California Corner: Loss of Use under Commercial General Liability Insurance Policies Includes the Inability to Use a Property in a Particular Manner

Julia K. Holt

Most commercial general liability (“CGL”) policies contain standard, insurance industry-drafted language regarding an insurer’s duty to defend and indemnify its insured. The language typically states something like, the insurer “will pay those sums that the insured becomes legally obligated to pay as damages because of . . . ‘property damage’ to which this insurance applies. We will have the right and duty to defend the insured against any ‘suit’ seeking those damages.” Commercial General Liability Insurance Policy Form No. CG 00 01 04 13, § I, Coverage A.1.a. (Insurance Services Office, Inc. 2012). “Property Damage” is defined as “[p]hysical injury to tangible property, including all resulting loss of use of that property” or “[l]oss of use of tangible property that is not physically injured.” Id. at § V, ¶ 17.a and b.

The second definition of “property damage” provides coverage when the allegations do not amount to physical injury of tangible property. However, insurers often attempt to strictly narrow the coverage available by arguing that certain types of lost use are not covered because they are merely the loss of economic privileges that accompany the property, such as the right to hold a liquor license or to use the property a certain way via a permit. In other words, insurers often argue that “loss of use” of tangible property requires the total loss of all uses on the property, not merely some uses. The California Court of Appeal recently rejected this argument. See Thee Sombrero, Inc. v. Scottsdale Ins. Co., 28 Cal. App. 5th 729, 239 Cal. Rptr. 3d 416 (2018).

At issue in the case was a property Thee Sombrero owned that had a conditional use permit to use the property as a nightclub, but required city approval of a specific floor plan, including a single entrance door equipped with a metal detector. The property was leased to tenants that operated a nightclub with security provided by CES, which had a commercial general liability policy with Scottsdale Insurance Company. After the property was leased, a patron was killed in a shooting at the nightclub. Thee Sombrero then learned that CES had converted a storage area into a VIP entrance without a metal detector, which was in violation of the conditional use permit. The city revoked the permit to use the property as a nightclub, but ultimately allowed the property to be used as a banquet hall. Thee Sombrero sued CES for breach of contract and negligence, and obtained a default judgment for the diminution in value of the property between when it could be used as a nightclub and when it could be used as a banquet hall.

Scottsdale refused to cover CES for the judgment. It argued it was not covered because it was “merely the loss of an intangible right to use property in a certain way,” because it could still be operated as a banquet hall, and that “property damage does not include economic loss” from the diminution in value of not being able to operate the property as a nightclub. Id. at 734. Thee Sombrero sued Scottsdale. The trial court held that the diminution in value of the property “is economic loss, but economic loss is not lost use of tangible property.” Id.

The appellate court reversed because “[t]he loss of the ability to use the property as a nightclub is, by definition, a ‘loss of use’ of ‘tangible property.’ It defies common sense to argue otherwise.” Id. at 736. The court explained that Scottsdale’s focus on the loss of the permit, which is not tangible property, was misplaced because “the appropriate focus is not on the loss of the entitlement, but rather on the loss of use of tangible property that results from the loss of the entitlement.” Id. at 737. More importantly, the court found that “the reasonable expectations of the insured would be that ‘loss of use’ means the loss of any significant use of the premises, not the total loss of all uses.” Id. As a result, the court held that

[t]he correct principle, then, is not that economic losses, by definition, do not constitute property damage…. Rather, the correct principle is that losses that are exclusively economic, without any accompanying physical damage or loss of use of tangible property, do not constitute property damage.

Id. at 739. The court concluded that the diminution in value of the property was a covered loss of use of tangible property covered by Scottsdale’s policy.

Accordingly, after the court’s holding in Thee Sombrero, an insured should carefully assess any denial under the “loss of use of tangible property that is not physically injured” definition of property damage. This is especially so if the insurer’s reasoning is that the loss is not covered because it is merely an economic loss.