Performance Warranties in Computer Contracts


Warranty clauses are one of the most frequently negotiated provisions in agreements for the purchase or license of computer hardware and software. The reason for this is clear: computer litigation is on the increase. A review of published decisions by state and federal courts during the period from 1985 through 1996 indicates that the number of computer cases has increased steadily. In this environment, the importance of well-drafted performance warranty provisions hardly can be overstated. The more well-defined the rights and remedies, the less likely it will be that courts will have the opportunity to superimpose their own view of fairness (which is often based on an imprecise understanding of the nature of the technology as well as the relationship between the parties) on the parties' negotiated agreement.

APPLICABLE LAW

The first question to address when drafting a warranty provision is what law will apply to the warranty. Today, current Article 2 of the Uniform Commercial Code (UCC) will govern any "[sales] transactions in goods" (UCC ' 2-102). Article 2 has been interpreted to apply to transactions for the purchase and sale of computer hardware or integrated hardware/software systems (Chatlos Systems, Inc. v. Cash Register Corp., 635 F.2d 1081 (3d Cir. 1980), cert. dismissed, 457 U.S. 1112 (1982); Carl Beasley Ford, Inc. v. Burroughs Corporation, 361 F. Supp. 325 (E.D. Pa. 1973), aff.d 493 F.2d 1400 (3d Cir. 1974)). Current UCC Article 2 also has been interpreted to govern transactions involving standard software packages (Advent Systems Limited v. Unisys Corporation, 925 F.2d 670 (3d Cir. 1991); RRX Indus., Inc. v. Lab-Con, Inc., 772 F.2d 543 (9th Cir. 1985)).

The current UCC Article 2 has been extended to apply to a variety of transactions which are not literally "sales" of "goods," including licenses (as opposed to sales) of computer software (Communications Group, Inc. v. Warner Communications, Inc., 527 N.Y.S.2d 341 (1988) NMP Corp. v. Parametric Technology Corp., 958 F. Supp. 1536 (N.D. OK 1997)); custom programming services (on the basis that a custom software program is analogous to specially manufactured goods) (Analysts Int.l v. Recycled Paper Products, 1988 WL 17626 (N.D. Ill. 1988)); and contracts for the development of software (Downriver Internists v. Harris Corp., et al., 929 F.2d 1147 (6th Cir. 1991)). Some courts, however, still take the position that custom software is not a "good," but rather a "service" which is, therefore, not covered by the provisions of the UCC (H/R Stone Inc. v. Phoenix Business Sys., Inc., 660 F. Supp. 351 (S.D.N.Y. 1987)).

Since 1995, the National Conference of Commissioners for Uniform State Laws ("NCCUSL") and the American Law Institute ("ALI") have been in the process of revising UCC Article 2. The revisions currently include a proposed Article 2B which will govern software contracts, contracts for custom software development, and information licenses. UCC ' 2B-103(a), May 1997 Draft. Goods with embedded software would not be covered by Proposed Article 2B. UCC ' 2B-103(d)(3), May 1997 Draft. Proposed Article 2B innovates the idea of a "mass market license," which is defined as a standard form that is prepared for and used in a "transaction in a retail market for information involving information, directed to the general public as a whole under substantially the same terms for the same information and involving an end user licensee [who] is an end user and acquired the information in a transaction under terms and in a quantity consistent with a ordinary transaction in the general retail distribution" (but excluding a transaction between two non-consumers in which the total consideration exceeds an amount which has not yet been agreed upon, a transaction in which the information is customized or otherwise specially prepared, a license of the rights to publicly perform or display a copyrighted work or a commercial site license or access control between two business parties (Draft UCC ' 2B-102(26)). The goal of the Article 2B drafting committee is to have both the ALI and NCCUSL vote on the final version of proposed Article 2B in the summer of 1998. The Article would then have to be enacted by each state, which is likely to take an additional two to three years. Although not yet effective, courts have already cited proposed Article 2B (see, ProCD v. Zeidenberg, 86 F. 3d 1447, 1452 (7th Cir. 1996)), and, therefore, this chapter addresses proposed Article 2B where it would dictate an outcome that might vary from current law.

The Magnuson-Moss Act was enacted by Congress in 1975 in response to the widespread misuse by merchants of express warranties and disclaimers. It also sought to overcome some of the problems which consumers encountered with UCC warranties, such as complex language that rendered the warranty terms incomprehensible, warranties that appeared to give more protection than they actually did, and lack of meaningful access to the courts. The Magnuson-Moss Act dictates the form of any "written warranties" or "service contracts" for "consumer products" (15 USC ' 2302). "Consumer products" are defined as tangible personal property which is normally used for personal, family, or household use (16 CFR ' 700.1(a)). As a result, it seems clear that computer hardware and software that is sold through retail outlets such as Computerland, Businessland, and Egghead, or that is distributed over the Internet to individual users, will constitute consumer products and, as such, will be subject to the warranty disclosure requirements of the Magnuson-Moss Act (Chertok, "The Applicability of the Magnuson-Moss Warranty Act to Sales of Home Computer Systems", Computer L. Rep. 816 (1984)). The Magnuson-Moss Act creates a federal private cause of action for consumers injured by violation of any obligation under the Act, any warranty subject to the extensive regulatory requirements of the Act, and any implied warranty, the deceptive and unconscionable limitation of which was a major focus of the Act's regulatory provisions.

Even though many computer products qualify as consumer products, the Magnuson-Moss Act does not apply to transactions between merchants relating to these products. The Interpretations of the Magnuson-Moss Warranty Act published by the Federal Trade Commission note that [m]any consumer products are covered by warranties which are neither intended for, nor enforceable by, consumers. A common example is a warranty given by a component supplier to a manufacturer of consumer products. (The manufacturer may, in turn, warrant these components to consumers.) The component supplier's warranty is generally given solely to the product manufacturer, and is neither intended to be conveyed to the consumer nor brought to the consumer's attention in connection with the sale. Such warranties are not subject to the Act, since a written warranty under section 101(6) of the Act must become "part of the basis of the bargain between a supplier and a buyer for purposes other than resale. 16 CFR '700.3(c). It is also necessary to review state warranty laws to determine whether they apply to the transaction.

COMPONENT PARTS OF STANDARD WARRANTY PROVISION

Although they may not be found in the same section of the agreement, a standard warranty provision can be divided into three parts:

  1. warranties and disclaimers of warranties;
  2. remedies and limitations of remedies; and
  3. limitations of liability.

In fact, limitations of liability should not be included in the same section of the agreement as the performance warranty and limited remedy, for the reasons discussed below. The remainder of this chapter will discuss issues which arise in drafting each of these parts of a standard warranty provision. The chapter assumes that the performance warranty is covered by the UCC, but is not covered by the Magnuson-Moss Warranty Act or any state warranty law.

(1) Warranties and Disclaimers of Warranties

Express Performance Warranty. The first portion of a warranty usually contains the supplier's express warranty concerning its product. The standard hardware warranty typically provides that it is "free from defects in material and workmanship." A standard software warranty provides that the software "performs substantially in accordance" with an identifiable set of functional specifications.

Some software suppliers warrant only that the media is free from defects in material and workmanship and attempt to disclaim all other warranties concerning the condition of the software program itself. It is unclear whether a court will uphold such a broad disclaimer of warranties in light of UCC cases which have held that even a generic product name, such as "automobile" or "haybaler," constitutes an express warranty that the automobile will carry passengers and the haybaler will bale hay. A&M Produce Co. v. FMC Corp., 186 Cal. Rptr. 114, 125 (Ct. App. 1982)

In Consolidated Data Terminals v. Applied Digital Data Systems, Inc., 708 F.2d 385 (9th Cir. 1983), Consolidated Data Terminals (CDT), a distributor, sued Applied Digital Data Systems (ADDS) for damages arising out of transactions involving computer terminals. The agreement between CDT and ADDS included, in addition to an integration clause, the following warranty:

ADDS warrants each new communications and terminal product manufactured by it to be free from defects in material and workmanship under normal use and service for a period of 90 days from the date of shipment. ADDS. sole obligation under this warranty is limited to making good, at its factory, any product or any part or parts thereof found to be defective, provided the buyer bears the cost of shipping charges in connection with the repair or replacement of the defective equipment. . . . ADDS MAKES NO WARRANTY, EXPRESS OR IMPLIED, AND ANY IMPLIED WARRANTY OF MERCHANTABILITY OR OF FITNESS FOR A PARTICULAR PURPOSE WHICH EXCEEDS THE FOREGOING WARRANTY IS HEREBY DISCLAIMED BY ADDS AND EXCLUDED FROM ANY AGREEMENT MADE BY ACCEPTANCE OF ANY ORDER PURSUANT TO THIS AGREEMENT.

In reliance on the above language, ADDS claimed that even if the computer terminals failed to perform as promised, the disclaimer negated any other ADDS promises contained in oral or written descriptions of the goods or in any promotional literature. The court found that the disclaimer could not be permitted to override language in the specifications for the terminals, which represented that they would operate at a speed of 19,200 baud.

A court that uses the reasoning in the Consolidated Data Terminals case may be eager to find that statements in the user documentation for an "accounts payable" program constitute an express warranty that the software is capable of tracking and paying accounts or that a program identified in its end user documentation as a "page layout" program constitutes an express warranty that the software is capable of being used to lay out pages. Suppliers may wish to consider providing an express performance warranty with a limited exclusive remedy, rather than risk having a court find an express warranty in spite of a broad disclaimer and read into the contract all of the remedies in the UCC for breach of the express warranty (as discussed below).

Use of Integration Clause. It is not necessary to use the words "warrant" or "guarantee" to create an express warranty. Reference to product specifications, advertising, promotional materials, or incorporation of a proposal document in the contract may be sufficient to make it a part of the agreement and to ensure that any express warranties contained in any such documents become a part of the parties. contract. Express warranties can also arise by a "description of the goods" or by a "sample or model" (UCC ' 2-313(1)).

In order to preclude precontractual statements, descriptions, or models from becoming part of the contract, every agreement should contain an integration, or merger, clause, similar to the following:

This Agreement, together with the exhibits hereto, constitutes the entire agreement between the parties. This Agreement supersedes, and the terms of this Agreement govern, any prior or contemporaneous oral or written communications with respect to the subject matter hereof, all of which are merged herein. It is expressly understood and agreed that no employee, agent, or other representative of Supplier has any authority to bind Supplier with respect to any statement, representation, warranty, or other expression unless the same is specifically set forth in this Agreement. It is also understood and agreed that no usage of trade or other regular practice or method of dealing between the parties hereto shall be used to modify, interpret, supplement, or alter in any manner the terms of this Agreement. This Agreement may only be changed by mutual agreement of authorized representatives of the parties in writing.

This provision typically will be found in the miscellaneous or general provisions of the agreement rather than in the performance warranty section itself. Under UCC ' 2-202, an integration clause should preclude evidence of prior or contemporaneous representations or agreements regarding the same subject matter. For example, in Pennsylvania Gas Co. v. Secord Bros., Inc., 34 App.Div.2d 906, 357 N.Y. Supp.2d 702 (1974), the court found that even though certain statements in a supplier's promotional brochure constituted express warranties, they did not survive the warranty disclaimer provisions of the contract where there also was an integration clause in the written agreement. See also, Computerized Radiological Services, Inc. v. Syntex Corporation, 595 F.Supp. 1495 (E.D.N.Y. 1984), modified on other grounds, Computerized Radiological Services, Inc. v. Syntex Corporation, 786 F.2d 72 (2d Cir. 1986), in which the court allowed parol evidence in a suit for breach of warranty to proceed, even though the contract between the parties disclaimed such warranty, because the contract nowhere stated that it was the "complete and exclusive statement of the parties. agreement." These cases, however, must be contrasted with Sierra Diesel Injection Serv. v. Burroughs Corp., 890 F.2d 108 (9th Cir. 1989), in which the court found that the computer seller's printed form contracts did not represent a final integrated contract despite the presence of an integration clause.

However, the presence of an integration clause may not preclude evidence of prior or contemporaneous representations or agreements where the agreement is clearly missing material terms and conditions. For example, in L.S. Heath & Sons, Inc. v. AT&T Information Systems, Inc., 9 F.3d 561 (7th Cir. 1993) a manufacturer of chocolate products decided to upgrade and enhance its computer and telecommunications capabilities and solicited proposals from interested suppliers, including Honeywell, IBM, and AT&T. AT&T presented a Final Recommendation and proposal to Heath, which restated Heath's eight main objectives and provided that, "starting with a System 75 as the backbone we will progressively build to a complete intregated [sic] data processing and voice/data communications network that satisfies all of your aforementioned objectives. AT&T can make this statement.AT&T-IS can provide from one source all of your voice and data needs." Heath selected AT&T, and they subsequently signed a two-page Master Agreement. After approximately 18 months, the project began to experience difficulties, and at the end of the third year, Heath sued AT&T for, among other things, breach of the express warranties AT&T had made in its Final Recommendation and proposal. The Seventh Circuit found for Heath, holding that the parties did not intend the two-page Master Agreement to constitute the complete agreement (despite the presence of an integration clause) because key terms were missing, and sent the case back to the trial court to determine if the Final Recommendation constituted an express warranty.

Exclusions from Warranty. Suppliers also should be sure to include any appropriate exclusions from the warranty provisions. For example, a hardware supplier will want to exclude from the warranty any hardware which has been maintained by an unauthorized third party or which has been subjected to unusual physical or electrical stress. A software supplier will want to limit its warranty to errors which can be reproduced in a specified hardware and system software environment and to exclude any software which has been modified by the customer or any third party.

Implied Performance Warranties. UCC Article 2 recognizes two implied performance warranties: the warranty of merchantability (UCC ' 2-314) and the warranty of fitness for a particular purpose (UCC ' 2-315). The implied warranty of merchantability requires that the goods be fit for the ordinary purpose for which they are used (UCC ' 2-314). The implied warranty of fitness for a particular purpose arises only if the seller "at the time of contracting has reason to know any particular purpose for which the goods are required and that the buyer is relying on the seller's skill or judgment to select or furnish suitable goods" (UCC ' 2-315). (Current Article 2 and proposed Article 2B of the UCC also include two nonperformance-related implied warranties, the implied warranties of title and of noninfringement (see UCC ' 2-312 and Draft UCC ' 2B-401, May 1997 Draft), which are beyond the scope of this chapter.)

Proposed Article 2B also recognizes the implied warranties of merchantability and fitness for a particular purpose (see, UCC ' 2B-403 and ' 2B-405, respectively, May 1997 Draft). In mass market transactions, the warranty of merchantability is quite similar to UCC ' 2-314. In other transactions, however, the warranty of merchantability is limited to a warranty that "any physical medium [or] media on which the program is transferred is merchantable and that the computer program will perform in substantial conformance with any promises or affirmations of fact contained in the documentation or specifications provided by the licensor at or before the delivery of the program" (UCC ' 2B-403, May 1997 Draft). Proposed Article 2B also expressly states that the implied warranty of merchantability "does not pertain to informational content in software, or to the quality, aesthetic appeal, marketability, accuracy, or other characteristics of the informational content" (UCC ' 2B-403(c), May 1997 Draft).

The current Article 2 implied warranty of fitness is recharacterized in proposed Article 2B as an implied warranty of "effort to achieve a purpose." It applies, "[e]xcept with respect to the aesthetic value, commercial success or market appeal of informational content, if a licensor at the time of contracting has reason to know of any particular purpose for which [the program or information] is required and that the licensee is relying on the expertise of the licensor to select, develop, or furnish a suitable [program or information]:

  1. if, from all the circumstances, it appears that the contract is for a price for performance that will not be paid if the end product is not suitable for the particular purpose, there is an implied warranty that the information will be fit for such purpose; but
  2. if, from all the circumstances, it appears that the licensor was to be paid for the amount of its time or effort regardless of the suitability of the end product, there is an implied warranty that the licensor will make a workmanlike effort to achieve the licensee's purpose." (UCC ' 2B-405(a), May 1997 Draft.)

Section 2B-405(b) of proposed Article 2B also states that "[i]f an agreement requires a licensor to provide or select a single or integrated system consisting of components, and the licensor has reason to know that the licensee is relying on the expertise of the licensor to select the components, there is an implied warranty that the components selected will function together as a system." Finally, proposed Article 2B grants an implied warranty of accuracy of informational content when it is provided "in a special relationship of reliance" or through "services in collecting, compiling, transcribing, processing or transmitting." This implied warranty does not extend to published information content. See UCC ' 2B-404, May 1997 Draft.

During the Article 2B drafting process, proposals were made to include an additional implied warranty by the licensor of software that it was free of viruses. The May 1997 draft instead includes only an obligation (as opposed to a warranty) that "[u]nless the circumstances clearly indicate that a duty of care could not be expected, a party shall exercise reasonable care to ensure that its performance or message when completed by it does not contain an undisclosed virus" (UCC ' 2B-313(b), May 1997 Draft). This duty is owed by both parties to a contract and is satisfied if the party exercised reasonable care. In addition, except in mass market licenses involving delivery of information on a physical medium, the obligation can be disclaimed by contract language stating that no action was taken to ensure exclusion of a virus or that a risk exists that viruses have not been excluded. UCC ' 2B-313(c).

Disclaimers of Implied Warranties. Under current Article 2, a contractual warranty provision will typically include a disclaimer of the implied warranties of merchantability and fitness, as well as the warranties of title and noninfringement. A disclaimer of the implied warranty of merchantability must be conspicuous, if in writing, and must mention merchantability (UCC ' 2-316(2)). A disclaimer of the implied warranty of fitness for a particular purpose must be in writing and it must be conspicuous, although it does not have to mention the particular words contained in the UCC (UCC ' 2-316(2)). In general, where such disclaimers are conspicuous, they are valid and binding. Imaging Financial Services, Inc. v. Graphic Arts Services, Inc. 1997 U.S. Dist. LEXIS 3776 (N.D. Ill. 1997).

Failure to comply with these requirements may render the disclaimer unenforceable. In Communications Group v. Warner Communications, Inc., 527 N.Y.S.2d 341 (1988), for example, the court found that the disclaimer of implied warranties did not use words specified by the UCC and was not sufficiently conspicuous as required by the UCC. See also, Sierra Diesel Injection Serv., Inc. v. Burroughs Corporation, 890 F.2d 108 (9th Cir. 1989), in which the court stated: "Whether a disclaimer is conspicuous is not simply a matter of measuring the type size or looking at the placement of the disclaimer within the contract. A reviewing court must ascertain that a reasonable person in the buyer's position would not have been surprised to find the warranty disclaimer in the contract." See also, Computerized Radiologial Services, Inc. v. Syntex Corporation, 595 F.Supp. 1495 (E.D.N.Y. 1984), modified on other grounds, Computerized Radiological Services, Inc. v. Syntex Corporation, 786 F.2d 72 (2d Cir. 1986), in which the court found that a disclaimer of the implied warranty of fitness for a particular purpose was inoperative because it was not conspicuous as required by the UCC.

In Mesa Business Equipment, Inc. v. Ultimate Southern California, Inc., et al. (In re Mesa Business Equipment), 1991 WL 66272 (9th Cir. 1991), on the other hand, the Ninth Circuit Court of Appeals held that a waiver of implied warranties contained in a software agreement was effective even though it was not properly conspicuous as required by the UCC. The parties had signed five contracts, including an Application Software Agreement which contained the following language:

The amounts to be paid to the seller under this Agreement do not include any assumption of risk, and the seller disclaims any and all liability for incidental or consequential damages arising out of the use or operation of the programs provided herein. The warranties set forth herein are in lieu of all other warranties, express or implied, arising out of or in connection with any program (or the use or performance thereof), including, but not limited to, the implied warranties of merchantability and fitness for a particular purpose.

Mesa filed a Chapter 11 bankruptcy petition as well as an action against Ultimate asserting various causes of action, including breach of express and implied warranties, fraud, and negligence. Despite technical noncompliance with the UCC requirements for disclaimers, the court found that the disclaimer was enforceable on the grounds that Mesa had engaged an experienced analyst to assist it in evaluating suppliers of a new computer system, was aware of the disclaimer, and had even discussed its inclusion in the agreement during negotiations.

Even technical compliance with the requirements of UCC ' 2-316, however, does not guarantee that the warranty disclaimer will be enforced if it is found to be "unconscionable." In A&M Produce Co. v. FMC, 186 Cal.Rptr. 114 (Ct.App. 1982), the court held that an unconscionable disclaimer of warranty may be denied enforcement despite technical compliance with the UCC. In finding unconscionability, the court noted that the contract was a printed form contract, there was ample evidence of unequal bargaining power, and there was a lack of any real negotiation over contract terms. See also, Rynders v. E. I. Du Pont, De Nemours & Company, 21 F.3d 835 (8th Cir. 1994).

To the extent such disclaimers might be used in mass market licenses governed by proposed Article 2B, their enforcement will be controlled by the general rule found in section 2B-308. That section provides that a licensee adopts the terms of a mass-market license if the licensee agrees or manifests assent to the license before or in connection with the initial use of, or access to, information. If one of those terms is a warranty disclaimer, it generally will be enforceable. Such disclaimers will not be enforceable, however, if they create an obligation, or impose a limitation, that the licensor should know would cause an ordinary and reasonable licensee to refuse the license if that party knew that the license contained the particular term. UCC ' 2B-308, May 1997 Draft. This focus on the licensor's expectations is at variance with current Article 2.

If a supplier is providing goods to a remarketer (e.g., an Original Equipment Manufacturer or Value Added Reseller) for redistribution to end users, the performance warranty typically provides that it extends only to the immediate purchaser. This may not be sufficient to prevent actions by third parties who purchase from the remarketer. In Spagnol Enterprises v. Digital Equipment Corporation, 568 A.2d 948 (Pa.Super. 1989), the court held that a buyer that had purchased computer equipment from such a remarketer could sue the supplier, Digital Equipment, for breach of the implied warranties of merchantability and fitness for a particular purpose even though there was no written agreement between the buyer and Digital Equipment. See also, Israel Phoenix Assurance Co., Ltd. v. SMS Sutton, Inc., 787 F. Supp. 102, 104 (W.D. PA. 1992); Rynders v. E.I. Du Pont, De Nemours & Co., 21 F.3d 835, 839 (8th Cir. 1994); UCC ' 2-318. In Transport Corp. v. IBM, 30 F.3d 953 (8th Cir. 1994), the Eighth Circuit held that a disclaimer of implied warranties in the remarketer agreement between IBM and its reseller was extended to the reseller's customers. However, in light of conflicting case law on this point, the supplier should ensure that the remarketer takes affirmative steps in its contracts with its customers to disclaim any warranties by its suppliers as well as by the remarketer.

(2) Remedies and Limitations of Remedy

Remedy Provisions. The second portion of the warranty should state the remedy for breach of warranty. Unless the contract states that the remedy is exclusive, the UCC remedies for breach of warranty will apply in addition to any remedy stated in the warranty (UCC ' 2-719(1)(b)). These UCC remedies include rejection of nonconforming goods, costs of cover, and consequential damages, or acceptance of the goods with recovery of the difference between the value of goods as delivered and the value of the goods had they been as warranted, plus consequential damages (UCC ' 2-711 through 2-720).

The remedy for hardware is typically limited to an obligation to repair or replace the hardware, at the supplier's option. The typical software remedy is limited to an obligation to fix errors that significantly affect performance. These warranties should require that the customer file any warranty claims within a specified warranty period. If the customer is not required to file its claim during the warranty period, it can file a claim much later so long as it asserts that the defect occurred during the warranty period. The supplier will also want to clearly state that the remedies set forth in the warranty provision are the exclusive remedies for any breach of warranty.

The supplier should consider including the following conditions precedent to its obligations to provide the exclusive remedy:

  • a requirement that the customer provide sufficient detail to allow the supplier to reproduce the error or demonstrate to the supplier the occurrence of the defect or error;
  • a statement that all corrections will be made at the supplier's facility and/or a statement that the expense of any travel to the customer's facility will be borne by the customer;
  • a requirement that the customer obtain a return material authorization from the supplier before returning the defective product, or
  • a statement of any costs that the customer will be required to bear.

For example, the customer may be required to bear the costs of shipping a defective hardware product to the supplier, or the customer may be required to reimburse the supplier for its services in the event that the supplier confirms that there is no error in the software or that the error was caused by the customer.

Failure of a Remedy to Meet Its Essential Purpose. Under ' 2-719(2), the limitation of remedy will be upheld "unless circumstances cause [it] to fail of its essential purpose," in which case the limitation is voided and the customer may seek any remedies available pursuant to the UCC. There are two ways of determining whether a remedy has failed of its essential purpose. Dowty Communications v. Novatel Computer Systems Corp., 817 F. Supp. 581, 585 (D. Md. 1992), aff.d, 33 F.3d 390 (4th Cir. 1994), cert. Denied, 115 S.Ct. 1254 (1995); U.S. Metalsource Corp. v. W&B Associates, Inc., 1997 U.S. Dist. LEXIS 4182 (S.D.N.Y. 1997). Using the first method, the court determines the potential breaches which the parties envisioned when they agreed to limit their remedies and compares the actual breach to the parties. expectations. In other words, if the parties. expectations at the time of contracting are consistent with what actually occurred, then the limited remedy has not failed of its essential purpose and should be enforced. Using the second method, the court determines whether the allegedly breaching party complied with its obligation to provide the agreed upon remedy or remedies. If the court determines that the breaching party failed to provide the agreed upon remedy, then the remedy has failed of its essential purpose.

In Milgard Tempering, Inc. v. Selas Corp. of America, 902 F.2d 703, 704 (9th Cir. 1990), the Ninth Circuit stated: "A limited repair remedy serves two main purposes. First, it serves to shield the seller from liability during the attempt to make the goods conform. Second, it ensures that the buyer will receive goods conforming to the contract specifications during a reasonable period of time." The court noted, "It is not necessary to show negligence or bad faith on the part of the seller, for the detriment to the buyer is the same whether the seller's unsuccessful efforts were diligent, dilatory or negligent." The court found that the limited "repair or replace" remedy had failed of its essential purpose where the seller had been unable to provide the buyer with a conforming, "sure fire" glass tempering furnace despite two and one-half years of effort.

The finding of the Milgard court that a remedy fails of its essential purpose if the buyer does not receive conforming goods within a reasonable period of time calls into question the efficacy of a typical software supplier remedy which provides only that the supplier will use its "best efforts" to fix errors in the software. If the supplier is unable to fix an error, the Milgard court might find that the remedy had failed of its essential purpose since the buyer never received conforming goods even if the supplier could prove it used its best efforts to fix the error.

In order to avoid the UCC remedies being read into its agreement, the supplier should consider use of an alternate exclusive remedy. In Ritchie Enterprises v. Honeywell Bull, Inc., 730 F.Supp. 1041, 1045 (D. Kan. 1990), for example, the contract between Ritchie and Honeywell Bull included the following provision:

Customer's exclusive remedy and Honeywell's entire liability in contract, tort, or otherwise for equipment is the repair or exchange of any parts which Honeywell determines during the applicable warranty period are defective in workmanship or material. All exchanged parts are the property of Honeywell. If, however, after repeated efforts, Honeywell is unable to repair or exchange such a defective part, then Customer's exclusive remedy and Honeywell's entire liability in contract, tort, or otherwise is the payment by Honeywell of actual damages in an amount not to exceed the amount paid for the irreparable device.

Litigation arose when Ritchie purchased a computer from the defendant, Honeywell, to handle Ritchie's order entry system. After the equipment was installed, Ritchie began testing it. Honeywell made some effort to correct or to repair Ritchie's problems, but Ritchie claimed that this limited remedy failed of its essential purpose and that the disclaimed warranties of merchantability and fitness for a particular purpose were, therefore, revived. The court rejected this claim, stating that, "This view confuses the distinction made in the Code between disclaimers of warranties (' 2-316) and limitations of remedies (' 2-719). Though related, these concepts are different in that disclaimers attempt to limit the circumstances of liability while remedy limitations restrict the buyer to certain forms of relief. . . . Despite any argument that the limited remedy failed of its essential purpose, plaintiff is bound by the written exclusion of the express and implied warranties, and its only warranty claim is based on the express warranty in the . . . Agreement against defects in material and workmanship." Id. at 1047.

Ritchie also argued that it had exhausted the limited remedy of repair without the system being brought into conformance with the warranty and that it should, therefore, be entitled to seek any other remedies available at law. Honeywell responded that the agreed remedy was not limited to repair but included return of the purchase price. The court held:

Although material factual issues exist as to whether the repair or replacement remedy has failed, the case sub judice is unique in that the . . . Agreement also provides for a backup remedy of actual damages not to exceed the purchase price if Honeywell, after repeated attempts, is unable to repair the defective part.

* * *

Plaintiff has not come forth with any facts to show this backup remedy was denied to them or to evidence defendant's concealment of facts which essentially made this remedy financially both unavailable and impractical because of plaintiff's business commitment to the defective product. The facts show, instead, the plaintiff pulled the plug on the Honeywell system after six months of unsuccessful testing and then purchased and installed an IBM computer to run the same order entry system. The limited remedies set forth in the . . . Agreement have not failed of their essential purpose, and plaintiff's damages for breach of the express warranty of material and workmanship are limited to the actual damages not to exceed the purchase price of the Honeywell system. Id. at 1049.

The use of alternate exclusive remedies, however, does not guarantee that the primary remedy will not be found to have failed of its essential purpose. In Ragen Corp. v. Kearney & Trecker Corporation, 912 F.2d 619 (3d Cir. 1990), Ragen, a manufacturer of computer and nuclear reactor parts, decided to purchase MM800s, computerized machines to bore, drill, and mill metal pieces, sold by K&T, a manufacturer of high speed machining equipment. The proposal included a sole and exclusive remedy limited to repair or replacement at seller's option, or return of the product and refund of the purchase price. It also included a disclaimer of liability for consequential damages. Ragen began experiencing problems with the MM800s soon after installation in 1979. K&T spent more than 7,000 hours repairing and servicing the equipment at Ragen's plant over a period of almost five years. The court of appeals found that Ragen could recover consequential damages, despite the contractual exclusion because the exclusive remedy had failed of its essential purpose, since K&T had never been able to fix the equipment and the alternative remedy of return of the purchase price was unconscionably low.

Liquidated Damages. A liquidated damages clause in a license from Electronic Data Systems Corporation to a hospital end-user of a $2,000,000 computer system was found to limit recovery to approximately $4,000. The court found that the clause was invalid because it did not provide the customer with an adequate remedy and, thus, failed of its essential purpose as a matter of law under the UCC. The court, however, did not invalidate a clause excluding consequential damages, which was held to be independent of the liability limit. Wayne Memorial Hosp., Inc. v. Electronic Data Sys. Corp., 1990 US DIST LEXIS 20796 (E.D.N.C. May 17, 1990).

(3) Limitations of Liability

The third part of a warranty consists of the limitations of liability. The most frequently used limitation of liability is the exclusion of consequential and incidental damages, which frequently is accompanied by an absolute cap on supplier's liability to the amounts received by it pursuant to the agreement. Consequential damages may be excluded unless the limitation is unconscionable (UCC ' 2-719(3)).

Enforceability of Liability Limitations When Remedy Fails of Essential Purpose. There is a split among the courts as to whether a limitation of liability will be voided where an exclusive remedy fails of its essential purpose. In Chatlos Systems v. NCR Corp., 635 F.2d 1081 (3d Cir. 1980), cert. dismissed, 457 U.S. 1112 (1982), the Third Circuit held that exclusive remedies and limitations of liability are two separate ways in which a vendor can limit its liability and should be considered separately. In S.M. Wilson & Co. v. Smith International, Inc., 587 F.2d 1363 (9th Cir. 1978), the Ninth Circuit took a similar position in a noncomputer case. Plaintiff buyer of tunnel-boring equipment sued seller for breach of contract and breach of implied warranty of fitness, among other things. The court, applying California law, found that failure of the limited repair remedy to serve its essential purpose did not void the contractual exclusion of consequential damages. The court noted that the holding was based on the facts of the case (the parties were of relatively equal bargaining strength) and was not intended to establish that a consequential damage limit will always survive a failure of an exclusive remedy. Accord, Golden Reward Mining Co. v. Jervis B. Webb Co., 772 F.Supp. 1118 (D.Ct. for South Dakota, 1991); Smith v. Navistar International Transportation Corp., 957 F.2d 1439 (7th Cir. 1992). Subsequently, however, in RRX Indus., Inc. v. Lab-Con Inc., 772 F.2d 543 (9th Cir. 1985), the Ninth Circuit invalidated a consequential damages exclusion in a computer system contract once it found that the agreed limited remedy had failed of its essential purpose. See also, Hawaiian Tele. Co. v. Microfilm Data Sys., Inc., 829 F.2d 919 (9th Cir. 1987), and Milgard Tempering, Inc. v. Selas Corp. of Am., 902 F.2d 703 (9th Cir. 1990).

It is impossible to reconcile all of these cases. However, the cases suggest there are at least two things which a supplier can do to enhance the enforceability of a disclaimer of consequential damages even if the limited remedy is struck on the basis that it has failed of its essential purpose. First, the limited remedy should be a part of the warranty provision, but any limitations of liability should be included in an unrelated section of the agreement. In Hawaiian Tele. Co. v. Microform Data Sys., Inc., 829 F.2d 919 (9th Cir. 1987), the court ignored a limitation on liability which was contained in the warranty section because the defendant never delivered the computer system, and therefore, the warranty section (which, unfortunately for Microform Data Systems, included the limitation of liability) was never triggered. Accord, Novatel Communications, Inc. v. Cellular Telephone Supply, Inc., 856 F.2d 151 (11th Cir. 1988).

Second, the agreement should include a statement that the parties have agreed that the disclaimer of consequential damages (and any other limitations of liability included in the agreement) will survive even if the limited remedy is struck. In Milgard Tempering, Inc. v Selas Corp. of America, 902 F.2d 703, 704 (9th Cir. 1990), the Ninth Circuit noted that, "the failure of a repair remedy does not automatically remove a cap on consequential damages" and predicted that [Washington] courts would take a case-by-case approach to determining whether the exclusive remedy and damage exclusions are either "separable elements of risk allocation" or "inseparable parts of a unitary package of risk allocation" (citing the district court in Fiorito Bros., Inc. v. Fruehauf Corp., 747 F.2d 1309, 1314-15 (9th Cir. 1984)). A contractual provision acknowledging the severability of these provisions in an action between sophisticated parties should be persuasive evidence that such provisions are "separable elements of risk allocation."

Proposed Article 2B "continues the presumption that contractual choices should be enforced unless there is a clear, contrary policy reason to prevent enforcement or there is over-reaching" (UCC ' 2B-704, Reporter's Notes, May 1997 Draft). This means that parties generally may limit by contract the remedies available upon breach. See esp., UCC ' 2B-703. Whereas case law under current Article 2 is split regarding the effect of the failure or unconscionability of a limited remedy on a contractual exclusion of consequential damages, proposed Article 2B expressly provides that the two contract terms are independent unless the contract provides otherwise. UCC ' 2b-703(c), May 1997 Draft.

Contractual Limitations Period. Another limitation on liability which has been used successfully is the contractual limitation of time to sue. UCC '2-725(1) provides that an action for breach of contract must be commenced within four years after the cause of action has accrued. However, the parties can reduce this period to as little as one year. In International Business Machines Corp. v. Catamore Enterprises, 548 F.2d 1065 (1st Cir. 1976), cert. denied, 431 U.S. 960 (1977), decided under Article 2, IBM sold Catamore a computer system for production control. According to Catamore, IBM orally agreed to furnish a computerized control system on a "turnkey" basis, including software programming. When the system failed to work, Catamore withheld payment. IBM filed a complaint in which it sought to collect $68,000 from Catamore for rental of equipment and payment for services. Catamore counterclaimed, asserting breach of express and implied warranties, breach of contract, and false representations. After trial, the jury returned a verdict in favor of IBM in the amount of $68,000 and a verdict for Catamore on its counterclaims in the amount of $11 million. On appeal, the First Circuit found that the clause in the contract providing that an action for breach of contract could not be brought more than one year after a cause of action arose precluded Catamore from prevailing on its counterclaims for breach of warranty and breach of contract. As a result, the First Circuit vacated the judgment and remanded the action for a new trial. Accord, Reynolds Industries, Inc. v. Mobil Oil Corp., 618 F.Supp. 419 (D. Mass 1985); NMP Corp. v. Parametric Technology Corp., 958 F. Supp. 1536 (N.D. Okla. 1997). Proposed Article 2B follows the current Article 2 rules, but it allows a one-year extension if the breach could not have been discovered earlier. In addition, it allows parties to extend the limitations period by contract up to eight years (UCC ' 2B-705(a), May 1997 Draft).

Finally, it is also useful to include an acknowledgment by the customer that the purchase price or license fee reflects the negotiated warranty provisions, since under California Evidence Code ' 622, such recited facts are conclusively presumed to be true between the parties.

Conclusion

You may have heard the saying that, "Software programming is the newest profession in the world, and it shares the same ethics as the oldest." No matter how well drafted the warranty provisions in a computer agreement are, they will not protect the supplier in the event that the supplier has engaged in business practices which constitute negligent or intentional misrepresentation or fraud. The district court in Glovatorium v. NCR Corp., 684 F.2d 658 (9th Cir. 1982), in its oral opinion upholding a jury award of punitive damages in excess of $2,000,000 (9.1 times the amount of the actual damages awarded) recited a litany of unacceptable marketing practices which supported the jury's finding of intentional misrepresentation:

Without going into any detail, it's clear that NCR approved the sale of this microcomputer system with a Spirit program when it was still testing the subject 'the product' and knew that it was subject to numerous problems and shortcomings, without disclosing that fact to the plaintiff.

It permitted the sale of the system for a purpose, namely, route accounting, for which it had never been used before, for which there was no program in existence, and which NCR didn't have any reason to believe it could successfully perform.

After the computer was delivered, NCR failed to provide the programming that it had promised and failed for the most part to fix the problems that were developing and to provide the support which it had promised it would provide.

It went as far as to permit its employees secretly to switch the units, by switching serial numbers, without ever reprimanding them or even making [an] apology.

And finally, to the very eve of the trial, NCR maintained a position that it was essentially blameless, that most of the responsibilities were the plaintiff's and that it wasn't its own fault and its efforts to resolve the controversy were minimal, to say the least.

Almost all of the cases charging computer companies with breach of warranty have alleged negligent and intentional misrepresentation as well. If a nondemurrable cause of action for misrepresentation is stated along with a cause of action for breach of warranty, in California, oral testimony concerning precontract representations will be admitted despite the existence of an otherwise valid integration clause in the license agreement (APLications, Inc. v. Hewlett-Packard Co., 501 F. Supp. 129 (S.D.N.Y. 1980), aff.d 672 F.2d 1076 (2d Cir. 1982), Hartman v. Shell Oil Co., 68 Cal.App.3d 240, 137 Cal. Rptr. 244 (Ct. App. 1977)). In addition, a contractual limitation precluding recovery of consequential damages will not apply to a claim for fraudulent misrepresentation. Id. See also, UCC ' 2-721 which provides: "Remedies for material misrepresentation and fraud include all remedies available under this article for nonfraudulent breach;" Colonial Life Insurance Company of America v. Electronic Data Systems Corp., 817 F. Supp. 235 (D.N.H. 1993), in which the court, noting there are limits to the enforceability of clauses disclaiming consequential damages and capping liability, found that, "If EDS is shown to have acted fraudulently, in bad faith or in a 'willful and wanton' manner, the protection afforded by the limitation of liability clause [will] not be available." Id. at 243 (quoting PK's Landscaping v. New England Tel., 128 N.H. 753, 757, 519 A.2d 285, 288 (1986). Contractual limitations of time to bring an action also will not apply to fraud claims (Financial Timing Publications, Inc. v. Compugraphic Corp., 893 F.2d 936 (8th Cir. 1990)). As in Glovatorium, punitive damages far in excess of any direct or consequential damages may be awarded even if there is no evidence of malicious, reprehensible, or outrageous conduct.

The Glovatorium case highlights the interrelationship between the law of warranties and misrepresentations and makes it clear that lawyers cannot draft contracts in a void. The performance warranty can be a powerful and effective tool for defining and limiting the supplier's obligations to its customer for product defects, but only if the supplier's business practices ensure that any claims of misrepresentation will be denied.

PERFORMANCE WARRANTY CHECKLIST

  1. Does the warranty clearly state the standard to which the vendor is subject (e.g., "free from defects in material and workmanship" for hardware; "performs substantially in accordance with end user documentation" for software)?
  2. Does the warranty specify the time period within which the customer must notify the vendor of any warranty claims?
  3. Does the warranty include appropriate exclusions (e.g., exclusions for hardware which has been maintained by an unauthorized third party or which has been subjected to unusual physical or electrical stress, exclusions for software errors which cannot be reproduced, which occur in an unsupported hardware and system software environment, or which has been modified by the customer or any third party)?
  4. Does the warranty include appropriate conditions precedent to the vendor's obligation to provide the exclusive remedy (e.g., a requirement that the customer provide sufficient detail to allow the vendor to reproduce the error or demonstrate the occurrence of the error, a statement that all corrections will be made at the vendor's facility and/or borne by the customer, a requirement that the customer obtain a return materials authorization, or a statement of any costs that the customer will be required to bear)?
  5. Does the warranty include sole and exclusive remedies for breach of warranty?
  6. Does the warranty include an alternate exclusive remedy in the event the first remedy fails of its essential purpose?
  7. Does the Agreement contain a conspicuous disclaimer of the implied warranty of merchantability and does it also disclaim the implied warranty of fitness for a particular purpose, the warranty of title, and the warranty of noninfringement?
  8. If the vendor is supplying goods to a remarketer for redistribution, does the agreement require the remarketer to disclaim any warranties by its suppliers in its contracts with customers?
  9. Does the agreement include language stating that no action was taken to ensure exclusion of any viruses or that a risk exists that viruses have not been excluded?
  10. Does the agreement allocate liability for year 2000 noncompliance?
  11. Are the following limitations of liability set forth in a separate section of the agreement from the warranty?
    1. Disclaimer of consequential and incidental damages.
    2. A reasonable cap on the vendor's aggregate cumulative liability.
    3. A contractual limitation on time to sue.
  12. Does the agreement include a statement that the parties have agreed that the disclaimer of consequential damages (and any other limitations of liability included in the agreement) will survive even if the limited remedy in the warranty is invalidated?
  13. Does the agreement contain an acknowledgment by the customer that the purchase price or license fee reflects the negotiated warranty provisions?