Litigation Already Underway

Introduction

When it comes to the Y2K problem, nothing is absolutely certain and many things are very uncertain. But judging from the growing intensity of demand letters and court filings, it is fair to predict that Y2K-related litigation will be a real world concern for many more businesses than virtually anybody would have predicted even a few short months ago.

As reported by ABC News and Time magazine in March, nearly 80 Y2K lawsuits have been filed, up from only three as of January, 1998, and the number is growing by the day. These stories relied upon data generated by the Gartner Group, a Connecticut-based consulting company focusing on Y2K issues. This consulting firm also has reported that Y2K lawsuit demand letters have increased dramatically and confirm the trend toward greater litigation. As of March, there were 790 such demand letters, compared to just 11 in early 1998. Also cited by the Gartner Group is the likelihood that many insurance carriers will be uncooperative when it comes to Y2K claims, thus triggering even more lawsuits. The details of settlements are also beginning to emerge, including one with a potential value of over $50 million.

This is just the beginning. We're still over six months away from January 1, 2000. The growing number of pending lawsuits and demand letters do not include the wave of lawsuits that will be filed after computer failures began to occur later this year. Although it is impossible to predict with accuracy how many full-fledged disasters will arise as a result of bad software, hardware and embedded systems, we now know that some significant problems will materialize. Even if the gridlock that some have predicted does not come to pass, the losses and problems that do occur necessarily will foster burdensome litigation (remember, this is America), which itself will foster additional burdensome litigation, and so on. Even if the disruptions are moderate in comparison to what is expected, losses will mean that plenty of firms will seek to be made whole again. Moreover, we can expect these losses to occur up and down the supply and distribution chain.

The number of dollars involved are staggering. Conservative estimates are that between 300 and 600 billion dollars will be at stake in the Y2K litigation explosion our country will experience in the next few years. The London-based Lloyd's insurance firm has predicted that Y2K claims will exceed $1 trillion. A computer industry research firm has put the total cost of Y2K remediation, including software, hardware and database repairs, plus litigation expenses and damage awards, at $1.635 trillion.

Even acknowledging that these are estimates, everyone agrees that serious Y2K failures cannot be avoided entirely. The Gartner Group estimates that 25%-50% of all computerized organizations will not achieve full Y2K compliance in time. This estimate is supported by a Standish Group International study, which found that 90% of all IT projects are delivered late or never completed. Especially with Y2K, therefore, an ounce of prevention is definitely worth a pound of cure.

Types of Cases Already Filed

A. Hardware Cases Underway

1. Produce Palace International v. TEC-America, Inc.

This case was the first Y2K lawsuit filed in the United States. It involved a cash register system purchased by Produce Palace, a store in Michigan. The system, which was designed to integrate cash register, inventory and credit card processing, was manufactured by TEC-America. According to the complaint in the case, the system "froze" whenever a credit card with a year 2000 expiration date was used. TEC-America could not fix this problem, and Produce Palace sued in Michigan state court for the cost of replacing the system. Shortly after an initial round of motions, the case settled for approximately $250,000. The settlement reportedly also required TEC America to pay up to $50,000 in reimbursement of attorneys' fees and other costs. This case was recently reported in Time magazine.

2. Hannah Films, Inc. v. Micron Electronics Inc.

This case involves a class action filed in Utah state court on behalf of everyone who has purchased a PC from Micron that is not Y2K-compliant. The complaint alleges that Micron PCs are defective because they cannot process dates beyond 1999 and that Micron is wrongfully charging for Y2K upgrades.

3. Beatie, King & Abate v. Lucent Technologies, Inc.

This is a potentially far-reaching case filed on January 12, 1999 by a New York law firm against Lucent and AT&T. The case alleges that these companies marketed and sold 59 various products that were not Y2K-compliant even after they knew about the possibility of widespread problems. The products range from voice mail systems to video conferencing products. The principal contention of the lawsuit is that the defendants have known about the Y2K problem since the mid-1980s and failed to disclose it to their customers. Plaintiff has sought to transform the case into a class action on behalf of all persons who have purchased such defective equipment. A very similar lawsuit, Modern Drummer Publications Inc. v. Lucent Technologies Inc., recently has been filed in New Jersey state court.

B. Cases Against Software

These cases involve claims that software manufacturers sold programs that were not Y2K-compliant. Like many Y2K lawsuits, these claims are often filed as class actions. Plaintiffs normally are asking the courts to order the software companies to provide a free solution to the Y2K-compliance problem, often an upgraded version of the software, or a "patch" that will remedy the problem.

Very few of these cases have resulted in judicial decisions. Most of them are in the discovery phase of litigation. In some cases, where plaintiffs have not yet suffered any identifiable loss as a direct result of the alleged Y2K-compliance defect, judges have dismissed the complaints as premature.

1. The First Case: Atlaz International, Inc. v. Software Business Technology

Filed in California state court on December 3, 1997, the Atlaz case was the first lawsuit against a software company. Atlaz argued that it purchased a database accounting software from SBT that was not Y2K-compliant and further asserted that later versions of the same software were capable of handling post-Year 2000 accounting functions. Atlaz has requested a free upgrade, which SBT had declined to provide. Instead of purchasing the Y2K-compliant version of the software, Atlaz filed suit. Shortly thereafter, SBT agreed to provide a free software patch and the parties settled the case.

2. A Representative Sample of Software Cases

a. Massachusetts Cases

In Levenbaum Insurance Agency v. Active Voice, a class action filed last July in Boston, an insurance firm sued a provider of computer-based voice mail systems on behalf of all purchasers of these systems in Massachusetts. The complaint alleges that Active Voice has failed to provide a Y2K-complaint upgrade available for all its products without charge.

Similarly, in Qual-Craft Industries v. RealWorld Corp., filed last June in Norfolk Superior Court, a purchaser of non-Y2K-compliant accounting software sued for a free upgrade. RealWorld had tried to force users of the defective software to purchase the upgrade for $3,000 or more. In late April, a judge approved a massive settlement requiring RealWorld to provide free and discounted software upgrades to as many as 50,0000 end users. This settlement reportedly could cost RealWorld as much as $55 million. Its president has publicly acknowledged that this figure is several times the total annual revenue of the company.

b. Cases Against Intuit, Inc.

Intuit, Inc., the manufacturer of the Quicken program, has been sued in numerous cases in at least two jurisdictions. These cases were based on the Y2K-noncompliance of Versions 5 and 6 of Quicken and Intuit's policy of providing a software patch at a cost of $35. Three cases were filed in California and merged into a class action. In New York, three class actions have been filed. In both jurisdictions Intuit argued that plaintiffs had suffered no damages because the program had not yet malfunctioned and would not malfunction until the Year 2000. This argument prevailed in each of these cases, which were dismissed by the courts of New York and California. Since that time, however, Intuit has promised to make a free software patch available by the middle of this year.

c. Cases Involving Medical Manager Corp.

Class actions have been filed in seven states against Medical Manager Corp., provider of a medical practice management software system widely used by physicians across the country. Filed in various states last summer (New Jersey, California, New York, New Jersey, Illinois, Pennsylvania and Florida), the basic claim in each of these cases is the same - that Medical Manager has known and has actively concealed the Y2K-compliance issue from purchasers of the system and has failed to provide free patches. The relative status of these claims is somewhat uncertain at this time, although we recently have learned that Medical Manager has offered a free Y2K patch to settle these class actions and that a $1.5 million damage pool has been created to resolve related issues.

d. Other Accounting and Billing Software Cases

Paragon Networks International v. Macola involved a claim brought in Ohio against a provider of an accounting software package that cannot process dates after December 31, 1999. Macola is accused of providing an upgrade that is too expensive.

Similarly, in Zee's Home Decorating Centers, Inc. v. DacEasy, Inc., a Texas case, plaintiff has alleged that the DacEasy for DOS Version 7.0 is not Y2K-compliant. Interestingly, in this case Zee's alleges that the product manual asserts that the software is Y2K-compliant and that DacEasy simultaneously is charging its customers for Y2K upgrades.

e. First Case Against Microsoft

The first Y2K lawsuit against Microsoft has been filed and already dismissed. Brought as a class action last December, the complaint alleged that Microsoft knowingly designed FoxPro and Visual FoxPro (database development programs) so that they could not handle the Year 2000 date changeover. A federal judge in Illinois recently dismissed the lawsuit, Kaczmarek v. Microsoft Corp., N.D. Illinois, 98-C-7921, on the grounds that no defect existed in the software because the consumer can "fix" any Y2K problems by reading the manual and adjusting the program.

C. Claims Against Consultants

A Massachusetts case involved the first Y2K claim against a consultant. Filed in Norfolk Superior Court last August, Young v. J. Baker Inc., involved a dispute about the obligations of Andersen Consulting to J. Baker under a 1989 consulting contract. J. Baker had engaged Andersen to select, design and implement a merchandising software system. In 1998, when J. Baker discovered that the system was not Y2K-compliant, it demanded that Andersen remedy the problem. Andersen refused, and instead brought a declaratory judgment action asserting that the system met all contract specifications. The contract did not address Y2K-compliance specifically and the parties apparently had never discussed the issue in contract negotiations.

The case was mediated late last year and subsequently settled. We are informed that the mediator found that Andersen had not breached the consulting contract and that J. Baker was not entitled to the $3 million in damages it had claimed.

A similar result obtained in ASE Limited v. INCO Alloy International, a Pennsylvania case that grew out of a contract obligating ASE to provide software design services that INCO asserted included Y2K remediation. INCO sought to recover almost $4 million in costs it had paid for such remediation to IBM. We are informed that late last year an arbitrator denied INCO's claim because of insufficient evidence that the underlying software design contract required Y2K compliance.

D. Against Retailers

In the first consumer action filed, a California man has sued Circuit City and similar other computer retailers for various sales practices he believes are unfair. Johnson v. Circuit City Inc., Calif. Super. Ct., Contra Costa Cty., (January 14, 1999). The complaint asserts that the stores have failed to inform their customers that some of their products may not be Y2K compliant. The complaint also states that the retailers have failed to disclose that many of these non-compliant products "can often be "fixed" at no cost or nominal cost." On April 20, 1999, a California state judge denied Circuit City's motion to dismiss the case, in which the defendant had argued that the products were not defective because they still worked and that Circuit City had no legal duty to disclose the Y2K status of their merchandise to customers.

E. Claims Against Insurers

Without question, litigation of insurance claims relating to Y2K losses will be explosive. Not only will the insurers vigorously contest any and all Y2K-based insurance claims, it is reasonable to predict that companies will likewise assert coverage issues with the enthusiasm and vigor previously experienced during the Superfund era of insurance litigation.

To our knowledge, there is only one Y2K coverage case pending in the United States. On December 4, 1998, Cincinnati Insurance Company filed suit in Iowa federal court, Cincinnati Insurance Co. v. Source Data Systems. In a strategically revealing development, the insurer filed a declaratory judgment action seeking a ruling that it does not owe Source Data Systems a duty to defend or indemnify it with respect to a contract action brought by a purchaser of Y2K-non-compliant software. The underlying case, Pineville Community Hospital Association, Inc. v. Keene Inc., filed in Kentucky state court, involved a claim by the hospital that a software maker owed damages because the company knew or should have known that the hospital information system sold would not by Y2K-compliant.

In the insurance case, the carrier claims that it is entitled to a declaration in its favor for several reasons relating to the specifics of the insurance contract between it and the insured. Cincinnati Insurance argues that the Pineville case is not an "occurrence" as that term is defined in the policy, that no "property damage" has been alleged and that the losses suffered by the policy holder were not "fortuitous." These are typical arguments presented by carriers in insurance coverage litigation. These materials will address these issues in greater detail in Section D below, which provides a general primer on insurance issues in the Y2K context.

CONCLUSION

What do these cases tell us? Depending on the nature of your claim and who you are, there is good news and there is bad news.

For users of hardware, the news is mostly good. We believe that there is a pattern emerging that tends to obligate manufacturers of hardware to provide free Y2K upgrades. If you are such a manufacturer, the news is not so good.

For users of software, the results have been mixed, although a trend seems to be developing. In general, software users will have an easier time getting relief (upgrades and service) if they can demonstrate that they are experiencing actual Y2K-related problems now. If so, the trend seems to be in your favor. If not, you risk dismissal on the grounds that your case is premature. (If you are Microsoft, however, just keep paying the lawyers, but settle all jury cases promptly.)

Regarding specialized systems designed by consultants, you must examine carefully the underlying design consulting contract. Based on the results we've observed in the J. Baker and ASE cases, unless your contract contemplates Y2K issues, or Y2K issues were addressed in negotiation of the deal, your consultant probably will not be obligated to remediate your system.

If you are a retailer, stay tuned, but be prepared for the normal pro-consumer bias often found in our state courts. If you are a retail consumer of computer products, keep insisting on free Y2K upgrades.

Finally, the insurance situation is in flux, and will be for the foreseeable future. This topic is discussed more completely in Section D, below.

These cases are the tip of the iceberg. They represent claims that are the first wave of Y2K litigation. The more far-reaching aspects of the Y2K litigation explosion will occur in categories of cases not discussed above. Once the basic issues of law and fact have been resolved between hardware manufacturers and their consumers, between software manufacturers and their consumers, and between and among the consultants and other service providers and their consumers, the litigation will evolve into the second wave of claims. This second wave of claims will involve disputes between customers and middlemen, between end users and contract service agents, between distributors and retailers of every type of product imaginable that is sold, managed, or distributed via a computer system, between citizens and government regarding the implications of government's failure to take various actions, and between other economic actors where the consequences of computer failure have resulted in economic losses, property damages, and physical injuries.