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Manufacturer’s Corner: Incorporating Software Into Your Products (Part 3)

Now that we have completed our brief detour into what the Supreme Court could maybe do with the BP oil spill case if it decides to do anything with it,[1] we resume our ongoing series on what law applies when you incorporate software into your products.  Here are links to part one and part two.  And here is a summary of parts one and two: courts don’t know what law applies, so they sort of mutter to themselves while gesturing vaguely at random parts of Article 2 of the Uniform Commercial Code in an entirely unsatisfying manner.  Saved you a couple of clicks there.  I know you’re busy.

That kind of uncertainty does not work for you.  You recognize that whether Article 2 prevails over the general common law of contracts is an important issue that informs everything from contract formation, to performance, to remedies.  It is not a question you want to save for later.  And, since you are a manufacturer working in a world where products are increasingly embedded with software so they can integrate with each other, you find yourself on the bleeding edge of this formidable issue.  How do you bring yourself certainty?

Let’s start by considering the buy side.  You make refrigerators, and you want to sell one equipped with software that will tell the end user he or she is running low on yogurt and offer an option to order more.  You do not specialize in yogurt-management software, so after an extensive RFP process, you select a yogurt-management software specialist to develop and license appropriate software to you.  Did you just transact in goods such that Article 2 applies?

Well, the cases go both ways.  By way of example, in 2000 a federal court in Illinois held that a license agreement for a typeface (which it considered a license for use of software) was not within the scope of Article 2 because it wasn’t a sale.[2]  In 1997, on the other hand, a federal court in Oklahoma held that the license of customized software to a switchboard manufacturer for use in its manufacturing operations was a transaction in goods subject to Article 2.[3]  In 1998, the Seventh Circuit applied Article 2 to a multiparty transaction where, among other things, a company hired another company to adapt certain software and license it to be integrated into a system to be built for a third party (and then sold to a fourth party).[4]

That will not do.  Again, you need certainty.  One thing you could do if you want Article 2 to apply is to style the transaction as a sale rather than a license, though that may prove challenging as a practical matter in that (a) it turns a long-term cost into an immediate cost,[5] and (b) it’s just not how software transactions are generally structured.  A simpler way that might just work would be to call out Article 2 in the choice-of-law provision in the contract, rather than simply stating that the law of State X will apply.[6]  This may seem strange on its face – Article 2 defines its own scope, how can parties agree to subject something outside that scope to Article 2? – but under the present state of the law, it could work.  First, most courts follow the general rule that transactions of off-the-rack software fall within the scope of Article 2, so the choice-of-law provision may not do much that a reviewing court wouldn’t do anyway.  Second, in closer cases (such as licensing agreements for customized software), at least two federal courts elected not to drill down into the issue, and instead threw up their hands and basically said, sure Article 2 works fine for software transactions, why not.[7]  Third, there’s some authority that parties to a mixed goods-and-services contract can select whether Article 2 applies or not.  So, to the extent a customized software license is a hybrid goods-and-services contract – and I submit to you that it usually is – the same result should obtain.  Fourth, the Texas Supreme Court once applied a UCC choice-of-law provision to a services contract, so this is not entirely unheard of.[8] 

The sell-side is probably easier.  You’re selling a refrigerator, after all.  But what about that feature that allows the buyer to order more yogurt?  Will that be included in the purchase price of the refrigerator, or will there be a separate monthly cost for it?  If the latter, you may actually be looking at two separate transactions – one to which Article 2 will apply, and the other to which it may or may not apply, probably depending on which court you draw and whether you included a choice-of-law provision in the subscription agreement, just as on the buy-side.

As you can tell, this is not a simple matter.  It’s definitely one that will vary based on your facts and circumstances, but I believe that a strong choice-of-law provision can minimize the uncertainty.  That said, you must also consider whether you want Article 2 to apply.  I typically prefer it, but reasonable minds can differ on that front.  The issue deserves careful consideration all around.

[1] In my update to that post, I stated that the Supreme Court “relisted” the cert petition for its November 25 conference.  An astute reader brought to my attention that the Supreme Court in fact “rescheduled” consideration of the cert petition for its November 25 conference.  That is not a meaningless distinction!  (Though it sure sounds like it should be).  In fact, the reader pointed out that he is not aware of any case that has been rescheduled in which the Court granted cert.  The sample size is small – the Court just rolled out the “rescheduled” nomenclature this year – but the point is interesting enough that I include it here.

[2] Berthold Types Ltd. v. Adobe Systems, Inc., 101 F. Supp. 2d 697, 698 (N.D. Ill. 2000).  That’s an incomplete analysis, by the way, because Article 2 covers “transactions” in goods, not just sales.

[3] NMP Corp. v. Parametric Technology Corp., 958 F. Supp. 1536, 1542 (N.D. Okla. 1997)

[4] Micro Data Base Systems, Inc. v. Dharma Systems, Inc., 148 F.3d 649, 654 (7th Cir. 1998).

[5] Though you could always finance it if the counterparty is willing to do so.

[6] Be sure to specify that the UCC, including Article 2, applies.  The Supreme Court of Texas once held that a contractual provision calling for application of the UCC as enacted in Texas was not sufficient to subject a services contract to Article 2 any more than it was sufficient to subject the contract to Article 3 on commercial paper or Article 9 on secured transactions.  Northern Nat. Gas Co. v. Conoco, Inc., 986 S.W.2d 603, 606 (Tex. banc 1998).  The Court did apply the general provisions of the UCC contained in Article 1, though, so the choice-of-law provision wasn’t deemed ineffective, it was just deemed ineffective to do what one of the parties wanted or expected it to do.

[7] Micro Data, 148 F.3d at 654 (“we can think of no reason why the UCC is not suitable to govern disputes arising from the sale of custom software—we’ll follow it”); iLan Sys., Inc. v. Netscout Serv. Level Corp., 183 F. Supp. 2d 328, 332 (D. Mass. 2002) (“Admittedly, the UCC technically does not govern software licenses, and very likely does not govern the 1998 VAR Agreement, but with respect to the 1989 transaction, the UCC best fulfills the parties’ reasonable expectations.”).

[8] But see footnote 5 for some important information on all that.  Would the Court have applied Article 2 if the choice-of-law provision expressly called for it?  I get the impression the answer is “yes.”