Advanced Contracts and Commercial Law Seminar

Alexandra Tolmatska

April 29, 2013

Software Transactions and Article 2 of the UCC

Abstract

Software transactions occupy a unique position at the intersection of sales, services, licensing, and intellectual law doctrines. The difficulty in analyzing software transaction issues results from the intangible intellectual property aspect of software and the tangible physical medium which contains a computer program. Software’s ability to be a service or a good also has led to judicial uncertainty. Different courts have come to different conclusions on the questions of whether software is governed by the UCC Article 2 or common law. The Article addresses some of the most prominent cases and developments for classification of software transactions and the application of Article 2 to software transactions.

I. Introduction

Our life increasingly depends on computers in virtually every area: sales and purchases, billing,

banking, accounting, and taxes. We don’t mail letters – we send e-mails. We don’t buy books–

we download e-books. We buy e-tickets and participate in on-line auctions. We use computers

for creating documents and for making phone calls, for operating complex medical equipment

and synchronizing traffic lights. The list of what we do through computers is endless.

However, the computers without computer programs or software cannot function. Software is

the special product, the special kind of “goods,” the product of an intellectual process which

refers to the “elusive concept.”1 It is just “sets of instructions that will cause the machine to

1 Advent Systems Ltd v. Unisys Corp., 925 F.2d 670, 674 (1991). The purchaser acquired software licenses for resale worldwide. Though software referred to in the agreement as a “product,” the seller argued that software was not a “good” but intellectual property outside the ambit of the UCC. The court found that software fitted the definition of a “good” in the UCC because “once in the form of a floppy disk or other medium, the program is tangible, moveable and available in the marketplace.”

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perform a specific task.” 2 Software as a product mostly involves a transfer of information. And

this nature of software led to controversy in commercial litigation over whether software is a

“good” and whether software transactions are subject to the UCC.

II. What is Software and How It Is Acquired

A. Definition and Characteristics of Software

Software is a general term that describes computer programs. It consists of lines of code written

by computer programmers that have been complied into a computer program. Software is virtual

and does not take up any physical space. When you buy a software program, it often comes on a

disc, which is a physical means of storing software. 3

The courts refer to “software” as instructions and commands that enable the computer to function

and perform certain specific tasks by providing instructions, or commands, to the computer

system,4 and as a medium that stores input and output data as well as computer programs. 5

“[S]oftware is used to manage the operations of a computer; it schedules and controls jobs, keeps

track of the placement and storage of information, manages traffic, and generally enables a

computer to process a particular application.” 6

2 Comptroller v. Equitable Trust Co., 464 A.2d 248, 250 (1983). The licensor granted the licensee a right to use computer programs in the business data processing field. The court found that for property tax purposes software had “a tangible nature.” The court reasoned that software was tangible because “magnetic impulses” carried out by tapes and conveyed to the computer through software were tangible. 3 http://www.techterms.com/definition/software4 Norwest Corp.v. C. I. R., 108 T.C. 358, 359-60 (1997). The Buyer purchased software for use in its banking and related businesses under license agreements. The court found that the computer software was tangible personal property eligible for the investment tax credit. 5 Advent Sys. v. Unisys Corp., 925 F.2d 670, 674 (3rd Cir. 1991). See footnote 16 Norwest Corp.v. C. I. R., 108 T.C. 358, 359-60 (1997). See footnote 4

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“Programs are codes prepared by a programmer that instruct the computer to perform certain

functions. When the program is transposed onto a medium compatible with the computer’s

needs, it becomes software.”7

Thus, “[t]he software is not merely knowledge, but rather is knowledge recorded in a physical

form which has physical existence, takes up space on the tape, disc, or hard drive, makes

physical things happen, and can be perceived by the senses.”8 Accordingly, software has both the

intangible intellectual property aspect and the tangible physical medium which contains a

computer program.

Due to the predominant information aspect of the software, software transactions focus mostly

on the computer information and contractual rights to use it. The physical medium alone is of

little value. The thing of value contracted for is the intellectual property, the information, the

instructions compiled into computer program. Unlike a buyer of goods, the purchaser (e.g.,

buyer, lessee, or licensee) of a copy of computer information has little interest in the original

diskette, CD or tape that contained the information unless the computer information remains on

that media and nowhere else. 9

B. How Software is Acquired

Software can be transferred from the seller to the customer through the transfer of physical,

tangible media such as CDs or DVDs. Also, much software is not sold over the counter, but

rather ordered over the Internet and delivered by wire. “There is no box; there is only a stream of

7 Advent Sys. v. Unisys Corp., 925 F.2d 670, 674 (3rd Cir. 1991). See footnote 18 Microsoft Corp. v. Franchise Tax Bd., 2012 Cal. App. LEXIS 1284 (2012). In franchise tax case, the court noted that “computer software purchased by an end-user consumer may be characterized as tangible property.” 9 Jennifer B. Cannata, “Time is Running Out for Customized Software: Resolving the Goods Versus Service Controversy for Year 2000 Contractual Disputes,” 21 Cardozo L.Rev. 283, 317 (1999).

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electrons, a collection of information that includes data, an application program, instructions,

many limitations, and the terms of sale. The user purchases a serial number, which activates the

software’s features.” 10

Frequently, software is not purchased, but is acquired through creation of customized programs,

modification to existing programs, services provided along with access to software, downloading

software from internet, licensing agreements, and so on. Regardless of how the program is

conveyed to the customer, the customer receives the intangible set of instructions which he

downloads into his computer. The thing of value to the customer is information and not the

tangible medium.

III. Software Transactions within the Scope of the UCC

A. “Goods” Only

Commercial transactions are governed by two bodies of contract law: the state common law and

the Uniform Commercial Code (the “UCC”) as adopted by the states. The applicability of the

UCC to the specific transaction depends on the determination of whether the object of the

transaction is a “good.” If the object of the transaction is not a “good,” the transaction is not

governed by the UCC but instead is subject to the state common law which varies among

jurisdictions.

Transactions in goods are governed by Article 2 of the UCC. Under Article 2, the “goods” are

defined as “all things (including specially manufactured goods) which are movable at the time of

identification to the contract for sale other than the money in which the price is to be paid,

10 ProCD, Inc. v. Zeidenberg, 86 F.3d 1447, 1451-1452 (7th Cir. 1996). The consumer purchased software on CD-ROM disks. The court treated the transaction as the sale of products subject to the UCC terms.

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investment securities and things in action.” 11 The definition of goods is based on the concept of

“movability.”12 Thus, in order to be “goods” under the UCC Article 2, the software must be

movable, identifiable, and transferable.

B. Leases of Software Neither Subject to Article 2 Nor to Article 2A of the UCC

Article 2 applies only to the sale of goods. Leases of goods are regulated by Article 2A of the

UCC. Article 2A of the UCC covers leases of goods and “applies to any transaction, regardless

of form, that creates a lease.” 13 It defines “goods” as “all things that are movable,” but the term

“goods” does not include “general intangibles.” 14 Article 2A does not define general intangibles

but refers to Article 9 definition instead. 15 Going to Article 9, the definition of general

intangibles includes software.16 Thus, software is not treated as goods in Article 2A and is

explicitly excluded from Article 2A under the concept of general intangibles. Accordingly, leases

of software neither subject to Article 2 nor Article 2A of the UCC.

C. Service Contracts are Not Governed by Article 2 of the UCC

Service contracts and materials used in connection with the performance of service contracts are

excluded from Article 2 because Article 2 applies only to “transactions in goods,”17 and “unless

the context otherwise requires, ‘contract’ and ‘agreement’ are limited to those relating to the

present or future sale of goods.”18 For the UCC to govern, contracts for software must be deemed

11 UCC § 2-105.12 UCC § 2-105, Official Comment 1.13 UCC § 2A-102.14 UCC § 2A-103(1)(h).15 UCC § 2A-103(3).16 UCC § 9-102(a)(42).17 UCC § 2-10218 UCC § 2-106(1)

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to be contracts for goods and not for services. Service contracts are governed by individual state

contract law.

“Mixed” contracts which involve both goods and services are subject to the legal tests for

deciding whether Article 2 governs the mixed transaction. Most states favor “the predominant

factor test,” which requires a judicial determination of which aspect of the contract – sale or

service – was more significant.19 If the “goods” element dominates the “service” element of the

transaction, Article 2 can apply.

D. License Agreements are Not Governed by Article 2 of the UCC

As mentioned above, Article 2 is limited to transactions relating to the present or future sale of

goods.20 A “sale” consists in the passing of title from the seller to the buyer for a price.” 21

Often, software is not sold to users. The software creators enter into license agreements which

oblige users to maintain the software as proprietary information and to pay either a one-time

license fee or periodic fees during the license term. 22 A license does not pass title to the

software, but merely conveys contractual permission to use this software. As one court noted,

“[a]dmittedly, the UCC technically does not govern software licenses” … and software licenses

exist in a legislative void.” 23 The same court also observed that “business persons reasonably

expect that some law will govern them. For the time being, Article 2’s familiar provisions…

19 Allied Indus. Serv. Corp. v. Kasle Iron & Metals, Inc., 405 N.E. 2d 307 (1977). The court established the rule that “where the predominant factor and purpose of a contract is the rendition of service, with the furnishing of goods only incidentally involved, the party agreeing to furnish and supply such service and goods is not a seller of "goods."20 UCC § 2-106(1)21 UCC § 2-106(1).22 Andrew Rodau, Computer Software: Does Article 2 of the Uniform Commercial Code Apply?, 35 Emory L.J. 853 (1986)23 i.Lan Sys., Inc. v. Netscout Serv. Level Corp., 183 F. Supp. 2d 328, 332 (2002). The vendor purchased software that monitored computer networks and resold software to customers. Software also contained the clickwrap license agreement. The court has held that the clickwrap license agreement is subject to the UCC.

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better fulfill those expectations than would the common law.” 24 As a result, despite Article 2

requirements of a sale, some courts have assumed that Article 2 governs software licenses. 25

E. Practical Effects of the UCC Application to Software Transactions

Applying the UCC to software transactions offers substantial benefits to the parties of the

transaction because the Code offers a uniform body of law on a wide range of questions likely to

arise in computer software disputes: implied warranties, damages, disclaimers of liability, the

statute of limitations, formation and modification of contract, to name a few.

Also, the UCC is “liberally construed and applied to promote its underlying purposes and

policies, which are: (1) to simplify, clarify and modernize the law governing commercial

transactions, (2) to permit the continued expansion of commercial practices through custom,

usage and agreement of the parties; and (3) to make uniform the law among the various

jurisdictions.”26

The UCC achieved substantial uniformity in commercial transactions that extent beyond one

state. The Code also eliminated the necessity for companies to comply with different laws in

different states. As such, the UCC goals are very important for the nationwide software business.

IV. Legal Status of Software Transactions

As explained above, Article 2 may apply to software transactions if the transactions involve

transfer of goods. To determine whether the transaction involves a transfer of goods, courts

generally use a two-step approach. First, they look whether software is “goods” under Article 2.

24 Id.25 Id.26 UCC § 1-103(a).

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Second, if the court determines the software is a good, then the court examines whether the

transaction involves both goods and services. If the transaction involves both goods and services,

the court applies the legal test for deciding whether Article 2 of the UCC governs such a

transaction.

As one of the courts noted in respect to the software transactions, on the one hand, the “ordinary

sale of ‘off-the-rack’ software [is] a transaction in goods,” and, on the other hand, “a transaction

predominantly involving the intellectual property rights to the software [being] outside the scope

of Article 2 [of the UCC].”27

Courts, attorneys, and business professionals frequently struggle with the question whether

software is an intellectual property or whether it is “goods.” A sampling of decisions from

various jurisdictions shows that courts have generally recognized that computer software

qualifies as “goods” for purposes of the UCC and the transfer of software is a “sale” falling

under Article 2. 28

A. Software as “Goods” when “Movable”

Article 2 defines goods as “all things (including specially manufactured goods) which are

movable at the time of identification to the contract for sale other than the money in which the

price is to be paid, investment securities and things in action.” 29

27 Dealer Mgmt. Sys., Inc. v. Design Auto. Group, Inc., 822 N.E.2d 556 (2005). The court had to decide whether a contract for the provision of software was predominantly for goods or services. The court held that the contract at issue in that case was predominantly for goods only after analyzing the facts of the contract in light of the predominant purpose test and the acknowledgment that software occupies a continuum between goods and services depending on the interplay between the contract and the attendant facts. 28 “Within the last decade, the vast majority of courts have concluded that software is a good for the purposes of the UCC.” Joshua R. Steiman, Applying UCC Article 2 to Software, 40 No. 1 UCC L. J. ART 4 (2007).29 UCC § 2-105(1).

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In Communications Groups, Inc., the plaintiff designed and installed the special computer

software equipment for the defendant’s particular needs to store data relating to thousands of

defendant’s monthly telephone calls and to process and print this data on defendant’s main

computer frame. 30 The court has held that the software is “goods.” The court reasoned that

“regardless of the software's specific form or use, it seems clear that computer software,

generally, is considered by the courts to be a tangible and movable item, not merely an intangible

idea or thought and therefore qualifies as a "good" under article 2 of the UCC.”31

The court in Advent reasoned that “a computer program may be copyrightable as intellectual

property does not alter the fact that once in the form of a floppy disc or other medium, the

program is tangible, moveable and available in the marketplace.” 32 Analyzing whether software

is “movable” and “tangible,” the court noticed that computer programs can be distributed

because they are “implanted in a medium.” 33 To prove the “movability” characteristic of the

software, the court analogized software with a compact disc recording of an orchestral rendition

and also with a book. “The music is produced by the artistry of musicians and in itself is not a

“good,” but when transferred to a laser-readable disc becomes a readily merchantable

commodity. Similarly, when a professor delivers a lecture, it is not a good, but, when transcribed

as a book, it becomes a good.” 34

In Sagent, the purchaser bought software and related products for technical support for resale to

the customers under the license agreement.35 The software was encoded on at least one CD-

ROM, and the CD-ROM was shipped to the purchaser. The court found that software encoded on

30 Communications Groups, Inc. v. Warner Communications, Inc., 138 Misc. 2d 80, 83 (1988).31 Id.32 Advent Sys. v. Unisys Corp., 925 F.2d 670, 674 (3rd Cir. 1991). See footnote 1.33 Id.34 Id.35 Sagent Tech., Inc. v. Micros Sys., 276 F. Supp. 2d 464, 467 (2003).

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CD-ROM which was shipped to the customer met the “movability” test. 36 The court also held

that though the transaction was labeled as a license, it is for “all practical purposes is a sale of

computer software.” 37 “Although the software itself technically is not a “good,” the medium

upon which it is distributed and sold – the CD-ROM – is a “good.” 38 The court noticed that

software is movable because “computer programs could not be conceptually severed from the

disks on which they sold.”39

Although another court held that software itself was not a good but intellectual property,40 the

same court recognized that software became good when “stored on a disk for worldwide

distribution.” 41

Thus, various courts in different jurisdictions recognized that computer software qualifies as

“goods” for purposes of the UCC because software is a movable item when incorporated in a

medium.

B. Software as “Goods” when “Devoid of a Medium”

Similarly, the courts characterized software purchased and downloaded online as “goods”. In

Specht, the plaintiffs downloaded software from the defendant’s website.42 The court has held

that “the parties’ relationship essentially is that of a seller and a purchaser of goods” because the

36 Id.37 Id.38 Id. 39 Id.40 Triple Point Tech., Inc. v. D.N.L. Risk Mgmt., Inc., 2000 U.S. Dist. LEXIS 22327 (D.N.J. 2000). The buyer bought the seller’s interest in the computer program under the “Asset Purchase Agreement.” Under the terms of the Agreement, the purchaser bought “all seller’s intellectual property rights… including all right, title and interest in that certain power trading software program, and all proprietary products, all source codes of software products…” The court has held that the purchaser bargained for the “design information qua information” and not for the medium on which the information was transferred. Merely because the program has to be contained on a floppy disk or CD-ROM for transfer does not subject the purchase agreement to the UCC.41 Id.42 Specht v. Netscape Communs. Corp., 150 F.Supp. 2d 585 (2001).

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plaintiff requested the defendant’s product by clicking on an icon marked “Download,” and the

defendant then tendered the product.

In the same manner in Gross, the plaintiff purchased software online based on the defendant’s

representations that the software would accurately detect, report and repair errors and enhance

the performance of PC. 43 Later the plaintiff found the software unsatisfactory and alleged that

the defendant breached express warranty that the software could perform accurate diagnostic

tests on computer systems. The court has held that software is a “good,” and the UCC applies.

The court reasoned that “although Plaintiff purchased and downloaded software from the

internet, and did not install the software from a CD, the “essence of the agreement” is the same,

[the consumer products sales transaction].”44

Thus, Article 2 may govern software transactions in which computer users do not install the

software from mediums but download and purchase software from the internet.

C. Software as “Goods” when Incidental Services are Involved

Software also can be described as services because development of a computer program is a

labor-intensive process which requires substantial knowledge, time, and effort.45 As a rule, pre-

existing, standardized, “generally-available” software constitutes goods46, no matter what is the

form of acquisition. Also, many courts consider software as “goods” even though a finished

software product may reflect a substantial investment of programming services” 47 and even

43 Gross v. Symantec Corp., 2012 WL 3116158 (2012).44 Id.45 Comptroller of the Treasure v. Equitable Trust Co., 464 A.2d 248, 250 (1983).46 Olcott Int’l & Co. v. Micro Data Base Sys., 793 N.E.2d 1063, 1071 (2003). The buyer contracted to purchase pre-existing, standardized software modules from the seller. The software modules were not created especially for the buyer. The court held that the contract at issue was for the sale of goods, not services, and Article 2 applied.

47 Architectronics, Inc. v. Control Sys., 935 F.Supp. 425, 432 (1996). The plaintiff granted the defendant the right to use its software for the development of the “derivative work” which was the new software and the right to use, copy, and distribute the “derivative work.” The court found that the agreement between the parties was not subject to

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though incidental services are provided along with the sale of the software. 48 Such ancillary

services include installation, employee training, repair services, system upgrading and technical

support. 49

For example, in Wachter, the buyer purchased an accounting and project management software

system. 50 The contract also included installation of the software, a full year of maintenance, and

training and consulting packages. The seller shipped the software and assisted the buyer in

installing software on the buyer’s computer system. After encountering problems with the

software, the buyer sued the seller for breach of contract and breach of warranty. The court

applied the UCC and reasoned that maintenance, training and consulting services were incidental

to the purchase of software. Such services would not have been necessary if the buyer had not

purchased the software. Thus, the court concluded that the software at issue qualified under the

definition of goods and applied the UCC. 51

In Dahlmann, the plaintiffs entered into contracts with the defendants to purchase property

management systems incorporating hardware, software, installation, training, and support

services for the plaintiffs’ two hotels. 52 The court explained that “simply because the agreements

provided for installation, training, and technical support,” they are not automatically converted

into services contracts.” 53 The court concluded that the services provided with the sale of the

software were “not substantially different from those generally accompanying computer system

Article 2 because the parties “bargained primarily for the right to mass-market the product,” and not for the right to use the software.

48 Wachter Mgmt. Co. v. Dexter & Chaney, Inc., 144 P.3d 747 (2006). 49 Dahlmann v. Sulcus Hospitality Techs., Corp., 63 F. Supp. 2d 772, 775 (1999); RRX Industries, Inc. v. LabCon, Inc., 772 F.2d 543, 546 (1985)50 Wachter Mgmt. Co. v. Dexter & Chaney, Inc., 144 P.3d 747 (2006). 51 Id.52 Dahlmann v. Sulcus Hospitality Techs., Corp., 63 F. Supp. 2d 772, 775 (1999).53 Id.

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contracts” and were incidental to the agreements for the system. 54 The court held that the

agreements for software package development and installation were within the scope of the

UCC. 55

The action in RRX Industries arose out of a computer software contract under which the

defendant supplied the plaintiff with a software system for use in the plaintiff’s medical

laboratories. 56 The contract obligated the defendant to timely install an operational software

system, to repair malfunctions, and to train the plaintiff’s employees. The court found that “the

employee training, repair services, and system upgrading were incidental to sale of the software

package and did not defeat characterization of the system as a good.” 57

Thus, the variety of courts held that though software may be accompanied by ancillary services,

software is still “goods” subject to Article 2. Installation, training, repairs, system upgrading and

technical support are incidental to the sale of software and necessary only when the buyer

purchases software.

D. Software as the “Specially Manufactured Goods.”

As mentioned above, Article 2 defines goods as “all things (including specially manufactured

goods).”58 The courts also recognize that custom software is a “good.”

For example, in Dharma Sys., the plaintiff contracted with the defendant and ordered the custom

software - the specialized database management system designed to be used by the IRS.59 The

54 Id.55 Id.56 RRX Industries, Inc. v. LabCon, Inc., 772 F.2d 543, 546 (1985)57 Id.58 UCC § 2-105. 59 Micro Data Base Sys. v. Dharma Sys., 148 F. 3d 649, 654-655 (7th Cir. 1998).

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plaintiff found the software defective and sued the defendant for the breach of contract. The

court held that the custom software is a good and applied Article 2 to the software transaction. 60

In Newcourt Fin., the computer company agreed to provide a custom software and computer

support to the mortgage company. 61 The court held that custom software is a good under the

UCC.

The court in Advent Sys. also reasoned that “the fact that some programs may be tailored for

specific purposes need not alter their status as “goods” because the Code definition includes

“specially manufactured goods” and services are only incidental to such goods.62

The academic commentators also allege that “customized software should be considered a good

under the UCC.”63 “There is no valid reason that customized software should be excluded from

the UCC based upon the explicit language of Article 2 and its intended scope.” 64

Thus, software adapted to the customers and the custom-made software which involves a lot of

services may be considered as a “specially manufactured goods” and be governed by Article 2.

E. Some Courts Do Not Recognize that Software is “Goods”

Though most courts held that software is a good, some courts concluded that software is not as

such. For example, in Triple Point Tech., the court has determined that “computer source and

program codes are intellectual property and not a “good” under the UCC.” 65

60 Id.61 Newcourt Fin. USA, Inc. v. FT Mortgage Cos., 161 F.Supp.2d 894, 897 (2001).62 Advent Sys. Ltd. v. Unisys Corp., 925 F.2d 670, 675 (3d Cir. 1991).63 Jennifer B. Cannata, Time Is Running Out for Customized Software: Resolving the Goods Versus Service Controversy for Year 2000 Contractual Disputes, 21 Cardozo L. Rev. 283, 316-17 (1999).64 Id. 65 Triple Point Tech., Inc. v. D.N.L. Risk Mgmt., Inc., 2000 U.S. Dist. LEXIS 22327 (D.N.J. 2000). See Footnote 42.

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In Architectronics, the court distinguished tangible software use rights from intangible

intellectual property rights. 66 The court analyzed the software transaction and concluded that the

parties did not bargain for the right to use software. 67The parties contracted primarily for the

right to mass-market the product. Thus, the court held that the software transaction did not

involve transaction in goods, because the predominant feature of the contract was a transfer of

intellectual property rights. 68

In Data Processing Servs. v. L.H. Smith Oil Corp., the court reasoned that the customer

bargained for the vendor’s knowledge, skill, and ability in developing a computer system to meet

the customer’s specific needs, and not for means by which the vendor’s skills and knowledge

were to be transmitted. 69 The court found that “magnetic tape, floppy or hard discs, etc.” were

incidental to the software transaction and Article 2 may not apply.70

Likewise, the number of scholars comment that some courts incorrectly apply Article 2 to

information licenses and accordingly, to software transactions.71 They are certain that

information, including software, is not a “good.” Applying Article 2 to software transactions is

“precluded by the terms of the statute itself and problematic as a matter of policy.” 72 The authors

of the idea recommend applying common contract law to software transactions because software

is information, and not a “good.”

66 Architectronics, Inc. v. Control Sys., 935 F. Supp. 425, 432 (1996).67 Id.68 Id.69 Data Processing Servs. v. L.H. Smith Oil Corp., 492 N.E.2d 314, 318 (1986). The vendor was to develop and deliver to the customer the various computer software to meet the customer’s specific needs. The contract did not involve the sale of computer hardware or generally-available standardized software.70 Id.71 Holly K. Towle, Enough Already:It Is Time to Acknowledge That UCC Article 2 Does Not Apply to Software and Other Information, 52 S. Tex. L. Rev. 531, 580-82 (2011).72 Id.

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V. Determining Whether Software is “Services”

Software’s ability to be a service or a good has led to judicial uncertainty. Different courts have

come to different conclusions whether software is a good or a service. A significant factor for the

court to decide whether software is a good or a service is the degree of development and

customization or programming required by the buyer. 73

"At one end of the spectrum is a consumer who walks into the local electronics store, pulls a

shrink-wrapped word processing program from the shelf, pays the cashier and goes home with it.

Such a sale is very clearly one for a good. At the other end of the spectrum is a programmer that

invents and develops new software [from scratch] for a particular customer. In that case, the

contract is more like a services contract." 74

Transactions predominantly involving intellectual property rights 75 and transactions involving

the development of entirely new software, “from scratch,” usually constitute services. 76 “The

UCC does not apply to an agreement to design and develop a product, even if compensation

under that agreement is based in part on later sales of that product… The service element of the

transaction so dominates the subject matter of the contract that, even though a tangible end

product seemingly within the definition of ‘goods’ was produced, the contract is more readily

characterized as one for services.”77

73 Page v. Hotchkiss, 2003 Conn. Super. LEXIS 3341 (2003). The defendant performed the programming work for the plaintiff and produced a customized computer program. The defendant worked 15-30 hours on the project and was paid an hourly wage. The court found that the essence of the software transaction was a service because the plaintiff purchased the defendant’s work and labor. 74 Id.75 Architectronics, Inc. v. Control Sys., 935 F.Supp. 425, 432 (1996); Advent Sys. v. Unisys Corp., 925 F.2d 670, 676 (3rd Cir. 1991); Triple Point Tech., Inc. v. D.N.L. Risk Mgmt., Inc., 2000 U.S. Dist. LEXIS 22327 (2000). 76 Pearl Investments, LLC v. Standard I/O, Inc., 257 F. Supp. 2d 326, 353 (2003); Smart Online, Inc. v. Opensite Technologies, Inc., 2003 WL 21555316 (2003).77 Pearl Investments, 257 F. Supp. 2d 326, 353 (2003).The parties agreed that the developing party would create software to carry out the automated arbitrage transactions. The customer was paid on a time and material basis. The court concluded that "for purposes of applicability of the UCC, development of a software system from scratch primarily constitutes a service.”

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A. Mixed or Hybrid Software Transactions

The contracts involving both the sale of software (“goods”) and installation, training, support,

customizations, modifications of the software and a transfer of intellectual property (“services”)

are mixed or hybrid transactions. To decide whether a mixed or hybrid transaction falls within

the reach of Article 2, courts have used three different analytical tests.

The first test under Foster, bifurcates the transaction into the “goods” portion that includes goods

and the “non-goods” portion that includes contracts, goodwill and licenses. 78The “goods”

portion applies Article 2, and the “non-goods” portion applies common law. 79

The second test, “the gravamen test,” determines whether the focus of the lawsuit is on the goods

or the services aspect of transaction. “If the gravamen of the action focuses on goods, then the

UCC governs. If the focus is on the quality of the services rendered, then common law applies.”80

The third and the most popular test is the “predominant purpose test.” When applying the

predominant purpose test, the courts determine whether the dominant factor or essence of the

transaction is rendition of services, with goods incidentally involved, or is rendition of goods,

with labor incidentally involved. “In determining whether a contract is one of sale [of goods] or

to provide services, the court looks to the essence of the agreement to see whether service

predominates over any sale aspect, such as supply of materials by the principal to the service

entity ... Whether a contract is one for the sale of goods, or for work and labor to be rendered,

may depend on whether the primary intent is merely to provide for the delivery of goods, or

whether the essential consideration is work and labor to be performed at the employer's instance

and for his use rather than for the producer's benefit ... It is of no moment that the materials to be 78 Foster v. Colorado Radio Corp., 381 F.2d 222 (10th Cir. 1967). 79 Id.80 In re Trailer & Plumbing Supplies, 578 A.2d 343, 345 (1990).

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processed [were] transferred from the defendant's possession to the plaintiff's: where service

predominates, and the transfer of personal property is only incidental to the transaction, it is a

contract for work, labor and materials and not a sale.” 81

B. How Courts Determine Whether a Mixed or Hybrid Software Transactions Fall Within

Article 2

The analysis of mixed or hybrid software transactions is very fact-based. For example, in

Dharma Sys., the contract involved the sale of software delivered in hard copies (“goods”). The

contract also provided for customization of a computer pre-existing program (“services”). 82 The

court considered the whole transaction to be a contract for goods. The court analogized the

customization process to the manufacturing process needed to customize the product for the

customer’s special needs. The court reasoned that “although the contract recites that half of the

total contract price is for “professional services,” these were not services to be rendered but

merely the labor to be expended in the manufacture of the good from existing software.”83 The

court did not recognize a “hybrid” sale in the software transaction, “for this would imply that

every sale of goods is actually a hybrid sale, since labor is a service and labor is an input into the

manufacture of every good.” 84

In RRX Industries, the court was confronted with a software transaction which involved the sale

of software, installation of the software on the buyer’s computer and correction of any errors in

81 State v. Maximus, Inc., X06CV075011488S, 2009 WL 1142570 (2009). The parties entered into agreement on upgrading online law enforcement messaging and database system. The defendant agreed to build the revised collect system, provide web browser and a message switch, and test the revised system to ensure that it complied with the requirements of the agreement. The court found that the parties’ agreement was predominantly for labor and materials and not for the purchase of goods. 82 Micro Data Base Sys. v. Dharma Sys., 148 F.3d 649, 654 (7th Cir. 1998). The contract for the sale of software and creation of the custom-made program by adaptation of the customer’s pre-existing program. The court applied Article 2 to the software transaction.83 Id.84 Id.

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the software discovered after installation. 85 The seller agreed to develop the software system

which would correct any malfunctions or “bugs” that arose in the buyer’s system. The contract

obligated the seller to install the software into the buyer’s computer system, to train the buyer’s

employees in the operation of the software and to upgrade the software in the future. The court

found that the sale of the software was the predominant feature of the transaction, with the

services being only an incidental part of the transaction. 86

In Dealer Management, the court had to decide whether a contract for the provision of an

accounting management system was predominantly for goods or services.87 The court applied the

predominant purpose test to decide the issue. In applying that test, the court considered the

following facts.

The written agreement was entitled “purchase order.” The agreement provided for a sale of

various separately-priced software components in a form of “source code license” for use for an

unlimited amount of time in exchange for a single payment.

In addition, the services provided were installation, training, and support – the services which

“are not substantially different from those generally accompanying package sales of computer

systems consisting of hardware and software.” Thus, the services were only incidental to the sale

of the software.

The agreement did not suggest that any of the software was developed from scratch. Further, the

contract amount attributable to the software was more than $20,000, while the amount

attributable to services was less than $15,000. Although the court reasoned that “comparing the

85 RRX Indus. V. Lab-Con, Inc., 772 F.2d 543 (9th Cir. 1985).86 Id.87 Dealer Mgmt. Sys. v. Design Auto Group, Inc., 822 N.E. 2d 556 (2005).

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relative costs of materials and labor may be helpful in the analysis, but is not dispositive,” 88 the

court concluded that the contract was predominantly for the sale of goods and not services.89

In Inter-Americas, the parties entered into the contract which included the sale of software,

hardware, and licenses, and also the installation of the system and converting the information

contained on the software program to the new files. The court found that the installation and

conversion of information would have been unnecessary if the customer had not bought the

software. The court considered the services incidental when the customer paid only $35,000 for

services out of $240,000 of the contract price. The court held that “a contract involving both

software and services will be governed by the UCC if without the purchase of the software, the

services would have been unnecessary.” 90

In Bruel, the parties entered into an agreement on supplying noise-monitoring and radar

equipment and systems. 91 The agreement also provided for the upgrade of the noise monitoring

and radar systems, annual servicing agreements, and software adjustments and upgrading. The

software upgrades specified under the agreement included “significant efforts devoted to

developing new software programs and customizing existing software programs.” 92 The

software was newly developed for the customer and was not an “off-the-shelf” product that the

customer could have obtained.

In determining whether an agreement is predominantly for goods, a court reviewed the

contractual language relating to the design, installation and delivery of the object of the

88 Id.89 Id.90 Inter-Americas Ins. Corp., Inc. v. Imaging Solutions Co., 185 P.3d 963, 969 (2008).91 Bruel & Kjaer v. Vill. of Bensenville, 969 N.E.2d 445, 451 (2012).92 Id

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agreement. 93 The court found that the agreement referred to the parties as “buyer” and “seller”

and generally, by its language, contemplated a sale of goods via the passing of title from the

seller to the buyer for the equipment and systems that were the subject of the agreement. In

addition, the agreements provided that the seller was to deliver, assemble, install, test, and make

fully operational the equipment that was the subject of the agreement. The seller also promised to

provide various services “in consideration” of the buyer’s purchase of the equipment and

systems. Thus, the court recognized that “the terminology employed by the agreement called for

the sale of goods rather than provision of services.” 94 The court also noted that the buyer was to

make a single payment for delivery and installment of the equipment, rather than multiple

payments based on time and type of services provided. In addition, there was no breakdown in

the price between the cost of the equipment and the cost of the labor needed to make it

operational. Also, the court found that the point of the agreement was to furnish the equipment.

The services for the installation of the equipment and the creation and modification of software

which enabled the equipment to function properly were only incidental to the sale of goods.

Thus, the court considered the totality of the facts and contractual language and held that the

agreement was predominantly for goods and not for services. 95

The contrary result was achieved in State v. Maximus, Inc. where the agreement was concluded

to upgrade the law enforcement messaging and database system. The court found that the

predominant aspect of the parties' agreement was for labor and materials and not for the sale of

goods. 96

93 Id.94 Id.95 Bruel & Kjaer v. Vill. of Bensenville, 969 N.E.2d 445, 451 (2012).96 State v. Maximus, Inc., X06CV075011488S, 2009 WL 1142570 (2009). See Footnote 81.

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The court in Page v. Hotchkiss, also found services in customizing an off-the-shelf database

software program. 97 Once the customer purchased the software, the seller commenced his

programming work. The customer paid for customization of the software on an hourly basis.

The court found that the essence of the software transaction was a service because the customer

purchased the seller’s work and labor, and the essential consideration of the transaction was the

seller’s hourly labor. The court held that the goods which the customer received were incidental

to the transaction. 98

To sum up, if the software transaction includes both transfer of preexisting software and other

services, such as customization, installation, testing, or maintenance, then the transaction is

treated as mixed or hybrid transaction, and the predominant purpose test should apply.

Article 2 is likely to apply to the software transactions when (1) the services performed are

merely incidental to the software transaction, (2) the transaction involves customization of the

software, (3) the subject matter of the transaction is “off-shelf” software (the software which was

not developed from scratch), (4) the cost of the software exceeds the cost of the services, or (5)

the cost of the software exceeds relative cost of materials and labor.

Software transactions are more likely to be considered contracts for services subject to the

common law where (1) the seller is paid for services, (2) the seller is paid on an hourly and

material basis to develop the software, or (3) the cost of labor and materials exceeds the cost of

the software.

VI. Determining Whether License Software Agreements are Subject to the UCC

97 Page v. Hotchkiss, 2003 Conn. Super. LEXIS 3341 (2003). See Footnote 73.98 Id.

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Sometimes, software is provided to users through license agreements. Licensing of software may

afford tremendous control for the licensor of the software. Licenses protect new products from

duplication. Historically, the purpose of licensing computer program copy was to employ

contract terms to augment trade secret protection in order to protect against unauthorized

copying at a time when, first, the existence of a copyright in computer programs was doubtful

and, later, when the extent to which copyright provided protection was uncertain. 99 At the same

time, when copyrighted works are not licensed, but sold, the “first sale doctrine applies.” The

first sale doctrine allows owners of copies of copyrighted works to resell their copies without

restriction. 100 The first sale doctrine does not apply to a person who possesses a copy of the

copyrighted work without owning it, such as a licensee. 101 “It is this distinction between sales

and licenses that has caused the use of software licensing agreements to flourish and become the

preferred form of software transactions. “ 102

If Article 2 is viewed as a statute strictly limited to its express language, then courts would

generally determine a license of software to be outside the scope of Article 2.103 A license does

not pass title to the software, but merely conveys contractual permission to use this software.

Therefore, a sale, which is required by the express wording of Article 2, has not taken place. 104

In Berthold Types Ltd., the court held that the transaction was not subject to Article 2 because it

involved only granting a license and not a sale of goods. Article 2 was not applied because there

99 Nadan, Software Licensing in the 21st Century: Are Software “Licenses” Really Sales, and How Will the Software Industry Respond?, 32 AIPLA Q.J. 555, 559 (2001). 100 Vernor v. Autodesk, 2010 US App LEXIS 18957 (2010).101 Id.102 Id.103 Joshua R. Steiman, “Applying UCC Article 2 to Software,”40 No. 1 UCC L.J. ART.4 (2007).104 Berthold Types Ltd. v. Adobe Sys., 101 F.Supp. 2d 697, 698 (2000). The defendant agreed to incorporate the plaintiff’s computer programs in its own software under the license agreement between the parties.

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was no transfer of title in the license agreement. 105 Likewise, the court in Digital Ally held that

the license of software is not a sale transaction, even if software is considered a good, and thus it

is not governed by Article 2. 106

The comprehensive test for resolving distinction between sale and license in the context of

software was developed in Vernor v. Autodesk. 107 In Vernor, Autodesk was a manufacturer of

the design software used by architects, engineers, and manufacturers. Autodesk offered its

software to customers under licensing agreements, which customers were required to accept

before installing software. The licensing agreement provided that Autodesk retained title to all

copies and that the customer had a nonexclusive and non-transferable license to use it. Vernor

purchased a used copy of Autodesk’s software at a garage sale and sold it on eBay. The court

ruled that Vernor was not an owner of the software and, hence, was not entitled to sell copies on

eBay. The court rejected Vernor’s contention that because he was entitled to keep possession of

the software he was a purchaser, rather than a licensee. In resolving the issue, the court

articulated a three factor test for distinguishing between a software licensee and an owner of a

copy. “We hold today that a software user is a licensee rather than an owner of a copy where the

copyright owner (1) specifies that it is a license, (2) significantly restricts the user’s ability to

transfer the software, and (3) imposes “notable use restrictions.”108 The court applied this test to

Autodesk’s license agreement, which explicitly reserved Autodesk’s title to software copies and

imposed significant transfer and use restrictions. The court held that Autodesk’s customer from

105 Id.106 Digital Ally, Inc. v. Z3 Tech., LLC, 2010 WL 3974674 (2010). The defendant agreed to design, manufacture, and deliver to the plaintiff certain hardware modules using related software components for use in the plaintiff’s products under the license agreement. The court held that the agreement was not governed by Article 2 because title

to the licensed material was not transferred. 107 Vernor v. Autodesk, 2010 US App LEXIS 18957 (2010).108 Id.

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whom Vernor acquired the used copies was a licensee, not an owner of the copies. Thus, neither

Autodesk’s original customer nor Vernor could sell or resell copies of the software under the

first sale doctrine. 109

Nevertheless, the overlap of terminology between sale and license has caused confusion within

the courts and has led to some acceptance of a license as a sale. To determine whether the

software was licensed or sold, the court in SoftMan Prods. Co. looked to the character of the

ownership and determined whether a licensee has enough control over the software to be

considered an owner.110 “Ownership of a copy should be determined based on the actual

character, rather than the label, of the transaction by which the user obtained possession. Merely

labeling a transaction as a lease or license does not control. The pertinent issue is whether the

user may be required to return the copy to the vendor after the expiration of a particular period. If

not, the transaction conveyed not only possession, but also transferred ownership of the copy.” 111

SoftMan Prods. Co. enumerated factors which indicate on the transfer of title to the software: (1)

temporary unlimited possession, (2) absence of time limits on copy possession, (3) pricing and

payment schemes that are unitary not serial, (4) licenses under which subsequent transfer is

neither prohibited nor conditioned on obtaining the licensor’s prior approval, and (5) licenses

under which the use restrictions principal purpose is to protect intangible copyrightable subject

matter, and not to preserve property interests in individual program copies. 112

109 Id.110 SoftMan Prods. Co. v. Adobe Sys., 171 F. Supp. 2d 1075, 1086 (2001). The defendant purchased software under the license agreement, unbundled software and distributed incomplete versions of it. The court interpreted the license agreement as a sale finding the transfer of title to software from the seller to the purchaser.111 Id. at 1086.112 Id.

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In determining whether a transaction is a sale or a license, courts also looked to the economic

realities of the exchange. For example, in SoftMan Prods., the parties entered into the license

agreement. Under the agreement, the purchaser obtained a single copy of the software with

documentation. The purchaser paid the single price at the time of the transaction, and such

payment constituted the entire payment for the license. The purchaser also accepted the risk that

the software could be damaged or lost. The court held that such evidence suggested a transfer of

title in the good. “The transfer of a product for consideration with a transfer of title and risk of

loss generally constitutes a sale.” 113

In UMG Recordings, Inc. v. Augusto, the court also distinguished between ownership and

licensing.114 UMG Recordings sent free promotional CDs to music critics and radio disk jockeys.

The labels on CDs stated that resale or transfer of possession was not allowed. Few of the

recipients ever refused shipment or returned the CDs to UMG. Augusto acquired a number of

CDs from various third parties and sold them on eBay. In the court’s view, the language on the

CD labels did not give rise to a license. Because no license existed, “UMG’s transfer of

possession to the recipients, without meaningful control or even knowledge of the status of the

CDs after shipment, accomplished a transfer of title.”115 The court focused on the fact that UMG

had “virtually no control” over the CDs it distributed, and had “no assurance” that any recipient

assented to the license. Accordingly, UMG did not retain “sufficient incidents of ownership”

over the CDs to be considered their owner. The court reasoned that because UMG distribution

method allowed the recipients to receive and retain the CDs without accepting the terms of the

statements printed on the labels, the “transfer of unlimited possession in the circumstances

113 Id. at 1085-1086.114 UMG Recordings, Inc. v Augusto, 2011 U.S. App. LEXIS 52 (2011).115 Id.

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present here effected a gift or sale.”116 Also, a transaction that nominally involves a mere license

to use software will be considered a sale under the UCC if it “involves a single payment giving

the buyer an unlimited period in which it has a right to possession.” 117

In M.A. Mortenson Co. v. Timberline Software Corp., the buyer purchased the licensed software

under the license agreement. According to the terms of the agreement, the seller shipped program

diskettes in plastic pouches, installation instructions, user manuals, and the sealed protection

devices for the software. 118 The court held that because computer software falls within

definition of a “good” under Article 2 of the UCC, the license software agreement is also subject

to Article 2 of the UCC. 119

Thus, the courts interpret license software transactions as sales and apply Article 2 when (1) the

license transfers title to the software to the buyer, (2) the license gives the buyer an unlimited

period of software possession, (3) the risk of damage or loss of the software is on the buyer, or

(4) the transaction involves single price or single payment for the software. When the seller

expressly imposes restrictions on the transfer of the software or when the seller retains title to the

software, Article 2 does not apply.

VII. Conclusion

The application of Article 2 to software transactions merits a case-by-case analysis and depends

upon two conclusions. First, software must be a good under definition of Article 2. Second,

software transaction must involve sales. Article 2 may also be extended to software licensing

116 Id.117 SoftMan Products Co., LLC v. Adobe Systmes Inc., 171 F.Supp. 2d 1075, 1086 (2001). 118 M.A. Mortenson Co. v. Timberline Software Corp., 998 P.2d 305 (2000).119 Id.

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when such transactions transfer title to the software from the seller to the buyer and when the

buyer has enough control over the software to be considered an owner.

In dealing with hybrid software transactions involving goods and services, the courts mostly

apply the predominant purpose test. The test helps to decide which aspect of the contract – sale

or services is more significant. The courts find that goods aspect of the contract dominates and

Article 2 applies when (1) the services performed are merely incidental to the software

transaction, (2) the transaction involves customization of the software, (3) the software was not

developed from scratch, (4) the cost of the software exceeds the cost of services, or (5) relative

cost of materials and labor is less than the cost of the software itself. The services aspect of the

contract dominates and common law applies when (1) the seller is paid for services, (2) the seller

is paid on an hourly and material basis to develop the software, or (3) when the cost of labor and

materials exceed the cost of the software.

It is very important to determine whether Article 2 applies to software transactions. Application

of Article 2 to software transactions promotes uniformity, predictability, and ultimately, growth

for the national market of software. Application of Article 2 also provides more protection for

customers because the UCC offers substantial benefits to customers through the provisions on

warranties, damages, disclaimers of liability, the statute of limitations, to name a few.

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