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At its annual meeting in May 2009, the American Law Institute (“ALI”), best known for its “Restatements of the Law” and model codes, approved its “Principles of the Law of Software Contracts.” The “Principles” are not Restatements that purport to state the law as it is. Rather, they are recommended legal principles that, in some cases, do not reflect the current state of the law and will not have the force of law unless and until incorporated into legislation or adopted by courts in particular cases.

On September 22, 2009, John Lynch, a partner in Pryor Cashman’s Intellectual Property, Media and Litigation Groups, analyzed the Principles in a Web Seminar presented to insurance industry professionals. The seminar’s participants develop and market insurance products for the information technology industry, and analyze claims made against insureds in the areas of information technology, intellectual property and media.

Lynch’s seminar focused on two of the ALI’s proposed Principles that, if adopted by legislatures or the courts, would significantly alter the law of contracts as applied to computer software transactions. First, the Principles state that in connection with the sale of software, any factual statements made by the seller relating to the software, including statements made in advertising or in materials included in the software’s packaging, will create an express warranty that the software will conform to the factual statement. Significantly, such an express warranty could arise out of statements that are not in the parties’ contract (including statements made on a software developer’s website or in advertising), that were not directed at the purchaser, that were not relied on by the purchaser or which the purchaser was not even aware of.

Next, Lynch addressed the Principle’s proposed new  “Implied Quality Warranty” which provides that the seller of software “warrants to any party in the normal chain of distribution that the software contains no material hidden defects of which the transferor was aware at the time of the transfer. This warranty may not be excluded.” The Implied Quality Warranty does not exist under current law. It is easily foreseen that numerous issues will be presented when disputes arise out of software transactions:  What is a “defect”, particularly in an industry where few product releases are “bug”-free? When is a defect material? In what circumstances will a defect be deemed to have been hidden? Many in the software development industry have questioned why this new implied warranty, which would exist only with respect to software contracts, cannot be excluded by the agreement of sophisticated parties whereas existing implied warranties, such as the implied warranty of merchantability and the implied warranty of fitness for a particular purpose, can be, and typically are, excluded.

Lynch warned his audience that the Implied Quality Warranty presents particular risk to software developer because the ALI’s Principles also provide that parties cannot agree to exclusive limited remedies or to exclude the award of consequential damages (including lost profits) in connection with a breach of the Implied Quality Warranty. It is widely recognized in the software industry that software developers often are relatively small businesses who would not be able to participate in the market if they had to take on the risk of large consequential damage or lost profits judgments. Accordingly, it is standard practice for purchasers of software to agree to specified exclusive remedies (such as repair, replacement or refund) and to the exclusion of consequential damages. This landscape would be altered considerably if the courts adopt the ALI’s proposed ban on exclusive remedy provisions and limitations on liability in connection with breaches of the proposed Implied Quality Warranty.