERICA ONLINE v. ST. PAUL MERCURY INSURANCE 9
substance apparent to the senses." Id. These common definitions
essentially equate the terms "tangible" and "physical" and defeat any
sense of ambiguity that AOL attributes to the term "tangible." Thus,
employing these ordinary meanings, we conclude that the physical
magnetic material on the hard drive that retains data, information, and
instructions is tangible property.

But the conclusion that physical magnetic material on the hard
drive is tangible property is quite separate from the question of
whether the data, information, and instructions, which are codified in
a binary language for storage on the hard drive, are tangible property.
Certainly the hard drive itself is a medium in which the data, informa-
tion, and instructions are stored, but the data itself must be considered
apart from the medium. Thus, if a hard drive were physically scarred
or scratched so that it could no longer properly record data, informa-
tion, or instructions, then the damage would be physical, affecting the
medium for storage of the data. But if the arrangement of the data and
information stored on the hard drive were to become disordered or the
instructions were to come into conflict with each another, the physical
capabilities and properties of the hard drive would not be affected.
Such disordering or conflicting instructions would amount to damage
to the data and information and to the instructions (i.e., the software)
but not to the hard drive. The magnetic material on the hard drive
could be reoriented and reordered with reinstallation of the instruc-
tions. So it is that we make the distinction between hardware and soft-
ware.

All data, information, and instructions used in a computer are codi-
fied into a binary language, and the binary language is processed by
the computer by the operation of switches that are "on" or "off." The
unique combination within a group of switches that are on and off
forms bytes of codified information representing letters, numbers, and
other commands, upon which further operations and processes are
built. The switches are configured on or off by electricity. Thus, when
the letter "p" is pressed on the keyboard, the electrical pulses trans-
mitted through the switches invoke a code that opens and closes
switches in a particular configuration that transmits a "p" to the
screen. Once data are created in the processing systems of a com-
puter, they may be stored magnetically on hard drives or disks that
record the on-and-off configurations.
10 AMERICA ONLINE v. ST. PAUL MERCURY INSURANCE
Thus, software begins with a set of instructions written by pro-
grammers and translated into binary code which is then transmitted
to the computer through the electronic charges turning on some but
not all switches and creating a configuration of on and off switches.
As a result of these configurations, the computer performs the speci-
fied tasks of the programmer, and the established configurations are
retained magnetically.

With this description, albeit simplified, the distinction between data
or instructions and the physical machines that give them meaning
becomes apparent. Instructions to the computer and the data and
information processed by it are abstract ideas in the minds of the pro-
grammer and the user. The switches and the magnetic disks are
media, as would be paper and pencil. Loss of software or damage to
software thus is not damage to the hardware, but to the idea, its logic,
and its consistency with other ideas and logic. Of course, without any
code and instructions, the hardware consists simply of millions of
electronic switches, circuits, and drives that can be turned on or off
but that cannot function as a computer. To a user, such a computer
would be "dead." But regardless of whether the software is rendered
unusable, the hardware remains available for instructions and record-
ing.

By analogy, when the combination to a combination lock is forgot-
ten or changed, the lock becomes useless, but the lock is not physi-
cally damaged. With the retrieval or resetting of the combination —
the idea — the lock can be used again. This loss or alteration of the
combination may be a useful metaphor for damage to software and
data in a computer. With damage to software, whether it be by recon-
figuration or loss of instructions, the computer may become inopera-
ble. But the hardware is not damaged. The switches continue to
function to receive instructions and the data and information devel-
oped on the computer can still be preserved on the hard drive. While
the loss of the idea represented by the configuration of the computer
switches or the combination for the lock might amount to damage,
such damage is damage to intangible property. It is not damage to the
physical components of the computer or the lock, i.e., to those com-
ponents that have "physical substance apparent to the senses." See
Webster’s Third New Int’l Dictionary, supra, at 2337 (defining "tan-
gible property").
 AMERICA ONLINE v. ST. PAUL MERCURY INSURANCE 11
The insurance policy in this case covers liability for "physical dam-
age to tangible property," not damage to data and software, i.e., the
abstract ideas, logic, instructions, and information. Thus, while it cov-
ers any damage that may have been caused to circuits, switches,
drives, and any other physical components of the computer, it does
not cover the loss of instructions to configure the switches or the loss
of data stored magnetically. These instructions, data, and information
are abstract and intangible, and damage to them is not physical dam-
age to tangible property. See Lucker Mfg. v. Home Ins. Co., 23 F.3d
808, 819 (3d Cir. 1994) (holding that where the real value of an
anchoring system design "is in the idea, not in the physical plans that
memorialize it, any loss in value of the design represents a loss in the
value of the idea, which is not a loss of use of tangible property");
State Auto Prop. & Cas. Ins. Co. v. Midwest Computers & More, 147
F. Supp. 2d 1113, 1116 (W.D. Okla. 2001) (holding in an insurance
context that "[a]lone, computer data cannot be touched, held, or
sensed by the human mind; it has no physical substance. It is not tan-
gible property").

The claims in the underlying actions assert that AOL’s Version 5.0
software damaged consumers’ software, including their preexisting
operating system software. They allege that Version 5.0 "ruthlessly
modifie[d] or overwr[ote] critical Windows communications files and
change[d] many of the default communications settings." They assert
that the installation of Version 5.0 cut off non-AOL Internet access
and caused computer system instability. Indeed, with a large amount
of reconfiguration, the computer could lack any instruction (operating
system) and could just "die." But all of these damages are related to
the instructions configuring the switches and the data preserved on the
hard drive. The physical aspects of the switches and the hard drives
were not damaged — they were reconfigured. With yet more recod-
ing, the reconfigurations could be reversed and the initial operating
systems and application software reinstalled. Obviously such a pro-
cess could become costly. As relevant to this suit, however, such soft-
ware damage and the cost to restore it would not be covered by the
policy of insurance issued to AOL by St. Paul. St. Paul covered
AOL’s liability for physical damage to tangible property of others.

Going beyond the allegations contained in the underlying com-
plaints, which under Virginia law are determinative of whether St.
12 AMERICA ONLINE v. ST. PAUL MERCURY INSURANCE
Paul is obligated to provide a defense, AOL refers to testimony of
consumers in the underlying actions to demonstrate that the damages
claimed were for physical damage to tangible property. But even if
we review these excerpts, they do not demonstrate that AOL’s Ver-
sion 5.0 caused physical damage to the hardware.

Thus, for example, plaintiff Eric Lloyd answered, in a deposition,
that he decided to sue AOL "[a]round the time my computer went
haywire, meaning it died entirely." In response to the question
whether he was "talking about when [he] couldn’t get from DOS into
Windows," the plaintiff answered, "Correct." Plaintiff Merk French,
who testified that his "keyboard was like the top of this table, it had
no effect," elaborated that, after installation of Version 5.0, his com-
puter would not shut down and when he performed a hard boot, the
computer was often unresponsive, i.e., the operating system would
refuse to recognize commands given through the keyboard. In a simi-
lar vein, plaintiff Mark Harken testified that after he installed Version
5.0, his computer froze virtually every time that he logged onto AOL,
and he described "freezing" as "you couldn’t operate the system."
Plaintiff Robert Kerr, Jr., testified that when he was unable to access
programs after installing Version 5.0, he could sometimes cure the
problem by shutting down the computer and starting it again. And
while plaintiff Eddie Jean Harp asserted in her class-action complaint
(consolidated in the multidistrict litigation) that her use of Version 5.0
"caused physical injury to her computer and software," her allegations
focusing on Version 5.0’s effects on "computer systems of the plain-
tiffs" clarify that the injury was to files, settings, and operating sys-
tems — all software.

Even though a few other testimonial complaints are vague enough
to suppose initially that the plaintiffs complain of damage to physical
property, a closer look at the complaints reveals that the plaintiffs
actually complain of damage to software. For example, plaintiff Lau-
rie Bejoian testified that after experiencing problems with Version
5.0, she took her computer to a service center, where she requested
a new hard drive. Plaintiff Russell Hightower testified that, sometime
after he installed Version 5.0, his computer "developed a malfunction
on the motherboard" and that when he took it in for repairs, he was
told "it was damaged and not reparable." Plaintiff Eric Lloyd testified
that his computer "died entirely." And Alice Patricia Carrick testified
 AMERICA ONLINE v. ST. PAUL MERCURY INSURANCE 13
that after she installed Version 5.0, her computer began making click-
ing noises when she entered a command through the computer’s touch
pad. At best for AOL, these excerpts contemplate computer damage
broadly, suggesting damage to both hardware and software. But the
fact that a service center replaced a hard drive or a motherboard is no
more indicative of a hardware problem than a software problem, even
though replacement of the hardware might have been less expensive
than attempting to reconfigure or adapt the software. And this vague
deposition testimony of a few plaintiffs complaining of the general
failure of their computers must be viewed alongside the hundreds of
claims of the other plaintiffs, whose allegations reflect a common
complaint about damage to software resulting from the installation of
Version 5.0. As the consumers have generally alleged, AOL’s Ver-
sion 5.0 had "substantial bugs and incompatibility with numerous
applications and operating systems," and that the software’s installa-
tion process was "defectively designed and/or unreasonably danger-
ous." These are all software problems that do not amount to physical
damage to tangible property.

III

AOL contends that even in the absence of physical damage to tan-
gible property, it was exposed to property damage claims because
"property damage" is defined by the policy to include loss of use of
tangible property of others. It notes that the consumers’ underlying
complaints allege loss of use of their computers and computer periph-
erals because of the installation of AOL Version 5.0. The district
court agreed with AOL’s characterization of the underlying claims
that loss of use was alleged in the complaint, but it denied any cover-
age because such damage was excluded by the "impaired property"
exclusion contained in St. Paul’s policy. AOL argues that the district
court erred in construing the impaired property exclusion to bar cov-
erage for loss of use.

The relevant portions of the impaired property exclusion read as
follows:

We won’t cover property damage to impaired property, or
to property which isn’t physically damaged, that results
from:
14 AMERICA ONLINE v. ST. PAUL MERCURY INSURANCE
• your faulty or dangerous products or completed work;

***

Impaired property means tangible property, other than your
products or completed work, that can be restored to use by
nothing more than:

• an adjustment, repair, replacement, or removal of your
products or completed work which forms a part of it . . . .

AOL argues that this exclusion cannot be applied because the under-
lying consumer complaints "allege physical damage to and loss of use
of computers that could not be fixed simply by repairing, removing,
or replacing AOL Version 5.0, thus taking the claims outside the defi-
nition of impaired property."

This argument, however, fails to address the relevant portion of the
exclusion, which reads in edited form:

We won’t cover property damage [including loss of use of
tangible property] . . . to property which isn’t physically
damaged, that results from . . . your faulty . . . products.

The straightforward meaning of this exclusion bars coverage for loss
of use of tangible property of others that is not physically damaged
by the insured’s defective product. This exclusion places a limitation
on the coverage of consequential damages, restricting coverage to loss
of use of other persons’ properties that are physically damaged. With-
out the limitation, St. Paul’s risk would have been much greater and
the premiums for such a policy undoubtedly would have been more
expensive. St. Paul would have been asked to defend claims, for
example, that because the computer was rendered defective because
of the faulty Version 5.0, the store could not operate its computers,
and because the store could not operate its computers, it had to close,
causing loss of use of the premises and the business. The limitation
imposed by the impaired property exclusion is designed specifically
to deny coverage for this broader risk. See Seagate Tech., Inc. v. St.
Paul Fire & Marine Ins. Co., 73 F.3d 370 (Table), 1995 WL 759217,
 AMERICA ONLINE v. ST. PAUL MERCURY INSURANCE 15
at *1 (9th Cir. Dec. 22, 1995) (finding no duty to defend based on
impaired property exclusion where loss of use of inventory that was
not physically damaged was caused by insured’s faulty product or
failure to fulfill terms of contract).

As has been demonstrated in Part II, ante, the faulty Version 5.0
software caused damage to other software, including operating sys-
tems. But there has been no demonstration or claim that the physical
or tangible components of any computer were damaged. In the
absence of property that is physically damaged, AOL’s arguments for
covering loss of use must be rejected.

Because we conclude that the impaired property exclusion applies,
we need not address St. Paul’s issue on cross-appeal — whether the
underlying complaints allege loss of use.

IV

For the reasons given, the judgment of the district court is affirmed.

AFFIRMED

TRAXLER, Circuit Judge, dissenting:

Whether computer software should be considered tangible or intan-
gible property is a difficult question that has yet to be definitively
answered by the state courts. In my view, however, it is unnecessary
to even reach that question, because the allegations of the underlying
complaint sufficiently allege damage to the computers themselves,
thus bringing the claims against AOL within the scope of the policy’s
coverage for claims of "physical damage to tangible property of oth-
ers." Accordingly, I respectfully dissent.

I.

States have been considering the question of whether computer
software is tangible or intangible property for many years. Most of the
cases have arisen in the tax context, with states considering whether
computer software is subject to sales tax, ad valorem taxes, and the
16 AMERICA ONLINE v. ST. PAUL MERCURY INSURANCE
like. No real consensus view has emerged, although there has perhaps
been a somewhat recent shift in the states’ approach to the issue. Most
of the earlier cases concluded that computer software is intangible
property. See, e.g., James v. Tres Computer Sys., Inc., 642 S.W.2d
347, 348-49 (Mo. 1982) (en banc) (concluding that computer software
contained on magnetic tapes is not tangible property for purposes of
use tax imposed on out-of-state purchases of tangible property); First
Nat’l Bank of Springfield v. Department of Revenue, 421 N.E.2d 175,
179 (Ill. 1981) (same); First Nat’l Bank of Fort Worth v. Bullock, 584
S.W.2d 548, 550 (Tex. App. 1979) (concluding that computer soft-
ware is not tangible property for purposes of sales tax); Commerce
Union Bank v. Tidwell, 538 S.W.2d 405, 407 (Tenn. 1976) (conclud-
ing that computer software is not tangible personal property: "What
is created and sold here is information, and the magnetic tapes which
contain this information are only a method of transmitting these intel-
lectual creations from the originator to the user. It is merely incidental
that these intangibles are transmitted by way of a tangible reel of tape.
. . ."); District of Columbia v. Universal Computer Assocs., Inc., 465
F.2d 615, 618 (D.C. Cir. 1972) (concluding that software embodied
in punch cards is not tangible property: "It is the information derived
by the machine from the cards which stays in the computer, and
which is employed repeatedly by the machine when it is used by Uni-
versal. What rests in the machine, then, is an intangible—‘knowledge’
—which can hardly be thought to be subject to a personal property
tax."). In the more recent cases, however, the courts have tended to
treat computer software as tangible property. See, e.g., First Data
Corp. v. State, 639 N.W.2d 898, 903-04 (Neb. 2002) (concluding that
computer software is tangible property for purposes of a special sales-
tax exemption); Wal-Mart Stores, Inc. v. City of Mobile, 696 So. 2d
290, 291 (Ala. 1996) (computer software is tangible personal property
for purposes of tax on gross receipts); South Cent. Bell Tel. Co. v.
Barthelemy, 643 So. 2d 1240, 1244 (La. 1994) (concluding that com-
puter software is "corporeal property" and thus tangible property sub-
ject to sales and use tax); Comptroller of the Treasury v. Equitable
Trust Co., 464 A.2d 248, 261 (Md. 1983) (concluding that computer
software is tangible property subject to Maryland’s sales tax: "A
meaningful sequence of magnetic impulses cannot float in space.").*

*The applicability of the tax cases to the insurance question before this
court is less than clear. In the tax arena, courts are typically considering
 AMERICA ONLINE v. ST. PAUL MERCURY INSURANCE 17
The relatively few courts to have considered the tangible-intangible
question in the context of determining coverage or a duty to defend
under a commercial general liability policy have reached differing
results. See State Auto Prop. & Cas. Ins. Co. v. Midwest Computers
& More, 147 F. Supp. 2d 1113, 1116 (W.D. Okla. 2001) ("Alone,
computer data cannot be touched, held, or sensed by the human mind;
it has no physical substance. It is not tangible property."); American
Guarantee & Liab. Ins. Co. v. Ingram Micro, Inc., No. 99-185 TUC
ACM, 2000 WL 726789, *2-3 (D. Ariz. April 18, 2000) (concluding
that computer system that lost stored data and functionality was phys-
ically damaged within the meaning of a liability insurance policy); see
also Computer Corner, Inc. v. Fireman’s Fund Ins. Co., 46 P.3d
1264, 1266 (N.M. Ct. App. 2002) (noting district court’s unappealed
ruling that computer data stored on a hard drive is tangible property);
Retail Sys. Inc. v. CNA Ins. Cos., 469 N.W.2d 735, 737 (Minn. Ct.
App. 1991) (concluding that loss of computer tape containing valu-
able data fell within scope of liability policy covering claims involv-
ing physical injury or destruction of tangible property because, in
part, "[t]he data on the tape was of permanent value and was inte-
grated completely with the physical property of the tape").

The question in this case, of course, is how computer software
should be characterized under Virginia law. See, e.g., Liberty Mut.
Ins. Co. v. Triangle Indus., Inc., 957 F.2d 1153, 1156 (4th Cir. 1992)
(explaining that "a federal court sitting in diversity has a duty to apply
the operative state law as would the highest court of the state in which
the suit was brought"). Unfortunately, there is no Virginia law on
point, nor have I found any analogous cases that suggest how the Vir-
ginia courts would resolve the issue. Given the absence of controlling
Virginia law, the lack of consensus among the courts that have con-

the tax consequences of a particular transaction involving computer soft-
ware. Such an inquiry involves very specific statutory language and often
requires the courts to determine things like the "ultimate object" of the
transaction or the "essence of the transaction," Tres Computer Sys., 642
S.W.2d at 349, issues that do not arise in the contract-based insurance
arena. Thus, the fact that computer software has (or has not) been treated
as tangible property for taxation purposes does not necessarily mean that
software should (or should not) be treated as tangible property for pur-
poses of this insurance dispute.
18 AMERICA ONLINE v. ST. PAUL MERCURY INSURANCE
sidered the issue, and the increasing importance of computers and
computer software to every aspect of our daily lives, I would be
inclined to certify the issue to the Supreme Court of Virginia if reso-
lution of the question was necessary in this case. See Grattan v. Board
of Sch. Comm’rs, 805 F.2d 1160, 1164 (4th Cir. 1986) ("A federal
court’s certification of a question of state law to that state’s highest
court is appropriate when the federal tribunal is required to address
a novel issue of local law which is determinative in the case before
it."). As I explain below, however, I do not believe that this case turns
on the question of whether computer software and data is tangible or
intangible property.

II.

Because the issue in this case is whether St. Paul was obligated to
provide a defense to AOL, our focus must be on the allegations of the
underlying complaint. See Lerner v. General Ins. Co. of America, 245
S.E.2d 249, 251 (Va. 1978) ("[A]n insurer’s obligation to defend is
broader than its obligation to pay, and arises whenever the complaint
alleges facts and circumstances, some of which would, if proved, fall
within the risk covered by the policy.") (emphasis added). An insurer
can avoid its duty to defend "[o]nly when it appears clearly the
insurer would not be liable under its contract for any judgment based
on the allegations." Parker v. Hartford Fire Ins. Co., 278 S.E.2d 803,
804 (Va. 1981) (per curiam) (internal quotation marks and alteration
omitted).

The district court believed that the claims against AOL really
involved damage not to computer hardware, but to computer soft-
ware, the "‘brains’ of the computer." America Online, Inc. v. St. Paul
Mercury Ins. Co., 207 F. Supp. 2d 459, 469 (E.D. Va. 2002). Thus,
the district court concluded that "[t]he allegations of injury to the
computer itself are more properly characterized as a loss of use of the
computer." Id. AOL contends that the district court’s interpretation of
the MDL complaint is impermissibly narrow. According to AOL, the
complaint, properly read, alleged damage to the computer itself, not
just to computer software. Because a computer is tangible property,
AOL contends that the allegations of the MDL complaint were suffi-
cient to trigger St. Paul’s duty to defend. I agree with AOL that the
 AMERICA ONLINE v. ST. PAUL MERCURY INSURANCE 19
allegations of the MDL complaint are sufficient to bring the claims
within the scope of the St. Paul policy.

The underlying MDL complaint alleged that when AOL Version
5.0 was installed, it

cause[d] serious injury to [the plaintiffs’] computer system
and preexisting software. The default options provided by
AOL 5.0 . . . modif[ied], add[ed] or alter[ed] over 200 files
on the user’s computer system, primarily Windows systems
files, many of which are essential components of Windows’
operating and networking systems. The installation of ver-
sion 5.0 results in a user unknowingly creating multiple ver-
sions of the same essential system files, which results in
system instability and/or non-operability.

J.A. 145 (emphasis omitted). Throughout the complaint there are alle-
gations that version 5.0 caused things like "corrupt[ion of] the com-
puter systems," J.A. 130, "complete operating system failure," J.A.
161; "system crashes and computer freezes," J.A. 165; alteration and
reconfiguration of the computers, J.A. 165; and "complete system
failure." J.A. 169. Given that the computer itself is, of course, tangible
property, I believe that these allegations are sufficient to trigger St.
Paul’s duty to defend against claims involving "physical damage to
tangible property of others."

These allegations clearly indicate the MDL plaintiffs’ belief that
the installation of version 5.0 caused actual damage to their computer
hardware. While the plaintiffs might not have been able to prove that
version 5.0 caused physical damage to their computers, the ultimate
inability to prove a claim is not relevant to the duty-to-defend inquiry.
See Virginia Elec. & Power Co. v. Northbrook Prop. & Cas. Ins. Co.,
475 S.E.2d 264, 266 (Va. 1996) ("The insurer has the obligation to
defend the insured in such circumstances even though the obligation
to pay is not ultimately invoked. . . . Stated differently, the insurer has
a duty to defend against risks covered by the policy even though the
defense successfully litigates the issue of its lack of obligation to pay
the claim."); cf. Centennial Ins. Co. v. Applied Health Care Sys., Inc.,
710 F.2d 1288, 1290 (7th Cir. 1983) (concluding that complaint alleg-
ing loss of computer data because of malfunctioning "controllers"
20 AMERICA ONLINE v. ST. PAUL MERCURY INSURANCE
potentially sought damages within scope of liability policy covering
claims for "physical injury to or destruction of tangible property").

The MDL complaint alleged that AOL version 5.0 caused serious
injury to the plaintiffs’ computer systems and hardware by re-writing
the code or "instructions" that allowed the computers to operate. As
AOL points out, these instructions leave a physical imprint on the
computer hard drive. See Brief of Appellant at 11-12 ("Once data is
stored in a cell of a hard drive, that cell is physically different from
a cell without data, and the physical differences between the two cells
can be detected through the use of certain tools. Data stored on a hard
drive is visible with the use of a microscope."). While it may be that
version 5.0 merely re-arranged, rather than destroyed, the instructions
on the user’s hard drive, that re-arrangement of the instructions
changed the physical structure of the computer hardware. And in my
opinion, a change in the physical structure of the computer that ren-
ders the computer inoperable must be viewed as physical damage to
the computer itself.

In one sense, most of what we think of as typical physical damage
to tangible property is merely the re-configuration of parts of that
property. Few would dispute that a car with a dented door is physi-
cally damaged, but all that has happened is that the metal making up
the door has been re-configured in a way not intended by the manu-
facturer. The car is still able to function exactly as it did before the
unfortunate dent, and another re-configuration of the metal will put
the car back into its original condition. But during the time the car
door was configured to include a dent, the car was physically dam-
aged. This analogy, of course, is a rough one, and I do not mean to
suggest that questions about whether a computer has been physically
damaged can necessarily be resolved as easily as the same questions
about a car. Nonetheless, this example does help bring home the point
that property can be physically damaged even though no part of the
property is destroyed and even though it can be fixed by simply put-
ting its parts back in the intended order.

If the MDL complaint is read as potentially stating a claim for
physical damage to the computer hardware, as I believe it should be,
then the question of whether computer software in the abstract is tan-
gible or intangible simply is not relevant. The policy provides cover-
 AMERICA ONLINE v. ST. PAUL MERCURY INSURANCE 21
age for claims of physical damage to tangible property, not tangible
physical damage to tangible property. Therefore, even if, as the dis-
trict court concluded, computer software is not tangible because it is
not "capable of being touched or perceptible to the senses," America
Online, Inc., 207 F. Supp. 2d at 467, St. Paul still has a duty to defend
because the allegations of the MDL complaint could support the con-
clusion that the intangible software worked physical damage on the
tangible computer hardware. See Parker, 278 S.E.2d at 804 ("We can-
not say that Turpin’s pleadings clearly show that any recovery against
the Parkers would not have been covered by the insurance policy.
While some of the language of the pleadings is couched in terms of
intentional trespass[, which would not be covered by the policy], the
pleadings, without amendment, could have supported a judgment of
unintentional trespass[, which would be covered by the policy].").

In sum, I believe that the MDL complaint includes allegations of
physical damage to computers themselves, not just computer soft-
ware, thus triggering St. Paul’s duty to defend against claims of
"physical damage to tangible property." By construing the MDL com-
plaint to allege damage to computer software and data only, I believe
that the district court read the complaint too narrowly. See Fuisz v.
Selective Ins. Co. of America, 61 F.3d 238, 242 (4th Cir. 1995) ("If
a complaint, however ambiguous, may be read as premising liability
on alternative grounds, and either ground states liability potentially or
arguably covered by the policy, the insured is entitled to a defense.")
(quoting Donnelly v. Transportation Ins. Co., 589 F.2d 761, 767 (4th
Cir. 1978)). Because I believe that St. Paul had a duty to defend AOL
against the allegations asserted in the MDL complaint, I respectfully
dissent from the majority’s affirmance of the district court’s order.