ContractsProf Blog

ALI Principles of the Law of Software Contracts

Speaking of the recently-approved Principles of the Law of Software Contracts (the subject of our sister section's call for proposals below), here's an overview and remarks from Reporter Bob Hillman for the benefit of those who have not already read them on Concurring Opinions:

Maureen O’Rourke, the Associate Reporter on the Principles of the Law of Software Contracts, and I are posting the following to acquaint readers with the Principles and also to respond to some criticism of one section of the Principles that creates, under certain circumstances, an implied warranty of no known material hidden defects in the software.

On May 19, the membership of the American Law Institute unanimously approved the final draft of the Principles of the Law of Software Contracts. As the Introduction to the project states, the Principles “seek to clarify and unify the law of software transactions.” The Principles address issues including contract formation, the relationship between federal intellectual property law and private contracts governed by state law, the enforcement of contract terms governing quality and remedies, the meaning of breach, indemnification against infringement, automated disablement, and contract interpretation.

The Introduction to the Principles explains further that “[b]ecause of its burgeoning importance, perhaps no other commercial subject matter is in greater need of harmonization and clarification. . . . [T]he law governing the transfer of hard goods is inadequate to govern software transactions because, unlike hard goods, software is characterized by novel speed, copying, and storage capabilities, and new inspection, monitoring, and quality challenges.” Many of the rules of Article 2 of the UCC therefore apply poorly to software transactions or not at all, and the Principles are intended to fill the void.

The Principles are not “law,” of course, unless a court adopts a provision. Courts can also apply the Principles as a “gloss” on the common law, UCC Article 2, or other statutes. Nor do the Principles attempt to set forth the law for all aspects of a transaction, but instead rely on sources external to the Principles in many areas.

The Principles apply to agreements for the transfer of software or access to software for a consideration, i.e., software contracts. These include licenses, sales, leases, and access agreements. The project does not apply to the exchange of digital media or digital databases. It applies a predominant purpose test to determine applicability to transactions involving embedded software or software combined in one transfer with digital media, digital databases, and/or services.

We are the Reporter and Associate Reporter of the software principles. We have been greatly aided by our advisors, consultative group members, ALI Council members, liaisons from the National Commissioners on Uniform State Law, Business Software Alliance, and the American Bar Association, and many additional lawyers from industry and other groups who, over the last five and one-half years, have met with us, talked with us on the phone, and exchanged e-mails with us. We believe the project moved along smoothly largely because of the efforts of all of these groups and individuals.

Nevertheless, in the two weeks leading up to approval in May, we received communications from a few software providers evidencing concern largely with one section of the Principles. Section 3.05(b) creates a non-excludable implied warranty that the software “contains no material hidden defects of which the transferor was aware at the time of the transfer.” The section only applies if the transferor receives “money or a right to payment of a monetary obligation in exchange for the software.” Because the section may be the most controversial provision, we devote the rest of this post to the issue.

Despite concerns that section 3.05(b) creates “new law,” it simply memorializes contract law’s disclosure duties and tort’s fraudulent concealment law. The section makes clear that these rules apply to software transfers in order to allocate the risk to the party best able to accommodate or avoid the costs of materially defective software. Obviously this is the transferor in situations where only it knows of the material defect and the transferee cannot protect itself. The section requires that the transferor knows of the defect at the time of the transfer (negligence in not knowing is not enough to trigger liability), the defect is material, and it is hidden.

A few software providers have concerns that the concepts of “hidden,” and “material defect” are obtuse and will “increase litigation” or require a flood of “detailed notices” to prospective users. These concepts, however, are hardly unknown to the law. A comment to section 3.05(b) says that a “hidden” defect occurs if the “defect would not surface upon any testing that was or should have been performed by the transferee.” This is nothing new. See, e.g., UCC 2-316(3)(b) (”there is no implied warranty with regard to defects which an examination ought in the circumstances to have revealed to [the buyer]“).

A few software providers also worry about the meaning of “material defect.” The comments to section 3.05(b) point out that the section simply captures the principle of material breach: Does the defect mean that the transferee will not get substantially what it bargained for and reasonably expected under the contract? The criticism that “materiality” is too vague, if accurate, would mean that contract law would have to abolish its material breach doctrine too.

Putting together the requirements of actual knowledge of the defect at the time of the transfer, that the transferee reasonably does not know of the defect, and that the defect constitutes a material breach means that a transferor would be insulated from liability in situations identified by the concerned software providers as problematic. These include where the transferor has received reports of problems but reasonably has not hadtime to investigate them, where the transferee’s problems are caused by uses of which the transferor is unaware, where the transferor learns of problems only after the transfer, and where the problems are benign or require reasonable workarounds to achieve functionality. The best example of when section 3.05(b) would apply is, as comment b to the section says, where the transferor already knows at the time of the transfer that the software will require “major workarounds . . . and cause[] long periods of downtime or never [will] achieve[] promised functionality,” the transferee cannot discover this for itself, and the transferor chooses not to disclose the defect.

As we have already said, the section simply memorializes existing law. Under the common law, a contracting party must disclose material facts if they are under the party’s control and the other party cannot reasonably be expected to learn of the facts. Failure to disclose in such circumstances may amount to a representation that the facts do not exist and may be fraudulent. See, e.g., Shapiro v. Sutherland, 76 Cal. Rptr. 2d 101, 107 (Cal. Ct. App. 1998) (”Generally, where one party to a transaction has sole knowledge or access to material facts and knows that such facts are not known or reasonably discoverable by the other party, then a duty to disclose exists.”); Hill v. Jones, 725 P.2d 1115, 1118-19 (Ariz. Ct. App. 1986) (”[U]nder certain circumstances there may be a ‘duty to speak.’ . . .  [N]ondisclosure of a fact known to one party may be equivalent to the assertion that the fact does not exist. . . . Thus, nondisclosure may be equated with and given the same legal effect as fraud and misrepresentation.”). The Restatement (Second) of Contracts section 161(b) states that “[a] person’s non-disclosure of a fact known to him is equivalent to an assertion that the fact does not exist . . . where he knows that disclosure of the fact would correct a mistake of the other party as to a basic assumption on which that party is making the contract and if non-disclosure of the fact amounts to a failure to act in good faith and in accordance with reasonable standards of fair dealing.” Section 161, comment d of the Restatement (Second) adds “In many situations, if one party knows that the other is mistaken as to a basic assumption, he is expected to disclose the fact that would correct the mistake. A seller of real or personal property is, for example, ordinarily expected to disclose a known latent defect of quality or title that is of such character as would probably prevent the buyer from buying at the contract price.”

One concern of a commentator is that fraudulent concealment is a tort, implying that it has no place in the Principles. But the principle appears prominently in the Restatement (Second) of Contracts section 161. And why not memorialize a principle that discourages a party in a contract setting from hiding material facts that the other party reasonably does not know? The commentator notes that fraudulent concealment requires intent to deceive, but wouldn’t that be the usual inference if a transferor licenses software it knows is materially defective and knows the transferee cannot discover it?

A few organizations also are concerned that section 3.05(b) cannot be disclaimed. But there are plenty of cases that do not allow a party to contract away liability for concealment. One critic wonders why a statement such as “I am not giving any assurances about there being no defects in this software,” should not insulate a transferor from liability. A reasonable licensee, assuming the good faith of the licensor, would believe that this licensor does not intend to make any express warranties or implied warranties of merchantability or fitness, not that the licensor knows that the software is materially defective so that the software will be largely worthless to the licensee. A transferor playing this game is surely in bad faith and, frankly, engaging in reprehensible conduct. But there is a way to ensure no liability under this section, namely to disclose material hidden defects. In effect, disclosure is the disclaimer.

Bob Hillman and Maureen O’Rourke
June 2, 2009

The Concurring Opinions post -- which Bob asked me to re-post, with the blessings of the Concurring Opinions folks -- has provoked several comments and has been the subject of a follow-up post by David Hoffman, one of Concurring Opinions's thirteen regular contributors.  Dave's post has generated its own comments.  While we here at ContractsProf might have a vested interest in generating site traffic, it may be more efficient to funnel feedback through a single conduit.  Because Concurring Opinions got the ball rolling, feel free to comment, or to respond to existing comments, there.

[Keith A. Rowley]

Plaudits for (Living) Contracts Professors

Brian Leiter's Law School Reports, a reliable source of information about moving and shaking in legal academia, reported yesterday that Contracts professor and current dean of the Seattle University School of Law Kellye Testy will become the new dean at the University of Washington School of Law.  I met Kellye at the 1999 AALS Conference on Contracts in Washington, DC and have had several opportunities to talk and correspond with her since then.  She's terrific.  Congratulations, Kellye!

This also affords me the opportunity for long overdue acclaim for our friend Tadas Klimas, who has made the trip from Lithuania to the International Contracts Conference and the AALS Contracts Mid-Year in Montreal.  Some of you may recall that Tadas was the dean for several years of the Vyatus Magnus University School of Law in Vilnius and actively sought to Westernize legal education in his country.  He has also taught as a visiting professor at Stetson, as well as at universities in Spain and Brazil.  Earlier this year, Lithuanian President Valdas Adamkus decreed Tadas a Cavalier of the Lithuanian Order of Merit.  Sveikiname, Tadas!

[Keith A. Rowley]

A Lesson in Contract Drafting to Trump All Others

What is the drafting lesson to trump all others?  The usual: one size does not fit all.  

AmLaw Daily reports that Trump Corporation leases space in one of the co-op buildings it constructed in New York in the 1980's.  The co-op board of that building (Trump Plaza Owners, Inc.) is looking to evict Trump Corporation, alleging it is nearly $87,000 in arrears.  

At the helm of the effort to remove Trump from the building is the president of the co-op, Andrew Perel (his day job is as an environmental law partner at Steptoe & Johnson).  And here's where Mr. Perel provides the lesson: 

"The funny part of it is what one of his internal lawyers must have done years ago," Perel says. "Normally Trump is the landlord, not the tenant. So what they did is they took one of their leases and just changed the names. And so it's not a very favorable lease if you're the tenant."

* * * The co-op gave notice of default to Trump Corporation on April 10, but the company still didn't pay its rent. The lease terminated May 6, five days past the deadline required to pay the rent and avoid termination.

"If you don't pay the rent when Donald Trump is your landlord, he comes down on you like a hammer," Perel says. "Well lo and behold, he signed a lease that was his own lease and he's the tenant. And he missed April and May.

Maybe the other lesson is: what's good for the goose, is good for the gander.

[Meredith R. Miller]

Is Miss California in Breach of Contract?

Miss California - Carrie Prejean - has been getting a lot of press play lately.  Just recently, at the Miss USA pageant, she got into a little bit of a jam when responding to Perez Hilton's question about same-sex marriage.  Now, in a story written for ContractsProf Blog, the LA Times reports that she may lose her crown for breach of contract:

Officials with the Miss California USA Pageant said today in Beverly Hills that title-holder Carrie Prejean is in breach of contract and "entered the contest under false pretenses." Donald Trump, who owns the Miss USA pageant, will decide tomorrow whether she will keep her crown.

Prejean didn't inform contest officials about her involvement with anti-gay marriage organizations and failed to show up for public appearances as required under her contract with the Miss USA organization, said Keith Lewis and Shannon Moakler, co-executive directors of Miss California USA.

Prejean's brief reign has been clouded by controversy over semi-nude photos and her comments on gay marriage. She made national headlines last month when during the Miss USA pageant she said that marriage should be between a man and woman.

She said in later interviews that she does not support gay marriage (California voters voted to prohibit gay marriage last November). Some have questioned whether her comments cost her the Miss USA title, and she's been the subject of much criticism from pro-gay-marriage activists. Her supporters believe she is being singled out because of her views on gay marriage, which they say are the same as President Barack Obama's.

Now, Miss California officials say they are looking into whether Prejean violated rules by working for a group opposed to gay marriage and by posing semi-nude. It's unclear whether she could lose her California crown if officials determine that she broke the rules. Prejean has said she did nothing wrong.

Donald Trump, who runs Miss USA, told KIIS-FM (102.7) radio last week that he would review the photos. California pageant officials said they first thought that there was only one racy photo but have since discovered there are four. “This completely changes things for us,” Keith Lewis, co-director of the Miss California USA pageant, said last Wednesday in a statement. “Yesterday, we thought she had explained things accurately. We need to revisit this issue with her."

The Donald loves a controversy -- suddenly people are actually paying attention to his Miss USA enterprise (for other examples see this and this).  I think he'll tell Miss California: "You breached the contract.  You're fired."   

[Meredith R. Miller]

After a Home Short Sale, Lender May Still Seek the Difference

For underwater homeowners who opt for the short sale, this WSJ article suggests that they still might have to tread water.  In a short sale, a seller facing foreclosure can work out a deal with the lender to sell the property for less than the outstanding debt, which the lender will accept as a payoff.  However, as the article explains, this doesn't necessarily mean that the borrower is "home free":

In a growing number of cases, holders of mortgages or home-equity loans are requiring borrowers in short sales to sign a promissory note, which is a written promise to pay back a loan or debt. Real-estate agents and attorneys say they have seen an increase in requests for promissory notes as mortgage companies look to short sales as an alternative to foreclosure.

In many states, lenders have always had the right to pursue former homeowners for unpaid mortgage debt. Yet until recently, most borrowers who ran into trouble were able to refinance or sell their homes and pay off their loans. Now, falling home prices are widening the gap between home values and mortgage balances, and the number of homeowners who can't make their mortgage payments is rising as the economy has weakened. More than 3.8 million homes will be lost in 2009 and 2010 because borrowers can't make their mortgage payments, according to forecasts from Moody's Economy.com.

Some borrowers are surprised to find themselves on the hook. Jodie Byrd sold her home in the Los Angeles area in a short sale last summer after her husband lost his job and the couple realized they wouldn't be able to make their mortgage payments. The sale price covered the $685,000 mortgage, but their lender, Washington Mutual Co., then began pursuing them for the $21,600 balance on their second mortgage.

Ms. Byrd says a clause in their contract gave Washington Mutual the right to pursue the debt, but adds that her real-estate agent said that wasn't likely to happen. The couple eventually settled the claim for $4,000.

A spokesman for J.P. Morgan Chase & Co., which acquired Washington Mutual last year, says it's the company's policy not to comment on individual cases. Speaking generally, he says, "a short sale may resolve the first mortgage, but the second mortgage ... would be a separate negotiation with the lender or servicer."

Some experts say that mortgage companies may pursue leftover debt, or "deficiencies," in greater numbers as the housing market settles. Lenders are "doing everything possible to work with their borrowers and trying to bring stability back to the lending and real-estate market," says Marc Ben-Ezra, an attorney in Ft. Lauderdale, Fla., who represents mortgage companies in foreclosures. "However, the ability to get a deficiency judgment is a valuable right that I think lenders will pursue aggressively in the future as the market stabilizes."

What, then, is the incentive for the borrower to opt for a short sale instead of foreclosure?  It seems that, if the borrower's counsel can't get the bank to consider the loan paid in full, the better option for the borrower is to allow the house to go into foreclosure.  Why would anyone counsel the borrower to opt for a short sale if the borrower has to sign a promissory note for the difference?  As I understand it, either option is bad for a borrower's credit. 

[Meredith R. Miller]

Man claims campground had contract duty to protect him from water balloon

A New Hampshire man who suffered injuries when he was hit by a water balloon fired by a slingshot is suing his campground, claiming that the facility owed a duty to protect him from being attacked.

Things apparently get rowdly on Maine's Saco River during the summertime The plaintiff was taying at the Fiddlehead Campground (left), which advised residents to  " 'avoid rowdy groups canoeing on the river' by staying at the campground, where campers agree to standard campground groups that 'help control noise and unruly behavior."  Plaintiff nevertheless was hit in the eye by a water balloon launched 67 feet away by three men using a large slingshot.  He is apparently claiming that the campground's advice created a promise that he would be safe if he stayed there.

[Frank Snyder]

Speaking of TARP

The Government's Troubled Assets Relief Program has now grown to about $3 trillion--about the size of last year's entire federal budget, according to the quarterly report to Congress made by its Special Inspector General (SIGTARP).  Other highlights of the report:

-- SIGTARP and the Treasury Department are still putting significant efforts into figuring out how to recoup $145 million in AIG executive bonsues.

-- They're also investigating whether AIG should have tried to negotiate downward its payments to its counterparties, instead of paying them at 100 percent of face value.

-- The new Auto Warranty Commitment Program, which backs auto warranties on General Motors and Chrysler products purchased after March 30, 2009 will be handled through a special purpose entity and funded at about $1.1 billion.  If you bought before that date, your warranty claims will apparently be dealt with in bankruptcy.  Sorry.

-- To speed things up, the IG has taken a lot of shortcuts in the process of awarding contracts, many of which are going to law firms and accounting firms.

-- The TARP program will be hiring a lot more employees.

[Frank Snyder]

Government endorses pre-dispute employee waivers . . . at least sometimes

Contract law types are aware that employers are more and more using the idea of contractual waivers as a way of getting employees to surrender rights, often in advance of any accrual of the actual right.  Well, what's good for Hooters Restaurants (see Hooters of America v. Phillips) is apparently good for the United States Government.

Worried that they might get sued by employees whose contracts are being rewritten new Treasury regs on executive compensation, the government asked Chrysler Financial (a sister company of Chrysler Motors) to get their employees to sign waivers of their rights to sue as a condition of additional aid under the Trouled Assets Relief Program:

Treasury asked Chrysler Financial to obtain waivers from the top 25 Chrysler Financial executives that would have waived legal claims against Treasury and Chrysler Financial resulting from the recent changes in executive compensation requirements for TARP recipients. Chrysler Financial’s management, however, informed Treasury that it was unable to obtain waivers from all 25 executives, therefore the request for additional funding was denied.

Two interesting points to this.  First, employees were asked to sign waivers without knowing exactly what limits their compensation would be subject to, since the applicable regulations aren't final.  Second, Chrysler Financial, which is privately held, is controlled by its shareholders, Cerberus Capital Management, who apparently aren't much interested in reducing the amounts they're paying their executives.

By the way, Chrysler Financial, which is struggling but isn't yet in its death throes, is denying that executive compensation is the reason it didn't take the money.  It says it didn't need it. 

[Frank Snyder]

Signs of the [New York] Times

The latest group of money-grubbing executives clinging to their perks while laying off employees and asking union workers for concessions turns out to be the top dogs at the New York Times.  CEO Janet Robinson earned $5,578,451, a nice 35 percent raise over the previous year.  This, despite the fact that the company's stock has lost some 90 percent of its value over her five-year stint and the company posted a much bigger loss in the first quarter than analysts expected.  Meanwhile, the Gray Lady has been cutting staff, selling assets, and warning unions that they'll have to take pay cuts.

Perhaps tellingly, the only outisde ad on the business page announcing the paper's losses is a postage-stamp sized plug for books about, and framed photos of, Sen. Ted Kennedy.  Wonder how much that brings in?

[Frank Snyder]

Consumer exploitation, nonprofit division

You may have missed a New York Times story a couple of days ago about one of the most oppressed classes of debtors in the country:  students who borrowed for their educations.

While TV and radio commercials offering to help debtors with $15,000 in credit card bills to reduce their debts or get a fresh start in bankruptcy, some students are stuck with $150,000 in student loans.  And all the TV ads in the world can't help you with these.  A student loan "can't be bargained with . . . can't be reasoned with . . . doesn't feel pity, or remorse, or fear.  And it absolutely will not stop, ever, until you are dead."  

Over at Instapundit, Glenn Reynolds wryly notes that "when it comes to consumer exploitation, higher education has no room to strike moral poses vis-a-vis the for-profit sector."

[Frank Snyder]