November 16, 1998 98-R-1357

FROM: Kevin E. McCarthy, Principal Analyst

RE: Proposed Article 2B to Uniform Commercial Code

You asked for a summary of the proposed Article 2B of the Uniform Commercial Code (UCC) and a discussion of the pros and cons of this proposal.

SUMMARY

The National Conference of Commissioners on Uniform State Laws (NCCUSL) has proposed adding Article 2B to the UCC to deal with transactions in information. The Article is very broad in scope. While it focuses on mass-market software, it covers all transactions in software and all licenses of other information. The Article establishes rules on the formation, interpretation, and enforcement of electronic contracts. It establishes new rules about warranties. The Article would generally not affect existing state laws, such as those dealing with unfair competition, but would supersede certain laws affecting electronic commerce.

The Article's proponents believe that it creates a structure that balances the interests of providers and consumers. Software licensors benefit by settling that mass-market licenses (associated with such products as Windows 98) are enforceable. Consumers benefit by the establishing of procedural and substantive safeguards. These include the right to a free refund for mass-market software if the consumer refuses the license and returns the software. More generally, proponents of the current proposal believe that it will facilitate the development of electronic commerce, make its future less chaotic, and help maintain America's lead in the information age.

Opponents of the current draft believe that it is biased in favor of licensors. They object to many of the Article's provisions, including its rules on contract formation and choice of law. They also believe that its use of broadly defined concepts may create confusion as to the obligations of parties in information contracts. They also think that the current draft could inhibit competition in information industries and create conflicts with copyright law.

The summary of Article 2B is based largely on the annotated draft produced by the NCCUSL which can be found on the Internet at http://www.law.upenn.edu/bll/ulc/ucc2b/2b898 as well as “Article 2B: Transactions in Software and 'Information' ” by Joseph P. Verdon, The New York Law Journal (August 13, 1997) which is available on-line at http://www.ljx.com/internet/0813ucc2b.html. The discussion of the pros and cons of the proposed Article come from a variety of sources, including editorials and other pieces accessible through an Internet site devoted to Article 2B issues at http://www.2bguide.com. This website also contains the various drafts of the Article, links to relevant law review Articles, and discussion pages.

INTRODUCTION

Article 2 of the UCC, which deals with sales of goods, also serves as the commercial law governing sales of mass-market software. However, information transactions differ substantively from sales of goods. One major difference is the conditional nature of such transactions. Under federal copyright law, the owner of the copyright to computer software and most other digital products holds the exclusive right to make and distribute copies, engage in public display of the work, and modify the work. Even if a purchaser acquires a copy of information, the copyright holder retains control over various uses of the copy. Another major difference between sales of goods and information transactions is that in the latter it is the information contained in the goods, rather than the goods themselves, that have value.

Article 2 does not take into account the specific nature of software and other information products. In addition, no uniform state laws explain how website hosts may contract with their customers for access and other use of the site. In light of these facts, the NCCUSL and other groups have been working for more than 12 years to amend the UCC to specifically address information transactions.

As discussed below, the discussions over Article 2B have been quite contentious and the proposal has changed substantially through its various drafts. For example, earlier drafts had provisions dealing with software licensors' obligations regarding computer viruses, which were subsequently dropped. The current draft was debated at the annual meeting of the NCCUSL in July 1998. The committee drafting the proposal will meet in November. The American Law Institute (ALI) Council may review it at its December 1998 meeting so that it could be presented for a vote of the ALI membership in May 1999. Proponents of the proposal hope to finalize it so that it can be submitted to state legislatures for the 2000 session.

PROPOSAL

The Article establishes new rules addressing such topics as the validity of electronic contracts, the enforceability of mass-market licenses for software, and implied warranties for information products, among others. The Article affects not only the software industry, but also the banking, publishing, and entertainment industries.

With the exception for a small number of provisions, the parties to a particular agreement can alter the applicable terms of the Article. The Article excludes activities in many traditional fields

of licensing including patent, motion picture, and broadcasting, other than transactions in digital and related industries. It states that it does not alter any law creating or limiting intellectual property rights or privileges in information. It does not cover sales of books, newspapers, or magazines, or personal or entertainment services contracts. Nor does it cover computer programs embedded in other products, such as automobiles. The Article's scope has been the subject of extensive debate, and its opponents question whether its exclusions are as broad as they appear to be.

Software Contract. A software contract is a (1) license of software, (2) sale of a copy of software, or (3) contract to develop software. Except for some software contained in another product, all software contracts are included.

Access Contract. Access contracts include Internet and on-line services. Thus, a contract with Westlaw is within this Article, as are the specific access events that occur under the contract. Also included are cases where information is available for a fee at a website and obtained by contractual access to the information electronically. Since this is a contract statute, it does not cover situations where information is simply made available and no contract exists. If the material accessed is within this Article (i.e., software or information licenses), the Article applies to the access contract and to the accessed material. In the case of other types of material other law applies. For example, Article 2 of the UCC would apply to the sale of goods.

License. A license is a contract for conditional rights, privileges, or permissions to use information, an information processing resource, or an informational property right. A license exists only if the contract expressly conditions the rights or permissions conveyed or expressly grants less than all rights in the information. Except for computer software, this Article does not deal with unrestricted sales of copies of information even though sales of copies are subject to restrictions under copyright or patent law. Licenses include access contracts and consignments of copies. They do not include sales or the creation of a financier's interest.

Mass-Market Transactions. Many of the Article's provisions deal with mass-market transactions. These are transactions made by individuals and other transactions directed to the general public under substantially the same terms for the same information with an end-user licensee. Transactions with businesses and other organizations are not considered mass-market transactions if: (1) the information is customized for the licensee or (2) they include a contract for redistribution or for display of a copyrighted work. Mass-market transactions also do not include site licenses or access contracts.

Mass-market software delivered on a diskette generally comes in “shrinkwrap” packaging. Such packaging contains a notice that opening the package constitutes acceptance of the terms of the accompanying license agreement. Similarly, a computer user must click a box stating that he accepts the terms of the license before downloading software distributed electronically. Software licensors often use such licenses to disclaim warranties and impose limits and conditions on the licensee's use of the software. The courts have handed down conflicting decisions as to the validity of such licenses.

Article 2B sets the ground rules for creating electronic contracts and using electronic signatures for contract adoption to make business transactions in cyberspace as legitimate as traditional transactions. These include provisions making electronic records equivalent to paper records, by using the term “record” where other UCC Articles use “writing”. In Article 2B, a record is “information that is inscribed on a tangible medium or that is stored in an electronic or other medium and is retrievable in perceivable form.” The Article uses the term “authentication” to supersede “signature.” A party could authenticate a record through various electronic means including encryption, as well as by a signature. Article 2B rules are designed to be uniform and allow use of all technologies.

The Article introduces the concept of an “electronic agent” which is a computer program or other automated means to act on a party's behalf. Such agents are used to make contracts, find information, and interact with other computers. Under the Article, if a party enables an electronic agent to act on its behalf, the party is bound by the agent's actions.

A contract can exist even if no individual reviews or reacts to the electronic message or the information delivered. This adapts traditional theories of consent and agreement to electronic commerce. In electronic transactions, automated systems can send and react to messages without human intervention. However, Article 2B specifies that before anyone can claim that a person made an electronic contract, they must first prove that they provided the person with a commercially reasonable procedure for their concluding that the person authorized the contract.

Article 2B uses the rule of perfect tender (the standard used in Article 2 of the UCC) as a performance standard for mass-market transactions. For other transactions, Article 2B establishes the standard of substantial conformance to the software's documentation. Under this standard, minor defects in the software would generally not warrant rejection. The Article contains many other provisions regarding electronic contracts, including one that explicitly makes exceeding a license a breach of contract.

Article 2B sets specific standards for creating and enforcing mass-market licenses. Licenses are enforceable if the consumer “manifests assent” to the license before or after using it. Assent can take the form of a signature or by conduct that, under the license, constitutes acceptance of the electronic record or term of the contract so long as the party could decline to take such action after reviewing the license. If the licensor knows or should know that a specific license term would cause a reasonable person to refuse the license, the term does not become part of the license unless the licensee “manifests assent” to the specific term.

If the terms of the license are only available for review after the licensee has paid its fee, the license is only binding if the licensee has the right to a refund if it stops using the software and returns all copies. In addition, the licensee is entitled to consequential damages, notably shipping expenses. Licensors must also compensate licensees for foreseeable losses incurred in viewing a license. The licensor cannot disclaim these provisions, as they can under current law.

Similarly, Article 2B creates a consumer defense to a transaction if there is an error in the computer system or transmission or if the consumer simply hits the wrong button and has no chance to correct his error. All the consumer has to do is provide notice of the error and return the product.

Under the Article, disputes regarding electronic transactions are adjudicated based on the law where the licensor is based, unless the contract contains a different choice of law provision. In the case of the physical delivery of tangible copies such as diskettes, the default choice of law is based on the location where the copy is received.

In most cases, Article 2B retains the implied warranties found in Article 2 (the annotated draft of Article 2B contains a chart comparing warranty provisions in the two Articles). It also establishes implied warranties of merchantability and fitness for ordinary purposes. It creates a new implied warranty for consulting, data processing, and informational content contracts. The Article gives a warranty that no inaccuracy exists due to the provider's lack of reasonable care. The warranty applies only to merchants in the particular type of information and excludes information distributed to the public. This exclusion stems from First Amendment concerns about the value of encouraging distribution of information. The Article states that there is no implied warranty of accuracy when a party acts as the conduit for information prepared by another party.

The Article supersedes the current law under which the licensee's opportunity to inspect information waives the licensor's implied warranty that the use of the information will not infringe upon the rights of third parties, such as publishers and other copyright holders. It also supersedes the law under which contractual use restrictions on licensed information can endure even after the license agreement creating them has been cancelled or terminated.

Other state laws, including unfair competition and trade secret law, supplement this Article. For example, state laws may limit the term during which a contract restriction on competition can be enforced. Consistent with the stated purpose of the UCC, Article 2B deals with general

contract law and commercial contract law principles. It does not promulgate a consumer protection code, although it does contain certain consumer protections. With the exception of the Article's electronic commerce rules, a state's consumer protection statutes or regulations trump the general contract law of this Article. For example, a consumer protection statute that mandates disclosure of local service outlets or the location of the licensor's main business office in a consumer transaction is not affected by Article 2B.

The Article does override contrary state law requiring a “writing,” a “signature” or a “conspicuous” term to the extent that it provides electronic commerce rules on issues such as authentication and the like. This premise operates only within the scope of the Article.

PROS AND CONS

Proponents of the proposed Article believe it will reduce uncertainty and non-uniformity of licensing law and create a balanced structure for electronic contracting. They assert that the Article confirms contract freedom in commercial transactions, provides strong protection for published informational content, and defines the relationship between licensors, licensees, and retailers of software and other information products.

Proponents believe that creating a uniform legal system for software products and services will facilitate the development of electronic commerce. In particular, they argue that Article 2B will benefit small firms that seek to conduct business over the Internet, but lack the resources to research electronic-contract laws from state to state. Proponents note while the software, publishing, data, entertainment, banking, and information industries are converging in their use of information technologies, they are currently subject to distinct common law provisions.

Proponents argue that software firms and other licensors will benefit by the creation of a workable method for contracting in Internet, including rules governing choice of law and choice of forum. They believe that the choice of law provision, in particular, is needed to address the fact that software is sold internationally over the Internet. They argue that licensors will benefit by the settling of the enforceability of mass-market licenses.

Proponents also state that the “shrink-wrap” licenses and other standard form contracts authorized by the Article are needed to control risk, protect software firms, and keep software affordable. They note that even some opponents to the current draft, including Consumer's Union, use “shrink-wrap” licenses for their own products. Some analysts outside of the software industry believe that the Article may help fill a gap in intellectual property law by authorizing standard form contracts to protect commercial databases which are not subject to copyright law.

Proponents believe that software purchasers will benefit from the creation of procedural and substantive safeguards for mass-market contracts, notably the right to free refunds upon refusal of a mass-market license. Proponents of the Article believe that it will benefit purchasers by expanding implied warranties and creating a warranty for data accuracy. Moreover, several of these warranties cannot be disclaimed under Article 2B, while they can under current law. In sum, they claim that Article 2B increases consumer protections relative to those contained in Article 2. For the first time in state uniform law, some consumer protections are also extended to businesses.

More generally, proponents stress that the process for drafting Article 2B has been open, with extensive debate taking place on its more controversial points. They believe that it provides enough flexibility to encourage commerce while increasing consumer protection. The software

industry, which has been a major supporter of the current draft of the Article, has a website summarizing its position at http://www.2bguide.com/docs/amemo981.html. Another website presenting a similar perspective is http://www.bsa.org.

Consumer advocates, such as the Consumer's Union, believe that the Article is substantially slanted in favor of licensors at the expense of consumers. Consumer's Union believes that the Article calls for the widest possible enforceability of contract terms even if they were by the licensor with the consumer being unable to negotiate their terms. It believes that the overall effect of the proposal is to give software and on-line service consumers few rights, which can be easily waived. The organization's arguments are laid out on the Internet at http://www.2bguide.com/docs.cun.html. The Federal Trade Commission has raised similar concerns, which are discussed at http://www.ftc.gov/be.v980032.htm.

Other provisions that have attracted substantial opposition are the Article's choice of law and forum rules. Under the proposal consumers who use software for business or professional purposes would be required to defend their rights in the state or country and court chosen by the software manufacturer. This might limit the rights of consumers by making court actions prohibitively expensive, particularly if the chosen jurisdiction does not have small claims courts.

More generally, some opponents of the current draft believe that its definition of key terms is so loose that it will create confusion among parties as to their contractual obligations. For example, the wide range of methods by which a party can “manifest assent” by conduct may bind the party to an agreement that he has never seen or intended to engage in.

Opponents also believe that the Article could inhibit competition in information industries in several ways. They believe the provision that allows for disclosure of terms after the sale has been made may make it impossible for consumers to comparison shop. Others cite “nondisclosure” clauses in some licenses. These clauses can prohibit purchasers from publicly criticizing the product, for example through negative product reviews. Such clauses might violate the First Amendment, but this would not be relevant if the software manufacturer chose a foreign country as the venue for trials. Some businesses have also opposed the current draft because it could authorize manufacturers to prohibit “reverse engineering,” the process by which users decipher the code behind the program to make it compatible with other programs. These concerns may be addressed if the NCCUSL adopts a provision barring contract provisions that violate public policy. This provision was adopted as a “sense of the house” at the last annual meeting of the NCCUSL, but has not been formally adopted and is strongly opposed by the software industry.

Finally, some opponents believe that the proposal may create conflicts with copyright law, particularly with regard to its fair use provisions, leading to extensive litigation. Another uncertainty arises from mixed contracts, involving elements of copyright law and the UCC. These issues are discussed in a May 18, 1998 National Law Journal Article, available on the Internet at http://www.ljx.com/practice/intellectualproperty/express/051398/revucc.htm.

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