When sued for breach of contract by dissatisfied customers for allegedly failing to deliver the agreed-upon software or other claims relating to their software, software suppliers frequently rely on limitation provisions similar to the following: "Licensor will not be liable on any claim, whether in contract, tort or otherwise, for any consequential damages (including, without limitation, loss of profits)." While this language appears to limit the vendor's liability for lost profits, recent case law has cast doubts on the enforceability of such provisions. 

Often, such a provision is combined with a provision limiting the remedies available to the customer to one of repair or replacement of the subject software.  For example, software usually has a provision that states, "Licensor's entire liability and Licensee's exclusive remedy shall be the repair or replacement of the software not meeting Licensor's limited warranty."

Sometimes this provision is paired with yet another provision stating that the amount of the licensor's liability for such a breach "shall not exceed any amounts paid by Licensee" for the use of the software.  What if the licensor is unable to repair the software despite repeated attempts and refuses to replace it?  Whether such limitations on the customer's remedies are enforceable in those circumstances has recently been called into question by two recent decisions of the United States District Court for the Eastern District of Pennsylvania.

Remarkably, given the large number of software licenses being used today, there are relatively few cases in the area of computer law dealing with these issues.  As a preliminary matter, even though the software agreement itself is frequently characterized as a "license," computer software programs are generally considered to be "goods" rather than a service, and their sales are thus subject to the Uniform Commercial Code.  See, e.g., Chatlos Sys. Inc. v. Nat'l Cash Register Corp., 635 F.2d 1081 (3d Cir. 1980); RRX Industries Inc. v. Lab-Con Inc., 772 F.2d 543 (9th Cir. 1985). However, where only software (and not hardware and software) is involved, there is some inconsistency in the cases as to their treatment.  See Arlington Electrical Const. v. Schlinder Elevator Corp., 1992 WL 43112 (Ohio Ct. App. March 6, 1992).
 

What constitutes failure?

Section 2-719 of the model Uniform Commercial Code (UCC) provides that if a remedy stated in the parties' agreement "is expressly agreed to be exclusive," then, as a general rule, it is the sole remedy.  In support of their argument that consequential damages may be excluded, software manufacturers generally cite to | 2-719(3), which permits the exclusion of consequential damages unless the exclusion is found to be "unconscionable." This provision, however, may not bar the consequential damages being sought by the licensee even in cases in which consequential damages are not unconscionable.  While the exclusion of consequential damages may generally be permitted, | 2-719(2) can sometimes be used to override the general rule: "Where circumstances cause an exclusive or limited remedy to fail of its essential purpose, remedy may be had as provided in this Act." See U.C.C. 2-719(2).

The official comment to | 2-719 states that "under subsection (2), where an apparently fair and reasonable clause because of circumstances fails in its purpose or operates to deprive either party of the substantial value of the bargain, it must give way to the general remedy provisions of this Article."  Off. Comm 1, | 2-719.  Thus, if a limitation on the buyer's remedy fails of its essential purpose, all of the available U.C.C. remedies (including consequential damages), may be available under | 2-715.

Whether a remedy fails in its essential purpose depends in part on whether it restores the user to the position the user would have been in, had the promised software been delivered.  Some courts have held that a remedy fails of its essential purpose when the vendor is "either unwilling or unable" to correct the defect within a reasonable time.  Chatlos Systems Inc., 635 F.2d at 1085.

Once it is determined that the remedy has failed of its essential purpose, the issue is whether a separate clause excluding consequential damages also fails, or whether the exclusion of consequential damages survives, so long as it is not unconscionable.  In Chatlos, the court enforced the exclusion of consequential damages, treating it as an independent provision, despite a finding of a failure of essential purpose.  The court treated the limited repair remedy and the exclusion of consequential damages as discrete methods of limiting recovery for breach of warranty and decided they should be judged by different standards.  Specifically, the court found that the repair remedy was to be judged by the failure-of-essential-purpose standard, while the consequential damages disclaimer was to be reviewed under the unconscionable standard.  635 F.2d at 1086. See also Colonial Life Ins. Co. of America v. Electronic Data System Corp., 817 F. Supp. 235 (D.N.H. 1993).

However, in a recent case in the Eastern District of Pennsylvania, the court was directly faced with the issue of the enforceability of a replace-or-repair remedy and a limitation on consequential damages.  Caudill Seed & Warehouse Co. v. Prophet 21 Inc., 123 F. Supp. 2d 826 (E.D. Pa. 2000), motion for reconsideration granted in part, denied in part, 126 F. Supp. 937 (E.D. Pa. 2001). In Caudill, the plaintiff had licensed certain software from the defendant for use in the plaintiff's warehouse business.  In its complaint, the plaintiff alleged that the software never functioned as represented, that on numerous occasions the defendant failed to fix the problems and finally, that the plaintiff was forced to buy replacement software.  The defendant moved to dismiss the complaint, arguing that the license agreement limited the remedies of the plaintiff to replacement or repair of the software and also disclaimed any liability for consequential damages.

The license agreement specifically provided that "licensee's sole and exclusive remedy for any failure of the software shall be the warranties contained herein." Id. at 828.  The warranty provision provided that for one year, at no charge, the defendant would make all corrections to make the software operate.  The license agreement also limited the defendant's liability for direct, indirect, consequential or resulting damages or injury arising out of the software, and limited the defendant's liability for the plaintiff's lost profits, time, business, records or other monetary damages.  Id.  After considering these provisions, the court then reviewed | 2-719(b) and concluded that "[a] finding that the essential purpose of a remedy was not satisfied typically arises 'when the exclusive remedy involves replacement or repair of defective parts, and the seller because of his negligence in repair or because the goods are beyond repair, is unable to put the goods in warranted condition.'" Id. at 829.  The court looked at the complaint and concluded that the plaintiff had indeed alleged that the software was never repaired or replaced because of the defendant's negligent, reckless or intentional conduct. The court therefore held that the exclusive remedy for breach of warranty in the licensing agreement failed of its essential purpose, and the limitation-on-liability clause therefore did not defeat all of the plaintiff's claims.  Id.

The Caudill court then had to determine whether the disclaimer of consequential damages should be enforced.  The court noted that district courts in the 3d Circuit have generally followed Chatlos in enforcing damages disclaimers unless they are unconscionable, even when an exclusive remedy in the agreement has failed of its essential purpose.  Id. at 830.  The court noted the legal quagmire that has divided courts across the nation, stating that, "The controversy is over whether the failure of an exclusive remedy referenced in a limitation on liability clause should result in the mooting of the remaining limitations on liability, including damage disclaimers." Id. at 830.

Two interdependent clauses

The court then analyzed the language of | 2-719, concluding that "when an exclusive remedy fails, a buyer may seek the entire range of remedies available under the U.C.C.," including consequential damages.  Id.

In so holding, the court made it clear that it believed that the exclusive remedy clause and the disclaimer of damages clause are "two inextricably linked, interdependent clauses; the disclaimer of damages clause cannot rationally exist without some remedy, and when the sole remedy fails, so must the damages disclaimer." Id at 833, n.10.  See also Amsan LLC v. Prophet 21 Inc., 2001 WL 1231819 (E.D. Pa. Oct. 15, 2001); Consolidated Data Terminals v. Applied Digital Data Systems Inc., 708 F.2d 385 (9th Cir. 1983); Kalil Bottling Co. v. Burroughs Corp., 619 F.2d 1055 (1980) (involving computer hardware).

Previously, the leading case in the software context holding that a consequential damage provision cannot survive the determination of failure of essential purpose had been RRX Industries Inc. v. Lab Con Inc., 772 F.2d 543 (9th Cir. 1985). In that case, the court concluded that where the default of the seller was so "total and fundamental," a consequential damage limitation, although not necessarily unconscionable, was properly "expunged from the contract." Id. at 546. The court emphasized that the vendor did not provide a system that worked as represented or fix the "bugs" in the software.  Indeed, the customer was left without a usable system.  The limited remedy, however, required that the vendor fix the "bugs." In the court's view, the essential purpose of this remedy was to provide a functional system.  However, this limited remedy failed not only because the vendor did not fix the "bugs," but also because the system did not work as represented.  This constituted a total and fundamental failure.

The 9th Circuit also made it clear in a subsequent case that where a working system was never installed, the limited-repair remedy and its exclusion of consequential damages were not applicable.  Hawaiian Telephone Co. v. Microform Data Systems Inc., 829 F.2d 919, 925 (9th Cir. 1987).

Thus, what Judge Lowell Reed appears to have done in the more recent Caudill decision is to eliminate the "total and fundamental failure" requirement previously articulated in RRX. The focus of the Caudill court is on the language of | 2-719 itself, which requires a "failure of essential purpose" of the remedy.  This interpretation should make it easier for software licensees to obtain relief where the failure of the system is less than total and fundamental.