Southwest Wins Appeal in Cyber Excess Coverage Dispute With Liberty

The 5th U.S. Circuit Court of Appeals ruled in mid-January that Southwest Airlines can continue to seek reimbursement under its Liberty Mutual cyber risk policy for costs incurred during a 2016 massive computer failure.

The appeals court panel disagreed with the district court’s conclusion in Southwest Airlines Company v. Liberty Insurance Underwriter Inc. that the costs incurred by Southwest were purely discretionary.

The costs in question arose from a July 2016 computer failure that caused a three-day disruption of Southwest’s flight schedule. More than 475,000 Southwest customers experienced either a flight cancellation or a delay of two hours or more. Southwest calculated that it sustained more than $77 million in losses from the computer failure.

Weeks before the computer crash, Southwest secured a cyber risk insurance policy from AIG for system failure coverage and a series of excess policies. Under the Liberty policy, the insurer provided excess coverage under the terms of AIG’s cyber risk policy for up to $10 million in losses. Liberty’s policy was above three other excess insurers and AIG, and was only implicated if Southwest’s system-failure-related losses exceeded $50 million.

By March 2018, Southwest had collected $50 million from AIG and other insurers on the first three excess tiers. Liberty, however, denied Southwest’s claim by disputing five categories of the airline’s claimed losses. Without those claimed losses, Southwest’s covered losses would total less than $50 million and would therefore fail to trigger Liberty’s policy.

Liberty argued that Southwest’s claimed losses in the form of promo codes, travel vouchers, cover refunds, Rapid Rewards points and advertising costs were a result of the airline’s subsequent business decisions and thus not covered. Southwest sued Liberty for breach of contract and bad faith.

The district court ruled in favor of Liberty, concluding that Southwest’s costs were not caused by the computer failure but rather were the result of “various and purely discretionary customer-related rewards programs, practices and market promotions.” The district court also ruled that coverage was barred under two policy exclusions. Southwest appealed.

In reviewing Southwest’s appeal, the 5th Circuit said the district court erred in concluding that Southwest’s five categories of costs were all precluded as a matter of law because they were discretionary. The court found the categories met the causation standard for the policy’s system failure coverage provision.

The court, however, avoided answering whether the system failure was the sole cause for each of the costs Southwest claims. The court said Southwest would need to explain, for example, how its claims for a week of advertising for a single-day interruption of its ad campaign would not grant the company a windfall.

“[Costs] that Southwest incurred for mitigation may be recoverable, but recovery that would put Southwest in a better position than it would have occupied without the interruption would seem to be beyond the scope,” wrote circuit judge James E. Graves Jr.

Liberty argued that even if Southwest’s claimed costs are covered, they are barred under a policy exclusion that says the insurer is not liable for any loss arising out of consequential damages. The appeals court found Liberty’s interpretation of consequential damages too narrow in practice, stating that it may not cover much beyond the cost of technical repairs to Southwest’s computer systems.

Liberty’s interpretation would “effectively wipe out entire portions of the policy,” Graves Jr. wrote, pointing out that it would not cover the cost of fines and penalties assessed against Southwest by civil authorities.

Liberty presented a second exclusion stating the insurer will not pay for any loss arising out of liability to any third party, interpreting third party to include Southwest customers. The court disagreed with Liberty’s broad definition of third party, arguing that it would wipe out financial obligations to other third parties, including payroll obligations to Southwest employees and fines owed to regulators.

“The term ‘third parties’ therefore does not apply to Southwest’s customers and, in turn, does not preclude costs related to Southwest’s payments to its customers,” the panel said.

The appeals court remanded the case back to the U.S. District Court for the Northern District of Texas for further proceedings consistent with its opinion.