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Common law remedies for computer failures.

The standard computer contract provides commercial buyers little relief for system failures. Attorneys should consider suing for fraud or negligent misrepresentation.

Computers are everywhere. They are a necessary tool of modern life. When computers fail--as many lawyers know from personal experience and from the experiences of their clients--the damage can far exceed the investment in the software or even the cost of the computer system.

Unfortunately, when a computer fails, the commercial buyer's ability to recover the full amount of damages sustained is often severely limited, if not extinguished, by the terms of the standard contract covering the sale of software and hardware. This contract almost always includes numerous exculpatory provisions, such as warranty disclaimers and integration or merger clauses. These clauses state that the written agreement is complete on its face, supersedes all prior agreements on the same subject, and bars the introduction of evidence concerning any prior term or agreement on that subject matter. The contract also typically limits the remedies available to repayment of the purchase price or repair or replacement of the defective hardware and software.

Nevertheless, by carefully investigating the purchase of the computer system and its subsequent nonperformance, you may discover ways to avoid the harsh terms of what is, in essence, an adhesion contract. In addition, an investigation may establish that your client can sue for fraudulent inducement or negligent misrepresentation. In many jurisdictions, parol, or oral, evidence is admissible to show fraud in the inducement of the contract--even if the contract contains a valid merger or integration provision--because fraudulent inducement invalidates the entire contract.(1)

Also, many states have enacted some type of consumer protection act to save consumers from, among other things, unbargained-for warranty disclaimers. However, because a "consumer" is usually defined as an individual or, at best, a sole proprietor, a commercial purchaser of a customized computer network or computer software would not be able to obtain the protection of such statutes.

Investigating a lawsuit against a computer hardware or software manufacturer, or a systems integrator that customizes software and hardware manufactured by others, is the same as investigating any other complicated lawsuit. Do not review the contract in a vacuum. Instead, carefully interview the client's upper management and information technology personnel to determine the following:

* Why did the client decide to buy the system?

* How did the client contact prospective vendors?

* What investigation did the vendors perform before bidding?

* What representations were made to induce the client to sign the contract?

This detailed investigation will help you determine whether the contract is governed by the Uniform Commercial Code (UCC) and if so whether any provisions of the contract can be voided. Most important, it will help you decide whether your client can state an independent claim for fraudulent inducement or for negligent misrepresentation.

You must first determine whether the contract was primarily for the sale of goods or services. Contracts for the sale of goods are governed by the UCC, and contracts for the sale of services are governed by state common law.

Most computer-related transactions are considered the sale of goods.(2) Unfortunately, the Uniform Commercial Code's warranties, along with the express terms of the standard computer contract, preclude bringing a negligence claim under a tort theory of liability.(3)

However, if you can prove the contract's predominant purpose is the sale of services, then the agreement is a service contract.(4) The general rule is that a contract is for services rather than goods only when the service portion of the contract "predominates" and the sale of goods is incidental.(5)

Because of the high cost of buying and continually updating hardware and software, many companies prefer to outsource their computer-processing needs. In this situation, a contract that initially appears to be for goods may actually be a contract for services.

In addition, system integrators often recommend that a customer buy software from a third party and then customize the software based on the customer's needs. Again, if you can prove that the contract is entirely or substantially for services, you may be able to establish a negligence claim that is unaffected by the exclusions and limitations in the contract.

Contractual limits on recovery

Unfortunately, if the UCC applies to the entire contract, you will have an uphill battle. Most computer contracts disclaim the implied warranties of merchantability and fitness for a particular purpose and greatly limit any express warranties. For a contract to exclude the implied warranty of merchantability, the UCC only requires that the exclusion be "conspicuous" and "mention merchantability."(6) To exclude the warranty of fitness for a particular purpose, the relevant contract language need only be "conspicuous."(7)

The UCC defines "conspicuous" as language that a "reasonable person against whom it is to operate ought to have noticed." Contract language is "conspicuous" if it is in "larger or other contrasting type or color."(8) Consequently, your client will not have an implied warranty claim unless it was able to remove or substantially modify the standard warranty exclusions.

Similarly, the express warranty in the contract usually will not help your client. It will probably simply warrant against defects in materials or software for some limited time period, often as short as 90 days. However, the contract might also include specific language stating that the system will perform according to particular specifications. This language may prevail over the contract's general disclaimer of express warranties and form the basis of a breach of warranty claim.(9)

As mentioned previously, the standard computer contract usually limits a buyer's remedies to return of the goods and repayment of the price paid or repair and replacement of the defective product. The limitation-of-remedy clause usually establishes the buyer's sole remedy and the seller's total liability. To make matters worse, the clause also typically waives consequential and incidental damages.

Your client can overcome a limitation-of-remedy clause only when the remedy fails its "essential purpose."(10) This occurs when, for example, the goods fail to perform to warranted specifications despite the seller's repair efforts.(11)

If the remedy has failed its "essential purpose," the buyer can avail itself of the remedies in the UCC.(12) These include consequential and incidental damages. However, the standard computer contract will probably limit or exclude recovery of these damages. This limitation will be upheld unless it is unconscionable, and proving unconscionability in a commercial context is very difficult.

Even if you can defeat the limitations and exclusions of warranties, remedies, and damages, you will probably face other obstacles. These include venue-selection clauses, foreign choice-of-law selection clauses, extremely short statutes of limitation, and other similar provisions that make it almost impossible for your client to obtain redress for the damages it suffered.

Often the only way to obtain redress is an action for fraudulent inducement or negligent misrepresentation before the execution of the contract. Interviews with your client's employees may show that the computer system vendor misrepresented the system's functionality in many material respects. Furthermore, the seller's employees or consultants may confide to your client's employees, as they try to fix the computer system, that similar problems have occurred during other implementations. This type of evidence can provide the groundwork for a fraudulent inducement or concealment action.

"Vaporware" is a computer product that--unbeknownst to the buyer--has not yet been created or perfected. Computer hardware and software manufacturers and system integrators will often affirmatively represent that the system can achieve certain performance standards relating to, among other things, speed, capacity, and functionality. These representations may be false. Also, because commercial installations of new computer systems can take months or years, the seller will often make representations about the system's performance that are simply a hope as to what performance levels will be many months or years later.

These misrepresentations are often written responses to a customer's written request for information or a request for proposal sent to the vendors competing for a prospective buyer's business. They are often made only after the vendors have analyzed the buyer's business and its need to upgrade its computer systems.

In preparing a fraud or negligent misrepresentation claim, interview your client's relevant employees; Very often, material oral representations that later prove false are made in front of many witnesses.

You should also examine all documents provided to and received from all competing vendors before the contract was made. Analyze all e-mail messages between your client's information technology personnel and the winning vendor's personnel. These will frequently document the oral representations that your client relied on when deciding to buy the system. You must carefully document and categorize the specific misrepresentations that are made, as fraud must be pled with particularity.(13)

Discovery

Computer fraud cases require discovery of the software at issue and the data generated in its development and testing. A good working knowledge of computer software development and the computer industry is extremely beneficial when trying these cases.

Virtually all of these cases are basically a dispute about the quality of software. The capabilities of hardware are far easier to objectively analyze and measure than those of software. Software programs are continually revised, and new versions are released often. You must provide your experts with complete copies of all versions of the software. Otherwise, the experts will be unable to test the software and render opinions about its quality.

To obtain all versions of a piece of software, you must first get from the vendor a complete list of all versions. Next, pinpoint the location of those versions on the vendor's computer hardware and storage media. As software is developed and distributed, it probably exists on a central server, as well as on desktop computers, CD-ROMS, backup tapes, and various types of media used for distribution. Different versions typically exist on different sets of computer hardware, often designated "production," "test," "development," and "sandbox."

Request the name of the manufacturer, model number, serial number, and exact location of every computer on which the software has resided. Also submit a request under Federal Rule of Civil Procedure 34--or its state equivalent--for physical inspection and testing of this computer hardware, including any disk drive or backup tape on which the software has resided. In addition, under Rule 34, during this inspection and testing, you can obtain copies or samples of all relevant software in the hardware that is being inspected and tested.

Also examine other data accumulated during the development phase. All major software development efforts include "bug tracking" software, which keeps track of reported problems so that they can be fixed before the software is released. The bug-tracking software often contains thousands of entries. This information is highly relevant when bugs have caused the software to fail.

During development, organizations commonly release "alpha" and "beta" versions of the software. "Alpha" versions are raw and unfinished, released only to highly experienced users or testing personnel. "Beta" versions are much more refined, intended for release when the bugs are removed. Typically, there is extensive feedback from the users of these versions, which can reveal the defendant's actual knowledge of problems. This information can help you compare the defendant's actual knowledge with the representations made to your client.

Many software development organizations have a quality assurance (QA) department. In addition to keeping reports and other documents about the company's activities, the QA department will typically have tests plans, data, and results for each piece of customized software it receives for evaluation.

Two types of testing normally performed during software development are "stress testing" and "benchmarking." Stress testing is designed to simulate heavy use of the software to determine its performance.

Benchmarking is a type of stress testing in which a standard testing program simulates heavy use of the software. Make sure your experts have copies of all programs used for stress testing and benchmarking, together with any plans, data, and results.

Often, knowledge of backup procedures is necessary to obtain all the relevant data and versions of software. All computer organizations routinely back up their data. Backups are copies of hard drives that are usually transferred to tape. Organizations use a variety of backup schemes, each with a different frequency and method. Sometimes the organization creates "full" backups, which are complete images of the hard disk drives being backed up. More often, "incremental" backups are used, in which a full copy is made periodically and "incremental" copies are made each day, preserving only the data that have changed since the last full copy.

Complete discovery of backup copies involves determining the frequency and method of the backups. You must also obtain a copy of the software used to create them. You should ascertain the organization's retention policy regarding the copies, and the location of the facilities where they are stored. In addition, you should request physical inspection, copying, and testing of the backup media.

As in almost all commercial litigation, at the beginning of formal discovery in a computer fraud case, you should send the defendant a deposition notice under Federal Rule of Civil Procedure 30(b)(6)--or its state equivalent--asking the company to identify the personnel involved. Software development usually involves creating English-language "specifications," which describe the functions to be performed by the computer programs. The specifications are then translated into computer language "program code" by programmers.

You need to know who wrote the specifications and program code for the customized software that was sold to your client. The people who write the specifications are often different from those who write the program code. Furthermore, those who test the software may be in yet another division. These people can help you determine the cause of the problem and what the defendant knew about it before and after the contract was executed.

Your client is usually not the only organization using the software or a variant of the software at issue. It is very helpful if you can track down other commercial entities that have had problems with the software that are similar to your client's. Compare what representations were made to other buyers, when they were made, and how the defendant tried to fix the problems that other buyers encountered during installation. Ask for the names of all entities to whom the defendant has sold the software or any close variant of it.

Members of software user groups exchange information, usually on the Internet, about software developers and their experiences with a program. These groups vary in size, and some are better organized than others.

User groups can provide information that will help you analyze your case, and comments from members about similar problems may support your client's claim of fraudulent inducement or negligent misrepresentation. Members can also help locate potential experts. Most of these groups have their own Web sites--which may charge an access fee--and you can usually find the user group you want by searching the Internet.

The Internet is also extremely helpful in finding experts, as are trade publications. There is a trade publication and there are massive paperback volumes for every major software system. These publications contain extensive bibliographies on the software.

Fraudulent inducement

The elements of the tort of fraudulent inducement are

* the defendant's misrepresentation of a material fact;

* the defendant's knowledge that the misrepresentation was false or was made with reckless disregard as to whether it was true or false;

* the defendant's intention to deceive the plaintiff; and

* the plaintiff's reasonable reliance on the truthfulness of the misrepresentation in a way that proximately caused the injury.(14)

The fact finder should determine whether a statement is one of fact or mere puffery or opinion. However, in many jurisdictions the parol evidence rule, which prevents the admission of extrinsic evidence to explain the terms of a written contract--in combination with a contractual integration or merger clause--will bar a fraud claim.

Even if you can prove fraud, other obstacles may block recovery of tort damages. Defense counsel will probably argue that your client is essentially prosecuting a breach of contract case and is confined to contractual claims and remedies, as limited by clauses in the contract. In these instances, the court may reject the tort claims as an attempt to circumvent the contract's limitation-of-damages clauses.(15)

However, where one party makes fraudulent misrepresentations to induce another to enter a contract, the fraud claim is independent of the contract and is actionable as a tort claim.(16) In these circumstances, limitation-of-damages clauses are ineffective. Some courts have held that a computer vendor may not escape liability in fraudulent inducement cases by relying on integration or limitation-of-liability clauses in the contract.(17)

If you can prove fraud, the damages your client may recover include the amount paid for the computer system minus the benefits obtained, if any; labor expenses associated with the system's defective performance; expenses incurred obtaining different computer services; program conversion costs; the cost of installing and removing the system; and equipment maintenance costs.(18) A plaintiff may also recover punitive or exemplary damages for fraud.

Negligent misrepresentation

If it is difficult to prove fraudulent inducement, consider bringing a claim of negligent misrepresentation. Negligent misrepresentation involves the same elements as fraudulent inducement except that a plaintiff need not establish that the vendor knowingly made false statements.(19) This difference is critical when dealing with a corporate defendant. The company's marketing department usually does not know--nor does it want to know--what the software development department knows about the software's ability to comply with the representations made to your client to close the sale.

Although it is easier to prove than fraud, negligent misrepresentation may not void a limitation-of-liability clause.(20) Furthermore, not every state recognizes this tort. Those that do require proof of a duty between the vendor and the user as well as a showing that the vendor breached this duty.(21)

The duty involves something more than an arm's-length transaction between a buyer and seller. Some courts have characterized it as a "special relationship" of trust and confidence where there is a duty to "speak with care."(22) However, other courts have held computer vendors liable for innocent misrepresentations.(23)

Failures of customized commercial computer systems cause substantial damage to business organizations and their employees. They and their families suffer physically and emotionally from the stress of trying to make the conversion or installation of a new computer system work. Many employees lose their jobs and have their careers destroyed or significantly damaged because the sales force of a computer company misrepresented the capability of computer software and hardware.

With planning, you can weave the human drama associated with the computer system failure into your case so that the fraud or negligent misrepresentation claim is compelling. A careful investigation and analysis of the facts and applicable law may show that your client can successfully sue for fraud or negligent misrepresentation and potentially recover substantial damages.

Litigators network in ATLA's commercial section

ATLA's Commercial Litigation Section offers members "the opportunity to interface more frequently and on a personal basis with top commercial litigators around the country," said section chair Wyatt Durrette of Richmond, Virginia.

Benefits of joining the section include a newsletter published two to four times annually, an annual membership directory, continuing legal education (CLE) programs, and opportunities to network with other members at ATLA's Annual Convention and on ATLA.org.

As the newly appointed chair, Durrette hopes to organize at least one weekend CLE program during the year. He is also committed to building the section's membership. He describes the section as "a tremendous learning experience [that] creates the opportunity to expand your network and friends."

Topics addressed during the 2000 Annual Convention in Chicago included factors to consider in selecting a case, damage theories in class actions, and emerging areas in commercial litigation. The section also held a half-day networking session with Chinese Arbitration Bureau members.

Section members can participate in an online discussion forum by clicking "List Server" on the section's homepage at http://www.atla.org/cgi-bin/groups/ grpmain.pl?group=commercial. (Members who haven't registered with ATLA.org must first click "Get Password" at http://www.atla.org.) Recent inquiries on the list serve involved a search for lawyers who have handled a specific type of case, questions about statutes of limitations, and correspondence regarding the Chicago convention. The list serve and section newsletters are "the primary vehicles to network and share ideas," said Mark Kelley of Charleston, West Virginia, the section's immediate past chair.

The section has nine subcommittees, each with an appointed chairperson available to assist members with cases. The subcommittees are Bankruptcy, Business Torts/RICO, Class Actions, Consumer Protection, False Claims Act, Franchise, Intellectual Property/Trade Secrets, Lender Liability, and Securities.

In addition to Durrette and Kelley, section officers include Frank Lamothe of New Orleans, chair elect; P. John Brady of Kansas City, Missouri, vice chair; Arthur Bailey of Jamestown, New York, secretary; and, Glenn Formica of Cheshire, Connecticut, newsletter editor.

Roughly 1,000 ATLA members currently participate in the section. Annual membership dues are $40. Members interested in joining the section should contact ATLA at (800) 424-2725, ext. 312.

Notes

(1.) Sierra Diesel Injection Serv. v. Burroughs Corp., 648 F. Supp. 1148 (D. Nev. 1986); Coal Resources, Inc. v. Gulf + W. Indus., Inc., 756 F.2d 443 (6th Cir. 1985); In re Amica, Inc., 135 B.R. 534 (Bankr. N.D. Ill.1992).

(2.) Advent Sys. v. Unisys Corp., 925 F.2d 670 (3d Cir. 1991).

(3.) See generally RAYMOND T. NIMMER, THE LAW OF COMPUTER TECHNOLOGY [sub sections] 6-7, 6-9 (1997).

(4.) RRX Indus. v. Lab-Con, Inc., 772 F.2d 543 (9th Cir. 1985).

(5.) Triangle Underwriters, Inc. v. Honeywell, Inc., 457 F. Supp. 765 (E.D.N.Y. 1978), aff'd in part and rev'd in part, 604 F.2d 737 (2d Cir. 1979), afl'd after remand, 651 F.2d 132 (2d Cir. 1981).

(6.) U.C.C. [sections] 2-316(2) (2000).

(7.) Id.

(8.) U.C.C. [sections] 1-201(10).

(9.) Consolidated Data Terminals v. Applied Digital Data Sys., Inc., 708 F.2d 385 (9th Cir. 1983).

(10.) U.C.C. [sections] 2-719(2).

(11.) Consolidated Data Terminals, 708 F.2d 385, 392.

(12.) U.C.C. [sections] 2-719(2).

(13.) Liane E. Schleifer, Comment, Damage Awards and Computer Systems: Trends, 35 EMORY L.J. 255, 257 (1986); see also FED. R. CIV. P. 9(b). State rules of pleading are similar. See, e.g., MO. R. CIV. P. 55.15.

(14.) Management Assistance, Inc. v. Computer Dimensions, Inc., 546 F. Supp. 666 (N.D. Ga. 1982); Consolidated Data Terminals, 708 F.2d 385.

(15.) See Cincinnati Gas & Elec. Co. v. General Elec. Co., 656 E Supp. 49 (S.D. Ohio 1986).

(16.) Triangle Underwriters, Inc., 604 F.2d 737, 747.

(17.) VMark Software, Inc. v. EMC Corp., 642 N.E.2d 587, 594 n. 11 (Mass. App. Ct. 1994); see also Applications, Inc. v. Hewlett-Packard Co., 501 F. Supp. 129, 136 (S.D.N.Y. 1980).

(18.) Misrepresentation in Sale or Lease of Computer, 20AM. JUR. P.O.F. 3d [sections] 23 (1999), citing Applied Data Processing, Inc. v. Burroughs Corp., 394 F. Supp. 504 (D.C. Conn. 1975); see also Consolidated Data Terminals, 708 F.2d 385; VMark Software, Inc., 642 N.E.2d 587.

(19.) Furniture Consultants, Inc. v. Datatel Minicomputer Co., No. 85 Civ. 8518 (RLC), 1986 WL 7792, at *7 (S.D.N.Y. 1986).

(20.) See Ostalkiewicz v. Guardian Alarm, 520 A.2d 563, 569 (R.I. 1987).

(21.) Misrepresentation in Sale or Lease of Computer, supra note 18, at [sections] 7.

(22.) Id., citing Mathis v. Yondata Corp., 480 N.Y.S. 2d 173 (N.Y. Sup. Ct. 1984).

(23.) Id., citing International Bus. Machs. Corp. v. Catamore Enters., Inc., 548 E2d 1065 (1st Cir. 1976); Computer Servicenters, Inc. v. Beacon Mfg. Co., 328 F. Supp. 653 (D.S.C. 1970); Clements Auto Co. v. Service Bureau Corp., 444 F.2d 169 (8th Cir. 1971).

P John Brady is a partner with Shughart, Thomson & Kilroy in Kansas City, Missouri.
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Date:Oct 1, 2000
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