The growth in the business market for computers over the last several years has resulted in a tremendous increase in the potential for user dissatisfaction and litigation. There have already been several significant recoveries against major vendors, and it is likely that thus far the industry has seen only the tip of the iceberg.1 Although cases involving multi-million dollar claims may be infrequent, in coming years it will be the rare commercial litigator who doesn't become involved in a suit against a computer manufacturer or software developer which alleges delivery delay, delivery failure, or failure of an installed system to perform adequately.
As litigators new to cases of this sort soon discover, computer breach of warranty cases present significant obstacles to proving liability. The attorney often must make a sizable investment of time learning the basic principles of hardware and software technology so that the factual issues of a case can be understood and effective communications with experts and technical advisors can take place. In the typical case, the plaintiff is faced with contractual warranty and disclaimers and remedy limitations,2 and therefore is forced to go beyond proof of mere breach of warranty and develop evidence proving "failure of essential purpose"3 or fraud.4 If the computer transaction exclusively or predominantly involves the sale of software, the plaintiff's attorney may face the question whether the transaction involves the sale of goods and therefore whether the Uniform Commercial Code's much cherished implied warranty and damages provisions are available.5
Because liability-related problems are so likely to monopolize pre-trial preparation in cases of this sort, there is a dangerous tendency to defer preparations of the damages case until shortly before trial. As will be seen below, the damages side of a computer case may also involve unusual factual and legal issues that call for creativity and early planning by plaintiff's counsel. This article is a guide to the development of an aggressive damages case in the computer contract setting.
"Benefit Of The Bargain" Damages
The basic measure of damages under Article 2 of the Uniform Commercial Code is set forth in
§ 2-714(2):
The measure of damages for breach of warranty is the difference at the time and place of acceptance between the value of the goods accepted and the value they would have had if they had been as warranted, unless special circumstances show proximate damages of a different amount.
This is known as the "benefit of the bargain" formula.
The burden is on the plaintiff seeking benefit of the bargain damages to offer proof both of the value of the goods as warranted and the value as accepted. In most cases (subject to an exception discussed below), the purchase price agreed to in the contract will serve as the plaintiff's evidence of the value of the goods as warranted. However, it is essential that the plaintiff take the proper steps to develop evidence of the value of the goods as delivered. The consequences of failure to do so are illustrated by the court's action in Fargo Machine & Tool Company v. Kearney & Trecker Corp.6. Although the plaintiff was able to prove breach of warranty in the sale of a piece of computer-automated industrial equipment, the court found that the plaintiff was foreclosed from recovering benefit of the bargain damages "by failing to either allege or offer proof on the issue of the 'value of the goods accepted,' i.e., in their defective state."7 The court further found that it could not award damages under a more general "fall-back" provision which would allow it to award damages for losses "resulting in the ordinary course of events from the seller's breach as determined in any manner which is reasonable," U.C.C. §2-714(1), since the plaintiff had also failed to submit any evidence of what expenditures would be required to make the goods conform to warranty.8
Proving benefit of the bargain damages in a computer warranty case will almost always require an expert witness who can evaluate the deficiencies in the computer system and research systems with comparable features that existed in the marketplace at the time of delivery. Even if, as often will be the case, the expert cannot find a system that will serve as the basis for a direct comparison, his research will form the basis for an expert opinion concerning the defective system's value. In the most extreme case, the expert's testimony will be that the system as delivered was worth less to the plaintiff and therefore benefit of the bargain damages should be the entire purchase price.9 The search for an expert witness in computer breach of warranty litigation should begin early. Because the computer industry is so young and its members characteristically are self taught, finding an expert with qualities that will satisfy the demands of an experienced trial lawyer is likely to be far more difficult than might be the case in more traditional cases.
In most applications of benefit of the bargain damages the plaintiff's efforts will be limited to proving the value of the goods as delivered, with the contract price serving as evidence of the value of the goods as warranted. However, plaintiffs' lawyers should be alert to the possibility that the value of the goods as warranted may be substantially greater than the actual contract price. The potential benefits of this strategy are illustrated by the dramatic results obtained by the plaintiff in Chatlos Systems, Inc. v. National Cash Register Corp.10 In Chatlos Systems, the plaintiff purchased a computer system from NCR for a contract price of $46,020.00. The evidence at trial established the value of the system as delivered to be $6,000.00. However, benefit of the bargain damages were not limited to the difference between the purchase price and the value as delivered, or $40,020.00. The district court accepted the plaintiff's expert's testimony that the fair market value of the NCR system as warranted actually was $207,826.50, resulting in benefit of the bargain damages of $201,826.50, almost five times the purchase price of the goods. The Third Circuit affirmed this judgment, rejecting NCR's contention that the fair market value of the computer system as warranted should be limited to the contract price of the system in question, that is, the value of the same goods which were the subject of the contract in fully operable condition.11
The approach taken by plaintiff's counsel in Chatlos Systems can be particularly effective in computer warranty litigation. Due to the rapid pace of technology, vendors frequently represent their products as technically comparable to competing systems but at a significantly lower price. If such a product fails and litigation ensues, the purchaser's lawyer should explore the possibility of maximizing benefit of the bargain damages by establishing a fair market value of the product as warranted in the amount of the more expensive competing products.
In addition to benefit of the bargain damages, a plaintiff whose transaction is covered under the Code may be entitled to incidental and consequential damages under U.C.C. §2-715. Section 2-715 provides that:
Some of the consequential and incidental damages which are available in computer product litigation are discussed below.
Manpower Costs
Although one of the purposes of business computerization is to reduce employee time and increase efficiency, the computer purchaser may find the opposite to be the case if the system is defective. When a system performs inadequately, it is not uncommon for employees at all levels of the company to spend enormous amounts of time dealing with hardware and software problems. This may include management level meetings and phone calls and correspondence with the vendor attempting to get the vendor to resolve the problems. At the clerical level, employees often are forced to spend substantial amounts of time reentering lost data, checking the computer output against manual methods for errors, and performing the computer's functions during computer "down-time."
The purchaser's attorney should encourage his or her client to carefully record these costs and aggressively seek their recovery in litigation. Although there is a line of cases holding that employees salaries which are overhead costs are not recoverable,12 the better (and more prevalent) view is that employee salaries allocable to time spent dealing with defective computer equipment are recoverable.13 The calculation of employee salaries should include payroll taxes and employee benefits.
The employee salaries which may form the basis for damage claims can vary greatly from case-to- case. For example, where a purchaser is upgrading to a different or more powerful computer system, it is not uncommon for the data in the old system to undergo a computer-generated conversion to make it compatible with the new system. Such conversions can be both computer and employee intensive; if the installation fails, damages for employee salaries allocable to this time should be sought.14 Similarly, if the computer installation requires a substantial amount of employee training, consideration should be given to recovering the value of this time.15 If, as is often the case, a great deal of manual data entry has been necessary in the system's start-up phase, this clerical time should also be claimed as damages. Monies paid to independent contractors in connection with installation and programming should be recoverable as well.
Under certain circumstances, the recovery of employee salaries can be carried even one step further. If the computer software or hardware vendor has represented that the implementation of its product will allow the purchaser to save employee costs, these salaries should be recoverable for the period between installation and rescission, or until such time as the purchase could reasonably have mitigated damages.16
Lost Profits And Goodwill
In evaluating incidental and consequential damages, the plaintiff's lawyer should always consider lost profits as an item of damages. If the plaintiff is a distributor or an OEM,17 lost profits may in fact be the most significant element of damages.18 Closely related to lost profits may be a distributor or OEM's loss of goodwill resulting from the sale of defective products to end users.
However, OEM and distributor warranty cases are not without serious obstacles for plaintiffs, due in large part to the often one-sided nature of distribution agreements and the wide variety of manufacturers in the computer industry, making alternative sources of supply relatively accessible. A recent case illustrating the difficulties that a distributor can face in warranty cases is the Ninth Circuit's decision in Consolidated Data Terminals v. Applied Digital Data Systems.19 In Applied Digital the plaintiff, CDT, entered into a distribution agreement with the defendant, ADDS, to sell ADDS computer terminals to end users. The terminals proved defective and CDT terminated the agreement, seeking damages for lost profits and lost goodwill, among other claims. The district court awarded CDT $111,842.50 for lost profits that CDT proved it would have realized had the distributorship arrangement continued.
The court of appeals reversed this award for two reasons. First, the court found that the defective terminals were only one factor among several in CDT's decision to terminate its distribution agreement with ADDS, and therefore lost profits attributable to this decision were not awardable.20 Second, the court found that CDT had offset this loss of revenue with sales of another manufacturer's terminals, despite the district court's finding that these substitute products were not competitive" in price or in actuality" with ADDS' product and their sales had no mitigating effect.21 Moreover, in dicta which has serious negative implications for OEM and distributorship suits of this sort, the court stated that it "seriously doubt[ed]" whether lost profits due to CDT's decision to terminate the ADDS distribution were sufficiently foreseeable as a result of a breach of warranty to be recoverable as consequential damages.22
As to CDT's claim of lost goodwill (which the trial court had not addressed), CDT alleged that its customers would blame it for the product failures caused by ADDS' terminals, and therefore be less likely to purchase computer equipment from CDT in the future. Although the court's brief treatment of this issue suggests that damages for loss of goodwill may be available to a reseller when a vendor has reason to know that its product will be resold, the court found no evidence of any monetary injury resulting from CDT's alleged loss of goodwill and therefore denied damages.
Apart from distributor/OEM suits, lost profits and lost goodwill may be recoverable if the plaintiff is a business end user and the defendant's defective computer system led to lost profits. Typically, this will involve faulty billing, deleted or unshipped customer orders, and lost sales. However, claims for lost profits should not be limited solely to the relatively obvious instances in which a breach of warranty has resulted in a reduction in the plaintiff's sales. A defective computer system's failure to control costs can also have an indirect but no less real impact on profits. For example, in Chatlos Systems the plaintiff was able to show that the failure of the defendant's accounting system to accurately track inventory levels resulted in excess inventories and therefore lost profits.23
Miscellaneous Damages
The plaintiff may also be able to recover a variety of miscellaneous incidental and consequential damages, including financing costs, installation and removal expenses and the value of the space occupied by the computer. With respect to financing costs, the plaintiff's attorney should determine whether the plaintiff has financed the purchase or lease of the defective system, and if so attempt to recover finance charges as consequential damages. Interest expenses are recoverable whether financing was provided by the defendant or a third party.24
Installation and removal costs are recoverable as incidental damages, including the direct and indirect costs of site preparation and restoration of the site after removal.25 The plaintiff should also press for the cost of the space occupied by the machine. This may be determined by developing a formula for the annual rental of the plaintiff's facility, determining from this the cost per square foot and multiplying that cost by the space occupied by the computer installation. The resulting figure should be adjusted by the time period that the computer was on the plaintiff's premises.26
Conclusion
Although some of the more common damage claims in computer breach of warranty cases have been touched on here, every case presents unique facts and issues and therefore opportunities for creative lawyering. Early preparation of the damages case not only ultimately strengthens the plaintiff's trial presentation, but encourages the development of a realistic assessment by both parties of the strength and weaknesses of the case for purposes of settlement discussions.
Footnotes
1
. Under U.C.C. §2-316, a seller of commercial goods may exclude warranties. Section 2-316(1) allows a seller to negate or limit express warranties. Section 2-316(2) allows a seller to exclude or modify the implied warranties of merchantability and fitness so long as this is done in a conspicuous writing.2
. Under U.C.C. §2-719, the parties to a commercial transaction may exclude or limit incidental and consequential damages.3
. A seller's limitation on remedies may be overcome if the plaintiff can show "failure of essential purpose." U.C.C. §2-719(2). The "failure of essential purpose" exception applies only when the defect is so severe as to deprive the plaintiff of "the substantial value of the bargain." U.C.C. §2- 719, Comment 1.4
. See The Glovatorium, Inc. v. NCR Corp., 684 F.2d 658 (9th Cir. 1982); Accusystems, Inc. v. Honeywell Information Systems, Inc., 580 F. Supp. 474 (S.D. N.Y. 1984). A third means of piercing remedy limitations is to show that the provision is unconscionable. U.C.C. §2-719(3). However, unconscionability rarely is found in a commercial setting. See WHITE & SUMMERS, UNIFORM COMMERCIAL CODE, §4-2, at 149 (2nd ed. 1980).5
. Article 2 of the Code governs only "goods," which are defined as "all things (including specifically manufactured goods) which are movable at the time of identification to the contract for sale." U.C.C. §2-105. Although very few cases have considered whether software, standing alone, falls within the scope of Article 2, at least one court has held that the U.C.C. does not apply. See Computer Servicecenters, Inc. v. Beacon Mfg. Co., 328 F. Supp. 653 (D. S.C. 1970), aff'd, 443 F.2d 906 (4th Cir. 1971). But see Hartford Mutual Inc. Co. v. Siebels, Bruce & Co., 579 F. Supp. 135 (D. Md. 1984) (issue one of fact to be decided by jury). See also generally Computer Software as a Good Under the Uniform Commercial Code: Taking a Byte Out of the Intangibility Myth, 65 BOSTON U. L.R. 129 (1985).6
. 428 F. Supp. 364 (E.D. Mich. 1977).7
. Id. at 382.8
. Id. at 383.9
. See Schatz Distributing Co., Inc. v. Olivetti Corp. of America, 7 Kan. App. 2d 676, 647 P.2d 820, 34 U.C.C. 578 (1982).10
. 479 F. Supp. 738 (D. N.J. 1979), remanded, 635 F.2d 1081 (3d Cir. 1980), aff'd, 670 F.2d 1304 (3d Cir. 1982), cert. denied, 457 U.S. 1112 (1982).11
. 670 F.2d at 1304.12
. See, e.g., Wilson v. Marquette Electronics, Inc. 630 F.2d 575, 586 (8th Cir. 1980); AES Technology Systems, Inc. v. Coherent Radiation, 583 F.2d 933, 942 (7th Cir. 1978); Fargo Machine, supra, 428 F. Supp. at 383.13
. See, e.g., Convoy Company v. Sperry Rand Corp., 672 F.2d 781, 786 (9th Cir. 1982); Dunn Appraisal Company v. Honeywell Information Systems, Inc. 687 F.2d 877, 883 (6th Cir. 1982); Stahl Mgmt. Corp. v. Conceptions Unlimited, 554 F. Supp. 890, 894 (S.D. N.Y. 1983); Chatlos Systems, supra, 479 F. Supp. at 747 (allowing salaries for time devoted to working with defendant, except as to Chief Executive Officer's time).14
. In Dunn Appraisal, supra, the plaintiff recovered not only the salary of an employee who worked on a conversion project, but the fee paid to an employment agency for finding that employee. 687 F.2d at 884.15
. See Applied Data Processing, Inc. v. Burroughs Corp., 394 F. Supp. 504, 507 (D. Conn. 1975).16
. See Chatlos Systems, supra, 479 Supp. at 747.17
. OEM or "original equipment manufacturer" is the industry term for a company which purchases computer hardware and systems software from a vendor and adds value, in the form of applications software or other components, and then resells both the hardware and software at a markup to end users.18
. See State Office Systems, Inc. v. Olivetti Corp. of America, 762 F.2d 843 (10th Cir. 1985).19
. 512 F. Supp. 581 (N.D. Cal. 1981), aff'd in part and rev'd in part, 708 F.2d 385 (9th Cir. 1983).20
. 708 F.2d at 394.21
. Id. at 395. The court found that under CDT's distribution agreement with ADDS, CDT was prohibited from selling any product "deemed by ADDS to be competitive with ADDS' equipment," and therefore any objective comparison of ADDS's terminals and the substitute terminals was irrelevant. Id. at 395, n.11.In addition to vacating the district court's award of lost profits, the Ninth Circuit vacated the court's findings of fraudulent misrepresentation and tortious interference with contract on procedural grounds, thereby setting aside the trial court's award of $28,702 for tortious interference and $500,000 in punitive damages. Id. at 395-400. Following this decision, CDT was left only with $15,000 in incidental and consequential damages and the opportunity to retry its fraud and tortious interference claims.
22
. Id. at 394.23
. 479 F. Supp. at 747.24
. See Chatlos Systems, supra, 479 F. Supp. at 744; Schatz Distributing, supra. Contra: Barnard v. Compugraphic Corp., 667 P.2d 117, 121 (Wash. Ct. App. 1983).25
. See Dunn Appraisal, supra, 687 F.2d at 883.26
. Chatlos Systems, supra, 479 F. Supp. at 747.The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.