Potential Y2K Breach of Contract Claims

The sale or lease of computer software is generally treated as a "transaction in goods," falling within the scope of the Uniform Commercial Code ("U.C.C."). See U.C.C. §2-102 (1996). This article, and virtually all briefs filed in existing Year 2000 software sales cases, treat the sale of software as a good. Services fall outside of the U.C.C., and are analyzed under the existing case law analyzing "common law" contracts. While the bulk of work in the creation of any software might be considered a service, the final delivery of software code in one tangible form or another has led most courts to consider software sales a good covered by the U.C.C.. E.g., Stephen G. Sand, Annotation, Validity, Construction, and Application of Computer Licensing Software Agreements, 38 A.L.R.5^th 1, 20-21 (1996). This is not a foregone conclusion under varying facts, however, and the issue should be considered if common law presents a different legal analysis from a corresponding U.C.C. provision. This is especially true if the software provider engages in substantial consulting with the purchaser in developing the product, and is paid for consulting time, rather than just for the end product. Similarly, common law analysis as a service may be appropriate if the provider covenants to support the product over a long term and the support provision includes service elements that dominate the contractual relationship. Moreover, IT consultants who plan the development and acquisition of software from vendors are more traditional service providers, and probably would fall outside of the U.C.C. With this background, it should be recognized that the U.C.C. and common law contract analyses will be the same in many areas, and will differ significantly in only limited aspects - perhaps the most significant of which is warranties, one of the key bases for a breach of contract. With respect to consumer goods, the provisions of the federal Magnuson-Moss Warranty Act and state and federal unfair business practice statutes may also be critical.

The basis for claiming a breach of contract might rest on express provisions specifically describing the performance criteria or design specifications of software. In addition, however, claims may arise from obligations to service or maintain the software; an inability to perform Year 2000 functions may trigger these obligations. Moreover, express or implied warranties regarding the product will give rise to Year 2000 claims. Finally, representations about the product made outside of the express written provisions of the contract may be argued to be part of the contract, including representations made in negotiations and, in some instances, even advertising representations.

Express provisions describing the software or its performance capabilities are not always straightforward. Until the last few years, most contracts did not expressly mention Year 2000 issues, and efforts will be made to interpret specifications and capabilities to include these functions. In the earliest Year 2000 decisions, courts have ruled that contracts without express representations of Year 2000 capabilities do not support Year 2000 liability. See e.g., Paragon Networks Int'lv. Macola; ASE Limitedv. INCO Alloys Int'l, Inc. (referred to arbitrator, who held "[T]here was no evidence presented which would indicate that the issue of Year 2000 mitigation or remediation was ever added to the contract by a writing signed and agreed to by both parties ... . [Year 2000] remediation was not clearly called for in the contract documents."). Nevertheless, these are early decisions and highly fact specific. In general, the more the contract focuses on capabilities that inherently require Year 2000 functionality, the better the argument is that general language incorporates such capabilities.

More importantly, even in contracts that contain Year 2000 compliance provisions, the inescapable issue is that the term "Year 2000 Compliant," or similar language, has no agreed meaning. Multiple organizations have attempted to provide some meaning to the term, but with no mutual agreement.¹ In fashioning new contracts, thought should be given to the end-user's needs and how these will be met by the software. With this background in mind, the parties can write a specific provision describing the types of functionality that will be necessary or that will at least alleviate some of the definitional issues.

Much of the litigation addressing Year 2000 issues has and will continue to address warranties, which may be either express or implied, and which are limited and interpreted pursuant to many limitations and requirements. These restrictions are generally imposed by the U.C.C., or by specific state statutes. Generally, any "affirmation of fact" the seller makes to the buyer regarding the goods which is part of the "basis of the bargain" creates a contractual warranty obligation to fulfill the promise. U.C.C. §2-313(1)(a); see also Hauterv. Zogarts, 14 Cal. 3d 104, 115 (1975). This broad language permits allegations that product descriptions and marketing materials provided before the contract is executed have created express warranties, and at least one software provider has reportedly settled a class action suit based on such marketing materials by offering free upgrade patches. Atlaz Int'l, Ltd.v. Software Business Technologies, Inc., et al., No.172539 (San Mateo Cal. Super. Ct., filed Apr.2, 1997) (marketing referred to software as "designed to meet the needs of business today and into the next century"). On the other hand, a similar action was dismissed in Paragon Networks Int'lv. Macola, No.98CV0119 (Ohio Ct. C.P., filed Apr.1, 1998) (referring to "Accounting Software You'll Never Outgrow"). The Macola court held that, under the language of Macola's contracts, Macola had fulfilled all its contractual and other legal obligations to end users. These early cases, however, will be of little utility in providing certainty because they do not bind other courts, and the variation in contract language and performance is too wide to allow ready application to other settings.

Implied warranties rest on obligations that are imposed by law into all contracts covered by the U.C.C., or a local state's governing statute. The two implied warranties of the U.C.C. are a warranty of merchantability generally and a warranty of fitness for particular purposes. The warranty of merchantability requires that the product be fit for its ordinary uses, and is included in all contracts under the U.C.C. unless it is properly limited or excluded. U.C.C. §2-314; see generally, Hauter, 14 Cal. 3d at 117. Similarly, an implied warranty of fitness for a particular purpose may be imposed where the seller has reason to know that the buyer is relying on the seller's expertise to provide a product fit for a particular intended use. U.C.C. §2-315; see generally, Eichler Homesv. Anderson, 9 Cal. App. 3d 224, 231 (1970). Simply selling a computer product knowing that the buyer intends to use it in the year 2000 may expose a seller to a claim under both of these warranties. Several of the actions filed against Intuit regarding Quicken financial software have made such allegations, albeit unsuccessfully so far.

State statutes may make substantial alterations to these warranties. The California Consumer Warranty Act, for example, expressly provides that the fitness for a particular purpose implied warranty applies to consumer transactions. Cal. Civ. Code §§1791.1, 1792.1, 1792.2. Some states limit implied warranties to the sale of goods; others provide the warranties, or similar warranties, with respect to services.

Limiting express and implied warranties, or excluding them, is also controlled by the U.C.C., and such limitations are ineffective unless the procedural and substantive requirements of the U.C.C. are met. Generally such limitations must be agreed by the parties and conspicuously stated. Sometimes specific language must be used, such as describing the sale as "as is" or "with all faults." See Cal. Civ. Code §§1792.3, 1792.5 (implied warranties).

Privity, or the requirement that one have a contract with the opposing party, must also be considered with respect to warranties. Generally privity is no longer required in order to sue on an express warranty, so that in many states a suit could be brought for economic or personal injury against the software manufacturer by the ultimate user even if a distributor or consultant actually sold the software to the end user. See Seelyv. White Motor Co, 63 Cal. 2d 9, 14 (1965). Implied warranties more often still require privity, although an important exception is California's rule that privity is not required for implied warranty claims brought by consumers. Cal. Civ. Code §1792.

In addition to U.C.C. standard warranties, and state modifications of or additions to these, the provisions of the federal Magnuson-Moss Warranty Act will apply to consumer transactions. 15 U.S.C. §2301 et seq. This act provides further requirements regarding the form of any warranties, that for most purposes require that any written warranty at a minimum obligate the warrantor to repair or replace a defective product, or refund the price. The Magnuson-Moss Warranty Act also prohibits the disclaimer of implied warranties if any express warranties are made with the sale. Thus the Magnuson-Moss Warranty Act provides substantial restrictions that apply to any effort to provide warranties for consumer products.

While this section primarily addresses contract issues, it is important for manufacturers and consumers to recognize that operating in the commercial marketplace will expose the transaction to the various unfair business practices acts of the federal and state governments. These acts often provide vary broad and vague definitions of unfairness, and some of these acts have been applied to contractual representations and warranties, including California's Unfair Business Practices Act. Cal. Bus.& Prof. Code §17200 et seq. Marketing practices will be considered, as well as contract terms, in deciding such issues.

There are other damage control steps to consider in advance of any problem. People with knowledge of computer hardware and software documentation and histories within a business should be interviewed, and asked to assist in building contract, insurance, and technical document histories as part of any Year 2000 action plan. Efforts made to address Year 2000 legal issues should be expressly documented. For example, showing that legal advice was the dominant purpose might increase the chances for protecting such frank internal analyses as privileged. Other specific steps should be taken as befit the particular circumstances

The U.C.C. states, "[a] breach of warranty occurs when tender of delivery is made, except when a warranty explicitly extends to future performance."⁴ A defendant software producer is therefore likely to argue that the breach occurred and the statute of limitations began to run at the tender of the product. This argument requires that the warranty not be interpreted as one for future performance. To illustrate the problem, assume that the breach involved the following standard warranty language: "Producer warrants that the software, which is produced to the specifications outlined above in this agreement, will run accurately on the purchaser's operating system."

The warranty is in the present tense and operates as soon as the software is installed. No representation is made that the software will run accurately in perpetuity on the purchaser's operating system. Thus, the courts might conclude that the quoted language does not warrant future performance.⁵

For warranties with language similar to the above hypothetical, the breach would be determined to occur at the time of tendering, barring any actions brought four years from that date. This means that for software delivered before 1996, most actions are likely to be time-barred by the time the purchaser has a chance to appreciate the magnitude of Year 2000 damages.⁶

Long-term software contracts are especially vulnerable. Assume the contract clearly requires support by the software provider beyond the Year 2000. This might well support various arguments that there is a legal requirement that the software be rendered Year 2000 compliant. As noted, however, the U.C.C. warranty provision puts the buyer on notice that any breach of warranty occurs on the delivery or tender of the software. Here software providers clearly will argue that buyers, especially business purchasers, should have proceeded to inquire at the time of receipt whether the software was Year 2000 compliant.

Purchasers of software are likely to argue that the breach does not occur until the software actually fails. If failure does not occur until the Year 2000, that would allow some purchasers until the Year 2004 to assess damages and sue manufacturers and vendors for damages. But some systems are already producing aberrant results: a 105-year-old woman has been issued a reminder by the state to register for kindergarten, and, as noted earlier, restaurant software systems have rejected credit cards that expire in or after the year 2000. Further, for the purpose of delaying the statute from running, purchasers may argue that a material breach did not occur until the system became inoperative.

The few decisions to date have not focused on the statute of limitations issue, but some courts have looked at the question of substantive breach. The ASE and Macola cases have held that providing software that works when first installed meets contractual requirements that do not expressly call for Year 2000 capability. The Intuit decisions have held that no breach has occurred yet because there has been no Year 2000 function failure, and thus there is no breach at this point in time. This ruling was sought by the defendants to dismiss the current lawsuits, but it may prove harmful to defendants down the road when limitations arguments are brought after actual harm can be alleged. It is also important to note that other software suppliers in the settled cases discussed above, may have had contract language that created greater exposure.

Another likely argument in the Year 2000 contract actions is that of anticipatory repudiation. U.C.C. 2-610 defines an anticipatory repudiation as a breach, so that when a party repudiates a contract with respect to future performance, the aggrieved party may treat the repudiation as a breach and resort to any remedy for breach. Thus, if a software producer clearly and affirmatively repudiates its obligations under the warranty prior to the actual failure, the statute of limitations will begin to run.⁷ Software producers are likely to give early notice to their licensees and purchasers that the product is not going to be able to perform as expected after the millennium, which would be a useful defense tactic because it would force users of the software to mitigate damages from that point forward. Users would unequivocally be put on notice that it was up to them to avoid any potential losses or economic damages by taking corrective action, and that their failure to take such action shifted liability for such consequential damages.

This type of notice has already been given by many providers, and prompted lawsuits in return. For example, according to a recent complaint in New York state court, Garpac Corp. notified Milton Bradley that software designed to support Milton Bradley's garment industry work over a 50-year term might provide erroneous information when required to calculate dates beyond the year 2000. Milton Bradley Corp.v. Garpac Corp, No. 9900463 (Sup. Ct. N.Y., filed Jan. 28, 1999). Similarly, a class action filed against IBM and MEDIC Computer Systems alleged that the companies notified customers of bundled hardware and software for medical offices that the package was not Year 2000 compliant. Yuv. IBM, et al, No. 98C8241 (N.D. Ill., filed Dec. 22, 1998).

One can also expect to see defendants plead the affirmative defense of impracticability.⁸ Corbin says that "[a] performance may be so difficult and [extremely] expensive that it is described as 'impracticable' and enforcement may be denied on the ground of impossibility."⁹ A premise underlying this defense, however, may be found lacking: Case law interpreting the doctrine has developed a three-prong test, the first of which is that a contingency, or unexpected event, must occur. Plaintiffs will undoubtedly argue that it was certainly predictable and expected that computers using two digits for calendar years would roll to "00" after the end of Year 1999. Further, two-digit fields were the standard throughout the industry and, to at least some extent, this standard was the result of a conscious, market-driven choice to save memory space. On the other side, defendants might argue that, with the fast track to technological obsolescence that we have seen, it was unlikely that computers and software using two-digit year codes would be in use in the Year 2000, or that the use of two-digit year coding was a decision driven by general market conditions (recall, memory used to be more expensive, and saving two digits of code space every time a year was entered may have made considerable sense). In short, the practice of using two-digit date fields cannot be considered an "unknown" problem.

In the end, the arguments about impracticability will come down to fundamental questions of economic policy. For example, in another context (the Clear Air Act, 42 U.S.C.A. §7411), lawmakers wanted the law to be technology-forcing and therefore chose the "Best Available Technology" standard over other, more economically efficient, lax, "industry practice" standards.¹⁰ It is conceivable that lawmakers or courts will require corporate consumers to adapt to whatever standard-of-the-week that the IT industry may create to solve the Year 2000 problem. Alternatively, lawmakers may be satisfied with shifting the burden of compliance back to the IT industry, and thereby creating strong disincentives for corporate clients to be technologically proficient.

When a promisor defends against a claim of breach by asserting that the costs of completion have greatly increased, courts often analyze the case under the "frustration of purpose" doctrine.¹¹ Some courts have suggested that the impossibility defense and frustration defense have the same function.¹² An interesting line of cases has evolved relating to the increase of completion costs associated with inflation.¹³ These cases hold that when inflation jumps to a level three times as high as that in effect at the time of contracting, and that increased rate causes the costs of completion to increase by at least 100%, the party asserting frustration will be released from its duty to shoulder all of the increased costs.¹⁴Commentators have suggested that, under this doctrine, no party can ever "obtain complete relief from the terms of his contract; at most he gains the right to have the other contracting party share in the loss."¹⁵ Commentators further suggest that courts are likely to follow any price-escalation clauses in the contract, and, if none, will consider which party is more capable of bearing such costs.¹⁶

Finally, courts may find liability for breach but modify the damages because the purchaser failed to fulfill its duties to mitigate. The standard measure of damages for breach of warranty is the difference between the value of the goods as accepted and as warranted.¹⁷ The code also allows for the recovery of proximate damages shown by special circumstances and consequential damages.¹⁸ Consequential damages are defined as "[a]ny loss resulting from general or particular requirements and needs of which the seller at the time of contracting had reason to know and which could not reasonably be prevented by cover or otherwise . . . or injury to person or property proximately resulting from any breach of warranty."¹⁹ Consequential damages must be reasonable and foreseeable.²⁰

The courts have allowed recovery in breach of warranty actions for many types of damages beyond the standard difference between the value of the goods as warranted and as accepted. Those damages include: lost profits;²¹ loss of use of the defective goods, including the cost of renting replacement equipment;²² loss of customers and business goodwill;²³ and time and money expended on reasonable efforts to make the goods conform to warranty, even where the buyer does not begin repair until after liability is resolved.²⁴

Based on certain tendencies in the computer industry, there is also the possibility of simple, pragmatic solutions. In cases where "unforeseen" increased costs are not so extreme as to render performance impossible, but are severe enough to impede performance, courts have declined to discharge the duties to perform, and in some instances have allowed the breaching party to make a new promise of performance in exchange for increased compensation.²⁵ That might be an answer for computer warranties: the industry can enter into negotiations with clients to perform the necessary modifications, while sharing the costs. Or the industry could ask that, if clients want their ongoing service contracts renewed, they pay increased premiums, which would allow the industry to complete all modifications, while spreading the risk among clients that some systems will require extraordinary modification costs. In short, there will be abundant opportunities for imaginative innovations and re-arrangements. This is already evidenced in the Massachusetts case of Youngv. Baker, which, after a successful mediation of a computer consultant's duties to a major retailer regarding a computer system almost a decade old, resulted in the voluntary dismissal of the action, without any payments by either party.

2..U.C.C. § 2-725(1). RETURN

3..U.C.C. § 2-725(2). RETURN

4..U.C.C. § 2-725. RETURN

5..California law is unclear as to how explicit a warranty must be to extend to future performance, but the Ninth Cir-cuit, applying Washington law, has followed the majority rule requiring that "the warranty of future performance must be unambiguous, clearly stated, or distinctly set forth." Washington Recreational Vehicles, Inc. v. Swift Adhesives, Inc., 23 F.3d 1547, 1550 (9th Cir. 1994). RETURN

6..See Gary E. Clayton et al., The Year 2000 Headache, 28 Tex. L. Rev. 753, 790 (1997); Robert G. Gerber, Comment, Computers and the Year 2000: Are You Ready?, 30 J. Marshall L. Rev. 837, 850-52 (1997). RETURN

7..See, infra. RETURN

8..See Arthur L. Corbin, Corbin on Contracts § 1325, at 266 n.29 (1981). RETURN

9..Id. RETURN

10..See, e.g., Kennecott Copper Corp. v. Train, 546 F.2d 1149 (9th Cir. 1975). RETURN

11..Corbin, supra note 29, § 1360-61 (1999 Supp.). RETURN

12..See American Trading and Production Corp. v. Shell Int'l Marine Ltd., 453 F.2d 939, 942 (2d. Cir. 1972). RETURN

13..See Corbin, supra note 29, § 1360 (1999 Supp.). RETURN

14..See, e.g., Publicker Industries, Inc. v. Union Carbide Corp., 17U.C.C. Rep. Serv. (Callaghan) 989, 992 (E.D. Pa. 1975). RETURN

15..Corbin, supra note 29, § 1360 (1999 Supp.). RETURN

16..Id. RETURN

17..Cal. Com. Code § 2714(2) (West 1964). RETURN

18..Id. RETURN

19..Id. § 2715. RETURN

20..Camrosa County Water Dist. v. Southwest Welding and Mfg. Co., 49 Cal. App. 3d 951, 957 (1975). RETURN

21..Tremeroli v. Austin Trailer Equipment Co., 102 Cal. App. 2d 464, 482 (1951). RETURN

22..Id. RETURN

23..Stott v. Johnston, 36 Cal. 2d 864, 872 (1951). RETURN

24..Camrosa County Water Dist., 49 Cal. App. 3d at 956. RETURN

25..See Corbin, supra note 29, §§ 1276-92 (generally, on doctrines of accord and satisfaction). RETURN