Second Circuit Nixes Gallery’s Coverage Suit for COVID-19 Losses

Recently, the Second Circuit Court of Appeals affirmed the dismissal of a gallery’s lawsuit seeking insurance coverage for its losses caused by COVID-19 shutdown orders.  The Second Circuit found that, without any actual physical loss or damage to the insured’s property, there can be no claims for business interruption insurance due to government-ordered shutdowns in the wake of COVID-19.  The case is 10012 Holdings, Inc. dba Guy Hepner v. Sentinel Insurance Company, Ltd., 21 F.4th 216 (2d Cir. 2021), and we discuss it below.

Background

Guy Hepner operates a brick-and-mortar art gallery in New York, and suspended its operations in 2020 to comply with government restrictions on non-essential businesses.  As a result, the gallery could no longer sell artwork at its gallery and moved to online sales.  The company was insured under a widely used business property insurance policy.  The gallery sought coverage under the policy for its business income losses and expenses related to the gallery’s closure. 

The applicable policy provides three principal types of coverage relevant to the case: “Business Income,” “Extra Expense,” and “Civil Authority.”  The Business Income provision requires the insurer to cover certain business losses incurred if the gallery suspended its operations due to “direct physical loss of or physical damage to” its property “caused by or resulting from a Covered Cause of Loss.”  The policy defines “Covered Cause of Loss” as “risks of direct physical loss” not otherwise excluded by the policy.  The “Extra Expense” provision reimburses “reasonable and necessary Extra Expense” incurred during a “period of restoration” of the premises following “direct physical loss or physical damage to” the gallery’s property “caused by or resulting from a Covered Cause of Loss.”  The “Civil Authority” provision extends coverage for business income losses if access to the gallery’s premises “is specifically prohibited by order of a civil authority as the direct result of a Covered Cause of Loss to property in the immediate area of” the gallery’s premises.

The insurer denied coverage on the ground that COVID-19 did not cause property damage at the gallery’s place of business or to property within its vicinity, as required under the policy. 

The gallery sued its insurer for breach of contract and a declaratory judgment that the insurer was liable for coverage of its COVID-19-related business losses, claiming that the policy’s reference to “physical damage” or “physical loss” includes the loss of use of property as a result of the suspension of business operations.  In December 2020, the district court (Judge Lorna Schofield) dismissed the gallery’s claims for failure to state a claim.  The district court held that the gallery could not recover under either the Business Income provision or the Extra Expense provision because, under New York law, these provisions are limited to losses involving physical damage to the insured’s property, which the gallery did not allege it suffered.  The district court also found that the Civil Authority provision of the policy did not apply, because the gallery did not allege that the closures of neighboring properties directly resulted in the closure of the gallery’s own premises, as the provision requires.

The Appeal

The gallery appealed, and by decision dated December 27, 2021, the Second Circuit affirmed the district court’s decision.

On appeal, the gallery argued that it was entitled to coverage under the Business Income and Extra Expense provisions because the policy’s use of the term “direct physical loss,” which the policy does not define, includes circumstances where the gallery is deprived of access to its business property.  The Second Circuit rejected this argument, relying on a decision from a New York state appellate court in Roundabout Theatre Co. v. Cont’l Cas. Co., 751 N.Y.S.2d 4 (1st Dep’t 2002).  In that case, the Appellate Division, First Department (a New York State intermediate appellate court) denied the theater company business interruption coverage when it was forced to cancel several performances as a result of a municipal order closing the street for safety reasons following a nearby construction accident.  The policy’s business interruption provision covered loss of property “caused by the perils insured against” which the policy defined as “all risks of direct physical loss or damage to the [insured’s] property, not otherwise excluded.”  Given the plain meaning of the words “direct” and “physical” and the structure of the policy overall, the Appellate Division held that the provision unambiguously provides coverage only where the insured’s property suffers direct physical damage, not for mere loss of use of the premises.

Finding the policy language in the two cases similar, the Second Circuit noted “[w]e are unaware of any contrary authority in New York that diverges from the holding in Roundabout Theatre, which …courts in New York have … uniformly applied since the start of the COVID-19 pandemic to deny coverage under similar insurance provisions where the insured property itself was not alleged or shown to have suffered direct physical loss or physical damage.”   Since the gallery alleged only that it lost access to its property as a result of governmental shutdown orders, and not that it suspended operations because of physical damage to its property, the gallery could not recover under either the Business Income or Extra Expense provisions, per the Second Circuit.

As to the Civil Authority provision, the Second Circuit held that it did not apply for two reasons.  First, “[s]huttering a gallery because of possible human infection does not qualify as a ‘risk of direct physical loss.’”  Second, even if COVID-19 posed a “risk of direct physical loss,” coverage under the Civil Authority provision contemplates that the executive orders prohibiting access were prompted by risk of harm to neighboring premises.  Here, the gallery did not allege that the potential presence of COVID-19 in neighboring properties directly resulted in the closure of the gallery’s property – rather, it alleged that its closure was the direct result of the risk of COVID-19 at the gallery’s property. 

The gallery requested, in the alternative, that the Second Circuit certify the question of state law to the New York Court of Appeals (the highest state court in New York), and the Second Circuit denied the request.  While the court noted that many lawsuits raising the same interpretive question have been filed in federal courts, there would be a delay in those cases pending the Court of Appeals’ determination, and in any event, every New York court interpreting the phrase “direct physical loss” has read it the same way and denied coverage.  And the court noted that there are nine cases in New York’s intermediate courts of appeal, and the Court of Appeals “will have every opportunity to address this question and endorse or correct our interpretation of New York law, should it wish to do so.  In the meantime, following what the lower New York courts have uniformly done is justified.” 

Take-Away Point

With this holding, the Second Circuit has ruled that under New York law, business losses resulting from COVID-19 and related shutdown orders do not constitute direct physical loss or physical damage to property, and thus, do not trigger coverage under business property insurance policies requiring direct physical loss.