• Protecting Consequential Damages Waivers In Software License Agreements
  • April 29, 2003 | Authors: John F. Zabriskie; Martin J. (Marty) Bishop
  • Law Firms: Foley & Lardner LLP - Chicago Office; Foley & Lardner LLP - Milwaukee Office
  • Lawyers representing software companies often try to get "belt and suspenders" protection for their clients, particularly when negotiating license agreements for mission-critical software. A common approach is to couple an exclusive remedy provision, which frequently limits a licensee's recourse to repair or replacement of defective software, with a provision excluding consequential damages. Ironically, courts increasingly are seizing on supposed similarities in the nature of these protections as a justification for invalidating a consequential damages exclusion (the "suspenders") when the exclusive remedy provision (the "belt") is deemed to fail of its essential purpose, even in license agreements between sophisticated businesses. See, e.g., Caudill Seed and Warehouse Co., Inc. v. Prophet 21, Inc., 123 F. Supp. 2d 826 (E.D. Pa. 2000) This article discusses this unsettled area of law and suggests ways counsel can attempt to draft around the problem.

    Courts Follow The UCC But Arrive At Different Results

    The Uniform Commercial Code ("UCC"), which applies to most commercial license agreements for software,1 encourages freedom of contract by permitting parties - particularly sophisticated businesses - great leeway in drafting commercial agreements. UCC Section 2-719 embodies that policy of freedom of contract by expressly authorizing parties to agree to their own remedies and damages, regardless of whether they are greater or lesser than the UCC's default provisions. UCC §2-719(1)(a). Thus, the UCC specifically endorses limiting a buyer's remedies to "repair and replacement of non-conforming goods." UCC §2-719(1)(a). Only if that exclusive remedy "fail[s] of its essential purpose" will the buyer be permitted other remedies. UCC §2-719(2). Section 2-719(3) permits parties to limit or exclude consequential damages unless doing so would be unconscionable; it also creates a presumption that the limiting or excluding of commercial loss is not unconscionable. UCC §2-719(3).

    A license agreement with both an exclusive remedy provision and a consequential damages waiver benefits both licensors and licensees. Licensors benefit by eliminating exposure to potentially prohibitive damages if, for some reason, the software does not perform as expected. With their exposure so limited, licensors are able to offer software at a lower price than they otherwise could and have incentives to develop new software, thereby also benefiting licensees.

    The assumption underlying this type of bargain is that the exclusive remedy of repairing or replacing the software will be real and meaningful, ultimately providing the licensee with the software's intended benefits. Indeed, the comment to Section 2-719 states that freedom of contract notwithstanding, a contract must provide "at least minimum adequate remedies." UCC §2-719 cmt. 1. In the real world, a licensee may allege that the software provided by the licensor does not function as warranted. Thus, a licensor, for whatever reason, simply may be unable to provide (or unable to demonstrate that it provided) the licensee with software that functioned properly, at least in the licensee's computing environment. When these allegations are proven, the licensor retains the benefit of its bargain (limited liability), but the licensee is left with little to show for its payment of the license fee. Section 2-719(2) addresses this potential imbalance by providing that "where circumstances cause an exclusive or limited remedy to fail of its essential purpose, remedy may be had as provided in this Act." UCC §2-719(2). If the licensor is unable to adequately repair or replace the software, courts are not reluctant to find that the exclusive remedy failed of its essential purpose, thereby opening the door to additional remedies.2 See, e.g., RRX Industries, Inc. v. Lab-Con, Inc., 772 F.2d 543, 547 (9th Cir. 1985). Such a finding is particularly likely when the exclusive remedy consists only of repair or replacement and does not have a monetary component, such as a refund of fees paid. See, e.g., Caudill Seed, 123 F. Supp. 2d at 828-29 (finding that exclusive remedy of only repair or replace failed of its essential purpose); Global Link Communications, Inc. v. Homisco, Inc., 1998 WL 774981 (N.D. Ill. 1998) (same).

    But what effect will a failed exclusive remedy provision have on a consequential damages waiver? Unfortunately, the answer is murky because courts are divided. Some courts allow a licensee to collect consequential damages despite the waiver, while others reach the opposite result by enforcing the waiver notwithstanding the exclusive remedy having failed its essential purpose. Still others say that the question is inherently circumstantial and can be dealt with only on a case-by-case basis. Each of these three lines of cases will be examined briefly.

    The Interdependent and Inextricably Linked Approach

    Courts permitting a licensee to collect consequential damages despite a consequential damages waiver use a variety of rationales for reaching that result. Some hold that Section 2-719(2)'s language providing that any UCC Article 2 remedy is available when an exclusive remedy fails of its essential purpose governs, notwithstanding that Section 2-719(3) separately authorizes the waiver of consequential damages. See, e.g., RRX Industries, 772 F.2d at 547. Other courts find that exclusive remedy provisions and consequential damages waivers, as well as the respective UCC sections authorizing those provisions, are inextricably intertwined, so that if the former provision fails so, too, must the latter fail. See, e.g., Caudill Seed, 123 F. Supp. 2d at 833 n10.3

    Regardless of the rationale, the result reached in these cases -- voiding a consequential damages waiver when an exclusive remedy provision fails of its essential purpose -- is contrary to freedom of contract principles established by the common law and adopted by the UCC. Sophisticated commercial parties go to great lengths to insure that the complex mix of interests and compromises reflected in all agreements is mutually satisfactory to the parties. Normally, courts are loathe to override the parties' judgment and substitute their own. So while it is hard to object to the observation that exclusive remedy provisions often appear together with consequential damages waivers, Caudill Seed, 123 F. Supp. 2d at 832, it is more difficult to accept a court telling sophisticated commercial entities that they really must have intended for the consequential damages waiver to be unenforceable if the exclusive remedy provision failed, even when the agreement is to the contrary. See, e.g., id. Barring an extremely rare finding of unconscionability in a commercial setting, what better source for a court to look to in ascertaining the parties' intent than the actual language agreed to by businesses negotiating at arm's length? One could argue that courts are not rewriting the contract but merely interpreting it to infer the parties' intent when an event occurs that the parties did not anticipate; for example, the repair or replace remedy being unsuccessful. But, if courts must resort to inferences, freedom of contract suggests that the dispositive inference should be that sophisticated businesses contemplated the situation of a good faith repair or replacement effort eventually failing, but still agreed to a consequential damages exclusion. In any event, counsel need to be aware that some courts may rescue a party from "unilateral disarmament," even when the licensee freely agreed to bear the risk of consequential damages. See id. at 833.

    The Independent and Valid Approach

    In contrast, a number of courts hold that Sections 2-719(2) and (3) are independent and, accordingly, a consequential damages waiver will survive a failure of the essential purpose of an exclusive remedy provision. See, e.g., Chatlos Systems Inc. v. NCR Corp., 635 F.2d 1081, 1086 (3d Cir. 1980); Wayne Memorial Hospital, Inc.v. Electronic Data Systems, Corp., 1990 WL 606686, 7 (E.D.N.C. 1990); Harper Tax Service, Inc. v. Quick Tax Ltd., 686 F.Supp. 109, 112 (D. Md. 1988). These courts reason that because Sections 2-719(2) and (3) include different standards -- one looking to the failure of the remedy and the other triggered by unconscionability -- the provisions are intended to operate separately. See, e.g., Chatlos Systems, 635 F.2d at 1086; Otobai, Inc. v. Auto Tell Services, Inc., 1994 WL 249766, *11 (E.D. Pa. 1994). This rationale is founded on the rule of statutory construction that the particular governs the general. See Otobai,1994 WL 249766 at *11. Thus, because Section 2-719(3) speaks specifically to consequential damages rather than the general remedies referred to in Section 2-719(2), a consequential damages waiver should survive the failure of the essential purpose of an exclusive remedy provision. See id.

    This rationale is compelling and most true to the Code's general notion that the parties should be free to contract as they see fit. See Colonial Life Insurance Company of America v. Electronic Data Systems Corp., 817 F. Supp. 235, 240 (D.N.H. 1993) (quoting J. White & R. Summers, Uniform Commercial Code, §§12-10 at 526-28 (3d ed. 1988)). The parties to a contract know (or should know) their own interests best, and the risk allocation associated with licensing software should be left to them. See id. Limitations inserted by the parties should be given meaning by a court because they reflect an anticipated risk structure and decisions on price and other terms. Provided that the licensing agreement is not unconscionable at the time it was made, courts should enforce the limitations on loss allocated by and between two sophisticated business concerns negotiating at arms length. To do otherwise would disrupt the pricing structure based on the allocation of risk originally agreed to by the parties.

    The Case-By-Case Approach

    Some courts take an intermediate approach. Rather than read out all consequential damages waivers from contracts on a wholesale basis, these courts instead hold that when a limited remedy fails its essential purpose, courts should consider the availability of consequential damages on a case-by-case basis. See, e.g., Global Link Communications, 1998 WL 77498 at *6. Courts following this approach, however, do not employ the same set of criteria in evaluating each case's unique circumstances. Some focus on Section 2-719(2) and find that the facts surrounding the failure of the exclusive remedy are most important. See, e.g., id. at *6 n.7-8. Other courts focus on Section 2-719(3) and find that facts relating to possible unconscionability are of prime importance. See, e.g. Chatlos Systems, 635 F.2d at 1086-87; Ritchie Enterprises v. Honeywell Bull, Inc., 730 F. Supp. 1041, 1049-50 (D. Kan. 1990). Despite these different formulations, however, courts following this intermediate approach tend to consider many of the same factors, such as the licensor's efforts to repair or replace the software, the precise nature and purpose of the contract, the parties' respective bargaining power and sophistication, the position the licensee is in after the exclusive remedy fails, and whether the consequential damages exclusion was stated expressly or merely implied in the agreement.

    This approach, while flexible, is also problematic, particularly from the licensor's perspective: it denies the contracting parties certainty regarding agreed upon risk allocation. Furthermore, where a dispute over product performance turns into litigation, it is difficult to resolve the matter at the pleadings stage, regardless of the merits of the dispute. See, e.g., Global Link Communications, 1998 WL 774981 at *7 (denying motion to dismiss complaint seeking consequential damages because it was possible that plaintiff could prove facts entitling it to consequential damages despite the waiver of such damages in the contract).

    Out of the Quagmire?

    As one court aptly noted, these different approaches have created a "legal quagmire" requiring that practitioners be familiar with the varying case law concerning Section 2-719 in all jurisdictions whose laws could govern a software license. See Caudill Seed, 123 F. Supp. 2d at 830. Even with that familiarity, however, practitioners likely cannot avoid the quagmire entirely. Of course, neither licensor nor licensee want the situation to deteriorate to the point where there is an issue over whether the exclusive remedy provision failed of its essential purposes. The licensor needs to make reasonable efforts to deliver functioning software, and the licensee needs to live by the contractual provisions it agreed to, including in all likelihood an acknowledgement that the software may not meet the licensee's particular needs or be error free or its use free of interruption. Despite good faith on both sides, however, disputes inevitably will arise.

    When that happens, the original drafting of the license may turn out to be the key to the survival of a consequential damages waiver. There are several drafting strategies that may enhance the strength of a consequential damages waiver:

    • Put the exclusive remedy provision and the consequential damages waiver in different sections of the license. At least one court holding that the two types of provisions were independent found it significant that the provisions appeared in separate sections of software license at issue. Colonial Life Ins. Co. v. Elec. Data Systems Corp., 817 F. Supp. 235, 241 (D.N.H. 1993); compare Global Link Communications, 1998 WL 774981 at *6 (in construing a software agreement in which an exclusive remedies provision and a consequential damages waiver were in the same section, court held that "sometimes" consequential damages can be awarded "even if a contract prohibits such an award.") (emphasis in original);

    • Include a severability clause expressly stating that the consequential damages waiver survives a finding that the exclusive remedy failed of its essential purpose, thereby underscoring the intended separateness of the two provisions;

    • Expressly recite that the consequential damages waiver was part of the consideration for the agreed upon price. Such a provision highlights the importance of the consequential damages waiver to the overall agreement; and

    • Add to the exclusive remedy provision a refund of some or all of the license fee paid. This could be crucial to establishing that the exclusive remedy gives the licensee the requisite "minimum adequate remedy." UCC §2-719 cmt. 1. It may turn out that the licensor cannot ultimately deliver functioning software or software that functions to the licensee's satisfaction. Refunding the license fee, however, is a step a software vendor almost always can take to improve the licensee's position. The absence of a remedy that improved the position of the licensee stuck with non-functioning software appeared to weigh on the mind of at least one court that invalidated a consequential damages waiver when the repair and replacement remedy failed of its essential purpose. See, e.g., Caudill Seed, 123 F. Supp. 2d at 832-33.

    Given the murkiness of the law, there are obviously no guarantees. Adopting one or more of these suggestions, however, may maximize the likelihood that a court will enforce the parties' mutual agreement to include both an exclusive remedy provision and a consequential damages waiver in a software license.

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    1 Although software licenses can be characterized only imperfectly as a "sale," most courts today will find that software is a "good" and thus hold that software licenses are governed by Article 2 of the UCC, which "applies to transactions in goods." UCC §2-102. See, e.g., Micro Data Base Systems, Inc. v. Dharma Systems, Inc. 148 F.3d 649, 654-55 (7th Cir. 1998); I.Lan Systems, Inc. v. Netscout Service Level Corp., 183 F. Supp. 2d 328, 332 (D. Mass. 2002); but see Berthold Types Ltd. v. Adobe Systems, Inc., 101 F. Supp. 2d 697, 698 (N.D. Ill. 2000). Even in situations where the license agreement also includes services (e.g., installation, training, or consulting services), courts will look to the "essence" of the agreement to determine whether goods or services predominate, and several courts have found that the services necessary to the construction and implementation of a software system are merely incidental to the essence of the agreement which is, at its core, a contract for the sale of goods. E.g., Newcourt Financial USA, Inc. v. FT Mortgage Companies, Inc., 161 F. Supp. 2d 894, 897-99 (N.D. Ill. 2001); see, e.g., Rosenblatt & Co. v. Davidge Data Systems Corp., 743 N.Y.S.2d 471, 472 (N.Y. App. Div. 2002).

    2 This same result is reached more readily if counsel for the licensor is not careful to have the sole remedy expressly agreed to in the license as being exclusive. See UCC §2-719(1)(b) (if "remedy is expressly agreed to be exclusive, . . . it is the sole remedy.")

    3 Another way a consequential damages waiver may not provide the intended protection is if the license agreement does not explicitly enumerate each category of excluded damages. See, e.g., Computrol, Inc. v. Newtrend, L.P., 203 F.3d 1064, 1071 n.5 (8th Cir. 2000) (noting that a restriction on "special, incidental, or consequential damages," by itself, may be insufficient to bar lost profits).